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Accounting Essays - Foreign Direct Investment

Reasons for multi-national corporation's to engage in foreign direct investment

In order to understand the reasons why a multi-national corporation would engage in foreign direct investment, one will need to first of all understand the meaning attached to both concepts.  A multi-national corporation is a company that is headquartered in one country but has operations in one or more other countries.  Sometimes it is difficult to know if a firm is a multi-national corporation because multinationals often downplay the fact that they are foreign-held.  For example, many people are unaware that Nestle, the chocolate manufacturer, is a Swiss company; Northern Telecom is Canadian; and Ford Motor now owns Jaguar, the British – based auto maker.  Similarly, approximately 25 per cent of banks in London are foreign-owned, but this is not evident by their names.  In addition, 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, Rugman (1982).  It is also worth noting that most foreign direct investment is conducted by companies within the 'triad' nations.  The triad is a group of three major trading and investment blocs in the international arena.  The nations are US, European Union, and Japan.  With this in mind we can now move on to talk about all the aspects that relate to the push by multinational corporations to engage in foreign direct investment.

Now, foreign direct investment or rather this equity investment carried out by multinational corporations can take a variety of forms.  One is through the purchase of an ongoing company.  For example, Santander Central Hispano (SCH), the Spanish lender, which is Spain's biggest bank, bought Abbey National of the United Kingdom, in order to ring up 150 million euros of cost savings in the first year after the merger, rising to 300 million euros in the second and 450 million euros in the third, BBC (2004).  Rather than building this business from scratch, Banco Santander bought its way into the financial sector of the United Kingdom through FDI.  Another form of FDI is to set up a new overseas operation as either a joint venture or a totally owned enterprise.  For example, Matsushita, the Japanese company is now positioning itself to become a major competitor in the European digital industry and has recently entered into a joint venture with British Telecommunications plc for the purpose of developing multimedia wireless services and products, Pringle (2000).  In general, the objective of FDI is to provide the investing company with the opportunity to actively manage and control a foreign firm's activities.  There are a number of advantages that multi-national corporations (MNC) face or rather factors that encourage MNC to take ownership position or gain control of foreign assets.  The following examines these advantages.  They are:

Increase sales and profits

Some of the largest and best-known multinationals earn millions of dollars each year through overseas sales.  In the EU, for example, companies in smaller economies need to look outside of their home borders.  This helps to explain why 60 per cent of Royal Dutch/Shell's assets and 75 per cent (see appendix Table 1) of BP's assets are in foreign markets, including the markets of other EU members.  In addition, although Switzerland is not in the EU, nearly 90 per cent of Nestlé's assets are outside Switzerland.  The same is true of revenues.  Over 50 per cent of Royal Dutch/Shell's sales originate outside its home markets (the Netherlands and the UK) and nearly 70 per cent of BP's sales are from outside the UK.  In addition, global markets often offer more lucrative opportunities than do domestic markets.  This helps to explain why Coca – Cola and IBM now earn more sales revenue and profits overseas than they do in the US, and why PepsiCo has become Mexico's largest consumer products company.

Enter rapidly growing markets

Some international markets are growing much faster than others, and FDI provides MNC's with the chance to take advantage of these opportunities.  A good example is China.  Over the past few years the Chinese economy has grown at an annual rate of around 7 – 8 per cent.  This is quite good given that its GDP is in the range of $1 trillion.  The data also shows that if the country continues to move toward a market-driven economy, MNC's are likely to find a huge demand for goods and services that cannot be satisfied by local firms alone.  Simply put, China is a market where most multinationals want to have a presence despite the fact that there are many problems in doing business there and virtually no MNC has yet been able to extract an adequate return on its investment.

Reduce costs

A MNC can sometimes achieve substantial lower costs by going abroad than by producing at home, for example, Japan does not have enough land for most manufacturing companies to embark on setting up corporations, hence they have had to invest in countries like, China and Scotland .  If labour expenses are high and represent a significant portion of overall costs, a MNC may be well advised to look to other geographic areas where the goods can be produced at a much lower labour price.  Surprisingly perhaps, in recent years some Canadian manufacturers have been moving operations across the border to take advantage of lower US labour unit costs.  A second important cost factor is materials.  If materials are in short supply or must be conveyed a long distance, it may be less expensive to move production close to the source of supply than to import the materials.  A third critical cost factor is energy.  If the domestic cost of energy for making the product is high, the company may be forced to set up operations overseas near sources of cheaper energy.  A fourth important factor is transportation costs.  In the recent past Chinese textile firms had gained a major share of the US market.  Production costs were so low that, even after adding in transportation expenses, they were able to beat out most competitors.  In recent years many firms have used all four of these reasons to justify moving assembly operations to other countries. 

Gain a foothold in economic blocs

As mentioned there are three major international economic blocs (triad).  MNC's that acquire a company in one of these blocs or that enter into an alliance to do business in one of these economic strongholds can obtain a number of benefits including the right to sell their output without having to be burdened by import duties or other restrictions.  In the case of the EU, over the last decade the membership of this bloc has increased to 15 with the admission of Austria, Finland, and Sweden.  Currently, Bulgaria, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, the Slovak Republic and Slovenia are being considered for membership.  International MNC's wanting to do business in the EU are finding it important to gain a foothold in this region through FDI.  This also relates to the Asian bloc, which comprises of Australia, China, India, Indonesia, Malaysia, the Philippines, South Korea, Taiwan, and Thailand.  In addition the NAFTA, which comprises of the US, Canada, Mexico, and possibly Chile in the future will become a fourth member; in which the final result will be three extended triads and any company wishing to do business worldwide will have to have a presence in all three blocs.

Protect domestic markets

Another reason for FDI is to protect one's domestic market.  Many MNC's are now entering an international market in order to attack potential competitors and thus prevent them from expanding their operations overseas.  Most multinationals reason that a competitor is less likely to enter a foreign market when it is busy defending its home market position.  Similarly, sometimes an MNC will enter a foreign market in order to bring pressure on a company that has already challenged its own home market.  For example, 10 days after Fuji began building its first manufacturing facility in the US, Kodak announced its decision to open a manufacturing plant in Japan, Rugman (2003).

Protect foreign markets

Sometimes MNC's will use FDI in order to protect their foreign markets.  In the US, for example, from 1981 to 1991 the total number of service stations had declined by over 50 percent.  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, Rugman (2003).  The company refines and markets petroleum products and realized that if it could attract a growing number of customers to its service stations, it could profit handsomely by moving its products directly downstream to the final consumer.

Acquire technological and managerial know-how

Still another reason for FDI is to acquire technological and managerial expertise.  One way of doing this is to set up operations near those of leading competitors.  This is why some US firms have moved some of their research and development facilities to Japan.  With this strategy, they find it is easier to monitor the competition and to recruit scientist from local universities and competitive laboratories.  Kodak is an excellent example.  The company made the decision to build 180,000 square foot research centre and it started cultivating leading scientists to help with recruiting.  Kodak used all the same approaches that Japanese firms employ in the US; financing research by university scientists and offering scholarships to outstanding young Japanese engineers, some of whom would later join Kodak.  As a result, Japan is now the centre of Kodak's worldwide research efforts in a number of high-technology areas, Shapiro (2003). 

Like exports and imports, FDI is a driver of international business and many companies use FDI to establish footholds in the world marketplace by setting up operations in foreign markets or by acquiring businesses there.  When looked at from an overall perspective, FDI data show that industrialized countries have invested very large amounts of money in other industrialized nations as well as smaller amounts in less developed countries (LDCs) such as those in Eastern Europe or newly industrialized countries such as Korea and Singapore.  However, most of the world's FDI is invested both by and within the three 'triad' major groups as mentioned earlier, the US, European Union, and Japan.  The US is an excellent example of a country that is a major target of investment as well as a major investor in other countries.  By 1999 the US had become such a major investment target that foreign holdings were almost $1.1 trillion (See Table 2 on inward stocks of world foreign direct investment).  The largest destination of FDI is the European Union (15 countries) with almost $1.7 trillion, and then Asia with almost $1 trillion.  This shows that the US is a prime site for FDI.  The Barriers to entry that MNC 's face include issues such as innovation, factor conditions, demand conditions, related and supporting corporations, and firm strategy, structure, and rivalry.  In the computer industry, for example, Intel's research and development (R&D) arm created a continuing flow of new – age computer chips – each more powerful than its predecessor.  And at the upper end of this market, IBM's R & D prowess helped it capture more and more of the business demand for powerful computers, while at the lower end Dell Computer's dominated the field with its high-quality PCs that were sold at rock bottom prices.  This is where innovation acts as a barrier to entry for a corporation.  Factor conditions include land, labour, and capital.  As a result, if a country has a large, relatively uneducated workforce, it will seek to export goods that are highly labour-intensive.  Demand conditions also acts as a barrier to entry in the sense that a nation's competitive advantage is strengthened if there is strong local demand for its goods and services.  This demand provides a number of benefits.  First it helps the seller understand what the buyers want.  Second, if changes become necessary, such as customer desires for a product that is smaller, lighter, or more fuel efficient, the local seller has early warning and can adjust or innovate for the market before more distant competitors can respond.  Related and supporting corporations, when suppliers are located near the producer, these firms often provide lower-cost inputs that are not available to the producer's distant competitors.  In addition, suppliers typically know what is happening in the industry environment and are in a position to both forecast and react to these changes.  By sharing this information with the producer, they help the producer maintain its competitive position.  Firm strategy, structure, and rivalry, this adds that no one managerial system is universally appropriate.  Nations tend to do well in industries where the management practices favoured by the national environment are suited to their industries sources of competitive advantage.  For example, in Japan, successful firms are often those that require unusual cooperation across functional lines.  In addition to this they do also face political and foreign exchange risks which can sometimes not be foreseen before entry into a foreign country.

Now, Buckley and Casson (1976) (theory of direct investment) argue in opposition to the Hymer (1976) - Kindleberger (1969) theory of oligopolistic advantage, that in he post second world war, a simultaneous occurrence of five elements led to the rapid growth of multi national corporations activity, they are, the rise in demand for technology intensive products; efficiency and scale economy gains in knowledge production; problems associated with organizing external markets for this new knowledge; reductions in international communication costs; and increasing scope for tax reduction through transfer pricing.  They particularly focused on the third factor, the existence of market imperfections, which generates benefits of internalization.  Here, a distinction was made among five elements, the absence of futures markets for knowledge production, requiring both the planning of knowledge development and its exploitation by the firm; the inability of external markets to allow optimal price discrimination when selling proprietary knowledge; the frequent occurrence of bilateral bargaining problems between monopolistic suppliers and monopsonist buyers of knowledge; buyer uncertainty, when purchasing new knowledge; and various difficulties associated with pricing knowledge.  They also add that internalization occurs only to the point where the benefits equal the costs.  Buckley and Casson (1976) already recognized four sets of parameters relevant to the internalization decision namely, industry specific factors (related to the nature of the product and the structure of the external market); region-specific factors; nation-specific factors, including government policies; and firm-specific factors, with a focus on the ability of the management to organize an internal market.  As a whole they looked at MNC as an international intelligent system for the acquisition and collation of basic knowledge relevant to R&D, and for the exploitation of the commercially applicable knowledge generated by R&D.  This according to them should lead to a worldwide network of basically similar plants, conditional upon the absence of very low transport costs, high scale returns at the plant level or strong comparative advantage associated with one location.  For them, the MNC was a centrally administered control system that derives its comparative efficiency from imperfections in external markets.  Interestingly, they also demonstrate a keen awareness of the transaction costs associated with managing an internal market across borders (in addition to the possible resource costs resulting from the joint organization of various activities with a different optimal scale, and the costs of political discrimination against foreign firms) and the related requirement to decentralize many value added activities.  They distinguished among three types of transaction costs, which they called communication costs, the costs associated with the need for a high volume of accounting and control information as compared to a conventional external market; the overhead costs, which could be very substantial if each internal market within the MNC requires its own communication system; the costs related to the need to check the accuracy of the information provided by local managers(subsidiary), including on the spot visits.


It will be worthwhile to conclude that corporations throughout the triad nations are constantly looking for new ideas that will make them more competitive.  In particular, EU and American firms are always seeking to emulate Japanese business practices that have proved so successful in the international arena.  In the US, for example, the chairman of the Federal Reserve System has expressed the belief that US antitrust practices are out of date and that competitors should be allowed to acquire and merge with each other in order to protect themselves from world competition.  This idea has long been popular in Japan where keiretsus, chaibols, or business groups, which consist of a host of companies that are linked together through ownership and/or joint ventures, dominate the local environment and are able to use their combined wealth and connections to dominate world markets.  Today many firms are copying this type of cooperation, in a more simply manner, what happens in one part of the triad often has an effect in other parts.  Hence, from an accounting point of view reasons such as reduced costs (outsourcing) and gaining a foothold in economic blocs (triad nations), are factors that can be said to be more prominent than all the other reasons mentioned.  This stems from the fact that relative costs, revenues, and tax considerations play a major important role in MNC's decision for FDI in a country, therefore, they are more important than the other reasons mentioned in the latter.


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