Within‐Country Growth Options Versus Across‐Country Switching Options in Foreign Direct Investment

• DOI: http://doi.org/10.1111/j.2042-5805.2014.1073.x
• Date: 01 May 2014
• Author: Seung‐Hyun Lee,Mona Makhija,Sangcheol Song
• Published date: 01 May 2014

WITHIN-COUNTRY GROWTH OPTIONS VERSUS

ACROSS-COUNTRY SWITCHING OPTIONS IN

FOREIGN DIRECT INVESTMENT

SANGCHEOL SONG1*, MONA MAKHIJA2, and SEUNG-HYUN LEE3

1Haub School of Business, Saint Joseph’s University, Philadelphia,

Pennsylvania, U.S.A.

2Fisher College of Business, The Ohio State University, Columbus, Ohio,

U.S.A.

3School of Management, University of Texas at Dallas, Richardson, Texas,

U.S.A.

This article considers the value associated with foreign direct investment under different types

of uncertainty related to the international context. We examine how configuring foreign direct

investments differently within and across countries provides the firm with flexibility under

exchange rate uncertainty and market growth uncertainty. We find that across-country switch-

ing options embedded in investments dispersed across countries are more associated with

higher firm value under high exchange rate uncertainty, while within-country growth options

embedded in those concentrated within countries are more associated with higher market

growth uncertainty. We also find that across-country switching options call for higher owner-

ship levels, while within-country growth options require lower ownership levels in interna-

tional investment portfolio. Copyright © 2014 Strategic Management Society.

INTRODUCTION

High levels of uncertainty make it hard for firms to

determine appropriate courses of action that are

associated with high performance (Chi, 2000; Folta,

1998). For this reason, it is beneficial for the firm to

invest in real assets in a manner that does not lock it

into one course of action, but instead provides

choices (Bowman and Hurry, 1993; Dixit and

Pindyck, 1994). Multinational firms in particular are

exposed to many significant forms of uncertainty,

including unanticipated fluctuation in the relative

value of currencies, unexpected changes in demand,

and institutional disruption (Allen and Pantzalis,

1996; Campa, 1993; Kogut and Chang, 1996;

Makhija, 1993; Miller and Reuer, 1998; Tong and

Reuer, 2007). Under such conditions, it would be

valuable if their foreign direct investment (FDI) was

structured in a manner that embedded options and

provided flexibility (Fisch and Zschoche, 2011;

Huchzermeier and Cohen, 1996; Kogut, 1991; Lee

and Makhija, 2009a; McGrath and Nerkar, 2004).

International investments may, for example, provide

growth options—preferential access to future growth

opportunities embedded in host countries (Kogut,

1991; Kogut and Kulatilaka, 1994; Kogut and

Chang, 1996; Kulatilaka and Perotti, 1998; Tong,

Reuer, and Peng, 2008)—or allow switching

options, such as being able to switch production or

sales across countries in response to macroeconomic

changes in any given country (Chung et al., 2010;

Fisch and Zschoche, 2011; Huchzermeier and

Cohen, 1996; Kogut and Kulatilaka, 1994; Lee and

Song, 2012).

Keywords: foreign direct investment; exchange rate uncer-

tainty; market growth uncertainty; switching options; growth

options; ownership

*Correspondence to: Sangcheol Song, Haub School of

Business, 5600 City Ave., Philadelphia, PA 19131, U.S.A.

E-mail: ssong@sju.edu

Global Strategy Journal

Global Strat. J., 4: 127–142 (2014)

Published online in Wiley Online Library (wileyonlinelibrary.com). DOI: 10.1111/j.2042-5805.2014.1073.x

Copyright © 2014 Strategic Management Society

Despite the theoretical value of flexibility in the

international context, the evidence provided by prior

research is mixed. We believe there are three main

reasons for the divergent findings on international

flexibility. The first stems from the fact that flexibil-

ity is valuable only under heightened uncertainty,

requiring careful consideration of the external con-

ditions in which international investments are

studied. Much of the empirical literature does not

adequately control for or assess this aspect of the

firm’s environment (e.g., Allen and Pantzalis, 1996;

Tang and Tikoo, 1999; Tong and Reuer, 2007).1

Second, researchers have not fully taken into

account the possibility that an investment carries

different option types and requires different flexibil-

ity needs. Even though examining different option

types at the same time sometimes calls for different

levels of analysis, considering only one type of

option may not be sufficiently informative. Finally,

with only limited exceptions (e.g., Tong and Reuer,

2007), studies have not taken into account the

control and governance of these investments (which

affect the firms’ ability to manage them in a flexible

manner under uncertainty).

The purpose of this research is to address these

concerns. We begin by considering two types of

options of interest to multinational firms. The first is

within-country growth options, created by interna-

tional investments that provide a foothold or initial

platform in a host country through which the firm

can identify and exploit future growth opportunities

in a more fine-tuned manner (Kogut and Chang,

1996; Kogut, 1991; Tong et al., 2008). The second is

across-country switching options, gained through

international investments that allow the firm to trans-

fer value-adding activities from one location to

another in response to unanticipated macroeconomic

fluctuation in any of its host countries (Allen and

Pantzalis, 1996; Huchzermeier and Cohen, 1996;

Kogut and Kulatilaka, 1994; Tang and Tikoo, 1999;

Lee and Makhija, 2009a; Lee and Song, 2012).

Although the two options can both be gained from a

firm’s international investments, they are inherently

different. Each requires a distinct structuring of

investments which, in turn, provides value only

under specific conditions of uncertainty. Since the

two types of options can coexist in a firm’s portfolio

of FDI, one type can have the effect of masking the

other’s effects in empirical analyses. It is important,

therefore, to identify and decompose the contribu-

tion of each type to firm value.

To address this issue, we begin by examining the

depth and breadth of a firm’s FDI portfolio, which is

at the heart of its ability to derive within- and across-

country options (Kogut and Kulatilaka, 1994; Lee

and Makhija, 2009b; Pantzalis, Simkins, and Laux,

2001; Tang and Tikoo,1999). In order to disentangle

their effects, we next identify conditions of uncer-

tainty in which the value of cross-country switching

options theoretically exceeds the value of within-

country growth options and vice versa. We consider

two types of environmental uncertainty associated

with exchange rates and market growth that multi-

national firm face in their host countries. We test the

effects of different FDI portfolio configurations on

the value of multinationality under both conditions

of host country uncertainty using a sample of 2,160

observations from 140 publicly traded manufactur-

ing multinational firms listed on the Korean Stock

Exchange from 1991 to 2007. Employing a panel

data methodology, we find that cross-country

switching options are associated with more value

under high exchange rate uncertainty, while within-

country growth options are associated with greater

value under high market growth uncertainty. Owner-

ship level is also found to affect the ability of firms to

gain flexibility from their international investments.

THEORETICAL UNDERPINNINGS

Within-country growth options in foreign direct

investments

When a firm wishes to invest in countries thought to

hold great economic potential but characterized by

unknown environmental conditions, it is valuable for

the firm to configure its investment in a manner that

allows for learning (Chi and McGuire, 1996; Tong

et al., 2008). A small initial investment in a host

environment can provide a firm with the opportunity

to assess unfolding economic conditions and

develop a better understanding of the local environ-

ment before making further commitments (Cuypers

and Martin, 2010; Kogut, 1991; Tong et al., 2008). It

can then expand and deepen its investment in stages

as greater understanding of this environment—the

workings of the economy, customer preferences,

government rules and regulations, workers and

suppliers—develops (Kogut and Chang, 1996;

1For an exception, see Belderbos and Zou (2009).

128 S. Song, M. Makhija, and S.-H. Lee

Copyright © 2014 Strategic Management Society Global Strat. J., 4: 127–142 (2014)

DOI: 10.1111/j.2042-5805.2014.1073.x