THEORETICAL FRAMEWORK OF FOREIGN DIRECT INVESTMENT

THEORIES OF FDI

There are a number of theories explaining FDI. Except for the MacDougall-Kemp hypothesis, FDI theories are primarily based on imperfect market conditions. A few among them are based on imperfect capital market. The others take non-economic factors into account. Still others explain the emergence of MNCs exclusively among developing countries.

MacDougall-Kemp Hypothesis

One of the earliest theories was developed by G.D.A. MacDougall (1958) and subsequently elaborated by M.C. Kemp (1964). Assuming a two-country model – one being the investing country and the other being the host country – and the price of capital being equal to its marginal productivity, they explain that capital moves freely from a capital abundant country to a capital scarce country and in this way the marginal productivity of capital tends to equalize between the two countries. This leads to improvement in efficiency in the use of resources that leads ultimately to an increase in welfare. Despite the fact that the output in the investing country decreases in the wake of foreign investment outflow, national income does not fall insofar as the country receives returns on capital invested abroad, which is equivalent to marginal productivity of capital times the amount of foreign investment. So long as the income from foreign investment is greater than the loss of output, the investing country continues to invest abroad because it enjoys greater national income than prior to foreign investment. The host country too witnesses increase in national income as a sequel to greater magnitude of investment, which is not possible in the absence of foreign investment inflow.

Industrial Organisation Theory

The industrial organization theory is based on an oligopolistic or imperfect market in which the investing firm operates. Market imperfections arise in many cases, such as product differentiation, marketing skills, proprietary technology, managerial skills, better access to capital, economies of scale, government-imposed market distortions, and so on. Such advantages confer on MNCs an edge over their competitors in foreign locations and thus, help compensate the additional cost of operating in an unfamiliar environment.

One of the earliest theories based on the assumptions of an imperfect market was propounded by Stephen Hymer (1976). To Hymer, a multinational firm is a typical oligopolistic firm that possesses some sort of superiority and that looks for control in an imperfect market with a view to maximizing profits. Despite the fact that the international firm is posted disadvantageously in a foreign host country where it has not intimate knowledge of language, culture, legal systems and consumers’ preference, it possesses certain specific advantages that outweigh the disadvantages. The firm-specific advantages in Hymer’s view are mainly the technological advantages that help the firm to produce a new product different from the existing one. It is in fact related to the possession of

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knowledge, which helps in developing special marketing skills, superior organizational and management set-up, and improved processing. What is significant in this theory is that these advantages are transmitted more effectively from one unit to the other irrespective of their geographical distance. Since the market is imperfect, rival firms do not avail of the technological advantage. International firm harvests huge profits. Graham and Krugman (1989) found empirically that it was the technological advantage possessed by European firms that had led them to invest in the USA. Caves (1971) feels that firm-specific advantages are transmitted more effectively if the firm participates effectively in the production in the host country than through other ways such as export or licensing agreements.

Location-specific Theory

Hood and Young (1979) stress upon the location-specific advantages. They argue that since real wage cost varies among countries, firms with low cost technology move to low wage countries. Again, in some countries, trade barriers are created to restrict import. MNCs invest in such countries in order to start manufacturing there and evade trade barriers. Sometimes it is the availability of cheap and abundant raw material that encourages the MNCs to invest in the county with abundant raw material.

Product Cycle Theory

Hymer explained “why” foreign investment takes place. Hood and Young explained “where” foreign investment takes place. It was Raymond Vernon (1966) who added “when” to “why” and “where”, based on data obtained from US corporate activities. Reymond Vernon’s theory is known as the product cycle theory.

Vernon feels that most products follow a life cycle that is divided into three stages. The first is known as the “innovation” stage. In order to compete with other firms and to have a lead in the market, the firm innovates a product with the help of research and development. The product is manufactured in the home country primarily to meet the domestic demand, but a portion of the output is also exported to other developed countries. The quality of the product, and not the price, forms the basis of demand because the demand is price-inelastic at this stage.

The second stage is known as “maturing product” state. At this stage, the demand for the new product in other developed countries grows substantially and it turns price-elastic. Rival firms in the host country itself begin to appear at this stage to supply similar products at a lower price owing to lower distribution cost, whereas the product of the innovator is often costlier as it involves the transportation cost and tariff that is imposed by the importing government. Thus in order to compete with rival firms, the innovator decides to set up a production unit in the host country itself, which would eliminate transportation cost and tariff. This leads to internationalization of production. The imposition of tariff in the host country encouraging foreign direct investment is confirmed by Uzawa and Hamada, but they feel that entry of foreign capital in protected industry reduces welfare in the host country (Kojima, 1978).

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In the final or “standardized product” stage, a standardized product and its production techniques are not longer the exclusive possession o the innovating firm, rival firms from the home country itself, or from some other developed countries, put stiff competition. This is not unusual because the follow-the-leader theory developed by Knickerboker (1973) suggests that there is a tendency among followers to snatch the benefits of international production from the innovator. At this stage, price competitiveness becomes even more important; and in view of this fact, the innovator shifts the production to a low cost location, preferably a developing country where labour is cheap. The product manufactured in a low cost location is exported back to home country or to other developed countries.

Literature on the subject identifies one more stage in the product’s life cycle. It is known as “dematuring” stage, when development in technology or in the consumers’ preference breaks down product standardization. Sophisticated models of the product are manufactured again in technology advanced, high income countries so that the firm can have a close linkage with consumers’ tastes and with the basic infrastructure required for production. Cheap labour does not matter much at this stag as sophisticated models involve a capital intensive mode of production. Globerman (1986) has explained the four stages with a simple example of television set that was first produced in the United States of America and then in other advanced countries. Technology became standardized. Production became concentrated in Japan owing to the cheap labour cost. Lastly, the dematuring stage appeared when sophisticated models were developed and produced in the USA itself.

The product cycle theory clearly explain the early post-Second World War expansion of US firms in other countries. But with changes in the international environment, different stages of the product life cycle did not necessarily follow in the same way. Vernon (1979) himself has pointed out this limitation in his later writing, showing how in the second stage itself firms were found moving to the developing world to reap the advantages of cheap labour. This was possible with the narrowing of the information gap.

Again, the assumptions of the theory that the “export threat” causes a firm to set up a subsidiary in that country are not always true. If this is true, all US firms should have set subsidiaries abroad in countries to which they had been exporting (Bhagwati, 1972). Yet again, development in the second stage and in the third stage is contradictory in the sense that the former is anti trade oriented vis-à-vis the latter, which is trade-oriented. In fact, it is this difference that characterizes US firms and differentiates them from the Japanese ones (Kojima, 1985).

Internalization Approach

Buckley and Casson (1976) too assume market imperfection, but imperfection, in their view, is related to the transaction cost that is involved in the intra-firm transfer of intermediate products such as knowledge or expertise. In an international firm,

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technology developed at one unit is normally passed on to other units free of charge. This means that the transaction cost in respect of intra-firm transfer of technology is almost zero, whereas such costs in respect of technology transfer to other firms are usually exorbitantly high putting those firms at a disadvantage. Coase (1937) too believes that MNCs bypass the regular market and use internal prices to overcome the excessive transaction cost of an outside market. Thus, it is the internationalization benefit manifesting in cost-free intra-firm flow of technology or any other knowledge that motivates a firm to go international. It can be said that the views of Burckley and Casson are more or less in common with the contents of the appropriability approach of Magee (1979) that emphasizes on potential returns from technology creation as a prime mover behind internationalization of firms.

There are, of course, critics who argue that intra-firm transaction cost may not necessarily be low. If subsidiaries are located in an unfamiliar or uncongenial environment, the transaction cost is generally high. Kogut and Parkinson (1993) are of the view that if the transfer of intermediate goods involves substantial modification of well established practice, transaction cost is very large. Franke, Hofstede, and Bond (1991) opine that if the cultural differences between the home country and the host country are wide, the internalization process will be a costly affair.

Again, the internationalization theory, say Rugman (1986), is a general theory explaining FDI and so it lacks empirical content. However, in a subsequent study, he feels that with a precise specification of some additional conditions successful testing is possible. Buckley (1988) himself is suspicious of the very limitation, but is hopeful of getting satisfactory results from a rigorous and precise test.

Eclectic Paradigm

Dunning’s eclectic paradigm is a combination of the major imperfect market-based theories of FDI, that is, industrial organization theory, internalization theory and location theory. It postulates that, at any given time, the stock of foreign assets owned by a multinational firm is determined by a combination of firm specific or ownership advantage (O), the extent of location bound endowments (L), and the extent to which these advantages are marketed within the various units of the firm (I). Dunning is conscious that configuration of the O-L-I advantages varies from one country to the other and from one activity to the other. Foreign investment will be greater where the configuration is more pronounced.

Again, he introduces a “dynamised add-on” variable to his theory. This is nothing but a variable of strategic change, which may be either autonomous or a strategy induced change. International production during a particular period would be the sum of the strategic responses of the firm to the past configuration of O-L-I and to changes in such configuration as a sequel to exogenous and endogenous changes in environment. The example of autonomous change in strategy may be that a firm makes foreign investment more in innovatory activities because of greater O-advantage, or it invests more in a particular country because of L-advantage or it adopts a different marketing strategy

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depending upon the greater amount of I-advantage. Similarly, the strategy induced change may be evident from the fact that a market seeing investment has a different O-L-I configuration from that of a resource based investment. And ultimately, it is the varying configuration that shapes the direction and the pattern of FDI (Dunning, 1980, 1993).

The eclectic approach thus, has wider coverage. It has also been empirically tested by Dunning himself with satisfactory results.

Currency based Approaches

The currency based theories are normally based on imperfect foreign exchange and capital market. One such theory has been developed by Aliber (1971). He postulates that internationalization of firms can best be explained in terms of the relative strength of different currencies. Firms from a strong-currency country move out to a weak-currency country. In a weak-currency country, the income stream is fraught with greater exchange risk. As a result, the income of a strong-currency country firm is capitalized at a higher rate. In other words, such a firm is able to acquire a large segment of income generation in the weak-currency country corporate sector.

The merits of Aliber’s hypothesis lie in the fact that it has stood up to empirical testing. FDI is the United States of America, Canada and United Kingdom has been found to be consistent with the hypothesis. However, the theory fails to explain why there is FDI in the same currency area.

Another theory based on the strength of currency has been developed by Kenneth Froot and Jeremy Stein (1989). The view is that depreciation in the real value of currency of a country lowers the wealth of domestic residents vis-à-vis the wealth of foreign residents. As a result, it is cheaper for foreign firms to acquire assets of domestic firms. The authors have found that this factor has been one of the determinants of foreign investment in the United States of America.

Yet another theory in this context has been propounded by Richard Caves (1988) in one of his later writings. Caves mentions a couple of channels through which exchange rate influences FDI. First, changes in exchange rate influence the cost and revenue stream of firm. If the domestic currency depreciates, the import bill will inflate, diminishing in turn the net income. But, if export expands in the wake of currency depreciation, income will rise. Secondly, exchange rate changes influence FDI by giving rise to capital gains. Depreciation in the value of currency, which is expected to be reversed in the near future, will lead to capital gains following appreciation. In lure of capital gains, foreign capital will flow in. This theory has been tested empirically by Caves himself, who finds a negative correlation between the level of exchange rate and the level of FDI in the USA.

Politico-economic Theories

The politico-economic theories concentrate on political risk. Political stability in the host countries leads to foreign investment therein (Fatehi-Sedah and Safizedah, 1989).

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Similarly, political instability in the home country encourages investment in foreign countries (Tallman, 1988). However, Schneider and Frey (1985) believe that the theory underlying the political determinants of FDI is less well developed than those involving economic determinants. The political factors are only additive ones influencing foreign investment.

Modified Theories for Third World Firms

The theories discussed above also apply to international firms headquartered in developing countries, but they need some modifications. These firms have long been importing technology from industrialized countries. But since imported technology is mainly designed to cope with a large market, firms export a part of their output after meeting the domestic demand. The products become gradually mature and then the firms set up units in the product importing countries. But it is different from the product cycle theory insofar as the firms do not necessarily innovate the product; rather they modify the product to suit the consumers’ needs in different contractual. The modification is of scaling-up kind when it concerns the consumers in the developed countries. For the low income consumers, it is a scaling-down modification. However, it cannot be denied that modification of these types confers upon the firms a sort of firm-specific advantage (Sharan, 1985). Winlee Ting (1982) cites an example of a Taiwanese firm manufacturing pressure cookers and table fans. The firm modified the imported technology and set up units not only in the developing countries but also in the country from where it had originally imported the technology.

Again, the firms in developing countries possess a pool of cheap labour that accompanies the investment. On the other hand, the developing host country possesses, in some cases, abundance of natural resources, which attracts investment from other developing countries. This is very much in common with the locational theory of FDI discussed above. Thus, the theories discussed so far applies also to MNCs of the developing world.

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Joint Venture

India’s leading tractor maker Mahindra & Mahindra’s American arm, Mahindra’s USA Inc, has decided to set up an assembly unit in Canada to locally produce and market a range of low-horsepower cab tractors, with features like AC, heater, personal stereo and even a sun-roof.

Venture is expected to be in placed by mid-2005.

The firm will also source cab tractors from Japan’s Mitsubishi and Tong Yang of South Korea, and market them in Canada under the Mahindra badge. The tractors will all be in the 0-100hp segment, which accounts for a chunk of US and Canadian markets.

BENEFITS AND COSTS OF FDI

When direct investment flows from one country to another, it creates benefits both for the home country and the host country. At the same time, it involves some costs too. Thus, when a firm decides to make FDI, it takes into consideration the benefits and costs to be accrued, not only to its home country but also to the host country. The host country perspective is no less significant, because cooperation from the host government depends upon the benefits derived by the host country.

In the present section, the benefits and costs of FDI are mentioned from the point of view of the home country as well as the host country. Since the host country perspective is more sensitive, it will be discussed first.

Benefits to the Host Country

Availability of Scarce Factors of Production: FDI helps attain a proper balance between different factors of production through the supply of scarce factors and fosters the pace of economic development. FDI brings in capital and supplements the domestic capital. This is a significant contribution where the domestic savings rate is too low to match the warranted rate of investment. FDI brings in scarce foreign exchange, which activates the domestic savings that would not have been put into investment in the absence of foreign exchange availability. It happens when the investment outlay possesses a foreign exchange component and in absence of foreign exchange, domestic savings remain idle. It also happens when local investors are afraid of the large risk involved in the investment project. In case of FDI, foreign investors share the risk and the investment project is implemented.

One can say that a country can get scarce foreign exchange also through foreign borrowing and other forms of investment. But FDI is superior to all of them. It is because FDI, which takes a longer-term view of the market, is more stable than non-FDI flows. Statistics reveal that the coefficient of variation of real FDI was on an average 0.94 and 0.63, respectively, during 1980-1989 and 1990-1997, compared to 1.96 and 1.76 for non-FDI flows during the corresponding period (United Nations, 1999). Moreover, it does not create debt. Profit is repatriated only when it actually exists.

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Riding on growing demand for its tractors, Mahindra USA had posted a 20% jump in turnover in 2004 at $125 million.

In response to rising US demand, Mahindra USA had opened a second assembly plant and distribution centre in Georgia.

Source: Adapted from TOI report.

Sometimes FDI is accompanied by labour force that performs jobs that the local labour force is either not willing to do or is incapable of doing on account of lack of desired skill. Besides, the foreign labour force infuses non-traditional mental attitudes among the local labour force.

Besides, foreign investors make available raw material and improved technology. Raw material is normally not a very important consideration for the host country, but this factor becomes significant when the question of some vital raw material is concerned. At the same time, host countries often encourage FDI inflows because they procure improved technology; and more importantly, an ongoing access to continued research and development programmes of the investing country. Statistics reveal that over 90 per cent of the R&D activities giving rise to the creation of new product and process technology are concentrated in seven industrialized countries. Other countries reap the benefit from these innovative activities when they are transferred to them in the form of FDI through MNCs. The transfer takes two forms – one is internalized to the affiliates under the same ownership and control and the other is externalized to other firms in form of franchises, licenses, sub-contracting and so on. Externalized transfer is found in cases where technology is simple and secrecy considerations are not very important, but it is often costly. Internalized transfer is often cheaper and can be made at different levels of operation. Whatever may be mode of transfer, it benefits the recipient. In the short-term, the benefit manifests in the form of increased productivity, new products and lower costs. In the long term, it depends on how much the recipient learns from the technology and is able to deepen and develop its own capabilities. For the economy as a whole, the benefits also include the diffusion of technology and its spillovers to other firms.

As regards diffusion, it depends on how intense the linkages are in the host country. Since MNCs prefer to establish linkages with foreign firms, local linkages are often poor. However, such trends are gradually changing. Mani (1999) points out the Japanese MNCs have been transplanting their traditional keirestsu links from their home country to host countries. Again, Kumar (1998) found in the case of US and Japanese MNCs operating in a sample of 74 host countries that the affiliate R&D intensity was positively and significantly related to the scale of R&D activity and the availability of scientists and engineers in the host country.

Improvement in the Balance of Payments: FDI helps improve the balance of payments of the host county. The inflow of investment is credited to the capital account. At the same time, the current account improves because FDI helps either import substitution or export promotion. The host country is able to produce items that were being imported earlier. FDI is able to augment export because foreign investors bring in the knowledge of exporting mechanics and of foreign markets. They bring in improved technology to produce goods of international standards and at a lower cost. They posses a world-reputed brand name, which is helpful in promoting export. They are also more capable of availing export credits from the cheapest source in the international financial market. In the United States of America, for example, MNCs – both local and foreign combined – accounted for three-fourths of the total export in 1996. They have done well in the export of natural resources, processed agricultural products, and of services, but they have done

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far better in the export of manufactured goods. In fact, they pursue the export activities not only in the existing pattern of comparative advantage, but more importantly they exploit this advantage (Helleiner, 1973). These MNCs operate in low technology activities and derive competitive strength in export on the basis of cheap labour or cheap raw material. In case of medium and high technology activities, they are able to export well on the basis of their vertical set-up or because of their involvement in large scale processing of natural resources. They bring in dynamisms in the sense that they move on to the next level of technological complexity. In a primary goods exporting country, dynamism means launching of simple manufactured products. In case of countries with simple manufactured exports, they move to higher value added products. An UNCTAD study shows a positive correlation between FDI and export dynamism in the developing world (United Nations, 1999).

Building of Economic and Social Infrastructure: When foreign investors invest in sectors such as basic economic infrastructure, social infrastructure, financial markets, and marketing system, the host county is able to develop a support system that it required for repaid industrialization. Even if there is no investment in these sectors, they very presence of foreign investors in the host country creates a multiplier effect. A support system develops automatically.

Fostering of Economic Linkages: Foreign firms have forward and backward linkages. They make demand for various inputs, which in turn helps develop input supplying industries. They employ labour force, which helps raise the income of employed people, which helps raise the income of employed people, which in turn raises the demand and industrial production in the country. In all, the total investment in the host country increases by more than the amount of FDI. This is nothing but the “crowding-in effect” of FDI. An empirical study of Borensztein et al (1995) shows that the crowding-in effect of FDI is very common. Table 1 shows a broad framework of the relationship between foreign firms and local firms.

Strengthening of Government Budget: Foreign firms are a source of tax income for the government. They pay not only income tax but also the tariff on their import. At the same time they help reduce governmental expenditure requirements through supplementing the government’s investment activities. All this eases the burden on the budget.

Benefits for Home Country

FDI benefits the home country too. The country gets the supply of necessary raw material if the investor makes investments in the exploration of a particular raw material. The balance of payments improves insofar as the parent company gets dividend, technical service fees, and other payments. It is also because of the rising export of the parent company to the subsidiary. If FDI takes place in order to develop a vertical set-up abroad, the export is quite significant. When persons accompany the investment, it results in greater employment of the nationals. The parent company gains access to new financial markets through investment abroad.

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Table 1: Backward Linkage and Other Relationships between Foreign Affiliates and Local Enterprises and Organizations

Relationship of foreign affiliate to local enterprise Relationship of foreign affiliate to non-business institutionFrom Backward (sourcing) Forward (distribution) Horizontal (co-operation

in production)“Pure” market transaction

“Off-the-shell” purchases

“Off-the-shell” sales

Short-term linkage Once-for-all or intermittent purchases (on contract)

Once-for-all or intermittent sales (on contract)

Longer-term linkage

Longer-term (contractual) arrangement for the procurement of inputs for further processing

Subcontracting of the production of final or intermediate products

Longer-term (contractual) relationship with local distributor or

Outsourcing from domestic firms to foreign affiliates

Joint projects with competing domestic firm

R&D contracts with local institutions such as universities and research and research centres

Training progammes for firms by universities

Traineeships for students

Equity relationship Joint venture with Establishment of new

supplier-affiliate (by existing foreign affiliate)

Joint venture with distributor or end-customer

Establishment of new distribution affiliate (by existing foreign affiliate)

Horizontal joint venture Establishment of new

affiliate (by existing foreign affiliate) for the production of same goods and services as it produces

Joint public-private R&D centres/training centres/universities

“Spillover” Demonstration effects in unrelated firms - Spillover on processes (incl. technology)- Spillover on product design- Spillover on formal and on tacit skills (shopfloor and managerial)

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Effect due to mobility of trained human resourcesCompetition effects

Source: UNCTAD

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Moreover, the government of the home country generates revenue by taxing the dividend and other earnings of the parent company. There is also revenue from tariff on imports of the parent company from its subsidiary abroad. Again, since FDI is a complement to foreign and, it helps develop a closer political tie between the home country and the host country, which is beneficial for both countries.

Cost to the Host Country

It is a fact that the inflow of foreign investment helps improve the balance of payments, but the outflow on account of import and the payments of dividend, technical service fees, royalty and so on deteriorates the balance of payments. There is evidence to prove that such outflows have exceeded the investment inflows in some of the years in India (Sharan, 1978). This is not only the case of balance of payments. Raw materials are exploited keeping in view the interest on the home country, which sometimes mars the interest of the host country. Again, the parent company supplies the technology to the subsidiary, but normally does not disseminate it to the host market. The result is that the host country remains dependent on the home country for the technology, which is often received at an exorbitant price. Sometimes the technology is inappropriate for the local environment and in that case, the loss to the host country is large.

As far as employment of the locals is concerned, MNCs normally show reluctance to train local people. Technology is normally capital intensive, which does not assure larger employment.

Sometimes, manufacturing by the foreign investors does not abide by the pollution norms, the norms regarding optimal use of natural resources, or the norms regarding location of industries. All this goes against the interest of the host country.

Foreign investors are generally more powerful. Domestic industrialists do not compare with then, with the result that the domestic industry fails to grow. This is nothing but the “crowding-out” effect of FDI. The study of Kumar and Pradhan (2002) finds that in 29 out of 83 cases, there was a clear-cut crowding-out effect. Foreign companies in such cases, charge higher prices for the product in view of their oligopolistic position in the market. Higher prices hamper the interest of the consumers as well as lead to inflationary pressure. Foreign companies infuse foreign culture into the industrial set-up and also in the society. Sometimes, they are so powerful that they are able to subvert the government.Cost to Home Country

The cost accruing to the home country is only little. However, it cannot be denied that investments abroad takes away capital, skilled manpower, and managerial professionals from the country. Sometimes the outflow of these factors of production is so large that it hampers the home country’s interest.

The MNCs operate in different countries in order to maximize their overall profit. To this end, they adopt various techniques that may not be in the interest of the host

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country. This leads to a tussle between the host government and the home government, leading to deterioration bilateral relations.

Thus, FDI is not an unmixed blessing. It does posses bright features, but at the same time, it has dark sport too. Thus, global benefit can be achieved only if it is carefully handled.

M&As AND VALUE OF THE FIRM

M&A is a gainful strategy only when the value of the combined firm is greater than the sum of the value of the two firms computed individually in absence of a merger. In form of an equation,

Gain = VAB – (VA + VB) (1)

However, the gain so derived has to be compared with the cost of M&A, which is arrived at after deducting the value of the target firm from the price that the acquiring firm pays to the target company. This means that the net gain from M&A accruing to the acquiring firm exists only when:

[VAB – (VA + VB)] > (Price – VB] (2)

Thus, in this context, it is significant to know what price the acquiring firm should pay to the target firm for acquisition and what would be the impact of the changes in price on the post-merger value of the firm. The price is known as the consideration value fixed within the two extremes. One is the floor price for the package, any price below which is not acceptable by the target company. It is basically the market value of the shares of the target company. For example, if Firm A acquires Firm B and if the market value of Firm B’s share is $15, the consideration value must be least be $15. In practice, it is more than $15, as the premium will attract Firm B for acquisition.

However, it does not mean that the amount of premium will swell infinitely. If it moves up beyond a certain limit, the value of the acquiring firm will reduce and the very objective of the acquiring firm behind the merger will be marred. This limit is known as the ceiling price, where the EPS of the acquiring firm in the post-merger period is equal to that in the pre-merger period. In other words, the ceiling price would be equal to the product of the EPS of the target firm and the P/E ratio of the acquiring firm.

Suppose the financial data of the two firms is as follows:

Firm A Firm B

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Present earnings ($)Shares (no.)EPS ($)Market value of shares ($)Price-earning ratio

20,000.005,000.00

4.0032.008.00

8,000.003,000.00

2.6716.006.00

At the floor price, the value of Firm B in the post-merger period will be the same as during the pre-merger period. The owners of Firm B will get 16/32 x 3,000 or 0.5 share in Firm A for one share in Firm B. Thus, the wealth of Firm B in the post-merger period will be $32 x 1500 shares or $48,000, which is equal to $16 x 3,000 shares during the pre-merger period.

At this floor price paid, the EPS of Firm A after the merger will increase to $(20,000 + 8,000) / (5,000 + 1,500 shares) or to $4.31. Assuming a price-earning ratio of 8.0, the value of one share of Firm A after the merger will be $4.31 x 8.0 or $34.48 and the value of one the merged firm will be $34.48 x 6,500 shares = $224,120, which is higher than the sum of the value of the two firms in the pre-merger period. Using equation 1, the net gain from merger will be:

${224,120 – (160,000 + 48,000) } – (48,000 – 48,000)

= $16,120.

The greater the price than the floor price, the lower the gain to the acquiring firm as well as the higher the gain to the target company. However, Firm A may pay a large premium to Firm B in order to allure the latter for acquisition. The ceiling will reach where the price will be equal to the product of the EPS of the target company and the price-earning ratio of the acquiring firm. In the above example, it is $2.67 x 8 = $21.36. At this price, Firm B will receive 0.6675 share in Firm A in lieu of one share or in all 2,003 shares in Firm A, meaning that there will be in all 7,003 shares in the merged firm. The EPS will be $28,000/7,003 shares = $4.0, which is equal to the pre-merger EPS in Firm A. Assuming the price-earning ratio of 8, the value of the merged firm will be $32 x 7,003 shares or $224,096. Thus, at both the ceiling price and the floor price, the value of the merged firm is almost the same. But at the ceiling price, the net gain to the acquiring firm would just be zero because the gain from the merger will be reaped entirely by the target company.

Considering Value Floor price = Market price of the share of the

target firm Ceiling price = EPS of the target firm x Price-

earning ratio of the acquiring firm Actual consideration value existing between

floor and ceiling price is influenced by bargain between the acquiring firm and the target firm 14

In practice, the actual price is determined between these two limits, depending upon the bargaining power of the acquiring firm and the target firm; and accordingly, the net gain is shared partially by the acquiring firm and partially by the target firm. Suppose, the consideration value is $20 per share of Firm B. In this case, Firm A will issue 0.625 share for each share in Firm B, which will be in all 1,875 shares. The value of owners’ wealth in Firm B would now be $32 x 1,875 shares or $60,000, as compared to $48,000 in the pre-merger period. The EPS of the merged firm would be $28,000 / 6,875 shares or $4.07. Assuming a price-earning ratio of 8, the value of the merged firm will be $32.56 x 6875 shares or $223,850, which is higher than the sum of the value of the two firms in the pre-merger period. The net gain to the acquiring firm as per equation 1 will be:

$ {223,850 – (160,000 + 48,000)} – (60,000 – 48,000)

= $3,850.

Thus, at a price agreed upon between the floor and the ceiling, both the acquiring firm and the target firm will reap the benefits; and as a result, both will agree to the merger. However, there are cases when the acquiring firm goes for acquisition even when its net gain is zero. But this is done if some other significant benefits are going to accrue to the acquiring firm.

The consideration value has so far been discussed in the absence of any changes in the international environment. But in international M&A, such changes cannot be overlooked. One of such changes in change in the exchange rate. The lower the existing spot rate of the currency of the country to which target company belongs the lower the price to be paid by the acquiring firm. If it is higher, the salvage value will be higher from the viewpoint of the acquiring firm. If the future spot rate is expected to be higher, the acquiring firm will receive a larger cash flow.

Secondly, it is the required rate of return that influences the value of the acquisition. It is because the cost of capital varies from one country to another. This is why the acquisition of a particular country’s firm may be more beneficial than in another country.

Thirdly, the value of acquisition differs in case of different countries because the ability to use financial leverage varies among countries. Since acquisition is financed mostly through borrowings, acquisition of firms in a country where flexibility to borrow is larger is more common. For example, in the United States, a high debt ratio if not preferred, and the acquiring firm does not get much incentives on this count.

Last but not least, there are legal formalities regarding tax and accounting. If they are favourable, they create competitive advantages for acquiring firms. This means that when these rules are more favourable and liberal, the acquiring firm may bid a higher price for acquisition.

CONTROL OF MNCs

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Since a lion’s share of FDI is accounted for by MNCs, their positive contribution to the economy of the home country / host country is represented by the benefits derived by them from the FDI. The benefits have already been discussed, which means that the operation of MNCs is conducive for economic development, not only in the home country/host country but in the global economy as well. However, the problem is that MNCs are more interested in their own good, and frame and implement strategies accordingly, with the result that their strategy comes into conflict with the interest of the home country/host country. This is why it is often argued that the activities of MNCs need to be controlled so that the interest of the home country / host country is better served.

Conflicts with Home Country and Measures of Control

It is found that a larger number of multinational corporations shift their profits to a tax haven and from there make further investment in different host countries. Again, they hide their actual profit through the transfer pricing technique in order to evade taxes. It is true that they do it in order to minimise their tax burden, but it is a loss of foreign exchange and income to the state exchequer.

Sometimes R&D activities are spread over a number of subsidiaries. It is true that the requirements of the host countries are taken into consideration but the home country remains deprived of such facilities. This creates a negative impact on the employment of scientific and technical personnel.

Again, MNCs enjoy economies of scale on account on their large production, with the result that they charge low prices for products that are priced high in the domestic market. Consequently, domestic manufactures are thrown out of the market in their home country.

More often, under competitive pressures, MNCs locate a part of their operation in resource rich/labour cheap countries under a vertical set-up. This helps cut costs and enables the company to enjoy competitive advantage but causes loss of employment generation and full use of the locally available resources in the home country.

These are the major reasons for conflict of interest between the home country government and MNCs. In the sequel, the home country takes up a number of measures. It is easier for the domestic government to take up restrictive measures insofar as the home country executives as well as the home country shareholders may support the government’s move.

First of all, the home government can prohibit any investment in, or any technical collaboration with, a particular host country. For example, the US Government had not allowed the transfer of the latest computer technology to East European countries during

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1980s. Secondly, it can design fiscal and monetary disincentives to deter any outflow of investment. Discriminatory tax can be levied. Exchange control mechanism can be implemented. When the US balance of payments was sailing through rough weather during late 1950s and early sixties, the Government had restricted the outflow of its currency for overseas investment. Thirdly, the home government can tighten the approval rules and regulations ultimately restricting FDI outflow. In India, during 1970s and 1980s, the Government had permitted foreign joint venture and also capital investment, but the policy was restrictive. Fourthly, the government can introduce extra-territoriality provisions and can interfere with the activities of its MNC’s foreign subsidiary, although this option is rarely exercised. Last but not least, the home government can design an anti-trust law that can trim its MNCs wings and restrict its operations in foreign markets.

Conflict with the Host Government and the Measures of Control

The conflict between MNCs and the home government is not as severe as it is with the host government. There is often a feeling in the host country that the MNCs are taking advantage of cheap resources available there and share the largest share of the resultant profits. As a result, is that the government imposes high tax on the profits of the MNCs. MNCs do not like this because they feel that they are utilizing unused resources, catering to the demand of the local population, and giving employment to the local population.

Trade unions oppose multinationals because they do not find themselves in a bargaining position, in view of maneuverability power of the firm during strikes. Again, when senior positions are filled up by expatriates, it causes loss of employment which is detrimental to the host country interests.

Local firms competing with MNCs also do not favour them. The host structure in local industries is often high, in view of poor technology and lower size of production. Local firms cannot market goods at a lower price as the MNCs are able to. The result is that they are easily driven out of the market.

Sometimes consumers resent the existence of the MNCs. It is often found that after MNCs are able to drive out local manufacturers from the market on account of cheaper and more cost-effective products, they enjoy a monopolistic position. They raise the price abnormally and exploit consumers.

MNCs charge an abnormally large price for the transfer of technology. They bring their own inputs imported from the home country or sister unit in some other country at a high price. They use transfer pricing on a large scale. All this adds to the balance of payments of the host country. In India, for example, it was found that balance of payments was severely affected by the operation of the MNCs during 1970s (Sharan, 1978).

Last but not least, MNCs adopt unethical practices, such as manufacturing health-hazard products, bribing the officials, encouraging cross-border transfer of funds circumventing the exchange control regulations in the host country, and so on, in many

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cases. In a few cases, by bribing the politicians, they cause threat to the very political set-up in the host country (Boatright, 1993).

Thus, with a view to limit the malpractices of MNCs, the host government tries to implement some measures. First, the government insists on appointing government representatives on the management board and on manning the senior positions with local personnel who are expected to work in the interest of the host country. Recruitment for low grade job with locals may lead to employment generation.

Secondly, the government insists on domestic participation in the equity share capital. The profits are distributed among the local shareholders, minimizing the outflow of scarce foreign exchange. Moreover, in such cases, there is every possibility of policy of policy design, keeping intact the interest of the host country.

Thirdly, the government insists on purchase of inputs from local sources. The practice provides stimulus to local industries supplying input, helps conserve scarce foreign exchange, and also curbs the possibility of transfer pricing.

Fourthly, the host government puts in restrictive clauses in the import rules and encourages strict surveillance in order to check unwarranted activities.

Last but not least, the host government expropriates the assets of MNCs lying in its own country. Sometimes, it pays the compensation, but at other times it does not. Even if compensation is paid, the amount is normally inadequate, and it usually takes a long time to be realized. However, it is the last resort, especially where MNCs do not at all abide by the host country rules and regulations.

Code for Control at the International Level

For the first time in 1971, the Group of 77 resolved to have surveillance on the activities of MNCs so that the balance of payments of the low income countries is not strained on account of greater outflow. Again, it was reiterated at the Non-aligned Conference of 1972 that foreign investment should be in conformity with the national development objective in the host country. During 1970s, the UN Commission on Transnational Corporations prepared a code of conduct for MNCs. The code requires an MNC to abide by the socio-cultural objectives, share information with the host government and not to engage in unethical activities.

Again, in 1977, the International Labour Organisation adopted a code that was concerned with employment, training, working conditions and industrial relations. The code stressed the need for consultation between the MNCs’ management and the employees for a meaningful negotiation on a particular issue of discord.

The UNCTAD too issued two codes with respect to the operation of MNCs. The first code issued in 1980 was concerned with the prevention of restrictive business practices. The second code issued in 1983 related to the transfer of technology. Emphasis

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was given on a reasonable payment for the technology received, especially by developing countries and on the building up of technological capabilities in the technology receiving developing countries.

There are thus a number of mechanisms for controlling MNCs’ operation both at the national and the international levels. The mechanisms at the national level are better implemented. But those at the international level are only suggestive and not biding on MNCs, with the result that they are not very effective. The need of the day is to make the international codes legally binding.

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