Rule of law

Though China is known for its ‘lack of rule of law and weak property rights institutions,' what can be puzzling to some is that it has become the world's number one destination for foreign direct investment (FDI). Exploring this riddle is ‘ Foreign Direct Investment under Weak Rule of Law: Theory and Evidence from China ,' a recent research paper by Xiaozu Wang, Lixin Colin Xu, and Tian Zhu ( www-wds.worldbank.org ).

The authors observe that the rule of law is not necessary for a country to attract FDI. They add that since good economic fundamentals can attract FDI inflows in the absence of the rule of law, these are more important for a country without the rule of law than for countries with it. Among other findings in the paper are that a locality can attract more investment by improving economic fundamentals, but not by simply lowering tax rates; and that a government leader who has a longer-term career horizon and cares about his or her reputation may be able to attract more investment.

It can be interesting to know that an institutional factor considered by the authors is the cost of maintaining guanxi (relationship) with the relevant government officials and departments. “In China, maintaining guanxi means dining and wining, and it is costly. We therefore expect this cost to have a negative impact on FDI,” the authors note. One learns that the ratio of entertainment and travel costs (ETC) to sales is used as a proxy for the cost of guanxi ; and that ETC, an expenditure item in standard accounting books of firms in China, is a large sum, amounting to about 20 per cent of the total wage bills in the sample firms of the investment climate survey of the World Bank.

Can be a reassuring read for Indian players.

Confused topics

Where does the WACC (weighted average cost of capital) equation come from? Which equity premium is used by professors, analysts and practitioners? Why do many professors still use calculated (historical) betas in class? These are some of the questions discussed by Pablo Fernández in ‘ Ten Badly Explained Topics in Most Corporate Finance Books ' ( www.ssrn.com ).

Take, for instance, ‘equity premium' (also called market risk premium, equity risk premium, market premium, and risk premium), which is ‘one of the most important and most discussed but elusive parameters in finance,' according to Fernández. Part of the confusion arises from the fact that the term equity premium is used to designate four different concepts, the author explains. “(1) Historical equity premium (HEP): historical differential return of the stock market over treasuries. (2) Expected equity premium (EEP): expected differential return of the stock market over treasuries. (3) Required equity premium (REP): incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity. (4) Implied equity premium (IEP): The required equity premium that arises from assuming that the market price is correct.”

There is a rather schizophrenic approach to valuation, frets Fernández. He finds that while all authors admit different expectations of equity cash flows, most authors look for a single discount rate. “It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship…”

Stimulating study for finance professionals.

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