What is Foreign Direct Investment - Term Paper Example

Topic:' What is Foreign Direct Investment (FDI)' Introduction For a start up or a small company, the local market is enough to sustain its growth appetite during the initial growth. A startup has inherent strengths like better understanding of the local market and consumer requirements that help it get stabilized and grow rapidly in the local market. After the initial years the home country and the local market cannot sustain growth of a company and the company must look to expand its business beyond national geographies. Expanding to other markets is no more an optional strategy for a firm- it is more of a necessity. However, this expansion should be a planned, strategic and well execute one. FDI FDI, or Foreign Direct Investment is defined as the scenario where "A company from one country obtains controlling interest in a (new or existing) firm in another country, and then operates that firm as a part of the multinational business of the investing firm. FDI may be financed through parent company transfer of funds to the new affiliate, borrowing from home-country lenders, borrowing in the host country by the parent company, or any combination of these strategies." (FDI Definition, n.d.) Foreign direct investment is also a measure of ownership of private enterprise, its stocks and resources, and used as a growing tool in economic globalization. These investments add up to the GDP (gross domestic product) of industrialized and industrializing economies. There are quite a few different modes of entry to foreign markets, but almost all of them can be categorized under the following four- exporting, licensing, franchising and direct investment. Each of these entry modes have their own set of advantages and disadvantages, and the appropriateness of each of them depends of the market dynamics of the guest country as well as the factors specifics to each company. Why might firms favour FDI rather than exporting, licensing or franchising' Foreign Direct Investment allows the investing firm varied degree of control over its overseas business activities. FDI, additionally, offers higher profitability options to the investing company. Control is one of the most important characteristics of FDI, and hence FDI is generally adopted as a preferred mode of entry when control and coordination is critical to the success of international drive of the company. Foreign direct investment is also preferred when the host market prefers buying products that are locally manufactured. Many governments also actively promote FDI as FDI directly adds value to the local economy and generates employment. Additionally, many retail as well as institutional customers feel that local manufacturing presence results in better after sales service and decreases the overall cost of ownership. However, FDI has its own set of disadvantages too. FDI, by definition, involves higher commitment level for the company, and the company is exposed to a range of risks including political, geographical and economic risks. FDI is also subject to probable depreciation of the value of its investment in case of an adverse fluctuation of exchange rates. Despite the fact that FDI is generally encouraged by the government, there are cases where government policies act as a roadblock for FDIs. In many countries, government policies forbid foreign countries from owning majority control of a local company in selective or all industries. In some other countries, there are various levels of restrictions in repatriation of profits. Companies opting for foreign direct investment as the entry mode to other economies or markets also have to face additional challenges in terms of allocating additional bandwidth, adapting to local political, legal and business environments. (Marchick D.M. and Slaughter M.J., June 2008) There are broadly three different modes for foreign direct investment: (1) Greenfield approach: In this mode, the firm builds new capacities from scratch. This approach is generally cheaper than other options, but has a higher gestation period. (2) Brownfield approach: In this strategy, the company takes over existing assets and manufacturing capacity. (3) Joint venture: As the name suggests, this involves getting into a partnership with a local company. The Greenfield Approach In the Greenfield approach, the company builds a new business operation from scratch. The nomenclature is inspired by the image of initiating from a fresh green site, and then creating the manufacturing set on that site. In this strategy, the company acquires land, builds new manufacturing facilities, recruits new team members or transfers existing team members from overseas teams, and then initiates business. Just like any other strategy, the Greenfield approach has its own set of advantages and disadvantages. Among other advantages, the company can identify the project location that perfectly fulfills its requirements and build modern, state of the art manufacturing facilities. Local as well as national governments often offer financial and other incentives to attract foreign direct investment as they generate new employment. Additionally, foreign direct investment that brings in new state of the art technology also benefits the local economy by making its vendors adopt to new and better technology/manufacturing practices, thereby increasing the competitiveness of the local vendors. The entity formed out of FDI also enjoys all the advantages of starting afresh. The newly born entity is free for all legacy problems that might be plaguing the mother company, like outdated technology/machinery, existing debt, complacent work culture, tough work rules, and entrenched labor unions. One of the best examples of this advantage is GM's small car assembly plant at Eisenach, erstwhile East Germany. GM could implement the highly efficient Japanese style lean manufacturing strategies in this plant as it did not have to deal with the well embedded relatively inefficient work style of its American factories. (Bennet J., October 1994) Adapting to a new, alien culture is often one of the more important challenges faced by foreign companies, and a Greenfield approach gives the investing company sufficient time to adjust to business, economic and cultural idiosyncrasies of the local country. The multination enterprise can, hence, adapt to the new environment at its own pace thereby ensuring stable learning. Cultural differences are in fact one of the most important factors that decide the mode of market entry for a multinational enterprise, and higher the divergence between the two cultures, higher is the possibility that the multinational enterprise will opt for a direct investment route. (Slangen A. and Hennart J., n.d.) On the flipside, the Greenfield approach has some major disadvantages. Among the most important disadvantages is the fact that the exit route is long drawn, difficult, and often results in loss on investment in case of an hostile departure. Successful implementation of the Greenfield approach is time consuming, and depending on the scale, can even take years to be completed thereby drastically increasing the opportunity cost. Additionally, project site in the new location may not be available or may be costly. There can also be problems in building new manufacturing capacities due to lack of local expertise and experience. While building the new manufacturing set up in an emerging economy, the multinational enterprise may also need to adhere to archaic government regulations, thereby making the entire process long drawn and economically unfeasible. The foreign company may also need to invest heavily in training the new recruits to meet higher manufacturing and efficiency standards. (Moon C.W. and Shin G.C., n.d.) The Acquisition Strategy An alternative to the Greenfield FDI approach is taking management control of an existing player doing business in the destination country. The actual process of taking control of an existing local company may be complex involving multiple teams of M&A specialists, legal and financial professionals, but the underlying motive of such a strategy is quite simple. By acquiring an already established concern, the investing company gains access to already existing manufacturing set up, employees, insights to market, brand names and distribution set up relatively quickly and without incurring opportunity cost. Additionally, the acquired firm's revenues contribute to the top-line and profits from day 1 unlike in Greenfield strategy where revenues start coming in only after months or years of gestation periods. Sometimes, overseas acquisitions are also done undertaken by a multinational enterprise as a mode of executing an important change in strategy. Among the disadvantages of the acquisition strategy, the investing firm has to assume all financial and other liabilities of the acquired firm. Additionally, the capital investment is done upfront as compared to the Greenfield approach where the investment is spread a wider time span. Exports: Exporting is perhaps the easiest mode of entering a foreign market. Exporting to a new market requires minimal or no upfront investment, requires the least set up time, and involves little or no long term commitment from the organization. However, there are some inherent and strong disadvantages of the organization. Factors working against exports as an entry mode Government Policies: While home countries actively encourage exports to foreign markets and offer a range of incentives in the form of government policies and financial incentives, host countries tend to impose a range of policy and financial hurdles to make imports uncompetitive. Adapting to local requirements: Goods manufactured in the home country and exported to other countries are generally designed for local consumers and hence these goods may not perfectly suit the host countries' requirements. Distribution cost: The landing and distribution costs for exported goods will be substantially higher as compared to locally manufactured products. N addition to higher costs, exporting involves a longer and often stretched out supply chain, thereby increasing the response time of the firm to local business dynamics. Consumer perception: Consumers tend to associate imported goods with delayed or low after sales service, and minimal consumer interaction. Licensing In this mode of internationalizing the business, the parent company agrees to let a company in the host country to use its properties like trademarks, patents and production knowhow in exchange of royalty or license fees. Licensing offers minimal financial risk, and is one of the easiest modes of entering a foreign market. Licensing can be used to evaluate the readiness of a market, and the acceptability that the company may enjoy in the long term. Additionally, this mode of foreign market entry allows the multinational entity to gain acceptance in a new country without investing significant amount of financial resources and managerial bandwidth. Licensing also allows the multinational entity to replicate its domestic success in foreign markets without substantial investment. However, licensing has three major disadvantages: 1) the possibility of erosion of brand value due to sub-par manufacturing/sales/after sales service offered by the local partner, 2) possible opportunity cost, and 3) Sharing of technology. Additionally, in case of a difference in opinion between the two parties, the business may be subjected to long drawn litigation. Probable erosion of brand value: Despite all the support from the licensor, the final quality of a product depends to a large extent on the abilities of the local partner. In case the local partner lacks the necessary knowhow to produce, market and offer after sales service, consumer perception of the licensee brand may take a serious beating. Opportunity cost: Most licensing agreements have a cooling off period during which the licensor is not allowed to enter the host country either through a completely owned subsidiary, or along with a different local partner. This can lead to a substantial opportunity cost in case the licensor decides to terminate the agreement and re-enter the market. Loss of technology: The strategic repercussion of licensing proprietary technology of a firm is an important concern. The local player may be able to master the technology by reverse engineering, and then may turn out to be a future competitor of the license company. This is one of the most critical risks that are associated with licensing as a mode of entry to foreign markets. (Foreign Entry Mode, n.d.) Franchising Franchising can be considered to be quite similar to licensing. However, there are quite a few important differences between these two modes of internationalization. The franchisee generally represents a revenue sharing agreement where as licensing, in a lot of cases, represents a constant amount that is paid by one party to another. Additionally, the degree of co-ordination required between the two parties in franchise mode is much higher as compared to the license mode. The multinational business entity that has opted for the franchisee to enter a host country faces almost all the risks as it would have faced in the licensing mode. In addition to these, the risk of a possible brand value erosion is substantially higher in franchising, as franchising generally involves usage of the parent brand to market goods. International franchising may also be more complicated than domestic franchising. (Entering Foreign Markets, n.d.) Conclusion The choice of entry mode to a new country is influenced by a range of factors including risk appetite, growth potential of the host country and degree of conduciveness of business environment. Each of the four modes of internationalization has its own set of advantages and disadvantages. While exports is the easiest mode and involves least capital and other risks, franchising and licensing offer a mix of low risk and higher returns/growth. Among all entry modes to foreign markets, FDI is the preferred one for a large number of multinational business enterprises. FDI offers much higher degree of control, conveys a long term commitment to consumers, vendors, society and the government, and higher profits. Reference: Bennet J., (October 1994), G.M. Success in an Unlikely Place, retrieved December 1, 2008, from http://query.nytimes.com/gst/fullpage.html'res=9901E4DC1E3FF932A05753C1A962958260&sec=&spon=&pagewanted=all Entering Foreign Markets, (No Date), Chapter 11, The University of Texas, Dallas, retrieved December 1, 2008, from http://www.utdallas.edu/'irem/chap11.ppt FDI Definition, (No Date), The George Washington University, World Investment Report, Financial Times, retrieved December 1, 2008, from http://www.gwu.edu/'introint/lecture3/tsld006.htm Foreign Entry Mode, (No Date), retrieved December 1, 2008, from http://www.buec.udel.edu/fange/475/Entry_Mode.ppt Marchick D.M. and Slaughter M.J., (June 2008), Global FDI Policy, Yale Law School, retrieved December 1, 2008, from http://www.law.yale.edu/documents/pdf/cbl/Marchick_FDI.pdf Moon C.W. and Shin G.C., (No Date), Overcoming Cultural Gap Through Firm Cultural Diversity In International Corporate Venturing: An Empirical Test Of Learning Perspective, retrieved December 1, 2008, from http://marketing.byu.edu/htmlpages/ccrs/proceedings99/moon.htm Slangen A. and Hennart J., (No Date), Cultural Distance And Foreign Direct Investment: A Comprehensive Model Explaining The Impact Of National Cultural Differences On Entry Mode Choice And Subsidiary Performance, retrieved December 1, 2008, from http://www.aueb.gr/deos/EIBA2002.files/PAPERS/C203.pdf Read More