Foreign Direct Investment as a Real Option: The Role of Managerial Flexibility and Uncertainty in Foreign Investment Decision

Abstract

This study examines the characteristics of switching option equilibrium of a multinational firm. Based on an extensive literature survey, the point of this study we emphasise is that foreign direct investment (FDI, hereafer) is exercised by a real option motivation. In this paper, we assume that an international firm serves foreign markets by either export or FDI. The choice between the two operations is determined by stochastic dynamic optimisation. The real option model of McDonald and Siegel (198) is applied to the investment decision of the firm. The results show that (1) under market uncertainty the firm will be able to maximise its value by switching between export and FDI, (2) the threshold exchange rate to switch between the two operations is different from the one derived from Net Present Value principle, (3) a delayed decision of switching mode depends on uncertainty of exchange rate, and (4) the more volatile the exchange rate is, the more the firm is inclined to maintain the current operation mode and the more the value of the firm increases. These results suggest that an o\international company may implement FDI even without any competitive advantage the company enjoys. Our findings are qualitatively different in several aspects from those shown by Dixit (1989). A numerical example is also examined to clarify these results.