Please read the following lecture notes and answer questions posted afterword:

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. 2 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. . 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 3 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) 4 - 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 5 - 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 6 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 7 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)] 8 - 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. 9 Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporatewide 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 1 - 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

Part A (0.5 points): Using one or more stories from recent Wall Street Journal articles (USA or Europe editions), describe how the story(s) helps you understand one (or more) of the concepts discussed in the notes/ text from up to and including this week [giving priority to concepts from this week]. Remember what we are trying to do here is to see practical examples of the concepts discussed in the notes/ text. Discuss the related concept(s) as laid out in the lecture notes and the text, and in the light thereof, link the story(s) to your answer.

Part B (0.5 points): Using one or more stories from recent Wall Street Journal articles (Asia or India editions), describe how the story(s) helps you understand one (or more) of the concepts discussed in the notes/ text from up to and including this week [giving priority to concepts from this week]. Remember what we are trying to do here is to see practical examples of the concepts discussed in the notes/ text. Discuss the related concept(s) as laid out in the lecture notes and the text, and in the light thereof, link the story(s) to your answer. Notes for both parts A and B: Remember to identify clearly the Lecture Note #(s)/ Text Chapter #(s) and page numbers clearly. Remember to attach the url(s) / pdfs of your sources of information. Insert the citations in your discussions at the appropriate. Note that the response to the assigned activity should be posted on the DB itself (NOT as an attachment) otherwise you will loose points. Also providing supporting material such as copies of articles/ data as Word or pdf documents were appropriate as attachments - highlighting the relevant information can add value to your posting.

Due dates:

Your posts to week 2s DB activity must be done by Wednesday 11.50 PM ET of week 3 viz. 05/31. If you do not post your response on time, you will earn a zero as your DB activity credit for the week. Since the activity is divided into parts, you can earn partial credit for the parts posted on time.