Chapter 17
Foreign Direct Investment and
Political Risk
Edited and prepared by KY Leong
Copyright © 2021 Pearson Education Ltd. All Rights Reserved
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The Foreign Direct Investment Decision (1 of 5)
• The OLI Paradigm helps to explain the strategic
decision to undertake a foreign direct investment.
• O is for ownership advantages
• L is for location advantages
• I is for internationalization advantages
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The Foreign Direct Investment Decision (2 of 5)
Ownership advantages
• 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 firmspecific, not easily copied, and transferable.
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The Foreign Direct Investment Decision (3 of 5)
Location advantages
• Factors are typically market imperfections or genuine
comparative advantages that attract FDI to particular locations.
• Factors might include a low-cost but productive labor force,
unique sources of raw materials, a large domestic market,
defensive investments to counter other competitors, or centers
of technological excellence.
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The Foreign Direct Investment Decision (4 of 5)
Internalization advantages
• A key ingredient for maintaining a firm-specific competitive
advantage is possession of proprietary information and control of
the human capital that can generate new information through
expertise in research.
• Minimizing transactions costs is a key element in a successful
internationalization strategy.
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The Foreign Direct Investment Decision (5 of 5)
• Financial strategies are directly related to the OLI Paradigm.
• The MNE’s financial managers can proactively formulate
financial strategies in advance.
• Reactive financial strategies depend on discovering market
imperfections.
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Structural Choices for Foreign Market Entry
• A MNE’s decision to invest abroad is followed by choices
of which markets and how to enter them—through which
business forms and structures.
• The choice of both target markets and entry structures
will establish what types of political risk the firm then
faces.
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Choosing Entry Structures (1 of 7)
• In principle, the greater the depth of market penetration desired
with greater expected returns, the greater the investment required
with higher potential risks.
• The globalization process includes a sequence of decisions
regarding where production is to occur and who is to own and
control assets, both production facilities and intellectual property.
• See Exhibit 17.2
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Exhibit 17.2 The Foreign Direct Investment Sequence
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Choosing Entry Structures (2 of 7)
• Exporting Versus Production Abroad:
• There are several advantages to limiting a firm’s activities to
exports as exporting has none of the unique risks facing FDI,
joint ventures, strategic alliances and licensing with minimal
political risks.
• 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.
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Choosing Entry Structures (3 of 7)
• Licensing and Management Contracts Versus Control of Assets
Abroad:
• Licensing is a popular method for domestic firms to profit from
foreign markets without a large commitment of funds
• However, there are disadvantages which include:
• License fees are lower than FDI profits
• Possible loss of quality control
• Establishing possible competitors
• Technological improvements by the licensee which then
enter your home market
• Possible loss of FDI opportunity at a later date
• Risk that technology will be stolen
• High agency costs
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Choosing Entry Structures (4 of 7)
• 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.
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Choosing Entry Structures (5 of 7)
• Joint Venture Versus Wholly Owned Subsidiary:
• A joint venture is defined as shared ownership in a foreign
business.
• Some advantages of a MNE working with a local joint venture
partner include:
• Better understanding of local customs, mores and institutions
of government
• Providing for capable mid-level management
• Some countries do not allow 100% foreign ownership
• Local partners have their own contacts and reputation which
aids in business
• Local partners may possess key technology
• Public image may be enhanced with partial local ownership
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Choosing Entry Structures (6 of 7)
–Joint Venture Versus Wholly Owned Subsidiary
▪Potential Conflicts with a Joint Venture
–Local and foreign partners may have divergent views about the
need for cash dividends, or about the desirability of growth financed
from retained earnings versus new financing
–Transfer pricing on products or components, bought from or sold to
related companies, creates a potential for conflict of interest
–Ability of a firm to rationalize production on a worldwide basis can
be jeopardized if such rationalization would act to the disadvantage
of local joint venture partners
–Financial disclosure of local results might be necessary with locally
traded shares or a local partner, whereas if the firm is wholly owned
from abroad such disclosure is not needed
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Choosing Entry Structures (7 of 7)
–Joint Venture Versus Wholly Owned Subsidiary
▪Potential Conflicts with a Joint Venture (cont.)
–Valuation of equity shares is difficult
–It is highly unlikely that foreign and host-country partners have
similar opportunity costs of capital, expectations about the
required rate of return, or similar perceptions of appropriate
premiums for business, foreign exchange, and political risks
–Insofar as the venture is a component of the portfolio of each
investor, its contribution to portfolio return and variance may be
quite different for each
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Political Risk: Definition and Classification
• Political Risk
• The possibility that political events in a particular country will influence the
economic well-being of a firm operating in that country
• In order for an MNE to identify, measure, and manage its political risks, it
needs to define and classify risks as:
• Firm-specific risks
• Country-specific risks
• Global-specific risks
• See Exhibit 17.3
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Exhibit 17.3 Classification of Political Risks
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Additional Notes:
Chapter 17
Foreign Direct Investment
and Political Risk
Why Country Risk Analysis Is Important
1. Country risk is the potentially adverse impact of a country’s
environment on an MNC’s cash flows.
2. Country risk analysis can be used to monitor countries where
the MNC is currently doing business
3. MNC can use country risk analysis to revise its investment or
financing decisions in light of events such as:
a. Terrorist attack
b. Major labor strike in an industry
c. Political crisis due to a scandal
d. Concern about a country’s banking system
e. Imposition of trade restrictions on imports
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Copyright © 2010 Cengage Learning. All Rights Reserved
Country Risk Factors: Political Risk
Attitude of
consumers in
the host country
War
Actions of the
host
government
Blockage of fund
transfers
Inefficient
bureaucracy
Currency
inconvertibility
Corruption
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Country Risk Factors: Financial Risk
Economic Growth influenced by:
1. Interest rates: higher interest rates tend to slow growth
and reduce demand for MNC products
2. Exchange rates: strong currency may reduce demand
for the country’s exports, increase volume of imports,
and reduce production and national income.
3. Inflation: inflation can affect consumers’ purchasing
power and their demand for MNC goods.
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Assessment of Risk Factors
1. Macroassessment of country risk: overall risk assessment of a
country
2. Microassessment of country risk: assessment of a country as
it relates to the MNC’s type of business.
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Measuring Country Risk
1. Variation in methods of measuring country risk
2. Comparing risk ratings among countries
a. Use of foreign investment risk matrix (FIRM)
3. Actual country risk ratings across countries
a. Many countries experienced a decline in country risk ratings due to the
credit crisis.
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Incorporating Risk in Capital Budgeting
Adjustment of the discount rate: lower risk rating implies
higher risk and higher discount rate.
Adjustment of the estimated cash flows: adjust estimates
for the probability that cash flows may not be realized.
Assessing Risk of Existing Projects: review country risk
periodically after project has been implemented.
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Preventing Host Government Takeovers
1. Use a short-term horizon
2. Rely on unique supplies or technology
3. Hire local labor
4. Borrow local funds
5. Purchase insurance
6. Use project finance
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Mode of internationalisation
• International trade (export and/or import) most conservative
• Licensing (provide its tech: copyright, patents at a cost, low q. ctrl)
and Franchising (provide specialized sales strategy for periodic fee)
• Joint venture (jointly owned & operate by 2 or more firms to
penetrate foreign mkts)
• Acquisitions of existing operations.
• Establishing new foreign subsidiaries
• Direct foreign investment (FDI)
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Objective of managing financial resources of MNC
Is it ?
• Maximising sale income
• Minimising cost of capital
• Maximising profit
• Accessing scare resources
• These are not the objectives, The financial
objective is
• maximize shareholder wealth.
Conflicts with the MNC Goal: Subsidiary managers may be
tempted to make decisions that maximise the values of their
respective subsidiaries.
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Agency problem
• When a corporation’s shareholders’ goals differ from its
managers’ goals, a conflict of goals can exist—the agency
problem.
• Agency costs are normally larger for MNCs than for purely
domestic firms, due to:
• the difficulty in monitoring distant managers,
• the different cultures of foreign managers,
• the sheer size of the larger MNCs, and
• the tendency to downplay short-term
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Impact of Management Control
• The magnitude of agency costs can vary with the management
style of the MNC.
• A centralized management style reduces agency costs.
However, a decentralized style gives more control to those
managers who are closer to the subsidiary’s operations and
environment.
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Management Styles of MNCs
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Management Styles of MNCs (Continued)
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Strategies for overcoming agency problem
Sources: Bekaert G.,Hodrick R. J.(2009); International Financial management, Pearson
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Factors to be considered in IFM
- Language & culture
- Logistics
- Human resource
- Financial markets
management
- Accounting system
- Marketing
- Distribution
- Corporate governance
- Other business conventions
(legal, accounting, taxation,
regulation, etc.)
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Valuation Model for an MNC: Domestic Model
 E (CF$,t )
V = 
t 
t =1  (1 = k )

n
▪ where E(CF$,t) represents expected cash flows to be
received at the end of period t,
▪ n represents the number of periods into the future in
which cash flows are received, and
▪ k represents the required rate of return by investors.
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Valuation Model for an MNC: International Cash
Flows


E (CF$,t ) =  E (CF j ,t ) E (S j ,t )
m
j =1
▪ where CFj,t represents the amount of cash flow
denominated in a particular foreign currency j at the end of
period t,
▪Sj,t represents the exchange rate at which the foreign
currency (measured in dollars per unit of the foreign
currency) can be converted to dollars at the end of period t.
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Valuation model for MNC
𝑉=
σ𝑚
𝑗=1 𝐸 𝐶𝐹𝑗,𝑡 × 𝐸 𝑆𝑗,𝑡
(1 + 𝑘)𝑡
• Multinational investment policy
- Higher returns from existing investments
- To identify new investment opportunities – max. firm value
• Multinational financial policy
- Reduced capital costs through access to international
capital markets (inv. Risk mgt and hedging) - max. firm’s
value by min. cost of k
• Foreign exchange rate
MNC’s cash flow
How an MNC’s Valuation is Exposed to Uncertainty
(Risk)
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Risk versus risk exposure
•
Risk exists whenever actual outcomes can differ from
expectations
•
A company has an exposure to risk when its value can
change with unexpected changes in business conditions
International business usually increases an MNC’s
exposure to:
•
 exchange rate movements
 foreign economies
 political risk
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