Competitive Strategies:

Modes of Entry and FDI

Professor Daniel F. Spulber

Enron India

What risks did Enron face going into the

Dabhol project?
Political risk: expropriation of
investment
Political risk: renegotiation of contracts
after investment
Contract risk: problems with local
partners
Currency risk
Market risk: costs of energy and
demand for electric power
Recovery of investment costs (FDI)

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Enron India

How did Enron prepare for the risks of the

project?
Long term contracts: purchase
agreement, Maharashtra State Electrical
Board was a credible buyer
Political risk: participation of Overseas
Private Investment Corp, US Export-
Import Bank, International Finance
Corp.
Revenues tied to US dollar
Partners GE and Bechtel
Substantial research

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Enron India

How could Enron have dealt with risk more

effectively?
Enron could have relied less on FDI
Enron could have emphasized
transactions, making arrangements for
construction, power supply contracts,
and technology transfer
More reliance on local partners to
construct and operate project
Greater participation of other Indian
institutions

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Enron India
Why did Enron choose ownership (FDI)?
To exercise control over assets in
investment projects
To control technology due to limits on
intellectual property rights
To improve operational effectiveness
To learn about market for future projects
To avoid expected contract risk

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Enron International Operations

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Financial Highlights: Growth in assets

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 FDI is a key aspect of International Business
FDI is what makes the company a multinational firm

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 FDI
FDI includes cross-border business investment and M&A.
(not portfolio investment)

World FDI inflows:

$209 billion (1990) (Cross-border M&A: $151 b.)
$1,492 billion (2000) (Cross-border M&A: $1,144 b.)
$735 billion (2001) (Cross-border M&A: $594 b.)
$651 billion (2002) (Cross-border M&A $ 370 b.)
$560 billion (2003) (Cross-border M&A $ 297 b.)
Compare with world total gross fixed capital formation: $7,294 b.
(2003)

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 FDI
World FDI inward stock: $8,245 billion (2003)

Sales of foreign affiliates: $17,580 billion (2003)

(Compare with international trade of $9,228 billion (2003)
Gross product of foreign affiliates: $3,706 billion (2003)
(Compare with world GDP of $36 trillion in 2003).
Total assets of foreign affiliates: $30,362 billion (2003)

Employment of foreign affiliates: Over 54 million people

(2003 estimated)

Data from United Nations World Investment Report and

UNCTAD website
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 FDI
2003 $
Billions
FDI inflows FDI outflows
Developed 367 570
countries

Developing 172 36
countries

Central and 21 7
Eastern
Europe
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 International modes of entry and value at risk
FDI whether M&A or company growth puts full value
at risk.
Toyota factory, Wal-Mart store
Managers of an international business choose the mode of
entry based on a trade-off between risk versus control in
the particular supplier or customer country

Joint ventures, not only share knowledge, but also share

investment costs and value at risk

Spot or contract sales can substantially reduce value at risk

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 International modes of entry and value at risk
Choice of entry mode jointly determines
degree of control and extent of risk

M&A
Degree of commitment depends on
Growth Increase in contractual duration and vertical integration
Alliances/ control,
Joint With less knowledge of other countrys
Ventures market, choose lower degree of commitment
Increase in
Licenses commitment
As knowledge increases over time, can
Contract and risk
increase degree of commitment to get closer
Spot to desired entry mode.

Contractual transactions may give optimal

mix of control and commitment

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 Choosing target countries for FDI

Costs of investment project K

Estimate potential expected returns V(K)

Determine risks associated with revenues and costs in host

country -- Best estimates of expected cash flow

Apply appropriate risk-adjusted discount rate r

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 Choosing target countries for FDI

Manager considers trade off between risk and return

Country A
NPV = - K + VA/(1 + rA)

Country X
NPV = - K + VX/(1 + rX)

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 Apply NPV analysis to choose
target country for FDI

Example: Investment cost is K = $2,000

Investment in Country A yields an expected net cash flow
of $12,600 with risk-adjusted discount rate of 20%
NPV Country A = $8,500

Investment in Country X yields an expected net cash

flow of $13,000 with risk-adjusted discount rate of
30% NPV Country X = $8,000

Invest in Country A
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 Apply NPV analysis to choose
level of FDI

V (K )
Choose K to max K
(1 r )
V ( K *)
Investment K solves 1
(1 r )

Therefore, 1 + r = V'(K*)

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 Companies invest less in riskier countries
all other things equal

Expected marginal return to FDI equals 1 + r.

$/K Note diminishing marginal return to investment

1 r V ( K *)
1 + 0.3

1 + 0.2

V(K)

K* K* K
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 FDI Example: Choosing the level of investment
K V(K) = K +
Let r = 0.2
3.2K .25K2 V(K)/(1 + 0.2)
What level of
1 2.95 1.458
investment
2 5.40 2.5 should the
manager
3 7.35 3.125 choose?
4 8.80 3.333 *** V'(K) = 3.2 .5K.
1 + 0.2 = 3.2 .5K*
5 9.75 3.125
K* = 4.
6 10.20 2.5

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 Why is FDI so common in international business?
Advantages of FDI

Production or distribution facilities in a country can reduce

costs of trade (transportation, tariff and nontariff barriers,
transaction costs, and time) Toyota in US

Production within a country takes advantage of domestic

sourcing of parts, components, services

Investment and employment in host country gain political

support for the international business:
quid pro quo investment Cemex and Southdown

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 Why is FDI so common in international business?
Advantages of FDI

Closer to customers for manufacturers

Necessary for retail and wholesale companies Wal Mart,

Carrefour, Ingram Micro

Take advantage of low-cost labor, highly-skilled labor, and

proximity to resources

Reduce costs of trade from import/export

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 Advantages of vertical FDI

Coordination advantages through the value chain

Access to production facilities, sourcing networks and

distribution networks

Keeping technology and intellectual property in-house

Substitution of internal transactions for market transactions

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 Advantages of Horizontal FDI
M&A acquisition of competitors for market power or cost
savings
M&A to achieve economies of scale and scope
(Daimler/Chrysler, VW)
M&A to purchase of technology
M&A to acquire brand names
Production avoids costs of trade relative to export
As hedge against demand and supply fluctuations --
Cemex
Market power in international purchasing (e.g.
Vodaphone/Airtouch purchases wireless equipment for its
many operations)

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 Disadvantages of FDI

Risk that firm many not recover investment and returns to

investment in supplier country

FDI increases capital investment, reduces flexibility

FDI ties business to particular country locations for

production or distribution

Vertical FDI makes the firm more vertically integrated

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 FDI Trends
Shift of investment mix toward services
About half in 1990, about two thirds in 2000

Shift of investment to outsourcing abroad (offshoring +

outsourcing) reduction in vertical integration

Globalization (lower costs of trade) leading to reduction in

vertical FDI

Globalization (market integration) likely to lead to increases in

horizontal FDI
UNCTAD World Investment Report 2004

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 Licensing versus FDI
Why is FDI more prevalent than technology licensing?

Licensing agreements depend heavily on international

enforcement of intellectual property rights
International licensing also entails costs of trade
International licensing is quite common amongst
developed countries, reaching levels up to 1/3 of domestic
R&D expenditures
International licensing experiencing rapid growth

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 Overview and Take-Away Points
FDI a major feature of international business composition
of FDI undergoing transformation from vertical to
horizontal

FDI offers advantages in terms of ownership and control and

avoiding trade barriers

Choose target countries based on expected cash flow and

costs of investment and discount using risk adjusted rate of
return

Adjust level of investment to reflect expected cash flow and

risk-adjusted rate of return

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