International Finance Discussion Papers (IFDP)
August 1988
Interactions Between Domestic and Foreign Investment
Guy V.G. Stevens and Robert E. Lipsey
Abstract:
This paper studies both the domestic and foreign fixed investment expenditures of a sample of U. S. multinational firms. In addition to explaining empirically each type of investment, an important goal is to determine whether there are significant interactions between expenditures in the different locations.
Two types of interaction--one, financial, and the other, production-based--are explored theoretically and empirically. The financial interaction is the result of a model which assumes a risk of bankruptcy and its associated costs; under these circumstances, the firm faces an increasing cost of capital as a function of its debt/equity ratio. Domestic and foreign investment will be interdependent, since, in competing for finance, each affects the cost of capital in the other location. Production interactions can arise when, because of start-up costs or other factors that produce nonlinear cost functions, it may become, profitable to shift production from the home to the foreign location.
The hypotheses are tested on a unique sample of micro-economic data covering the domestic and foreign operations of seven multinational firms for a period of 16 to 20 years. In general the firm-level investment functions fit reasonably well for both domestic and foreign expenditures. An interdependence between domestic and foreign investment was confirmed frequently through the finance side, but only once via production.
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