|


 
   


  

 

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)

2
 

ow 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

v
 

ow 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

Ö
 

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

=

  
D20è billion (1èè0) (Cross-border M&A: D1s1 b.)
D1,Öè2 billion (2000) (Cross-border M&A: D1,1ÖÖ b.)
D]vs billion (2001) (Cross-border M&A: DsèÖ b.)
D:s1 billion (2002) (Cross-border M&A D v]0 b.)
Ds:0 billion (200v) (Cross-border M&A D 2è] b.)
Compare with world total gross fixed capital formation: D],2èÖ b.
(200v)

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‡ World FDI inward stock: DV,2Ös billion (200v)

‡ Sales of foreign affiliates: D1],sV0 billion (200v)

(Compare with international trade of Dè,22V billion (200v)
‡ Gross product of foreign affiliates: Dv,]0: billion (200v)
(Compare with world GDP of Dv: trillion in 200v).
‡ Total assets of foreign affiliates: Dv0,v:2 billion (200v)

‡ Employment of foreign affiliates: Over sÖ million people

(200v estimated)

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200v D
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‡ 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

12
  
 

  


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‡ Choice of entry mode jointly determines
degree of control and extent of risk

þ

‡ Degree of commitment depends on
þ 
 

  contractual duration and vertical integration
þ  
 control
 
 ‡ With less knowledge of other country¶s



market, choose lower degree of commitment


 
þ  

commitment
‡ As knowledge increases over time, can
þ 
 
risk
increase degree of commitment to get closer
þ 
to desired entry mode.

‡ Contractual transactions may give optimal

mix of control and commitment

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‡ 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

1Ö
 | 
   

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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: Investment cost is K = D2,000

Investment in Country A yields an expected net cash
flow of D12,:00 with risk-adjusted discount rate of
20% NPV Country A = DV,s00

Investment in Country X yields an expected net cash

flow of D1v,000 with risk-adjusted discount rate of
v0% NPV Country X = DV,000

    

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( )
  max â
(1 â a )

( *)

    1

(1 â a )

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

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Expected marginal return to FDI equals 1 + r.

D/K Note diminishing marginal return to investment

1â a
2
( *)
1 + 0.v

1 + 0.2

V¶(K)

K* K* K
1V
 FDI Example: Choosing the level of investment
A  A ! %A'
Let r = 0.2
"#$A%#$&A$  A  (')#$
What level of
( $#*& (#+&,
investment
$ &#+) $#& should the
manager
" -#"& "#($& choose?
+ ,#,) "#"""... V'(K) = v.2 ± .sK.
1 + 0.2 = v.2 ±.sK*
& *#-& "#($&
K* = Ö.
/ ()#$) $#&

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‡ 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:
³quid pro quo investment´ ± Cemex and Southdown

20
 =  

 
 
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‡ 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

21
 

  


‡ 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

22
 

  ) 

‡ 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)

2v
 


 

‡ 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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Why is FDI more prevalent than technology licensing?

‡ Licensing agreements depend heavily on international

enforcement of  


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

2:
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*
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‡ 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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