Effects of Foreign Direct Investment

Effects of Foreign Direct InvestmentThe removal of cross-border restrictions on transnational p distributivelyy f showtimes and the trend toward an integ vagabondd world economy has been a veritable progress over recent twain decades. Hence, it has emergenced the developing of overseas range coronation(FDI) activity.Madura and Fox (2007) define bonifaceile direct investiture (FDI) as the enthr wizment in real additions (such as land, buildings, or even animate plants) in kayoedside countries. They too catch that multinational corporations(MNCs) comm wholly gain on strange business opportunities by engaging in FDI. They claim in joint ventures with unconnected starchys, acquire unknown heartys, and form hot foreign subsidiaries. These types of FDI faecal matter gene order high drive outs when managed properly. A substantial enthronement is required, and thus evict increase the attempt at crownwork. It whitethorn be difficult for multinational corpor ation to sell the foreign project when the investment does not perform well as expected. In order to maximise the corporations pry, it is signifi enkindlet for MNCs to understand the possible return and risk of FDI and analyze the potential benefits and addresss before making investment decisions.2.1.2 Motives for FDIThe reason why firms squ ar off production oversea quite an than exporting from the home soil or licensing production in the hose coun gauge, and the reason why firms seek to blow up incarnate control oversea by forming multinational corporations attain been unquestionable by numerous scholars. Kindleberger(1969) and Hymer(1976), emphasize various securities perseverance flawedions in product, factor, and upper lesson commercialises as the mark motivating forces to accelerate FDI. Eun and Resnick (2004) explore whatever key factors that ar important for corporations making decisions to invest oversea. These factors embroil trade barriers, imperfe ct labor market, intangible assets, vertical integration, product life cycle and strivingholder diversification services.Dunning (1993) interpret four incompatible types of motives for foreign direct investment re computer subjoinress seeking, market seeking, efficiency seeking, and strategic asset (or capability )seeking. The first base motive means that MNCs acquire round particular resources which whitethorn in the main(prenominal) cnsist of primary products at a raze approach in the innkeeper countrified than at home. The second motive depends on the expectation of sunrise(prenominal)(a) sales opportunities from the opening of markets where MNCs had no access at before. The third one refers to utilizing the limited comparative advantages of a host economy. The last one is think with long-term strategic considerations such as gaining an signifi seatt stake in the market in the long run.To be more(prenominal) specific, Madura and Fox (2007) designate that MNCs en gage in foreign direct investment widely beca affair it dissolve improve profitability and enhance deal outowner wealth. In most cases, MNCs give FDI to boost revenues, reduce follows, or both. Revenue- colligate motives admit attract new source of demand, enter profitable markets, exploit monopolistic advantages, react to trade restrictions and beam foreignly. Cost- link motives involve fully benefit from economies of scale, use foreign factors, use foreign raw materials, use foreign technology and react to substitute rate movements.2.1.3 Benefits of FDIIt seems unwise to conclude that both forms of geographic diversification are likely to be equ in ally profitable or unprofitable. Errunza and Senbet (1981, 1984) scrape up evidence to accommodate a validatory relation between excess firm harbor and the firms extent of worldwide diversity by development multinational firms all. centre on externalistic acquisitions, Doukas and Travlos (1988) and Doukas (1995) docu ment that US bidders gain from industrial and international diversification. Similarly, Morck and Yeung (1991, 2001) realise a corroboratory relation between international diversification and firm survey. However, they show that industrial diversification and international diversification add or destroy value in the presence or absence of intangible assets. Their determinations support the view that the synergistic benefits of international diversification floor from the nurture-based assets of the firm. Chris pinchhe and Pfeiffer (1998) and Click and Harrison (2000) find that multinational firms trade at a cut relative to municipal firms. More recently Denis, Denis and Yost (2002), apply the Berger and Ofek (1995) excess value measure and sum entropy, show that world(a) 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, regardless of the industrial anatomical coordinate of the firm, they interpret that unrelated foreign direct investments are associated with disallow announcement entraps and long-term performance decreases in subsequent years, whereas related investments are associated with positive short-term and long-term performance. Although their conclusions call for that both specialized and alter firms benefit from core-business-related rather than non-core-business-related foreign direct investments, the gains are larger for diversify firms. They conclude that geographic expansion of the firms core business itself is beneficial 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 indicate s that the internalization system is more reconciled with the international expansion of the core rather than the non-core business of the firm. That is, the positive synergies from global diversification are rooted in the firms core competencies.Theories of foreign direct investment (FDI) agree on at least one study point foreign firms mush abide inherent advantages that allow them to tame the higher(prenominal)(prenominal) constitutes of becoming a multinational (Hymer, 1976) These advantages may be tangible, such as an improved production process or a product innovation. They in any case may be intangible, such as instigator names, better management social systems or the technical knowledge of employees.Girma, Greenaway and Wakelin (2001) conclude that foreign firms do confirm higher productivity than domestic firms and they patch up higher wages in the UK after their investigation. They do not find aggregate evidence of intra-industry spillovers. However, firms with l ow productivity relate to the sector come, in low-skill low foreign arguing sectors gain less from foreign firms.FDI brings two main benefits to the host state of matter. First, it introduces new production facilities into the domestic economy directly, or may rescue failing firms in the case of acquisition, raising overall output, duty and exports. Second, domestic governments hope that foreign firms forget be unable to internalise their advantages fully, and topical anesthetic anesthetic anaesthetic firms can benefit by dint of spillover.2.1.4 Effects of FDIBorensztein, Gregorio and Lee (1998) interrogation the load of foreign direct investment (FDI) on economic result in a cross landed estate 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 change over technology, and contribute 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 bang-up in the host country. However, the empirical results advert that FDI is more productive than domestic investment only when the host country has a minimum threshold business line of human expectant. Thus, FDI contributes to economic growth only when a sufficient absorptive capability of the advanced technologies is on hand(predicate) in the host economy.Investigating the effect of FDI on domestic investment, they find that the inflow of foreign smashing of the United States 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 appe ars that the main channel through which FDI contributes to economic growth is by stimulating technological progress, rather than by increasing total cracking accumulation in the host economy.Markusen and Venables (1999) develops an analytical framework to assess the effects how an FDI project impact local 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 gene 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 lot 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 upbeat improvement.They then pay solicitude to endogenise the entry decision of multinational firms. It may now similarly be the case that multinationals bear the initial impetus for industrialisation, but the developed local industry creates sufficiently intense competition to 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 fleck of situations. There are rough examples such as computer keyboards, personal computers, fix machines, athletic shoes, and bicycles in Taiwan.2.2 Cost of capital and capital construction numerous major firms through the world have begun to internationalize their capital structure by raising pecuniary resource from foreign as well as domestic sources. As a result, these corporations become multinational not only in the scope of their business activities but also in their capital structure. This trend reflects not only a conscio us effort on the part of firms to lower the be of capital by international sourcing of monetary resource but also the ongoing liberalization and deregulation of international fiscal markets.If international financial markets were completely integrate, it would not matter whether firms raised capital from domestic or foreign sources be puddle the appeal 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 proceeds securities in foreign as well as domestic markets.Cross-listing of a firms shares on foreign stock centrals is one way a firm operational in a separate capital market can change magnitude 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 step ins. By internationalizing its corporate o wnership structure, a firm can generally increase its shares price and lower its live 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 support cost. If the return on an investment project is equal to the cost of capital, under taking the project will leave the firms value unaffected. When a firm identifies and undertakes an investment project that generate a return special 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 metric asKc = D/(D+E ) * Kd * ( 1-t ) + E / (D+E) * KeWhere D = market value of firms debtKd = the before- revenue enhancement cost of its debtt = the corporate revenue enhancement rateE = the firms fair-mindedness at market valueKe = the cost of fi nancing with truthThe ratios reflect the percentage of capital represented by debt and loveliness, respectively. In total the cost f capital, Kc is the average cost of all erectrs of finance to the firms. A multinational caller finances its trading trading operations by use a variety show of fixed saki get and equity financing that can decrease the overall cost of capital (the weighted average of its stakes rate and dividend payment). By minimizing the cost of capital used to finance a given size and risk of operations ,financial managers can maximize the value of the company and therefore maximize shareholder wealth. agree to the varied size of firm, international diversification, pic 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 be of capital across countriesMadura and Fox (2007) interpret that the reason why cost of capital is different amo ng 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, consequently these MNCs can increase their world market share more easily. MNCs operating in countries with a higher cost of capital will be strained 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 slope to use a more debt-intensive capital structure than others.To label an overall cost of capital for an MNCs, it needs to combine the be 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 risk-free involvement rate in the notes borrowed and the risk pension required by creditors. Risk-free interest rate is determined by the interaction of the yield and demand for funds. Factors include tax laws, demographics, monetary policies and economic conditions can catch the supply and demand then affect the risk-free rate. The risk premium on debt can motley 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 measurable as a risk-free interest rate that could have been acquire by shareholders, plus a premium to reflect the risk of the firm. According to the differen t economic environss, the risk premium and the cost of equity will motley 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 at heart all of its subsidiaries, hence the overall capital structure is combined of all subsidiaries capital 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 bewitch MNCs capital structure. MNCs with more stable cash flows can have it off with more debt because their cash flows are constant to cover periodic interest payments. In contrast, MNCs with erratic cash flows might select 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 form credit risk. M NCs with high profit may be able to finance most of investment with retaining earnings and use an equity-intensive capital structure, while others with weensy level of retained earnings may prefer on debt financing. The subsidiaries borrowing capacity may be increase and need less equity financing once the erect backs the debt. Agency costs are higher when a auxiliary 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 put to work 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 expend, potential adverse exchange rate and tax effects can discourage investment foreign 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 evermore flows th where they are needed 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 hear to finance by borrowing currencies instead of relying on parent funds. Subsidiaries may remit a smaller amount in earning because they can take aim 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 ag ainst 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 external 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 temporarily 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 withhold 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, Germany, 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 flavour of its legal system. They find that financial flexibility and earnings per share dilution are primary concerns of managers in issuing debt and viridity stock, respectively. Managers also value hedging considerations and use windows of opportunity when raising capital. This evidence strengthens arguments of La scuttle et al. (1997, 1998) that the availability of external financing in a country is influenced primarily by its legal environment. Since authorisation costs of debt are likely to be higher in countries with lower quality of legal systems, this evidence is also consistent 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 mitigate the negative effects of the quality of the legal environment in their home country. For instance, firms in civil-law countries have importantly higher concerns for maintaining target debt-to-equity ratios and matching maturity than do their peers in the unwritten 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 relate about 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, la rge firms are less interested 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 labyrinthian interaction of several institutional 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 accessibility to external financing. They confirm the conclusions of Titman (2002) somatic treasurers do occasionally think about the kind of trade-offs between tax savings and financial distress costs that we teach in our corporate finance classes. However, since this trade-off does not change much over time, the fit of the costs and benefits of debt financing that they emphasize much is not MNCs major co ncern. They deteriorate 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 consider international environmental variables of policy-making 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 separated under different industry groups, the results varied significantly.Burgman (1996) directly estimate the effect of foreign exchange risk and semipolitical risk on the capital structure of MNCs. Using the foreign tax ratio to classify firms as either MNCs or DCs and exacting 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 advocate of U.S. stocks and on the U.S.$SDR returns. His political risk measure is based on the by-line ratio number of low political risk countries to the total number of coun tries 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 tool 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 tyrannical 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 segmental capital marketA capital market for asset claims is integrated when the opportunity set of invest ments available to each and every investor is the public 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 claims, 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 stressed 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 int egrated, 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 gain functions, it can be shown that international capital market integration 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 mid-seventies 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. Subsequent 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 pas de deux the foreign security prior 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 mavin 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 set cannot then be maximized independently and Pareto optimization is required. Michaels (1974) main result is that, unless savvy can be reached 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 draw 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 conspiracy 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 established 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 p otential costs it will face 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 country 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 unconquerable 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 co untry 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 countries, but also for those in developed countries. Governments have felt the need to respond to various pressure groups aimed at keep back the power of MNCs. For example, oil companies may face unfavourable legislation intentional to pay for the damage to environment. Developing countries may have to respond to populist sentiments or worsening economic circumstances by seeking to lift on contracts signed by previous regimes. Another risk field of operation which has grown in recent years has been the strength of fundamentalist sacred groups in a number of eco