Review on the Effects of Foreign Direct Investment Finance Essay

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The removal of cross-border restrictions on international capital flows and the trend toward an integrated world economy has been a substantial progress over recent two decades. Hence, it has increased the growth of foreign direct investment(FDI) activity. Madura and Fox (2007) define foreign direct investment (FDI) as the investment in real assets (such as land, buildings, or even existing plants) in foreign countries. They also find that multinational corporations(MNCs) commonly capitalize on foreign business opportunities by engaging in FDI. They engage in joint ventures with foreign firms, acquire foreign firms, and form new foreign subsidiaries.

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These types of FDI can generate high returns when managed properly. A substantial investment is required, and thus can increase the risk at capital. It may be difficult for multinational corporation to sell the foreign project when the investment does not perform well as expected. In order to maximize the corporations’ value, it is significant for MNCs to understand the potential return and risk of FDI and analyze the potential benefits and costs before making investment decisions. 2.1.2 Motives for FDI The reason why firms locate production oversea rather than exporting from the home country or licensing production in the hose country, and the reason why firms seek to extend corporate control oversea by forming multinational corporations have been developed by many scholars. Kindleberger(1969) and Hymer(1976), emphasize various market imperfections in product, factor, and capital markets as the key motivating forces to accelerate FDI. Eun and Resnick (2004) explore some key factors that are important for corporations making decisions to invest oversea. These factors include trade barriers, imperfect labor market, intangible assets, vertical integration, product life cycle and shareholder diversification services. Dunning (1993) interpret four different types of motives for foreign direct investment: resource seeking, market seeking, efficiency seeking, and strategic asset (or capability )seeking. The first motive means that MNCs acquire some particular resources which may mainly cnsist of primary products at a lower cost in the host country than at home. The second motive depends on the expectation of new sales opportunities from the opening of markets where MNCs had no access at before.

The third one refers to utilizing the specific comparative advantages of a host economy. The last one is related with long-term strategic considerations such as gaining an significant stake in the market in the long run. To be more specific, Madura and Fox (2007) indicate that MNCs engage in foreign direct investment widely because it can improve profitability and enhance shareholder wealth. In most cases, MNCs utilize FDI to boost revenues, reduce costs, or both.

Revenue-related motives include attract new source of demand, enter profitable markets, exploit monopolistic advantages, react to trade restrictions and diversify internationally. Cost-related motives involve fully benefit from economies of scale, use foreign factors, use foreign raw materials, use foreign technology and react to exchange rate movements. 2.1.3 Benefits of FDI It seems unwise to conclude that both forms of geographic diversification are likely to be equally profitable or unprofitable. Errunza and Senbet (1981, 1984) find evidence to support a positive relation between excess firm value and the firm’s extent of international diversity by using multinational firms only. Focusing on international acquisitions, Doukas and Travlos (1988) and Doukas (1995) document that US bidders gain from industrial and international diversification.

Similarly, Morck and Yeung (1991, 2001) find a positive relation between international diversification and firm value. However, they show that industrial diversification and international diversification add or destroy value in the presence or absence of intangible assets. Their findings support the view that the synergistic benefits of international diversification stem from the information-based assets of the firm. Christophe and Pfeiffer (1998) and Click and Harrison (2000) find that multinational firms trade at a discount relative to domestic firms. More recently Denis, Denis and Yost (2002), using the Berger and Ofek (1995) excess value measure and aggregate data, show that global diversification reduces shareholder value by 18%, whereas industrial diversification results in 20% shareholder loss. In contrast, Bodnar, Tang and Weintrop (1999), relying on a similar valuation measure, find share-holder value to increase with global diversification. Doukas and Lang (2003) take firms which made foreign new plant announcements during the period 1980 – 1992 as a sample, regardless of the industrial structure of the firm, they interpret that unrelated foreign direct investments are associated with negative announcement effects and long-term performance decreases in subsequent years, whereas related investments are associated with positive short-term and long-term performance.

Although their findings indicate that both specialized and diversified firms benefit from core-business-related rather than non-core-business-related foreign direct investments, the gains are larger for diversified firms. They conclude that geographic expansion of the firm’s core business itself is beneficial to shareholder value. In contrast, they find that geographic expansion of the firm’s peripheral (non-core) business harms firm value and performance. Hence the evidence indicates that the internalization theory is more consistent with the international expansion of the core rather than the non-core business of the firm. That is, the positive synergies from global diversification are rooted in the firm’s core competencies. Theories of foreign direct investment (FDI) agree on at least one major point: foreign firms mush have inherent advantages that allow them to overcome the higher costs of becoming a multinational (Hymer, 1976) These advantages may be tangible, such as an improved production process or a product innovation.

They also may be intangible, such as brand names, better management structures or the technical knowledge of employees. Girma, Greenaway and Wakelin (2001) conclude that foreign firms do have higher productivity than domestic firms and they pay higher wages in the UK after their investigation. They do not find aggregate evidence of intra-industry spillovers. However, firms with low productivity relate to the sector average, in low-skill low foreign competition sectors gain less from foreign firms. FDI brings two main benefits to the host country. First, it introduces new production facilities into the domestic economy directly, or may rescue failing firms in the case of acquisition, raising overall output, employment and exports. Second, domestic governments hope that foreign firms will be unable to internalise their advantages fully, and local firms can benefit through spillover. 2.1.4 Effects of FDI Borensztein, Gregorio and Lee (1998) test the effect of foreign direct investment (FDI) on economic growth in a cross-country regression framework by utilizing data on FDI flows from industrial countries to 69 developing countries over the last two decades.

The results suggest that FDI is significant for transfer technology, and contribute more to growth than domestic investment. Moreover, they find that the contribution of FDI to economic growth is improved by its interaction with the level of human capital in the host country.

However, the empirical results imply that FDI is more productive than domestic investment only when the host country has a minimum threshold stock of human capital. Thus, FDI contributes to economic growth only when a sufficient absorptive capability of the advanced technologies is available in the host economy. Investigating the effect of FDI on domestic investment, they find that the inflow of foreign capital ‘crowds in’ domestic investment rather than ‘crowds out’. FDI support the expansion of domestic firms by complementarity in production or by increasing productivity through the spillover of advanced technology. A one-dollar increase in the net inflow of FDI is associated with an increase in total investment in the host economy of more than one dollar, but do not appear to be very robust. Thus, it appears that the main channel through which FDI contributes to economic growth is by stimulating technological progress, rather than by increasing total capital accumulation in the host economy. Markusen and Venables (1999) develops an analytical framework to assess the effects how an FDI project affect local firms in the same industry. There are two forces for the effect of entry of a multinational firm on the domestic industry.

One is a competition effect, under which multinationals displace domestic final-goods producers, and the other is a linkage effect back to intermediate-goods producers, creating complementarities which could benefit domestic final-goods producers. They explore the determinants of the relative strengths of these effects. In circumstances of initial equilibrium with no local production, multinational entry can push the economy over to an equilibrium with local production in both the intermediate and final-goods industries, with a resulting welfare improvement. They then pay attention to endogenise the entry decision of multinational firms. It may now also be the case that multinationals provide the initial impetus for industrialisation, but the developed local industry creates sufficiently intense competition to eventually drive the multinationals out of the market. Hobday (1995) finds initial multinational investments in developing East Asia created backward linkage effects to local suppliers in a large number of situations. There are some examples such as computer keyboards, personal computers, sewing machines, athletic shoes, and bicycles in Taiwan. 2.2 Cost of capital and capital structure Many major firms through the world have begun to internationalize their capital structure by raising funds from foreign as well as domestic sources. As a result, these corporations become multinational not only in the scope of their business activities but also in their capital structure. This trend reflects not only a conscious effort on the part of firms to lower the cost of capital by international sourcing of funds but also the ongoing liberalization and deregulation of international financial markets. If international financial markets were completely integrated, it would not matter whether firms raised capital from domestic or foreign sources because the cost of capital would be equalized across countries. On the other hand, some markets are less than fully integrated, firms may be able to create value for their shareholders by issuing securities in foreign as well as domestic markets. Cross-listing of a firm’s shares on foreign stock exchanges is one way a firm operating in a segmented capital market can lessen the negative effects of segmentation and also internationalize the firm’s capital structure.

For example, IBM, Sony, and British Petroleum are simultaneously listed and traded on the New York, London, and Tokyo stock exchanges. By internationalizing its corporate ownership structure, a firm can generally increase its shares price and lower its cost of capital. 2.2.1 Definition of cost of capital Eun and Resnick define the cost of capital as the minimum rate of return an investment project must generate in order to pay its financing costs. If the return on an investment project is equal to the cost of capital, under taking the project will leave the firm’s value unaffected. When a firm identifies and undertakes an investment project that generate a return exceeding its cost of capital, the firm’s value will increase. It is significant for a value-maximizing firm to try to lower its cost of capital. Madura and Fox (2007) explain that a firm’s weighted average cost of capital (referred to as Kc ) can be measured as: Kc = [D/(D+E )] * Kd * ( 1-t ) + [E / (D+E)] * Ke Where: D = market value of firm’s debt Kd = the before-tax cost of its debt t = the corporate tax rate E = the firm’s equity at market value Ke = the cost of financing with equity The ratios reflect the percentage of capital represented by debt and equity, respectively. In total the cost f capital, Kc is the average cost of all providers of finance to the firms. A multinational company finances its operations by using a mixture of fixed interest borrowing and equity financing that can minimize the overall cost of capital (the weighted average of its interest rate and dividend payment). By minimizing the cost of capital used to finance a given size and risk of operations ,financial managers can maximize the value of the company and therefore maximize shareholder wealth. According to the different size of firm, international diversification, exposure to exchange rate risk, access to international capital markets and exposure to country risk, the cost of capital for MNCs may different from that for domestic firms. 2.2.2 Costs of capital across countries Madura and Fox (2007) interpret that the reason why cost of capital is different among countries is relevant for three reasons. First, MNCs based in some countries may have more competitive advantages than others not only for the different technology and resources across countries, but also the cost of capital. MNCs in some countries will have a larger set of feasible projects with positive net present value because of the lower cost of capital, hence these MNCs can increase their world market share more easily. MNCs operating in countries with a higher cost of capital will be forced to decline projects. Second, MNCs may be able to adjust their international operations and sources of funds to capitalize on differences in the cost of capital among countries.

Third, the different component as debt and equity in the cost capital can explain why MNCs based in some countries tend to use a more debt-intensive capital structure than others. To estimate an overall cost of capital for an MNCs, it needs to combine the costs of debt and equity, and weight the relative proportions of debt and equity. The cost of debt to a firm is primarily determined by the risk-free interest rate in the currency borrowed and the risk premium required by creditors. Risk-free interest rate is determined by the interaction of the supply and demand for funds. Factors include tax laws, demographics, monetary policies and economic conditions can influence the supply and demand then affect the risk-free rate. The risk premium on debt can vary among countries because of the different economic conditions, relations between corporations and creditors, government intervention, and degree of financial leverage. In addition, a firm’s cost of equity represents an opportunity cost – what shareholders could earn on investments with similar risk if the equity funds were distributed to them.

This return on equity can be measured as a risk-free interest rate that could have been earned by shareholders, plus a premium to reflect the risk of the firm. According to the different economic environments, the risk premium and the cost of equity will vary among countries. 2.2.3 MNC’s capital structure decision Madura and Fox.(2007) indicate that an MNC’s capital structure decision includes the choice of debt versus equity financing within all of its subsidiaries, hence the overall capital structure is combined of all subsidiaries’ capital structures.

The advantages of using debtor equity vary according to the corporate characteristics specific to each MNC and specific to countries where the MNCs establish subsidiaries. They interpret some specific corporate characteristics which can influence MNCs’ capital structure. MNCs with more stable cash flows can deal with more debt because their cash flows are constant to cover periodic interest payments. In contrast, MNCs with erratic cash flows might prefer less debt. MNCs with lower credit risk have more access to credit, their choice of using debt or equity can be affected by factors which influence credit risk. MNCs with high profit may be able to finance most of investment with retaining earnings and use an equity-intensive capital structure, while others with small level of retained earnings may prefer on debt financing. The subsidiaries’ borrowing capacity may be increase and need less equity financing once the parent backs the debt. Agency costs are higher when a subsidiary in foreign country can not be monitored easily be investor from parent’s country. In addition, they also describe the specific country characteristics unique to each host country can influence MNCs’ choice of debt versus equity financing and thus influence their capital structure. Firstly, some host countries have stock restrictions which means the governments allow investment only in local stocks.

This kind of barrier of cross-border investing, potential adverse exchange rate and tax effects can discourage investment outside home countries. MNCs operated in these countries where investor have fewer stock investment opportunities may be able to raise equity at a relatively low cost, and they would prefer using more equity by issuing stocks. Secondly, according to the government-imposed barriers on capital flows along with potential adverse exchange rate, tax and country risk effects, loanable funds do not always flows th where they are needed most and the price of them can vary across different countries. MNCs may be able to obtain loanable funds at lower cost in some countries and they will prefer the debt financing. Thirdly, regard of the potential weakness of the currencies in subsidiaries’ host countries, an MNC may attempt to finance by borrowing currencies instead of relying on parent funds. Subsidiaries may remit a smaller amount in earning because they can make interest payments on local debt, and thus reduce the exposure to exchange rate. Conversely, subsidiaries may retain and reinvest more of its earnings when the parent believes a subsidiaries’ local currency will appreciate against its own currency.

The parent may provide an cash infusion to finance growth in the subsidiaries, and thus transfer the internal funds from the parent to subsidiary possibly resulting in more external financing by the parent and less debt financing by the subsidiary. Fourthly, possibility of a kind of country risk is that the host country will temporarily block funds to be remitted by subsidiary to the parent. Thus aubsidiraies may prefer to local debt financing. At last, MNCs make interest rate payments on the local debt when they are subject to a withholding tax. Foreign subsidiaries may also use local debt if the host country impose high corporate tax rates on foreign earnings. Bancel and Mittoo (2004) survey on the cross-country comparisons of managerial views on determinants of capital structure in a sample of 16 European countries: Austria, Belgium, Greece, Denmark, Finland, Ireland, Italy, France, Germany, Netherlands, Norway, Portugal, Spain, Switzerland, Sweden, and the UK. They show that factors related to debt are influenced more, and those related to equity are influenced less, by the country’s institutional structure, especially the quality of its legal system.

They find that financial flexibility and earnings per share dilution are primary concerns of managers in issuing debt and common stock, respectively. Managers also value hedging considerations and use “windows of opportunity ” when raising capital. This evidence strengthens arguments of La Porta et al. (1997, 1998) that the availability of external financing in a country is influenced primarily by its legal environment. Since agency costs of debt are likely to be higher in countries with lower quality of legal systems, this evidence is also consistent with theories of capital structure such as agency theory that assign a central role to debt contracts and bankruptcy law (Harris and Raviv, 1991). They find that although a country’s legal environment is an important determinant of debt policy, but it plays a minimal role in common stock policy. They find that firms’ financing policies are influenced by both their institutional environment and their international operations.

They also show that firms can adopt strategies to mitigate the negative effects of the quality of the legal environment in their home country. For instance, firms in civil-law countries have significantly higher concerns for maintaining target debt-to-equity ratios and matching maturity than do their peers in the common-law countries.

Further, they find that firms operating internationally have significantly different views than do their peers in several ways. For example, firms that have issued foreign debt or equity in the sample during the last ten years are more concerned about credit ratings. Firm-specific variables that are commonly used in the capital structure literature to explain leverage also explain cross-country differences in managerial rankings of several factors. For example, large firms are less concerned about bankruptcy costs, and high growth firms consider common stock as the cheapest source of funds and use windows of opportunity to issue common stock.

These results support the arguement by Rajan and Zingales (1995, 2003), that firms’ capital structures are the result of a complex interaction of several institutional features as well as firm characteristics in the home country. Their results support that most firms determine their optimal capital structure by trading off factors such as tax advantage of debt, bankruptcy costs, agency costs, and accessibility to external financing. They confirm the conclusions of Titman (2002): “Corporate treasurers do occasionally think about the kind of trade-offs between tax savings and financial distress costs that we teach in our corporate finance classes. However, since this trade-off does not change much over time, the balancing of the costs and benefits of debt financing that they emphasize much is not MNCs’ major concern. They spend much more time thinking about changes in market conditions and the implications of these changes on how firms should be financed.” Lee and Kwok (1988) examine the impact of international environmental factors on some firm-related capital structure determinants which in turn affect the MNC’s overall capital structure. They consider international environmental variables of political risk, international market imperfections, complexity of operations, opportunities for international diversification, foreign exchange risk and local factors of host countries, and test agency costs and bankruptcy costs.

They find that MNCs tend to have higher agency costs of debt according to Myers’ definition than DCs. This finding remained unchanged even when size and industry effects were controlled. Though MNCs appeared to have lower bankruptcy costs than DCs, the difference largely disappeared when the size effect was controlled. Quite contrary to the conventional wisdom, the empirical findings showed that MNCs tended to be less leveraged than DCs. This finding remained even when the size effect was controlled. However, when companies were separated under different industry groups, the results varied significantly. Burgman (1996) directly estimate the effect of foreign exchange risk and political risk on the capital structure of MNCs. Using the foreign tax ratio to classify firms as either MNCs or DCs and controlling for industry and size effects, Burgman finds that MNCs have lower debt ratios and higher agency costs than DCs. Furthermore, international diversification does not appear to lower earnings volatility. To estimate the sensitivity of a firm to foreign exchange risk, Burgman conducts a regression analysis of the stock returns of each sample firm on the returns of an index of U.S. stocks and on the U.S.$:SDR returns.

His political risk measure is based on the following ratio: number of low political risk countries to the total number of countries in which the firm operates. Low political risk countries are the top 20 in the country risk rankings provided by Euromoney in 1989. The results of a regression analysis for his sample of MNCs suggest that the debt ratios of these companies are positively related to both risks. Burgman concludes that this evidence is consistent with the hypothesis that MNCs use debt policy as a tool to hedge foreign exchange risk and political risk. Chen et al. (1997) conducted regression analyses to investigate the effect of international activities (as measured by foreign pre-tax income) on capital structure. They report that even after controlling for firm size, agency costs of debt, bankruptcy costs and profitability, the long-term debt ratios of MNCs are lower than those of DCs. However, within their sample of MNCs, debt ratios increase with the level of international activities. 2.2.4 Segmented capital market A capital market for asset claims is integrated when the opportunity set of investments available to each and every investor is the universe of all possible asset claims. In contrast, a capital market is segmented when certain groups of investors limit their investments to a subset of the universe of all possible asset claims. Such market segmentation can occur because of ignorance about the universe of possible asset claims, or because of transactions costs (brokerage costs, taxes, or information acquisition costs), or because of legal impediments.

From an international perspective, market segmentation typically occurs along national borders, a condition wherein investors in each country acquire only domestic asset claims. Grubel, Levy and Sarnat, and Lessard employ a mean-variance portfolio theoretic framework, have stressed the benefits of diversifying investments across national borders, namely the pooling of risks that results from investing in projects that are less than perfectly correlated. Subrahmanyam points out that when segmented capital markets are integrated, in addition to the diversification effect (always positive), there is a wealth effect (possibly negative) which arises out of changes in the macro-parameters of the risk-return relationship.

For the special cases of quadratic, exponential, and logarithmic utility functions, it can be shown’ that international capital market integration is Pareto-optimal, that is, the welfare of individuals in the integrated economies will not decline, and will generally improve. The positive effect of an expansion in the opportunity set offsets any negative wealth effect. The market reformed and liberalized in developed economies in the 1970s and emerging economies during the second half of the 1980s led to the removal of many barriers. The deregulation and the development of local equity markets allowed the possibility of foreign portfolio investments (FPIs). Overall, FPIs would provide a new source of capital and internationalize the domestic capital markets. Subsequent improvements in risk sharing and risk matching would cause the cost of capital to fall.

Errunza and Miller (2000 ) use a sample of 126 firms from 32 countries, document a significant decline of 42% in the cost of capital. In addition, they show the decline is driven by the ability of U.S. investors to span the foreign security prior to cross-listing. The findings support the hypothesis that financial market liberalizations have significant economic benefits. 2.2.5 Interaction between subsidiary and parent financing decisions In segmented markets the parent and its subsidiaries will generally have different valuation objectives and investment-acceptance criteria. Under some conditions these depend on the international financing mix. Decentralization can be optimal in the sense of global maximization, provided that the parent is unrealistically free, ex-ante, to optimize its percentage ownership in the subsidiaries at the beginning of each planning period. In the case of a two-country firm, the subsidiaries’ maximands are independent of the parent’s. But when the parent’s ownership position is predetermined at a fixed level, as it is normally, the situation is radically different. Market values cannot then be maximized independently and Pareto optimization is required.

Michael’s (1974) main result is that, unless agreement can be reached on a compensation principle, the joint venture’s cost of capital will be indeterminate. In such circumstances optimal financial planning for the MNC as a whole may be impossible. Concluding remarks draw attention to the attendant possibility that the MNC in this case may be unstable and/or inefficient. 2.2.6 The MNC’s capital structure decision An MNC’s capital structure decision involves the choice of debt versus equity financing within all of its subsidiaries. Thus, its overall capital structure is essentially a combination of all of its subsidiaries’ capital structures. MNCs recognize the tradeoff between using debt and using equity for financing their operations. The advantages of using debt as opposed to equity vary with corporate characteristics specific to each MNC and specific to the countries where the MNC has established subsidiaries. Madera and Fox (2007) indicate some common firm-specific characteristics that affect the Mac’s capital structure such as stability of Mac’s cash flows, Mac’s credit risk, Mac’s access to retained earnings, Mac’s guarantees on debt and Mac’s agency problems.

They also point the unique host country characteristics can influence the MNC’s choice of debt versus equity financing and therefore influence the MNC’s capital structure. These characteristics include stock restrictions in host countries, interest rates in hose countries, strength of host country currencies, country risk in host countries and tax laws in host countries. 2.3 Risk analysis 2.3.1 Country risks With operations under the jurisdiction of a foreign government the firm is also exposed to political risk, therefore it must estimate the potential costs it will face due to unstable governments, regime change and changes in policies. Political risk may be defined as a particular exposure to risk which depends on the actions of a government, and its assessment or analysis for a MNC is a decision-making tool for investing in foreign countries. An MNC must assess country risk not only in countries where it currently does business but also in those where it expects to export or establish subsidiaries. Many country risk characteristics related to the political environment can influence an MNC. Madura and Fox (2007) indicate that an extreme form of political risk is the possibility that the host country will take over a subsidiary. In some cases of expropriation, some compensation is awarded, and the amount is decided by the hose country government. In other cases, the assets are confiscated and no compensation is provided. Expropriation can take place peacefully or by force.

They also explore other common forms of country related risks include attitude of consumers in the host country, actions of host government, blockage of fund transfers, currency inconvertibility, war, bureaucracy and corruption. Over recent decades, there has been a significant increase in political risk for MNCs. This is true not only for an MNC’s operations in developing countries, but also for those in developed countries. Governments have felt the need to respond to various pressure groups aimed at curbing the power of MNCs. For example, oil companies may face unfavourable legislation designed to pay for the damage to environment.

Developing countries may have to respond to populist sentiments or worsening economic circumstances by seeking to renege on contracts signed by previous regimes. Another risk area which has grown in recent years has been the strength of fundamentalist religious groups in a number of economically important regions. Shapiro (1999) and Buckley (2000) argue that government intervention in the economy increases the likelihood of political risk for the MNCs. Proponents of free markets strongly support this view, arguing that government intervention creates a number of inefficiencies in the markets that discourage competition, justify the privilege of state-controlled enterprises, promote unnecessary bureaucracy, and overall stifle initiative. Clark and Marois(1996) and Wilkin (2000) categorise negative political risks as macro and micro risks. Macro political risks are those which affect MNCs in general, whereas micro political risks are those which relate to specific firms in specific countries.

Shapiro identifies them as: expropriation; currency and trade controls; changes in tax and labour laws; regulatory restrictions; and requirements for additional local production( 1996:747). Simon’s framework includes wider societal issues such as public opinion, alliance shifts, revolutions and coups (quoted in Demirag and Goddard, 1994). Expropriation is generally regarded as the most obvious and extreme form of political risk. The realities of the current global economic climate mean that many countries may not resort to such drastic measures, due to the very unfavourable situation that such an action may create for them in the long term. This could be in the form of international economic isolation and cessation of support from the International Monetary Fund and the World Bank. This support is vital for continued economic progress in developing countries, and any cessation of it may mean an even tougher economic environment for these countries. Before commencing operations an MNC should undertake a dispassionate and careful analysis of the political risk of operating in the foreign country concerned. Operations in developing countries may require a more thorough analysis of the costs versus benefits, and a large degree of uncertainty may always be present in starting operations in a developing country.

This should be weighed against the perceived benefits and calculated returns on investment. It is important for the MNC to take a calculated and educated view of the situation. There is no commercial activity without risk, and a degree of risk will therefore have to be accepted. Some of the important aspects that need to be looked at are: political stability, or degree of acceptable instability; economic factors; savings, development and social stability; government budget deficits; and transparency and openness of the economy. It must also be recognised that recent developments in terrorism risk are bringing a new dimension to political risks. While terrorism in the past may have been identifiable as a ‘county’ risk, such as the IRA in the UK, Abu Nidal in Israel and the Shining Path in Peru.

There is the growth of terrorist groups in the 21st century who are not associated with a specific nation-state or narrow geographical region. The actions of such groups may disrupt a business across a range of activities and locations, rather than simply disrupting operations in a specific country. The most obvious answer when faced with political risk would perhaps be to avoid it completely by deciding not to do business in a particular country, but this has to be balanced against the loss of an opportunity to make a profit, and the more global nature of certain political risks. Given the risks inherent in business generally, it would normally only be the most extreme situations that require avoidance. The decision would most probably be made, on commercial grounds, to accept a degree of political risk and attempt to manage such risk effectively. Political risk, like other risks, may be managed by diversification across various territories. Henisz (2000) shows that multinationals face an increasing threat of expropriation if political hazard in the host country increases.

However, the degree of risks depends on the strategic behaviour of the multinational, which may partner with host-country firms that have a comparative advantage in interactions with the host-country government. Harms (2002) estimated the impact of financial risk on equity investment flows which includes the sum of FDI and portfolio investment to developing countries.

Using a panel data set of 55 developing countries and the period 1987 to 1995, he find that lower financial risk is associated with an increase in FDI and portfolio investment. On the other hand, Egger and Winner (2005), utilize a sample of 73 countries over the period 1995 to 1999 and find a positive linkage between corruption and FDI. In the presence of excessive regulation and other administrative controls, they propose that corruption may act as a “helping hand”? to encourage FDI inflows. Recently, several studies have analysed the relationship between fundamental democratic rights and FDI. Using different econometric techniques and periods, Harms and Ursprung (2002), Jensen (2003), and Busse (2004) interpret that multinational corporations are more likely to be attracted where there is democracy. On the other hand, Li and Resnick (2003) argue that competing causal linkages are at work. They find that democratic rights lead to improved property rights protection, which increases foreign investment. Apart from this indirect impact on FDI, increases in democracy may reduce FDI. These studies use pooled time-series analysis, but not all of them account for possible endogeneity of the independent variables while some often focus on very specific indicators such as democratic rights, omitting a broader range of policy-related variables. Busse and Hefeker (2007) explore the linkages among political risk, institutions, and foreign direct investment inflows and show that government stability, internal and external conflict, corruption and ethnic tensions, law and order, democratic accountability of government, and quality of bureaucracy are highly significant determinants of foreign investment inflows. 2.3.2 Exchange rate risks In foreign direct investment (FDI), most firms face exchange rate risk because the exchange rate between the home and host currencies might change in the future. When transactions are contractually finalized (transactions exposure), the firm’s value might change because of the sensitive exchange rate movements (economic exposure). The importance of exchange-rate variability for domestic and international investment flows has been argued quite a lot. In industrialized economies, the presumed effects of exchange-rate variability have influenced the choice of international monetary regimes.

The Smithsonian Agreement was discussed in the early 1970s and again at the time of the Plaza Accord during the mid-1980s. In the early 1990s, the negative implication of variable exchange rates was a theme for designing the Exchange Rate Mechanism (ERM) operable over currencies in the European Monetary System (EMS). The currency crises within the ERM in September 1992 and Spring 1993 refocused attention on the rationale for limiting short-term nominal exchange rate movements and on the validity of arguments that exchange rate variability is costly and dampens real economic activity. Igawa (1983), Cushman (1985, 1988) and Goldberg and Kolstad (1995) examine bilateral FDI flows between the U.S. and a few of developed countries (U.K., France, Germany, Canada and Japan), they find a positive relationship between exchange rate risk and FDI. On the other hand, Kelly and Philippatos (1982) argue that the investments appeal less when the exchange rate risk is greater. Clare (1992, 1998), Benassy-Quere, Fontagne, and Lahreche-Revil (2001) and Brzozowski (2006) focus on cross-country studies and all find a negative relationship between exchange rate risk and FDI. Benassy-Quere, Fontagne, and Lahreche-Revil’s (2001) study covers FDI flows from 17 OECD nations to 42 developing countries, finding a negative response to exchange rate risk. Brzozowski’s (2006) study covers FDI flows to 32 transition and emerging countries, and shows a relationship not as strong as expected, is still negative. Clare’s (1992) study covers the FDI flow from the U.S. to 14 developed and 15 developing countries, and finds a strong negative relationship for each set of countries as well as across the entire spectrum of countries. Clark, Hooper and Kohlhagen, Gotur, Cushman (1983, 1988), De Grauwe, Maskus, and others focus on tudies of the effects of exchange rate risk on trade and find that exchange rate risk reduces trade. However, earlier results (Hooper and Kohlhagen) lend little support to this hypothesis; although Cushman (1988) find significant adverse effects of exchange rate risk on U.S. trade flows.

Pick (1990) analyzes the effects of exchange rate risk on U.S. agricultural exports to ten different countries and estimate a model which incorporates exchange rate risk. but it also shows that exchange rate risk is not always important. His results suggest that the exchange rate risk was not significant in the seven developed markets, but significant to determine U.S. agricultural exports. Anderson and Garcia ( 1989) examine the effects of exchange rate uncertainty on bilateral soybean trade flows and finds that imports for Japan, France, and Spain are sensitive to short-term variations in nominal bilateral exchange rates. Madura and Fox, R.(2007) suggest that the exchange rate risk from financing with bonds in foreign currencies can be reduced by using one of the alternative strategies. MNCs may be able to offset their exposure to exchange rate risk by issuing bonds denominated in the local currency. Alternatively, the MNC might obtain debt financing in its home currency at a lower interest rate, but it will not be able to offset its earnings in the foreign currency.

Recall that countries where bond yield are high tend to have a high risk-free interest rate and that a high risk-free interest rate usually occurs where inflation is high. Also consider that the currencies of countries with relatively high inflation tend to weaken over time. Thus, it is difficult for MNCs consider obtain long-term financing. Issue debt in the local currency and reduce exposure to exchange rate risk, or issue debt denominated in its home currency at a lower interest rate but with considerable exposure to exchange rate risk. Neither solution is without problems. 2.3.3 Interest rate risks Madura and Fox (2007) interpret that higher interest rates tend to slow the growth of an economy and reduce demand for the MNC’s products.

Lower interest rates often stimulate the economy and increase demand for MNC’s products. Normally, an MNC will not use a maturity that exceeds the expected life of the business in that country. Madura and Fox (2007) indicate that the MNC is exposed to interest rate risk when it uses a relatively short maturity, or the risk that interest risk will rise, forcing it to refinance at a higher interest rate. It can avoid this exposure by issuing a long-term bond (with a fixed interest rate) that matches the expected life of the operations in the foreign country.

The disadvantage is that long-term interest rates may decline in the near future, but the MNC will be obliged to continue making its debt payments at a higher rate. There is no perfect solution, but the MNC should consider the expected life of the business and the yield curve in the per annum rate for bonds of differing maturities. The difference is shaped by the demand for and supply of fund at various maturity level in a country’s debt market. 3. Methodology 3.1 Reseach methods and data (not be finished) Here, this dissertation use the second data gathered from the companies and research based on other scholars’ research. 3.2 The International Capital Asset Pricing Model(ICAPM) Madura and Fox (2007) indicate that the International Capital Asset Prcing Model (ICAPM) can be regarded as more formal treatment of the cost of capital elements than mentioned before. This model is an international extension of the Capital Asset Pricing Model (CAPM). The CAPM addresses a single currency area and single financial market where there are no restrictions on financial transactions.

The ICAPM extends this analysis to multiple currency areas and multiple financial markets. Both these two models seek to answer the question what discount rate should be applied to the future cash flows of a particular project. Kj = Rf + βj ( Rm – Rf ) Where: Rf = risk free rate of return Rm = market return Î’ = beta of a particular share or a project The application of the CAPM model and the ICAPM model presents considerable practical problems for an MNC. The company first has to find a like project of a similar risk class to identify an appropriate beta. Highly correlated measures of return can produce very different betas. There is a problem of meaning. Why a beta is particularly high or low or why it changes is not easy to explain.

Selecting the appropriate beta may well not be easy. A final critique is that the model is not complete. The application of the ICAPM or any discount cash flow model does not account for the role of real options in investments. Capital asset pricing theory suggests that the cost of capital should be genrerally lower for MNCs than domestic firms. MNCs have a greater opportunity to diversify across different financial markets. The systematic or non-diversifiable element of their investment should be lower. However, invest abroad is risky, more risky than domestic investment.

The non-systematic part of risk may therefore reasonably be expected to be greater. MNCs diversification opportunities may be limited because different market is possible, but the product and demand for the product is fairly narrow. The extensive use of derivatives by MNCs is an attempt to lower such risk. It is hard to say an MNC will have a lower cost of capital than a purly domestic firm in the same industry. However, this discussion can be used to understand an MNC may attempt to take full advantage of the favourable aspects that reduce its cost of capital.

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Review On The Effects Of Foreign Direct Investment Finance Essay. (2017, Jun 26). Retrieved February 5, 2023 , from

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