If possible, I would appreciate it if someone could read the articles and use the lecture notes to touch upon key aspects in the articles

Part A:

https://www.wsj.com/articles/goldman-sachs-under-fire-for-venezuela-bond-deal-1496100583

Part B:

https://www.wsj.com/articles/china-huishan-faces-corporate-governance-meltdown-1496063811

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University of Massachusetts Lowell

Manning School of Business

FINA.4910.061 International Finance

(Online 10 Week Accelerated Course)

Lecture Notes [Week 2]

Week 2

Topic: Global Capital Budgeting; Foreign Direct Investment (FDI); Capital Budgeting Component Cash Flows

Introduction

Hello and welcome to Week 2 of this course on International Finance. As discussed last week, there are 3 broad ways in which we can think about what is involved in the managing of money towards achievement of value creation:

1. Manage money coming in/ Manage inflows/ Manage sources of funds/ Manage earnings

2. Manage money going out/ Manage outflows/ Manage uses of funds/ manage the spending

3. Planning and Analysis

This week, we focus on managing the spending of money by investing, especially in physical assets, to create value.

Since we are looking forward and maybe move into uncharted territory (i.e. foreign countries), we need to look forward (i.e. plan) and analyze before we actually move forward and commit money.

In general, we can follow the following steps for capital budgeting purposes:

1. Idea generation

2. Data gathering and analysis

3. Decision making

4. Implementation

5. Follow up or Post-implementation audit

6. Rebalancing at any stage as and where necessary.

Last week, we had discussed the taking up of a project or projects in other countries for various strategic motives such as market, sources of raw materials, production efficiency etc.

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This week, we expand by initially taking a look at the theory behind Foreign Direct Investment (FDI), including a closer look at the various modes of foreign investment, followed by a closer look at issues related to multinational capital budgeting.

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Sustaining and Transferring Competitive Advantage

In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.

The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

There are several competitive advantages enjoyed by MNEs.

- Economies of scale and scope

- Managerial and marketing expertise

- Advanced technology

- Financial strength

- Differentiated Products

- Competitiveness of home market

Economies of scale and scope

Economies of scale and scope:

Can be developed in production, marketing, finance, research and development, transportation, and purchasing

Large size is a major contributing factor (due to international and/or domestic operations)

- Production economies (large-scale automated plant and equipment; worldwide production specialization)

- Marketing economies (efficient advertising, creation of brand recognition, distribution, warehousing, servicing systems)

- Financial economies (access to wider range of financial instruments and sources of funds)

- In-house R&D

- Transportation economies (larger lot sizes)

- Purchasing economies (quantity discounts)

Managerial and marketing expertise

Managerial and marketing expertise:

Includes skill in managing large industrial organizations (human capital and technology)

Also encompasses knowledge of modern analytical techniques and their application in functional areas of business

Maybe able to develop managerial expertise in foreign country (to counteract superior local knowledge of the host country)

- Export to market before establishing production facility

- Imports or licensing or FDI for raw materials and human capital

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Advanced technology

Advanced technology:

Includes both scientific and engineering skills

Financial strength

Financial strength:

Demonstrated financial strength by achieving and maintaining a global cost and availability of capital

This is a critical competitive cost variable that enables them to fund FDI and other foreign activities

Differentiated products

Differentiated products:

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, and, which may also lead to new differentiated products

Difficult for competitors to copy and likely for them to lag behind

Competitiveness of the home market

Competitiveness of the home market:

A strongly competitive home market can sharpen a firms competitive advantage relative to firms located in less competitive ones

This phenomenon is known as the diamond of national advantage and has four components

- Factor conditions

- Demand conditions

- Related and supporting industries

- Firm strategy, structure and rivalry

The OLI Paradigm and Internalization

The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.

The OLI Paradigm firm must have some competitive advantage in its home market:

O owner-specific (competitive advantage in the home market that can be transferred abroad)

- must be firm-specific, not easily copied, transferrable to foreign subsidiaries

- Not necessarily firm specific: economies of scale, financial strength, purchasable/ licensable/ copyable technology, differentiated products

L location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage)

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- low-cost productive labor force, unique sources of raw materials, large market, technology centers

I internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)

- proprietary information, control over new information

Where to Invest?

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.

In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firms hurdle rate.

In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm decision making is limited by the ability to gather and process data.

2 approaches to FDI

- Behavioral Approach

- International Network Theory

Behavioral Approach to FDI

Based on Swedish firms behavior

- initially invest in countries with close psychic distance (countries with similar cultural, legal and institutional environments)

- initial investment modest in size to minimize risk

- based on experience, expand psychic distance and investment size

International Network Theory to FDI

- As firms evolve, a network evolves connecting the parent firm and subsidiaries

- Decentralized control increases

- Subsidiaries compete amongst themselves and the parent firm as well

- Each becomes embedded in host countrys network as well as the broader global network

- Ownership of parent company may become transnational

- Influences may travel in different and multiple directions within the national and international network

How to Invest Abroad: Modes of Foreign Investment

As may be seen from the FDI Sequence (Foreign Presence and Foreign Investment), there several modes of investing abroad:

- Exporting versus production abroad

- Licensing versus control of assets abroad

- Management contracts versus control of assets abroad

- Joint venture versus wholly owned subsidiary

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- Greenfield investment versus acquisition

- Strategic alliances

Exporting versus production abroad

Exporting versus production abroad:

There are several advantages to limiting a firms activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing such as political risks and agency costs (Note: to be discussed later)

The amount of front-end investment is typically lower than other modes of foreign involvement

Some disadvantages include

- the risks of losing markets to imitators and global competitors (not only in foreign markets but in the home market as well)

- not being able to internalize and exploit the benefits of R&D as effectively

Licensing versus control of assets abroad

Licensing versus control of assets abroad:

Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds

However, there are disadvantages which include:

License fees are lower than FDI profits

Possible loss of quality control

Establishment of a potential competitor in third-country markets

Risk that technology will be stolen

High agency costs

Possible loss of opportunity to earn a higher rate through FDI

Management contracts versus control of assets abroad

Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure

Management contracts probably lessen political risk because the repatriation of managers is easy

International consulting and engineering firms traditionally conduct their foreign business on the basis of a management contract

Joint venture versus wholly owned subsidiary

Joint venture versus wholly owned subsidiary:

A joint venture is here defined as shared ownership in a foreign business

Some advantages of a MNE working with a local joint venture partner are:

Better understanding of local customs, mores and institutions of government

Providing for capable mid-level management as well as top management

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Some countries do not allow 100% foreign ownership

Local partners have their own contacts and reputation which aids in business

The local partner may possess an appropriate technology

Sales potential may be enhanced by enhanced public image

However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:

Increased political risk if the wrong partner is chosen

Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)

Transfer pricing issues

Difficulties in the ability to rationalize production on a worldwide basis

Public disclosures that may be required

Greenfield investment versus acquisition

Greenfield investment versus acquisition:

A Greenfield investment is defined as establishing a production or service facility starting from the ground up

An acquisition is defined as the purchase of an existing firm or facility

Note:

Compared to a Greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names

Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

Strategic alliances

The term strategic alliance conveys different meanings to different observers.

In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.

A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service

Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

Foreign Direct Investment Originating in Developing Countries

In recent years, developing countries with large home markets and some entrepreneurial talent have spawned a large number of rapidly growing and profitable MNEs

These MNEs have not only captured large shares of their home markets, but also have tapped global markets where they are increasingly competitive

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The Boston Consulting Group has identified six major corporate strategies employed by these emerging market MNEs

Taking brands global

Engineering to innovation

Leverage natural resources

Export business model

Acquire offshore assets

Target a niche

Emerging Market Multinationals - Global Strategies and Competition: The three Trade-Offs

- Trade-Off # 1: Volume vs. Margin

- Trade-Off # 2: Rapid Expansion vs. Low Leverage

- Trade-Off # 3: Growth vs. Dividends

Operating Strategies after the FDI Decision

Some key areas of consideration include:

Local sourcing

Facility location

Control of transportation

Control of technology

Control of markets

Brand name and trademark control

Thin equity base

Multiple-source borrowing

Multinational Capital Budgeting

Multinational Capital Budgeting is the process by which the firm makes decisions relating to investments in real assets in foreign countries for the long-term.

Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions as well as reinvestment decisions it should be justified by traditional financial analysis.

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting.

Note: However, there are some added complexities which need to be taken into account

The basic steps for potential projects are:

Identify the initial capital invested or put at risk

[Note: viz. the Initial Investment (II)]

Estimate cash flows to be derived from the project over time

[Note: viz. the Operational Cash Flows (OCFs)]

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- include an estimate of the terminal or salvage value of the investment

[Note: viz. the Terminal Cash Flow (TCF)]

Identify the appropriate discount rate to use in valuation

Apply traditional capital budgeting decision criteria such as NPV and IRR to determine acceptability, and if required, the ranking.

Complexities of Budgeting for a Foreign Project

Capital budgeting for a foreign project is considerably more complex than the domestic case due to:

Parent cash flows must be distinguished from project cash flows

Parent cash flows often depend on the form of financing

Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary

Note: This may hold true for the parent firm as well. In other words, there may be a cannibalization effect.

The parent must explicitly recognize remittance of funds because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function

An array of nonfinancial payments can generate cash flows from subsidiaries to the parent such as license fees and imports from the parent

Managers must keep the possibility of differing rates of national inflation in mind because of possible direct effects on cash flows as well as indirect effects on competitiveness

Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on the value of local cash flows, as well as indirect effects on the competitive position of the foreign subsidiary

Use of segmented national capital markets may create an opportunity for financial gains or may lead to additional financial costs

Use of host-government-subsidized loans complicates both capital structure and the parents ability to determine an appropriate weighted average cost of capital for discounting purposes

Managers must evaluate political risk, because political events can drastically reduce the value or availability of expected cash flows

Terminal value is more difficult to estimate, because potential purchases 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

Note: The impact of these complexities is often incorporated in the evaluation by adjusting the expected cash flows from the project and/ or adjusting the discount rate to reflect the added sources of risk.

Project versus Parent Valuation

A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent.

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Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect the firms many interest groups.

However, this viewpoint violates a cardinal concept of capital budgeting that financial cash flows should not be mixed with operating cash flows.

Note: This may be a problem if there are problems due to impositions by the host country such as repatriation of funds from the project (including dividends where applicable) to the parent, and forced reinvestment in the host country.

Evaluation of a project from the local viewpoint serves some useful purposes, but is should be subordinated to evaluation from the parents viewpoint.

In evaluating a foreign projects performance relative to the potential of a competing project in the same host country, we must pay attention to the projects local return.

Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds (with the same maturity as the projects economic life).

Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project.

If they are unable to earn superior returns on foreign projects, their stockholders would be better of buying shares in local firms, where possible, and letting those companies carry out the local projects.

Most firms appear to evaluate foreign projects from both parent and project viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm).

Note: Most firms tend to take the long-term perspective rather than the short-term since temporarily blocked funds may not cause too much of a problem in terms of returns and/ or liquidity.

Note: In addition to the traditional discounted cash flow techniques, MNEs also tend to conduct a Real Options Analysis which is discussed below.

Real Options Analysis

The discounted cash flow (DCF) analysis used in capital budgeting and valuation in general, has long had its critics.

Importantly, when MNEs evaluate competitive projects, traditional cash flow analysis is typically unable to capture the strategic options that an individual invest option may offer.

This has led to the development of real options analysis.

Real options analysis is the application of the option theory to capital budgeting decisions.

Real options Analysis is a different way of thinking about investment values.

Note: This is useful

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- When projects may follow different value paths depending on conditions prevailing at different decision making points in time

- Usually this relates to projects with long life spans or projects with long implementation periods

- When market or political conditions are changing rapidly

At its core, it is a cross between decision-tree analysis and pure option-based valuation.

Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects:

The option to defer

The option to abandon

The option to alter capacity

The option to start up or shut down