International Financial Management

FOREIGN DIRECT INVESTMENT AND

CROSS-BORDER ACQUISITIONS
 Chapter Outline
Global Trends in FDI
Why Do Firms Invest Overseas?
• Trade Barriers
• Imperfect Labor Market
• Intangible Assets
• Vertical Integration
• Product Life Cycle
• Shareholder Diversification Services
Cross-Border Mergers and Acquisitions
Political Risk and FDI
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 Introduction
Firms become multinational when they undertake
foreign direct investments (FDI)
• FDI often involves the establishment of new
production facilities in foreign countries but may
also involve mergers with and acquisitions of
existing foreign businesses.
Whether FDI involves a greenfield investment
(building brand-new production facilities) or cross-
border mergers and acquisitions of existing
businesses, it affords the multinational corporation
(MNC) a measure of control
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 Global Trends in FDI 1

FDI flows represent new additions to the existing stocks of

FD I
• During the six-year period 2012‒2017, total annual
worldwide FDI outflows amounted to $1,423 billion on
average.
• Top 10 countries account for about 64% of the total worldwide FDI
outflows during this six-year period.
• During the same six-year period, the United States
received the largest amount of FDI inflows, $300 billion
per year on average, among all countries.
• Top 10 countries account for about 48% of the total worldwide FDI
inflows.
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 Global Trends in FDI 2

FDI stocks are the accumulation of previous FDI flows

Overall cross-border production activities of MNCs are best
captured by FDI stocks
• Total worldwide FDI stock, which was about $514 billion in
1980 rose to about $7,400 billion in 2000 and $31,000 billion
in 2017.
• As of 2017, the United States, Germany, the United Kingdom,
France, Japan, Switzerland, Canada, the Netherlands, and
China held the most outward FDI stocks.
• For FDI inward stock, on the other hand, the United States,
the United Kingdom, China, Germany, France, Canada, and
the Netherlands are the most important hosts, as of 2017.
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 Why Do Firms Invest Overseas?
We do not have a well-developed, comprehensive theory of
FDI, but several theories can shed light on certain aspects
of the FDI phenomenon
Key factors that are important in firms’ decisions to invest
overseas:
• Trade barriers.
• Imperfect labor market.
• Intangible assets.
• Vertical integration.
• Product life cycle.
• Shareholder diversification services.
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 Trade Barriers 1

International markets for goods and services are often

rendered imperfect by the acts of governments
• Governments may impose tariffs, quotas, and other
restrictions on exports and imports of goods and
services.
• May impose complete bans on the international trade of
certain products.
Facing barriers to exporting its products to foreign markets,
a firm may decide to move production to foreign countries
to circumvent the trade barriers

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 Trade Barriers 2

Trade barriers can also arise naturally from

transportation costs
• Such products as mineral ore and cement that
are bulky relative to their economic values may
not be suitable for exporting because high
transportation costs will substantially reduce
profit margins.
• In these cases, FDI can be made in the foreign
markets to reduce transportation costs.

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 Imperfect Labor Market
Labor services in a country can be severely underpriced
relative to their productivity because workers are not
allowed to freely move across national boundaries to seek
higher wages
• Among all factor markets, the labor market is the most
imperfect.
• Severe imperfections in the labor market led to persistent
wage differentials among countries.
• When workers are not mobile because of immigration
barriers, firms themselves should move to the workers in
order to benefit from the underpriced labor services.

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 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.
MNCs often enjoy comparative advantages due to special
intangible assets they possess
• According to the internalization theory of FDI, firms that
have intangible assets with a public good property tend to
invest directly in foreign countries in order to use these
assets on a larger scale and, at the same time, avoid the
misappropriations of intangible assets that may occur while
transacting in foreign markets through a market
mechanism.
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 Vertical Integration
MNCs may undertake FDI in countries where inputs are
available in order to secure the supply of inputs at a stable
price
• Furthermore, if MNCs have monopolistic or oligopolistic
control over the input market, this can serve as a barrier
to entry to the industry.
Vertical FDIs may be backward or forward:
• Backward vertical FDI involves an industry abroad that
produces inputs for MNCs.
• Forward vertical FDI involves an industry abroad that
sells an MNC’s outputs.
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 Product Life Cycle
Product life cycle theory, proposed by Vernon (1966),
suggests the following:
• When U.S. firms first introduce new products, they choose
to keep production facilities at home, close to customers.
• As demand for the new product develops in foreign
countries, the pioneering U.S. firm begins to export to those
countries.
• As the product becomes standardized and mature, it
becomes important to cut the cost of production to stay
competitive.
• FDI takes place when the product reaches maturity and
cost becomes an important consideration.
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EXHIBIT 16.5 The Product Life Cycle

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 Shareholder Diversification
Firms may be able to provide indirect diversification to their
shareholders if barriers to the cross-border capital flows exist
• When a firm holds assets in many countries, the firm’s
cash flows are internationally diversified, and shareholders
can indirectly benefit from international diversification even
if they are not directly holding foreign shares.
• Capital market imperfections as a motivating factor for F DI
are likely to have become less relevant given that many
barriers to international portfolio investments have been
dismantled in recent years.

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 Cross-Border Mergers and Acquisitions 1

In recent years, a growing portion of F DI has taken the form

of cross-border mergers and acquisitions, accounting for
more than 50% of FDI flows in terms of dollar amount
• Rapid increase in cross-border M and A deals can be
attributed to the ongoing liberalization of capital markets
and the integration of the world economy.
• As a mode of FDI entry, cross-border M and A’s offer two
key advantages over greenfield investments: speed and
access to proprietary assets.
• Popular mode of investment for firms wishing to protect,
consolidate, and advance their global competitive
positions.
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 Cross-Border Mergers and Acquisitions 2

Synergistic gains are obtained when the value of the

combined firm is greater than the stand-alone
valuations of the individual (acquiring and target) firms
• May or may not arise from cross-border
acquisitions, depending on the motive of acquiring
firms.
• Firms may decide to acquire foreign firms to take
advantage of mispriced factors of production and to cope
with trade barriers.
• Cross-border M and A deals are most likely to
involve firms with different national cultures.
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 EXHIBIT 16.7 Average Wealth Gains from Cross-Border Acquisitions:
Foreign Acquisitions of U.S. Firms

R and D/Sales (%) Average Wealth Gains (in Million U.S.$)

Country of Number of
Acquirer Cases Acquirer Target Acquirer Target Combined

Canada 10 0.21 0.65 14.93 85.59 100.53

Japan 15 5.08 4.81 227.83 170.66 398.49

U.K. 46 1.11 2.18 –122.91 94.55 –28.36

Other 32 1.63 2.80 –47.46 89.48 42.02

All 103 1.66 2.54 –35.01 103.19 68.18

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 Political Risk and FDI 1

Political risk refers to the potential losses to the parent firm

resulting from adverse political developments in the host country
• Range from the outright expropriation of foreign assets to
unexpected changes in the tax laws that hurt the profitability
of foreign projects.
Depending on the incidence, political risk can be classified into
two types:
1. Macro risk, where all foreign operations are affected by
adverse political developments in the host country.
2. Micro risk, where only selected areas of foreign business
operations or particular foreign firms are affected.

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EXHIBIT 16.8 Frequency of Expropriations of Foreign-Owned Assets

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 Political Risk and FDI 2

Depending on the manner in which firms are affected,

political risk can be classified as follows:
1. Transfer risk, which arises from uncertainty about cross-
border flows of capital, payments, know-how, etc.
2. Operational risk, which is associated with uncertainty
about the host country’s policies affecting the local
operations of MNCs.
3. Control risk, which arises from uncertainty about the
host country’s policy regarding ownership and control of
local operations.

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 Measuring Political Risk
Political risk is not easy to measure, but experts evaluate a
set of key factors, such as:
• The host country’s political and government system.
• Track records of political parties and their relative strength.
• Integration into the world system.
• The host country’s ethnic and religious stability.
• Regional security.
• Key economic indicators.
Corruption Perceptions Index (C PI) provides a composite
measure of perceived corruption in the public sector

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 EXHIBIT 16.9 Political Risk Analysis: Vietnam

Sovereign Rating: Moody's:B1, Outlook: Stable; S and P: BB‒, Outlook: Stable

Political Strengths Economic Strengths
• Political stability with Communist Party in government since end of • Transformation to market-oriented economy since late 1980s.
the country’s civil war in 1975. • High GDP growth facilitated by foreign investment.
• Widespread support for the CP V (Vietnam Communist Party) • Well-educated and cheap labor force.
reflects its success in raising living standards and creating and • Sizable natural resources and advantageous location.
maintaining security. • Membership in TPP trade agreement.

Political Weaknesses Economic Weaknesses

• Inconsistent and evolving regulations. • Large fiscal deficits and weak banking system.
• Unreliable legal system and corruption. • Plethora of state-owned enterprises and less diversification.
• A lack of financial transparency, insufficient protection for minority • Industry and credit policies favor state-owned enterprises.
owners, and poor corporate governance. • Lack of infrastructure.

Political & Governance Indicators Economic Indicators

• World Bank Ranking—Ease of doing business 68th/190 • GDP ($US bn) 241
• Freedom House—Political rights and civil liberties Not Free • GDP per capita ($US) 2.482
• Transparency International Ranking—Corruption Perception Index • Real GDP growth (15-year average, %) 6.8
117th/180 • Fiscal balance (% of GDP) –4.7
• OECD country risk rating (Scale: 0‒7, 0 is least risk, 7 is highest • Public debt (% of GDP) 57.8
risk) 5 • Foreign direct investment (% of GDP) 7.3
• Current account (% of GDP) 22
• External debt (% of GD P) 49.7
• Foreign reserves (% of GDP) 26.3

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 EXHIBIT 16.10 Political Risk Analysis: Turkey

Sovereign Rating: Moody’s: Ba3, Outlook: Negative; S and P: B+, Outlook: Negative

Political Strengths Economic Strengths

• Transition to democracy at the end of 1970s. • Key dimensions of economic performance on par with central and
• Significant liberalization and stabilization by a drive to join eastern European countries.
European Union. • Was able to weather the recent global economic crisis.
• Rapid decline in poverty incidence. • Debt is highly sought after by foreign investors.
• Healthy growth forecast.

Political Weaknesses Economic Weaknesses

• Instability fueled by conflict between the army and the civilian • Mounting macroeconomic imbalances and major reliance on foreign
government. financing.
• Strained relations between religious conservatives and secular • Widening current account deficit, surging credit growth and building
modernists. inflation pressures.
• Proximity to war-torn Syria. • High business cycle and currency risk.
• Lira is a volatile emerging market currency.

Political & Governance Indicators Economic Indicators

• World Bank Ranking—Ease of doing business 43rd/190 • GDP ($US bn) 769
• Freedom House—Political rights and civil liberties Partly Free • GDP per capita ($US) 9,445
• Transparency International Ranking—Corruption Perception Index • Real GDP growth (15-year average, %) 2.6
78th/180 • Fiscal balance (% of GDP) –1.9
• OECD country risk rating 5 (Scale: 0‒7, 0 is least risk, 7 is • Public debt (% of GDP) 30.4
highest risk) • Foreign direct investment (% of GDP) 1.7
• Current account (% of GDP) –5.7
• External debt (% of GDP) 56.7
• Foreign reserves (% of GDP) 12.0

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 Political Risk and FDI 3

To manage political risk, consider the following:

• MNCs can take a conservative approach to foreign
investment projects when faced with political risk.
• Once an MNC decides to undertake a foreign project, it
can take various measures to minimize its exposure to
political risk.
• MNCs may purchase insurance against the hazard of
political risk.

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 Discussion Question

1. How would you explain the fact that China emerged

as one of the most important recipients of FDI in
recent years?
2. Explain Vernon’s product life-cycle theory of
FDI. What are the strength and weakness of
the theory?
3. Applying FDI theory to discuss how the U.S. -
China trade war impact on FDI inflows to Vietnam.

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