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In your own words, define two methods to adjust for varying levels of risk when conducting a capital budgeting analysis. Be sure to address the result on net present value and the benefits and drawbacks of the two methods. Your response should be at least 200 words in length. All sources used, including the textbook, must be referenced; paraphrased and quoted material must have accompanying citations.
Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2012). Fundamentals of multinational finance. (IV ed., pp. 43-443). New York: Pearson.
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People don’t want a quarter-inch drill.They want a
quarter-inch hole. -Theodore Levitt, Harvard Business School.
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i F:
5
I Demonstrate how key competitive advantages support MNEs’strategy to originate and
sustain direct foreign investment.
* Show how the OLI Paradigm provides a theoretical foundation for the globalization
process.
* Identify factors and forces that must be considered in the determination of where
multinational enterprises invest.
I Iilustrate the managerial and competitive dimensions of the alternative methods for
foreign investment.
il Identify the strategies used by MNEs originating in developing countries to compete
in
global markets.
* Define and classify foreign political risks.
a Analyze firm-specific risks.
I Examine country-specific risks.
* Identify global-specific risks.
The strategic decision to undertake foreign direct investment (FDI), and thus become an
MNE, starts with a self-evaluation. This self-evaluation combines a series of questions
including the nature of the firm’s competitive advantage, what business form and commen-
surate risks the firm should use and accept upon entry, and what political risks-both
macro and micro in context-the firm will be facing. This chapter explores this sequence of
self-evaluation, as well as methods for both measuring and managing the political risks con-
fronting MNEs today in both the established industrial markets and the most promising
emerging markets. The Mini-Case at the end of this chapter, Corporate Competition from
the Emerging Markets, highlights the growing complexity of emerging market competi-
tiveness in the global economy, and how many of tomorrow’s most competitive MNEs
may be arising from the emerging markets themselves.
CHAPTEFI 15 Foreign Direct lnvestmentand Political Risk 409
rd
Sustaining ancl Transferring Carnpetitive Aclvamtage
In deciding whether to invest abroad, management must first determine whether
the firm
has a sustainable competitive advantage thaienables it to compete effectively in
the home
market. The competitive advantage **t U” firm-specific, transferable, and powerful enough
to compensate the tirm for thJ potential disadvantages of operating abroad (foreign
exchange risks, political risks, and increased agency costs-)’
Based on observations of firms that hauJsuciessfully invested abroad, we
can conclude
that some of the competitive advantages enjoyed by MNEs are 1) economies
of scale and
scope arising from their large size;Z) rnanaglrial and marketing expertise;
3) superior tech-
,rotfgy owirig to their heavy emphasis on iesearch; 4) financial strength; 5) differentiated
prod
ii
“tr; anJ sometimes 6) competitiveness of their home markets’
Fconomies ef Scale and $coPe
Economies of scale and scope can be developed in production, marketing,
finance’ research
and development, transport;tion, and purchasing’ A11 of these areas have
significant compet-
itive advantages of U”i-ng iuigt, whether size is lue to international or domestic
operations’
Production economies can come from the use of large-scale automated
plant and equipment
or from an ability to rationalize production through global specialization.
For example, some ar,tomobil” manufactureis, iuch as Ford, rationalize manufacturing
by producing engines in one country, transmissions in another, and bodies in another
and
assembling sIill elsewhere, with the location often being dictated by comparative
advantage’
Marketing-economies occur when firms are large enough to “t”.11″
most efficient advertising
media to
-create
global brand identification, as well as to establish global distribution, ware-
housing, and servicing systems. Financial economies derive from access to the
full range of
financial instruments-ani *our””, of funds, such as the Euroequity and Eurobond
markets’
In-house research and development programs are typically restricted to large
firms because
of the minimum-size thresholb for eitablishing a laboratory and scientific staff.
T?ansporta-
tion economies accrue to firms that can t[ip itt carload or shipload lots’ Purchasing
economies come from quantity discounts and market power’
lVlanagerial and Marketing Hxperti*e
Managerial expertise includes skill in managing large-industrial organizations
from both a
human and a technical viewpoint. It also “.r.J*fut.”s
knowledge of modern analytical tech-
niques and their application in functional areas of business. Managerial expertise can
be
developed throughrprior experience in foreign markets’ In most.empirical studies multina-
tional firms have been observed to export to I market before establishing a production facil-
ity there. Likewise, they have prior experience sourcing raw materials and human capital
in
oiher foreign countries either through imports, licensing, or FDI- In this manner, the
MNEs
can partiaily overcome the supposed .up”iiot local knowledge of host-country firms’
Adrran*eei Te*hnCIlogy
Advanced technology includes both scientific and engineering skills’ It is not limited
t
o
MNEs, but firms in iie most industrialized countries have had an advantage in terms of
access to continuing new technology spin-offs from the military and space Programs’
Empirical studies have supported the imp;rtance of technology as a characteristic
of MNEs’
Financial $trenEtlr
Companies demonstrate financial strength by achieving and maintaining a global
cost and
avaltaUitity of capital. This is a critical competitive cosl variable that enables them to fund
FDI and other foreign activities. MNEs thai are resident in liquid and unsegmented capital
470 PA FT 5 Foreign lnvestment Decisions
markets are normally blessed with this attribute. However, MNEs that are resident in small
industrial or emerging market countries can still follow a proactive strategy of seeking for-
eign portfolio and corporate investors.
Small- and medium-size firms often lack the characteristics that attract foreign (and
maybe domestic) investors. They are too small or unattractive to achieve a global cost of cap-
ital.This limits their ability to fund FDI, and their higher marginal cost of capital reduces the
number of foreign projects that can generate the higher required rate of return.
Differentiated Froduets
Firms create their own firm-specific advantages by producing and marketing differentiated
products. Such products originate from research-based innovations or heavy marketing
expenditures to gain brand identification. Furthermore, the research and marketing process
continues to produce a steady stream of new differentiated products. It is difficult and costly
for competitors to copy such products, and they always face a time lag if they try. Having
developed differentiated products for the domestic home market, the firm may decide to
market them worldwide, a decision consistent with the desire to maximize return on heavy
research and marketing expenditures.
Competitiveness of the Home Market
A strongly competitive home market can sharpen a firm’s compefitive advantage relative to
firms located in less competitive home markets. This phenomenon is known as the “competi-
tive advantage of nations,” a concept originated by Michael Porter of Harvard. The theory’s
primary concepts are summarized in Exhibit 1,5.1.
1
A firm’s success in competing in a particular industry depends partly on the availability of
factors of production (land, labor, capital, and technology) appropriate for that industry. Coun-
tries that are either naturally endowed with the appropriate factors or able to create them
will
probably spawn firms that are both competitive at home and potentially so abroad. For example,
a well-educated work force in the home market creates a competitive advantage for firms in cer-
tain high-tech industries. Firms facing sophisticated and demanding customers in the home mar-
ket are able to hone their marketing, production, and quality control skills. Japan is such a market.
Firms in industries that are surrounded by a critical rnass of related industries and suppliers
will be more competitive because of this supportirig cast. For example, electronic firms located
in centers of excellence, such as in the San Francisco Bay area, are surrounded by efficient, cre-
ative suppliers and enjoy access to educational institutions at the forefront of knowledge.
A competitive home market forces firms to fine-tune their operational and control strate-
gies for their specific industry and country environment. Japanese firms learned how to otgatnze
to implement their famous just-in-time inventory control system. One key was to use numerous
subcontractors and suppiiers that were encouraged to locate near the final assembly plants.
In some cases, host-country markets have not been large or competitive, but MNEs located
there have nevertheless developed global niche markets served by foreign subsidiaries. Global
competition in oligopolistic industries substitutes for domestic competition. For example, a
number of MNEs resident in Scandinavia, Switzerland, and the Netherlands fall into this cate-
gory. They include Novo Nordisk (Denmark), Norske Hydro (Norway), Nokia (Finland), L.M.
Ericsson (Sweden),Astra (Sweden),ABB (Sweden/Switzerland), Roche Holding (Switzerland),
Royal Dutch Shell (the Netherlands), LJnilever (the Netherlands), and Philips (the Netherlands).
Emerging market countries have also spawned aspiring global MNEs in niche markets
even though they lack competitive home-country markets. Some of these are traditional
exporters in natural resource fields such as oil, agriculture, and minerals, but they are in
lMichael Pofier,The Competitive Advantage of Nctions,I-nndon: Macmillan Press. 1990.
C l-i A P T E n I i; Foreign Direct lnvestment and Political
Risk
Determinants of National Competitive Advantage
A ,rm,s competitiveness can be significantty stren.gthened based
on its having competed in a highly
competitive home market. i;i”‘J”,;iii iompetitive ia*iiSb must be based on at teast one
of four
critical comqonents.
‘ The factors of production–land’ labor’. capital’ technology-
————r-r ff.”r ** core ti itre specific industry might include specific
411
Factor Conditions
Related lndustrles
:’.’ i ]-:r:J.J]].]i
:
Firm Strategy,
Structureand Rlvalry
labor skill sets or
A firm that has competed successfully in a fogal ry1e1’^*-^. ;
-.——–+ which requires
an integration.of related suppliers and panner’
, I tirml, inctuOing governrnenl is q$1q$gg$ il
Many of the world’s most competitive firms have learned
to
adaot to ro”ur tl”i”it”in ;’#i; *;v;’ aitering strategv and i
structure lo find the best fit for profilqble growrh”**-…,’g”-@
source: Based on concepts described by Michael Porler
in “The competitive Advantage of Nations.” Harvard
gusiness
Rev iew. March* APril 1 99
0
transition to becoming MNEs. They typically start with foreign-sales
subsidiaries’ joint ven-
tures, and strategic attiances. Examites’are Petrobrds (Brazil),
YPF (Argentina),.and cemex
(Mexico). Another category i, tir* that have been recently privatized in the telecommuni-
cations indusrry. E””-;;;;; T”l”fo.to, de Mexico and Telebr6s (Brazil)’ Still others started
a-s electroni” .o*pon”nt manufacturers but are making the transition
to manufacturing
abroad. Examples ur” iu,,’rung Electronics (Korea) and Acer Computer
(Taiwan)’
The *Ll Faradig*t and lnternalizaticn
The oLI Paradigm (Buckley and casson, 1976;Dunning,L977) is an attempt to
create an
overall framework to explain why MNEs choose FDI rather than serve
foreign markets
through alternative modes such as licensing, joint ventures, strategic alliances’
management
contricts, and exPorting’z
The OLI paradignistates that a firm must first have some competitive
advantage in its
home market-“O” oI owner-specific-that can be transferred abroad if the
firm is to be suc-
cessful in foreign direct investment. Second, the firm must be attracted
by specific chara.cter-
istics of the foreign rnarket-“L’or location-specific-that will allow it to exploit
its
comperitive advantages in that market. Third, the iirm will maintain its
competitive position
by attempting to control the entire value chain in its industry-“I” or internalization’
This
leads it to tor:eign direct investment rather than licensing or outsourcing.
Definitions. The “o” in oLI stands for owner-specific advantages’ As described earlier’
a
firm must have competitive advantages in its home market’ These
must be firm-specific’ not
easily copied, and in a form that all,ows them to be transferred
to foreign subsidiaries’ For
example, economies of scale and financial strength are not necessarily
firm-specific because
2peter J. Buckley and Mark casson, TJle Ftitre of the Mttltinational Enterprise, London:
Macmillan’ 7976;and
John H. Dunning,”Tlade Location of Economic Activity and the MNE: A-searci
for an Eclectic Approach”‘ in
TJte Interttational Allocotiort of Ecottotttic Acrrvlty, Bertil Ohlin, Per-Ove Hesselborn’
and Per Magnus Wijkman’
eds., New York: Holmes and Meier, 1977 ‘pp’
395-418′
:li::
,tLt:.
,Ri:
::&:.
The nature of local customers—customers that are
o”ij”ci”s, ditlgeni, soplristicated, focused.on specific
‘rssues or duatity or satetv-a!l_L{19.99TP*ltJgl33!
472 PA il T : Foreign lnvestment Decisions
they can be achieved by many other firms. Certain kinds of technology can be purchased.
licensed, or copied. Even differentiated products can lose their advantage to slightly altered
versions, given enough marketing effort and the right price.
The “L” in OLI stands for location-specific advantages.These factors are typically market
imperfections or genuine comparative advantages that attract FDI to particular locations.
These factors might include a low-cost but productive labor force, unique sources of raw
materials, a large domestic market, defensive investments to counter other competitors, or
centers of technological excellence.
The “I” in OLI stands for internalization.According to the theory, the key ingredient for
maintaining a firm-specific competitive advantage is possession of proprietary information and
control of the human capital that can generate new information through expertise in research.
Needless to say, once again, large research-intensive firms are most likely to fit this description.
Minimizing transactions costs is the key factor in determining the success of an internal-
ization strategy. Wholly owned FDI reduces the agency costs that arise from asymmetric
information, lack of trust, and the need to monitor foreign partners, suppliers, and financial
institutions. Self-financing eliminates the need to observe specific debt covenants on foreign
subsidiaries that are financed locally or by joint venture partners. If a multinational firm has
a low global cost and high availability of capital, why share it with joint venture partners, dis-
tributors, licensees, and local banks, all of which probably have a higher cost of capital?
The Financiai Strategy
Financial strategies are directly related to the OLI Paradigm in explaining FDI, as shown in
Exhibit I5.2. Proactive financial strategies can be controlled in advance by the MNE’s
financial managers. These include strategies necessary to gain an advantage from lower
Finance-Specific Factors and the OLI Paradigm: “X” lndicates a Connection between FD
I
and Finance-Specific Strategies
Ownership Location lnlernalization
ges Advantages
proactive Financiar strategies :Advantlge:
Advanta
1. Gaining and maintajning a global cost and availability of capital
a. Competitive sourcing of capital globally X X
b. Strategic preparatory cross-listing X
c. Providing accounting and disclosure transparency X
d. Maintaining compeiitive commercial and financial banking relationships X
e. Maintaining a competitive credit rating X X X
2. Negotiating {jnancial subsidies and/or reduced taxation to increase free cash flow X X
3. Reducing financial agency cost through FDI x
4. Reducing operating and transaction exposure through FDI X
Reactive Financial Strategies
‘1 . Exploiting undervalued or overvalued exchange rates X
2. Exploiting undervalued or overvalued stock prices X
3. Reacting to capital control that prevents the free movement of funds X
4. Minimizing taxation X X
Source: Lars Oxelheim, Arlhur Stonehill, and Trond Randoy, “On the Treatment of finance Specific Factors With;n the OLI Paradigm,” lnternationa!
Business
Review 10 \2AO1l, pp. 381-398.
f.l I-i l:i i:) f r:r li I 5 Foreign Direct lnvestment and Political Risk
global cost and greater availability of capital. other
proactive financial strategies are nego-
tiating financial subsidies andloi reduced iu*uiio”‘to
increase free cash flows’ reducing
financial agency “rrr,
^;;r;;;h
FDt, and reducing operating and transaction exposure
through FDI’ r r-:L:+ r < e J^^anrr ^n rliqcnverins market Reactive financiai strategies, as illustrated in Exhibit
15.2, depend on discovering mar
imperfections. For exampie, tie MNE:ui “*pl”i;;isaligned “””hu.tg”
rates and stock prices’
It also needs to react t;;;;;tuJ”onttot, that prevent the
free movement of funds and react to
opportunities to minimize worldwide taxation’
*eeie€iseg Wl:ex”e t$ Emvesfi
The decision about where to invest abroad is influenced
by behavioral factors’ The decision
about where to invest abroad for the first time is not
the same as the decision about where to
reinvest abroad. A firm learns from its tirst tew investments
abroad and what it learns influ-
“”””ir,’to”‘ilrl:1lr:”rT:T,?li.ntiry its competitive advantages.rhen it should search worrd-
rvide for market imperfection, urrd ,o-pu;il; advantage*until it finds
a country where it
expects to enjoy a competitive advantage large enough
io generate a risk-adjusted return
above the firm’s hurdle rate’
In practice, tr*rtuu” Le”n obr”rued to follow a sequential search
pattern as described
in the behavioral theory of the firm’ Homai rationality
is bounded by one’s ability to gather
and process all the irrt-j,*utlon that would be needed
to make a perfectly rational decision
based on all the facts. This observation ri”* u”tti”J two behavioral
theories of FDI described
next-the behavioral approach and international network
theory’
The *ehavl*ra!APProa*fr t0 FD!
The behavioral approach to analyzing the FDI decision
is typifiecl by the so-called Swedish
School of economist;: Th” Sweiistr Sctrooittu. tutt’er
suci”ssfully explained not just the
initial decision to invest abroad but also later decisions
to reinvest elsewhere and to change
the stfucture of a firm’s international involvement
over time’ Based on the international-
ization process of a sample of Swedish MNE;’ the economists
observed that these firms
tended to invest first in ctuntries that were noi too
far distant in psychic {erms,
close.psy-
chic distancedefined countries with a “,rtt.,*],
t”gal, and institutional enl’ironment similar
to Sweden,s, such as Norway, Denmark, ri”i”rJ, c”rmany, and the
united Kingdom’ The
initial investments *”r” -oJ.rt in size to *inl*i'” the risk of an uncertain
foreign envi-
ronment. As the Swedish firms learned from their initial
investments’ they became willing
to take greater .irr, *iin ,”rp””t to both J” pry”iri” distance of the countries
and the size
of the investments’
fu!f’ltr isi * F’i*twsrk P*t”*6:ectiv*
As the Swedish MNEs grew and matured, so did the
nature of their international involve-
ment’ Tociay, each MNE is perceived as,ueir,g a member
of an international network,
with nodes based in each of the foreign ,uu.”ioiuri”r, as well as
the parent firm itself’
3Johansen, John and F. Wiedersheim-Paul, “The Internationalization
of the Firm: Four Swedish Case Studies”‘
Journal of Management Studies. Vol. l2, No. 3, lgT5; and John
Johansen and Jan Erik Vahlne”‘The lnternationaliza-
tion of the Firm: A Model of Knowledge Development and Increasing
Foreign Market Commitments,” Jottnul of
lnternatiottal Business Strrdies,Vol 8, No’ 1′ 1977′
418 PAFi 5 Foreign lnvestmentDecisions
H3*EicieaE R{sE<
In addition to business and foreign exchange risks, foreign direct investment faces political
risks. Horv can multinational firms anticipate government regulations that, from the firm’s
perspective, are discriminatory or wealth depriving? Normally a twofold approach is utilized.
At the macro level, firms attempt to assess a host country’s political stabiiity and attitude
toward foreign investors. At the micro level, firms analyze whether their firm-specific activities
are likely to conflict with host-country goais as evidenced by existing regulations.The most dif-
ficult task, however, is to anticipate changes in host-country goal priorities, new regulations to
implement reordered priorities, and the likely impact of such changes on the firm’s operations.
*etining and Gla*sifying Falitieal ffiisk
In order for an MNE to identify, measure, and manage its political risks, it needs to define and
classify these risks. Exhibit 15.4 classifies the political risks facing MNEs as being firm-
specific, country-specific, or global-specific.
Q Firm-specific risks, also known as micro risks, are those risks that affect the MNE at the
project or corporate level. Governance risk due to goal conflict between an MNE and its
host government is the main political firm-specific risk.
& Country-specific-risks, also known as macro risks, are those risks that also affect the MNE
at the project or corporate level but originate at the country level. The two main political
risk categories at the country level are transfer risk and cultural and institutional risks. Cul-
tural and institutional risks spring from ownership structure, human resource norms, reli-
gious heritage, nepotism and corruption, intellectual property rights, and protectionism.
* Global-specific risks are those risks that affect the MNE at the project or corporate level
but originate at the global level. Exampies are terrorism, the antiglobalization movement,
environmental concerns, poverty, and cyber attacks.
sffiEffiffi classification of Political Risks
Transfer Risk
I
I
I
‘ Blocked tunds
I Cultural and
I lnstitutional Risk
I
II
Global-Specific
Risks
. Terrorism and war
‘ Antiglobalization
movement
. Environmental
conce{ns
‘ Poverly
‘ Cyber attacks
‘Ownership structure
‘ Human resource norms
‘Religious heritage
‘ Nepotism and corruption
‘ lntellectual property rights.
Protectionism
Country-Specific
Risks
.::’-: :j4′?s@’ia)r
I
tt
****l-
I Governance risks
Firm-Specific
Risks
419
C f iA i-r l’i: [1 ] 5 Foreign D’irect
lnvestment and Political
Risk
i..
.:
ii:
at.
i
1,
Thismethodofclassificationdifferssharplyfromthetraditionalmethodthatclassifies
risksaccordingtotheJr*iprin”‘o'”*no*’X’lt’;n:i[t[*ii:1″”X”‘?”#iitl;?ll’]3[
tti|t** ;;r?lassitication system.becuutl
existing and recomrn””J”a
sirategies to manage
these risks’
f :::’,T:iT”:ffi’T:.if”T”:’:’lf ifi T’::i’rryi:*’3is’|ab’i’fvoralro3″:llov
is onlv the first “”p’ ‘i”1″‘t’*
real objectiv” n;;”tlifutl ti'” “rt”ct
of political changes on
acriviiies ot a specific;ir,n.
i”O””O, diiferent i”‘”igt fi’-s operatinE
within the same country
mav have uery difrere’il’l;il;;;;l;;t””r*itii,
t””’r.,””g* 1″
hostlcountrv policv or regula-
tions. one does nor “*f”.,
a-Kentucky ur,”o]En1″o””n
rr^i”r.ir” to experiente
the same risk as
u fotO manutacturing
nlant’
rhe need ror,o*’-lotll,n “””rv”::1:r-li:ti,i,UT5,tr;n1i1J’F;,;’;:*::’.1″.:it”:!il:::;
studies undertaken
i1 ftiut” t1 pttf”ttt]’o:Xliisk
analysts rarely “*” at””
on the degree of
‘bil;-;;;uation that outside Professtoni
macro-political risk wl-‘ictt
exittt in u1V.t”l$
l”XlitliJ; attributes of specific
countries to the
“””ii-[ou'” poliiical risk analysts relate’tI
oarticular character;tl”^*o i””::’ol1:tl:””;;;;’;;tlnt
i”*”-tvtineral extractive
firms’
manufacturing ri.*r, ,urtinationar
uuntr,-pJui” in,u’unt”^:rull*W::ti:il;H:1
chains are au “-o’l;o””‘
i”1J”*;^qt1 *’ff;fihlgl
jlJ”li ;;srire ttrat the politicar or
e,t[n *itft the best possible
firm-spectttc i
economic riroutiooiiYiirrlo,'”rr-“s”.n i1;ffi;#;tt
* plan protective steps in advance
to
minimize the risk “t
i”‘”g”-ttoir unanticipated changes’
ili”T:Trfi i,.,:3Tffiiilli’:r:’1?sTJ*S’*rt*:i’J:”?i”Ti#;i;ffi:1:?:;;l
inJurt.v, and government
study country
ment foreign p”n”y o””i”i* *utt”tt’
and defense planners’
orical stability of the
country
Political
“‘o ‘l’ff” ‘i'”‘rW
r;;y1X an anaivsis of
the htsr’ut’-;;;;;;;””mic stabilitv’
;Hl*{r 1 :xffi ,T,lj HlJ’ :fi”iIi’: r’3:
;:T :i,;!}iiil:’* ; i ” d ; v r ea
d in g i’ c a I
newspapers, *or,ior*’*oi”?to
r”f”ui”’io” broadcasts’
*”til;;;;lications. from diplo-
matic sourc*, *ppi”girre
knowledge ;i;;’;;;;ilg “*p””
;;islultants’ contacting
other
business persons,,ito-iruu”
had recent “;;;;;ii”
rto’t;;;tty’ and finally conducting
on-site visits’–i;”,n:,.11*:rilT’;;””ff
T:J’H::il::’#ri,!'””it’:,’1ffi’#;il”f ili;#T:il;
diplomaiic ,”1Y.1.-.
or economicr, rn” ,””i””.y’ir’to
pr”ai.t “” “-‘””ti”n
of the same trends
whether in Polttr< inro rhe furure.,,"O"".lrl'ii;;;i*
*n#'”d'”io”f”Oitt u ‘^oiivt*it
change in direction’
who predic*o ,ili”?;h;;;;i r.rotr””i”t”ll’
i” tr'”,rnilippines? rndeed’
who pre-
dicred trre co’apsJ.i “.**””i,**1*
3’Jlt{y”::l:lt,3i#ffln:::”:*;l””ti;;”
4
who predict”u tn”l”u?pt”*ia*t
s”harto in Indonesra t”
“Ji'”;;;ttptt”t”
reminder of
Finance in
p’n’ti)”;;] t;;;di r puurit f'”tests in
pgvP’t serve as one corporate
ren
,,,oilgL”.iix’!:,i-“J,$*i;::ti’f :xmp jiihm:Jl|:l;1xi j:ff J;J:
order to p'”p”‘iit”‘iiJ’ trtt unknown’
A number of insttt
u
;;;;;; risk ratings on a regular basis’
f:’
.:,
‘;.
l:a
,i.!,
it
.,ni
ii.
l4′:*:
q:
1
:ia
t’i
r{..’
+.:
:*:,
gi!
.*l
f;
;i}f
r;{:
420 f A, n’i 5 Foreign lnvestment Decisions
ls.t
Apache Takes a Hit from Egyptian Protests
The January and February 201 ‘1 protests in Egypt took
billions of dollars of value away from Apache Corporation
(NYSE: APA). The U.S.-based oil exploration and produc-
tion company has signilicant holdings and operations in
Apache Corporation’s Share Price (NYSE: APA)
$128
Egypt, and the political turmoil that engulfed the country in
early 2011 caused the investment public to start dumping
Apache’s shares. Although actual oil and gas production
was not disrupted during this period, Apache did evacu-
aie all expatriate workers from Egypt. Egypt made up
roughiy 30% of Apache’s revenue in 201 ‘1 , 26Vo ol loIal
production, and 13% of its estimated proved reserves o{
oil and gas.
$127.56/share on January 17
$1 26
$124
$12
2
$1 20
$1 18
$116
Price falls to $1 14.84/share
on January 28
wilh 4$4.4 rnillion shares outstanding,
Apache’s market value dropped $4.6 billion
in 11 days-1Oo/o of the company’s
total value.
Fr**{ietin g G {r*b”t [-Fi g:s:* i f i* {] i:::k
Predicting global-specific risk is even more difficult than the other two types of political risk.
Nobody predicted the surprise attacks on the World Tiade Center and the Pentagon in the
United States on September 11,2A01. On the other hand, the aftermath of this attack, that is,
the war on global terrorism, increased U.S. homeland security, and the destruction of part of
the terrorist network in Afghanistan was predictable. Nevertheless, we have come to expect
future surprise terrorist attacks. U.S.-based MNEs are particuiarly exposed not only to
Al-Queda but also to other unpredictable interest groups willing to use terror or mob action to
promote such diverse causes as antiglobalization, environmental protection, and even anarchy.
Since there is a great need to predict terrorism, we can expect to see a number of new
indices, similar to country-specific indices, bui devoted to ranking different types of terrorist
threats, their locations, and potential targets.
Firrr-t’p**!iic l{isBc*
The firm-specific risks which confront MNEs include foreign exchange risks and governance
risks.The various business and foreign exchange risks were detailed in Chapters 10 and 11.
We focus our discussion here on governance risks.
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C Li A Fr T I F 1 5 Foreign Direct lnvestment and Political Risk 421
Governance Risks. Governancerlsk is the ability to exercise effective
control over an MNE’s
operations within a country’s legal and political environment. For an MNE’
however’ gover-
nance is a subject similar in structure to consolidated profitability-it must be addressed
for
the individual business unit and subsidiary, as well as for the MNE as a whole’
The most important type of governance risk for the MNE on the subsidiary
level arises
from a goal conflict between Uona tiOe objectives of host governments
and the private firms
op”ruriig within their spheres of influencl. Gou”ttt111ents are normally
responsive to a con-
stituency consisting of iheir citizens. Firms are responsive to a constituency
consisting of
their owners and other stakeholders. The valid neids of these two separate
sets of con-
stituents need not be the same, but governments set the rules. consequently,
governments
impose constraints on the activities of private firms as part of their normal
administrative
and Ie gislative functioning’
Historically, conflicts-between objectives of MNEs and host governments.
have arisen
over such issues as the firm’s impact on economic development,
perceived infringement on
national sovereignty, foreign control of key industries, sharing or nonsharing
of ownership
and control witnloial inteiests, impact on a host country’s balance of payments,
influence on
the foreign exchange value of its currer-rcy, control over export markets,
use of domestic ver-
,us foreiln executilves and workers, and exploitation of national resources’
Attitudes about
conflicts are often colored by views about free enterprise versus state
socialism’ the degree of
nationalism or internatior,uiir- present, or the place of religious views in delermining
appro-
priate economic and financial behavior.
The best approach to goal conflict management is to anticipate problems
and negoti-
ate understandings aheaJof time. Differeni cultures apply different ethics to
the ques-
tion of honoring prior “contracts,” especially when they were negotiated
with a previous
administratiOn. Nevertheless, prenegoirbtrbn-or?tl’c.ncerVarJrt-ars:rs^’-rrrvtnnflit+prir*rirta”
a better basis for a successful future for both parties than does.overlooking
the possibil-
ity that divergent objectives will evolve ou”, ii-*. Prenegotiation often includes negoti-
ating investment agreements, buying investment insuranci and guarantees,
and designing
risk-reducing opefating straiegils 6 be used after the foreign investment decision has
been made.
lnvestment Agreements. An investment agleement spells out specific
rights and responsibil-
ities of both the foreign firm and the host gou”rn*ent. The presence
of MNEs is as often
sought by developmerit-seeking host govern-ments as a partic;lar foreign
location sought by
un lrtNp. en parties have alternatives and so bargaining is appropriate.
An investment agreement should spell out policies on financial and managerial
issues’
including the following:
t The basis on which fund flows, such as dividends, management fees, royalties, patent fees’
and loan repayments, may be remitted
O The basis for setting transfer prices
i The right to export to third-country markets
* Obligations to build, or fund, social and economic overhead projects, such as schools’
hospitals, and retirement sYstems
* Methods of taxation, including the rate, the type of taxation, and means by which the rate
base is determined
* Access to host-coun try capitalmarkets, particularly for long-term borrowing
i Permission for 100% foreign ownership versus required local ownership fioint venture)
participation
422 PAnT 5 Foreign lnvestment Decisions
Price controls, if any, applicable to sales in the host-country markets
Requirements for local sourcing versus import of raw materials and components
Permission to use expatriate managerial and technical personnel, and to bring them and
their personal possessions into the country free of exorbitant charges or import duties
Provision for arbitration of disputes
Provisions for planned divestment, should such be required, indicating how the going con-
cern will be valued and to whom it will be sold
lnvestment lnsurance and Guarantees: OPIC. MNEs can sometimes transfer political risk to
a host-country public agency through an investment insurance and guarantee program. Man.v
developed countries have such programs to protect investments by their nationals in devel-
oping countries.
The U.S. investment insurance and guarantee program is managed by the government-
owned Overseas Private Investment Corporation (OPIC). OPIC’s stated purpose is to
mobilize and facilitate the participation of U.S. private capital and skills in the economic
and social progress of less-developed friendly countries and areas, thereby complementing
the developmental assistance of the United States. OPIC offers insurance coverage for
four separate types of political risk, which have their own specific definitions for insurance
purposes:
l. Inconvertibitity is the risk that the investor will not be able to convert profits, royalties.
fees, or other income, as well as the original capital invested, into dollars.
Z. Expropriation is the risk that the host government takes a specific step that for one year
prevents the investor or the foreign subsidiary from exercising effective control over use
of the property.
3. War, revolution, insurrection, and civil strife coverage applies primarily to the damage of
physical property of the insured, although in some cases inability of a foreign subsidiary
to repay a loan because of a war may be covered.
4. Business income coverage provides compensation for loss of business income resulting
from events of political violence that direclly cause damage to the assets of a foreign
enterprise.
Operating Strategies after the FDI Decision. Although an investment agreement creates obli-
gations on the part of both foreign investor and host government, conditions change and
igreements are often revised in the light of such changes. The changed conditions may be
elonomic, or they may be the result of political changes within the host government-The firm
that sticks rigidty to the legal interpretation of its original agreement may well find that the
host governri”oi iit*t applies pressure in areas not covered by the agreement and then possi-
bly reinterprets the agreement to conform to the political reality of that country. Most MNEs,
in their own self-interest, follow a policy of adapting to changing host-country priorities
whenever possible.
The eJsence of such adaptation is anticipating host-country priorities and making the
activities of the firm of continued value to the host country. Such an approach assumes the
host government acts rationally in seeking its country’s self-interest and is based on the idea
that ihe firm should initiate reductions in goal conflict. Future bargaining position can be
enhanced by careful consideration of policies in production, logistics, marketing, finance,
organization, and personnel.
a
a
a
a
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C H;\ P T E R .j 5 Foreign Direct lnvestment and Political Risk 42
3
Local sourcing. Host governments may require foreign firms to purchase raw
material and
components lJcaly u, i *uy to maximize vaiue-added benefits and to increase local employ-
ment. From the viewpoint of the foreign firm trying to adapt to host-country
goals, local
sourcing reduces political risk, albeit at a trade-off with other factors’
Local strikes or other
turmoil may shut down the operation and such issues as quality control,
high local prices
because of lack of economies of scale, and unreliable delivery schedules
become important’
often, the MNE lowers political risk only by increasing its financial
and commercial risk’
Facility Location. Production facilities may be located so as to minimize risk’
The natural
location of different stages of production may be resource-oriented, footloose’
or market-
oriented. Oil, for instancle, is OritteO in and around the Persian Gulf, Russia,
Venezuela, and
Indonesia. No choice exists for where this activity takes place’ Refining is
footloose; a refin-
ing facility can be moved easily to another location or cOuntry’ WheneYer
possible’ oil co-mpa-
nies have built refineries in poiitically safe countries, such as Western Europe,
or small islands
(such as Singapore or CuraEao), even though costs might be reduced by refining
nearer the
oil fields. They have traded ieduced political risk and iinancial exposure
for possibly higher
transportation and refining costs.
Control of Transportation. Control of transportation has been an important
means to reduce
political risk. Oii pipelines that cross national frontiers, oil tankers, ore carriers,
refrigerated
ships, and railroads have all been controlled at times to influence the bargaining
power of
both nations and comPanies.
Control of Technology. Control of key patents and processes is a viable
way to reduce politi-
cal risk. If a host country cannot operate a plant because it does not have technicians
capable
of running the process, or of keeping up with changing technology, abrogation
of an- invest-
ment agrJement witfr a foreign firm”is inlikely. Controt of technology works
best when the
foreign firm is steadily improving its technology’
Control of Markets, Control of markets is a common strategy to enhance
a firm’s bargaining
pvsiJ,vrr. ,As e,ffec#l,e as .tlre O.PEC ca^’,teJ wa-“.il -‘a’Lcilg $le p^r’ite -ife’s.’ejved ‘fo-r
c’rude orl by ils
member countries in the 1970s, marketing was still controlled by the international
oil compa-
nies. OPEC’s need for the oil companiet ti*it”d the degree to which its members could dic-
tate terms. In more recent years, OFEC members have eitablished some
marketing outlets of
their own, such as Kuwait’s extensive chain of QB gas stations in Europe’
Control of export markets for manufactured goods is also a source of leverage
in deal-
ings between uNr,s and host governments. The MNE would prefer to serve world mar-
kets from sources of its own chlosing, basing the decision on considerations of
production
cost, transportation, tariff barriers,
-politicai
risk exposure, an-d competition’ The selling
p^tilt” ifr”t maximizes long-run proiitt from the viewpoint of the worldwide firm rarely
maximizes exports, or valuJ added, ftom the perspective of the host countries’ Some
will
argue that if the same plants were owned by local nationals and were not part of
a world-
wiie integrated system, more goods would be exported by th9 host country’ The contrary
argument” is thai self-contain-ed local firms might never obtain foreign market .share
because they lack economies of scale on the production side and are unable to market
in
foreign countries.
Brand Name and Trademark Control. Control of a brand name or trademark can
have an
effect almost identical to that of controlling technology. It gives the MNE a monopoly on
something that may or may not have substanlive value but quite likely represents
value in the
eyes of co”nsumers.Ability to market under a world brand nime is valuable for local
firms and
thus represents an imporiant bargaining attribute for maintaining an investment
position’
424 FAF f 5 Foreign lnvestmentDecisions
Thin Eguity Base. Foreign subsidiaries can be financed with a thin equity base and a latge
proporiion of local debt. If the debt is borrowed from locally owned banks, host-government
acti,ons that weaken the financial viability of the firm also endanger local creditors.
Multiple-source Borrowing. If the firm must finance with foreign source debt, it may borrow
from banks in a number of countries rather than just from host-country banks. If, for exam-
ple, debt is owed to banks in Tokyo, Frankfurt, London, and New York, nationals in a number
^ot
foreign countries have a vested interest in keeping the borrowing subsidiary financially
strong.If the multinational is U.S.-owned, a fallout between the United States and the host
goveinment is less likely to cause the local government to move against the firm if it also
owes funds to these other countries.
eouniry-$pecifie Hisks: Transfer Risk
Country-specific risks affect all firmg domestic and foreign, that are resident in a host coun-
try. e*friUit 15.5 presents a taxonomy of most of the coatemporary political risks that
emanate from a specific country location. The main country-specific political risks are
transfer rlsk, and cultural and institutional risks’
Blceked Funds
Transfer1sk is defined as limitations on the MNE’s ability to transfer funds into and out
of a
host country without restrictions. When a government luns short of foreign exchange and
cannot obtain additional funds through borrowing or attracting new foreign investment’
it
usually limits transfers of foreign exchinge out of the country’ a restriction known as
blocked
funds. Intheory, this does not discriminate against
foreign-owned firms because it applies to
Lu”ryon”; in piactice, foreign firms have more at stake because of their foreign ownership’
Depending on the size of i foreign exchange shortage, the.host government might simply
require apirovat of all transfers of funds abioad, thus reserving the right to set a
priority on
Management Strategies for Gountry-specific Risks
i
Transter Hlsk ,i
I
t
I
I
I
Blocked Funds
r Preinvestment strategy to
anticipate blocked funds
. Fronting loans
‘ Creating unrelated exports
‘ Obta;ning special disPensation
‘ Forced reinvestment
rl
:”
Cultural and l
lnstitutional Rlsk :i
rn
rqsffi€N#@ffitl
OwnershiP Structure
‘ Joint venture
Rellgious Heritage
. Understand and respect host
country religious heritage
Nepotism and CorruPtion
. Disclose bribery Policy to both
employees and clients
. Retain a local legal advisor
Human Hesource Norms
‘Local management and sta{fing
lntellectual ProPerty
‘Legal action in host
country courts
‘ Support worldwide treaty
to protect intellectual
property rights
Protectionism
‘ Support government
actions to create
regional markets
430 PA ilT 5 Foreign lnvestment Decisions
regional markets are eiimination of internal trade barriers, such as tariffs and non-tariff
bairiers, as well as the free movement of citizens for employment purposes. External trade
barriers still exist.
The EU is trying to become a “IJnited States of Europe,” with a single internal market
without barriers. It is not quite there, aithough the European Monetary Union and the euro
have almost eliminated monetary policy differences. The EU still tolerates differences in fis-
cal policies, legal systems, and cultural identities. In any case, the movement toward regional
muikets is very favorable for MNEs serving those markets with foreign subsidiaries’
Legal Liabilities. Despite good intentions, MNEs are often confronted with unexpected legal
liabilities. Globat Finance in Practice 15.2 illustrates why Hospira, a U.S.-based pharmaceuti-
cal manufacturer, decided to cancel a DFI project in Italy as a result of potentiai iegal and
associated financial liabilities.
S F*bal-$p*eif ie ffi i*l*s
Global-specific risks faced by MNEs have come to the forefront in recent years.
Exhibit i5.6 ru-*urizes some of these risks, and strategies that can be used to manage
them. The most visible recent risk was, of course, the attack by terrorists on the twin towers
of the World Tiade Center in New York on September 1.1.,2001. Many MNEs had rnajor
operations in the World Tlade Center and suffered heavy casualties among their employees.
In addition to terrorism, other global-specific risks include the antiglobalization movement,
environmental concerns, poverty in emerging markets, and cyber attacks on computer
information systems.
15.2
Drugs, Publie PolieY, and the Oeath
Fenalty in 20″!t
Foreign direct investment can be a very tricky thing’ Just ask
Hospira, a U.S.-based pharmaceutical manufacturer’ Hos-
pira, of Lake Forest, lllinois (U’S.), stopped manufacturing of
Pentotha! (sodium thiopental) in Nofth Carolina in the United
States in mid-2009. lt intended to shift all production to ltaly’
Hospira’s press release read as follows:
Hospira Statement Regarding PentothalrM
(Sodium ThioPental) Market Exit
IAKE FOREST, lll., Jan’ 21 , 2011 -Hospira announced
today it wil! exit the sodium thiopental market and no longer
attempt to resume production of its product, Pentothalil”
Hospira had intended to produce Pentothal at iis ltalian
plani. ln the last month, we’ve had ongoing dialogue with the
Italian auihorities concerning the use of Pentothal in capital
punishment procedures in the United States-a use Hospira
has never condoned. ltaly’s intent is that we control the
product all the way to the ultimate end user to prevent use in
capital punishment. These discussions and internal delibera-
tion, as well as conversations with wholesalers-the primary
distributors of the product to customers-led us to believe
we could nct prevent the drug from being diverted to depart-
ments of corrections for use in capital punishment procedures’
Based on this understanding, we cannot take the risk that
we will be held liable by the ltalian authorities if the product is
diverted for use in capital punishmqnt. Exposing our employees
or facilities to liability is not a risk we are prepared to take’
Given the issues surrounding the product, including the
government’s requirements and challenges bringing the drug
back to market, Hospira has decided to exit the market’ We
regret that issues outside of our control forced Hospira’s
decision to exit the market, and that our many hospital cus-
tomers who use the drug for its well-established medical
benefits will not be able to obtain the product from Hospira’
Source: HosPira.com
The news was met with dismay by the medical induslry’
Pentothal, at one-time a widely used anesthetic, is today
only used in a variety of special cases’ The drug is preferred
in specific cases because it does not cause blood pressure
to drop severely, including the care of the elderly, patients
with heart disease, or expecting mothers requlring emerging
C-sections in which the possibility of low biood pressure is
threatening. Second-best solutions would now have to be
good enough.
CitAPTIn 15 Foreign Direct lnvestmentand Political Risk 437
Terrorism and War. Although the World Tiade Center attack and its aftermath,
the war tn
Afghanistan, have affected nearly everyone worldwide, many other acts of terrorism
have
been committed in lecent years. More terrorist acts are expected to occur in the future’
Particuiarly exposed are the foreign subsidiaries of MNEs and their empioyees’ As
mentioned
earlier, foreignsubsidiaries are eslecially exposed to war, ethnic strife, and terrorism
because
they are symbols of their respective parent countries.
Crisis Planning. No MNE has the tools to avert terrorism. Hedging, diversification, insur-
ance, and the like are not suited to the task. Therefore, MNEs must depend on
governments
to fight terrorism and protect their foreign subsidiaries (and now even the parent firm)-
In
return, governments expect financial, material, and verbal support from MNE’s to support
antiterrlrist legislation and proactive initiatives to destroy terrorist cells wherever they
exist’
MNEs
“un
b” subject to damage by being in harm’s way. Nearly every year one or more
host countries experience some form of ethnic strife, outright war with other countries,
or ter-
rorism. It seems that foreign MNEs are often singled out as symbols of “oppression”
because
they represent their parent country, especially if it is the united States.
Cross-Border Supply Chain lntegration’ The drive to increase efficiency in manufacturing
has driven -u.ry MNE, to adoptlust-in-time (JIT) near-zero
inventory systems’ Focusing on
so-called inventory velocity, the speed at which inventory moves through a manufacturing
process, arriving only as needed und not before, has allowed these MNEs to genelate increas-
ing profits and lash ilows with less capital being bottled-up in the production cycle
itself’ This
firiiy tuned supply chain system, however, is suUlect to significant political risk if the supply
chain itself extends across borders’
supply chain lnterruptions. consider the cases of Dell computer, Ford Motor company’
Daiiy-Queen, Apple computer, Herman Miller, and The Limited in the days following
the
terrorist attacks
-oi
Septemte r {1,2001,.An immediate result of the attacks of the morning of
September 11 was the grounding of all aircraft into or out of the United States. Similarly,
the
tanO (trrtexico and Canada) and sea borders of the United States were also shut
down and not
reopened for several daysin some specific sites. Ford Motor Company shut down five of
its
manufacturing plants in ihe days following September 11 because of inadequate
inventories of
critical automotive inputs ,,rppU”a from Canad a. Dairy Queen experienced such significant
delays in key confecti,onary ingredients that many of its stores were also temporarily
closed’
Dell Computer, with on” of the most highly acclaimed and admired virtually integrated
suppiy chains, depends on computer parts and subassembly suppliers and manufacturers
in
both Mexico and Canada to tuttitt its everyday assembly and sales needs. In recent
years, Dell
has carried less than three full days sales of toial inventory-by cost of goods value. Suppliers
are integrated electronically with Deli’s order fulfillment system, and deliver required
com-
ponents*and subassemblies as sales demands require. But with the closure of borders
and
irounding of air freight, the company was literally brought
to alear standstill because of its
iuppty ch-ain’s relianle on the ability to treat business units and suppliers in different
coun-
tri”i us if they were all part of a single seamless political unit’ Unfortunately, that proved not
to be the case with this particular unpredictable catastrophic terrorist event.
As a result of these newly learned lessons, many MNEs are now evaluating the degree
of
exposure their own supply ciains possess in regard to cross-border stoppages or oth,er.cross-
border political
“u”nts.’1-i-tese
companies u.” .tot, howevel, about to abandon JIT’ It is esti-
mated that many U.S. companies alone have saved more than $1 billion a yeat in
inventory
carrying costs by using JI’i methods over the past decade. This substantial benefit is now
Ueini #;gned against ihe costs and risks associaled with the post-September 11 supply chain
inteIruptions.
432 Pl\ ii l- 5 Foreign lnvestment Decisions
To avoid suffering a sirniiar fate in the future, manufacturers’
retailers’ and suppliers are
now emploYing a range of tactics:
* Inventory Management. Manufacturers and assemblers are now considering carrying
more buffer inuentoiy in order to hedge against supply and
production-line disruptions’
Retailers, meanwhile, should think about the timing und fr”qu”ncy
of their replenishment’
Rather than stocking up across the board, companies are focusing
on the most critical
parts to the product”or service, and those components which are
uniquely available from
international sources.
* sourcing. Manufacturers are now being more selective about where the critical inputs
to
their products come from. Although sourcing strategies. will
have to vary by location
(those involving Mexico for example will diifer dramatically from Canada)’
firms are
attempting to work more closely with existing suppliers to
minimize cross-border expo-
sures and ieduce the potential costs with future stoppages’
* Transportation. Retailers and manufacturers alike are reassessing their cross-border
ship-
ping arrange*”nt,.lltt,ough the mode of transportation employed
is a function of value.
volume, and weight, many firms are now reassessing whether
higher costs for faster ship-
ment balance out the moie tenuous delivery under airline
stoppages from either labor, ter-
rorist, or even bankruptcy disruptions in the future’
AntiglobalizationMovement.Duringthepasidecade,therehasbeenagrowingrregative
reaction by some gr”rp- t” reducei trade barriers and efforts to create
regional markets’
particularly to NAFTA and the European union. NAFTA
has been vigorously opposed by
those sectors of the labor movement that could
lose jobs to Mexico’ opposition within the
European Union ,”nr”r, on loss of cultural identity, dilution of
individual national control as
new members are admitted, over-cen tralizalion of
po*”, in a large bureaucracy in Brussels’
and most recently, the disappearance of individual
national currencies in mid-2002′ when the
euro became the only .uttltt”y in 12 of the 15 member nations’
The antiglobalization movement has become more
visible following riots in Seattle dur-
ing the 2001 annual *””ti.rg of the wor-ld Tiade organization’ However’
antiglobalization
forces were not ,oi”if .”rpinsible for these riots, oi fo’ subsequent
riots in Quebec, and
prague in 2001. oth; dis;ffected groups, such as environmentalists and even
anarchists’
join”eA in to make their causes more visible’
MNEs do not have the tools to combat antiglobalism.
Indeed they are blamed for foster-
ingtheprobleminthefirstplace’Onceugui’,,”uNrsmustrelyongovernmentsandcrisis
plinning to manage these risks’
Environmental Goncerns. MNEs have been acCused
of “exporting” their environmental
problems to other countries. The accusation is that MNEs
frustrated by pollution controls in
their home country have relocated these activities
to countries with weaker pollution con-
trols. Another accusation is that MNEs contribute to
the problem of global warming’ How-
ever, that accusation applies to all firms in all countries’
It is based on the manufacturing
methods employed by specific industries and on
consumers’ desire for certain products such
as large automobites ani spott vehicles that are not fuel
efficient’
onceagain,solvingenvironmentalproblemsisdependentongovernmentspassinglegis-
lation and i-pf”-“niiig ptffttf”” control standards’ in 2001′ a
treaty attempting to reduce’
global warming was ratifi;d by most nations, with the notable
exception of the United States’
However, the Uniteiitut”, rru, promised to combat global warming
using its own strategies’
The United States oU1″”t”a to provisions in the *J’td*id” treaty
that allowed emerging
nations to foliow less restrictive standards, while
the economic burden would fall on the most
industrialized countries, particularly the United States’
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i
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o
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C i i h P-i E I’1 1 5 Foreign Direct lnvestment and Political Risk 4JJ
poverty. MNEs have located foreign subsidiaries in countries plagued by extremely
uneven income distribution. At one end of the spectrum is an elite class of well-educated,
well-connected, and productive persons. At the other end is a very large class of persons living
at or below the poverty level. They lack education, social and economic infrastructure, and
political power.
MNEs might be contributing to this disparity by employing the elite class to manage
their operations. On the other hand, MNEs are creating relatively stable and well-paying jobs
for thoie who would be otherwise unemployed and living below the poverty level. Despite
being accused of supporting “sweat shop” conditions, MNEs usually compare favorably to
their local competitbis. For example, Nike, one of the targeted MNEs, usually pays better,
provides more iringe benefits, *uitrtuin. higher safety standards, and-educates their work-
force to allow personnel to advance up the career ladder. Of course, Nike camot manage a
country’s poverty problems overall, but it can improve conditions for some persons.
Cyber Attacks. The rapid growth of the Internet has fostered a whole new generation of
scam artists and cranks that disrupt the usefulness of the World Wide Web. This is both a
domestic and an international protlem. MNEs can face costly cyber attacks by disaffected
persons with a grudge because of their visibility and the complexity of their internal infor-
mation systems.
At this time, we know of no uniquely international strategies that MNEs can use to
combat cyber attacks. MNEs are using the same strategies to manage foreign cyber attacks
as they use for domestic attacks. Once again, they must rely on governments to control
cyber attacks.
Sarrnmary I In order to invest abroad a firm must have a sustain- * Competitive advantages stem from economies of ,!lrrrr’/rrirr ri :r ij!,i it!!t(tdigitt ltrrttidts it titt:orettL’tii iotut’ i The OLI Paradigm is an attempt to create an overall * Finance-specific strategies are directly related to the !ilt;itilr’ .iiit!rtr’; +*tt! irtrtr, rltitt ttttitl iLt r’!)ttliti(1’Ltl irt thr * The decision about where to invest is influenced by I Psychic distance plays a role in determining the I The most internationalized firms can be viewed from a il!tr:tti:tt’tlit tttttttrrg.’rirtl ittitl tttrttpatiii”‘t’ iittti’ttsirt;1t ‘tl t!tr I Exporting avoids political risk but not foreign &rl ulti nati onal tapitatr Whales only get harpooned when they come to the surface, and t. fi ,qft $ t ru fi * gJ r,{_TtvE$ potential foreign investment.
* Adjust the capital budgeting analysis of a foreign project for risk. This chapter describes in detail the issues and principles related to the investment in real pro- Although the original decision to undertake an investment in a particular foreign country Multinational capital budgeting for a foreign project uses the same theoretical framework as * Identify the initial capital invested or put at risk. terminal or salvage value of the investment.
439 440 P A tl T 5 Foreign lnvestment Decisions
l Identify the appropriate discount rate for determining the present value of the expected cash flows.
1> Apply traditional capital budgeting decision criteria such as net present value (NPV) and
internal rate of return (IRR) to determine the acceptability of or priority ranking oi CetrnpEexities af Buelge€ing fcr a Forelgll Prcjec€ Several factors contribute to this greater complexity:
1> parent cash flows must be distinguished from project cash flows. Each of these two types
of flows contributes to a different view of value’
,1, parent cash flows often depend on the form of financing. Thus, we cannot clearly separate
cash flows from financing decisions, as we can in domestic capital budgeting’
t Additional cash flows generated by a new investment in one foreign subsidiary may.be in favorable from a single sutsidiary’s point of view but contributes nothing to worldwide
cash flows. t The parent must explicitly recognize remittance of funds because of differing tax systems, differ-
ences in the way financial markets and institutions function.
I An array of nonfinancial payments can generate cash flows from subsidiaries to the r;, Managers must anticipate differing rates of national inflation because of their potential
to cauie changes in competitive position, and thus changes in cash flows over a period
of time.
I Managers must keep the possibility of unanticipated foreign exchange rate changes in indirect
effects on the competitive position of the foreign subsidiary’
l’ Use of segmented national capital markets may create an opportunity for financial gains ., Use of host-government subsidized loans complicates both capital structure and the purposes.
I Managers must evaluate political risk because political events can drastically reduce the 1, Terminal value is more difficult to estimate because potential purchasers from the host,
parent, or third countries, or from the private or public sector, may have widely divergent
perspectives on the value to them of acquiring the project’
Since the same theoretical capital budgeting framework is used to choose among peting foreign and domestic pro;ects, lt is ciiticai that we have a common standard’ Thus’ ior”iin comllexities must be quantified as modifications to either expected cash flow or the
rate of discount. Although in piactice many firms make such modifications arbitrarily, available information, ttr’eoreiical deduction, or just plain common sense can be used less arbitrary and rnore reasonable choices. a-: H A fr l.I l.i j 6 Muttinational Capital Budgeting and Cross-Border Acquisitions
Prcject lrcrs$s Farent Valuatiol-l
4 41
A strong theoretical argument exists in favor of analyzing any foreign point of the parent. CaIh flows to the parent are ultimately the basis holders, reinvestment elsewhere in the world, repayment of corporate-wide purposes that affect the firm’s many intere.t gto,rpi. Flowever, since flows to its parent, or to sister subsidiaries, arJfinancial cash flows flows, the parent viewpoint usually violates a cardinal concept that financial cash flows should .rot U” mixed with operating cash is not important because the two are almost identical, but in some gence in these cash flows will exist. For example, funds that.are i”fut iution, or “forcibly reinvested,” are not available for dividends to the stockholders for repayment of parent corporate debt. Thelefore, shareholders will blocked earnings as contributing to the value of the firm, and in calculating interest coverage”ratios and other evidence of ability Evaluation of a project”from the local viewpoint serves some useful should be subordinated io evaluation from the parent’s viewpoint. In evaluating project,s performance relative to the potential of a competing try, we must pay attention to the project’s local return. Almost able to earn a ,etrrrr, to the yield available on host government bonds Ylh u
maturity the same u, tt pro1″”t’s economic life, if a free market exists for such bonds’ Host-
government bonds ordinarily reflect th_e local risk-free rate of equal to the expected rate of inflation.If a project cannot earn more the parent firm should buy host government bonds rather than invest or, better yet, invest somewhere else!
Multinational firms should invest only if they can earn a risk-adjusted return than locally based competitors can earn on the same project. If they are unable,to superior returns on for”ign projects, theit stockholders would be better ,bvial ,{irrr6 *rtrr,”epnts;Jile,.n”n^f”f-ttgJ-ho,secotqpanies carlv out from these theoretical arguments, surveys ou”,. ih” past 35 years show that in multinational firms continue to evaluate foreign invlstments from both the project viewPoint. reflects emphasis on
maximizing reported consolidated net earnings per share as.a corporate long as foreign ur” not blocked, they”can be consolidated with the earnings of both
the remaining subsidiaries and the parent. As mentioned previously, date foreign subsidiaries that are over 50% owned. If a firm is owned between by a parerit, it is called an affiliate. Affiliates are consolidated with the rata basis. Subsidiaries less than 20% owned are normally carried ments. Even in the case of temporarily btocked funds, some of the most necessarily eliminate a pro.ieci from iinancial consideration. They take of world business oPPortunities. least equal
to the parent firm’s reiuired rate of return (aiter adjusting for- changes), temporary btoctage of transfer may have littie practical eting outcome, because futu”re project cash fiows wi11 belncreased reinvestment. Since large multinuiionul* hold a portfolio of domestic and corporate iiquidity is nJt impaired if a few projects have blocked funds; alternate funds are available to meet atl plurrned uses of funds. Furthermore, a long-run spective on blocked funds does indeed lend support to the belief that funds are almost 442 P.q RT 5 Foreign lnvestment Decisions
permanently blocked. F{owever, waiting for the release of such funds can be frustrating, and In conclusion, most firms appear to evaluate foreign projects from both parent and proj- a.
EXBustrative Case: Cemrex En{en’s flmrtrlmesia j
It is early in 1998. Cementos Mexicanos, Cemex, is considering the construction of a cement Cemex has three driving reasons for the project: 1) the firm wishes to initiate a produc- Cemex, the world’s third-largest cement manufacturer, is an MNE headquartered in an Cemex’s shares are listed in both Mexico City and NewYork (OTC: CMXSY).The firm dominated by U.S. dollar investors. Ultimately, the Semen Indonesia project will be evaluated- #verview pany invests U.S. dollar denominated capital, which flows clockwise through the creation and Semen Indonesia will take only one year to build the plant, with actual operations com- lCemex is a real company. However, the greenfield investment described here is hypothetical. cHApl IR ] 6 Multinational capital Budgeting and cross-BorderAcquisitions 443
A Roj M;tto 1,, con”truction of semen lndonesia’s capital Budget
START
‘.i..
Cementos Mexicanosl,:: US$ invested in lndonesia*”-‘6il;;i ,,ffi I END justified (NPV > O)?
ParentViewpoint Cash ilows remitted
Semen lndonesia Esiimated cash flows I Ii Capital Budget industries to al1ow foreign ownership.The following analysis is conducted “haring projec;. This is a standard financial assumption made by Cemex for its foreign The projected inflation rates for Indonesia and the Unlted States are 30% 3o/o per annum, resPectivelY. rates
of 30o/o and 3% p”, urrrr.rrn, respectively, for the life of the project, forecasted spot exchange
rates follow the usual ppp calculation. For example, the foiecasted exchange of the project would be as follows:
Spot rate (year 1) : Rp10,000/US$ x ++# The following series of financial statements are based on these assumptions’
Capital lnvestment. Although the cost of building new cement manufacturing capacity where in the industrial couritries is now estimated at roughly $150/tonne of installed Cemex believed that it could build a state-of-the-art production and shipment facility tia at roughly $110/tonne (see Exhibit 16.2). Assuming a 20 million metric ton per year
(mmt/y) and a yeai 0 average exchange rate of Rp10,000/$, this cost will constitute
an investme nt of p.p11trittion ($2.2 UlUlon). This figure includes an investment of Rp17’6 lion in plant and giving rise to an annual depreciation charge of Rp1’76 trillion if we
urr.r*” a 10-year siraight-hJ depieciation schedule’The relatively short depreciation schedule
is one of the policies of th” Indottesian tax authorities meant to attract foreign investment’
Financing. This massive investment would be financed with 50% equity, all from Cemex’ 50% debt, 75Vo ftomCemex and25″/o from a bank consortium arranged by the Ind_onesian
government. Cemex’s own U.S. dollar-based weighted avetage.cost of capital (WACC) lurrently estimated at 11″.98%. The WACC on a locai Indonesian level in rupiah terms’ the project itself, was estimated at 33.257 in this chapter.
\
: I I 4 44
lnvestment
Au.’ug” t;#s; iri. iprg lnstalled capacity
lnvestment in US$
lnvestment in rupiah
Percentage of investment in plant and equipment
Plant and equipment (000s Rp)
Depreciation oi capital equipment (years)
Annual depreciation (millions)
Costs of Capital: Cemex Credit premium
Cost of debt
Corporate income tax rate
Cost of debt after-iax
Percent debt
Cost of Capital: Semen tndonesia
i’A i:i i :; Foreign lnvestment Decisions
lnvestment and Financing of the Semen lndonesia Project ‘ 10,000
$1 10
20,000
$2,200,000
22,000,000,000
B0%
17,600,000,000
10.00
(1,760,000)
o.ooo%
2.00a%
8.000%
35.000%
5.200o/o
40.Ao/”
Financing
Equity
Debt:
Rupiah debt
US$ debt in rupiah
Toial
Note: US$ debt principal
Cemex oeia
Equity risk premium
Cost oi equity
Percent equity
WACC
1 1,000,000,000
11,000,000,000
2,750,000,000
8,250,000,000
22,000,000,000 $82s,ooo
.1 7.O00%
16.500%
60.0%
11 .980o/o
ii rS ,!: u t } Risk-free rate
Credit premiunr
Cost of rupiah debt
lndonesia corporate jncome tax rate
Cost oi US$ debt, after-tax
Cost of US$ debt, (rupiah equivalent)
Cost of US$ debt, aftertax (rupiah equivalent)
Percent debt 33.000%
2.a)ao/o
35.000% 30.000%
5.200%
38.835%
27.1840/0
5O.Aa/”
Semen lndonesia beta
Equity risk premium Cost of equity
Percent equity 1,000
6.000%
40.000%
50.0%
33.257o/o
The cost of the US$ loan is stated in rupiah lerms assuming purchasing power pariiy and U.S. dollar and lndonesian inflation rates of 3% and 3O% per annum, The explicit debt structures, including repayment schedules, are presented in Exhibit 16.3. The majority of the debt, however, is being provided by the parent company, Cemex. After si( l., lI a. lF ”: F
“T ,ti fl
l(
,F’
i C H A PT E R 1 6 Multinational Capital Budgeting and Cross-Border Acquisitions 445
Semen lndonesia’s Debt Service Schedules and Foreign
10,000 12,621 15’930
Exchange Gains/Losses
20,106 25,376spot rare (Rp/$) Proiect Year
32,028
5 lndonesian loan @ 35% lor eight years (millions of lnterest payment
Principal payment
Total payment
rupiah)
(962,500) (928,921) (883,590) –ll?9,q$l—*011€191(1,058,43e) 0,058,439) (1,058,43e)
(822,393) (739,777\ (1,058,439) (1,058,43e)
($82.50) ($6g.ee) ($54 12) ($32’zz1 ($1e’78)
___,$1-3!,19_ jqt,8.65)__,_E-ffi q1)-,–lslJ-er9-,’,($l9Zg5,) cemex loan converted to Rp at scheduled and current spot rates (millions of Rp):
Cemex loan @ 10% lor five years (millions ol U.S- dollars)
Loan principal
lnterest payment 825
Scheduled at Rpl0,000/$:
lnterest payment Actual (at current spot rate): Principal payment Cash llows in Rp on Cemex loan (millions of Rp):
{2,176,32s) (2..17632sJ t2]76325J Q,176,329) (2’176’s2S\
(1 ,O41 ,262) (1 ,098,S49) (1 ,088,160) (958,480) (633,669)
-luqg’sq!-,.e’3%9-1q–!?’287′!941—-9f9!.1,9E-*-9i99.ry])= (2,746,82s) (3,466,864) (4,s75,654) (5,522’670) (6,970’360)
(825,000) {689,867) (216,262j (409,082) (s77,71Oi} (197,848) (541,221)
(1,635,108)
Total actual cash flows
IRR of cash flows
8,250,000
38.835% Foreign exchange gains (losses) on Cemex loan (millions of Rp): Foreign exchange gains (losses) on principal
Total foreign exchange losses on debt
The loan by Cemex to the lndonesian subsidiary is denominatecl in U.S. dollars. Therefore, the loan will have to hle repaid in U.S. dollars, time of the loan agreement, the spot exchange rate is Rp.l 0,000/$- This is ihe assumption used in calculating lhe “scheduled” repaying est in rupiah. The rupiah, however, is expected to depreciate in line with purchasing power parity. As it is repaid, the “actual” exchange rate will rise to a foreign exchange loss as it takes more and more rupiah to acquire U.S. dollars for debt service, both principal and interest. The foreign losses on this debt servlce will be recognized on the lndonesian income stalement-
Revenues. Given the current existing cement manufacturing in Indonesia, and its currently
depressed state as a result of the Asian crisis, all sales are based on export. The 2O mmtly facil-
ity is expected to operate at only 40″/o capacity (producing 8 million metric tonnes). Cement Cosls. The cash costs of cement manufacturing (labor, materials, power, etc.) are estimated
at Rp115,000 per tonne for L999, rising at about the rate of inflation, 30″h per year. Addi- 0, 6gfq9_-_g 7 65,57 1).__{4,q5,8,a 0) 446
Exchange rate {Rp/US$) PA RT 5 Foreign lnvestment Decisions
of inflation. As a result of ail production being exported, loading costs of $2.00/tonne and Semen Indonesia’s pro forma income statement is illustrated in Exhibit 16.4. This is the Semen lndonesia’s Pro Forma lncome Statement (millions of rupiah)
Sales volume
Sales price (US$)
Sales price (Rp)
Total revenue
Less cash costs
Less other production costs
Less loading costs
Less shipping costs
Total production costs
Gross profit
Gross margin
Less Iicense fees
Less general and administrative
EBITDA
Less depreciation and amodization
EBIT
Less interest on Cemex debt
Foreign exchange losses on debt
Less interest on local debt
EBT
Less income taxes (30%)
Net income
Net income (millions of US$)
Return on sales
tiividends distributed
Betained
10,000 12,62’l
1 15,930
2 20,106
3 25,376
4 12.00
58.00
32,028 1.857.627
B.O0
58.00 732,039
10.00 923,933
12.OO
58.00 5,856,31 1
(920,000)
(160,000)
(2o1,542r,
(1,00e10e)
(2,291,6s0)
3,564,660
60.9%
{117,126)
(1 ,138,965)
9,239,32s
(1,495,000)
(260,000)
(328,155)
(1,640,777)
(s,72s,9s2)
^ 59.7%
{184,787\
1 , 1 66,1 28 1 ,471 ,81 3 (405,600) (527,280) (685,464) ,-V-\339:l!!L(2,55e,6121 (s,327,4e5j 4R 6-0/^ 57.2o/o 56.0%
(445,831\(279,871) (353,235) (1,760,000) (1,760,000) (1,760,000) (1,760,000) (1,760,000)
(825,000) (689,967) (541,2211 (377,710) (197,848) (170,256) 1]20,846 1,507,145 1,861,285
(170,256) 1,120,846 1,1 11,514(1 ,138,e65) -19.4%
(1 ,1 38,965)
*1.8%
(170,256)
8.0%
56A,423
560,423
44 6.3%
555,757
555,757 1,302,900
41 5.Ba/o
651 ,450
651,450
(1 1) 56
EBITDA : earnings before interest, taxes, depreciation, and amonization; EBIT = earnings before interest and taxesi EBT : earnings betore taxes. as a result of losses, and are djstributed at a 50% raie in years 200G-2003.
All calculalions are exact, but may appear not to add due to reported decimal places . The tax payment for year 3 is zero, and year 4 is less than 307o, as a i ii CHA.PTER 1 6 Multinational Capital Budgeting and Cross-BorderAcquisitions
(year 1), 50% (year 2), and 60% in the following years. Management believes this is necessary
sln.e in-country cement manufacturers are averaging only 4Ao/” of capacity at this
time. subsidiary to the parent company af 2.0″/o of sales, and general and administrative expenses
for Indonesian operations ot g.OZ pel year (and growing an additional l% per year)’ Foreign debt privi-ded by the parent and are drawn from the boltom of Exhibit 16.3′ In summary the
subsiiiary operation is expected to begin turning an accountingprofit in its fourth year of
operations IZOOO;, with profits rising as capacity utilization increases over time.
Froiect Viewpcint CaPital Budget Exhibii 16.5. W;find the net cash flow, or free cash flow as it is often called, by summing and changes in net working capital (the sum of the net additions to receivables, inventories,
and payables necessary to support sales growth). and interest expense. Depreciation and amortization are noncash expenses of the firm and
therefore contribute pcsiiive cash flow Because the capital budget creates cash flows that cost of debt*interest-we do not wish to subtract interest twice. Therefore, taxes are recal- operations as a result of ittt”t”it expenses and forecast foreign exchange losses, so it is not cost of capital used in discountittg also includes the deductibility of debt interest in its Semen lndonesia Capital Budget: Project Viewpoint (millions of rupiah)
447
Exchange rate (Rp/U$)
Proiect Year 12,621 ‘,15,930 20,106 25,376 32,029 ‘ * (365,70e) (821,720) (1,423,495) (1,816,077) \2’277’BBzJ
l,160rg_0-0 1-re,O:gg-Q ” 1,169s9 2,619,920 3,677,347 5,081 ,487 5,997,512 7’075’059 -‘ ..’ -. . earf –
Less recalculated taxes @ 30%
Add back deprectation
Net operating cash flow
Less changes to NWC
lnitial investment (22,000,000) Free cash flow (FCF) (ZZ,OOO,OOOI return, the rate of discount yielding an NPV of exactly zero. Values in exhibit are exact and are rounded to the nearest miilion.
able competitive advantage in the home market.
This must be strong enough and transferable
enough to overcome the disadvantages of operating
abroad.
scale and scope arising from large size; managerial and
marketing expertise; superior technology; iinancial
strength; differentiated products; and competitiveness
of the home market.
r ! u i i i t t t I r t r r I tt’ g!, ti t ti I i : tt t i( ;;i l;r’i,,{‘.’t\.
framework to explain why MNEs choose FDI rather
than serve foreign markets through alternative modes,
such as licensing, joinf ventures, strategic alliances,
management contracts, and exporting.
OLI Paradigm, including both proactive and reactive
financial strategies.
tiett’ rt tiit ttl ir t t ; ot t,, ! t t re tittt ! li ttt tl ir tt tal c i t tr’ t’p ri ttt i tti’t sl.
economic and behavioral factors, as well as the stage
of a firm’s historical development.
sequence of FDI and later reinvestment. As firms
learn from their early investments they venture fur-
ther afield and are willing to risk larger commitments.
network perspective.The parent firm and each of the
foreign subsidiaries are members of networks. The
networks are composed of relationships within a
worldwide industry, within the host countries with
suppliers and customers, and within the multinational
firm itself.
:!l tt,;1i.,. ,!1r’tlt”’it ,’i :l’t”:’<;t i'1,"t't 1 .
exchange risk. It requires the least up-front invest-
ment but it might eventually lose markets to imitators
and globai competitors that might be more cost effi-
cient in production abroad and distribution.
ffiudg*ting and Cross-
ffi*rder Acquisiticns
turtles cen only move forward when they stick their neck out,
but investors face risk no matter what they do. -Charles A. Jaffe.
* Extend the dgmestic capital.budgeting analysis to evaluate a greenfield foreign project.
* Distinguish between the project viewpoint and the parent viewpoint when analyzing a
* Introduce the use of real option analysis as a complement to discounted cash flow analysis-
* Examine the use of project finance to fund and evaluate large global projects. ir
ductive assets in foreign countries, generally referred to as multin{ttional capital budgeting.The
chapter first describes the complexities of budgeting for a foreign project. Second, we describe
the insights gained by valuing a project from both the project’s viewpoint and the parent’s
viewpoint using a hypothetical investment by Cemex of Mexico in Indonesia. The chapter
then discusses both real option analysis and the use of project financing today. The following
section describes the stages involved in affecting cross-border acquisitions. We conclude the
chapter with the Mini-Case, Yanzhou (China) Bidsfor Felix Resources (Australia).
may be determined by a mix of strategic, behavioral, and economic decisions, the specific project,
as well as all reinvestment decisionq should be justified by traditional financial analysis. For
example, a production efficiency opportunity may exist for a U.S. firm to invest abroad, but the
type of planf, mlr of labor and capital, kinds of equipment, method of financing, and other proj-
ect variables must be analyzed within the traditional financial framework of discounted cash
flows. It must also consider the impact of the proposed foreign project on consolidated net earn-
ings, cash flows from subsidiaries in other countries, and on the market value of the parent firm.
domestic capital budgeting- with a few very important differences. The basic steps are as follows:
I Estimate cash flows to be derived from the project over time, including an estimate of the
potential Projects.
Capital budgeting for a foreign project is considerably more complex than the domestic case.
part or in whole taken away from inother subsidiary, with the net result that the project is
legaiand political constraints on the movement of funds, local business norms’ and
parent, including payment of license fees and payments for imports from the parent’
mind 6ecause of posiible direct effects on the value of local cash flows, as well as
or may lead to additional financial costs’
parent,s ability to determine an appropriate weighted average cost of capital for discounting
value or availability of expected cash flows’
com-
all
readily
to make
projecf from the view-
for dividends to stock-
debt, and other
most of a project’s cash
rather than operating cash
of capital budgeting’ namely’
flows. Often the difference
instances a sharp diver-
peffnanently blocked from
or
not perceive the
creditors will not count on them
to service debt’
purposes’ but it
a foreign
project in the same host coun-
any project should at least be
“urh
“q.rui
”
return, including a premium
than such a bond yield’
in a riskier project-
greater
earn
off buying shares in
the localproiects’A-part
practice
parent and
The attention paid to project returns in various surveys probably
financial goal’ As
“urning,
U’S’ firmsmust consoli-
ZAY” and 49o/”
parent ownef on a pro
as unconsolidated invest-
mature MNEs do not
a very long-run view
If reinvestment opportunities in the country where funds are blocked are at
anticipated exchange rate
effect on the capital budg-
by the returns on forced
foreign projects,
sources of
historical per-
never
sometimes the blocked funds lose value while blocked because of inflation or unexpected
exchange rate deterioration, even though they have been reinvested in the host country to
protect at least part of their value in real terms.
ect viewpoints. The parent’s viewpoint gives results closer to the traditional meaning of net
present value in capital budgeting. Project valuation provides a closer approximation of the
effect on consolidated earnings per share, which all surveys indicate is of major concern to
practicing managers.To illustrate the foreign complexities of multinational capital budgeting,
we analyze a hypothetical market*seeking foreign direct investment by Cemex in Indonesi
manufacturing facility on the Indonesian island of Sumatra. The project, Semen Indonesia
(the Indonesian word for “cement” is semen), would be a wholly owned greenfield invest-
ment with a total installed capacity of 20 million metric tonnes per year (mmt/y). Although
that is large by Asian production standards, Cemex believes that its latest cement manufac-
turing technologv would be most efficiently utilized with a production facility of this scale.
tive presence of its own in Southeast Asia, a relatively new market for Cemex; 2) the long-
term prospects for Asian infrastructure development and growth appear very good over the
longer term; and 3) there are positive prospects for Indonesiato act as a produce-for-export
site as a result of the depreciation of the Indonesian rupiah (Rp) in 1997.
emerging market but competing in a global arena. The firm competes in the global market-
place for both market share and capital. The international cement market, like markets in
other commodities such as oil, is a dollar-based market. For this reason, and for comparisons
against its major competitors in both Germany and Switzerland, Cemex considers the
U.S. dollar its functional currency.
has successfully raised capital-both debt and equity-outside Mexico in U.S. dollars. Its
investor base is increasingly global, with the U.S. share turnover rising rapidly as a percent-
age of total trading. As a result, its cost and availability of capital are internationalized and
in both cash flows and capital cost-in U.S. dollars.
A road map of the complete multinational capital budgeting analysis for Cemex in Indonesia
is illustrated in Exhibit 16.1. The basic principle is that, starting at the top left, the parent com-
bpeiation of an Indonesian subsidiary, which then generates cash flows that are eventually
returned in a variety of forms to the parent company-in U.S. dollars. The first step is to con-
struct a set of pro forma financial statements for Semen Indonesia, all in Indonesian rupiah
(Rp).The next step is to create two capital budgets, thep roject viewpoint andparent viewpoint–
mencing in year 1. The Indonesian government has only recently deregulated the heavier
I
I
ls the project investment
Capital Budget
(U.S.-dollars)
(Sumatra, lndonesia)
of project
Proiect VieYrpoint
(lndonesian ruPiah)io Cemex (Rp to US$)
assuming that pur-
power parity (eFf) holds foi the Rp/US$ eichange rate for the life of the Indonesian
investments’
per annum and
If we assume an initial spot rate of Rp10,000/uS$, and Indonesian and u’s’ lnflation
rate for year 1
: Rp12’621lUS$
any-
capacity,
in Suma-
“u’putity,
tril-
“quip-“nt,
and
was
for
o/” .The details of this calculation are discussed later
:
j
I
I
I
I
I
I
Cost of installeci capacity ($itonne)
Rrsx-lree rate
(all values in 000s unless otherwise noted)
.50
.,t!.i
*r
lri
.il
WACC
respectively, throughout the sublect period.
The loan arranged by the Indonesian government, part of the government’s economic devel-
opment incentive program, is an eight-year loan, in rupiah, aI”35o/o annual interest, fully amor-
tizing. The interest payments are fully deductible against corporate tax liabilities.
raising the capital from its financing subsidiary, Cemex will relend the capitai lo Semen
Indonesia. The loan is denominated in U.S. dollars, five years maturity, with an annual interest
rate of 10%. Because the debt will have to be repaid from the rupiah earnings of the Indone-
sian enterprise, the pro forma financiai statements are constructed so that the expected costs
of servicing the dollar debt are included in the firm’s pro forma income statement. The dollar
loan, if the rupiah follows the purchasing power parity forecast, will have an effective interest
expense in rupiah terms of 38.835Vo before taxes. We find this rateby determining the internal
rate of return of repaying the dollar loan in full in rupiah (see Exhibit 16.3).
‘:,
:::
:i
E
I
T
e
Loan principal 2’750’000
pq,we)
{236,046) (318,662)
($217.63) ($217.63) ($217.63) ($217’63) ($217 63)
Principal payment
Total payment
Principal payment
Total payment
lnterest payment
Total payment
(2,746,823) (3,466,864) (4,375,654) (5,522,670) {6,970,360)
fi,351,s29) fi,486,462)
(354,232) (881,453)
(1,7e8,61e) (Le7B 481)
(546,e40) (580,770) (435,821)Foreign exchange gains (losses) on interest
not rupiah’ At the
of principal and inter-
therefore give
exchange
pioaucea will be s;ld in the export market at $58/tonne (delivered). Note also that, at least
lor the conservative baseline analysis, we assume no increase in the price received over time.
tional production costs of Rp20,000 per tonne for year 1 are also assumed to rise at the rate
t^ t^^ -^E\ to enA QAl\ lA 7OA oal\(5/0,494) (l,zVU,535) (2, lVV,Jzc’ \o,rqo’o+ r,, tt” ve’vo ry
Proiect Year
shipping of $10.00/tonne must also be included. Note that these costs are originally stated in
U.S. dollars, and for the purposes of Semen Indonesia’s income statement, they must be con-
verted to rupiah terms. This is the case because both shiploading and shipping costs are inter-
national services governed by contracts denominated in dollars. As a result, they are expected
to rise over time only at the U.S. dollar rate of inflation (3%).
typical financial statement measurement of the profitability of any business, whether domes-
tic or international. The baseline analysis assumes a capacity utilization rate of only 40″/o
0
5
12.00
58.00
58.00
(i^ eoe
13,993,54’1 17 ,661 ,751 22,291 ,530
\2,332,2OO\ (3,031,860) (3,941,418)
(511,522) (665,499) (865,149)
(5,809,334) (7,552,134) (9,817,774)
8.184,207 10,109,617 12,473,756
(468,505) (831,539) (1,399,s54) (1,942,793) (2,674,e84)
2,975,A29 4,499,067 6,504,982 7,813,589 S,352,941
(570,494) (1,2e0,535) {2,199,325) (3,346,341) (4,794,031)
(e62,500) {e28,921} (883,5e0) (822,353} (735,777)
(s0)
Tax credjts resulting from cunent period losses are carried forward toward next year’s tax liablities. Dividends are not distributed in the firsl year of operations
result of tax loss canyjorwards from previous years.
*t
l
i.,
“*irting
Additional expenses in the pro forma financial analysis include license fees paid by the
exchange gains and losses are those related to the servicing of the U.S. dollar-denominated
The capital budget for the Semen Indonesia project from a project viewpoint is shown in
EBITDA (earnings before interest, taxes, depreciation, and amortization), recalculated taxes,
ilote that EBIT, nbt peils used in the capital budget, which contains both depreciation
will be discounted to present value with a discount rate, and the discount rate includes the
culated on the basis of EBITDA. (This highlights the distinction between an income state-
ment and a capital budget. The project’s income statement shows losses the first two years of
eipected to pay taxes. But the capital budget, constructed on the basis of EBITDA’ before
these financingand foreign exchange expenses, calculates a positive tax payment.) The firm’s
calculation.
10,000
0
12345
1.As:o2s
2t3e,067 – 4′,? 44,s82-^ lbse5ae z,sez’e4i
1,I_6_0-,999, L19.9.990
(240,670) (l3e,028) (436,049) (28e,776) (626’s14)
2,372,65A 3,538,319 4,645,438 5,707,736 27 ‘722,847
Terminal value
NPV @ ss.257% (7,855,886)
IRR 18.60/0
NWC = net working capital; NPV = net present value. Discount rate is Semen lndonesia’s WACC ot 33.257% lRR = internal rate of
