Direct Investment, Research Intensity, and Profitability

Abstract

The large amount of foreign direct investment by U.S. firms in recent years suggests that such firms had a high internal rate of return on investment abroad. In this paper we attempt to provide an explanation for this high rate of return. Our conclusion is that direct investors tend to be in research-intensive industries and that their profitability is associated with research and development, rather than with direct investment itself. By investing abroad, they spread the fixed cost of research activity, thereby increasing the return to such activity. Thus, the internal rate of return on foreign direct investment exceeds average rates of return observed in foreign economies. Combined with the fact that direct investors in manufacturing are typically research-intensive, this result suggests why capital may flow from countries with high rates of return to those with lower observed rates of return.