Corporate Finance FIN 622
We shall take care of following topics in this hand out:
Motives for foreign investment
Economic and other motives
Risk of confiscation
Motives for Foreign Investment
We can divide the motives of MNCs into two broad categories. These are:
- Strategic motives
- Economic 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.
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.
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.
Corporate Finance FIN 622
Different Ways to Commence International Operations:
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.
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
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.
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.
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 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
Corporate Finance FIN 622
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
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