Competitive Strategies: Modes of Entry and FDI

Professor Daniel F. Spulber

Enron India
What risks did Enron face going into the Dabhol project? Political risk: expropriation of investment Political risk: renegotiation of contracts after investment Contract risk: problems with local partners Currency risk Market risk: costs of energy and demand for electric power Recovery of investment costs (FDI)

Enron India
How did Enron prepare for the risks of the project? Long term contracts: purchase agreement, Maharashtra State Electrical Board was a credible buyer Political risk: participation of Overseas Private Investment Corp, US ExportImport Bank, International Finance Corp. Revenues tied to US dollar Partners GE and Bechtel Substantial research

Enron India
How could Enron have dealt with risk more effectively? Enron could have relied less on FDI Enron could have emphasized transactions, making arrangements for construction, power supply contracts, and technology transfer More reliance on local partners to construct and operate project Greater participation of other Indian institutions

Enron India
Why did Enron choose ownership (FDI)? To exercise control over assets in investment projects To control technology due to limits on intellectual property rights To improve operational effectiveness To learn about market for future projects To avoid expected contract risk

Enron International Operations

Financial Highlights: Growth in assets

FDI is a key aspect of International Business FDI is what makes the company a multinational firm

FDI FDI includes cross-border business investment and M&A. (not portfolio investment) World FDI inflows: $209 billion (1990) (Cross-border M&A: $151 b.) $1,492 billion (2000) (Cross-border M&A: $1,144 b.) $735 billion (2001) (Cross-border M&A: $594 b.) $651 billion (2002) (Cross-border M&A $ 370 b.) $560 billion (2003) (Cross-border M&A $ 297 b.) Compare with world total gross fixed capital formation: $7,294 b. (2003)
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FDI World FDI inward stock: $8,245 billion (2003) Sales of foreign affiliates: $17,580 billion (2003) (Compare with international trade of $9,228 billion (2003) Gross product of foreign affiliates: $3,706 billion (2003) (Compare with world GDP of $36 trillion in 2003). Total assets of foreign affiliates: $30,362 billion (2003) Employment of foreign affiliates: Over 54 million people (2003 estimated) Data from United Nations World Investment Report and UNCTAD website
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FDI 2003 $ Billions FDI inflows Developed countries Developing countries Central and Eastern Europe 367 FDI outflows 570

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International modes of entry and value at risk

FDI whether M&A or company growth puts full value at risk. Toyota factory, Wal-Mart store Managers of an international business choose the mode of entry based on a trade-off between risk versus control in the particular supplier or customer country Joint ventures, not only share knowledge, but also share investment costs and value at risk Spot or contract sales can substantially reduce value at risk
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International modes of entry and value at risk

Choice of entry mode jointly determines degree of control and extent of risk

M&A Degree of commitment depends on Growth Increase in contractual duration and vertical integration Alliances/ control,

Joint Increase in Ventures commitm As knowledge increases over time, can ent Licenses increase degree of commitment to get closer to desired entry mode. Contract and risk Spot
Contractual transactions may give optimal mix of control and commitment

With less knowledge of other countrys market, choose lower degree of commitment

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Choosing target countries for FDI Costs of investment project Estimate potential expected returnsV(K) Determine risks associated with revenues and costs in host country -- Best estimates of expected cash flow Apply appropriate risk-adjusted discount rate r K

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Choosing target countries for FDI Manager considers trade off between risk and return Country A NPV = - K + VA/(1 + rA)

Country X NPV = - K + VX/(1 + rX)

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Apply NPV analysis to choose target country for FDI

Example: Investment cost is K = $2,000 Investment in Country A yields an expected net cash flow of $12,600 with risk-adjusted discount rate of 20% NPV Country A = $8,500 Investment in Country X yields an expected net cash flow of $13,000 with risk-adjusted discount rate of 30% NPV Country X = $8,000 Invest in Country A
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Apply NPV analysis to choose level of FDI

Choose K to max K

V (K ) (1 + r )

V ( K *) Investment K solves 1 = (1 + r )
Therefore, 1 + r = V'(K*)
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Companies invest less in riskier countries all other things equal $/K Expected marginal return to FDI equals 1 + r. Note diminishing marginal return to investment

1 + r = V ( K *)
1 + 0.3 1 + 0.2 V(K) K* K* K
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FDI Example: Choosing the level of investment

K V(K) = K + 3.2K .25K2 V(K)/(1 + 0.2) 2.95 5.40 7.35 8.80 9.75 10.20 1.458 2.5 3.125 3.333 *** 3.125 2.5

1 2 3 4 5 6

Let r = 0.2 What level of investment should the manager choose? V'(K) = 3.2 .5K. 1 + 0.2 = 3.2 .5K* K* = 4.

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Why is FDI so common in international business? Advantages of FDI Production or distribution facilities in a country can reduce costs of trade (transportation, tariff and nontariff barriers, transaction costs, and time) Toyota in US Production within a country takes advantage of domestic sourcing of parts, components, services Investment and employment in host country gain political support for the international business: quid pro quo investment Cemex and Southdown

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Why is FDI so common in international business? Advantages of FDI Closer to customers for manufacturers Necessary for retail and wholesale companies Wal Mart, Carrefour, Ingram Micro Take advantage of low-cost labor, highly-skilled labor, and proximity to resources Reduce costs of trade from import/export

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Advantages of vertical FDI Coordination advantages through the value chain Access to production facilities, sourcing networks and distribution networks Keeping technology and intellectual property in-house Substitution of internal transactions for market transactions

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Advantages of Horizontal FDI M&A acquisition of competitors for market power or cost savings M&A to achieve economies of scale and scope (Daimler/Chrysler, VW) M&A to purchase of technology M&A to acquire brand names Production avoids costs of trade relative to export As hedge against demand and supply fluctuations -- Cemex Market power in international purchasing (e.g. Vodaphone/Airtouch purchases wireless equipment for its many operations)

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Disadvantages of FDI Risk that firm many not recover investment and returns to investment in supplier country FDI increases capital investment, reduces flexibility FDI ties business to particular country locations for production or distribution Vertical FDI makes the firm more vertically integrated

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FDI Trends Shift of investment mix toward services About half in 1990, about two thirds in 2000 Shift of investment to outsourcing abroad (offshoring + outsourcing) reduction in vertical integration Globalization (lower costs of trade) leading to reduction in vertical FDI Globalization (market integration) likely to lead to increases in horizontal FDI
UNCTAD World Investment Report 2004
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Licensing versus FDI Why is FDI more prevalent than technology licensing? Licensing agreements depend heavily on international enforcement of intellectual property rights International licensing also entails costs of trade International licensing is quite common amongst developed countries, reaching levels up to 1/3 of domestic R&D expenditures International licensing experiencing rapid growth

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Overview and Take-Away Points FDI a major feature of international business composition of FDI undergoing transformation from vertical to horizontal FDI offers advantages in terms of ownership and control and avoiding trade barriers Choose target countries based on expected cash flow and costs of investment and discount using risk adjusted rate of return Adjust level of investment to reflect expected cash flow and risk-adjusted rate of return

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