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Multinational Capital Budgeting and Foreign Direct Investment Decision

Capital Budgeting and Foreign Direct Investment Decision

Part I:

Foreign direct investment (FDI) plays an important role in stimulating economic growth of a country. FDI is defined as long-term investment by a foreign direct investor in an enterprise resident in an economy other than that in which the foreign direct investor is based. Kentucky Fried Chicken (KFC) is considering to expand in the African market. However, one should not ignore the fact that the African market is a risky market. Please read the following story:

KFC To Move Into Africa

After spending two decades introducing fried chicken and pizza to Chinese consumers, Yum! Brands Inc. now sees Africa as its next international jewel. Yum envisions 1,200 KFC restaurants in Africa by 2014, twice its current number. By 2014, the Louisville, Ky., restaurant-holding company expects to double its number of KFC outlets in Africa to 1,200. In the next four years, it aims to more than double its revenue on the continent to $2 billion. "Africa wasn't even on our radar screen 10 years ago, but now we see it exploding with opportunity," says David Novak, Yum!'s Chairman and Chief Executive Officer.

The improved political stability of various African governments, the region's vast population and a growing middle class in Africa -- where chicken is a dietary staple -- led Yum! to set its sights on the continent. The first KFC in South Africa opened in 1971 and Yum!, whose brands also include Pizza Hut, Taco Bell, Long John Silver's, and A&W Restaurants, is now branching out into Nigeria, Namibia, Mozambique, Ghana, Zambia and other African countries. American restaurant companies and retailers have been moving into emerging markets as growth in the U.S. and other developed countries has slowed, and Africa is increasingly being added to the list. Wal-Mart Stores Inc. recently offered to buy 51% of South African retail giant Massmart Holdings Ltd. Africa is attractive for Western brands because its resource-rich countries are adding infrastructure while increasingly urbanized areas are creating opportunities for retail development.

Approximately 40% of Africans live in urban areas now and the number of households with discretionary income is projected to increase by 50% to 128 million over the next decade, according to a recent study by the McKinsey Global Institute.

"People are now focusing on the emerging world, with a bit of a gold rush going on," says Graham Allan, CEO Yum! Restaurants International. "A lot of companies, especially Chinese ones, have invested in Africa," Mr. Allan adds. "We share the general view that Africa over the next 10 to 20 years will have massive potential."

Of the roughly one billion people in Africa, KFC estimates it currently reaches 180 million. When McDonald's Corp. arrived in South Africa in the mid-1990s, KFC worried about the impact the burger giant would have on its business. So KFC began opening new restaurants and remodeling existing ones to make them more modern. By the early 2000s, KFC had about 300 restaurants in South Africa. KFC quickly outpaced McDonald's, which has fewer than 200 restaurants in Africa. With more than 600 KFCs in South Africa now, the chicken chain has a 44% share of that country's $1.8 billion fast-food market, followed by South African chain Nando's, with 6%, and McDonald's and the local Chicken Licken, each with a 5% share. A McDonald's spokeswoman declined to comment on the company's expansion plans in Africa. The menus at African KFC's are similar to those in more developed markets, albeit with more chicken drumsticks and wings, and fewer boneless items such as sandwiches and nuggets.

"Africans are wary of processed food," says Keith Warren, General Manager of Yum!'s Africa business. "They want chicken on the bone." The chain seeks to appeal to wealthier Africans as well as to people living at an income level just above that of subsistence farming. Meals consisting of a chicken sandwich, fries and a drink can cost as much as the equivalent of $7, while two pieces of fried chicken and fries cost $3. The company also sells chicken sandwiches for $1 and four chicken wings for $1.20.

"The KFC brand is highly aspirational in Africa. People will save up to buy the $3 meal, even if only once every three months," Mr. Warren says. KFC sells chicken more cheaply in South Africa than most parts of the world because local labour costs are lower and chicken suppliers don't charge as much, partly because South Africa is a major producer of corn to feed the birds. Although Africa is rebounding from the recent economic and food crises, it's a slow march. The continent's gross domestic product is projected to grow 4.6% next year, below the average growth rate of 6.1% in 2007, according to the World Bank. When Africa's GDP growth slowed to 1.7% in 2009, seven million to 10 million Africans fell into poverty. Still, the low cost of doing business in Africa, coupled with a growing population, is expected to yield high returns for Yum!. The company, along with franchisees, plan to invest about $500 million in the expansion and the company expects to more than double its operating profit in Africa to $120 million by 2014. Yum!, in total, posted $10.8 billion in sales in 2009 and almost $1.6 billion in operating profit.

The expansion will present plenty of challenges. In some countries, KFC imports its chicken from South Africa and Brazil. But there is still "a lot of protectionism in Africa," Mr. Warren says. "In Nigeria and East Africa, imports of chicken are banned," he adds. In those places, KFC has been working with local suppliers to ensure the quality and safety of their chicken meets the company's specifications. Sometimes the company finds itself hamstrung by bureaucracy. "At my store in Angola, we were ready to start construction six months ago, but an official had a piece of paper he was tardy in handing over. We just started construction three weeks ago," Mr. Warren says.

Source:

Jargon, J. (2010, December 8). KFC savors potential in Africa --- Yum Brands unit plans to double number of outlets on continent, where middle class is growing. Wall Street Journal, New York, B. 1.

Please see the attached document for the problems.

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1) How big the risk is it for KFC to enter the African market? What can go wrong?
Answer: It was well known to the company that Africa is not going to be an easy place to do business despite the fact that the situation in many of the countries in Africa has improved. One of the biggest challenges for KFC would be managing its supply chain and dealing with the government protectionism and regulation. Whenever there are trade barriers and protection, foreign companies may end up with an unfavorable economic result.
Another thing that can go wrong for KFC while entering into the African market is that Africa's fast food industry is extremely competitive which is not the case with the rest of the continents. So despite the fact that there were opportunities in Africa, KFC needed to do their homework before entering into the market.

2) What would be your major concerns if you were the Chief Financial Officer of KFC and you were asked to find financing in the African market?
Answer: The following would be some of the concerns in finding finance in the African Market.
a) One of the concerns will be the cost of finance. The cost of capital will be high in comparison to the cost of capital in the US. The higher the cost of capital, the higher will be the discounting factor in computation of the net present value for the project.

b) Availability of long term finances depends on the economy of the country. Since the economy of the African continent is still in the improving stage, it will be very difficult for KFC to finance its project in Africa.

3) What is the project's net present value?
Answer: Net present value is the present value of all cash inflows minus the present value of all cash outflows. A positive NPV encourages a company to take up a particular project whereas a project having a negative NPV should be rejected.
Below is the computation of net present value of the proposed KFC project in Africa:

Year 0 1 2 3 4 5
Cash Inflows (ZAR 12,000,000) ZAR 3,350,000 ZAR 3,899,000 ZAR 1,122,000 ZAR 4,200,000
Salvage value of Restaurant ZAR 10,000,000
Withholding Tax @ 10% ZAR 335,000 ZAR 389,900 ZAR 112,200 ZAR 420,000 ZAR 1,000,000
Cash Flow after Tax (ZAR 12,000,000) ZAR 3,015,000 ZAR 3,509,100 ZAR 1,009,800 ZAR 3,780,000 ZAR 9,000,000 ...

Solution Summary

The expert examines multinational capital budgeting and foreign direct investments.

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