CHAPTER 16 FOREIGN DIRECT INVESTMENT AND CROSS-BORDER ACQUISITIONS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Recently, many foreign firms from both developed and developing countries acquired hightech U.S. firms. What might have motivated these firms to acquire U.S. firms? Answer: Many foreign firms might have been motivated to gain access to technical know-how residing in U.S. firms and at the same time monopolize its use. Refer to the reverseinternalization hypothesis discussed in the text. 2. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are driving Japanese investments in the region? Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to take advantage of underpriced labor services and cheaper land and other factors of production. Refer to the life-cycle theory of FDI. 3. Since the NAFTA was established, many Asian firms especially those from Japan and Korea made extensive investments in Mexico. Why do you think these Asian firms decided to build production facilities in Mexico? Answer: Asian firms might have been motivated to gain access to NAFTA of which Mexico is a member and circumvent the external trade barriers maintained by NAFTA. 4. How would you explain the fact that China emerged as one of the most important recipient of FDI in recent years? Answer: China attracted a great deal of FDI recently because foreign firms want to (i) take advantage of inexpensive labor and resources, and also (ii) gain access to the Chinese market that is often not accessible otherwise. 5. Explain the internalization theory of FDI. What are the strength and weakness of the theory? Answer: According to the internalization theory, firms that have intangible assets with a public good property tend to undertake FDI to take advantage of the assets on a large scale and, at the same time, prevent misappropriation of returns from the assets that may occur during arm’s length transactions in foreign countries. The theory can be effective in explaining greenfield investments, but not in explaining mergers and acquisitions. 6. Explain Vernon’s product life-cycle theory of FDI. What are the strength and weakness of the theory? Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the life-cycle of the products that they initially introduced. When a new product is introduced, the firm chooses to keep production at home, close to customers. But when the product become mature and foreign demands develop, the firm may be induced to start production in foreign countries, especially in low-cost countries, to serve the local markets as well as to export the product back to the home country. As can be inferred from the boxed reading on Singer in the text, the product lifecycle theory can explain historical development of FDI quite well. In recent years, however, the international system of production has become too complicated to be explained neatly by the lifecycle theory. For example, new products are often introduced simultaneously in many countries and production facilities may be located in many countries at the same time. 7. Why do you think the host country tends to resist cross-border acquisitions, rather than green field investments? Answer: The host country tends to view green field investments as creating new production facilities and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of existing domestic firms, without creating new job opportunities. 8. How would you incorporate political risk into the capital budgeting process of foreign investment projects? Answer: One approach is to adjust the cost of capital upward to reflect political risk and discount the expected future cash flows at a higher rate. Alternatively, one can subtract insurance premium for political risk from the expected future cash flows and use the usual cost of capital which is applied to domestic capital budgeting. 9. Explain and compare forward vs. backward internalization. Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to utilize the assets on a larger scale and at the same time internalize any possible externalities generated by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms in order to gain access to the intangible assets residing in the foreign firms and at the same time internalize any externalities generated by the assets. 10. What can be the reason for the negative synergistic gains for British acquisitions of U.S. firms? Answer: Negative synergies for British acquisitions of U.S. firms may reflect that British managers might have been motivated to invest in U.S. firms in order to pursue their own interests, such as building corporate empire, rather than shareholders’ interests. Negative synergies can be viewed as agency costs. 11. Define country risk. How is it different from political risk? Answer: Country risk is a broader measure of risk than political risk, as the former encompasses political risk, credit risk, and other economic performances. 12. What are the advantages and disadvantages of FDI as opposed to a licensing agreement with a foreign partner? Answer: The main advantage of FDI over licensing agreement with a foreign partner is that it provides protection against possible interlopers. The main disadvantage of FDI is that it is costly and time consuming to establish foreign presence in this manner and FDI is probably more vulnerable to political risk. 13. What operational and financial measures can a MNC take in order to minimize the political risk associated with a foreign investment project? Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and adjust the project’s NPV accordingly. Second, MNCs can form joint-ventures with local partners or form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against political risk from OPIC, Lloyd’s, etc. 14. Study the experience of Enron in India, and discuss what we can learn from it for the management of political risk. Answer: This question can be used as a mini-case or mini-project. Students can utilize various business/financial publications, such as Wall Street Journal, Financial Times, and Business week, to study the issue. 15. Discuss the different ways political events in a host country may affect local operations of an MNC. Answer: The answer can be organized based on the three types of political risk: Namely, transfer risk, operational risk, and control risk. Transfer risk arises from the uncertainty about cross-border flows of capital, payments, know-how, etc. Operational risk arises from the uncertainty about the host country’s policies affecting the local operations of MNCs. Control risk arises from the uncertainty about the host country’s policy regarding ownership and control of local operations of MNCs. 16. What factors would you consider in evaluating the political risk associated with making FDI in a foreign country. Answer: Factors to be considered include: (1) the host country’s political and government system; (2) track record of political parties and their relative strength; (3) the degree of integration into the world system; (4) the host country’s ethnic and religious stability; (5) regional security; and (6) key economic indicators. 17. Daimler, a German carmaker, acquired Chrysler, the third largest U.S. automaker, for $40.5 billion in 1998. But after years of declining profit and labor problem, Daimler sold off Chrysler to the U.S. private equity firm Cerberus for $7.4 billion in 2007. Study the DaimlerChrysler saga and identify the main factors for the failure of this cross-border merger. Suggested answer: Daimler-Chrysler merger failed to produce synergy effect due to the failure to integrate the two companies with different corporate cultures, inability to cut down labor costs due to a strong labor union at Chrysler, and the competitive pressure from Japanese carmakers. 18. Lured by extremely low labor costs in Bangladesh, many MNCs in the so-called fast-fashion business, including H&M, Inditex, parent of the popular Zara brand, Marks&Spencer, and Gap, are heavily outsourcing to Bangladesh. As a result, garment industry has become a major source of employment and income to Bangladesh. However, the industry has recently suffered a spate of disasters. In September 2012, about 110 workers died in a blaze at the Tazreen Fashions factory outside Dhaka, the capital city. What’s worse, in April 2013, more than 1,100 workers perished in the collapse of the Rena Plaza Building in Dhaka. In your opinion, (i) what are the root causes of the disasters? (ii) what should be done to prevent future disasters? Suggested answers: (i) The disasters may be primarily attributable to the weak legal protection of workers’ rights and the lack of proper government supervision of the health and safety conditions workers face in factories. (ii) Future disasters may be prevented by stronger legal and administrative protection of workers’ rights, better payments to the factory owners and workers to reduce the incentives to skirt the safety rules, better monitoring of workplaces by the outsourcing MNCs, and stronger organization among workers to better protect their own rights. MINICASE: ENRON VS. BOMBAY POLITICIANS 1) Discuss the chief mistakes that Enron made in India. Suggested answer: Enron was insensitive to the negative political sentiment against foreign investment in India and ignored the possibility that BJP may win the election and repudiate the contract with Enron. In addition, the deal was closed in a hurry and secretly, giving the impression that it might have involved corruption. 2) Discuss what Enron might have done differently to avoid its predicament in India Suggested answer: Enron could have done a more accurate analysis of political risk and considered the possibility of election victory of the nationalist party. In addition, Enron could have purchased an insurance policy against this political risk from Overseas Private Investment Corporation or other insurers. Further, involving a local partner could have dampened the nationalistic sentiment in India. Foreign Direct Investment and Cross-Border Acquisitions Chapter Sixteen Chapter Outline • Global Trends in FDI • Why Do Firms Invest Overseas? – Trade Barriers – Imperfect Labor Markets – Intangible Assets – Vertical Integration – Product Life Cycle – Shareholder Diversification • Cross-Border Mergers and Acquisitions • Political Risk and FDI Global Trends in FDI • Foreign direct investment often involves the establishment of production facilities abroad. • Greenfield investment involves building new facilities from the ground up. • Cross-border acquisition involves the purchase of an existing business. Global Trends in FDI • Several developed nations are the sources of FDI outflows. – Most world-wide FDI comes from the developed world. • This implies that MNCs domiciled in these countries should have certain comparative advantages in undertaking overseas investment projects. • Both developing and developed nations are the recipient of inflows of FDI. – Some developing countries, like China and Mexico, have begun to undertake FDI, albeit on a modest scale. Average Annual FDI (in USD b) 2007-2011 Foreign Direct Investment – Outflows (Inflows) in Billions of Dollars Annual Country 2007 2008 2009 2010 2011 Average Australia 16.9 33.6 16.7 12.8 20.0 20.0 (45.5) (47.2) (26.6) (35.6) (41.3) (39.2) Canada 57.7 79.8 41.7 38.6 49.6 53.5 (114.7) (57.2) (21.4) (23.4) (40.9) (51.5) China 22.5 52.2 56.5 68.8 65.1 53.0 (83.5) (108.3) (95.0) (114.7) (124.0) (105.1) France 164.3 155.0 107.1 76.9 90.1 118.7 (96.2) (64.2) (24.2) (30.6) (40.9) (51.2) Germany 170.6 72.8 75.4 109.3 54.4 96.5 (80.2) (8.1) (24.2) (46.9) (40.4) (40.0) Italy 96.2 67.0 21.3 32.7 47.2 52.9 (43.8) (-10.8) (20.1) (9.2) (29.1) (18.3) Foreign Direct Investment – Outflows (Inflows) in Billions of Dollars Annual Country 2007 2008 2009 2010 2011 Average Japan 73.5 128.0 74.7 56.3 114.4 89.4 (22.5) (24.4) (11.9) (-1.3) (-1.8) (11.1) Mexico 8.3 1.2 7.0 13.6 8.9 7.8 (31.5) (27.1) (16.1) (20.7) (19.6) (23.0) Netherlands 55.6 68.3 28.1 55.2 31.9 47.8 (119.4) (4.5) (36.0) (-9.0) (17.1) (33.6) Spain 137.1 74.7 13.1 38.3 37.3 60.1 (64.3) (80.0) (10.4) (40.8) (29.5) (45.0) Sweden 38.8 31.3 25.9 18.0 26.9 28.2 (27.7) (37.2) (10.0) (-1.3) (12.1) (17.1) Switzerland 51.0 45.3 27.8 64.8 69.6 51.7 (32.4) (15.1) (28.6) (20.4) (-0.2) (19.3) Foreign Direct Investment – Outflows (Inflows) in Billions of Dollars Annual Country 2007 2008 2009 2010 2011 Average United Kingdom 272.4 161.1 44.4 39.5 107.1 124.9 (196.4) (91.5) (71.1) (50.6) (53.9) (92.7) United States 393.5 308.3 267.0 304.4 396.7 334.0 (216.0) (306.4) (143.6) (197.9) (226.9) (218.2) World 2198.0 1,969.3 1,175.1 1,451.4 1,694.4 1,697.6 (1,975.5) (1,790.7) (1,197.8) (1,309.0) (1,524.4) (1,559.5) Why Do Firms Invest Overseas? • Trade barriers • Labor market imperfections • Intangible assets • Vertical integration • Product life cycle • Shareholder diversification Trade Barriers • Government action leads to market imperfections. • Tariffs, quotas, and other restrictions on the free flow of goods, services, and people. • Trade barriers can also arise naturally due to high transportation costs, particularly for low value-to-weight goods. Labor Market Imperfections • Among all factor markets, the labor market is the least perfect. – Recall that the factors of production are land, labor, capital, and entrepreneurial ability. • If there exist restrictions on the flow of workers across borders, then labor services can be underpriced relative to productivity. – The restrictions may be immigration barriers or simply social preferences. Labor Costs around the Globe (2011) Country Average Hourly Cost ($) Switzerland 60.40 Belgium 54.77 Sweden 49.12 Germany 47.38 Australia 46.29 France 42.12 Canada 36.56 Italy 36.17 Japan 35.71 United States 35.53 United Kingdom 30.77 Country Average Hourly Cost ($) Singapore 22.60 Israel 21.42 Korea 18.91 Brazil 11.65 Taiwan 9.34 Mexico 6.48 Philippines 2.01 China 1.64 India 1.45 Indonesia 1.15 Vietnam 0.73 Bangladesh 0.37 Intangible Assets • Coca-Cola has a very valuable asset in its closely guarded “secret formula.” • To protect that proprietary information, Coca-Cola has chosen FDI over licensing. • Since intangible assets are difficult to package and sell to foreigners, MNCs often enjoy a comparative advantage with FDI. Vertical Integration • MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable accounting price. • Vertical integration may be backward or forward: – Backward: e.g., a furniture maker buying a logging company. – Forward: e.g., a U.S. auto maker buying a Japanese auto dealership. Product Life Cycle • U.S. firms develop new products in the developed world for the domestic market, and then markets expand overseas. • FDI takes place when product maturity hits and cost becomes an increasingly important consideration for the MNC. Product Life Cycle New product Maturing product Standardized product Product Life Cycle • It should be noted that the product life cycle theory was developed in the 1960s when the U.S. was the unquestioned leader in R&D and product innovation. • Increasingly, product innovations are taking place outside the United States as well, and new products are being introduced simultaneously in many advanced countries. • Production facilities may be located in multiple countries from product inception. Shareholder Diversification • Firms may be able to provide indirect diversification to their shareholders if there exists significant barriers to the cross-border flow of capital. • Capital market imperfections are of decreasing importance, however. • Managers, therefore, probably cannot add value by diversifying for their shareholders, as the shareholders can do so themselves at lower cost. Cross-Border Mergers & Acquisitions • Greenfield investment – Building new facilities from the ground up. • Cross-border acquisition – Purchase of existing business. – Represents 40-50% of FDI flows. • Cross-border acquisitions are a politically sensitive issue: – Greenfield investment is usually welcome. – Cross-border acquisition is often unwelcome. Top 10 Cross-Border M&A Deals 1998-2011 Deal Value No ($ b) Acquiring Company Home Economy Acquired Company Host Economy 1 202.8 Vodafone Air Touch PLC United KingdomMannesmann AG Germany 2 98.2 RFS Holdings BV United KingdomABN-AMRO Holding NV Netherlands 3 74.3 Royal Dutch Petroleum Co Netherlands Shell Transport & Trading Co United Kingdom 4 60.3 Vodafone Group PLC United KingdomAir Touch Communications United States 5 52.2 InBev NV Belgium Anheuser-Busch Cos Inc United States 6 48.2 British Petroleum Co PLC (BP) United KingdomAmoco Corp United States 7 46.7 Roche Holding AG Switzerland Genentech Inc United States 8 46.0 France Telecom SA France Orange PLC (Mannesmann AG) United Kingdom 9 40.5 Daimler-Benz AG Germany Chrysler Corp United States 10 40.4 Vivendi SA France Seagram Co ltd Canada Average Wealth Gains from Cross-Border Acquisitions: Foreign Acquisitions of U.S. firms Country of Acquirer N R&D/Sales (%) Average Wealth Gain (U.S. $millions) Acquirer Target Acquirer Target Canada 10 0.21 0.65 14.93 85.59 Japan 15 5.08 4.81 227.83 170.66 U.K. 46 1.11 2.18 –122.91 94.55 Other 32 1.63 2.80 –47.56 89.48 All 103 1.66 2.54 –35.01 103.19 Political Risk and FDI • Unquestionably this is the biggest risk when investing abroad. • A more important question than normative judgments about the appropriateness of the foreign government’s existing legislation is, “Does the foreign government uphold the rule of law?” • A big source of risk is the non-enforcement of contracts. Political Risk and FDI • Macro risk – All foreign operations are put at risk due to adverse political developments. • Micro risk – Selected foreign operations are put at risk due to adverse political developments. Political Risk • Transfer risk – Uncertainty regarding cross-border flows of capital. • Operational risk – Uncertainty regarding the host country’s policies on a firm’s operations. • Control risk – Uncertainty regarding expropriation. Measuring Political Risk • The host country’s political and government system – A country with too many political parties and frequent changes of government is risky. • The track records of political parties and their relative strength – If the socialist party is likely to win the next election, watch out. Measuring Political Risk • Integration into the world system – North Korea and Iran are examples of isolationist countries unlikely to observe the “rules of the game.” • Ethnic and religious stability – Look at recent genocides around the world. • Regional security – Kuwait is a nice enough country, but it’s in a rough neighborhood. Measuring Political Risk • Key economic indicators – Political risk is not entirely independent of economic risk. – Severe income inequality and deteriorating living standards can cause major political disruptions. – In 2002, Argentina’s protracted economic recession led to the freezing of bank deposits, street riots, and three changes of the country’s presidency in as many months. Political Risk Analysis: Vietnam Sovereign Rating: Moody’s: B2, Outlook: Stable; S&P: BB-, Outlook: Negative Political Strengths Economic Strengths • Political Stability with Communist Party in government since end of the country’s civil war in 1975 • Widespread support for the CPV (Vietnam Communist Party) reflects its success in raising living standards and creating and maintaining security • Transformation to market oriented economy since late 1980s • High GDP growth facilitated by foreign investment • Well educated and cheap labor force • Sizeable natural resources and advantageous location Political Weaknesses Economic Weaknesses • Inconsistent and evolving regulations • Unreliable legal system and corruption • A lack of financial transparency, insufficient protection for minority owners, and poor corporate governance • Large fiscal and trade deficits and weak banking system • Plethora of state-owned enterprises and less diversification • Industry and credit policies favor state-owned enterprises Political & Governance Indicators Economic Indicators • World Bank Ranking- Ease of doing business 78th/183 • Freedom House - Political rights and civil liberties Not Free • Transparency International Ranking – Corruption Perception Index 116th/180 • OECD country risk rating 5 (Scale: 0-7, 0 is least risk, 7 is highest risk) • GDP ($US bn) 104 • GDP per capita ($US) 1,174 • Real GDP growth (15 year average, %) 7.3 • Fiscal balance (% of GDP) -6.4 • Public debt (% of GDP) 53.0 • Foreign direct investment (% of GDP) 6.6 • Current account (% of GDP) -3.8 • External debt (% of GDP) 42.1 • Foreign reserves (% of GDP) 11.6 Source: http://www.efic.gov.au ; 2011 figures Political Risk Analysis: Turkey Sovereign Rating: Moody’s: Ba1; Outlook: Positive; S&P: BB, Outlook: Positive Political Strengths Economic Strengths • Transition to democracy at the end of 1970s • Significant liberalization and stabilization by a drive to join European Union • Key dimensions of economic performance on par with central and eastern European countries • Was able to weather the recent global economic crisis • Debt is highly sought after by foreign investors • Healthy growth forecast Political Weaknesses Economic Weaknesses • Instability fuelled by conflict between the army and the civilian government • Strained relations between religious conservatives and secular modernists • Mounting macroeconomic imbalances and major reliance on foreign financing • Widening current account deficit, surging credit building inflation pressures • High business cycle and currency risk • Lira is a volatile emerging market currency growth and Political & Governance Indicators Economic Indicators • World Bank Ranking - Ease of doing business 65th/183 • Freedom House - Political rights and civil liberties Partly Free • Transparency International Raking- Corruption Perception Index 56th/180 • OECD country risk rating 4 (Scale: 0-7, 0 is least risk, 7 is highest risk) • GDP ($US bn) • GDP per capita ($US) • Real GDP growth (15 year average, %) • Fiscal balance (% of GDP) • Public debt (% of GDP) • Foreign direct investment (% of GDP) • Current account (% of GDP) • External debt (% of GDP) 742 10,399 4.0 -3.6 42.3 1.2 -6.5 42.5 • Foreign reserves (% of GDP) 14.3 Source: http://www.efic.gov.au ; 2011 figures Hedging Political Risk • Geographic diversification – Simply put, don’t put all your eggs in one basket. • Minimize exposure – Form joint ventures with local companies. • Local government may be less inclined to expropriate assets from their own citizens. – Join a consortium of international companies to undertake FDI. • Local government may be less inclined to expropriate assets from a variety of countries all at once. – Finance projects with local borrowing. Hedging Political Risk • Insurance – The Overseas Private Investment Corporation (OPIC), a U.S. government federally-owned organization, offers insurance against: 1. The inconvertibility of foreign currencies. 2. Expropriation of U.S.-owned assets. 3. Destruction of U.S.-owned physical properties due to war, revolution, and other violent political events in foreign countries. 4. Loss of business income due to political violence. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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