Direct foreign investment

GROUP 3
1) Mohim Chowdhury (16027)
2) Md. Arif Hossain (16086)
3) Rayhan Ahmed Provat (16090)
4) Wasiuzzaman Chowdhury (16091)
5) Md. Rafiqul Islam (16094)
6) Aninda Ghosh (16096)
7) Kazi Mohamad Onik Islam (16182)

Question: What is foreign direct investment?
• Foreign direct investment (FDI) occurs when a firm
invests directly in new facilities to produce and/or market
in a foreign country
• Once a firm undertakes FDI it becomes a multinational
enterprise
• There are two forms of FDI
o A greenfield investment (the establishment of a wholly
new operation in a foreign country)
o Acquisition or merging with an existing firm in the
foreign country

 Purchase of physical
assets or significant
amount of ownership of a
company in another
country to gain some
measure of management
 cBoyn ctroonltrast, portfolio
investment does not involve
obtaining a degree of control
in a company

NOTE:
Investing in foreign financial instruments (Portfolio
Investment like govt. bond, foreign stocks) IS NOT
FDI.

Green field
operation:
 Mostly in developing
nations
Mergers and
acquisitions:
 Quicker to execute.
 Foreign firms have
valuable strategic assets
 Believe they can
increase the efficiency
of the acquired firm
More prevalent in
developed nations

The Form of FDI: Acquisitions versus Green-
Fields
The majority of investments is in the form of
mergers & acquisitions:
Represents about 77% of all flows in
developed countries.
Represent about 33% of all flows in
developing countries.
Fewer target firms to acquire.

Market Imperfections
(Internalization)
A company undertakes FDI to
internalize a transaction that
is made inefficient because of
a market imperfection
 Trade barriers
(e.g., tariffs)
 Unique advantage
(e.g., special knowledge)

Economies of
scale
Sustaining
and
Transferring
Competitive
Advantage
Managerial
expertise
Advanced
technology
Financial
strength
Competitiveness
of home market
Differentiated
products

Exploit
competitive
advantage
Production
at home:
Exporting
Production
Abroad
Licensing
Management
Contract
Control Asset
Abroad
Joint
Venture
Wholly
Owned
Subsidiary
Greenfield
Investment
Acquisition
of a
Foreign
Enterprise

Horizontal
Direct
Investment
A multinational firm
(MNE) enters a foreign
country to produce the
same type of products
that it produces at
home
Often the case when
there exists high
barriers to trade (i.e.
tariffs, transportation
costs, import quotas)
Vertical direct
investment:
Can be of two types
based on the
requirements
More likely when there
are few trade barriers
and the different
production factors
exist at various prices
in different economies

Vertical direct investment:
Backward - investments into
industry that provides inputs into a
firm’s domestic production
(typically extractive industries)
Forward - investment in an industry
that utilizes the outputs from a
firm’s domestic production
(typically sales and distribution)

• The amount of FDI
undertaken over a
given period of
time (usually one
year).
Flow:
• Total
accumulated
value of foreign-owned
assets at
a given time.
Stock:
Outflows of FDI: are the flows of
FDI out of a country
Inflows of FDI: are the flows
of FDI into a country

A firm undertakes FDI when location, ownership, and
internalization advantages combine to make a location appealing
Location
advantage
(optimal location)
Ownership
advantage
(special asset)
Internalization
advantage
(efficiency)

FDI is expensive and risky compared to exporting or
licensing:
Costs of establishing facilities.
Problems with doing business in a different
Culture.
But still FDI occurs . Why???

• Exporting vs. FDI
• Advantages of exporting are
• None of the unique risks facing FDI, joint ventures, strategic
alliances and licensing
• Political risks are minimal
• Agency costs and evaluating foreign units are avoided
• The amount of front-end investment is lower
• Disadvantages are
• Firm is not able to internalize and exploit its advantages
• Risks losing market to imitators and global competitors
• Export back into domestic exporter’s own market

• Licensing VS. FDI
• Licensing is a popular method for domestic firms to
profit from foreign markets without the need to commit
sizable funds
• Political risk is minimal
• Disadvantages of licensing are
• License fees are likely lower than FDI profits although ROI may
be higher
• Possible loss of quality control
• Establishment of potential competitor
• Possible improvement of technology by local license which
then enters firm’s original home market

• The viability of an exporting strategy can be
constrained by transportation costs and trade
barriers
• When transportation costs are high, exporting can be
unprofitable
• Foreign direct investment may be a response to actual or
threatened trade barriers such as import tariffs or quotas

Impediments to the
sale of know how
Risk giving away
know-how to
competitors
Licensing implies
low control over
foreign entity
Know-how not
amenable to
licensing

• A firm will favor FDI over exporting as an
entry strategy when
▫ transportation costs are high
▫ trade barriers are high
• A firm will favor FDI over licensing when
▫ it wants control over its technological know-how
▫ it wants over its operations and business strategy
▫ the firm’s capabilities are not amenable to licensing

Yes
How high are
transportation costs and
tariffs?
Is know-how amenable
to licensing?
Is tight control over foreign
operation required?
Can know-how be protected
by licensing contract?
Then license
Export
FDI
FDI
FDI
High
Yes
No
Low
No
Yes
No

•Historically, most FDI has been directed at the
developed nations of the world, with the United
States being a favorite target
•FDI inflows have remained high during the early
2000s for the United States, and also for the
European Union
•South, East, and Southeast Asia, and particularly
China, are now seeing an increase of FDI inflows
•Latin America is also emerging as an important
region for FDI

Worldwide FDI Flows
World FDI inflows
 Developed (57%), developing (37%)
 European Union: 30% of world FDI
Developing nations
 China: 6.4% of world FDI
 All of Africa: 5.2% of world FDI
82,000 multinationals
with
810,000 affiliates

The Direction of FDI
FDI Inflows by Region 1995 -2007

Benefits of
International
Diversification Existing
Business
If Located
In U.S
If Located
In U.K
Mean
expected
annual
return on
investment
20% 25% 25%
Standard
deviation
.10 0.9 .11
Correlation - .80 .02
Merrimack CO. a U.S firm,
plans to invest in a new
project in either the U.S or the
U.K. Once the project is
completed , it will constitute
30% of the firm’s total funds
invested in itself. The
remaining 70% of its
investment in its business is
exclusively in the U.S.
Merrimack plans to assess the
feasibility of each proposed
project based on expected risk
and return, using a 5 year time
horizon. Other factors are
shown in the table:

Merrimack cont.
If the new project is located in the U.S. then
the firm’s overall expected after-tax return is:
푟푝= [(70%) × (20%)] + [(30%) × (25%)]= 21.5%
% of
funds
investe
d in
prevaili
ng
busines
s
Expecte
d return
on the
prevailin
g
business
% of
fund
invested
in new
U.S
project
Expecte
d return
on the
new U.S
project
Firm’s
overall
expecte
d return

• The variance of a portfolio (휎2
푝)composed of
only two investments (A and B) is computed as
:
• 휎2
푝= 휎2
푝휎2
푝 + 휎2
푝휎2
푝+2푤푎 푤푎 푤푎 푤푎 (퐶푂푅푅퐴퐵)

휎2
푝 =(.70)2 (.10)2 +(.30)2
(.09)2 +2(.70)(.30)(.10)(.09)(.80)
= (.49) (.01) + (.09) (.0081) +
.003024
= .0049 + .000729 + .003024
= .008653
휎2
푝 =(.70)2 (.10)2 +(.30)2
(.11)2 +2(.70)(.30)(.10)(.11)(.02)
= (.49) (.01) + (.09) (.0121) +
.0000924
= .0049 + .001089 + .0000924
= .0060814

Motives for DFI
 Profitability
 Enhancing Shareholder’s wealth
 Boosting Revenues
 Reducing Costs

Revenue Related
Motives
Attract new sources of demands
Enter profitable markets
Exploit monopolistic advantages
React to trade restrictions
Diversify Internationally

Attract new sources of
demands
A corporation often reaches a stage when
growth is limited in its home country
because of intense competition. Thus the
firm may consider foreign market where
there is potential demands.

Enter profitable market
If other corporations in the industry have proved
that superior earnings can be realized in other
markets an MNCs may also decides to sell in
those markets.(But a common problem with this
strategy is that established sellers in a new
market may prevent a competitor by lowering
their prices when new competitor attempts to
break into this market)

Exploit monopolistic
advantages
Firms may become internationalized if they
possesses resources or skills not available to
competiting firm. If a firm possesses
advanced technology and has exploited this
advantage successfully in local market as
well as international market.

React to trade
restrictions
In some cases MNCs use DFI as a defense
rather than aggressive strategy. Specifically
MNCs may pursue DFI to circumvent trade
barrier.

Diversify Internationally
By diversifying sales internationally a firm
can make its net cash flow less volatile. Thus
the possibility of liquidity deficiency is less
likely. In addition the firm may enjoy lower
cost of capital.

Cost Related Motives
Fully benefit from Economies of Scale
Use foreign factors of production
Use foreign Raw materials
Use foreign technology
React to exchange rate movement

Fully benefit from
Economies of Scale
A corporation that attempts to sell its
primary product to a new market may
increase its earning and shareholder’s wealth
due to economies of scale.(Lower cost per
unit resulting from increased production)

Use foreign factors of
production
Labor and land costs can vary dramatically
among countries. MNCs often attempt to set
up production where land and labor are
cheap.

Use foreign raw
material
Due to transportation cost of a corporation
may attempt to avoid importing raw
material from a given country. Especially
when it plans to sell the finished product
back to consumer in that country.

Use foreign Technology
Corporations are increasingly establishing
overseas plants or acquiring existing
overseas plants to learn the technology of
the foreign countries.

React to exchange rate
movement
When a firm perceives that a foreign
currency is undervalued the firm may
consider DFI in that country as the initial
outlay should be low.

Diversification analysis of int.
project
 Like any investor, an MNCs investment is concerned with risk
and return characteristics.
 Diversification of all investment portfolio reflects the MNCs
aggregate.
Example of Virginia, Inc. discussed bellow

Comparing portfolios along the
frontier
Along the frontier of efficient project portfolios, no portfolio
can be singled out as optimal for all MNCs because it differs
by MNCs willingness to acceptance of risk.

Comparing frontiers among mnc’s
Example of Eurosteel, Inc.,(who sells steel solely to European
nations) with Global Products, Inc.(sell a wide range of
product in European nations)
This discussion suggests that MNCs can achieve more desirable
risk-return characteristics from their project portfolios if they
diversify among products and geographic markets .

Diversification among countries
 A country’s stock market value reflects the expectations of business opportunities
& economic growth
 Economic conditions of a country are commonly correlated with other countries
overtime (recession in USA in 2002).

Decisions Subsequent to DFI
 Incase of foreign direct investment mainly periodic
decision are taken.
Decisions are taken to evaluate the further expansion.
Whether the decisions are made should be analyzed
on a case-by-case basis.

Decisions Subsequent to DFI
MNC’s
Funds
Used by the
subsidiary
Remitted to the
parent

Host Government Views of DFI
Host government
view
Incentives to
encourage DFI
Barriers to DFI

Host Country Effects of FDI
Benefits
–Resource -transfer
–Employment
–Balance-of-payment (BOP)
• Import substitution
• Source of export increase
Costs
–Adverse effects on the BOP
• Capital inflow followed by capital outflow + profits
• Production input importation
–Threat to national sovereignty and autonomy
• Loss of economic independence

INCENTIVES TO ENCOURAGE DFI
Tax break on earnings
Rent free land & buildings
Low interest rate & subsidized
energy
Reduced environmental regulations

Incentives to Encourage DFI
When the local govt. provides incentives???
When the MNC are in a production of goods which are
not direct substitute of local
When MNC are in manufacturing plant that exports the
products in another country

Incentives to Encourage DFI
Incentives strategy followed by some
developed countries :
 Study about Allied Research Association(a US based MNC)
and Belgium
 Governmental land sells procedure by France
 Finland and Ireland strategy in early 90s

Decision Framework for FDI
Export
FDI
FDI
FDI
License
Yes
Import
No Barriers?
No
Yes
No
Are transportation costs
high?
Yes
Is know-how easy to
license?
Yes
Tight control over foreign
ops required?
No
Is know-how valuable and is
protection possible?
No
Yes

Barriers To Foreign Direct
Investment
Red Tape
Barriers
Barriers
to FDI
Industry
Barriers
Environment
Barriers
Regulatory
Barriers
Ethical
Barriers
Protective
Barriers
Political
Barriers

Protective Barriers:
 the restrictions impose by government agencies incase of acquisitions
and mergers
 Restricts foreign ownership of any local company.
Red Tape Barriers:
 An implicit barrier to DFI involved with procedural and
documentation requirements.
 Regulation un uniformity of paperwork documents because of
different countries different requirements.

Industrial Barriers
 Local firms of some industries which have substantial
influence on the govt. likely to use their influence to prevent
competition from MNCs that attempt FDI.
 Sometimes these local firms make an alligation to enter MNCs
in local market.
Environmental Barriers
 Building codes, disposal of production waste material,
pollution controls are some basic example of environmental
barriers.
 Many European countries have recently imposed tougher
antipollution laws.

Regulatory Barriers:
 Each country has its own regulatory constraints relevant to taxes,
currency convertibility, earnings remittance, employ rights and
other issues which financial manager should consider. E.g.,
Germany limits store hours and requires recycling
 Revision of financial policies needed when there occurs any
changes in these regulations.

Ethical Differences
 There is no standard of business conduct applies to all countries,
for that a business practice unethical in one country may be
totally ethical in another.
Political instability:
 There is a negative relationship between FDI inflow and political
unrest such as strikes and riots in the host countries.
 An uncertain political environment deteriorates the trust as it
makes the investor feel insecure

Political instability:
 absence of transparency in the Government sector, corruption,
fanatic nationalism, perpetual change of the Government,
likelihood of terrorism are taken into account by the investors
before making investment decision in a foreign country.
 For example FDI by India varies with the changes of government
by political party in our country.

Direction and Source of FDI
 Most FDI flow has been to developed countries from
developed countries
– Much to the US from EU, Japan
 FDI increase to developing countries since ‘85
– Much to the emerging Asian and Latin America
economies
– Africa lagging

Steps in Multinational Capital Budgeting
1. Identify the initial capital
invested or put at risk.
2.Estimate cash flows to be
derived from the project over
time, including terminal or
salvage value
3.Identify the appropriate
discount rate for determining the
PV of the expected cash flows
4. Apply capital budgeting
decision criteria such as NPV or
IRR to determine the acceptability
of the project

Different perspective
Tax
Differentials
• The MNC needs to consider how the parents
government taxes the earnings
• If the parents government imposes high tax rate on
the remitted funds, the project may be feasible from
subsidiary’s point of view, but not from the parents
point of view
Restricted
Remittances
• There can be a potential project to be implemented
in a country where government restrictions require
that a percentage of subsidiary earnings remain in
the country
• Since the parent may never have access to the fund,
the project is not attractive to the parent.

Different perspective
Excessive
Remittances
• A parent may charge its subsidiary very high
administrative fees.
• This fees is expense to the subsidiary but revenue to the
parent.
• This fees represent revenue that may substantially
exceed the actual cost of managing the subsidiary.
• The project may be profitable from parents perspective
but loss from subsidiary perspective
Exchange Rate
Movement
• The earnings remitted to the parent are
normally converted from subsidiary's local
currency to the parent’s currency
• The amount received by the parent is therefore
influenced by the existing exchange rate

Complexities of budgeting for a foreign project
• Parent Cash flows must be distinguished from project cash flows. Each of
these two types of cash flows contribute to a different view of value.
•Parent cash flows often depend on the form of financing. Thus, we can’t
separate cash flows from financing decision.
•Additional cash flows generated by a new investment in one foreign
subsidiary may be in part or in whole taken away from another subsidiary
resulting in no contribution to worldwide cash flows.
• The parent must explicitly recognize remittance of funds because of
differing tax system, legal and political constraints on the movement of the
funds.
•Managers must evaluate political risk because political events can
drastically reduce the value of expected cash flows.

Process of remitting subsidiary earnings to the parent
Cash Flow Generated by
Subsidiary
After-Tax Cash Flows to
subsidiary
Cash Flow Remitted by subsidiary
Corporate tax paid to
host government
Retained Earnings by
subsidiary
After tax cash Flow remitted by
subsidiary
Conversion of
funds to parents
currency
With-holding tax paid to
host government
parent

Input for Multinational Capital
Budgeting
Initial Investment
Price and consumer Demand
Costs
Tax Law
Remitted Funds
Exchange Rates
Salvage Value
Required rate of return

Input for multinational capital budgeting
Initial
Investment
The Parent’s initial Investment in a project may constitute the
major source of funds to support a particular project. Funds
initially invested in a project may include not only whatever is
necessary to start a project but additional funds, such as working
capital, to support the project over time.

Price and
consumer
Demand
• The price at which the product could be sold can be forecasted
using competitive products in the market as a comparison. The
future price will most likely be responsive to the future
inflation rate in the host country, but future inflation rate is
uncertain. Thus, future inflation rates must be forecasted in
order to develop projections of the product price over time.
• Once a market share percentage is forecasted projected
demand can be computed. Demand forecasts can sometimes
be aided by historical data on the market share other MNCs in
the industry pulled when they entered this market.

Costs
• Variable cost can be developed from assessing prevailing
components (such as hourly labor costs and the cost of
materials). Such costs should normally move in tandem with
the future inflation rate of the host country.
• Due to not sensitive to change in demand fixed cost is easier
to predict

Tax Laws
• Tax laws on earnings generated by a foreign subsidiary vary
among countries. Some times the MNC receives tax deductions
or credits for tax payments by a subsidiary.
• Because after tax cash flows are necessary for an adequate for
capital budgeting analysis, international tax effects must be
determined.

Remitted
Funds
• Sometimes a host government will prevent a subsidiary from
sending its earnings to the parent. This restriction may reflect
an attempt to encourage additional local spending. Since the
restriction on fund transfer prevent cash from coming back to
the parent, projected net cash flow from the parents
perspective will be affected.

Exchange
rates
• Any international project will be affected by exchange rate
fluctuation during the life of the project, but these movements
are often very difficult to forecast. There are methods of hedging
against them, though most hedging techniques are used to cover
short term position . It is possible to hedge over longer periods
with long-term forward contracts or swap arrangements

Salvage
(liquidation)
value
• Every project has liquidation value at the end of the project. It
is difficult to forecast. It depends on several factors, including
the success of the project and the attitude of the host
government towards the project.
• Some projects have indefinite lifetimes, at the end of which
they will be liquidated . In some cases, political events may
force the firm to liquidate the project earlier than planned.

Required rate of
Return
• Once the relevant cash flows of a proposed project are estimated,
they can be discounted at the projects required rate of return,
which may differ from the MNC’s cost of capital because of that
particular project’s risk.

Multinational Capital Budgeting Example
• Spartan Inc. is considering the development of a subsidiary
in Singapore that would manufacture and sell tennis rackets
locally. Spartan’s management has asked various
departments to supply relevant information for capital
budgeting analysis. The project would end in 4 years.
•Initial Investment: An estimated 20 million Singapore Dollar (S$),
which include funds to support working capital would be needed for
the project.
•Price and demand : The estimated price and demand schedule
during each of the next 4 years are shown here:
Year 1 Year 2 Year 3 Year 4
Price per racket S$ 350 S$ 350 S$ 360 S$ 380
Demand in Singapore 60,000 units 60,000 units 100,000unit
s
100,000
units

• Costs: The variable costs (for materials, labor, etc.) per unit have
been estimated and consolidated as shown here:
Year 1 Year 2 Year 3 Year 4
Variable cost per
Racket
S$ 200 S$ 200 S$ 250 S$ 260
•Depreciation: The Singapore government will allow Spartan’s subsidiary
to depreciate the cost of the plant and equipment at a maximum rate of
S$ 2 million per year
•Taxes: The Singapore government will impose a 20 percent tax rate on
income. In addition it will impose a 10 percent withholding tax on any
funds remitted by the subsidiary to the parent.

• Remitted Funds: The Singapore government promises no
restrictions on the cash flows to be sent back to the parent firm
•Salvage Value: The Singapore government will pay the parent S$12
million to assume ownership of the subsidiary at the end of 4 years.
• Exchange Rate: The spot exchange rate of the Singapore dollar is
$0.50.
•Required Rate of return: Spartan Inc. requires a 15 percent return
on this project.

Capital Budgeting Analysis
Year 0 Year 1 Year 2 Year 3 Year 4
1. Demand 60,000 60,000 100,000 100,000
2. Price per
unit
S$350 S$350 S$360 S$380
3. Total
Revenue=
(1)*(2)
S$21,000,000 S$21,000,000 S$36,000,00
0
S$38,000,00
0
4.Variable Cost
per unit
S$200 S$200 S$250 S$260
5.Total Variable
cost=(1)*(4)
S$12,000,000 S$12,000,000 S$25,000,00
0
S$26,000,00
0
6.Annual lease
expense
S$1,000,000 S$1,000,000 S$1,000,000 S$1,000,000
7.Other fixed
annual
expense
S$1,000,000 S$1000,000 S$1000,000 S$1,000,000

8.Noncash
expense(depreci
ation)
S$2,000,000 S$2,000,000 S$2,000,000 S$2,000,000
9.Total
expense=(5)+(6)
+(7)+(8)
S$16,000,00
0
S$16,000,00
0
S$29,000,00
0
S$30,000,00
0
10.Before –tax
earnings of
subsidiary=(3)-
(9)
S$5,000,000 S$5,000,000 S$7,000,000 S$8,000,000
11.Host govt.
tax(20%)
S$1,000,000 S$1,000,000 S$1,400,000 S$1,600,000
12.After-tax
earnings of
subsidiary
S$4,000,000 S$4,000,000 S$5,600,000 S$6,400,000

13.Net cash
flow to
subsidiary=(12)
+(8)
S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
14.S$ remitted
bysubsid(100%)
net cashflow
S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
15.Withholding
tax on remitted
funds (10%)
S$6,000,00 S$6,000,00 S$7,600,00 S$8,400,00
16.S$ remitted
after
withholding tax
S$5,400,000 S$5,400,000 S$6,840,000 S$7,560,000
17.Salvage
value
S$12,000,00
0

18. Exchange
rate of S$
$0.50 $0.50 $0.50 $0.50
19.Cash Flow
to parent
$2,700,000 $2,700,000 $3,420,000 $9,780,000
20.PV of
parent cash
flow (15%
discount rate)
$2,347,826 $2,041,588 $2,248,706 $5,591,747
21.Initial
investment by
parent
$10,000,00
0
22.Cumulative
NPV
-$7,652,174 -$5,610,000 -$3,361,880 $2,229,867

n SVn
t k n
CFt NPV IO 1 (1 ) (1 )    
k n

Multinational Capital Budgeting another example
Prasanna Chandra 7th Ed. Chapter- 13
India pharma Limited, an India- based multinational company, is
evaluating an overseas investment proposal. India Pharma’s exports of
pharmaceutical products have increased to such an extent that it is
considering a project to build a plant in the U.S. The project will entail an
initial outlay of $100 million and is expected to generate the following
cash flows over its four year life.
Year Cash Flow (in millions)
1 $ 30
2 $ 40
3 $ 50
4 $ 60
The current spot exchange rate is Rs.45 per U.S. dollar, the risk free rate
in India is 11 percent and the risk free rate in the U.S. is 6 percent- these
rates observed in the financial markets.
India Pharmas required rate of return on a project of this kind is 15
percent. Should India Pharma undertake this project?

NPV approaches
There are mainly two basic ways of calculating NPV. These are:
Home Currency
Approach
• Convert all the dollar cash flows
into rupees(Use the forecasted
exchange rate)
• Calculate the NPV in rupees (use
the rupee discount rate)
Foreign Currency
Approach
• Calculate the NPV in dollars (use
the dollar discount rate)
• Convert the dollar NPV into
rupees (use the spot exchange
rate)

NPV approaches
Home Currency Approach: To apply this approach we have to come up with
the forecasted (or expected) exchange rates. The expected spot exchange
rate at time t is:
t
r




1
e h
t r
f
s s







1
0
Where:
e
t s
0 s
= the expected spot exchange rate at time t
= the current spot exchange rate
hr = the nominal risk free rate in home currency
f r = the nominal risk free rate in foreign currency

NPV approaches
In our example,
0 s = Rs.45, h r = 11 percent f r = 6 percent
Year Forecasted spot exchange rate
1 Rs.  1
45 1.11 = Rs. 47.12
1.06
2 Rs.  2
45 1.11 = Rs. 49.35
1.06
3 Rs.  3
45 1.11 = Rs. 51.67
1.06
4 Rs.  4
45 1.11 = Rs. 54.11
1.06
Using the forecasted spot exchange rates along with current spot rate of
Rs. 45 we can convert dollar cash flows into rupees as shown below:

NPV approaches
Year Cash Flow in Dollar
(millions) (1)
Expected Exchange
Rate (2)
Cash Flow in Rupees
(million)
(1)*(2)
0 -100 Rs. 45.00 -Rs. 4500
1 30 47.12 1413.6
2 40 49.35 1974.0
3 50 51.67 2583.5
4 60 54.11 3246.6

NPV approaches
Given a rupee discount rate of 15 percent, the NPV in rupees is:
NPV = -4500 +
3246 .6
2583 .5
1974 .0
1413 .6
 1.15
1  1.15
2  1.15
3  1.15
4   
= Rs. 1776.8 million
Foreign Currency Approach: To apply foreign currency approach we have to
come up with a risk-adjusted dollar discount rate corresponding to the risk
adjusted rupee discount rate of 15 percent. To do this we have to find the
risk premium implicit in 15 percent:
(1+ Risk-free rupee rate) (1+Risk premium) = (1+ Risk-adjusted rupee rate)
(1+ 0.11) (1+Risk premium) = (1+ 0.15)
Hence


1.11
(1 + Risk premium) = 


1.15
= 1.036

NPV approaches
Applying the above risk premium to the risk free dollar rate of 6 percent, we
find that the risk adjusted dollar rate is:
(1+ Risk adjusted dollar rate) = (1.06) (1.036) = ( 1.0982)
Given the dollar cash flows, the NPV in dollars is:
60
50
40
30
NPV = - 100 +  1.0982
  1.0982
2  1.0982
3  1.0982
4   
= $ 39.484 million
The spot exchange rate is Rs. 45 per dollar, the rupee NPV of the
project is:
NPV = 39.484 * Rs. 45 = Rs. 1776.8 million

Factors to Consider in Multinational
Capital Budgeting
• Exchange rate fluctuations
• Inflation
• Financing arrangement
• Blocked funds
• Uncertain salvage value
• Impact of project on prevailing cash fl ows
• Host government incentives
• Real options

Exchange Rate Fluctuations
• Exchange Rate fluctuates over time and It influences Multinational Capital
Budgeting decisions.
• Despite of difficulty in accurately forecasting exchange rates is well known, a
multinational capital budgeting analysis could at least incorporate other scenarios
for exchange rate movements, such as a pessimistic scenario and an optimistic
scenario.
• From the parent’s point of view, appreciation of the foreign currency would be
favorable since the foreign currency inflows would someday be converted to more
Home currency. Conversely, depreciation would be unfavorable since the weakened
foreign currency would convert to fewer home currency over time.

Analysis Using Different Exchange
Rate Scenarios: Spartan Inc.

Sensitivity of the Project’s NPV to Different Exchange
Rate Scenarios:
Spartan, Inc.

Inflation
• Capital budgeting analysis implicitly considers
inflation.
• Inflations are volatile & affects the capital budgeting
decisions over time.
• It is impossible to accurately forecast inflation when
it is high & volatile.
• Although fluctuations in inflation should affect both
costs and revenues in the same direction, the
magnitude of their changes may be very different in
some area. Such as, Import business.

• The joint impact of inflation and exchange rate
fluctuations on a subsidiary’s net cash flows may
produce a partial offsetting effect
• Such an offsetting effect is not exact or consistent as
inflation is only one of many factors influencing
exchange rates.
• But there is no guarantee that a currency will
depreciate when the local infl ation rate is relatively
high.

Financing Arrangement
• Subsidiary Financing
• Parent Financing
• Other Subsidiaries Financing

Subsidiary Financing
• Domestic capital budgeting problems would not include
debt payments in the measurement of cash flows.
• Foreign projects are more complicated, however, especially
when the foreign subsidiary partially finances the
investment in the foreign project.
• The estimated foreign cash flows that are ultimately
remitted to the parent and are subject to exchange rate
risk.
• A more accurate approach is to separate the investment
made by the subsidiary from the investment made by the
parent
• From the parent’s Perspectives, Capital budgeting focuses
on the comparing the present value of the cash flows
received by the parent to the initial investment by the
parent

Examples of Subsidiary Financing
(Spartans Inc.)
Assume that the subsidiary borrows S$10 million
to purchase the offices that are leased in the
initial example. Assume that the subsidiary will
make interest payments on this loan (of S$1
million) annually and will pay the principal
(S$10 million) at the end of Year 4, when the
project is terminated. Since the Singapore
government permits a maximum of S$2 million
per year in depreciation for this project, the
subsidiary’s depreciation rate will remain
unchanged. Assume the offices are expected to be
sold for S$10 million after taxes at the end of
Year 4 and that money will be used to repay the
loan.

Effects on NPV for the loan loan taken by
subsidiary.

Parent Financing
Consider one more alternative
arrangement, in which, instead of the
subsidiary leasing the offices or purchasing
them with borrowed funds, the parent
uses its own funds to purchase the offices.
Thus, its initial investment is $15 million,
composed of the original $10 million
investment as explained earlier, plus an
additional $5 million to obtain an extra
S$10 million (As $1=S$2) to purchase the
offices.
What will be the effect on NPV if Parents
finances the foreign subsidiary??

Effects on NPV for Parent financing

Financing with other subsidiaries
retained earnings
• Retained earnings of other foreign subsidiaries can be used to
finance some foreign projects.
• These projects are difficult to assess from the parent’s perspective
because their direct effects are normally felt by the subsidiaries
• One approach is to view a subsidiary’s investment in a project as an
opportunity cost.
• The cash flows from the parent’s perspective reflect those cash
flows ultimately received by parent as a result of the foreign project.
• The key cash flows from the parent’s perspective are those that it
ultimately receives from the project.
• International factors that will affect the cash flows (such as
withholding taxes and exchange rate movements) are considered in
this case.

Blocked Funds
• In some cases, the host country may block funds.
• Some countries require that earnings generated
by the subsidiary be reinvested locally for at least
3 years before they can be remitted.
• These also affect the accept/ reject decisions.
• Blocked funds penalize a project if the return on
the reinvested funds is less than the required rate
of return on the project.

Impacts of Blocked funds
• Reconsider the example of Spartan, Inc.,
assuming that all funds are blocked until the
subsidiary is sold. Thus, the subsidiary must
reinvest those funds until that time. Assume
that the subsidiary uses the funds to purchase
marketable securities that are expected to yield
5 percent annually after taxes.
In this situation what will be the NPV of the
project? Is it profitable rather than remittance?

Uncertain Salvage Value
• The salvage value of an MNC’s project typically has a
significant impact on the project’s NPV.
• If the value is uncertain, the MNC may incorporate various
possible outcomes for the salvage value and re-estimate
the NPV based on each possible outcome.
• Break-Even Salvage value is calculated in this situation
• If the actual salvage value is expected to equal or exceed
the break-even salvage value, the project is feasible.
• The break-even salvage value (called SV) is determined by
setting NPV equal to zero and rearranging the capital
budgeting equation, which is shown in the next slide

Formula of Break-even salvage value

From the Equation we learn that, The break-even
salvage value for the project can be
determined by--
(1) Estimating the present value of future cash
flows (excluding the salvage value)
(2) Subtracting the discounted cash flows from
the initial outlay, and
(3) Multiplying the difference times (1+k)^n.

• Reconsider the Spartan, Inc., example and
assume that Spartan is not guaranteed a price
for the project. In this case what will be the
Breakeven salvage value?

Impact of Project on Prevailing Cash
Flows
• The new project has no impact on prevailing cash
flows. In reality, however, there may often be an
impact.
• Reconsider the Spartan, Inc., example, assuming this
time that (1) Spartan currently exports tennis rackets
from its U.S. plant to Singapore; (2) Spartan, Inc., still
considers establishing a subsidiary in Singapore
because it expects production costs to be lower in
Singapore than in the United States; and (3) without a
subsidiary, Spartan’s export business to Singapore is
expected to generate net cash flows of $1 million over
the next 4 years. With a subsidiary, these cash flows
would be forgone.

• Generally when two projects are running in one
region, they compete with each other & that’s
why the existing project’s net cash flows become
lower in this case due to new project.
• Some foreign projects may have a favorable
impact on prevailing cash flows. For example, if a
manufacturer of computer components
establishes a foreign subsidiary to manufacture
computers, the subsidiary might order the
components from the parent. In this case, the
sales volume of the parent would increase.

Host Government Incentives
• Any incentives offered by the host
government must be incorporated into the
capital budgeting analysis.
• For example, a low-rate host government loan
or a reduced tax rate offered to the subsidiary
will enhance periodic cash flows. If the
government subsidizes the initial
establishment of the subsidiary, the MNC’s
initial investment will be reduced.

Real Options
• A real option is an option on specified real assets such
as machinery or a facility.
• Some capital budgeting projects contain real options in
that they may allow opportunities to obtain or
eliminate real assets.
• Since these opportunities can generate cash flows,
they can enhance the value of a project.
• The value of a real option within a project is primarily
influenced by two factors: (1) the probability that the
real option will be exercised and (2) the NPV that will
result from exercising the real option.

Probability Factors for which the real
option is exercised
• The intention to invest.
• The ability to invest.
• Political & Socio-economic conditions.

Adjusting Project Assessment For Risk
Three methods are used to adjust the
evaluation for risk:
• Risk Adjusted Discount Rate
• Sensitivity Analysis
• Simulation

Risk Adjusted Discount Rate
• This method calls for adjusting the discount rate to
reflect the project risk.
• If, Risk of the project = Risk of the existing Investment
of the firm, Then
Discount Rate = Average Cost of Capital of the firm
• If, Risk of the project > Risk of the existing Investment
of the firm; Then
Discount Rate > Average Cost of Capital of the firm
• If , Risk of the project < Risk of the existing Investment
of the firm; Then
Discount Rate < Average Cost of Capital of the firm

• The Risk Adjusted Discount Rate is:
rK = i + n + dk
• Where, rK is risk adjusted discount rate for project k, i is
the risk-free rate of interest, n is the adjustment for
firm’s nominal risk, dk is the adjustment for differential
risks.
• (i+n) measures the cost of capital, dk may be positive or
negative depending on how risk of the project under
consideration compares with the existing risk of the
firm.
• The adjustment of differential risks depends on
management perceptions and attitudes towards risk.

Examples of Risk adjusted discount
Rate
For Example, Real Automobiles Ltd., a multinational company,
Headquartered in Madrid, Spain; wants to Expand their
business in Bangladesh. The expected cash flows of their
Expansion project, involving an investment outlay of €
10000(Euro), are as follows:
Year Expected Cash Flow(Tk.)
1 200000
2 300000
3 400000
4 300000
5 200000

• The Risk free Discount rate for the Project is
6%, nominal risk is 4%, The firm uses the
following risk adjusted discount rate for
various types of investments:
Investment category Risk Adjusted Discount rate
Replacement Investment Cost of Capital
Expansion Investment Cost of Capital + 3%
Investment in related lines Cost of Capital + 5%
Investment in new lines Cost of Capital + 8%

In this case, cost of capital = 6% + 4% =10%
Risk Adjusted Discount Rate = 10% + 3%=13%
Using the risk free rate, cost of capital & risk
adjusted rate The present value of the project
is Calculated in the next 3 slides.

Present Value Using Risk Free rate
300000
400000
300000
200000
     
Taka Euro
 
11,78605.62( ) 10000( )
Euro Euro
 
11,786.06( ) 10000( )
1,786.06( )
10000( )
200000
(1.06)
(1.06)
(1.06)
(1.06)
(1.06)
2 3 4 5
Euro
Euro


Present Value Using adjusting nominal
Risk
300000
400000
300000
200000
     
 
10,59,366.29( ) 10000( )
Euro Euro
 
10,593.66( ) 10000( )
593.66( )
10000( )
200000
(1.10)
(1.10)
(1.10)
(1.10)
(1.10)
2 3 4 5
Euro
Taka Euro
Euro


Present Value Using Differential Risk
Adjusted Discount Rate
300000
400000
300000
200000
     
Taka Euro
 
981702.83( ) 10000( )
Euro Euro
 
9817.0282( ) 10000( )
182.97( )
10000( )
200000
(1.13)
(1.13)
(1.13)
(1.13)
(1.13)
2 3 4 5
Euro
Euro
 

Advantages of this Method
• This Approach is easy to use.
• It is the most commonly used technique.
Disadvantages of this method
• Difficulty to estimate the differential risk rate.
• The method assumes that risks are increased at a
constant rate. This is not correct at all.

Sensitivity Analysis
• Use of What –If Scenario
• The Objective of this analysis is to determine how
sensitive the NPV is to alternative values of input
variables.
• The estimates can also be revised

• Suppose, You are the Financial Manager of
Neuville Software & Business Services, which
is located in Germany. Neuville is considering
to set up a new Buisiness firms in Bangladesh.
Based on previous experience, the project
staff of Nueville has developed some figures
(Assume that the salvage value is zero, the
cost of capital is 12% & 1 Euro = 100 Taka)

• Since the cash flows from operations is an
Annuity, The NPV of the Neuville’s project is:
=-20000000 + (4000000 x PVIFA) (r=12%, n=10)
= -20000000 + 4000000 x 5.65022
= 22,60,089.21 (In Taka)
= 22,600.89 (In Euro)

Advantages of Sensitivity Analysis
• It reassesses the project based on various circumstances that
may occur in the future.
• It shows how robust or vulnerable the project is to changes in
values of the underlying variables.
Disadvantages of Sensitivity analysis
• It merely shows what happens to NPV when there is a change
in some variable, without providing the idea how likely the
change will be.
• It does not consider the change of multiple variables.
• The interpretation of results is subjective.

Simulation Analysis
• Simulation can be used for a variety of tasks
including the generation of probability
distributions for NPV, based on a range of
possible values for one or more input
variables.
• The simulation technique does not provide
emphasis on any particular NPV forecast
rather it provides a distribution of all possible
outcomes.

Steps involved in simulation analysis
(1) Modeling the project.
(2) Specifying the value of parameters & assigning
probability distributions for each variables
(3) Select a value , at random, from the probability
distributions of each variable.
(4) Determining the NPV based on the randomly generated
value.
(5) Repeat steps(3) and (4) a number of times to get a get a
large number of simulated net present values.
(6) Plot The frequency Distributions of NPV.

Example of Simulation
Bayern Foods, A German Based company, is evaluating an
investment project in BD.
They estimated that, The Risk free rate is 10%, initial
investment is €13000 and Exchange Rate is 1€ = 100 Taka.
The Annual Cash flow and project life are stochastic
exogenous variables with the following distributions:

The firm wants to perform 10 manual
simulations runs for this project.
Now calculate What is the Most profitable
project?

Advantages of this Model
(1) This method provides a range of choices to users based on judgmental
input.
Limitations of this Model
(1) Manually , it is a time consumable method.
(2) Inaccuracy of input leads to inaccurate results.
(3) Fluctuations of Exchange rate are barrier in this method.

Country risk
Country risk is the potentially adverse impact of a country’s environment on an MNC’s cash flow.
There are some unrelated events that can occur :
• A terrorist attack
• A major labor strike in an industry
• A political crisis due to a scandal within a country
• Concern about a country’s banking system that may cause a major outflow of
funds
• The imposition of trade restrictions on imports
These events could affect the potential cash flows to be generated by an MNC or the cost of financing
projects and therefore affect the value of the MNC.

Types of country risk
Country risk factors can be categorize mainly
into two parts:
a) political risk factors
b) financial risk factors

Political risk factors
It is political adverse situation that negatively
affect the MNC.
Some common political risk factors are:
o Take over by host country
o Attitude of consumers in the host country
o Actions of host government
o Currency inconvertibility
o Lack of restriction
o War
o Corruption

Takeover by host country
Government can take over subsidiary of an MNC
by:
 Giving no compensation
 Giving some compensation(amount decided by host govt.)

Attitudes of consumer in the host
country
Consumer may have the tendency to use only locally produced
goods and avoid foreign goods
In this situation a joint venture with local company may be more
feasible than export to the country or establish a subsidiary.

Action of host Government
Various actions of host government can affect the cash
flow of MNC. They may be:
o Impose pollution control standard
o Additional corporate tax
o Fund transfer restriction
o Require special permit
o Subsidize competitors
o Use of local employees for the managerial position

Lack of restriction
MNC may be adversely affected by Lack of restriction in the host
country.
Failure by host government to enforce copyright act against local
firm causes loss to MNC, which is caused by Lack of restriction.

Blockage of fund transfer
A host government may impose restriction on
transferring fund to the parent company. It may force
the subsidiary to undertake a project by the fund in the
host country, which is not optimal.

Currency inconvertibility
The earning generated in the host country may not be
converted to the currency of parent company. Then
the parent company may need to exchange it with
goods to extract benefit.

War
Some countries tend to engage in constant conflict with other
countries the safety or experience internal turmoil. This can affect
the safety of employees by an hired MNC.

Corruption
Corruption can adversely affect an MNC’s international
business by increasing cost and reducing revenue.
Corruption can occur:
a) between firms
b) between firm and the government

Financial risk factors
Financial risk factors are poor performance economic and
financial factors that can decrease the cash flow of MNC.
The factors may be:
o GDP growth
o Inflation trends
o Government budget level
o Exchange rate
o Inflation
o Unemployment
o Balance of trade etc.

Indicators of economic growth
Mainly depend on three factors:
• Interest rate
• Exchange rate
• Inflation

Types of country risk assessment
Country risk assessment are mainly two types
 Macro assessment (assessment of country without consideration of MNC’s
business)
 Micro assessment (assessment of country relating to MNC’s type of
business

Techniques to assess country risk
Various techniques may be used. Some widely used
techniques are:
 Checklist approach
 Delphi approach
 Quantitative analysis
 Inspection visit
 Combination of techniques

Measuring country risk
1) Political risk factors 2)Rating assign to
factors (range 1-5)
3)Weight assign to
factors( total 100%)
(4)=(2)*(3) value
of factor
Blockage of fund
transfer
4 30% 1.2
corruption 3 70% 2.1
Total political risk 100% 3.3
Financial risk factors
Interest rate 5 20% 1.0
Inflation rate 4 10% 0.4
Exchange rate 4 20% 0.8
Completion 5 10% 0.5
Industry growth 3 40% 1.2
Total financial risk 100% 3.9

1
Category
2
Rating
3
Weight
(4)=(2)*(3)
Political risk 3.3 80% 2.64
Financial risk 3.9 20% 0.78
100% 3.42

Reducing exposure to host government
takeover
Following are the most common strategy to reduce exposure to a
host government takeover:
 Use a short term horizon
 Rely on unique supplies or technology
 Hire local labor
 Borrow local fund
 Purchase insurance
 Use project finance

Context of FDI in Bangladesh
• Foreign Aid in Health, Food and Construction activities after
independence
• FDI increased after becoming a member of United Nations in
1974
• China, Middle East and few Western Countries were the major
FDI providers up to 1990
• Flow of FDI increased rapidly after the restoration of Democracy
in 1991
• FDI helps in Industrialization, employment creation, poverty
alleviation, export development, GDP growth, etc.
• Garments, Energy, Communication, etc. are lucrative sectors for
FDI

Major Sectors of FDI in Bangladesh
Sectors Average of FY
1996-00
Million USD
Average of FY 2001-
05
Million USD
Average of FY
2006-10
Million USD
Gas 134 218 114
Power 113 193 174
Telecom 17 17 17
FDI in EPZ 58 123 199
Other FDI 150 205 241
Total FDI inflow 472 757 744
(In Million USD)

FDI in EPZs
Yearly Investment in EPZ’s (Million USD)
YEAR (July- June) INVESTMENT ( Million USD )
2001-02 48.41
2002-03 55.61
2003-04 102.63
2004-05 115.04
2005-06 118.52
2006-07 112.89
2007-08 152.37
2008-09 302.19
2009-10 148.03
2010-11 221.99
2011-12 101.61
Total 1,479.29

FDI and Local Investment
Year Proposed local
Investment
Proposed foreign
Investment
Total Proposed
Investment
Project US$
(million)
Project US$
(million)
Project US$
(million)
2008-2009 1,754 2,662.31 135 3,621.15 1,889 6,283
2009-2010 1,930 2,848.98 191 1,728.26 2,121 4,577
2010-2011 1,336 2,480.72 132 2,137.53 1,468 4,618
2011-2012 876 1,831.44 92 617.68 968 2,449
Total 7,511 12,657 693 8,892 8,204 21,549

Major FDI providers in Bangladesh (Up to 2010)
Country Investment
USD Million
Percentage
(%)
Employment Opportunities
(person)
China 55.622 0.79% 7071
Hong Kong 45.121 0.64% 11147
India 93.803 1.34% 7982
Japan 19.517 0.28% 3397
KSA 1850.406 26.39% 2154
Malaysia 162.006 2.31% 833
South Korea 123.708 1.76% 46089
The Netherlands 351.197 5.01% 595
United Arab
Emirates
2229.898 31.80% 6513
United Kingdom 952.035 13.58% 26194
USA 735.376 10.49% 3881

FDI in South Asia
FDI in South Asia ( in Million USD )
Country 2008 2009 2010 2011
Afghanistan 238 243 300 185
Bangladesh 793 666 1036 716
Bhutan 6 73 30 36
India 20,328 25,001 40,418 34,613
Maldives 14 15 12 10
Nepal 7 6 1 39
Pakistan 4,273 5,590 5,438 2,387
Sri Lanka 480 603 752 404
South Asia 27,771 33,868 49,659 41,406
Source: World Investment Report (WIR), 2012.

FDI Projects in Bangladesh
FDI Projects in Bangladesh in 2010-11
Source - Board Of Investment ( BOI ), 2011
Projects Investment In USD
Million
Employment opportunities (person)
Agro Based 154.29 24,434
Chemical 1,985.94 6,147
Engineering 38.96 4,388
Food & Allied 19.11 1,662
Glass &Ceramic 8.19 328
Painting & Packaging 2.27 325
Tannery & Rubber product 4.01 602
Textile 221.26 84,578
service 4,575.90 18,758
Miscellaneous 2.83 735
TOTAL 7,012.77 141,957

Major Incentives for FDI in
Bangladesh
• Tax holiday of 5 – 10 years for power generating companies
• Concessionary duty and VAT on capital machinery and spares
• Rationalization of import duties and taxes
• Six month multiple visa for prospective investors
• Citizenship by investing USD 500,000 or transferring USD 1,000,000
• Permanent Resident status by investing USD 75,000
• Avoidance of double taxation with certain countries
• Facilities for repatriation of capital, profit, royalty, technical fee etc.
• Tax exemption on Royalty, Technical know-how and Expatriates’
Salary

Problems of FDI in Bangladesh
1. Absence of appropriate Infrastructural Facilities
2. Lack of Safety
3. Global Economic Downturn
4. Internal Political Issues
5. Global Political Factor
6. Scarcity of Skilled Manpower
7. Absence of Proper Policies by the Govt.
8. Global Competition

Direct foreign investment

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (20)

Similar to Direct foreign investment

Similar to Direct foreign investment (20)

Recently uploaded

Recently uploaded (20)

Direct foreign investment