Foreign Direct Investment and Other Global Market Entry Modes Essay
Multinational sales have grown tremendously in the last two decades. Growth of these sales has even outpaced the remarkable expansion of trade in manufactures. Consequently, the trade literature has sought to incorporate the mode of foreign market access into the “new” trade theory. This report recognizes that firms can service foreign buyers through a variety of channels: they can serve them through foreign subsidiaries by engaging in foreign direct investment (FDI), export their products to foreign customers, and license or contract with foreign firms to produce and sell their products.
This report focuses on the firm’s choice among export, license and FDI, and the factors for selecting a market entry mode.
2. Foreign direct investment (FDI)
2.1 Foreign Direct Investment
Foreign direct investment (FDI) is the direct ownership of facilities in the target country. It involves the transfer of resources including capital, technology, and personnel. Direct foreign investment may be made through the acquisition of an existing entity or the establishment of a new enterprise.
A foreign direct investment means acquiring control by owning more than 50 percent of the operation. But in practice, it is possible for any firm to gain effective control by owning less. In any event, a foreign direct investment
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2.2 FDI versus foreign portfolio investment(FPI)
It is necessary to distinguish the FDI from foreign portfolio investment (FPI). Foreign portfolio investment is investment by individuals, firms or public bodies (e.g., national and local governments) in foreign financial instruments (e.g., government bonds, foreign stocks). FPI does not involve taking a significant equity stake in a foreign business entity (i.e., the equity stake is less than 10 percent). FPI is determined by different factors than FDI and raises different issues.
2.3 The form of FDI: Acquisitions versus green-fields
Acquisition involves acquiring or merging with an existing firm in the foreign country.
Green-field investment is the investment that involves the establishment of a wholly new operation in a foreign country.
2.4 Horizontal FDI versus vertical FDI
Horizontal FDI is FDI in the same industry abroad as a firm operates at home.
Vertical FDI is a way of reducing a firm’s exposure to the risks that arise from investments in specialized assets.
Compare other entry mode like exporting and licensing, when other things being equal, FDI is expensive and risky. FDI is expensive because a firm must bear the costs of establish production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in another culture where the “rules game” maybe very different.
2.5 Advantages and disadvantages of FDI
(1) The benefits of FDI to a host country arise from resource-transfer effects, employment effects, balance-of-payments effects, and its ability to promote competition. Employment effects arise from the direct and indirect creation of jobs by FDI. Balance-of-payments effects arise from the initial capital inflow to export finance FDI, from import substitution effects, and from subsequent exports by the new enterprise.
(2) FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available. Such resource transfers can stimulate the economic growth of the host economy.
(3) By increasing consumer choice, foreign direct investment can help to increase the level of competition in national markets, thereby driving down prices and increasing the economic welfare of consumer.
(4) The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home country exports, and benefits from a reverse resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.
(5) FDI allows the transfer of technology-particularly in the form of new varieties of capital inputs-that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market.
(6) Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country.
(1) Increased Communication and Transportation Costs: Maintaining branch plants or subsidiaries in foreign countries necessitates costs in communication and transportation not faced by domestic firms. These include direct costs such as overseas phone calls and travel expenses for executives as well as time costs due to mail delays and so on.
(2) Language and cultural differences: Language and cultural differences between the home country and the foreign (“host”) inevitably create costs for the MNE that are not faced by domestic firms.
(3) Understanding local laws: Similarly, the MNE, at least initially, does not have a close familiarity with the host country’s business community, tax laws and other government procedures. Local laws often, in fact, tend to discriminate actively against the MNE.
(4) Added Uncertainty The MNE faces risks such as exchange rate changes, expropriation or other capricious government actions that are not as important to domestic firms. Thus if the firms and their owners are risk averse, the uncertainty faced by the MNE constitutes a true business cost.
(5) Higher Labor Costs The MNE frequently must station managers and technicians abroad. Often, only substantially higher wages can induce these personnel to live abroad.
4. Foreign Market Entry Modes
The decision of how to enter a foreign market can have a significant impact on the results. Expansion into foreign markets can be achieved via the following four mechanisms:
* Foreign Direct Investment
Exporting is the marketing and direct sale of domestically produced goods in another country. Exporting is a traditional and well-established method of reaching foreign markets. Since exporting does not require that the goods be produced in the target country, no investment in foreign production facilities is required. Most of the costs associated with exporting take the form of marketing expenses.
a. Direct- firm handles all tasks to sell within host country.
b. Indirect-firm delegates the tasks to an intermediary.
a. Minimizes political risk
b. Useful when market potential is hard to assess
c. Offers channel flexibility
d. Prepares firm for greater involvement
e. Offers ease in market withdrawal
a. Exchange rate fluctuations and governmental intervention can affect earnings
b. Lack of market presence can affect response time
c. Loss of marketing control can affect corporate image
Exporting is preferable to licensing and horizontal FDI as long as transport costs are minor and tariff barriers are trivial. As transport costs and /or tariff barriers increase, exporting becomes unprofitable, and the choice is between horizontal FDI and licensing.
Licensing is another way to start international operations. International licensing is an arrangement whereby a firm (the licensor) grants a foreign firm the right to use intangible (“intellectual”) property such as patents copyrights, manufacturing processes, or trade names for a specified period of time, usually in return for a percentage of the earnings, called royalty.
a. To firm, cost effective
b. To importing country, brings technology and managerial expertise
a. Can restrict firm’s full realization of market potential
b. Can create third market competitors
c. Can result in loss of control over technology and product quality
d. Can result in conflicts between parties
Since FDI is more costly and more risky than licensing, other things being equal, licensing is preferable to FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (a) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firm’s skills and know-how are not amenable to licensing.
(3) When licensing is employed?
(1) A firm lacks the capital, managerial resources, or knowledge of foreign markets, but it wants the additional profits with minimal commitment.
(2) As a way to test and proactively develop a market that can later be exploited by direct investment.
(3) The technology involved is not central to the licensor’s core business.
(4) Prospects of “technology feedback” are high.
(5) The licensor wishes to exploit its technology in secondary markets that may be too small to justify larger investments; the economies of scale may not be attainable.
(6) Host-country governments restrict imports or FDI, or both; or the risk of nationalization or foreign control is too great.
(7) The licensee is unlikely to become a future competitor.
(8) The pace of technological change is sufficiently rapid that the licensor can remain technologically superior and ahead of the licensee, who is a potential competitor.
4.3 Wholly Owned Subsidiaries
As the name implies, a wholly owned subsidiary is owned 100 percent by the foreign firm. Thus, in the United States today, Toyota Motor Manufacturing, Inc., and its facility in Georgetown, Kentucky, is a wholly owned subsidiary of Toyota Motor Corporation, which is based in Japan. (NUMMI is a separate and independent operation.) In Japan, Toys-R-Us, Inc. was the first large U.S.-owned discount store, and the company is expanding its wholly owned subsidiary there. Wholly owned subsidiaries have pros and cons. They provide for the tightest controls by the foreign firm. That firm also does not have to fear losing any of its rights to its proprietary knowledge. However, this is a relatively costly way to expand into foreign markets.
A wholly owned subsidiary is the optimal strategy because it generates the highest level of economic profit and maximizes control of critical knowledge indefinitely. This was based on a mathematical model that determined transfer prices in other entry strategies are higher than marginal costs, making subsequent operations inefficient.
5. Choosing A Mode Of Entry
5.1 Dunning’s eclectic theory
Dunning’s eclectic theory provides a helpful insight as to the best means of penetrating foreign markets. The theory considers three factors: ownership advantages, location advantages, and internalization factors, which in addition to other factors such as the firm’s need for control, the availability of resources, and the firm’s global strategy, help a firm decide between exporting, FDI, joint ventures, licensing, and franchising.
Ownership advantage: The firm must have a unique ownership advantage. This could be a product or a production process to which other firms do not have access, such as a patent, blueprint, or trade secret. But the advantage could also be as intangible as a trademark or a reputation for quality.
Location advantage: The foreign market must be more profitable to operate in than producing at home and exporting. This could be because of more raw materials, lower factor prices, a high cost of transportation, or market preferences. Many multinationals are in service industries that are traditionally thought of as having very high transport costs.
Internalization advantage: Internalization advantages are factors the affect the desirability of a firm producing a good or service itself rather than relying on an existing local firm to handle production. Transaction costs play a role in this. If transaction costs are high, the firm may select FDI or a joint venture as an entry method. If transaction costs are low, franchising, contract manufacturing, or licensing may be a better choice.
5.2 The factors that alter the entry modes
(1) Transportation costs
When transportation costs are added to production costs, it becomes unprofitable to ship some products a long distance. For products with a high value-to weight ration, transport costs are normally a very minor component of total landed cost. In such cases, transportations costs have little impact on the relative attractiveness of exporting, licensing, and FDI.
(2) Market imperfections
With regard to horizontal FDI, market imperfections arise in two circumstances when there are impediments to the free flow of products between nations, and when there are impediments to the sale of know-how. Licensing is a mechanism for selling know-how. Impediments to the free flow of products between nations decrease the profitability of exporting, relative to FDI and licensing. Thus, the market imperfections explanation predicts that FDI will be preferred whenever there are impediments that make both exporting and the sale of know-how difficult and/or expensive.
(3) Following competitors
(4) Strategic behavior
(5) Location advantages
5.3 Other Factors Affecting Mode Of Entry
(1) How quickly the firm wishes to commence operations in the market (outright purchase of a fully operational local business is usually the speediest method).
(2) Volatility of competition and competitive intensity in the countries concerned.
(3) The ease with which intellectual property can be protected (This is particularly important for licensing and joint ventures).
(4) The degree of market penetration desired (deep penetration normally requires a permanent presence within the relevant country).
(5) The firm’s experience and expertise in selling and operating abroad.
(6) Size of the margins taken by intermediaries in particular nations.
(7) Tariff levels, quotas and other non-tariff barriers to market entry.
(8) Availability of trained and competent personnel for staffing foreign subsidiaries.
(9) Political stability of the foreign countries the firm wishes to enter, and other risk factors. For example, might induce a firm to enter a market via FDI as opposed to exporting. In some countries legal and political issues will impact both entry method and the repatriation of profits. A country’s tax policies and government stability may also affect a firm’s strategy.
(10) The business ‘s financial resources and hence its capacity to purchase or set up foreign establishments (Lack of access to financial capital may mean that entry by ownership is impossible so that non-equity or partial equity modes are preferable; most likely for small firms).
(11) Physical and technical characteristics of the product (simple products are easy to manufacture abroad).
(12) Levels of competition (current and future levels of competition, number and size of competitors, the relative market share, pricing and distribution strategies, the relative strengths and weaknesses etc).
(13) Availability of marketing, financial and general business services in target foreign markets.
(14) Ease of communication with intermediaries (agents, consortium buyers, etc.) in specific countries.
(15) Local constraints on the foreign ownership of businesses and/ or licensing arrangements involving foreign firms.
In practice, many large companies with extensive foreign operations adopt a variety of market entry modes: exporting to some countries, licensing or operating joint ventures in others, or setting up wholly owned subsidiaries elsewhere. A mixture of these might be applied within a particular foreign state so that, for example, export to a country and licensed manufacture within that country occur side by side.
6. The Case of Euro Disney
Different modes of entry may be more appropriate under different circumstances, and the mode of entry is an important factor in the success of the project. Walt Disney Co. faced the challenge of building a theme park in Europe. Disney’s mode of entry in Japan had been licensing. However, the firm chose direct investment in its European theme park, owning 49% with the remaining 51% held publicly.
Besides the mode of entry, another important element in Disney’s decision was exactly where in Europe to locate. There are many factors in the site selection decision, and a company carefully must define and evaluate the criteria for choosing a location. The problems with the Euro Disney project illustrate that even if a company has been successful in the past, as Disney had been with its California, Florida, and Tokyo theme parks, future success is not guaranteed, especially when moving into a different country and culture. The appropriate adjustments for national differences always should be made.
When an organisation has made a decision to enter an overseas market, there are a variety of options open to it. These options vary with cost, risk and the degree of control, which can be exercised over them. These entry modes are from a variety of different forms of entry: licensing and franchising, through exporting (directly or through independent channels), to foreign direct investment (joint ventures, acquisitions, mergers, and wholly owned subsidiaries). Entry modes vary in the degree of control the firm has over invested tangible and intangible resources, and the transactions costs associated with that resource commitment. Different firms have different factors that are most important to them in making modal entry decisions.
Therefore before enter the global market; the firms must understand the nature of each of their modal choices. Modes vary in terms of the level of control, the quantity of required resources, and the amount of technology risk. Then, several key target market and company factors must be analyzed. Exporting is domestically located and administratively controlled, foreign licensing is foreign located and contractually controlled, and FDI is foreign located and administratively controlled. In summary, the choice of an entry mode will be a tradeoff between risk and reward, the level of resource commitment necessary and the level of control the firm seeks.