INBU 4200INTERNATIONAL FINANCIAL MANAGEMENT Lecture 13 Foreign Direct Investment (FDI) Cross Border Merges and Acquisitions and Greenfield Site Investment
Entering a Foreign Market • Any firm considering entering the foreign market must examine four basic issues: • Which foreign markets/countries to enter? • When to enter them (timing)? • What scale (financial commitment)? • What entry mode strategy should it use (organizational structure)?
Three Categories of Entry Modes • Exporting and Importing • Exporting: The act of sending goods from one country to other nations. Manufacture at home; ship product overseas. • Importing: The act of bringing goods into a country from other countries. • Contractual entry • Using contracts which permit foreign partners to manufacture and/or sell your products in another country. • Franchising and licensing. • Investment entry • Direct investment by your company in another country for the purpose of producing and/or selling your product overseas.
Investment Entry: FDI • Foreign Direct Investment refers to business investment which acquires a long term and controlling interest in an enterprise operating in a country other than that of the investor. • The percentage for classifying FDI control varies from country to country, however: • The U.S., Japan, the UN, and the OECD use 10% stake in the voting stock of a foreign enterprise as constituting FDI. • If it is less than 10% it is defined as portfolio investment.
Quick History of FDI • In the years after the Second World War global FDI was dominated by the United States. • The US accounted for around three-quarters of new FDI between 1945 and 1960. • FDI rose dramatically during the decade of the 1990s due in large measure to cross border merger and acquisitions activity. • From 1990 to 2000, the stock of outstanding stock of foreign direct investment increased from $1.7 trillion to $6.1 trillion. • Countries other than the US became major players. • But FDI flows peaked at $1.4 trillion in the year 2000.
FDI Since 2003 • Since 2003, FDI has increased again spurred by a renewal in cross border mergers and acquisition activity. • For 2005, FDI flows were estimated at just under $916 billion and the outstanding stock totaled $10 trillion. • Preliminary data for 2006 suggests further growth in FDI. • FDI flows for 2006 are estimated at $1.2 trillion, the second highest level since 2000. • Visit: http://www.unctad.org/Templates/webflyer.asp?docid=7993&intItemID=1634&lang=1
Notes to Previous Chart • The previous chart segregates World FDI into three major categories. They, along with their definitions, are as follows: • Developed Countries: World Bank definition based on Gross National Income per capita of $9,266 and above. About 40 countries. • Developing Countries: World Bank definition based on Gross National Income per capita less than $9,266. About 125 countries. • Commonwealth of Independent States (CIS): Refers to 11 former Soviet Republics: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Ukraine, and Uzbekistan.
FDI 2005 by Region and Country, Billions of US$ and % of Total • Amount Percent • World $916 100% • Developed Countries $542 59% • UK $164 18% • US $ 99 11% • France $ 64 7% • Emerging Countries $374 41% • China (with Hong Kong) $108 12% • China excluding Hong Kong $ 72 8%
Where does FDI go and where does it come from? • Inward FDI: Foreign direct investment coming into a particular country. Historically, the developed countries have captured the majority of this inward investment. • In recent years, however, an increasing percentage has gone to the developing countries (especially China and India). • See Appendix 1 for a discussion of FDI impacts on developing countries. • Outward FDI: Foreign direct investment leaving a particular country. Historically, developed countries have been the major FDI investors overseas. • The United States is the single largest investor, followed by the UK and France. • See Appendix 2 for data on US FDI
Basic Forms of FDI: Joint Ventures and Wholly Owned Subsidiaries
Wholly Owned Subsidiary and Joint Ventures • Wholly Owned Subsidiaries • The foreign facility is entirely owned and controlled by a “single” parent. • Honda U.S.A.; 100% owned by Honda (Japan) • Apple Retail Japan; 100% owned by Apple USA (see Appendix 3) • Joint Ventures • Shared ownership arrangement and the creation of a new company. • A separate company is created and jointly owned by two or more companies (or entities). • Hong Kong Disneyland: Hong Kong Government (53%) and Walt Disney Co (47%). • Starbucks Japan: Starbucks (50%) and Sazaby League (50%) (see Appendix 4)
Mergers, Acquisitions, and Greenfield • Mergers (two companies forming a new company): • Sony Corporation and Bertelsmann AG completed a merger on August 5, 2004 of Sony Music Entertainment and Bertelsmann's BMG. The new music company, called Sony BMG, is equally owned (50/50) by Sony and Bertelsmann. • Acquisition (one company acquiring another): • Ford Motor Company bought 100% of Jaguar Cars Limited for $2.8 billion in 1990. • Greenfield site investment (one company building a new facility): • Haier Corporation built a $40 million refrigerator manufacturing facility in South Carolina in 2000.
Cross Border M&A, the 1990s • During the 1990s, cross border mergers and acquisitions increased dramatically. • In 1991, the value of cross border M&A was estimated at just under $200 billion. • By 2000, the value had grown to $1.2 trillion. • This increase was fueled by global economic growth and increasing stock prices, especially the dot.com run-up. • The relative importance of FDI was also shown in its percent of global GDP, increasing from 0.5% in 1991 to around 4% by 2000.
Cross Border M&A, 2001 • The global economic slowdown in 2001 and falling stock prices contributed to a decline in cross border mergers and acquisitions. • In 2001, the total value of cross border M&A at $594 billion was only half that of 2000. • The number of cross-border M&A also declined from 7,800 in 2000 to 6,000 in 2001.
Cross Border M&A, the Present • Cross border M&A activity has recently accelerated. • In 2005, the number of cross border M&A totaled 6,134 (20% increase over 2004) with a combined value of $716 billion (88% increase over 2004). • The recent high level of M&A activity is accounted for by: • Increasing economic growth, • Rising stock prices. • Growing involvement of private equity funds and hedge funds in M&A activity (see Appendix 5 for data). • Ongoing liberalizations of country investment policies by individual governments (see Appendix 6). • For a comparison of 2000 with 2005 and data on specific M&As see Appendix 7.
Barriers to Cross Border Acquisitions • Even though governments have tended to liberalize their investment climate, barriers to cross border acquisitions still exist: • These barriers can be classified as: • Cultural • Associated with potential investment in a different culture • Domestic business arrangements • Business arrangements which hamper acquisitions: • Keiretsu in Japan • Specific government restrictions or requirements
Examples of Current Government Imposed Barriers • Mexico: Prohibits foreign ownership of oil companies. • Japan: Prohibits foreign ownership of mining companies. • Canada: Requires a review of all acquisitions of Canadian companies. • US: Foreign ownership of US airlines is limited to 25%. • China: Foreign ownership of Chinese banks is limited to 25%. • Australia: Foreign ownership of national newspapers is limited to 30%. • India: Prohibits foreign ownership of retail business such as supermarkets and convenience stores.
Greenfield Site Investment (GSI) • Since there is little data regarding the value of GSI, we are forced to examine the actual number of projects. This data shows the following for 2005: • Total: 9,488 by investor by destination • Developed Countries: 8,057 (85%) 3,981 (42%) • Developing Countries: 1,431 (15%) 5,507 (58%) • Thus, most GSI originates from developed countries and takes place in developing countries.
Popular Targets for GSI, 2005 Total by Destination: 9,488 (100%) European Union: 2,928 (30.9%) U.K. 514 (5.4%) France 358 (3.8%) United States: 527 (6%) Developing Asia: 3,323 (35%) China 1,196 (13%) India 564 (5.6%) Viet Nam 169 (1.8%) South East Europe and CIS 1,121 (11.8%) Russia 479 (5.1%) Latin America 543 (5.8%) Mexico 134 (1.4%) Africa 428 (4.5%) South Africa 59 (0.6%)
FDI Theories • Theory: The purpose is to “explain” or “predict” the behavior of a particular phenomena. • For example, why do firms engage in FDI? • The theoretical development of FDI began in the 1960s when models were advanced to explain the motives behind outward investments by U.S. multinationals (see Appendix 8). • Prior to this time, theoretical modeling was concerned primarily with explaining international trade: • Adam Smith: Theory of Absolute Advantage (1776) • Heckscher-Ohlin: Theory of Factor Endowments (early 20th century).
Early FDI Theory: 1960s • Monopolistic Advantage Theory of FDI: • Proposed by Stephen Hymer (1960, Ph.D. thesis, MIT). • Hymer suggested specific firm monopolistic advantages over their competition in foreign markets provided firms with the incentive engage in FDI. • Monopolistic advantage would allow firms to generate above average profits. • Monopolistic advantages resulted from: • superior production skills, patents, marketing abilities, capital size, management skills, or consumer goodwill on brand names.
International Product Life Cycle • Proposed by Raymond Vernon (1966) • Vernon’s theory explains the “timing and location” of FDI • Initially, firms undertake production in their home markets which are generally the highest income countries. • Control and risk avoidance are important here. • During the next stage, the firm will begin to export, first to other high income countries and eventually to others. • As the product matures and becomes standardized, the firm’s competitive strategy shifts from product advantage to securing a cost advantage. • In this stage the company is forced to seek lower cost production sites to remain competitive. • This involves establishing manufacturing facilities overseas (FDI). • Thus, Vernon suggest that firms undertake FDI at a particular stage in the life cycle of their production.
exports imports exports imports International Product Life Cycle The U.S. and other developed countries production Quantity consumption New product Maturing product Standardized product Developing countries consumption Quantity production New product Maturing product Standardized product
Eclectic Explanation of FDI • The eclectic approach attempts to identify possible motivating factors affecting a firm’s decision to engage in FDI. • Some of these factors focus on various market imperfection and include: • Trade barriers • Imperfect labor markets • Other motivating factors include: • Existence of Intangible assets (referred to as the internalization theory of FDI) • Vertical integration
Trade Barriers • Trade barriers are factors which discourage the physical movement of goods and services from one country to another. • Thus they have a potential negative impact on exporting and importing. • Trade barriers arise from: • Government policies, such as: • Tariffs and quotas • Natural factors, such as: • Distance and ensuing transportation costs • FDI is seen as a strategy for circumventing these trade barriers.
Trade Barriers and FDI: Examples • 1977: In response to U.S. import quotas on Japanese televisions, Japanese TV manufacturers opened production facilities in the U.S. • Matsushita, Sony Corporation, Hitachi, and Sanyo Electric Company • 1980s: In response to the 1981 voluntary restraint agreement between the U.S. and Japan Japanese automobile manufacturers established production facilities in the U.S. • Honda and Nissan in 1982 and 1983. Toyota, Mazda, and Mitsubishi in the mid-1980s. • 2000: In response to high transportation costs, Haier Corporation (China) established a $40 million refrigerator manufacturing facility in South Carolina.
Imperfect Labor Markets • Refers to firms locating in foreign countries because of under-priced labor costs (relative to its productivity) in those foreign countries. • Why is labor under-priced in certain countries? • Because labor cannot move freely across national borders to take advantage of higher wages elsewhere. • Imperfect Labor Markets explains FDI investment in: • Manufacturing (China, Mexico, Eastern Europe) • Nike in China. • Services (India; call centers). • United Airlines in India.
Labor Market Costs Around the World (2003) Persistent wage differentials across countries is often noted as one of the major reasons MNCs invest in FDI in developing nations. China about 1/4 the cost of labor in Mexico.
Internalization Theory of FDI • Suggests that firms possessing valuable intangible assets (e.g., technology, managerial talent, brand loyalty) will use their own subsidiaries, rather than “local” host country firms to capture returns. • Why? • Avoids misuse of assets by local partners • Avoids sharing technology. • Insures full control. • These firms “internalize” their foreign activities. • Through strategies involving either wholly owned subsidiaries or controlling interest in joint ventures. • This is Apple Retail’s strategy (see Appendix 3).
Vertical Integration Theory of FDI • Some firms engage in FDI to stabilize a critical supply chain (of inputs). • Provides these firms with the potential for a low-cost competitive advantage. • E.g., In 1996, Dole Food Company purchased Pascual Hermanos, the largest grower of fruit and vegetables in Spain. • Referred to as backward (or downstream) integration. • Majority of FDI involve backward integration • Firms may also engage in FDI to promote distribution, product sales and service to final buyers. • E.g., Automobile manufacturing companies establishing car dealerships in other countries (over 1,000 Honda dealerships in the United States). • Referred to as forward (or upstream) integration.
Political Risk and FDI • Defined: Refers to the potential losses to a foreign firm resulting from adverse political actions taken by host governments. • These adverse political actions include: • Changes in operating regulations affecting foreign firms (see Appendix 9; Coca-Cola in India). • Expropriation (confiscation) of the foreign firm’s assets by the host government. • Cuba expropriated $1 billion worth of US businesses in 1960 (US oil refineries, including Texaco and all US banks including, First National Bank of New York)
Three Political Risk Components • Transfer Risk • Uncertainty regarding cross-border flows of capital (i.e., the repatriation of profits). • Imposition of capital controls, changes in withholding taxes on dividends. • Operational Risk • Uncertainty regarding host countries policies and behavior with regard to firm’s operations. • Changes in environmental regulations, local content requirements, minimum wage laws, and corruption. • See Appendix 10 for a discussion of bribery • Control Risk • Uncertainty regarding control or ownership of assets • Changes in restrictions on maximum ownership by non-resident firms, nationalization of foreign assets.
Assessing Political Risk • Political risk is potentially one of the biggest risks that global firms face. • Firms must constantly assess and manage political risk. What are some external sources for doing so? • Corruption Indexes • http://www.transparency.org/ (no fee) • Country Analysis • http://www.state.gov/countries/ • http://library.uncc.edu/display/?dept=reference&format=open&page=68 • Political Risk Indexes • http://www.countrydata.com/ (fee based)
Managing (Hedging) Political Risk • Geographic diversification • Simply put, don’t put all of your eggs in one basket. • Minimize exposure • Form joint ventures with local companies. • Local government may be less inclined to expropriate assets from their own citizens. • Join a consortium of international companies to undertake FDI. • Local government may be less inclined to expropriate assets from a variety of countries all at once. • Finance projects with local borrowing.
Insuring Against Political Risk • Political risk insurance provided by: • The Overseas Private Investment Corporation (OPIC), a U.S. government organization. • OPIC offers insurance against: • The inconvertibility of foreign currencies. • Expropriation of U.S.-owned assets. • Destruction of U.S.-owned physical properties due to war, revolution, and other violent political events in foreign countries. • Loss of business income due to political violence • Political risk insurance is available for investments in new ventures and expansions of existing enterprises • Visit: http://www.opic.gov/
Appendix 3: Apple Retail Apple Retail has used a wholly owned subsidiary arrangement when engaging in FDI. The following slides discuss this.
Wholly Owned: Apple Retail • Apple’s retail store strategy has been to enter a foreign country under a wholly owned structure. • All Apple Retail stores are company owned (Apple leases the space). • Apple currently has 21 foreign retail stores (9 in the UK, 7 in Japan, 4 in Canada, and 1 in Italy). • Apple used this wholly owned strategy because it feels it “is able to better control the customer retail experience and attract new customers.” • Apparently Apple has no plans to change this strategy (see email message from Apple next slide). • Visit: http://www.apple.com/retail/storelist/