Effects of Foreign Direct Investment

Effects of Foreign Direct InvestmentThe removal of cross-b place restrictions on foreign enceinte of the United States flows and the trend toward an integrated globe economy has been a substantial progress over recent two decades. Hence, it has increased the growth of exotic organise investing(FDI) activity.Madura and drink (2007) define foreign direct enthronement (FDI) as the investment in real summations (such as land, buildings, or even existing plants) in foreign countries. They besides find that multi bailiwick corpo dimensionns(MNCs) commonly metropolisize on foreign business opportunities by engaging in FDI. They engage in joint ventures with foreign theaters, convey foreign firms, and framing new foreign subsidiaries. These types of FDI can retrovert superior returns when managed properly. A substantial investment is required, and thus can increase the risk at smashing. It whitethorn be difficult for multinational corporation to sell the foreign project wh en the investment does not perform well as expected. In order to maximize the corporations value, it is squ ar for MNCs to understand the potential return and risk of FDI and analyze the potential benefits and comprises before making investment conclusions.2.1.2 Motives for FDIThe reason why firms pose labor oversea rather than exporting from the home country or licensing production in the hose country, and the reason why firms seek to extend unified control oversea by forming multinational corporations have been developed by m both scholars. Kindleberger(1969) and Hymer(1976), emphasize various commercialise imperfections in product, factor, and corking commercializes as the get a line motivating forces to accelerate FDI. Eun and Resnick (2004) explore few key factors that atomic number 18 important for corporations making decisions to invest oversea. These factors intromit trade barriers, imperfect labor foodstuff, intangible assets, unsloped integration, product l ife cycle and shareholder diversification services.Dunning (1993) interpret four various types of motives for foreign direct investment resource seeking, market seeking, efficiency seeking, and strategic asset (or capability )seeking. The first motive means that MNCs acquire some particular resources which may mainly cnsist of primary products at a bring low appeal in the host country than at home. The second motive depends on the expectation of new sales opportunities from the opening of markets where MNCs had no access at before. The third base one refers to utilizing the particular comparative advantages of a host economy. The last one is related with long-term strategic considerations such as gaining an significant stake in the market in the long run.To be more specific, Madura and Fox (2007) indicate that MNCs engage in foreign direct investment widely because it can improve profitability and enhance shareholder wealth. In most studys, MNCs utilize FDI to boost revenues , reduce cost, or some(prenominal). Revenue-related motives include attract new source of demand, enter fat markets, exploit monopolistic advantages, react to trade restrictions and diversify internationally. Cost-related motives involve fully benefit from economies of scale, use foreign factors, use foreign raw materials, use foreign technology and react to throw rate movements.2.1.3 Benefits of FDIIt seems unwise to conclude that both forms of geographic diversification are likely to be equally profitable or unprofitable. Errunza and Senbet (1981, 1984) find evidence to give birth a positive relation between excess firm value and the firms extent of international diversity by utilize multinational firms only. Focusing on international acquisitions, Doukas and Travlos (1988) and Doukas (1995) document that US bidders gain from industrial and international diversification. Similarly, Morck and Yeung (1991, 2001) find a positive relation between international diversification and firm value. However, they show that industrial diversification and international diversification add or destroy value in the presence or absence seizure of intangible assets. Their findings support the view that the synergistic benefits of international diversification stem from the information-based assets of the firm. Christophe and Pfeiffer (1998) and Click and Harrison (2000) find that multinational firms trade at a discount relational to internal firms. More recently Denis, Denis and Yost (2002), using the Berger and Ofek (1995) excess value measure and aggregate data, show that globose diversification reduces shareholder value by 18%, whereas industrial diversification results in 20% shareholder loss. In contrast, Bodnar, Tang and Weintrop (1999), relying on a similar valuation measure, find share-holder value to increase with global diversification.Doukas and Lang (2003) take firms which made foreign new plant announcements during the period 1980 1992 as a sample, regard less of the industrial anatomical structure of the firm, they interpret that unrelated foreign direct investments are associated with negative announcement payoffs and long-term performance decreases in subsequent years, whereas related investments are associated with positive short-term and long-term performance. Although their findings indicate that both specialized and diversified firms benefit from core-business-related rather than non-core-business-related foreign direct investments, the gains are larger for diversified firms. They conclude that geographic expansion of the firms core business itself is undecomposed to shareholder value. In contrast, they find that geographic expansion of the firms peripheral (non-core) business harms firm value and performance. Hence the evidence indicates that the internalization theory is more ordered with the international expansion of the core rather than the non-core business of the firm. That is, the positive synergies from global dive rsification are rooted in the firms core competencies.Theories of foreign direct investment (FDI) agree on at least one study point foreign firms mush have inherent advantages that allow them to overcome the higher(prenominal)(prenominal) be of becoming a multinational (Hymer, 1976) These advantages may be tangible, such as an improved production process or a product innovation. They as well may be intangible, such as brand names, better management structures or the technical knowledge of employees.Girma, Greenaway and Wakelin (2001) conclude that foreign firms do have higher productiveness than domestic firms and they pay higher wages in the UK after their investigation. They do not find aggregate evidence of intra-industry spillovers. However, firms with low productivity relate to the celestial sphere comely, in low-skill low foreign competition sectors gain less from foreign firms.FDI brings two main benefits to the host country. First, it introduces new production facilitie s into the domestic economy directly, or may rescue failing firms in the case of acquisition, raising overall turn upput, employment and exports. Second, domestic governments hope that foreign firms allow be unable to internalise their advantages fully, and topical anesthetic firms can benefit through with(predicate) spillover.2.1.4 Effects of FDIBorensztein, Gregorio and Lee (1998) test the effect of foreign direct investment (FDI) on economical growth in a cross-country turnabout framework by utilizing data on FDI flows from industrial countries to 69 developing countries over the last two decades. The results suggest that FDI is significant for transfer technology, and contri juste more to growth than domestic investment. Moreover, they find that the contribution of FDI to economic growth is improved by its interaction with the level of human capital in the host country. However, the empirical results imply that FDI is more productive than domestic investment only when the host country has a minimum threshold livestock of human capital. Thus, FDI contributes to economic growth only when a sufficient absorptive capability of the advanced technologies is available in the host economy.Investigating the effect of FDI on domestic investment, they find that the inflow of foreign capital crowds in domestic investment rather than crowds out. FDI support the expansion of domestic firms by complementarity in production or by increasing productivity through the spillover of advanced technology. A one-dollar increase in the net inflow of FDI is associated with an increase in total investment in the host economy of more than one dollar, but do not appear to be very robust. Thus, it appears that the main channel through which FDI contributes to economic growth is by stimulating technological progress, rather than by increasing total capital accumulation in the host economy.Markusen and Venables (1999) develops an analytical framework to measure the effects how a n FDI project affect local anesthetic firms in the same industry. There are two forces for the effect of entry of a multinational firm on the domestic industry. One is a competition effect, under which multinationals displace domestic final-goods producers, and the other is a linkage effect back to intermediate-goods producers, creating complementarities which could benefit domestic final-goods producers. They explore the determinants of the relative strengths of these effects. In circumstances of initial equilibrium with no local production, multinational entry can push the economy over to an equilibrium with local production in both the intermediate and final-goods industries, with a resulting welfare improvement.They then pay attention to endogenise the entry decision of multinational firms. It may now withal be the case that multinationals bring home the bacon the initial impetus for industrialisation, but the developed local industry creates sufficiently intense competition t o eventually drive the multinationals out of the market. Hobday (1995) finds initial multinational investments in developing East Asia created backward linkage effects to local suppliers in a large number of situations. There are some examples such as computer keyboards, personal computers, sewing machines, athletic shoes, and bicycles in Taiwan.2.2 Cost of capital and capital structureMany major firms through the world have begun to internationalize their capital structure by raising funds from foreign as well as domestic sources. As a result, these corporations become multinational not only in the scope of their business activities but as well in their capital structure. This trend reflects not only a conscious effort on the part of firms to lower the cost of capital by international sourcing of funds but also the ongoing liberalization and deregulating of international financial markets.If international financial markets were completely integrated, it would not matter whether f irms raised capital from domestic or foreign sources because the cost of capital would be equalized across countries. On the other hand, some markets are less than fully integrated, firms may be able to create value for their shareholders by issuing securities in foreign as well as domestic markets.Cross-listing of a firms shares on foreign stock exchanges is one way a firm operating in a segmented capital market can lessen the negative effects of segmentation and also internationalize the firms capital structure. For example, IBM, Sony, and British Petroleum are simultaneously listed and traded on the New York, London, and Tokyo stock exchanges. By internationalizing its corporate ownership structure, a firm can generally increase its shares price and lower its cost of capital.2.2.1 Definition of cost of capitalEun and Resnick define the cost of capital as the minimum rate of return an investment project must generate in order to pay its financing be. If the return on an investme nt project is equal to the cost of capital, under taking the project will abdicate the firms value unaffected. When a firm identifies and undertakes an investment project that generate a return exceeding its cost of capital, the firms value will increase. It is significant for a value-maximizing firm to try to lower its cost of capital.Madura and Fox (2007) explain that a firms weighted average cost of capital (referred to as Kc ) can be deliberate asKc = D/(D+E ) * Kd * ( 1-t ) + E / (D+E) * KeWhere D = market value of firms debtKd = the before- revenue revenue cost of its debtt = the corporate tax rateE = the firms candor at market valueKe = the cost of financing with equityThe ratios reflect the percentage of capital represented by debt and equity, respectively. In total the cost f capital, Kc is the average cost of all providers of finance to the firms. A multinational company finances its operations by using a mixture of fixed interest get and equity financing that can min imize the overall cost of capital (the weighted average of its interest rate and dividend payment). By minimizing the cost of capital use to finance a given size and risk of operations ,financial managers can maximize the value of the company and therefore maximize shareholder wealth.According to the different size of firm, international diversification, painting to exchange rate risk, access to international capital markets and exposure to country risk, the cost of capital for MNCs may different from that for domestic firms.2.2.2 Costs of capital across countriesMadura and Fox (2007) interpret that the reason why cost of capital is different among countries is relevant for three reasons. First, MNCs based in some countries may have more competitive advantages than others not only for the different technology and resources across countries, but also the cost of capital. MNCs in some countries will have a larger set of feasible projects with positive net present value because of the lower cost of capital, hence these MNCs can increase their world market share more easily. MNCs operating in countries with a higher cost of capital will be forced to decline projects. Second, MNCs may be able to adjust their international operations and sources of funds to capitalize on differences in the cost of capital among countries. Third, the different component as debt and equity in the cost capital can explain why MNCs based in some countries tend to use a more debt-intensive capital structure than others.To guess an overall cost of capital for an MNCs, it needs to combine the costs of debt and equity, and weight the relative proportions of debt and equity. The cost of debt to a firm is primarily determined by the unhazardous interest rate in the currency borrowed and the risk superior required by quoteors. Risk-free interest rate is determined by the interaction of the depict and demand for funds. Factors include tax laws, demographics, monetary policies and economic conditions can influence the supply and demand then affect the riskless rate. The risk premium on debt can vary among countries because of the different economic conditions, relations between corporations and creditors, government intervention, and degree of financial leverage. In addition, a firms cost of equity represents an opportunity cost what shareholders could earn on investments with similar risk if the equity funds were distributed to them. This return on equity can be measured as a risk-free interest rate that could have been earned by shareholders, plus a premium to reflect the risk of the firm. According to the different economic environments, the risk premium and the cost of equity will vary among countries.2.2.3 MNCs capital structure decisionMadura and Fox.(2007) indicate that an MNCs capital structure decision includes the choice of debt versus equity financing deep down all of its subsidiaries, hence the overall capital structure is combined of all subsidiaries c apital structures. The advantages of using debtor equity vary according to the corporate characteristics specific to each MNC and specific to countries where the MNCs establish subsidiaries.They interpret some specific corporate characteristics which can influence MNCs capital structure. MNCs with more stable cash flows can passel with more debt because their cash flows are constant to cover periodic interest payments. In contrast, MNCs with erratic cash flows might prefer less debt. MNCs with lower credit risk have more access to credit, their choice of using debt or equity can be affected by factors which influence credit risk. MNCs with high profit may be able to finance most of investment with retaining gelt and use an equity-intensive capital structure, while others with small level of retained wage may prefer on debt financing. The subsidiaries borrowing capacity may be increase and need less equity financing once the call down backs the debt. situation costs are higher w hen a subsidiary in foreign country can not be monitored easily be investor from parents country.In addition, they also describe the specific country characteristics unique to each host country can influence MNCs choice of debt versus equity financing and thus influence their capital structure. Firstly, some host countries have stock restrictions which means the governments allow investment only in local stocks. This kind of barrier of cross-border investing, potential adverse exchange rate and tax effects can discourage investment outside home countries. MNCs operated in these countries where investor have fewer stock investment opportunities may be able to raise equity at a relatively low cost, and they would prefer using more equity by issuing stocks. Secondly, according to the government-imposed barriers on capital flows along with potential adverse exchange rate, tax and country risk effects, loanable funds do not always flows th where they are necessary most and the price of them can vary across different countries. MNCs may be able to obtain loanable funds at lower cost in some countries and they will prefer the debt financing. Thirdly, regard of the potential weakness of the currencies in subsidiaries host countries, an MNC may attempt to finance by borrowing currencies instead of relying on parent funds. Subsidiaries may remit a smaller amount in earning because they can make interest payments on local debt, and thus reduce the exposure to exchange rate. Conversely, subsidiaries may retain and reinvest more of its earnings when the parent believes a subsidiaries local currency will appreciate against its own currency. The parent may provide an cash infusion to finance growth in the subsidiaries, and thus transfer the internal funds from the parent to subsidiary possibly resulting in more out-of-door financing by the parent and less debt financing by the subsidiary. Fourthly, possibility of a kind of country risk is that the host country will tempora rily block funds to be remitted by subsidiary to the parent. Thus aubsidiraies may prefer to local debt financing. At last, MNCs make interest rate payments on the local debt when they are subject to a withholding tax. Foreign subsidiaries may also use local debt if the host country impose high corporate tax rates on foreign earnings.Bancel and Mittoo (2004) survey on the cross-country comparisons of managerial views on determinants of capital structure in a sample of 16 European countries Austria, Belgium, Greece, Denmark, Finland, Ireland, Italy, France, Ger legion(predicate), Netherlands, Norway, Portugal, Spain, Switzerland, Sweden, and the UK. They show that factors related to debt are influenced more, and those related to equity are influenced less, by the countrys institutional structure, especially the quality of its legal system. They find that financial flexibility and earnings per share dilution are primary concerns of managers in issuing debt and common stock, respective ly. Managers also value hedging considerations and use windows of opportunity when raising capital. This evidence strengthens arguments of La opening night et al. (1997, 1998) that the availability of external financing in a country is influenced primarily by its legal environment. Since fashion costs of debt are likely to be higher in countries with lower quality of legal systems, this evidence is also conformable with theories of capital structure such as agency theory that assign a central role to debt contracts and bankruptcy law (Harris and Raviv, 1991).They find that although a countrys legal environment is an important determinant of debt policy, but it plays a minimal role in common stock policy. They find that firms financing policies are influenced by both their institutional environment and their international operations. They also show that firms can adopt strategies to ebb the negative effects of the quality of the legal environment in their home country. For insta nce, firms in civil-law countries have significantly higher concerns for maintaining target debt-to-equity ratios and matching maturity than do their peers in the common-law countries. Further, they find that firms operating internationally have significantly different views than do their peers in several ways. For example, firms that have issued foreign debt or equity in the sample during the last ten years are more concerned closely credit ratings. Firm-specific variables that are commonly used in the capital structure literature to explain leverage also explain cross-country differences in managerial rankings of several factors. For example, large firms are less concerned about bankruptcy costs, and high growth firms consider common stock as the cheapest source of funds and use windows of opportunity to issue common stock. These results support the arguement by Rajan and Zingales (1995, 2003), that firms capital structures are the result of a complex interaction of several insti tutional features as well as firm characteristics in the home country.Their results support that most firms determine their best capital structure by trading off factors such as tax advantage of debt, bankruptcy costs, agency costs, and availableness to external financing. They confirm the conclusions of Titman (2002) Corporate treasurers do occasionally think about the kind of trade-offs between tax savings and financial distress costs that we larn in our corporate finance classes. However, since this trade-off does not change much over time, the balancing of the costs and benefits of debt financing that they emphasize much is not MNCs major concern. They spend much more time thinking about changes in market conditions and the implications of these changes on how firms should be financed.Lee and Kwok (1988) examine the impact of international environmental factors on some firm-related capital structure determinants which in turn affect the MNCs overall capital structure. They con sider international environmental variables of governmental risk, international market imperfections, complexity of operations, opportunities for international diversification, foreign exchange risk and local factors of host countries, and test agency costs and bankruptcy costs. They find that MNCs tend to have higher agency costs of debt according to Myers definition than DCs. This finding remained unchanged even when size and industry effects were controlled. Though MNCs appeared to have lower bankruptcy costs than DCs, the difference largely disappeared when the size effect was controlled. Quite contrary to the conventional wisdom, the empirical findings showed that MNCs tended to be less leveraged than DCs. This finding remained even when the size effect was controlled. However, when companies were illogical under different industry groups, the results varied significantly.Burgman (1996) directly estimate the effect of foreign exchange risk and political risk on the capital st ructure of MNCs. Using the foreign tax ratio to classify firms as either MNCs or DCs and controlling for industry and size effects, Burgman finds that MNCs have lower debt ratios and higher agency costs than DCs. Furthermore, international diversification does not appear to lower earnings volatility. To estimate the sensitivity of a firm to foreign exchange risk, Burgman conducts a regression analysis of the stock returns of each sample firm on the returns of an index of U.S. stocks and on the U.S.$SDR returns. His political risk measure is based on the following ratio number of low political risk countries to the total number of countries in which the firm operates. Low political risk countries are the top 20 in the country risk rankings provided by Euromoney in 1989. The results of a regression analysis for his sample of MNCs suggest that the debt ratios of these companies are positively related to both risks. Burgman concludes that this evidence is consistent with the hypothesis that MNCs use debt policy as a legal document to hedge foreign exchange risk and political risk.Chen et al. (1997) conducted regression analyses to investigate the effect of international activities (as measured by foreign pre-tax income) on capital structure. They report that even after controlling for firm size, agency costs of debt, bankruptcy costs and profitability, the long-term debt ratios of MNCs are lower than those of DCs. However, within their sample of MNCs, debt ratios increase with the level of international activities.2.2.4 Segmented capital marketA capital market for asset claims is integrated when the opportunity set of investments available to each and every investor is the universe of all possible asset claims. In contrast, a capital market is segmented when certain groups of investors limit their investments to a subset of the universe of all possible asset claims. Such market segmentation can occur because of ignorance about the universe of possible asset clai ms, or because of transactions costs (brokerage costs, taxes, or information acquisition costs), or because of legal impediments. From an international perspective, market segmentation typically occurs along national borders, a condition wherein investors in each country acquire only domestic asset claims.Grubel, Levy and Sarnat, and Lessard employ a mean-variance portfolio theoretic framework, have accentuate the benefits of diversifying investments across national borders, namely the pooling of risks that results from investing in projects that are less than perfectly correlated. Subrahmanyam points out that when segmented capital markets are integrated, in addition to the diversification effect (always positive), there is a wealth effect (possibly negative) which arises out of changes in the macro-parameters of the risk-return relationship. For the special cases of quadratic, exponential, and logarithmic utility functions, it can be shown that international capital market integr ation is Pareto-optimal, that is, the welfare of individuals in the integrated economies will not decline, and will generally improve. The positive effect of an expansion in the opportunity set offsets any negative wealth effect.The market reformed and liberalized in developed economies in the 1970s and emerging economies during the second half of the 1980s led to the removal of many barriers. The deregulation and the development of local equity markets allowed the possibility of foreign portfolio investments (FPIs). overall, FPIs would provide a new source of capital and internationalize the domestic capital markets. incidental improvements in risk sharing and risk matching would cause the cost of capital to fall. Errunza and Miller (2000 ) use a sample of 126 firms from 32 countries, document a significant decline of 42% in the cost of capital. In addition, they show the decline is driven by the ability of U.S. investors to span the foreign security antecedent to cross-listing. The findings support the hypothesis that financial market liberalizations have significant economic benefits.2.2.5 Interaction between subsidiary and parent financing decisionsIn segmented markets the parent and its subsidiaries will generally have different valuation objectives and investment-acceptance criteria. Under some conditions these depend on the international financing mix. Decentralization can be optimal in the sense of global maximization, provided that the parent is unrealistically free, ex-ante, to optimize its percentage ownership in the subsidiaries at the beginning of each planning period. In the case of a two-country firm, the subsidiaries maximands are independent of the parents. But when the parents ownership position is predetermined at a fixed level, as it is normally, the situation is radically different. Market value cannot then be maximized independently and Pareto optimization is required. Michaels (1974) main result is that, unless agreement can be reache d on a compensation principle, the joint ventures cost of capital will be indeterminate. In such circumstances optimal financial planning for the MNC as a whole may be impossible. Concluding remarks good deal attention to the attendant possibility that the MNC in this case may be unstable and/or inefficient.2.2.6 The MNCs capital structure decisionAn MNCs capital structure decision involves the choice of debt versus equity financing within all of its subsidiaries. Thus, its overall capital structure is essentially a combination of all of its subsidiaries capital structures. MNCs recognize the tradeoff between using debt and using equity for financing their operations. The advantages of using debt as opposed to equity vary with corporate characteristics specific to each MNC and specific to the countries where the MNC has conventional subsidiaries.Madera and Fox (2007) indicate some common firm-specific characteristics that affect the Macs capital structure such as stability of Macs cash flows, Macs credit risk, Macs access to retained earnings, Macs guarantees on debt and Macs agency problems. They also point the unique host country characteristics can influence the MNCs choice of debt versus equity financing and therefore influence the MNCs capital structure. These characteristics include stock restrictions in host countries, interest rates in hose countries, strength of host country currencies, country risk in host countries and tax laws in host countries.2.3 Risk analysis2.3.1 Country risksWith operations under the jurisdiction of a foreign government the firm is also exposed to political risk, therefore it must estimate the potential costs it will expression due to unstable governments, regime change and changes in policies. Political risk may be defined as a particular exposure to risk which depends on the actions of a government, and its assessment or analysis for a MNC is a decision-making tool for investing in foreign countries.An MNC must assess coun try risk not only in countries where it currently does business but also in those where it expects to export or establish subsidiaries. Many country risk characteristics related to the political environment can influence an MNC. Madura and Fox (2007) indicate that an extreme form of political risk is the possibility that the host country will take over a subsidiary. In some cases of expropriation, some compensation is awarded, and the amount is refractory by the hose country government. In other cases, the assets are confiscated and no compensation is provided. Expropriation can take place peacefully or by force. They also explore other common forms of country related risks include attitude of consumers in the host country, actions of host government, blockage of fund transfers, currency inconvertibility, war, bureaucracy and corruption.Over recent decades, there has been a significant increase in political risk for MNCs. This is true not only for an MNCs operations in developing c ountries, but also for those in developed countries. Governments have felt the need to respond to various pressure groups aimed at curbing the power of MNCs. For example, oil companies may face unfavourable legislation designed to pay for the damage to environment. Developing countries may have to respond to populist sentiments or worsening economic circumstances by seeking to renege on contracts signed by previous regimes. Another risk area which has grown in recent years has been the strength of fundamentalistic religious groups in a number of eco