Potential Risks and Advantages of Investing in Foreign Subsidiaries - Essay Example

Investment in Foreign Subsidiaries – Potential Risks and Advantages Introduction Investment in a foreign subsidiary requires a direct business relationship between a parent company and its subsidiary. If the investment has to be regarded as a Foreign Direct Investment then the parent company should possess minimum 10% of the ordinary shares of its foreign affiliates. Pulling in foreign direct investment (FDI) is becoming a crucial policy component for emerging countries to quest after growth and evolution. Very little disagreement on theoretical basis with regard to FDI’s possible positive affect on hosting country’s growth has been found. FDI has many advantages especially in the manufacturing sector because it leads to uniting of capital, technology, and managerial and marketing skills. Most emerging countries are deficient in technological capability and FDI would facilitate technology transfer and trim down the technology gap between developing countries and industrial countries. According to Blomstrom (1989) “it is suggested that spillovers or the external effects from FDI are the most significant channels for the dissemination of modern technology.” Rugman (1982) states that “foreign direct investment (FDI) is the ownership and control of foreign assets. In practice, FDI usually involves the ownership, whole or partial control of a company in a foreign country. This is called a foreign subsidiary.” A firm will perform well by directly investing in a foreign subsidiary: and this hypothesis statement will be proved in this paper. Potential risks in investing in a foreign subsidiary The following are the potential risks which a country may face from its host country while investing in its subsidiary:- Political Risk and Instability The determinations of former experimental reports depict that investment in foreign subsidiaries involve political risk of the host country. Political menace is conceived to be the most vital components to be considered while investing in a foreign subsidiary. This is because of the principle that irregularity and instability in the political environs of the host market augments the apparent risk and insecurity felt by the firm Lewis (1979). Quite a lot of learners (Fatehi - Sedeh and Safizadeh, 1989; Formica, 1996; Kobrin, 1979; Robock, 1971; Sethi and Luther, 1986) arrogated that there is no one cosmically consented explanation of political risk. It is most normally believed in terms of (normally host) government hindrance with business functioning. When executives from various multinational corporations were interviewed they all had the same thing to say. They stated that political upshots were one of the most crucial factors with reference to foreign investment decision (Aharoni, 1966; Basi, 1963; Bass et al., 1977; Schollhammer, 1974). The executives particularly cited that the steadiness of the host government and the approach of the host government towards investment in a foreign subsidiary were the most significant reflections in the investment decision. Kobrin (1978) arrogated the comportment of a negative relationship between political instability and foreign direct investment. But different research work conducted claimed that the association between political stability and foreign direct investment would be more obvious when an economically bedded conflict and the government had adequate directorial capacity to ultimately react to it. Environmental Risk Normally it can be said that the environment of the company is limitless. Nevertheless, a company is concerned only in that element of the environment which can have a control on its business. The company wanting to establish a subsidiary will consider only that part of the host country’s environment to which it has to react in order to endure. The environment intricacy and vitality reckons on a number of its constituents, drives that are acting in it and the kind of correlation between components and powers of the environment. Daft (1992) demonstrated the power of environment intricacy and its dynamism on the vagueness throughout. Country Risk Country risk pertains to the entire risk that a capitalist is considering. Country risk is not just the risk of political alterations, but it also refers to rebellion, the risk of strikes, etc (Brighan, 1994). Oxelheim (1996) underlines that factory approximation of country risk, can be attained by taking into account, data on awareness, internationalisation and possession structure in the host countrys industry and the subsidiary’s country. Potential Benefits in investing in a foreign subsidiary Investment in Foreign subsidiaries has demonstrated to be lively during financial calamities. For example, in East Asian countries, such venture was extremely steady during the worldwide financial crisis of 1997-98. (Dadush, Dasgupta, and Ratha, 2000; and). The flexibility of FDI during financial catastrophes was also obvious during the Mexican crisis during 1994-95 as well as the Latin American debt crisis during the 1980s (Lipsey, 2001). Economists are always inclined to favor the free flow of capital throughout national borders since it permits capital to look for the maximum rate of return. Unobstructed capital flows also render various other advantages, as mentioned by Feldstein (2000). Apart from these advantages according to Feldstein (2000) the benefits to host countries from investment in foreign subsidiaries can take numerous other forms like: a. Transfer of technology mainly in the form of new kinds of capital inputs. This cannot be attained through financial investments or trade in goods and services. b. Promotion of competition in the domestic input market is also a benefit of foreign subsidiary investment. c. Human capital development also takes place in the host country. d. Profits returned by FDI add to corporate tax incomes in the host country. Sometimes FDI are under so that the foreign markets of multi-national companies are protected. In the US, for instance, from 1981 to 1991 the total number of service stations decreased by more than 50%. According to Rugman (2003) “British Petroleum (BP), which had a substantial investment in this market, realized that in order to protect its investment it would be necessary to make a substantial investment in order to upgrade its stations and increase its market share.” The main purpose of the company was to refine and market petroleum products. Thus the company understood that if it could pull in a large number of clients to its service stations, it could gain generously by transferring its products straight downstream to the final user. Also FDI helps in acquiring technological and managerial expertise. Subsidiaries could be set up besides those of leading competitors. This strategy makes it easier to supervise the competition and to enrol scientist from local universities and competitive laboratories. Kodak is an outstanding example. The company decided to build 180,000 square foot research centre and it began civilising top scientists to aid with recruiting. Kodak made use of all the approaches, which Japanese firms apply, in the US like funding research by university scientists and extending scholarships to prominent young Japanese engineers with the anticipation that some of them would later on join Kodak. Consequently, Japan is at present the centre of Kodaks international research attempts in a number of high-technology fields, Shapiro (2003). Financial market flaws that consent to larger cash flows, lesser cost of funds and a decrease in risk through international variegation are key inducements for foreign direct investment. There are other motives for pursuing in foreign direct investment, like sales expansion, resource acquirement, variegation, competitive risk minimisation and political aims (Daniels et. all. 1998). Evaluation of projects to be invested The NPV (Net Present value) of a project is calculated and then based on it decision is taken as to whether the project is fit to be undertaken or not. It may sometimes so happen that a project may have a positive NPV from the home perspective, but fall short to regard applicable cash flows from the parent perspective. For instance, a positive NPV project in one country may only end up in eating away the revenues in another (Eugene et. all, 2007). Second, it may not be feasible to submit all or part of the local cash flows to the parent company and reinvestment chances in the local economy may be substandard to what the parent could do somewhere else, so, a less than highest use of funds. Cash flows from the project have to be calculated (Eugene et. all, 2007). Cash flows are also a mode of evaluating a project for investment in subsidiary company. The cash flows from the Parent company must be keyed out from project cash flows. Parent cash flows frequently reckon on the type of financing. Thus it is not possible to undoubtedly disconnect cash flows from financing verdicts, like it is done in domestic capital budgeting. Additional cash flows brought forth by a new investment in one foreign subsidiary could be either in part or on the whole taken away from another subsidiary. This leads to a net result of one project being profitable while another without any contributions. This ultimately results from the project not contributing anything to worldwide cash flows. Apart from this the parent company has to clearly discern remission of funds due to differing tax systems, legal and political restraints on the apparent movement of funds, local business rules and regulations, and deviations in the way financial markets and institutions operate (Moffett, 2002). Inflation of the subsidiary country also should be taken into account. It should be calculated along with the expected cash flows of the project rate of return. Virtual inflation strikes the anticipated exchange rate because of purchasing power parity (Moffett, 2002). Conclusion To conclude it can be said that there has being a lot of studies conducted with regard to investment in foreign subsidiary and most of the research point out that political and economic steadiness are essential circumstances to pull in direct investment from abroad. Country risks and environment risks are also other vital factors to be considered while making investment in a foreign subsidiary. Country risk actually takes place in two forms that is either in the form of sovereignty risk or transfer risk. While making a decision with regard to investing in a foreign subsidiary it is crucial that these factors are taken into consideration by the company. Reference 1. Aharoni, Yair. 1966. “The Foreign Investment Decision Process.” Boston, Harvard University Press. 2. Basi, R.S. 1963. “Determinants of United States Private Direct Investment in Foreign Countries.” Kent, Ohio, Kent State University. 3. Bass, B.M., McGregor, D.W. and Walter, J.L. 1977. “Selecting foreign plant sites: Economic, social and political considerations.” Academy of Management Journal. Vol.20: pp.535-551. 4. Blomstrom, M., 1989. “Foreign investment and spillovers: A study of technology transfer to Mexico.” Routledge, London. 5. 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