International Investment

Decisions and Working

Capital Management

UNIT 15 FOREIGN DIRECT INVESTMENT

Objectives
After going through this unit, you should be able to:

understand the recent trends in global FDI;

familiarize with the factors that motivate direct foreign investment in a country;

appreciate the decisions required to be taken subsequent to FDI;

explain Host Government view of FDI; and

discuss taxation issues relating to FDI.

Structure
15.1

Introduction

15.2

Global Trends in FDI

15.3

Factors Motivating FDI

15.4

FDI and some Subsequent Decisions

15.5

FDI and Host Government View

15.6

FDI and Taxation Issues

15.7

Summary

15.8

Self Assessment Questions

15.9

Further Readings/References

15.1 INTRODUCTION
In imperfect market conditions, multinational corporations (MNCs) taking advantage
of their supremacy over the rivals in terms of cost, quality, speed and flexibility
vigorously endeavour to expand their operations in different potential countries and
for that matter adopt entry strategies based on SWOT analysis and choose a particular
mode of entry. Foreign direct investment (FDI), which involves building productive
capacity directly in a foreign country, is one of the most important modes of entry
into foreign markets. MNCs conduct FDI through joint ventures with foreign firms,
cross-border mergers and acquisitions, and formation of new foreign subsidiaries.
In foreign direct investment, the parent company builds productive capacity in a
foreign country. In a cross-border acquisition, a domestic parent acquires the use of
an asset in a foreign company. A company can acquire productive capacity in a
foreign country in one of the two ways, viz; cross-border acquisition of assets and
cross-border acquisition of stock.
Cross-border acquisition of assets is the most straightforward method of acquiring
productive capacity because only the asset is acquired without the transfer of
liabilities to the purchaser. As against this, in a cross-border acquisition of stock, an
MNC buys an equity share in a foreign company. In a cross-border merger, two firms
pool their assets and liabilities to form a new organization.

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FDI as a mode of foreign market entry provides a permanent foothold in the foreign
market and can generate high returns when managed properly. However, FDI
requires a substantial investment which entails additional risks, such as foreign

exchange risk, political risk and cultural risk that do not exist in case of domestic
investment. These additional risks may or may not be offset by higher expected
earnings. Given this risk and return complexion of FDI, MNCs obviously tend to
analyze carefully the potential benefits and costs before deciding about the kind of
FDI. Table 15.1(a) & (b) gives an overview of FDI flows by region and selected
countries for the period 1993 to 2004.

Foreign Direct Investment

15.2 GLOBAL TRENDS IN I

There has been phenomenal growth in FDI in the world following the pursuance of
the policy of liberalization and globalization across different countries. FDI by
MNCs has now come to be recognized as a powerful means of linking national
economies and defining the character of the emerging global economy. Many MNCs
like Sony, Toyota, Royal Dutch Shell, IBM, GM, Coca-Cola, McDonald's, DaimlerBenz, and Nestle have established their presence worldwide through FDI. These
MNCs have invested burgeoning resources both tangible and intangible in different
parts of the world in their strive to take maximum mileage of their competitive
superiority.
Activity I
a) What are the various implications of cross border acquisition?
.........................................................................................................................................
.........................................................................................................................................
.........................................................................................................................................
.........................................................................................................................................
.........................................................................................................................................
b) List out three recent cross border acquisitions by Indian MNCs each in
Pharmaceutical, Petrochemicals and Aluminium.
i) Pharmaceutical
1
2. ...
3. ...

ii)

Petrochemical
..
..
...

iii) Aluminium

....

It is interesting to note that Japan, Italy, Switzerland and Australia could not attract
larger FDI inflows as compared to Spain particularly due to higher operational costs.
On account of a strong increase in foreign direct investment(FDI) flows to
developing countries, 2004 saw a slight rebound in global FDI after three years of
declining flows. At $648 billion, world FDI inflows were 2% higher in 2004 than in
2003. Inflows to developing countries surged by 40% to $233 billion, but developed
countries as a group experienced a 14% drop in their inward FDI. As a result, the
share of developing countries in world FDI inflows was 36%, the highest level since
1997. The United States retained its position as the number one recipient of FDI,
followed by the United Kingdom and China.
Some of the factors which can explain the growth of FDI in developing countries are
as follows:
1. Intense competitive pressure in domestic economy.
2. Rationalizing of production activities so as to reap economies of scale and lower
overall production costs.

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International Investment
Decisions and Working
Capital Management

30

Foreign Direct Investment

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International Investment
Decisions and Working
Capital Management

3. Higher commodity prices have stimulated FDI flows to countries rich in natural
resources such as oil and minerals.
4. Increased mergers and amalgamation activities at global level has also acted as
stimulant for FDI flows.
FDI outflows increased in 2004 by 18% to $730 billion, with firms based in
developed countries accounting for the bulk ($637 billion). In fact almost half of all
outward FDI originated from three sources: the United States, the United Kingdom
and Luxembourg. Developed countries as a group remained significant net capital
exporters through FDI; net outflows exceeded net inflows by $260 billion. While FDI
outflows from the European Union (Ell) declined by 25%, to $280 billion (a sevenyear low), most other developed countries increased their investment abroad. In the
case of the United States, outflows increased by over 90% to $229 billion, a record
high.
Countries continue to adopt new laws and regulations with a view to making their
investment environments more investor friendly. Out of 271 such changes pertaining
to FDI introduced in 2004, 235 involved steps to open up new areas to FDI along
with new promotional measures (table 15.2). In addition, more than 20 countries
lowered their corporate income taxes in their bid to attract more FDI. In Latin
America and Africa, however, a number of policy changes tended to make
regulations less favourable to foreign investment, especially in the area of natural
resources.
At the international level, the number of bilateral investment treaties (BITs) and
double taxation treaties (DTTs) reached 2,392 and 2,559 respectively in 2004, with
developing countries concluding more such treaties with other developing countries.
More international investment agreements were also concluded at the regional and
global level, potentially contributing to greater openness towards FDI. The various
international agreements are generally becoming more and more sophisticated and
complex in content, and investment-related provisions are increasingly introduced
into agreements encompassing a broader range of issues.
Foreign investors have been showing keen interest in India in recent years because of
low risk due to political and economic stability of the country and robust economic
growth as also due to favourable policy measures. According to a corporate study,
India has been found less risky than China as a business destination. India has been
ranked 10th out of 100 countries in the latest country risk analysis by Economic
Intelligence Unit. As a result, FDI flows to India, which has reached $ 5 billion in
2003 from $3.8 billion in 1999, is expected to go up to $ 13 billion in 2008.

15.3 FACTORS MOTIVATING FDI

In view of their superior competitive advantages over local firms in terms of
economies of scale, production differentiation, managerial and technological acumen,
speed of services, flexibility and financial strengths, MNCs extend their areas of
operations beyond domestic boundary so as to take advantage of existing
imperfections in national markets for products, factors of production and capital
markets and thereby improve profitability and enhance shareholders' value. Initially,
MNCs are motivated by strategic consideration of extending corporate control
overseas and preempting their competitors or gaining advantage over them in search
for markets, raw materials sources, or technological know how, but the ultimate
objective must be the accomplishment of favourable financial results sometime
during the life cycle of the investment.

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c)

List out three Indian Companies having gone abroad for vertical investment.

i)

Foreign Direct Investment

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International Investment
Decisions and Working
Capital Management

ii) ................................................................................................................................
iii) ................................................................................................................................
d) List out three Indian Companies having gone abroad for horizontal investment.
i)

................................................................................................................................

ii) ............
iii)
e) List out four Indian Companies having setup their manufacturing un its recently
in China.
i)

..................................................................................................................................

ii) ..
iii) ..
According to Ahorani, the foreign investment decision is typically a response to a
specific opportunity arising from stimulating forces inside or outside the firm, rather
than a systematic search for profitable investment opportunities abroad. The external
stimulus may originate with the host country, the MNC's clients, or distributors of its
products. Irrespective of whether the stimulus originates within the firm or from
outside, strategic motivations, such as the fear of losing a market, the "bandwagon
effect", or strong competition from abroad in the home market, would impel the firm
to seriously consider the opportunity. In addition, there are other strategic factors that
act as stimulating force for overseas investment. Thus, key factors that spur foreign
investment are discussed below:
Product and Market imperfections: MNCs possessing specific intangible capital in
the form of trade marks, patents, general marketing skills, and other organizational
abilities may be inspired to make overseas investment through new product
development and adaptation, quality control, advertising, distribution, after sales
service and the general ability to read changing market requirements and translate
them into saleable products and take advantage of market imperfections.
At times, MNCs prefer FDI to other modes of entry into overseas markets for
protecting misuse of their intangible assets by local firms. Coca-Cola chose FDI as a
mode of entry into foreign markets, and set up bottling plants instead of licensing
local firms mainly to protect the formula for its famed soft drink. If the company
licenses a local firm to produce coke, it has no guarantee that the secrets of the
formula will be maintained.
It must, however, be remembered that mere existence of market failure is not
sufficient to justify FDI, for the fact that local firms have an inherent cost advantage
over foreign investors and MNCs can succeed abroad only if the production or
marketing edge that they possess cannot be purchased or initiated by local firms.
They have to create and preserve on enduring basis effective barriers to direct
competition in product and factor markets.
Market Opportunities: Existence of tremendous market opportunities abroad and
fiercely competitive domestic market limiting the growth in demand and the
consequent decline in market share may stimulate MNCs to enter into high-potential
overseas markets. For instance, many of the developing countries, viz; Argentina,
China, Mexico, Chile and Hungary have, of late, been able to attract FDI flows
because of existence of attractive markets.

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Trade Barriers: Because of government created restrictions in the form of tariffs,

quotas, etc. on imports and exports hindering the free flow of the products across
national boundaries, a firm may decide to set up production plants in such countries
as means of circumventing the trade barriers. Honda, for example, set up plant in
Ohio

to produce cars to escape from the US Government tariff control. The recent spurt in
FDI in Mexico and Spain can be partly attributed to the desire of MNCs to
circumvent external wade barriers imposed by NAFTA and the European Union.

Foreign Direct Investment

Existence of Superior Profits in Overseas Markets: Possibility of making superior

earnings in certain overseas market may also allure the MNCs to divert their funds in
these markets, However, MNCs are likely to face competitive challenge from the
local firms who may prevent a new competitor from taking their business by
lowering their prices.
Imperfect Labour Market: The labour market is the most imperfect among all the
factors of production, and labour costs vary widely in different countries. Wage costs
in Mexico, Malaysia and India are relatively much lower. Substantially lower labour
costs in these countries have attracted MNCs like Black & Decker Corporator,
Eastman Kodak Co., Ford Motor Co., General Electric Co, Smith Corona, Zenith
Corp. and Honeywell to invest.
Access to Inputs: Due to transport costs, MNCs generally avoid importing raw
materials from a country where it is not available at a stable price, especially when
they plan to sell the finished product to consumers of that very country. Under the
circumstances, it would be pertinent to set up production plants in the country where
the raw materials are easily available in abundance. Many MNCs involved in
extractive/natural resources tend to directly own oil fields, mine deposits and forests
for these reasons.
Access to Foreign Technology: MNCs are growingly setting up manufacturing
plants or acquiring existing plants in those countries just to learn about the advanced
technology and use them to improve their own production process at their subsidiary
plants around be globe.
Capitalizing on Monopolistic status: According to Industrial Organizations Theory,
many firms having unique resources and skills not possessed by competing firms
tend to internationalize their operations to exploit the benefits of these unique
competencies particularly when they find that they had already exploited this
advantage successfully in local markets.
Product Life Cycle: Product life cycle theory of Raymond Vernon suggests that
firms undertake FDI at a particular stage in the life cycle of a new product introduced
to the market. According to Vernon, when US firms -first launched new products,
they decided to restrict production facilities to home market. Being the pioneer of
product, they can charge relatively high price in the initial stage because of
consumers insensitivity to the price at this stage. They have the opportunity to
improve the product keeping in view the changing needs of customers.
After the product is perfected and standardized to benefit from economies in
production and distribution, output would begin to exceed the home market
requirements. In the meanwhile, demand for the new product develops in foreign
countries, the pioneering firms decide to export the excess product to those countries.
With continued growth in product demand in overseas countries, US firms may be
tempted to set up production plants in those countries to cater to local markets.
As the product reaches maturity and the market is eventually flooded with similar
products leading to decline in profit margins, it becomes imperative for the firms to
cut cost to remain competitive. This may induce the firms to search for locations
overseas where imperfections in the factor market result in lower product cost. Thus,
FDI becomes useful RY MNCs when the product reaches maturity and cost becomes
predominant consideration.

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International Investment
Decisions and Working
Capital Management

It may, however, be noted that Vernon Theory developed in the last century when the
US was the unchallenged leader in R&D capabilities and product innovations, cannot
be the only basis for justifying FDI in foreign countries in view of growing
complexity in the behaviour and strategies of MNCs on the one hand and increasing
product innovations in many advanced countries and increasing complexity in
international system of production on the other. In the changed environment, firms
may set up production plants in a number of countries right from the introduction of
new product.
Behaviour of Foreign Exchange Rate: FDI decisions of MNCs are also influenced
by exchange rate movements because cost is one of the key determinants. Firms may
be tempted to invest in a country whose currency is perceived by a firm to be
undervalued as the initial investment outlay would be low.
At times, FDI is driven by the firm's desire to offset the changing demand for its
exports owing to exchange rate fluctuations.
Financial Market Imperfections: Existence of financial market imperfections
across the globe may provide impetus to MNCs to undertake FDI. Alongside their
capability to reduce taxes and circumvent currency controls, MNCs' desire to reduce
risks of exchange rate changes, currency controls, expropriation and other forms of
government intervention through international diversification may be the driving
force for FDI. The diversification effect stemming out of operation in a number of
countries having imperfect economic cycles and diverse economic and financial
conditions tends to reduce the volatility of MNCs' earnings. In addition, the firm may
enjoy a lower cost of capital as shareholders and creditors perceive the MNCs' risk to
be lower as a result of more stable cash flows.
Inefficient Financial System: At times, inefficiency in the system of allocation of
financial resources of a country resulting in the wide gap between demand for and
supply of funds to viable organizations can attract FDI to fill this gap. For example,
China got so much FDI essentially because the domestic financial system allocated
domestic savings very inefficiently in the sense that most of the money goes to the
inefficient firms like state-owned enterprises and more efficient firms, which may in
private sector remain deprived of desired funds. It is FDI which plays a crucial role in
as much as it provides financial support to private entrepreneurs who could not get
financing from the formal financial system.

15.4 FDI AND SOME SUBSEQUENT DECISIONS

So as to ensure sustainable competitive superiority to their rivals and continue to
make maximum mileage of opportunities in foreign markets, MNCs are supposed to
make periodic decisions particularly with regard to the following:
1. Whether further expansion should take place in a given location;
2. Whether to have the earnings generated by the project remitted to the parent
company or used by the subsidiary;
3. How barriers to entry can be maintained in the foreign country where MNC's
project is in operation?

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One of the most crucial decisions to be taken by MNCs subsequent to FDI is how to
maintain their competitive edge in the current foreign market. The MNCs might have
created in the initial years barriers to entry by continuously introducing new products
and differentiating existing ones. But over a period of time, technological leads have
tendency to erode. It would, therefore, be pertinent for the MNCs to employ other
factors to replace technology as a barrier to entry. One such variable could be the
presence of economies of scale. The existence of economies of scale signifies that
there are inherent cost advantages of being large. The more significant these

economies of scale are, the greater will be the cost disadvantage faced by a new
entrant to the market.

Foreign Direct Investment

Some MNCs such as Coca-Cola, McDonald's, Nestle and Procter & Gamble are
taking advantage of high advertising expenditures and highly developed marketing
skills to differentiate their products and keep out potential competitors who are
reluctant to incur high marketing costs of new product introduction. By so doing such
firms can exploit the premium associated with their strong brand names.
When it is found that the competitive advantages in their product lines or markets
become dissipated, it is worthwhile for the firm to enter new markets where little
competition currently exists. For example, Crown Cork and Seal, the Philadelphiabased maker of bottle top and cans, reacted to showing growth and heightened
competition in its US business by expanding overseas and set up subsidiaries in other
countries like Thailand, Malaysia, Zambia, Peru and Ecuador.
Firms can also explore the possibility of setting up subsidiaries in lower-cost
production sites because in that case costs can then be minimized by combining
production shifts with rationalization and integration of the firm's manufacturing
facilities worldwide.
Another device for successful survival could be to drop old products and turn
corporate skills to new products. Those failing to transfer their original competitive
advantages to new products or industries are left with no option but to divest their
foreign operations and return home.
As regards the utilization of the earnings generated by the foreign project, the firm
should allow its subsidiary to retain a portion of funds if that would be of more value
than the parent's use. Of course, certain proportion of the earnings will be required to
support the operations of the subsidiary but the rest of the funds could be remitted
back to the parent, sent to another subsidiary or reinvested for expansion purpose.

15.5 FDI AND HOST GOVERNMENT VIEW

Extent of FDI in a particular country is dependent upon a host of factors such as the
country's markets and resources as well as government regulations and fiscal and
financial incentives. Countries like Singapore and Hong Kong and more recently
China could attract burgeoning amount of FDI mainly because of liberal policy and a
few business restrictions. Our country has, of late, attracted huge funds from FDI to
the extent of $5335 million during 2003-04 because of the adoption of the policy of
globalization and economic liberalization permitting foreign investors to hold 49
percent ownership share in the infrastructural sectors including banks and telecom
sectors with government assurance to raise the ceiling to 74 percent. Some countries
offer various types of fiscal and financial concessions to attract foreign investments.
Mexico recently reduced its restrictions on automobiles produced there. It has
recently announced that it would allow foreign companies to own 100 percent of their
subsidiaries established in Mexico. In a refreshing contrast, Japan could not attract
much investment because of major entry barriers.
FDI as a means of accelerated economic growth should be assessed in terms of its
potential gains and disadvantages for the country. Some type of FDI may be more
attractive to some countries than others. Obviously, FDI will be most welcome in a
country if it solves its problem of unemployment and provides technology support
without taking business away from local firms. Further, FDI involving establishment
of a manufacturing plant which uses local labour and then export the products not
done by local firms would also be appreciated by the host country.

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International Investment
Decisions and Working
Capital Management

Host government, while evaluating a FDI proposal, should assess its potential
advantages and disadvantage to the economy. Where the potential gains are expected
to be greater than the potential disadvantages , every attempt should be made to
provide additional concessions such as tax holiday , rent free land & buildings ,
lower interest loans , subsidized energy and reduced environment restrictions so as to
attract foreign investors , the amount of the fiscal and financial incentives which a
government provides depends to a great extent , on the extent to which the FDI
brought by the MNCs would benefit that country . Table 15.1 gives a brief overview
of the FDI investment over the years , and the contribution of FDI in gross fixed
capital formation.

15.6 FDI AND TAXATION ISSUES

Taxation is a crucial issue that impacts cross border investments.In the absence of
other factors, the objective of multinational tax management is to minimize taxes and
maximize after tax cash flows. Hence, implications of taxation on overseas
investment should be considered in detail. In view of varying tax provision existing
in different countries , it is not possible to cover every aspect of corporate tax in
every country .However , there are certain common themes which do recur in the
domain of international taxation and it is upon these that we focus
Taxes on investment are imposed on three types of financial events , viz ; capital
gains realizations , dividend and interest income distributions and financial
transactions.
Withholding Taxes: Countries often impose a withholding tax paid on income and
dividends paid in their currency and within their borders. Thus, withholding taxes are
collected from foreign individuals and/or corporations on income they have received
from within a country. If a UK resident earns dividends in Canada, taxes will be
withheld and paid to the Canadian revenue authorities. Credit is generally received at
home for taxes withheld overseas. So the level of withholding primarily affect the
amount of taxes received by the respective tax authorities. If the UK resident has
amount l5pemoentwithheld in Canada aodiobna25pwrueotmarginal tux bracket in
Britain (assuming the tax rate on dividends to be 25percent), the UK tax payable will
be reduced to l0pertuat after credit for the l5percent is given. Higher withholding
rates therefore, generally mean that more tax is collected by the smaller amount by
the home government. Withholding taxes on foreign investments are generally
claimed as a tax deduction or credit by investors in their home country up to the
amount of home country tax liability.
Branch vs Subsidiary: A key aspect of corporate tax planning concerns whether to
operate abroad via a branch or through u subsidiary. If a foreign activity is not
expected to be profitable for a number of years, it may be advantageous to start with
a branch so that negative earnings abroad may be used to offset profits at home. The
tax laws of many countries allow brunch income to be consolidated in this way. In
case a company expects positive foreign income, and this income is not to be
repatriated, there may be tax advantages to a foreign subsidiary. Foreign branches
pay home taxes on income as it is earned. Foreign subsidiaries do not pay home taxes
until the income is repatriated to the home country.
Corporation Tax: Generally, if an NINC makes investments abroad, it is liable to
corporation tax on income received before deduction of foreign taxes. This rule
applies to foreign branches and foreign subsidiaries.

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As stated earlier, if British resident company carries on business abroad through a

branch or agency, it is chargeable to tax on all of the profits of the branch or agency
.Where business is carried on through a foreign subsidiary, the British Company's
liability arises only on actual amounts received Porn the subsidiary by way of interest

or dividend. Double tax relief is available in respect of the foreign tax suffered on
both income and other gains.

Foreign Direct Investment

Usually, only direct foreign taxes are taken into account for double tax relief, but if a
UK company receives dividends from a foreign company in which it owns 10percent
or more of voting power, underlying taxes on profits out of which the dividends are
paid, are taken into account as well. In this case, the amount included in UK profits is
the dividend plus both the direct and underlying foreign taxes. Double tax relief is
given, but the amount of relief on overseas income cannot exceed the UK
Corporation tax.
f)

What are the various taxes which an Indian MNC is required to pay on its
investment in Britain ?

Capital Gains Tax: Capital gains taxes on foreign investments are the most
straightforward. If a company earns capital gains on the disposal of foreign assets, it
is liable to pay capital gains taxes at the rate existing in the host country.

15.7 SUMMARY
Foreign Direct Investment is one of the most important modes of entry into foreign
Markets by MNCs. MNCs conduct FDI by way of joint ventures with foreign firms,
cross-border mergers and acquisitions, and formation of new foreign subsidiaries.
There has been phenomenal growth in FDI in the world following the pursuance of
the policy of liberalization and globalization across different countries. In view of
their superior competitive advantages over local firms, MNCs extend their areas of
operations beyond domestic boundaries. According to Ahorani, the foreign
investment decision is typically a response to a specific opportunity arising from
stimulating forces inside or outside the firm, rather than a systematic search for
profitable investment opportunities abroad. There are many strategic factors that act
as stimulating force for overseas investment. One of the most crucial decisions to be
taken by MNCs subsequent to FDI is how to maintain their competitive edge in the
current market. The extent of FDI in a particular country is dependent upon a host of
factors such as the country's markets and resources, government regulations, fiscal
and financial incentives. Taxation is a crucial issue that impacts cross border
investments. Hence implications of taxation on overseas investment should be
considered in detail.

15.8 SELF ASSESSMENT QUESTIONS

1.

Discuss recent trend in FDI in the globe.

2.

Why are MNCs driving investments in South Asian Countries like Thailand,
Malaysia and Indonesia ?

3.

Why are China and India emerging as attractive centers of FDI in recent years?

4.

What forces stimulate FDI in a country?

5.

What is internationalization theory of FDI? Discuss strengths and weaknesses of

the theory?

6.

Examine Vernon's theory as the basis for FDI.

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International Investment
Decisions and Working
Capital Management

7.

What stage of Product Life cycle justifies FDI?

8.

"Market imperfections provide the strong basis for FDI" Comment.

9.

"Inefficiency in financial system of a country can attract foreign investments".

Comment.

10. How does host government feel about FDI in the country?
11. "Taxation is a crucial issue that influences FDI in a country". Explain.

15.9 FURTHER READINGS

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1.

World Investment Report, 2005, UNCTAD, United Nations.

2.

Fuad A. Abdullah, (1987),Financial Management for Multinational firms,

Prentice-Hall International, USA.

3.

Aharons Yair, The Foreign Investment Decisions Process, Harvard Graduate

School of Business Administration, 1966, Boston, pp 54-55.

4.

Alan C. Shapiro, "Multinational Financial Management ", John Wiley & Sons
Inc. Singapore, 2003.

5.

Raymond Vernon, Storm over the Multinationals, Harvard University Press,

Cambridge, Mass, 1977.

6.

Benjamin L.Cohen, Multinational Firms and Asian Exports, Yale University

Press, New Haven, Conn, 1975

7.

Alan Rugman, "Risk Reduction by International Diversification", Journal of

International Business Studies, Fall, 1976, pp75-80.

8.

Yasheng Huang, Inefficiency Attracts FDI, Business world, March 24, 2003, p-3.