Lecture 8: International Capital Budgeting

Issues

How do we decide whether a firm should proceed with foreign project(s)?
In what way international capital budgeting differ from the domestic setting?
What role does the exchange rate play?
What are the complications with estimating the cost of capital for a foreign project?

How much cash flows is going to add to the underlying cash flows of the firm?

What is the appropriate discount rate

Apply Capital budgeting techniques, IRR, NPV etc.

Have to take into account complications, COC, and tax related issues and political risk, etc.

Net present Value

The NPV is the present value of future cash flows discounted at an appropriate rate minus the initial net cash outlay for the project.
In mathematical terms, the formula for net present value is:

$NPV = -I_{0} + \sum ^{ \infty}_{t=1}\frac{CF_{t}}{(1+r)^{t}}$

Projects with a positive NPV should be accepted; negative NPV projects should be rejected.
The discount rate is the expected rate of return on projects of similar risk.

Rules of thumb to use what approach

Free Cash Flow Definitions

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Figure out the incremental cash flows of the business

How much would taking a particular project add to the company

Two ways of looking at FCF

To the business

To Equity (equity holders)

FCF firm

FCF to firm can be paid out to all claimants of the firm. Can be used in NPV of the firm

FCF Equity

Preferred shareholders receive dividends before ordinary shareholders

Discount with cost of Equity capital

Cash flows to Claimholders

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Issue:

Use COC, you have domestic and non-domestic projects, How do you adjust the COC

Adjusted Present Value

An alternative valuation method is

$APV = NPV(100\% equity financed) + PV(tax shields) + PV(other imperfections)$

It is a series of present value calculations

As a standalone decision, is this a good project

Set aside all other complications that arise

Taking on debt, can be used as a tax shield - MM Proposition 2

Other imperfections

other frictions that exist when borrowing money, cannot make principle payments. Assets of the company can be seized, and the costs must be subtracted out

Information symmetry, agency problems

Stage 1: Project is 100% Equity Financed

Cash-flows: Need Free Cash Flows.

You need the rate that would be appropriate to discount the firm’s cash flows as if the firm/project were 100% equity financed.
- This rate, 𝑟𝐴 , is the expected return on equity if the firm were 100% equity financed.
  - To determine the return on assets ( 𝑟𝐴 ), you need to:
- Find comparables, i.e., publicly traded firms in same business.
- Estimate their expected return on equity if they were 100% equity financed by unlevering.

Appropriate discount rate is the return on assets. Should be equal to the return on equity

Find the interest rate - Find comparable firms list on the stock exchange

From comparable firms, find their Cost of equity (determine their unlevered COC)

Then use to determine Value of firm

Stage 2: PV of Tax Shields

The expected tax saving is $\tau_{c}r_{c}D$ $τ_{c} r_{c} D$ where $\tau_{c}$ $τ_{c}$ is the corporate tax rate
- D is the amount of borrowing is expected to remain stable

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Present value of cash flows, discount by COE

Stage 3: PV of Other “Imperfections”

PV of Distress Costs

These arise when firms take on debt
- Direct costs of financial distress
- Indirect costs of financial distress
They tend to be difficult to estimate
- Usually ignored.

The Costs of Issuing Securities
PV of Subsidised Financing

Companies in financial distress have difficulty hiring people

Other problems covered in corporate finance

Transactions costs involved

Cost of issuing securities. Roughly 8% of capital raised goes to investment bank because of processing the asset

Parent vs Subsidiary Cash flows

Whose perspective should the analysis take?
- Substantial difference between the parent vs subsidiary (project) cash flows
  - Royalty payments
  - Licensing agreements
  - Overhead management fees
  - The purchase of inputs from the parent
- The role of taxation and exchange controls
- The effect of exchange rates.

Investing in a project outside Australian borders

Costs that the subsidary incurs include management fees, royalty payments, overhead management fees, etc.

cash flows can be different for subsidiary vs parent company

tax is different, tax credit for parent company.

Need to consider exchange rates in the future

Example

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Need to do from subsidiary perspective first

5% of revenue is a royalty

Overhead allocation fees is 2% - cost to the subsidiary

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Cash flows of a parent

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Dividend to the parent

Pay taxes in the foreign country before paying

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Series of PV calculations

Selling inputs to subsidiary, is a revenue to the parent company

If you are going to default, risk of default is going to be the market rate

APV of Parent

The APV from the parent company’s point-of-view is the sum of the present value of cash flows and the impact of side- effects.

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What other issues could be included?
- Cannibalisation of export sales: Setting up manufacturing facilities in Europe reduces parent’s CFs. It reduces exports from parent company if it doesn’t have another market for those 40K in lost sales. This should reduce APV by the amount of the lost profit (€81.55). See worksheet.

How do you factor the cannibalisation of sales?

needs to be taken into account

Ultimately

need to test the NPV from both the subsidiary and parent company's perspective

Parent company's perspective that is going to dominate

Political risk, tax related issues, exchange rates

What about exchange rates?

Firms have revenues and costs in multiple currencies.
First Approach: Local Currency NPV
- Perform revenue and cost projections using local currency figures and then discount cash flows at the local currency cost of capital. Then convert local currency NPV to dollars (home currency) using current spot rate
- Denoted as
- This approach is useful when revenues and costs are in local currency, when investment capital is raised locally, and cash flow will be reinvested locally.
- Upside: Don’t have to forecast exchange rates.

Use this when all revenues and costs are in local currency

not going to be repatriating funds to local currency

Use prevailing exchange rate

Second Approach: Period-by-Period Conversion
- Use local currency projections and convert each periods cash flow into dollars using the forward rate or exchange rate projections.

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Discount the dollar cash flows with a dollar (or home country) discount rate with adjustments for country and project risks.
Explicit about exchange rate movements and discount rate adjustments.
Easier to perform sensitivity analysis.

Explicitly taking into account the exchange rate movements

Advantageous if doing sensitivity analysis, what economic exposure is going to have - don't expect parity conditions to hold in 5 years e.g.

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The two approaches are the same when the discount rates satisfy International Fisher Effect.
Keep in mind: Discount rates should be different for different time periods.

Dividing both sides by the spot exchange rate

Multiply both sides by the denominator terms Two approaches are essentially the same

Discount Rate: Horses for Courses

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Australia's market more integrated in the rest of the world

Can build a well-diversified portfolio in Australian market

Invest in highly risky projects, risk premium goes up

company risk - will depend on how it will add to the overall market portfolio

How much it will cost to buy the stock, over and above the market premium

Use world CAPM for countries that are well diversified into the world market

Other issues:

Aus company investing in overseas project

How do you calculate the market risk premium?

Higher royalty fees on copper, risk of appropriation (political risk) etc. How do you make adjustments to the premium?

Is the risk of purchasing assets of the company diversified?

If non-diversifiable, have to make adjustments to the risk premium

Are investors marginal (trade)

Do we need to add a country specific risk?

Country Risk

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Determine the market risk premium

Premium over and above the risk free rate

Calculate the risk premium

Investing in a project and need to make adjustments for the risk premium:

Use a risk premium of a developed market + additional risk from the country

Balance of payments numbers, political risk of a country, etc.

Country ratings

Measures of Country Risk Spreads

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Look at the yield spread between the developed country and country of emerging market.

Issue: looks at, when we are trying to determine the returns on equity instruments

Relative Equity Market Standard Deviations

Calculate stock returns of the developed markets and incorporate standard deviations of emerging market

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Really hard to get bond returns data

Generally harder to estimate

Estimating the cost of capital

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Different ways of calculating the emerging market premium

Depending on which approach, add on the country risk premium

Beta method

Calculate the risk premium, calculate the risk premium of the developed market plus adding the risk premium

Use this in countries with extractive industries. When there is political risk (differing exposure) then add the country risk to the beta

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Estimate lambda - sales you estimate from the local currency

Takeaways

Have to take into account cost of exchange rate
How to calculate the discount rate in an emerging country
- depends on whether a company's risk is diversifed or not.

Not in textbook - don't observe the COC, needs to be estimated