Finance and Accounting Shanka Dauley 3/12 Question The Vernon’s product life-cycle theory suggests that products normally pass through a cycle with distinct phases. A product is pioneered in a developed country, which holds a monopoly as the only country able to produce and supply the product. The product is initially available only for the people of that country. Exportation of product to developed countries takes place when it becomes successful in the home market. As the product’s demand increases, the pioneering firms take production closer to the market. A good example of this theory is the relationship between China telecommunication manufacturing sector and foreign direct investment (Yan, 2011). Huawei Technology followed the product lifecycle in provision of networking and telecommunication services and equipment. Foreign direct investments mostly occur in the maturity and declining stages of the life cycle. The theory helps firms to settle on whether to manufacture locally or go abroad to make their products depending on the product lifecycle stage. The entry timing decision of a firm to a host country is dependent on the product’s age as well as the relative cost of production in different host countries. One of the strength of this theory is that it provides powerful tool for providing marketing and guidance approaches that are appropriate at various stages. It is an important tool for providing an insight into a common pattern of industry sales. Nevertheless, the theory fails to elucidate whether foreign direct investments are better than licensing or exporting to a third party to expand abroad. Its applicability has also been weakened by the increasingly complicated international system of production. Question 2 As defined by investopedia, Greenfield investment refers to a type of foreign direct investment (FDI) whereby a multinational establishes a new business enterprise in a foreign state through erecting new operation facilities from the ground up. Most multinationals also hire new employees in the foreign country hence creating new long-term jobs. On the contrary, the multinationals also opt to buy an existing firm in the host country via acquisitions. When extending operations to foreign countries, companies often prefer a Greenfield investment as opposed to an acquisition in cases where the foreign market is not difficult to penetrate. Greenfield investments are often multifaceted and potentially expensive however, they have the most capacity to bring about above average returns (Hitt, 2009). For a successful Greenfield operation, a company may be needed to have knowledge as well as expertise of the existing market by third parties, for instance, business partners, consultants, or competitors. This type of entry approach takes much time because of the need to establish new operations, distribution networks, as well as the need to learn and put into practice the best marketing strategies to outcompete the rivals in a new market (Bartett 2009). The setup of a Greenfield investment setup can bring in numerous government benefits like subsidies, incentives, and tax-breaks. The set up also creates access to new technology, raw materials, production efficiency, diversification, and the capacity to avoid regulatory or political hurdles. Host countries tend to resist cross-border acquisitions, instead of Greenfield investments because they view the latter as a means of putting up new production facilities as well as job opportunities. where cross-border acquisitions are seen as foreign takeover of local companies without creation of new job opportunities. Greenfield investments and cross-border acquisition by Chinese firms have had a positive impact on China through creation of technological spillover benefits and developing research and development capacity (Wang, 2009). They are perceived to provide a net escalation in capital stock with consequent connotations for regional business operations as well as employment. In particular, investing firms are assumed to expand the domestic industry output hence allowing increased exports and reduced imports. more production means new jobs especially for the industry (Brigham Ehrhardt, 2011). (Norback Persson, 2001). Cross border investments are not preferred because the foreign investor normally acquires an established local company and make it a subsidiary business within its global portfolio. The acquisition may be 100% of buying minority or majority stake. Greenfield investments add new supply to the market (Wang, 2009). Question 3 Political risk is incorporated into the capital budgeting process of foreign investment projects through regulating the capital costs upward and thus discounting the potential future cash flows at an elevated rate. On the other hand, firms can take off the political risk insurance premium from the projected cash flows and employ the standard capital costs, which is used in local capital budgeting. The cost of capital is the minimum return rate, which a venture has to generate (Feils Sabac, 2000). The cost of capital decides whether the foreign investment will decrease or increase the firm’s stock price. Increasing the cost of capital leads to higher tariffs (Hill, 2009). The net present value for the venture can be adjusted through increasing the level of capital. Chinese firms usually undertake the foreign project when the adjusted net present value is positive (Hill, 2005). They also form consortiums with other multinationals or joint ventures with local partners (Zhou, 2008). Question 4 Forward internalization occurs when multinationals holding intangible assets make foreign direct investments with the aim of using the assets on a wider extent and concurrently internalizing possible externality produced by the assets. Alternatively, backward internalization occur when multinational companies acquire foreign companies with the intention of accessing intangible assets in the foreign companies and simultaneously internalizing externalities the assets have generated. Chinese firms use both forward and backward processes to expand into new markets and thus enhance the pull and push internationalization factors for domestic companies (Zhou, 2008). Moreover, Chinese firms also attempt to explain and predict a firm behavior and choices in an international setting over time. Question 5 It is important to include currency exchange risk into the capital budgeting foreign investment process by using the forward market and international transfer prices. The foreign exchange rate risk happens from undertaking worldwide business dominated in currencies save for the domestic currency because of high instability in foreign exchange rates causing increased risks of gain or loss. Transfer pricing is one strategy for minimizing foreign exchange losses from currency fluctuations and useful in shifting the losses (Levi, 2009). Appropriate transfer price used by Chinese firms have a significant impact on the net exposure of the firms (Hill, 2005). Funds in weak currency countries are moved using transfer pricing. Forward market and options are also financial arrangements, which can be incorporated, in the capital budgeting process to eliminate or reduce exposure to risk. The forward market allows a company to exchange two currencies on a future date at an agreed rate, hence facilitating it to cover itself in case fluctuation occurs and facilitating the foreign investment to reduce risk of currency fluctuation from occurring (Brigham Ehrhardt, 2011). Options can also allow a firm to cover exposure over a longer period of about six months to one year. A forward market is important in reducing risks that arise from changes in exchange rate when exporting, borrowing, importing, and investing (Kevin, 2010). References Brigham, E., Ehrhardt, M. (2011). Financial management: theory and practice. 13ed. Mason, OH: South-Western Cengage Learning. Feils, D., Sabac, F. (2000). The Impact of Political Risk on the Foreign Direct Investment Decision: a Capital Budgeting Analysis. Engineering Economist, 45 (2), 129-43. Bartett, C.A. (2009), Transnational Management:Text,Cases and Readings in Cross Border Management. 5th Ed., McGraw-Hill Higher Education Hill, C. (2005). International business. China: People’s University. Hitt, A. (2009), Strategic Management Competitiveness and Globalization, Nelson Education Ltd Investopedia. (2013). Greenfield Investments, Retrieved from http://www.investopedia.com/terms/g/greenfield.asp#ixzz2Iq2D1aFj Kevin, S. (2010). Commodity and financial derivatives. PHI Private Limited. Levi, M. (2009). International finance. 5ed. New York: Routledge. Norback, P., Persson, L. (2001). Investment Liberalisation- Who Benefits from Cross-Border Merger and Acquisitions? CEPR Discussion Paper n. 3166 Wang, A. (2009). The Choice of Market Entry Mode: Cross-Border MA or Greenfield Investment. 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