Investment is necessary for any business to raise funds for various costs in setting up the business.
If you are keen on business and want to understand better how companies across different countries work, you must know what Foreign Direct Investment (FDI) is. Investment is necessary for any business to raise funds for various costs in setting up the business. From raising funds for a small business through methods like Bootstrapping to attracting foreign investments in start-ups and unique ventures, it is the capital that shapes an entrepreneur’s vision into reality.
So, let us understand what FDI is and how it plays a decisive role in shaping the business landscape.
What is Foreign Direct Investment (FDI)?
Foreign direct investment is the investment by an entity in a company or business in another country to generate a stable interest. In the most basic sense, an FDI is made by one company into another located in another country, which means that foreign direct investment can be made by expanding a business in foreign countries.
For example, Apple’s, an American tech company, investment in setting up manufacturing units in China and India is a straight example of an FDI.
How does FDI work
To significantly expand the businesses and its assets while managing the liabilities in foreign counters, foreign direct investment effectively works by,
Establishing a subsidiary or associate company in a foreign country,
Obtaining the rights and controlling interest in an existing foreign company,
By orchestrating a merger or joint venture with a foreign company.
If an overseas company’s investment benefits the investor in the long term, technically known as lasting interest, it is then that investment termed as an FDI. A lasting part is guaranteed when investors receive around 10 percent of the decisive share in the company. This gives investors the authority to control the company’s decisions and workings they invest their money in. The element of control represents the intention to manage and influence the affairs of an overseas company.
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Researches have shown that financial development through FDI proves to be beneficial for the economies of countries and small businesses.
According to the guidelines set by the Organization for Economic Co-operation and Development (OECD), the margin for establishing control of FDI requires the investors to own at least 10% ‘voting stock’ of foreign companies. Voting stocks are shares that give shareholders the right to vote on a company’s corporate policy decisions.
But, in some cases, even less than 10 percent of the company’s voting stock can be used to establish effective control of the company. For example, it is possible to manage a more widely traded company, even if the percentage ownership of voting stock is low. The massive investor’s interest in the company increases the value of a widely traded company.
FDI is generally done in open economies with a skilled workforce and promising growth prospects for the investor, unlike highly regulated economies. Foreign direct investments also comprise the reinvested profits from foreign operations and intra-company loans to overseas subsidiaries.
Let us now understand the Types of FDIs
Generally, FDI is divided into two major categories, which are horizontal and vertical FDI.
Horizontal FDI
When a business expands its domestic functions to a foreign country, it is termed as horizontal FDI. In horizontal FDI, the business does the same functions as the company but in a country overseas.
For example, McDonald’s, the world’s largest chain of restaurants, has food outlets worldwide; and the operations in all McDonald’s restaurants are standardized, irrespective of where they are situated. This is horizontal FDI.
Vertical FDI
When a business expands its operations into a foreign country and does different functions related to the central business, it is termed as vertical FDI.
For example, in McDonald’s, if the company acquires a farm in Canada to produce vegetables for their restaurants, it will be vertical FDI.
Two more forms of FDI have resulted from the world becoming a global market in recent decades, as more and more countries opened up their economies to foreign businesses. These FDI methods are different from the traditional FDIs and are called conglomerate and platform FDI.
Conglomerate FDI
When a company subsumes a business that is not related to its principal business line in a foreign country, it is termed as conglomerate FDI. This investment is complicated and needs excessive resources as doing it means undertaking two significant challenges- entering a foreign country and entering a new industry or market.
For example, if Ford Motor Company acquired a clothing line in New Delhi, it would be conglomerate FDI.
Platform FDI
When a company expands its functions into a foreign country, but the products generated from the foreign operations are exported to a third country, it is called platform FDI. This FDI usually takes place in low-cost locations in free-trade areas. For example, if Ford Motor Company purchased manufacturing plants in Pakistan and exported cars to other South-Asian countries, it will be a platform FDI.
Benefits
Foreign direct investment is advantageous for both the investors and the foreign countries that get their business or assets. The perspective of economic prosperity encourages global trade and the exchange of more than just business, but different ideas and values as well. Most of the benefits for companies are based on cost savings and lowering risks to their business model, while for the host countries, the profit lies in the economic boost to the country.
Following are some of the benefits for businesses:
Market Diversity
Tax Benefits
Lower Labour Expenses
Preferred Tariffs
Grants and Subsidies
And the following are the benefits for the country that gets the business form foreign companies:
Economic Stimulus
Human Capital Development
Employment Growth
Increase in Management Skills, Experience and Technology
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Foreign direct investment is the investment by an entity in a company or business in another country to generate a stable interest.
Foreign Direct Investment and New Businesses
The relationship between FDI and new business start-ups is unique because foreign direct inflows significantly boost new businesses and start-ups, especially in developing countries. Various researches have shown that financial development through FDI proves to be beneficial for the economies of countries and small businesses.
Simply put, economic development facilitates the positive spread of FDI in new start-ups. That is why more open economies around the world are regularizing their financial market in a way that attracts more FDI and eventually adds to new businesses.
According to the government’s data, 18 out of the 30 ‘unicorn’ companies in India got significant foreign direct investments. A start-up with a valuation of over $1 billion is termed a unicorn. Some successful examples of Indian start-ups which got foreign direct investments are Byju’s- an Indian education technology firm, and Unacademic- an Edtech platform.
Disadvantages of FDI
Despite many advantages, foreign direct investment still has its disadvantages. Some of them are,
Displacement of local businesses: The entry of large foreign companies exposes local companies to more competition, often resulting in small businesses closing down.
Intromitting Profits: In this scenario, there are high probabilities that foreign companies will not reinvest profits back into the host country, leading to massive capital outflow.
Big Examples of FDI
FDI includes mergers, acquisitions, retail, services, logistics, and manufacturing, among various others, as successful examples of the practice. Following are some mega examples:
Apple dedicated a $507.1 million investment to expand its research and development operations in China.
China’s economy has grown dramatically in the past two decades due to FDI through which investors focused on China’s high-tech manufacturing and services industry.
FDI rules in India permits 100% foreign direct investment in single-brand retail businesses with no obstacles of red tapes and government interventions.
In a nutshell, foreign direct investment plays a significant role in boosting any country’s economic activities while simultaneously sharing opportunities from different parts of the world with businesses, rejuvenating the whole business and start-up ecosystem.
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