foreign portfolio and direct investment
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Foreign Portfolio and Direct
Investment
INTERNATIOANL FINACIAL
MANAGEMENT
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FDI and FPI
Economic development requires adequate
capital flows.
There are two forms of foreign investment inthe host country: Foreign Direct Investment
(FDI) and Foreign Portfolio Investment (FPI).
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FDI and FPI
FDI refers to international investment in which
the investor obtains a lasting interest in an
enterprise in another country.
Foreign Portfolio Investment (FPI) is the
investment by individuals, firms, or public
bodies in foreign financial instruments like
stocks, bonds, other forms of debt.
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FDI and FPI
Although FDI, almost by definition, tends to be
undertaken by multinational corporations, FPI
comes from more diverse sources, and may
originate, for example, from a small
company's pension fund or through mutual
funds held by individuals.
Both of them provide capital flows beyond
what is available through domestic savings.
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FDI and FPI
Both serve to boost investment and economic
activity in the domestic economy, allowing a
higher level of economic growth than would
otherwise be possible.
Both foreign direct and portfolio investment
bring a range of benefits for economic growth,
though there may be a marked difference
between those benefits.
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FDI
FDI refers to an investment made by an investorto acquire lasting interest in enterprises operatingoutside of the economy of the investor.
The investors purpose in making the investmentis to gain an effective voice in the management ofthe enterprise.
The foreign entity that makes the investment is
termed the "directinvestor". The enterprise inwhich direct investment is made is referred to asa "directinvestmententerprise".
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Reasons for FDI
Resourcesseeking- looking for resources at alower real cost.
Marketseeking- secure market share and sales
growth in target foreign market. Efficiency seeking- seeks to establish efficient
structure through useful factors, cultures,policies, or markets.
Strategicassetseeking- seeks to acquire assetsin foreign firms that promote corporate long termobjectives.
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Benefits to Multinational
Multinationals can get locationadvantages: Locationadvantages are defined as the benefits arising from ahost countrys comparative advantages (like betteraccess to resources or lower real cost from operating in
a host country). Multinationals can get improved performance:Structuraldiscrepancies are the differences in industrystructure attributes between home and host countries.Examples are when firms invest FDI money to enter
areas where competition is less intense, whereproducts are in different stages of their life cycle,where market demand is unsaturated, and where thereare differences in market sophistication.
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Benefits to Multinational
Multinationals can get very good return on investment(ROI): Companies get Ownership Advantages whichcome from the application of proprietary tangible andintangible assets in the host country. Companies also
apply their Core Competencies in the host countries.These are competencies that, by definition are rare,inimitable, non-substitutable, and valuable.
Multinationals can grow by learning: By operating inhost environments multinationals face stimuli that
force learning and development of capabilities andcompetitive advantages. This learning comes throughexposure to new markets, new practices, customs,ideas, cultures, markets, and competition.
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FDI ImpactonHost Country
FDI ImpactonSocial Environment:Among the mostdiscussed social issues are education, cultural impactand social impact.
FDI Impacton Employment:There are both positiveand negative impacts from FDI. Multinationalcompanies attempt to capitalize on abundant andinexpensive labor, while host countries seek to havefirms develop labor skills and sophistication. Host
countries often feel that the least desirable jobs aretransplanted from home countries; home countriesoften face the loss of employment as jobs move.
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FDI ImpactonHost Country
FDI ImpactonHost Country Business:The
subsidiarys business is likely to be more
productive than local competitors. The result
is uneven competition in the short run, and
competency building efforts in the longer
term. It is likely that FDI developed enterprises
will gradually develop local supportingindustries through supplier relationships in
the host country.
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Current Theorieson FDI
Productlifecycletheory:Ray Vernon asserted thatproduct moves to lower income countries as theymove through their product life cycle. The FDI impact issimilar: FDI flows to developing countries as products
evolve from being innovative to being mass-produced. Monopolistic Advantage Theory:A multinational has,
or creates monopolistic advantages that enable it tooperate subsidiaries abroad more profitably than localcompetitors. By creating and defending this
monopolistic advantage, through FDI, firms extracthigher returns than if they hadnt invested. Advantagescome through superior knowledge and fromeconomies of scale.
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Current Theorieson FDI
Internalizationtheory:When external marketsfor supplies, production, or distribution fails toprovide efficiency, companies can invest FDI to
create their own supply, production, ordistribution streams.
Eclectic Paradigm Theory:This is also known asthe OLI theory.When firms lever Ownership
specific advantages (O), Location specificadvantages (L), and Internalization advantages (I)together, they gain advantage from FDI.
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Foreign Portfolio Investment (FPI)
FPI is a category of investment instruments
that are more easily traded, may be less
permanent, and do not represent a controlling
stake in an enterprise.
These include investments via equity
instruments (stocks) or debt (bonds) of a
foreign enterprise that does not necessarilyrepresent a long-term interest.
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FPI
The difference between FDI and FPI can
sometimes be difficult to discern, given that
they may overlap, especially in regard to
investment in equity.
Ordinarily, the threshold for FDI is ownership
of "10 percent or more of the ordinary shares
or voting power" of a business entity (IMFBalance of Payments Manual, 1993).
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FDI & FPI Portfolio investment can be much more volatile than
direct investment.
Changes in the investment conditions in a country orregion can lead to dramatic swings in portfolioinvestment.
For a country on the rise, FPI can bring about rapiddevelopment, helping an emerging economy movequickly to take advantage of economic opportunity,creating many new jobs and significant wealth.
However, when a country's economic situation takes adownturn, sometimes just by failing to meet theexpectations of international investors, the large flowof money into a country can turn into a stampede awayfrom it.
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FDI & FPI
Because FDI implies a controlling stake in abusiness, and often connotes ownership ofphysical assets such as a equipment, buildings,
and real estate, FDI is more difficult to pull outor sell off.
Consequently, direct investors may be morecommitted to managing their internationalinvestments, and less likely to pull out at thefirst sign of trouble.
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FPI
This volatility has effects beyond the specificindustries in which foreign investments havebeen made.
Because capital flows can also affect theexchange rate of a nation's currency, a quickwithdrawal of investment can lead to rapiddecline in the purchasing power of a currency
and rapidly rising prices (inflation). Such quickwithdrawals can produce widespread economiccrises.
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BenefitsofFPI tothehostcountrys
capitalmarkets
Foreign portfolio investment increases theliquidity of host countrys capital markets, andcan help develop market efficiency as well.
Foreign portfolio investment can also bringdiscipline and know-how into the domesticcapital markets. In a deeper, broader market,investors will have greater incentives toexpend resources in researching new oremerging investment opportunities.
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BenefitsofFPI tothehostcountrys
capitalmarkets
Foreign portfolio investment can also help topromote development of equity markets and theshareholders voice in corporate governance.
Foreign portfolio investors may also help the hostcountrys capital markets by introducing moresophisticated instruments and technology formanaging portfolios. For instance, they may bring
with them a facility in using futures, options,swaps and other hedging instruments to manageportfolio risk.
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BenefitsofFPI tothehostcountrys
capitalmarkets
Foreign portfolio investment can also help topromote development of equity markets and theshareholders voice in corporate governance.
Foreign portfolio investors may also help the hostcountrys capital markets by introducing moresophisticated instruments and technology formanaging portfolios. For instance, they may bring
with them a facility in using futures, options,swaps and other hedging instruments to manageportfolio risk.
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CAPITAL BUDGETING
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Political Risk
Macro risks (all foreign corporations) Micro risks (industry-specific)
Categories:
Transfer risk uncertainty regarding cross-border cash flows
Operational risk
potential goal conflicts with local governments
Control risk
uncertainty regarding expropriations
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Capital budgeting
1) Identify initial capital investment.
2) Estimate future after-tax cash flows. Requires exchange rate forecasts
foreign tax considerations
3) Identify appropriate discount rate.
4) Apply capital budgeting criteria
(NPV, IRR
, ...)to evaluate and/or rank projects.
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Complexities of Budgeting
for a Foreign Project
Capital budgeting for a foreign project is considerablymore complex than the domestic case:
Parent cash flows must be distinguished from project cash
flows Parent cash flows often depend on the form of financing
Additional cash flows generated by a new investment inone foreign subsidiary may be in part or in whole takenaway from another subsidiary
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Complexities
W
hose perspective? Parent firm?
Foreign subsidiary?
Should the capital budgeting for a multi-national project be
conducted from the viewpoint of the subsidiary that will
administer the project, or the parent that will provide most of
the financing?
The results may vary with the perspective taken because the netafter-tax cash inflows to the parent can differ substantially from
those to the subsidiary.
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Subsidiary versus Parent
Perspective
Different perspectives matter:
when funds cannot be repatriated (temporarily?)
when considering intra-firm transfer pricing
intra-firm sales
royalties, license fees
when choosing the discount rate
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Subsidiary versus Parent
Perspective
The difference in cash inflows is due to :
Tax differentials
What is the tax rate on remitted funds?
Regulations that restrict remittances
Excessive remittances
The parent may charge its subsidiary very highadministrative fees.
Exchange rate movements
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Whoseperspective?
Value of project = NPV of cash flows to investor
Bottom line: useparent firms perspective
Start with subsidiarys project cash flows
Reconsiderthem from parents perspective
Blocked funds
Net out intra-firm payments
Consider spillover effects Cannibalization
positive effects
Tax factors
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How are cash flows repatriated?
Need to explicitly consider how (whether)
the parent firm can get the money out
Dividends (profit repatriation)
Intra-firm debt
Intra-firm sales (transfer pricing)
Royalties, license fees
Different tax/regulatory status
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Foreign Subsidiarys Income Statement
Sales
Cost of goods sold
Gross profit
General & administrative expenses
License fees
RoyaltiesManagement fees
Operating profit (EBITDA)
Depreciation & amortization
Earnings before interest & taxes (EBIT)
Foreign exchange gains (losses)Interest expenses
Earnings before tax (EBT)
Corporate income tax
Net income (NI)
Dividends
Retained earnings
Payments to parent
for goods or services
Payments for technology,
trademarks, copyrights,management or other
shared services
Payments of interest
to parent for intra-
firm debt
Distribution of
dividends to parent
Before-Tax
in the
Host Country
After-Tax
in the
Host Country
Payment to Parent Company
Potential Conduits for Moving Funds From
Subsidiary to Parent
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Multinational
Capital Budgeting
One common method of performing the
analysis is to estimate the cash flows and
salvage value to be received by the parent,
and compute the net present value (NPV) of
the project.
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MultinationalCapital Budgeting
NPV = initial outlayn
+7cashflow inperiodt
t=1 (1+
k)t
+salvagevalue
(1+k)n
k = the required rate of return on the project
n = project lifetime in terms of periods
If NPV > 0, the project can be accepted.
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MultinationalCapital Budgeting
Example:
Spartan, Inc. is considering the development
of a subsidiary in Singapore that willmanufacture and sell tennis rackets locally.
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Capital Budgeting Analysis: Spartan, Inc.
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Capital Budgeting Analysis: Spartan, Inc.
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Factors to Consider in MultinationalCapital Budgeting
1) Exchange rate fluctuations
Since it is difficult to accurately forecast
exchange rates, different scenarios can beconsidered together with their probability of
occurrence.
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Analysis Using Different Exchange RateScenarios: Spartan, Inc.
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Sensitivity of the
Projects NPV toDifferent ExchangeRate Scenarios:
Spartan, Inc.
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Factors to Consider in MultinationalCapital Budgeting
2) Blocked funds
Some countries require that the earnings
generated by the subsidiary be reinvested
locally for at least a certain period of time
before they can be remitted to the parent.
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Capital Budgeting with Blocked Funds: Spartan, Inc.
Assumethatallfundsare blockeduntilthesubsidiary issold.
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Factors to Consider in MultinationalCapital Budgeting
3) Uncertain salvage value
Since the salvage value typically has a
significant impact on the projects NPV, the
MNC may want to compute the break-even
salvage value.
4) Impact of project on prevailing cash flows
The new investment may compete with the
existing business for the same customers.
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Factors to Consider in MultinationalCapital Budgeting
5) Host government incentives
These should also be incorporated into the analysis.
6) Real options
Some projects contain real options for additional businessopportunities.
The option to defer
The option to abandon
The option to alter capacity
The option to start up or shut down
The value of such a real option depends on the probability of
exercising the option and the resulting NPV.
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Summary
Multinational capital budgeting is
conceptually similar to standard capital
budgeting
But:
parent/subsidiary complications
cash flow projections more complicated
Additional sources of risk
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Country Risk Analysis
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Why Country Risk Analysis Is Important
Country risk represents the potentiallyadverse impact of a countrys environment on
an MNCs cash flows.
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Country risk analysis can be used:
to monitor countries where the MNC is
currently doing business; as a screening device to avoid conducting
business in countries with excessive risk; and
to revise its investment or financing decisions
in light of recent events.
Why Country Risk Analysis Is Important
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Political Risk Factors
Attitude of consumers in the host country
Some consumers are very loyal to locally
manufactured products. Actions of host government
The host government may impose special
requirements or taxes, restrict fund transfers,
and subsidize local firms. MNCs can also behurt by a lack of restrictions, such as failure to
enforce copyright laws.
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Political Risk Factors
Blockage of fund transfers
If fund transfers are blocked, subsidiaries will
have to undertake projects that may not beoptimal for the MNC.
Currency inconvertibility
The MNC parent may need to exchange
earnings for goods if the foreign currency
cannot be changed into other currencies.
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War
Internal and external battles, or even the
threat of war, can have devastating effects. Bureaucracy
Bureaucracy can complicate businesses.
Corruption Corruption can increase the cost of conducting
business or reduce revenue.
Political Risk Factors
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Corruption Index Ratings for Selected CountriesMaximumrating=10.Highratingsindicatelow corruption.
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Financial Risk Factors
Indicators of economic growth
The current and potential state of a countrys
economy is important since a recession canseverely reduce demand.
A countrys economic growth is dependent on
several financial factors - interest rates,
exchange rates, inflation, etc.
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Types of Country Risk Assessment
A macroassessment of country risk is an overall
risk assessment of a country without considering
the MNCs business.
A microassessment of country risk is the risk
assessment of a country with respect to the
MNCs type of business.
The overall assessment thus consists ofmacropolitical risk, macrofinancial risk,
micropolitical risk, and microfinancial risk.
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Note that there is clearly a degree of
subjectivity in:
identifying the relevant political and financialfactors,
determining the relative importance of each
factor, and
predicting the values of factors that cannot bemeasured objectively.
Types of Country Risk Assessment
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Techniques ofAssessing Country Risk
The checklist approach involves rating and
weighting all the macro and micro political
and financial factors to derive an overall
assessment of country risk.
The Delphi technique involves collecting
various independent opinions and then
averaging and measuring the dispersion ofthose opinions.
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Techniques ofAssessing Country Risk
Quantitative analysis techniques like
regression analysis can be applied to historical
data to assess the sensitivity of the business
to various risk factors.
Inspection visits involve traveling to a country
and meeting with government officials, firm
executives, and consumers to clarifyuncertainties.
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Often, firms use a variety of techniques for
making country risk assessments.
For example, they may use the checklist
approach to develop an overall country risk
rating, and some of the other techniques to
assign ratings to the factors.
Techniques ofAssessing Country Risk
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Measuring Country Risk
The checklist approach involves:
Assigning values and weights to political and
financial risk factors,
Multiplying the factor values with their weights,
and summing up to give the political and
financial risk ratings,
Assigning weights to the risk ratings, and Multiplying the ratings with their weights, and
summing up to give the country risk rating.
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Example:Determining the Overall Country Risk Rating
E l
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Example:Derivation of the Overall Country Risk Rating
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The procedures for quantifying country risk
will vary with the assessor, the country
being assessed, as well as the type ofoperations being planned.
Firms use country risk ratings when
screening potential projects, and when
monitoring existing projects.
Measuring Country Risk
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Comparing Risk RatingsAmong Countries
One approach to comparing political andfinancial ratings among countries is theforeign investment risk matrix (FIRM).
The matrix displays financial (or economic)and political risk by intervals ranging frompoor to good.
Each country can be positioned on thematrix based on its political and financialratings.
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Incorporating Country Risk in CapitalBudgeting
If the risk rating of a country is acceptable, the
projects related to that country deserve
further consideration.
Country risk can be incorporated into the
capital budgeting analysis of a proposed
project either by adjusting the discount rate or
by adjusting the estimated cash flows.
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Adjustment of the discount rate
The higher the perceived risk, the higher thediscount rate that should be applied to the
projects cash flows.
Adjustment of the estimated cash flows
By estimating how the cash flows could be
affected by each form of risk, the MNC candetermine the probability distribution of thenet present value of the project.
Incorporating Country Risk in CapitalBudgeting
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Applications ofCountry Risk Analysis
As a result of the crisis that culminated in the
GulfWar in 1991, many MNCs reassessed
their exposure to country risk and revised
their operations accordingly.
The 199798 Asian crisis caused MNCs to
realize that they had underestimated the
potential financial problems that could occurin the high-growth Asian countries.
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Reducing Exposureto Host Government Takeovers
The potential benefits of DFI can be offset by
country risk, the most severe of which is a
host government takeover.
To reduce the chance of a takeover by the host
government, firms often:
Use a short-term horizon
This technique concentrates on recovering cash
flow quickly.
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Reducing Exposureto Host Government Takeovers
Rely on unique supplies or technology
In this way, the host government will not be able
to take over and operate the subsidiary
successfully.
Hire local labor
The local employees can apply pressure on their
government if they are affected by the takeover.
d
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Borrow local funds
The local banks can apply pressure on their
government if they are affected by the takeover.
Purchase insurance
Investment guarantee programs offered by the
home country, host country, or an international
agency insure to some extent various forms ofcountry risk.
Reducing Exposureto Host Government Takeovers
d i
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Use project finance
Project finance deals are heavily financed with
credit, thus limiting the MNCs exposure. The
loans are secured by the projects future revenuesand are non recourse. A bank may guarantee the
payments to the MNC.
Reducing Exposureto Host Government Takeovers
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