The Theoretical and Empirical Studies of Foreign Direct Investment Choice Based on Real Option Approach 1

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1 The Theoretcal and Emprcal Studes of Foregn Drect Investment Choce Based on Real Opton Approach XU Xuyong CUI Yongme School of Economcs and Management Bejng Jaotong Unversty, P.R.Chna, Abstract When Cross-border Mergers and Acqustons have became the man form of FDI, however, Chna's FDI nflow s stll Greenfeld nvestment. Based on ths phenomenon, ths paper bult a real opton dynamc model to analyze the factors of FDI choce. We dscover that uncertanty of nvestment envronment, the addtonal cost and flexblty are the man reasons. The man reason of most FDI nto Chna preferrng to the greenfeld nvestment s that the foregn drect nvestment concentrates n the manufacturng ndustry as well as the constrant of our country's legal and poltcal envronment. Key words Foregn drect nvestment, greenfeld nvestment, Cross-border M&A, Mode Choce, Real Opton. Introducton Wth the contnung globalzaton of the world economy and the nternatonal captal flows, foregn drect nvestment (FDI) s growng fast. The proporton of Cross-border mergers and acqustons n the amount of global FDI ncreases gradually from 40 percent n 940s to over 80 percent now and even More than 90% n the Unted States. Whereas, n a long tme, Chnese absorpton of foregn nvestment s manly n the mode of greenfeld nvestments. Although Cross-border M&As s developng n Chna, the proporton s stll low, snce foregn captal purchasng n the total amount of FDI s stll only about 0%. 3 So what are the reasons that cause transnatonal corporatons gradually abandon greenfeld nvestment and tend to cross-border M&As? And what s t that causes foregn nvestors prefer greenfeld nvestment n Chna? Ths paper stands on the poston of nvestors-multnatonal corporatons-tryng to explan these two ssues. Many studes have dentfed certan determnants that, wth respect to greenfeld nvestment and cross-border acquston, affect the choce of entry strategy. In the early study of the 980s Caves and Mehra (986) [] noted that entry mode s drven by the form of entrant s corporate organzaton and the characterstcs of ts product market. In addton, they ndcated that acqured experence n these felds such as knowledge of routnzed processes n nternatonalzaton, wll encourage a frm to choose acquston rather than greenfeld nvestment. In a qualtatve manner, Buckley and Casson (998) [] focused explctly on determnants nfluencng the choce between settng up an entrely new foregn faclty (greenfeld nvestment) or acqurng an exstng company n the host country. They thnk that the market structure s an mportant factor n determnng and they stressed the mportance of certan addtonal costs that trgger the choce whether to enter va greenfeld nvestment or acquston. For a long perod n Chna, study on FDI entry mode s less than overseas. Jangdebo and Wang Jaxn(00) [3] noted that the effect of foregn drect nvestment to the host market structure s nteracton. As for multnatonal companes FDI entry mode choce, untl the last few years the scholars start to research. Cheng Xnzhang and Hu Feng (003) [4] study from the perspectve of game theory expounded the dfference of profts between greenfeld nvestment and cross-border acqustons. And Supported by Natonal Natural Scence Foundaton of Chna ( ) Xu Xuyong, male, Zhejang, School of Economcs and Management, Bejng Jaotong Unversty. Cu Yongme, Vce Drector, Center for Chna Mergers and Acqustons Research Bejng Jaotong Unversty. E-mal: ymcu@bjtu.edu.cn 3 Data from the "World Investment Report 006" 35

2 through the establshment of a model that argues FDI approach decson-makng nonlnear affected by the extent of competton of the market. When the ntensty of competton s weak, greenfeld nvestment s the best way, when ferce competton, cross-border acqustons wll be selected. Yao Zhanq (005) [5], on the bass of the extent of technology transferrng, rased a nterests and contradctons analyss model between the host government and transnatonal corporatons. And he consdered the host country must consder the compettve effects of FDI entry ways and the mpact of technology transfer. However, prevous scholars consderng foregn drect nvestment mode are bascally from the vew of statc pont not n dynamcs way. Ths paper does not contnue to use the tradtonal net present value method to value the project, but n a real opton approach 4 to analyze the choce of FDI. Of course, ths does not mean that the net present value method bad, but n today's volatle envronment, a real opton approach s more flexblty than the net present value method-ether mmedately nvestment or never abandon-whch s one-dmensonal rgd decson-makng method. Based on the fnancal opton prcng methods, the real optons look nvestment decson as a random process affected by many uncertantes. It focus on explorng the flexble adjustng pont n the nvestment process and accordng to dfferent phase of the latest nformaton, more flexble to analyze and evaluate the present value of nvestment projects, thereby crcumventng and reducng nvestment rsks. The rest of the paper s structured as followed. Frst, we wll present the model: a two-phase market entry stuaton where each phase s connected to some sort of sunk cost and the flexblty to decde whether to ntate the phase or not. Second s the emprcal test. We explan the reasons that FDI n Chna manly tend to greenfeld nvestment. Fnally we dscuss the conclusons and recommendatons.. The model Model Assumpton Accordng to mcro-economc theory, the enterprse's objectve s pursung proft maxmzaton. It s assumed that the foregn nvestor s rsk neutral and that market entry through foregn drect nvestment follows a two stage process and that each stage s connected to a proft flow from the products sold at each stage as well as to some sort of sunk costs. The choce whch entry strategy an enterprse chooses has no nfluence upon the proft rates of other enterprses n the foregn market. () It s assumed that changes n the proft flow can be modeled by a random proft flow expressed by a geometrc Brownan moton [6]5. dπ ( t) = απ ( t) dt+ σπ ( t) dz () Where α s the rate of drft, σ represents the volatlty and dz s an ncrement of the Wener process. Gven a contnuously compounded rate of return r, the expected present value of the nvestment under the assumpton of an nfntvely lastng proft stream equals r ( s t ) π v v( π ) = E[ π ( s) e ds] = t r α () Snce v s a multple of π, the value of the nvestment project s also characterzed by a geometrc Brownan moton wth drft α and volatlty σ. () Wth respect to Buckley and Casson (998) t s assumed that addtonal costs of market entry that dffer wth respect to the chosen entry strategy. The paper dfferentates between: 4 Real optons method orgnated from Block and Scholes (973), Merton (973), and other scholars who developed the opton prcng model (optons prcng model, whch OPM). It plays an mportant role n use of fnancal dervatve products both n theory and practce. Stewart Myers (973) frst created the term "real optons". 5 Pennngs and Lnt (000) Brownan moton seems to ft best the observed prces n rapdly changng, technology-based markets. 35

3 Marketng costs (Cm) that summarze the cost assocated wth ganng knowledge about the new market, n order to optmally select supplers, dstrbuton channels, and marketng actvtes. Whle marketng costs Cm are present for a frm wllng to conduct a greenfeld nvestment one can neglect them for an acquston strategy due to the nternalzaton of nformaton advantages the target company possesses about the new market. Adaptaton costs (Ca) n order to modfy producton equpment. Adaptatons costs Ca, however, can be neglected for the greenfeld entry mode. They are unque only for the cross-border acquston entry mode n order to adapt the producton technology of the target to the frm s own producton technology and qualty standards. Costs of buldng trust (Cq, Cq ). Cq s ordered to produce products better adapt to the market and the cost of product nnovaton. For cross-border acqustons, Cq could be gnored, because the local manufacturers have long-term experence n the local sale of the products whch are very strong trusted. Cq refers to the cost of nternalzaton of acquston assets. E.g. Dfference between management culture of two countres needs some tme to fuson. However, for greenfeld nvestment, ths could be gnored. (3) Assumpton the up-front nvestment costs for buldng or acqurng the producton faclty n the new market are the same, we set I 0. In order to consder the host country's laws and regulatons envronmental mpact on nvestment mode choce, we consder the legal costs of C and C. C represents the laws and regulatons cost of greenfeld nvestment and C as the representatve of cross-border acqustons. (4) As Chang and Rosenzweg (00) [7] have depcted, a sequence structure lke ths s reasonable snce frms n ther sample,.e. 8 Japanese and European companes, entered the U.S. market.5 tmes on average. The frst phase represents the buldng phase, e.g. the establshment of a physcal presence by ether acqurng assets already n place or by buldng a producton plant. Ths phase serves as a platform,.e. an mportant prerequste to further expand the presence n the new geographcal market. So n ths paper foregn drect nvestment s consdered to be a two phase evolutonary entry sequence. The frst phase nvestment costs can be formulated explctly: FDI I + + I = + C ( φ )( C + C ) + φ ( C C (3), 0 a q m q ) = represents greenfeld entry, = for a cross-border M&A entry. φ, whch s n the case of a greenfeld entry and 0 for a cross-border M&A entry. Whle the frm nvests n the frst stage, t receves a project value of v the fluctuatons of whch are captured by dv(t) up to ths pont. dv ( t ) = α v ( t ) dt + σ v ( t ) dz ( t ) (4) As a result of the perceved uncertanty, the project value V of the second stage obeys a stochastc evoluton, too, whch s represented by dv(t). dv ( t ) = α V ( t ) dt + σ V ( t ) dξ ( t ) (5) 3 Wth α = r δ and α 3 = r δ 3 as the correspondng growth rates of the project values. The ndex addresses the two possble equty modes (greenfeld nvestment ( = ) or cross-border M&A ( = )). dz(t), dξ(t) represent a Wener process wth zero mean and varance equal to dt. σ, σ desgnate the varance of dv(t)/v(t) and dv(t)/v(t) respectvely due to envronmental rsk. Thus let α < α 3 and σ < σ ndcatng that the second project represents an enhancement of the frst and thus beng more nnovatve and uncertan than the frst one. In general, δ represent dvdends the project pays and can be nterpreted as opportunty costs for watng. Let δ < δ.the reason why the opportunty costs for watng are greater for cross-border acquston than for greenfeld nvestment results from the fact that once a target company has been dentfed, the decson whether to acqure or not addtonally ncurs the threat that another rval wll acqure the target. Whle ths threat ncreases the opportunty costs for the cross-border acquston mode t s not present for a greenfeld entry strategy. 353

4 Model descrpton Assumng that the world economy s rsk neutral and that the rsk free nterest rate s constant at r and based on the Bellman-equaton we get: rfdt= ε ( df ) (6) Whereby f denotes the opton value of v(t) andε ( ) represents the expectatons operator. Wth the ad of Itˆo s Lemma one obtans for the dfferental of f(v): df = f '( v) dv+ f ''( v)( dv) (7) ( dv ) =σ V dt As, we get f f σv + α 0 v rf = v v (8) α = r δ. as the growth rate of the value of projects ( α < r )and ndcatng whether the market entry s done by greenfeld nvestment ( = ) or cross-border M&A ( = ). The assocated boundary condtons for ths phase are as follows: f (0) = 0, (9.) f v = φ+ φe α v I FV * ( r ) t ( ) ( ) * FDI [, ( 0)], (9.) f ( v) ( r ) t FV ( 0) = ( φ+ φe α ) + = 0 * * v v= v v v= v (9.3) It s worthwhle to note here that a greenfeld entry takes tme to buld of length t. Thus, one has to * ( r α ) t v consder the future value of the nvestment project e whch the frm receves after makng the ntal nvestment outlay (see Fredl, 00). [8] It has the followng regular soluton: f ( v) = Bv γ Wth α α r γ = + [ ] + > 0 σ σ σ FDI Gven assumpton above about the entry costs, FDI I + +, 0 a q m q ) I (0) () I = + C ( φ )( C + C ) + φ ( C C, () φ ={ 0 f =, f = * Usng boundary condtons (9.) and (9.3), we can get B and v (the optmal tme for nvestment).and then we can get γ * Bv fv< v f ( vv, ) = ( r ) t FDI * ( φ + φe α ) v [ I, F ( V0 )] fv v (3) γ v = ( φ + φe ) [ I F ( V )], * ( r α ) t FDI, 0 γ (4) 354

5 γ B e I F V [ ] ( r α ( ) ( ) ) t γ ( ) FDI γ = φ+ φ [, ( 0)] γ γ (5) F(V 0 )represents opton value of second phase that obtaned through the frst phase of the nvestment. So, when the value of nvestment projects gets γ v e [ I C C F ( V )] * ( r α ) t = m + Cq 0 γ (6) Greenfeld nvestment wll be chosen. When the value of nvestment projects gets v γ [ I + C ( C FV ( )] * = 0 + a+ Cq ) 0 γ MNC wll choose Cross-border M&A. 3. The applcaton of FDI entry mode Accordng to data of the Statstcal Yearbooks from , FDI n the manufacturng sector are always occupyng a majorty proporton, and from the year 000 has mantaned a rsng trend. Frst of all, manufacturng products generally have hgh standardzaton and hgh unversalty and thus the products have smaller dependence on host local market preferences, consumer habts and psychologcal dependence. Therefore FDI va greenfeld nvestment not need a lot of money n the market study cost Cm and product trust cost Cq. In addton, there s stll a greater techncal lag between Chna and developed countres n the manufacturng sector. If choose cross-border M&A, t wll nevtably ncrease the technology adaptaton cost Ca. Furthermore, the culture dfference between Eastern and Western may lead the two sdes dfferences n aspects of enterprse management and staff ncentve, whch wll undoubtedly result n the ncreasng of trust costs Cq and ntegraton cost after acquston. These two ponts are both not conducve to take mode of mergers and acqustons. In addton country's legal and poltcal envronment s also very mportant. In recent years, Chna promulgated some laws and regulatons about encouragng foregn nvestment and acquston. However, there stll exst larger obstacles n Chna's current system of laws and regulatons on foregn mergers and acqustons. For example, one should announce and has to suspend tradng f holdng of a lsted company's shares reaches 5 percent. And then ncreasng every 5 percent should repeat the process. When reachng 30 percent the comprehensve offer request would be ssued. Ths complex process wll nevtably cause hgher legal cost C of acquston. In addton, varous local government departments n Chna consder more n the pont of socal ssues such as welfare, resettlement workers and unemployment. So that they also more wllng to encourage greenfeld nvestment. Therefore, foregn drect nvestment concentrated n the manufacturng sector and restrctons of our country's legal and poltcal envronment are the man reason that Chna's FDI nflow manly preferrng to the greenfeld nvestment. 4. Conclusons and recommendatons The paper analyzed FDI choce of multnatonal companes through the real optons research method and found that the uncertanty of nvestment envronment, addtonal related costs and the value F(V 0 ) of future nvestment opportuntes have great nfluence on the decson-makng of FDI choce. [] The greater uncertanty of nvestment envronment s, the larger mpled value of growth optons F(V 0 ) wll be. And both wll decrease the crtcal value of two ways (V * and V *) n the frst phase of nvestment. [] The host country's laws and regulatons and poltcal envronment have great mpact on FDI mode choce. (7) 355

6 [3] The man reason of most FDI nto Chna preferrng to the greenfeld nvestment s that the foregn drect nvestment concentrates n the manufacturng ndustry as well as the constrant of our country's legal and poltcal envronment. Accordng to the above concluson, there are followng recommendatons for ntroducng of foregn nvestment n Chna: () Encourage nvestment n the servce sector. Foregn nvestment have great role n Chna's servce ndustry especally fnancal, nsurance and telecommuncatons ndustres. As economc globalzaton deepens, the problem of management, techncal staff and techncal support have already exposed constranng the development of servce ndustry. Chna should attract more foregn nvestment n the servces ndustry reformaton and use foregn management deas and ndustry-leadng technology to rase ndustry compettveness. () Improve the construct of laws and regulatons. The blank of ant-trust laws and the revew of cross-border mergers and acqustons must be flled as soon as possble to establsh the basc framework of cross-border mergers and acqustons legal system. In the aspect of the revew of Cross-border M&As, Chna should adopt comprehensve standards of revew, ncludng natonal securty, competton polcy, ndustral polcy and other factors, whch can ensure a smooth ntroducton of foregn captal, but also can prevent monopoly n the domestc market of multnatonal companes. References [] Caves, R. and S.k. Mehra, Entry of foregn multnatonals nto U.S. manufacturng ndustres. In M.E. Porter(Ed.). Competton n global ndustres. 986, Boston: Harvard Busness School Press. [] Buckley, P.J. and M. Casson, Analyzng foregn market entry strateges: Extendng the nternatonal approach. Journal of Internatonal Busness Studes, (3): p [3] Debo Jang and Jaxn Wang, The nternatonal drect nvestment and market structure nteracton: Theory and Evdence. Jangsu Socal Scences, 00. 6: p [4] Zhangxn Cheng and Feng Hu, An Economc Analyss Framework of Trans-Natonal Corporaton s Choce Between Foregn Investment M odes. Journal of Xnjang Unversty (Socal Scence Edton), (4): p [5] Zhanq Yao, the Enterng of Transnatonal Companes, the Benefts of Host Countres and Regulaton Polcy. Industral Economc Research, 005 (): p. -7. [6] Pennngs, E. and O. Lnt, Market entry, phased rollout or abandonment? A real opton approach. European Journal of Operatonal Research, : p [7] Chang, S.-J. and P.M. Rosenzweg, The choce of entry mode n sequental foregn drect nvestment. Strategc Management Journal, 00(): p [8] Fredl, G., Sequental nvestment and tme to buld. Schmalenbach Busness Revew, (): p