Advantages and Disadvantages of Foreign Direct Investment - Coursework Example

International Business Name Institution Course Date Introduction There are a number of market entry modes that are available for companies wishing to go international into foreign markets overseas (Koch, 2001). When an organisation has decided to go international, there are a number of options open to it. Examples of entry modes include Exporting, Strategic Alliance, Licencing and Joint ventures to name a few. These entry modes vary on the basis of cost, risk, degree of control and return on investment. Physical distance today is no longer an issue and internalization is considered a necessity for both large and small organisations when the domestic market is overwhelmed by competition (Cavusgil and Li, 2002). Currently, more and more firms are opting to internationalize more rapidly than ever before. Internalization can be termed as the process through which an organisation develops an international business and becomes comprehensively involved in committing to international operations in predetermined markets. An organisation that choose to expand and grow its operations by reaching markets that are found beyond its national boundaries makes a decision on the mode of entry to be employed. With globalization and liberalization, it is not difficult for multinational companies to enter into new markets (Douglas, 2009). The entry of multinational companies into international markets can be found to be beneficial for the foreign company and to the domestic market. These multinational companies are getaway options to new technologies and innovation by making life more tranquil and comfortable. The idea of internalization by foreign multinational companies sound promising for both the company and the new market but it is not as easy as it sounds (Clark, Pugh and Mallory, 2007). This is attributable to the fact that every market is different in relation to economy, political, regulation and policies, technology and culture. This paper will detail out the advantages and disadvantages of exporting, joint venture and wholly-owned foreign direct investment as strategies of doing business overseas. The paper will also give the reasons why some companies use these entry modes while others do not using relevant theories. Exporting Generally, more companies take on exporting as a means of internalization compared to other strategies (Clark, Pugh and Mallory, 2007). Exporting is a relatively easier method to expand operations in foreign markets. Furthermore, it is relatively less risky compared to joint venture and wholly-owned foreign direct investment. One way to look at the foreign entry strategies is the transaction cost economics framework that tends to explain the entry mode decision as a contemplation of capital incurred in internationalizing against the capital of routing through the market (Clark, Pugh and Mallory, 2007). If it is cost effective to utilize market mechanism, companies would opt to export. Nevertheless, if it’s cost effective to internationalize the transactions alongside the value chain then companies would prefer using direct investment. For example, Toyota Motor Company utilizes this mode of entry very often as a commencement of their international development. This is due to the lower risks that accompany them. This has been one of the finest methods undertaken by Toyota Motor Company in gaining entry and experience of new markets for example, into the UK and Chinese markets. This entry mode is advantageous to the company because of the economies of scale. Advantages of Exporting One major advantage of exporting is the potential economies of scope that result from production volume. Increased level of production, distribution and even advertising leads to the decrease in cost of produce that a company is expected to incur (Jansson, 2008). Furthermore, decreased costs have an impact on potential profitability of an export venture. When an organisation decides to export its products and services to foreign markets, it is likely that there is competitiveness in the local market. Local competitiveness may result from enhanced productivity and efficiency (Jansson, 2008). The advantage of competitiveness in the local markets is that it ensures dominance compared to the competitors and products are considered superior than others thereby demand of the products in the local and international market increases. Exports are considered a low cost as well as low risk method of gaining entry to new markets compared to international joint venture and wholly-owned foreign direct investment (Jansson, 2008). Exports are regarded cost effective in gaining access to lucrative international market opportunities. When compared to more complex modes of entry such as international joint venture and strategic alliances, exports tend to enable an enhanced pace of entering foreign markets. Another advantage of exports is diversification. Companies that carry out their operations in more diversified markets face few risks than non-exporting firms (Jansson, 2008). This is founded upon the fact that countries are not bound by similar timing and type in the business cycle. Therefore, the likelihood that an economic failure occurs at the same time across countries where business operations are is minuscule. In addition, market spreading and expansion tend to moderate the risk of declining demand and returns from a single market. Disadvantages of Exporting Under the condition of inadequate information and data from partners like the intermediaries and agents in the new markets, exporters are frequently faced with the risk of uncertainty when it comes to decision making (McDougall, Oviatt and Shrader, 2003). In addition, the exporting firm may be required to depend highly on foreign agents due to the local political laws and regulations. According to international production theory, the benefit gained by the firms in carrying out foreign production depends highly on attractions of the foreign country. According to the theory, issues concerning government actions and regulations may have an effect on the attractiveness and entry modes for firms (Kim and Mauborgne, 2001). In addition, when an organisation operates in the international market, there is lack of cultural compatibility existing between the company and the foreign market due to cultural distance (Kumar and Singh, 2008). This is a disadvantageous to this mode of entry since cultural compatibility is an important component of the stability of any company. Lack of cultural compatibility may lead to communication difficulties in understanding the needs and wants of the foreign market which hinders ability of an exporter to antedate customer’s changing tastes and preferences. Furthermore, the nature of export arrangement may cause operational difficulties. Since the exporter depends highly on local intermediaries to certify availability and distribution of products in the new markets, thus the importers have less control in the foreign market activities (Johanson and Vahlne, 2000). In addition, since it is important to coordinate and direct the activities of the exporter and the intermediaries, this tends to be difficult. Wholly-Owned Foreign Direct Investment Foreign direct investment is said to be one of the significant economic figures. Foreign investment is the investment of capital in a chosen business enterprise operating in foreign countries (Chetty and Campbell, 2003). According to the Cave Economics theory, if companies want to invest horizontally, its property should have the advantage of local companies in the host country as a result of being resident. In this case, the company should decide Foreign Direct investment is more profitable than Joint venture and exporting. For example, Ford and General Motors factories have a number of foreign direct investments in other nations internationally. They have come up with various factories as well as invested in machinery in nations such as South Korea, Mexico to name a few. Through investing in these foreign countries, the company has been able to grow their production, save on the cost of labour and has helped them gain entry into their markets (Chetty and Campbell, 2003). Advantages of Wholly-Owned Foreign Direct Investment Normally, any country has specific import tariff that makes it difficult for foreign companies to carry out its business operations. In additional, many industries require companies to participate in international markets in order to ensure their goals are completely met. With wholly-owned Foreign Direct Investment, all these become easier (Chetty and Campbell, 2003). Many parent companies offer foreign direct investment for the purpose of adding expertise, products and technology. In addition, in contrast to exporters, foreign investors often receive tax incentives that are useful in business operation. In addition, another major benefit of wholly-owned foreign direct investment is the increase in income of the target country. With the creation of more jobs coupled with higher wages, the country’s income tends to increase. This often leads to economic growth. Larger companies offer higher salaries which increases the country’s income (Chetty and Campbell, 2003). Disadvantages of Wholly-Owned Foreign Direct Investment One disadvantage of foreign direct investment is the risk of political changes. Since political issues in some countries constantly change, FDI’s as a means of internalization is very risky. Moreover, most risk factors are often extremely high causing damage to a foreign investor (Westhead, Wright and Ucbasaran, 2001). Similarly, political changes may also result to expropriation. Expropriation is a situation where the government takes control over ones’ property and assets. If a person or a company invests in a number of foreign costs, it is evident that it will be more expensive to offer Foreign Direct Investment than when exporting products or services. Therefore, it is very crucial to prepare a large sum of money in order to set up foreign operations through FDI’s (Johanson and Vahlne, 2010). In addition, considering the fact that wholly-owned foreign direct investment is capital-intensive in relation to the investor, it is often very risky and economically non-viable (Malnight, 2001),. FDI’s have impacts on Country’s Investment. The rules and regulations that guide the exchange rates as well as the foreign direct investments may negatively affect the investing country. In some foreign nations, direct investment may be banned which may mean that it is fairly impossible to chase after an inviting opportunity. In addition foreign investments have the ability to affect exchange rates on the basis of the advantage to one Country and disadvantage to the other (Johanson and Vahlne, 2010). International Joint Venture International joint venture is the collaboration of two or more partners from different jurisdictions with an aim of exchanging resources, divide profits and share risks (Ben, David and Arthur, 2002). Some business organisations prefer to adapt joint venture as a means of entering into foreign markets. For instance, AirAsia entered into a joint venture with Expedia. This joint venture was performed in order to launch a new company which will be in charge of operating Expedia’s branded business in Japan as well as in East and South East Asia. This deal was made so as to oversee exclusive third party distribution of rights in the area for AirAsia as well as their long haul sector, AirAsiaX. This would be performed singly via the AirAsia websites and Expedia. The advantages that came with this joint venture included: lowering of risks operations, better local market intelligence and increased profitability (Prescott, Darrell and Salli, 2010). Advantages International Joint Venture One advantage of international joint venture is the ability to share risks. There exists a legal agreement between the business partners on how the risks are shared. In case of business failure and loss, all the parties involved take part in sharing the loss and risks (Ben, David and Arthur, 2002). In addition, in an uncertain business ventures, parties share risk of high-leverage. International joint venture presents a way of accessing foreign market fast and less costly which is able to be achieved by buying an existing organisation or starting a new venture. Furthermore, joint venture offers a faster access to distribution channels and non-resident partners acquire knowledge of the local market, enhancing profitability as a result (Wolf and Charles, 2002). Moreover, the sharing of cost of operation is very vital for small and medium-sized enterprises which do not have enough capital, technology or resources to pursue attractive opportunities. Unlike exporting and wholly-owned foreign direct investment, companies have the ability to be successful even with lack of enough capital for starting a new venture (Meirovich and Gavriel, 2010). Disadvantages International Joint Venture An international joint venture can be a frustrating experience and can at the end lead to failure if there is lack of adequate planning and positioning. Issues concerning market development, technology, regulatory uncertainties coupled with economic recessions are difficult to anticipate and can lead to debilitating impact on international joint venture (Meirovich and Gavriel, 2010). In addition, management issues can hinder its activities in spite of administering mechanisms to resolve conflicts. Additionally, market imperfection theory argues that companies seek international market opportunities in foreign countries as a strategy to fully capitalize in some capabilities that the competitors in the foreign countries lack. According to market imperfection theory, foreign production is the most desirable method of gaining firm’s advantage (Vaidya, 2009). However, joint ventures pose a problem as it is hard for them to be capitalized as an entity with regard to debt since most of them have finite operational duration resulting to poor performance (Vaidya, 2009). Unless they are fully capitalized, their debt financing may need to be guaranteed by the joint venture partners which tend to increase the level of risk. Furthermore, joint ventures have the possibility of creating a potential competitor in terms of one’s own joint venture partner. However, such issues can be resolved by addressing confidentiality provision and non-competition in the joint venture agreement (Ben, David and Arthur, 2002). Mode of Entry Decision by Multinational Companies There are some companies that use Joint venture, Wholly-owned foreign direct investment and exporting as a means of acquiring new markets while others do not. The decision of the mode of entry to be chosen is very critical and depends on many factors. Exporting has been used over the years by companies as a first step to exploring international markets (Johanson and Vahlne, 2010). Due to the advantages brought about by exporting such as diversification, economies of scale and fewer risks in relation to capital investment, many multinational companies can opt to expand their operation in foreign markets through exports (Johanson and Vahlne, 2010). Other companies can opt to use other means of entry into foreign markets due to the disadvantages offered by exporting strategy. Since exporting has posed the risk of distributor opportunism, some multinational companies that want to take control of their operations may not invest in exporting. Foreign direct investment is a preferable option in the case where a company wants control as it allows internalization for proprietary asset exchange. Nevertheless, since FDI calls for greater resource commitment in terms of capital, many companies shy away from it (London and Hart, 2004). Alliances such as Joint venture are known to overcome resource deficiencies thereby increasing the likelihood of internalization success. Multinational companies that prefer to adapt an entry strategy with finite lifetime and lower risks use joint venture (Wolf and Charles, 2002). In addition, other strategies such as licencing, ownership and partnership may bring greater advantages to some multinational companies. For instance, multinational companies may refer licencing to joint venture as it is simple and fast to implement and requires less business costs (Chi and McGuire, 2006). The mode of entry to international markets depends on the nature of business and the readiness to take risk and incur costs. Conclusion There are a number of entry mode options that multinational companies can adapt in exploring foreign markets. These modes include international joint venture, franchising, foreign direct investment, ownership and exporting to name a few. In comparison to joint venture and foreign direct investment, exporting as a means of going international has a number of advantages such as economies of scale, access to new markets, fewer risks in terms of capital investments, and diversification. Its disadvantages include the lack of full control over business operations in the foreign country, uncertainty in decision making and management difficulties. On the other hand, concerning wholly-owned foreign direct investment, it is considered appropriate for companies ready for greater resource commitment. FDI has the advantage of receiving tax incentives and increasing income in the host country. The joint venture entry mode is important in that it enables sharing of costs and risks among parties involved. 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