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CAPITAL BUDGETING ISSUES IN FAST-GROWING ECONOMIES

COST OF CAPITAL

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Plan

NPV is the sum of discounted cash flows

Cash flows come from capital budgeting

Where do discount rates come from?

Cost of capital cost of equity cost of debt weighted average cost of capital practitioner approach (country risks)

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How to value business opportunities?

Examples

Boeing considers building a component assembly plant in Sao Paulo. The plant would import components from Canada, employ Brazilian workers to assemble the components into modules, and re-exports all of its production back to Bombardier’s facilities in US.

Google analyzes entering the Russian portal market via a joint venture with Yandex search engine.

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Project valuation in emerging markets can be challenging

how would you go about valuing each investments?

would you construct your cash flow projections in Brazilian Real or Canadian dollars? Then, how would you convert between different currencies?

how would you measure country risks (political risk, corruption) and how would you adjust your cost of capital for country risks?

what about industry characteristics (e.g., aviation vs. internet access)?

How to value business opportunities?

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Main issues

Main issues arising when investing in EM

recognizing costs and revenues in multiple currencies

assessing country risk and incorporating them into discount rate

country risk includes macroeconomic volatility, potential regulatory or political change, poorly defined property rights and enforcement mechanisms

accounting for business volatility which is different from that of developed economy

accounting for potential events, e.g., expropriation or currency devaluation

These issues make project valuation in EM an art than a science

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Basic ideaBasic Principles

inflation and risk erode purchasing power of money. Hence, dollar received at 2011 will have different purchasing power from the same dollars received at 2012

we have to discount future cash flows with appropriate discount rates

as future cash flows are also exposed to uncertainty, we calculate expected value of cash flows at each time in the future before discounting

Present Value of Investment

where CFi is the expected cash flow at future year i and DR a discount rate that reflects the risk of the investment

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Basic Idea

Net Present Value is the Present Value of an investment project, “net” of initial investment to start the project

positive NPV indicates that the present value of the cash flows of the project outweighs the necessary investments; a negative NPV indicates the opposite

Net Present Value of Investment

If NPV > 0 Invest; If NPV < 0 Do not invest.

If NPVi > NPVj Invest in i; If NPVi < NPVj Invest in j.

NPV

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Steps

Project value determining steps

1. Forecasting investment requirements and expected free cash flows from a project

2. Determining the rate at which to discount the cash flows from the project (cost of capital)

3. Using the discount rate to calculate the net present value (NPV) of the project

4. Performing sensitivity analysis

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Currency conversionForeign exchange terminology and economic relationships

spot rate

forward rate

for any two countries and any two periods, the expected change in the exchange rate is equal to the difference in nominal interest rates, which is equal to the expected difference in inflation rates

what happens if the equality does not hold? Currency arbitrage

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Revenues and costs in multiple currencies

Capital budgeting with multiple currencies – two approaches

Local currency NPV

• project value is primarily determined by the events within the host country

• revenues and costs occur primarily in local currency, when investment capital is raised locally and free cash flow is reinvested locally

• pros: don’t need to forecast exchange rates

• cons:

• local cost of capital can be severely distorted, especially due to hyperinflation or government’s interest rate manipulation

• when there is (dis) advantage against foreign firms accessing local financing, this approach can (over) undervalue the project, compared to local firms

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Capital budgeting with multiple currencies – two approaches

Period-by period conversion

• produce local currency projections, then convert the period-by period cash flows into home country currency using forward rates or projected exchange rates

• resulting home country cash flows are then discounted at a rate derived from the home country discount rate.

• pros: analyst can explicitly consider how shifts in the exchange rate affect project

• cons:

• few forward rates are available beyond one year

• forecasting can be complicated when local governments intervenes in credit or foreign exchange market

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Revenues and costs in multiple currencies

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Cost of capital

Intuitive definition

minimum return required from the projects invested by a company

average cost of financing a company

it is the minimum required rate of return on an investment project that keeps the present wealth of the shareholders constant

it is also a discount rate used to determine how favorable an investment project is

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Equity cost of capital

The Capital Asset Pricing Model (CAPM) is a practical way to estimate.

The cost of capital of any investment opportunity equals the expected return of available investments with the same beta.

The estimate is provided by the Security Market Line equation:

r

i=r

f+

i(E[R

Mkt]-r

f)

Risk Premium for Security i

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Example

Suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson &Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 4% and you estimate the market’s expected return to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a higher cost of equity capital?

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Market indexes

Report the value of a particular portfolio of securities.

Examples: S&P 500

• A value-weighted portfolio of the 500 largest U.S. stocks Wilshire 5000

• A value-weighted index of all U.S. stocks listed on the major stock exchanges

Dow Jones Industrial Average (DJIA)• A price weighted portfolio of 30 large industrial stocks

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Market portfolio

Most practitioners use the S&P 500 as the market proxy, even though it is not actually the market portfolio.

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Market risk premium

Determining the Risk-Free Rate The yield on U.S. Treasury securities Surveys suggest most practitioners use 10 to 30 year

treasuries Where to obtain?

The Historical Risk Premium Estimate the risk premium (E[RMkt]-rf) using the historical

average excess return of the market over the risk-free interest rate

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Historical Excess Returns of the S&P 500 Compared to One-Year and Ten-Year U.S.

Treasury Securities

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Beta estimation

Estimating Beta from Historical Returns Recall, beta is the expected percent change in the

excess return of the security for a 1% change in the excess return of the market portfolio.

Consider Cisco Systems stock and how it changes with the market portfolio.

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Monthly Returns for Cisco Stock and for the S&P 500, 1996–2009

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Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 1996–2009

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Beta estimation

Estimating Beta from Historical Returns As the scatterplot on the previous slide shows, Cisco

tends to be up when the market is up, and vice versa.

We can see that a 10% change in the market’s return corresponds to about a 20% change in Cisco’s return. • Thus, Cisco’s return moves about two for one with the

overall market, so Cisco’s beta is about 2.

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Beta estimation

Estimating Beta from Historical Returns

Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess returns versus the market excess return.

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Using linear regression

Linear Regression

The statistical technique that identifies the best-fitting line through a set of points.

• αi is the intercept term of the regression.

• βi(RMkt – rf) represents the sensitivity of the stock to market risk. When the market’s return increases by 1%, the security’s return increases by βi%.

• εi is the error term and represents the deviation from the best-fitting line and is zero on average.

(R

i r

f)

i

i(R

Mkt r

f)

i

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Using linear regression

Linear Regression Since E[εi] = 0:

• αi represents a risk-adjusted performance measure for the historical returns.

– If αi is positive, the stock has performed better than predicted by the CAPM.

– If αi is negative, the stock’s historical return is below the SML.

Distance above / below the SMLExpected return for from the SML

[ ] ( [ ] ) i f i Mkt f i

i

E R r E R r

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Using linear regression

Linear Regression

Given data for rf , Ri , and RMkt , statistical packages for linear regression can estimate βi.

• A regression for Cisco using the monthly returns for 1996–2009 indicates the estimated beta is 1.80.

• The estimate of Cisco’s alpha from the regression is 1.2%.

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Practical considerations, comparables approach

All-equity comparables Find an all-equity financed firm in a single line of

business that is comparable to the project. Complications

• there are few firms without debt• creates problems for both your company and finding

comparable companies

Leverage would increase your company’s cost of equity!

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Equity cost of capital

Leverage makes equity riskier

Debt Betas One can estimate the debt cost of capital using the

CAPM. Debt betas are difficult to estimate because corporate

bonds are traded infrequently. One approximation is to use estimates of betas of bond

indices by rating category.

)1)(/)(( cdUUL ED

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Average Debt Betas by Rating and Maturity

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Equity cost of capital

• We often assume that debt beta is zero• Levered equity beta is then

• Intuitively, beta of equity of a levered company is higher for more levered company

• Even further simplifications assume no tax shield effect

)1)(/( cUUL ED

)//( VEUL

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Industry Betas

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Debt cost of capital

Debt Yields Yield to maturity is the IRR an investor will earn from

holding the bond to maturity and receiving its promised payments.

If there is little risk the firm will default, yield to maturity is a reasonable estimate of investors’ expected rate of return.

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Financing and the Weighted Average Cost of Capital

How might the project’s cost of capital change if the firm uses leverage to finance the project?

Perfect capital markets In perfect capital markets, choice of financing does not

affect cost of capital or project NPV

Taxes – A Big Imperfection When interest payments on debt are tax deductible, the

net cost to the firm is given by: Effective after-tax interest rate = r(1-τC)

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Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC)

Given a target leverage ratio:

1wacc E D C

E Er = r + r ( -τ )

E+D E+D

wacc U C D

Dr =r - τ r

E+D

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Example

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Which factors influence β ? cyclicality of revenues, leverage low β firms : utilities, food retailers, low fixed cost firms, low levered firms high β firms : high tech or homebuilders why is β of homebuilder high? homebuilder’s revenue is more sensitive to business cycle why is β of low levered firm low?

firms with debt should make interest payments regardless of sales or profits

Notes on beta

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What is country risk? ability to service its debt and to support the conversion of local earnings into

home country currency

How to measure country risk? yield on sovereign debt debt yield reflects two risk factors

1) country risk

2) exchange risk

premium

Accounting for country risk

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How to measure cost of equity in EM? add country premium

Equity Cost of Capital = (Rf + country premium) + β·(Rm – Rf)

country premium of developing economies

Accounting for country risk