Direct Investment: Definition and Types

Direct Investment Definition
Direct Investment Definition and Types

A direct investment, also known as a foreign direct investment (FDI), is an investment made by an entity based in one country in another country. A resident entity of one economy (the direct investor) seeks to acquire a long-term stake in a firm that is located in another economy (the direct investment enterprise) in FDI. Lasting interest suggests a long-term partnership between the direct investor and the direct investment firm and substantial influence over the latter’s management. When a company makes a direct investment in another country, they usually take a controlling stake in the company and will have a long-term interest. Direct investment provides this capital funding to companies in exchange for equity, but it is not usually distributed in regular equities. 

There are three different types of direct investment mainly. First horizontal FDI. Here, a business tries to expand its domestic operations internationally. Secondly, vertical FDI means a business trying to expand internationally through a different vector. And thirdly, the conglomerate is when a business acquires an unrelated business in another country. 

This article lets us learn more about foreign direct investment, its types, advantages, and disadvantages. 

What is Direct Investment?

Foreign direct investments mean investing in a company in a foreign country to gain controlling assets in the company. This can be done through mergers or acquisitions (buying out a company), building new facilities in another country, or even loaning to a foreign company in exchange for shares. To call it a foreign direct investment, a company needs to acquire at least a 10% controlling stake in a foreign company.  Through foreign direct investment, the investor company could have a hand in the management of the foreign company, start a joint venture, and/or transfer manpower, technology, or expertise. 

How does Direct Investment work?

Foreign direct investments work by acquiring a controlling stake over a company in a foreign economy.  A foreign investor will inject money to expand and speed up growth in established enterprises through investments.

FDIs provide a much-needed boost to enterprises that may be in bad financial health in developing and emerging economies like India and other regions of South-East Asia. The Indian government has taken a number of steps to guarantee that greater amounts of investment flow into the nation’s various industries, including IT, telecom, PSU oil refineries, and defense manufacturing.

In simple terms, the aim of foreign direct investment is to gain sufficient equity in a foreign company to be able to control the same. Sometimes, a company would start a business operation in another country. In other cases, a company would invest in a company in another country. Foreign direct investment need not mean a company acquiring a majority interest in another, a minority interest is still enough if there is enough stake to make a controlling impact. 

What are the main types of Direct Investment?

Foreign direct investments are divided into three. The categorization in FDI is based on how the investment is managed mainly.

Below is an explanation of the three main types of foreign direct investment. 

main types of Direct Investment
Main types of Direct Investment

1. Horizontal investment

A company could directly expand its business to a different country in a horizontal investment model. Here, the company would be doing the same business in foreign and domestic countries. 

The case of Mcdonald’s is a real-life example of horizontal investment. Here, the opening of McDonald’s restaurants in Japan would be seen as horizontal FDI.

2. Vertical investment

In a vertical investment, a company lands its footprint in another country by investing in a different supply chain. In other words, a company could do different business in a different country, but it could be, in some way, still related to the main business. 

A company invests in a foreign company that could supply or sell items When vertical FDI occurs, Backward and forward vertical integrations are additional categories for vertical FDIs. Nescafe, a Swiss coffee manufacturer, might, for instance, invest in coffee farms in nations like Brazil, Colombia, Vietnam, etc. Backward vertical integration is the term used to describe this type of FDI since the investing firm acquires from a supplier in the supply chain. A corporation is considered to engage in forward vertical integration when, on the other hand, it invests in a foreign rival that is further up the supply chain. For instance, an Indian coffee company would want to buy a French grocery brand.

Let us take an example to understand this better. Let us suppose a chain of fried chicken restaurants buys a controlling stake in a poultry company in a different country. The poultry company may not be the country’s main business, but it directly helps the business as it can deliver poultry to restaurants. 

3. Conglomerate investment

In the conglomerate investment model, a company could buy or invest in a totally unrelated business in another country.  This is an uncommon method of foreign direct investment as the companies will have to overcome two barriers. First, entering a new country, and second, entering a new business. An example of conglomerate investment would be if an IT company based in India acquired a restaurant company in France. FDI is not a direct component of the investor’s enterprise. For example, the American retailer Amazon might invest in the Indian automaker TATA Motors.

What is Foreign Direct Investment?

Foreign direct investment is when a resident entity (company or investor) invests in a firm or business in another country with the aim of acquiring a long-term interest in the foreign operation.   The Organization for Economic Co-operation and Development (OECD rules )’s state that this long-term partnership is created when the investor acquires at least 10% of the electoral power in the foreign corporation.

The exchange of capital, managerial know-how, and cutting-edge technology across nations is facilitated by foreign direct investment. This might encourage global economic integration and support a nation’s economic expansion.

What are the advantages of Direct Investment?

The main advantage of direct investment is economic growth. This economic growth is a result of the below advantages.

Economic advantages: The growth and development of market countries depend heavily on FDI. Developing nations require international financing and experience for their international sales growth, organization, and direction. To increase such jobs and pay for their members, these multinational corporations need private investments in their infrastructure, electricity, and water supply.

Job opportunities for the locals increase: The increased employment possibilities that foreign investment brings are among the most significant factors in a nation’s efforts to attract more. More FDI equity inflows benefit the industrial and services sectors, which in turn boosts employment. More employment implies more income, which boosts the economy.

Technological advancement: The company in the host nation has access to the most recent technological advancements, financial instruments, and operational techniques from around the globe. Increased productivity and efficiency result from introducing new and improved technologies to the local economy.

What is the disadvantage of Direct Investment?

  • The main disadvantage of FDI is geo-political. The business will get in trouble if any political risk arises between the counties. This will hurt both economies as well. This will negatively affect the markets of both countries as well. 
  • FDI occasionally has the potential to obstruct domestic investment. Local firms in countries started to become less interested in financing their family assets due to FDI.
  • Investors who fund enterprises in other nations might observe higher costs for exporting domestic goods. More funds are often spent on cognitive and mechanical resources than local workers’ wages.

Is investing in Direct stock investment?

No. Direct investments are called foreign private investments. Money invested by a private person or private company abroad is referred to as a private foreign investment. The fact that this form of investment is undertaken by an individual or a private entity sets it apart from other investments made by foreign public or governmental entities in other nations. This kind of investment, often called personal foreign investment, frequently stimulates the economies of other nations. Certain foreign investments are occasionally viewed as a form of foreign help, especially when they are made in developing countries or other economies that are having difficulty. However, this is not always the case. Foreign investments are subject to strict regulations, which can change according to the nation in which the investment is being made privately.

Is it more profitable to invest in Direct Investment?

Yes. Larger companies invest in direct investments with the aim of being profitable. FDI is profitable for the host country as well. Financial crises have shown that foreign direct investment (FDI) is resilient. During the 1997–1998 global financial crises, such investment was extremely stable in East Asian nations. In direct contrast, portfolio stock and borrowing flows, especially shorter flows, were prone to significant reversals throughout the same time period.  Both the Latin American debt crises of the 1980s and the Mexican crisis of 1994–95 showed the FDI’s ability to withstand financial disasters.

What is the difference between Indirect and Direct Investment?

Direct investment is another name for foreign direct investment. Foreign direct investment happens when a company invests in a company from another country. Indirect investment, also known as foreign portfolio investment is the term for investing in the financial resources of a foreign country, such as stocks or bonds traded on an exchange. Let us explore some other differences between indirect and direct investment.

  • An investor does not have to actively monitor the investment or the businesses that issue the investment while making an indirect investment. They lack direct control over the assets, in other terms. But FDI requires more closer management.
  • Indirect investments are typically of a short-term nature. Direct investments are undertaken with a long-term perspective.
  • Indirect investments are inherently unstable. The nature of FDI is stable.
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