FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk

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Corporate Finance FIN 622

Lesson 45

FOREIGN INVESTMENT

We shall take care of following topics in this hand out:

Motives for foreign investment

Economic and other motives

International operations

Different forms

Export

Branch

Subsidiary

Joint venture

Licensing agreements

Political risk

Risk of confiscation

Commercial risk

Financial risk

Motives for Foreign Investment

We can divide the motives of MNCs into two broad categories. These are:

- Strategic motives

- Economic motives

Strategic Motives:

Market Development: A MNC may invest in foreign country in order to expand to new markets. Such

companies have very strong product line and have expertise in the field of sales and marketing. Car

assembly plants in Pakistan are a good example of market development.

Backward Integration: companies may be stretching to other countries in search and import to the home

country cheap raw materials.

Cheap inputs: labor and raw materials in developing countries provide MNCs an opportunity to reduce

the cost of sales, as labor is expensive in developed countries. This results in larger profit margin.

Political safety: Political stability and non-interference is what a MNC is looking for. Above all every

company will ensure the safety of its investment.

Economic motives:

MNCs have competitive edge over the local companies due to their strengths.

Financial Strength: MNCs have much liquidity and funds available to invest internationally. Further, they

have the ability to raise the money internationally at cheap rates compared to local companies. This is

because of their ability to generate future cash flow. They have strong products, huge marketing network

and efficient human resources to influence the money market. They can also raise capital by issuing shares

and debt instruments because they have expertise with them.

Technological strength: MNCs are using latest and state of the art technology in the business. The ability

to use technology to achieve the business efficiencies manifest cost control and profit enhancement.

Economies of scale: As the MNCs are operating all over the world having strong distribution network,

the economies of scale is achieved by efficient utilization of fixed cost. This is the greatest advantage over

the local companies.

Human resources: MNCs can hire and do have the best managerial and marketing capabilities. The

human resources they employee are the world's best having diverse and inter-culture experience, which a

local company cannot afford to have.

International Operations:

A company can kick start international operation in many ways. The option that a company would select is

primarily dependent upon the surrounding circumstances. Most important factor would be the tax position

of the entity because a company may be exposed to double taxation in its home country and in the

country of operation.

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Different Ways to Commence International Operations:

Export

A company can feel its presence in the other country by exporting its products. This is probably a cheapest

and in-expensive way to begin international operation because the company does not even set up any office

in that country. It can tap the customers by approaching them online or through an agent. Although is cost

effective way but this may not prolong because customers normally do not attach value to such a company

who is "not" present physically in their country. They may feel the company will be able to meet its after

sales commitments and warranty issues. Further, the company is not in a position to seek market related

knowledge required to develop and improve markets and products. A company making export to other

countries is always at risk of being exposed to protective tariffs that may result in loosing the

competitiveness of the products in terms of price.

Branch

A company can commence it overseas operations swiftly by setting up a branch in other country. This will

result in corporate presence in the country and will remove the issues we discussed in the above paragraph.

A branch may have some staff members but a distribution network must exist. Even with the establishment

of branch, the customers show less loyalty to the company's product because it is not very time taking issue

to wind up the branch. Companies can close their branch with out any long proceedings. So starting

operations through branch is a short-term option. As stated earlier, there are some tax consequences in

running an overseas branch it is likely that the profit of the branch would be treated as profit s of the

parent company.

Subsidiary

A subsidiary is a legal entity in other country like the parent company. This represents long-term

commitment to foreign country and increases the business reputation. There is a tax advantage, as the home

country tax will only be levied until profits are repatriated to home. However, this is very expensive option

in terms of upfront cost and working capital.

Joint venture

A jointly controlled entity by two or more venturer having a joint motive. Normally one venturer comes of

local market or country of JV operations. Local venturer is considered expert and knowledgeable person as

far as local market is concerned. This will help managing the business like obtaining loans, statutory

regulation compliance, local laws, taxes etc.

Less risky as compared to subsidiary options.

A joint venture is a legal organization that takes the form of a short-term partnership in which the persons

jointly undertake a transaction for mutual profit. Generally each person contributes assets and share risks.

Like a partnership, joint ventures can involve any type of business transaction and the "persons" involved

can be individuals, groups of individuals, companies, or corporations.

Joint ventures are also widely used by companies to gain entrance into foreign markets. Foreign companies

form joint ventures with domestic companies already present in markets the foreign companies would like

to enter. The foreign companies generally bring new technologies and business practices into the joint

venture, while the domestic companies already have the relationships and requisite governmental

documents within the country along with being entrenched in the domestic industry.

Licensing agreements

Such agreements are cheap, as these do not require any capital expenditure to expand to foreign lands. In

other words, these are less risky. The license issuer receive fixed amount as a percentage of sales for

granting license to the licensee. However, the licensor has little control over the licensee as far as the quality

of goods is concerned. The licensor cannot exercise control over the licensee.

The licensee may transfer industrial secrets to another independent firm, thereby creating a rival.

Political risk:

Political risk can be divided into following categories:

1) Confiscation risk

The risk of loss of control, business may be taken over by the local govt. or intervention and interference by

the local authorities. This risk can be reduced by insurance policies.

A JV would be preferable in less or developing country. A subsidiary would be preferable in stabled and

developed countries. Even then, this risk is present and can be reduced by:

- High gearing

- High local loans/finances

- Share in equity from local resources

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2) Commercial risk

- There may be discriminative laws for foreign companies wages level or lower prices for products,

repatriation of profits and more emphasis to use local resources.

3) Financial risk

- Restricted access to local resources loans etc

- Terms of maximum foreign equity

- Restrictions on repatriation of capital and dividend

- Exchange and currency risk

- Measurement & management of political risk

- Comparative techniques like rating mapping

- Analytical techniques special reports, expert opinion

****************THE END**************

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