Relationships of Trade and Foreign Direct Investment Among China, Taiwan and the U.S. Hung-Gay Fung, Ph.D University of Missouri-St. Louis U.S.A.

Agenda General Issues about Trade and Foreign Direct Investment Modes of International Business Foreign Direct Investment Analysis Trade and Foreign Direct Investment among China, Taiwan and U.S.

Modes of International Business International Trade –Exports and imports of goods Licensing: –obligates a firm to provide its technology (copyrights, patents, trademarks or trade names) in exchange for fees for other benefits Franchising: – franchising obligates a firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in exchange for periodic fees.

International Business (continued) Joint Ventures –a venture jointed owned by several firms –GM’s joint ventures in different countries (China, Hungary and former Soviet states) M & A –allow firms to take control quickly in foreign markets –expensive and riskier (may not know local market well) Set up Rep Office, new subsidiary, branch –requires large investment –takes longer time for operation

Product Life Cycle Exporting Sales subsidiary Licensing Service Facilities Distribution system Production Overseas

Opportunities Increased Globalization enables Firms to: –expand their customer base (i.e., product cycle) –exploit lower costs of inputs abroad –arbitrage tax differences across markets –benefit from government subsidies (location) –raise capital at lower cost –diversify production –seek new technology

Risk and Constraints Increased Globalization Forces Firms to: –deal with currency turmoil –comply with local regulations antitrust labor laws environmental concerns capital controls disclosure –deal with political uncertainty

International Capital Flows Foreign Direct Investment (FDI) –investment in foreign companies for management and control Portfolio Investment –investment in foreign companies for capital gain (not concern for management) –great implications for crisis

Goals of MNC Maximize value of the organization –NPV of future cash flows deal with conflicts of interest – incentives issue – agency problems Manage different social and structural impediments such as regulations in countries

Another reason for FDI diversification Pure domestic investment International Investment Risk Number of projects

Better Risk/return Tradeoff Pure domestic investment International Investment Return Risk

Capital Budgeting In principle, – capital budgeting: the same for international and domestic –accept positive NPV projects In practice, international capital budgeting is more challenging. –future cash flows –discount rate –taxation Strategic considerations are often as important as financial considerations for evaluating FDI projects.

0 1 Cash Flows Analysis 2 n I..O. CF(1) CF(2)CF(2)

NPV Rule NPV =  CF t (1+k) t t T Where: CF t is the cash flows from the project at time t k is the discount rate or cost of capital (from CAPM or other method) - Initial Investment

NPV Investment Incremental. Terminal Value Expectations/ Certainty Eq. Discount rate Specific Financing Growth rate Discount rate Parent funds Ret. earnings Local debt Equity issue Summary of Factors in Capital Budgeting

Incremental Cash Flows Cannibalization –new product taking sales away from the firm’s existing products –those sales that would have been lost anyway should NOT be counted for cannibalization Sales Creation –Have foreign production facilities (Black $ Decker)

Sunk cost –not included Transfer Pricing –market price for the goods shipped Fees and Royalties –project should be charged only for additional expenditures (R & D, management cost, etc) attributed to the project Cash flows from subsidiary vs parent Risk analysis

Subsidiary vs Parent Cash flows generated subsidiary After-tax cash flows to subsidiary Cash flows available to be remitted to parent Tax to host government Earnings retained to subsidiary Cash flows to Parent and tax consideration Withholding taxes to host

Cash flows Diagram Sales ( Price x Quantity sold ) Less COG ( variable cost, lease expense, fixed annual, expense, loyalty, management fees, depreciation) = Earning before tax Less tax ( host government tax ) =Earnings to subsidiary Less withholding tax ( host country ) =Earnings to Parent ( converted in parent currency)

Cash Flows (local currency) to Subsidiary: 1. Earnings after tax to subsidiary 2. Depreciation of projects NPV of cash flows >0 means acceptance After-Tax Cash flows ($) to Parent 1. Dividends 2. Royalty 3. Management fees 4. Tax credits paid to host countries NPV of cash flows

FDI Overall Summary FDI is part of overall globalization of markets. Strategic considerations for undertaking foreign projects. Capital budgeting for FDI requires –forecasting the impact of future market conditions, –exchange rate estimates –taxes on the profitability of a project –discount rate has to appropriately account for risk.