Foreign direct investment

Definition

Foreign direct investment (FDI) refers to the investment made by a company or individual in one country into business interests in another country, typically by establishing business operations or acquiring assets. FDI plays a significant role in international capital budgeting as it involves allocating resources to foreign projects, which can be influenced by factors such as political risk, exchange rates, and expected returns on investment.

5 Must Know Facts For Your Next Test

1. FDI can take various forms, including establishing new operations (greenfield investments), merging with existing companies (mergers and acquisitions), or expanding current operations abroad.
2. Countries often attract FDI through favorable tax policies, incentives, and a stable political environment, which are crucial factors for multinational corporations when deciding where to invest.
3. The long-term nature of FDI makes it different from other forms of investment, as it often requires significant planning and capital commitment over multiple years.
4. FDI contributes not only to the economic development of the host country but also fosters technology transfer and job creation, enhancing the local economy.
5. Risks associated with FDI include changes in government policy, economic instability, and cultural differences that may impact the success of foreign investments.

Review Questions

• How does foreign direct investment influence a company's international capital budgeting decisions?
  • Foreign direct investment significantly impacts a company's international capital budgeting decisions by requiring an assessment of potential returns, risks, and costs associated with investing abroad. Companies must analyze various factors such as market size, competition, regulatory environment, and political stability before committing resources to foreign projects. Additionally, businesses often need to consider how foreign investments fit within their overall strategic goals and how they can allocate their capital effectively across different regions.
• Discuss the role of exchange rate risk in foreign direct investment and how companies can mitigate this risk.
  • Exchange rate risk plays a critical role in foreign direct investment because fluctuations in currency values can directly affect the returns on investment. Companies can mitigate this risk through various strategies such as hedging techniques using financial instruments like options or forward contracts. By locking in exchange rates or diversifying their investments across multiple currencies, firms can reduce their exposure to adverse currency movements while maintaining the potential for profitable returns from their foreign operations.
• Evaluate the impact of political stability on foreign direct investment decisions and its broader implications for global economic growth.
  • Political stability is a vital factor influencing foreign direct investment decisions because it directly affects investor confidence and the perceived risk associated with investing in a particular country. Stable political environments are generally more attractive to investors as they reduce uncertainties related to regulatory changes, expropriation risks, or civil unrest. As a result, countries with stable governments are likely to experience higher levels of FDI, which can stimulate economic growth through job creation, technology transfer, and increased productivity. Conversely, regions with political instability may deter investment and hinder their economic development prospects.

Related terms

Portfolio Investment: Investment in financial assets such as stocks and bonds in a foreign country, without the investor taking direct control of the underlying assets.

Capital Budgeting: The process of planning and managing a company's long-term investments and expenditures in projects that require large sums of capital.

Exchange Rate Risk: The potential for an investor's returns to be affected by changes in the value of one currency relative to another, particularly in international investments.