Chapter 16 - Foreign direct investment and international capital budgeting. In this chapter, the learning objectives are: To discuss the characteristics of FDI; to outline the theories of FDI; to describe the techniques of international capital budgeting; to examine the implications of taxation, country risk and transfer prices for international capital budgeting.
Chapter 16 Foreign Direct Investment and International Capital Budgeting Objectives • To discuss the characteristics of FDI • To outline the theories of FDI • To describe the techniques of international capital budgeting • To examine the implications of taxation, country risk and transfer prices for international capital budgeting Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-2 Definition • An investment project is classified as direct investment if the investor acquires ‘significant control’ over a firm Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-3 What is ‘significant control’? • Ownership of 10-25% • United States, Japan and Australia: 10% • France, Germany and United Kingdom: higher threshold • Belgium and the Netherlands: no specific number Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-4 Reasons for interest in FDI • Rapid growth and changing pattern of FDI • Concern about causes and consequences of foreign ownership • FDI channels resources to developing countries • The role played in transforming ex-communist countries Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-5 Modes of foreign market entry • • • • Export of the goods produced in the source country Licensing a foreign company to use technology Foreign distribution of products through a subsidiary Foreign (international) production Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-6 Choice between exporting and FDI • • • • Profitability Opportunities for market growth Production cost levels Economies of scale Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-7 Licensing • This involves the supply of technology and knowhow or the use of a trademark or a patent for a fee • It offers one way to generate revenue from foreign markets that are otherwise inaccessible Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-8 Franchising • Companies with brand-name products move offshore by granting foreigners the exclusive right to sell their products in a designated area Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-9 Types of FDI • • • • Greenfield investment Brownfield investment Mergers and acquisitions Joint ventures Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-10 The cost of capital for multinationals • This is likely to be different from that of domestic firms because multinationals: receive preferential treatment have better access to international capital markets are more diversified have volatile cash flows Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-43 The APV technique • The following items are taken into account: Remittable cash flows Tax savings and subsidies Effect on corporate debt capacity Other cash flows Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-44 International taxation • This is the taxation of cross-border transactions • Double taxation arises if income earned abroad is taxed at home and abroad Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-45 Approaches to international taxation • Classic approach: income received by each taxable entity is taxed • Integrated approach: aims at eliminating double taxation by: taxing undistributed earnings at a higher rate imputation tax system Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-46 Types of taxes • • • • • Corporate income tax Withholding taxes Indirect taxes Import duties Taxes on FX gains Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-47 Avoiding double taxation • Many countries have bilateral tax treaties with other countries • The OECD has developed a model tax convention • One way of avoiding double taxation is tax credits Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-48 Tax havens • A tax haven is a place where foreigners may receive income or own assets without paying taxes on them Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-49 Country risk • Country risk arises because of the possibility of losses due to country-specific economic, political and social events • It encompasses political risk and sovereign risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-50 Sovereign risk • The possibility of losses on claims on foreign governments and their agencies Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-51 Political risk • The possibility of losses due to changes in the rules governing FDI, as well as adverse political developments Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-52 Political risk: confiscation • Confiscation does not involve proper compensation • Expropriation implies compensation Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-53 Incorporating country risk into capital budgeting • Adjusting expected cash flows or the discount rate • Measuring the effects of country risk as the value of an insurance policy • Using option pricing to derive the price of country risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-54 Transfer pricing • The pricing of goods and services that are bought and sold (transferred) between members of a corporate family Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-55 Setting transfer prices • • • • Tax considerations Global regulation Management incentives and performance evaluation Marketing considerations and competition Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa (cont ) 16-56 Setting transfer prices (cont.) • • • • Risk and uncertainty Government policies The interests of joint venture partners The negotiating power of the subsidiary Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 16-57 ... Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 6- 8 Franchising • Companies with brand-name products... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 6- 4 Reasons for interest in FDI • Rapid growth and changing... expected return and risk Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 6- 15 The output and market