What Is A Foreign Direct Investment?

Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Understanding foreign direct investment

Foreign direct investment is a critical component of growing economies that are transitioning from agriculture and raw material exports to rapid industrialization. The firms in these economies require capital to expand beyond their own borders, while governments use FDI capital to create jobs, build infrastructure, or invest in energy and water security.

Free trade agreements are one way that foreign direct investment can be stimulated. When the North American Free Trade Agreement (NAFTA) was signed between the United States, Canada, and Mexico in 1994, foreign direct investment increased in Mexico by 150% that same year despite economic problems in the country caused by a weakened peso. Canada also benefitted from the agreement, receiving $16 billion in FDI revenue in just five years.

Three components of foreign direct investment

Foreign direct investment is comprised of three basic components:

  1. Equity capital – this, as we noted in the introduction, involves an investor purchasing shares in a business located in another country. Once the 10% threshold has been reached, the investor is assumed to have some control over company assets.
  2. Reinvested earnings – this describes the investor’s share of earnings that are not distributed as dividends by affiliates or not remitted to the investor. In other words, this is capital that is reinvested into the company.
  3. Other direct investment capital or inter-company debt transactions – this encompasses the borrowing or lending of funds between the direct investor and branches, associates, or subsidiaries. These funds may take the form of debt securities or supplier’s credits.

Foreign direct investment types

There are also four general types of foreign direct investment:

  1. Horizontal – where an investor invests funds abroad in the same industry that produces similar products and services. American company Nike may choose to invest in German firm Puma since they are both involved in athletic apparel and sports footwear.
  2. Vertical – here, the investment is made within a supply chain that may or may not be the same as the investment firm’s industry. Starbucks, for example, invest in the coffee producers that supply it with premium coffee beans around the world. In some instances, the other company in the supply chain may be acquired completely.
  3. Conglomerate – foreign direct investment is said to be conglomerate when there is no relationship between companies or industries. Investors in this scenario sometimes enter into joint ventures to compensate for their lack of experience in an industry.
  4. Platform – a more complex form where a business establishes a presence in another country to manufacture products that are then exported to a third country. In a hypothetical example, Volkswagen may invest in manufacturing facilities in China to then export vehicles to other parts of Asia.

Key takeaways:

  • Foreign direct investment (FDI) involves the purchase of an interest in a company by an entity that is located in another country. Free trade agreements are one way that foreign direct investment can be stimulated.
  • Foreign direct investment is also critical to the growth of emerging economies. It contains three components that describe the nature of the investment and the entities involved: equity capital, reinvested earnings, and other investment capital or debt transactions.
  • There are four types of foreign direct investment: horizontal, vertical, conglomerate, and platform. Each type is associated with a different investment strategy.

Connected Business Concepts

Circle of Competence

The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Warren Buffet Companies

Warren Buffett is an American investor, business tycoon, and philanthropist. Known as the “Oracle of Omaha”, Buffett is best known for his strict adherence to value investing and frugality despite his immense wealth. He is among the wealthiest people in the world. Most of his wealth is tied up in Berkshire-Hathaway and its 65 subsidiaries.

Price Sensitivity

Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

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