Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

Foreign Direct Investment

Dr. Ch. Venkata Krishna Reddy
Associate Professor
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Session Plan

• Foreign direct investment

– Introduction to FDI
– FDI and economic growth
– Benefits of FDI
– Determinants of FDI
Dr. Ch. Venkata Krishna Reddy
International Financial 2
Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Forms of cross-border financial flows

There are three basic forms of cross-border financial flows
– Portfolio investment
– FDI, and
– bank lending.
• FDI forms one of the most stable links between developing and
industrial countries.
Dr. Ch. Venkata Krishna Reddy
International 3
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

FDIs
Foreign direct investment (FDI) is an investment made by a firm or individual in
one country into business interests located in another country. Generally, FDI
takes place when an investor establishes foreign business operations or acquires
foreign business assets, including establishing ownership or controlling interest
in a foreign company.
FDI is investment in either real capital assets or financial assets with a minimum
of 10 percent equity ownership in a foreign firm.

Dr. Ch. Venkata Krishna Reddy

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

FDI and economic growth

Group Assignment

Dr. Ch. Venkata Krishna Reddy

International 5
Financial Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Benefits of FDI (for host countries)

FDI induces the transfer of technology and skills that are frequently in short supply.
it increases both national employment and domestic wages.
it provides local workers with an opportunity to learn managerial skills.
it contributes to tax revenues and helps balance the international balance of
payments.

Dr. Ch. Venkata Krishna Reddy

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

MODES OF FDI

 Construction of new plants

 Mergers and acquisitions
 Joint venture
 Equity alliances
 Licensing agreements
 Franchise agreements
 Contract manufacturing
Dr. Ch. Venkata Krishna Reddy
7
International
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

FDI BOOSTS ECONOMIC GROWTH THROUGH

 total productivity growth

 technology transfer
 increased domestic savings

Dr. Ch. Venkata Krishna Reddy

International 8
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

DETERMINANTS OF FDI INFLOW

•natural resource availability
•political stability
•infrastructure development,
•labor market condition
•market accession
•Intellectual Property Right (IPR) protection
•corruption,
•exchange rate and volatility of exchange rate
•interest rate
•regulatory framework of the country on repatriation of capital
Dr. Ch. Venkata Krishna Reddy
International 9
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

ARGUMENTS AGAINST FDI

 it brings about the loss of political and economic sovereignty.

 it controls key industries and export markets.
 it exploits local natural resources and unskilled workers.
 it undermines indigenous cultures and societies by imposing Western values
and lifestyles on developing countries.

Dr. Ch. Venkata Krishna Reddy

International 10
Financial Management
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Theories of FDI
Theory of technological advantages
• States that firms invest abroad to take advantage of their technological
capability
• MNC’s with technological advantages have something intangible that others
do not.

Dr. Ch. Venkata Krishna Reddy

International 11
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

PRODUCT LIFE CYCLE THEORY

• New products are produced and distributed in the market they are originally
designed to serve
• When they mature, they become standardized and can be produced
elsewhere too using less skilled manpower

Dr. Ch. Venkata Krishna Reddy

International Financial 12
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

OLIGOPOLY MODELS

• Once firms stop growing in their domestic market, they simply expand
overseas
• Such firms participate in industries that are oligopolistically characterized by
few dominant players

Dr. Ch. Venkata Krishna Reddy

International 13
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

INTERNALIZATION THEORY

• State that firms go international seeking vertical expansion-investment in the

supply chain.

Dr. Ch. Venkata Krishna Reddy

International 14
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

International cost of capital and capital structure

Cost of Capital
• A firm’s capital consists of equity (retained earnings and funds obtained by
issuing stock) and debt (borrowed funds).
• The cost of equity reflects an opportunity cost, while the cost of debt is
reflected in interest expenses.
• Firms want a capital structure that will minimize their cost of capital, and
hence the required rate of return on projects.

Dr. Ch. Venkata Krishna Reddy

International 15
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Different source of capital

• Borrowed capital
• Preference share
• Equity capital
• Retained earning
Dr. Ch. Venkata Krishna Reddy
International 16
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Cost of borrowed capital/ debenture

• Cost of perpetual debt
– Kd = P/C x 100
Here Kd = cost of debenture
P = interest payable (contractual rate)
C = capital received
Find the capital received value from this formula
If issued at par = par value – flotation charges
If issued at discount = par value – flotation charges- discount
If issued at premium = par value + premium – flotation charges
Dr. Ch. Venkata Krishna Reddy
International 17
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Cost of redeemable debt

• The formula is same as perpetual debt like Kd = P/C x 100
• but we calculate the value of P & C with these formula
• If debt issued at par
– P = contractual rate + flotation charges /period of issue
– C = par value – flotation charges/2
• If debt issued at discount
– P = contractual rate +( flotation charges + discount /period of issue)
– C = par value – (flotation charges + discount / 2)
• If debt issued at premium
– P = contractual rate + (flotation charges /period of issue)- (premium / period of issue)
– C = par value – (flotation charges/2) + (premium /2)
– Note if debenture are redeemed at premium than premium at redemption is adjusted in P as discount and in C as premium

Dr. Ch. Venkata Krishna Reddy

International 18
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Tax implications
• In above case we didn't consider tax implications, if we want
to calculate our cost of capital after tax then in case of debt,
the cost of capital after tax is calculated as below
• Kdt = Kd (1-t)
– Here Kdt = cost of debt after tax
– t = tax rate
Dr. Ch. Venkata Krishna Reddy
International 19
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Cost of preference share

• Cost of preference share are calculated just like cost of debt. Preference shares are also issued at par,
discount and premium and these are also redeemable or irredeemable same like debt. Hence the
calculation of P & C is same like Debt.
• The difference between debt and preference share is that in case of debt first we calculate cost of
debt before tax and after that we consider tax rate for calculating cost of debt after tax, but in case
of preference share cost of preference share which we calculated by main formula of cost of debt is
come after tax and if we want to calculate the cost of capital before tax than we consider tax in this
way
• Kpt = P/C x 100
• Where Kpt = cost of capital of preference share after tax
• Kp = Kpt/ (1-t)
• Here Kp = cost of capital of preference share before tax
Dr. Ch. Venkata Krishna Reddy
International 20
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Cost of Equity capital

• Dividend yield method:- Ke = D/P x100
• Earnings yield method:- Ke = E/P X100
• Dividend yield plus growing dividend method :- Ke = D/P x 100 +G
– Here Ke = cost of equity capital
– D = dividend per share
– P = market price per share
– E = earning per share
– G = growth rate in dividend (i.e. in earnings)
Dr. Ch. Venkata Krishna Reddy
International 21
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Cost of retained Earning

• Cost of retained earning Kr = AD/RE x100
Or
=Cost of Equity
– Here AD = Additional dividend from retained earnings
– RE = Retained Earnings
Dr. Ch. Venkata Krishna Reddy
International 22
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Weighted average cost of capital (WACC)

• Weighted Average cost of capital is combination and

average of all type of capital used by the company.
• WACC is calculated on the basis of the cost of the
capital of various type of capital and their proposition
in the overall capital.
Dr. Ch. Venkata Krishna Reddy
International 23
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

WACC (Cost of Capital ) Alternate Formula

A firm’s weighted average cost of capital is given by

where D is the amount of debt of the firm

E is the equity of the firm
kd is the before-tax cost of its debt
t is the corporate tax rate
ke is the cost of financing with
Dr. Ch. Venkata equity
Krishna Reddy
International 24
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Reasons of cost of capital for MNCs differ from that domestic firms
• The cost of capital for MNCs may differ from that for domestic firms because of the following
differences.
• Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors.
They can usually achieve smaller per unit flotation costs too.
• Access to International Capital Markets. MNCs are normally able to obtain funds through
international capital markets, where the cost of funds may be lower.
• International Diversification. MNCs may have more stable cash inflows due to international
diversification, such that their probability of bankruptcy may be lower.
• Exposure to Exchange Rate Risk. MNCs may be more exposed to exchange rate fluctuations, such
that their cash flows may be more uncertain and their probability of bankruptcy higher.
• Exposure to Country Risk. MNCs that have a higher percentage of assets invested in foreign
countries are more exposed to country Dr. Ch. Venkata Krishna Reddy
25
International
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

International Tax policies

• Equity returns on investment may be taxed by both the
host country and home country at a different time.
• Conventionally the host government acts first and
home country determines its tax policy based on host
country policies.

Dr. Ch. Venkata Krishna Reddy

International 26
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

International Tax policies

Host country policies
• The international norm is that the host country taxes corporate profits first ,and can
also impose withholding taxes on dividends or repatriation of profits
Home country policies
• Depend on host country tax policy
• Home country must establish tax policy considering two essential factors:
1) Treatment of foreign income and foreign tax paid
2) the timing of taxation
Dr. Ch. Venkata Krishna Reddy
International 27
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Home country policies

Treatment of foreign income and foreign tax paid

I. Exemption from domestic taxation
II. Tax profit earned abroad at the same rate as profit earned at home,
and then give full credit for tax paid abroad
III. Tax profit earned abroad at the same rate as profit earned at home, but
give a deduction for foreign tax paid, rather than a full credit
IV. Tax foreign profits, but then give no recognition for foreign taxes paid.
Dr. Ch. Venkata Krishna Reddy
International 28
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Home country policies

2) the timing of taxation
 Tax during the fiscal year in which they are
earned(a.k.a contemporaneous taxation)
 Tax when foreign profits are
repatriated(a.k.a tax deferral)
Dr. Ch. Venkata Krishna Reddy
International 29
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Country risk analysis

• Country risk represents the potentially adverse

impact of a country’s environment on the
MNC’s cash flows.
• Involves analysis of political risk factors and
financial risk factors.
Dr. Ch. Venkata Krishna Reddy
International 30
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Political risk factors

• attitude of consumers in the host country Some consumers may be very loyal to homemade products.
• attitude of host government
The host government may impose special requirements or taxes, restrict fund transfers, subsidize local firms, or fail to enforce
copyright laws.
• blockage of fund transfers
Funds that are blocked may not be optimally used.
• currency inconvertibility
The MNC parent may need to exchange earnings for goods.
• War
internal and external battles, or even the threat of war, can have devastating effects.
• Bureaucracy
Bureaucracy can complicate businesses.
• Corruption
Corruption can increase the cost of conducting business
Dr. Ch. Venkata or reduce
Krishna revenue.
Reddy
International 31
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Financial risk factors

• Current and Potential State of the Country’s Economy
a recession can severely reduce demand. Financial distress
can also cause the government to restrict MNC operations.
• Indicators of Economic Growth
A country’s economic growth is dependent on several
financial factors - interest rates, exchange rates, inflation, etc.
Dr. Ch. Venkata Krishna Reddy
International 32
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Types of Country Risk Assessment

A macro-assessment of country risk is an overall
risk assessment of a country without
consideration of the MNC’s business.
• A micro-assessment of country risk is the risk
assessment of a country as related to the MNC’s
type of business.
Dr. Ch. Venkata Krishna Reddy
International 33
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Types of Country Risk Assessment

The overall assessment of country risk thus consists of :

 Macro-political risk
 Macro-financial risk
 Micro-political risk
 Micro-financial risk
Dr. Ch. Venkata Krishna Reddy
International 34
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Techniques of Assessing Country Risk

• A checklist approach involves rating and weighting
all the identified factors, and then consolidating the
rates and weights to produce an overall assessment.
• The Delphi technique involves collecting various
independent opinions and then averaging and
measuring the dispersion of those opinions.
Dr. Ch. Venkata Krishna Reddy
International 35
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Techniques of Assessing Country Risk

• Quantitative analysis techniques like regression
analysis can be applied to historical data to assess
the sensitivity of a business to various risk factors.
• Inspection visits involve, traveling to a country and
meeting with government officials, firm
executives/or consumers to clarify uncertainties.
Dr. Ch. Venkata Krishna Reddy
International 36
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Improving investment climate

– quality of a country’s investment climate is determined by the risks and transaction costs
of operating a business, which is in turn determined by:
 Legal and regulatory framework
 Barriers to entry and exit
 Conditions in the market
 Infrastructural services
 Availability of labor, finance, information and other productive inputs
 Cut down in bureaucracy
 friendliness of the society Dr. Ch. Venkata Krishna Reddy
International 37
 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Next Topic

• Trade theory and commercial policy

Dr. Ch. Venkata Krishna Reddy

International 38
Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Thank you

Dr. Ch. Venkata Krishna Reddy

International 39