The internal financing hypothesis

In this sense, internal financing refers to the utilization of profit generated by a subsidiary to finance expansion of FDI by a multinational firm in the same country where the subsidiary operates.The internal financing hypothesis postulates that multinational firms commit a modest amount of their resources to their initial direct investment, whereas subsequent expansions are financed by reinvesting profits obtained from operations in the host country.This hypothesis therefore implies the existence of a positive relationship between internal cash flows and investment outlays, which is plausible because the cost of internal financing is lower.This hypothesis seems to be more appropriate for explaining FDI in developing countries, for at least two reasons: (i)the presence of restrictions on the movement of funds;and (ii)the rudimentary state and inefficiency of financial markets.