How Businesses Can Profit from Foreign Direct Investment
A business will always look for new ways to profit – its success is dependent on how well it can attract growth and keep the profits flowing. One of the modern ways of increasing profits is conducted through foreign direct investment (FDI). What is it about and how can it provide profits to businesses?
Here’s a look at the modern phenomena and the advantages businesses can enjoy when they engage with this business activity.
FOREIGN DIRECT INVESTMENT – THE KEY THINGS TO KNOW
Before we start examining how a business can benefit from foreign direct investment, let’s take a crash course on what FDI is about.
Investopedia’s definition of FDI states the following:
“An investment made by a company or individual in one country in business interests in another country”
You essentially have one a company in one country investing in another company in another country. While a government of a country or an individual can technically also make the investments, the interest here is solely on how companies use FDI.
The investment is a type of inward investment. The inward investments deal with external or foreign entities, with the transactions involving either investments or purchasing of goods from the external economy or business. FDI is an example of inward investment since the company is investing in a country that’s different from the company’s home country.
FDI should be distinguished from portfolio investments in which the company or the investor purchases equities of foreign-based companies. It is not about gaining equity, but more about gaining control – the investment is aimed at either establishing operations in the country or acquiring existing assets, which provide ownership or control to the business.
Since FDI deals with companies in two different countries, with differing rules and regulations, there are universal regulations that define and manage global FDI flows. The Organisation for Economic Cooperation and Development (OECD) has set guidelines, which determine the ways in which FDI can take place and what counts as FDI and not a traditional portfolio investment, for example. One of the key features of the OECD guidelines is the minimum ownership control the business must have in the foreign company in order for it to count as FDI.
The current guidelines state the ownership must be a minimum 10% of the ordinary shares or voting shares of the company. Nonetheless, the definitions together with the guidelines are flexible and companies can find themselves under de facto control – for example, by controlling the technology – even without the 10% controlling stake.
The key feature
The key feature of FDI is essentially that of control. This separates it from a traditional portfolio investment. When a business makes a foreign direct investment, it establishes either effective control or substantial influence over the decision-making process of the business or the operation.
This requirement for control is also what provides the structure for determining what counts as FDI and what doesn’t. As I noted above, according to the OECD definition, the business must have a 10% minimum ownership stake before its investment counts as FDI.
The methods of FDI
So, how does a company go about making a FDI? There are a number of different options for gaining control and investing in a company or business operation abroad. The most common methods of FDI include:
- Opening a subsidiary or an associate company in a foreign country
- Acquiring a controlling interest in a company that already exists in the foreign country
- Merging with another foreign company
- Starting a joint venture with a foreign company
Furthermore, FDI can occur in three strategically different manners. The nature of the foreign direct investment can be:
- Horizontal – Horizontal investments occur when the company’s investment abroad is related directly to the same activities it conducts at home.
- Vertical–In a vertical FDI strategy, the company uses the foreign investment as a way to add new stages of activities abroad. These can be divided into:
- Forward vertical FDI under which the company takes steps to become closer to the market – such as acquiring a distributor in the foreign country.
- Backward vertical FDI which means using international integration towards the acquiring of raw materials – such as buying a raw material plantation in a foreign company.
- Conglomerate – When the business invests in a controlling stake in an unrelated business abroad, the FDI is set to be a conglomerate type. The conglomerate FDI is uncommon, as it sees the company trying to break two barriers at once: entering both in a new country and a new industry.
FDI IN ACTION – EXAMPLE SCENARIOS
What does the above look in action? Let’s consider an example by examining the different scenarios outlined above through the eyes of Company A.
Company A is a clothing company that operates in Italy. The company could embark on FDI by doing the following things:
It can open a subsidiary company in China to enter the market. Since it is entering a foreign country in a field directly related to what it does in Italy, it’s making a horizontal FDI.
However, it could also buy a controlling stake in a Chinese clothing line. If it’s purchasing another clothing company in China, its investment would still be horizontal. It doesn’t have to acquire the whole company, as long as it has a controlling stake and it’s part of the decision-making process. Interestingly, even if Company A doesn’t have 10% stake, the investment would be considered FDI if it provides the management or the clothing line designs for the business.
On the other hand, Company A could decide to merge or simply acquire the Chinese clothing company in full. Again, you’re dealing with a horizontal FDI.
If Company A wants to use a vertical FDI strategy, it could purchase a clothing retailer in China and therefore, engage in forward vertical FDI. It wouldn’t buy another clothing company, but the retailer would provide it access to the Chinese clothing market. If the company would prefer to make a backward vertical FDI, it could purchase a silk manufacturer that would provide the raw materials for its clothes.
Finally, Company A could consider expanding its business operations and invest in a completely unrelated industry. It could, for instance, acquire a Chinese jewellery company and enter the both the Chinese market and the jewellery industry at once. This would be an example of the rare conglomerate FDI.
HOW TO PROFIT FROM FOREIGN DIRECT INVESTMENT
The United Nations Conference on Trade and Development has found foreign direct investments flows have exceeded over $1 trillion. This is an impressive figure considering the global FDI stood at $14 billion in the 1970s. So, what’s the attraction? How can a company profit from foreign direct investment?
Four key ways for businesses to profit from FDI
A business can benefit from FDI in four distinctive ways. These are:
Gaining access to new markets
The most obvious way a business can profit from FDI is by gaining access to new markets and thus, growing the business. The benefit is rather obvious – as the company invests in the business or starts a new operation in a foreign country, it enters that market and expands its market reach.
Increasing market access can help the business grow and expand its profit base. The gains might not just occur in a direct increase of market share in the specific industry, but also appear through access to distinct target customer groups.
Obtaining access to resources
A company may also benefit and boost its profits by increasing its access to resources. By investing in a foreign company, you can gain access to new technologies, resources, management skills and cooperation opportunities. All of these can help the business either save money or make more profit.
While the access to resources, such as management skills, can be a rather indirect way to increase profits, other resources can provide a more direct boost, such as having the raw materials for your product at your disposal.
Reducing the cost of production
Related to the above point is the boost in profits through the reductions of production costs. If you gain access to raw materials, you can naturally manufacture your product cheaper than if you first had to buy the materials.
Furthermore, vertical FDI deals with things like acquiring a production plant, which can boost profit by driving down the production costs – if you can make the products in your own factory, you won’t need to spend money on buying the finished product from a third-party supplier.
A common example of the ability to drive down the cost of production is making FDIs in countries with lower labor costs. Countries with lower labor costs can attract companies to transfer their factories elsewhere – a contentious topic in the modern world.
Simplifying its tax code and gaining tax benefits
Companies can also benefit from FDI in terms of taxation and how their profits are taxed at home and abroad. How does FDI boost profit through taxation? There are a few different scenarios. The company could:
- Enjoy more profits from its income in the new country due to the foreign country offering a more beneficial tax code – either there’s less taxation in general or the rates are lower/more advantageous.
- Enjoy tax deduction in its home country from any profit it makes in a foreign country.
- Enjoy tax deduction simply for making a FDI – countries can provide companies with tax benefits if they either invest in the foreign country or home countries of companies can allow tax deductions when FDI is made.
The tax benefits can be directly related to income and profits but can also be indirectly linked with these aspects of the business. For example, R&D in the new country might be taxed differently and the advantage of discovering new technologies can indirectly lead to bigger profits abroad and in the parent company’s country.
The above are the four main ways a company could profit from a foreign direct investment. Naturally, enjoying these benefits is not as straightforward as it may sound. Just as it’s difficult to start a business from scratch anywhere in the world, it can be difficult to replicate the success in another country or to gain a profitable market share in a country with established competition in the sector.
EXAMPLES OF THE PROFITABLE BOOSTS
So, what does the above look in real life? Let’s consider Company A and the different ways it could manage to boost its profits.
Company A, operating in Italy, would have a market share of 10% in the clothing sector. When it invests in the Chinese clothing company, it gains access to a new clothing market in China and gains an immediate market share of 3% in the country through the new company. In the future, it can boost its market share in both Italy and China.
Company A might have also acquired a clothing factory in China. Since it doesn’t have to buy the clothes it sells in Italy from a third-party seller, it can cut production costs and increase profits. A quirky example from real life is how Apple has been able to control the cost of making an iPhone by producing them in China. The Chinese workforce only amounts to 3.6% of the costs of the iPhone, according to the Economist.
The above is not just necessarily a boost in profit in terms of lower cost of production, but could also provide benefits in terms of access to resources, such as better sewing technology. The Chinese clothing manufacturer could have technologies in place that create durable clothing with less money and this can help increase the public interest on the clothing line – people will buy the t-shirts more because they stay in good condition for longer.
Finally, Company A can experience a boost in profit through taxation. It can deduct part of the investment costs and gain a better tax advantage or it might direct some of its foreign profits into a country with a lower corporate tax rate.
While the current tax planning strategies of major corporations are not always favorable to national economies, there’s no denying the benefits companies can enjoy by investing in foreign companies and markets. According to Fortune, America’s largest companies have around $2.5 trillion stashed in foreign ‘tax havens’; although not all of this is due to FDI.
WHAT TO REMEMBER WITH FDI – THE RRD RULE
FDI is a clear example of a strategy that can provide companies better opportunities to grow and it can help increase profits through a number of ways. However, if a business is considering a FDI investment, it has to conduct proper due diligence – similar to any investment type.
There are plenty of things the business must take care of in terms of guaranteeing FDI success but in order to get started familiarize yourself with the so-called RRD rule. RRD stands for risks, regulations and diversification. These are three areas of focus for any company set to embark on FDI:
- Risks – Like any investment, FDI can involve plenty of risks. The crucial fact about FDI is how the company will deal with a foreign country, which adds many unique risks into the equation. The political landscape is different and when you are investing in a developing economy, the political transformation can be heightened. Things such as political conflict or sudden nationalization are not uncommon, especially in new economies in Africa.
- Regulations – Since the company is dealing with a new country, it also has to deal with different legislation. In terms of FDI, countries can have strict rules and regulations in place and it’s important to clear these first before you even consider making a move on the country and its companies. The most obvious example of the regulatory impact is the complexity in China for joint ventures. Foreign companies can find it hard to team up with a local company and even entry to the Chinese market can be difficult, although the surrounding regulations have relaxed in recent times.
- Diversification – When embarking on FDI strategy, diversification is as beneficial as it is for any other investment types. It can be helpful to consider different strategies – horizontal, vertical or conglomerate – to ensure your company doesn’t put its eggs in a single basket. Furthermore, while entering a very different market can be problematic, vertical FDI could help provide even deeper market entry than purely following the horizontal strategy.
The RRD rule can help a company focus on the right things in its evaluation of the validity of foreign direct investments. To understand the decisions behind FDI and how corporations are venturing on these investments, check out the interview with Derek Collins, director in the Bank of Ireland – a country that has been able to attract FDI in growing numbers in the past few decades.
THE BOTTOM LINE
Foreign direct investments have ballooned in recent years. While there are plenty of pros and cons for this type of activity in terms of the local economies, there are valid reasons for businesses to look into it. The four major areas of profit come in the form of enhanced market access, gains in resources, reductions in production costs and favorable tax strategies.
The practice can be profitable if businesses are aware of the risks and regulations surrounding the practice, and they can strategically plan how, where and when they make the investments. If they get it right, the boosts in profits will surely follow.
Welcome to the 21st episode of our podcast with Scott Whitney from Actiance! You can download the …