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International Finance
Lecture 11
Page 2
International Finance• Course topics
– Foundations of International Financial Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure– Financial Management for a
Multinational Firm
Page 3
Financial Management for a Multinational Firm
• Foreign direct investment• International Capital Structure, Cost of
Capital• International Capital Budgeting
Page 4
Cost of Capital• For a levered firm, the financing costs
can be represented by the weighted average cost of capital:
• K = (1 – )ke + (1 – )i
• Where K = ___________ average cost of capitalke = cost of equity capital for a levered firm
i = pretax cost of debt = % of debt, debt to total market value ratio = _____________ corporate income tax rate
Page 5
The Firm’s Investment Decision and the Cost of Capital• A firm that can
reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders.
• Internationalizing the firm’s cost of capital is one such policy.
cost
of
cap
ital
(%
)
Investment ($)
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Cost of Capital in Segmented vs. Integrated Markets
• The cost of equity capital (ke) of a firm is the expected return on the firm’s stock that investors require.
• This return is frequently estimated using the Capital Asset Pricing Model (CAPM):
)(company , fMifie RRβRk
)Var(
),Cov(
M
Mii R
RRβ where
Page 7
Segmented vs. Integrated Markets
• If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio.
)( CANfTSX
CANi
CANfi RRβRR
versus )( WorldfWorldMSCI
Worldi
Worldfi RRβRR
Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital.
Page 8
Does the Cost of Capital Differ among Countries?
• There do appear to be differences in the cost of capital in different countries.– Local rates for debt and equity capital may differ– Leverage ratio may differ across countries
• In US, Canada, UK leverage _____, on average• In Europe, Japan leverage _______, on average
• When markets are imperfect, international financing can lower the firm’s cost of capital.
• One way to achieve this is to internationalize the firm’s ownership structure.
Page 9
Example: Novo Industri
Page 10
Cross-Border Listings of Shares
• Cross-border listings of stocks have become quite _________ among major corporations.
• The largest contingent of foreign stocks are listed on the ___________ Stock Exchange.
• U.S. exchanges attracted the next largest contingent of foreign stocks.
Page 11
Cross-Border Listings of Shares
• Cross-border listings of stocks benefit a company in the following ways.– The company can ________ its potential
investor base, which will lead to a higher stock price and lower cost of capital.
– Cross-listing creates a _____________ market for the company’s shares, which facilitates raising new capital in foreign markets.
– Cross-listing can enhance the ____________ of the company’s stock.
– Cross-listing enhances the ___________ of the company’s name and its products in foreign marketplaces.
Page 12
Cross-Border Listings of Shares• Cross-border listings of stocks have
costs.– It can be ____________ to meet the
disclosure and listing requirements imposed by the foreign exchange and regulatory authorities.
– Once a company’s stock is traded in overseas markets, there can be volatility __________ from these markets.
– Once a company’s stock is make available to foreigners, they might acquire a ___________ interest and challenge the domestic control of the company.
Page 13
Cross-Border Listings of Shares
• Cross-border listings of stocks do carry costs.– Daimler Benz’s net profit/loss (DM bn)
German Vs American Accounting rules
Page 14
Cross-Border Listings of SharesSelected Foreign Firms listed on the NYSE
Page 15
The Effect of Foreign Equity Ownership Restrictions
• While companies have _______________ to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners.
• In some countries, there are legal ____________ on the percentage of a firm that foreigners can own.
• These restrictions are imposed as a means of ensuring domestic ___________ of local firms.
Page 16
Pricing-to-Market Phenomenon
• Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm.
• But they are constrained by ownership constraints imposed on foreigners to purchase at most 20 percent.
• Because this constraint is effective in ________ desired foreign ownership, foreign and domestic investors face different market share prices.
• This dual pricing is the pricing-to-market phenomenon.
Page 17
Foreign Ownership Restrictions: Nestlé
• Nestlé used to issue two different classes of common stock: bearer shares and registered shares.– Foreigners were only allowed to buy ______
shares.– Swiss citizens could buy ____________ shares.– The bearer stock was ____________________
• On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.
Page 18
Nestlé’s Foreign Ownership Restrictions
12,000
10,000
8,000
6,000
4,000
2,000
0
11 20 31 9 18 24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
SF
Page 19
Foreign Ownership Restrictions: Nestlé
• Following this, the price spread between the two types of shares ___________ dramatically.– This implies that there was a major
_______ of wealth from foreign shareholders to Swiss shareholders.
– The price of bearer shares declined about 25 percent.
– The price of registered shares rose by about 35 percent.
Page 20
Foreign Ownership Restrictions: Nestlé
• Because registered shares represented about two-thirds of the market capitalization, the total value of Nestlé ______________ substantially when it internationalized its ownership structure.
• Nestlé’s cost of capital therefore _________.
Page 21
Foreign Ownership Restrictions: Nestlé
• Foreigners holding Nestlé bearer shares were exposed to __________ risk in a country that is widely viewed as a haven from such risk.
• The Nestlé episode illustrates – The importance of considering market
imperfections. – The peril of political risk.– The benefits to the firm of
internationalizing its ownership structure.
Page 22
The Financial Structure of Subsidiaries.• There are three different approaches to
determining the subsidiary’s financial structure.
1. Conform to the parent company's norm.2. Conform to the local norm of the country
where the subsidiary operates.3. Vary judiciously to capitalize on
opportunities to lower taxes, reduce financing costs and risk, and take advantage of various market imperfections.
Page 23
Financial Management for a Multinational Firm
• Foreign direct investment• International Capital Structure, Cost of
Capital• International Capital Budgeting
Page 24
Review of Capital Budgeting
• The basic net present value equation is
01 )1()1(
CK
TV
K
CFNPV
TT
T
tt
t
Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow (terminal value) in year T, including return of net working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
Page 25
Review of Capital Budgeting
• Cash flow estimation
)1()1)(( τIDτIDOCRCF ttttttt
Rt is incremental revenueOCt is incremental operating cost Dt is incremental depreciationIt is incremental interest expense is the marginal tax rate
Page 26
Review of Capital Budgeting
• Various ways to represent CF
)1()1)(( τIDτIDOCRCF ttttttt )1( τIDNI ttt
ttt DτDτOCR )1)((
tt DτNOI )1(
ttt τDτOCR )1)((
tt τDτOCF )1(
Page 27
Review of Capital Budgeting
• We can usettt τDτOCFCF )1(
01 )1()1(
CK
TV
K
CFNPV
TT
T
tt
t
to rewrite the NPV equation
01 )1()1(
)1(C
K
TV
K
τDτOCFNPV
TT
T
tt
tt
as:
Page 28
The Adjusted Present Value Model
• Can be converted to adjusted present value (APV)
01 )1()1()1(
)1(C
K
TV
K
τD
K
τOCFNPV
TT
T
tt
tt
t
01 )1()1()1()1(
)1(C
K
TV
i
τI
i
τD
K
τOCFAPV
Tu
TT
tt
tt
tt
u
t
Page 29
The Adjusted Present Value Model
• The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually.
• Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.
0111 )1()1()1()1(
)1(C
K
TV
i
τI
i
τD
K
τOCFAPV
Tu
TT
tt
tT
tt
tT
tt
u
t
Page 30
Domestic APV Example
• Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are:
0 1 2 3 4
-$1,000 $125 $250 $375 $500
The unlevered cost of equity is r0 = 10%:
Page 31
Domestic APV Example
• Now, imagine that the firm finances the project with $600 of debt at r = 8%.
• Pearson’s tax rate is 40%, so they have an interest tax shield worth t×I = .40×$600×.08 = $19.20 each year.
The net present value of the project under leverage is:
shieldtaxunlevered PVNPVAPV
4
1 )08.01(
20.19$50.56$
tt
APV
Page 32
Domestic APV Example
• Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:
loanunlevered NPVNPVAPV
59.63$
)08.1(
600$
)08.1(
)4.1(08.600$600$
4
4
1
loan
ttloan
NPV
NPV
Page 33
Capital Budgeting from the Parent Firm’s Perspective• Donald Lessard (1985) developed an APV model
for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.
T
tt
d
ttT
ud
TT
T
tt
d
ttT
tt
d
ttT
tt
ud
tt
i
LPSCLSRFSCS
K
TVS
i
τIS
i
τDS
K
τOCFSAPV
1000000
111
)1()1(
)1()1()1(
)1(
Page 34
APV Example• A US-based International Diesel Corporation (IDS-US) is evaluating
whether to build a diesel engine plant in the UK (IDS-UK). The estimated project after tax operating cash flows in millions GBP are below.
YEAR
0 1 2 3 4 5 5+
-26.5 2.2 3.3 5.6 6.3 6.3 19.0
• The optimal capital structure is 80% equity and 20% debt. GBP is expected to depreciate by 2% per year vis-à-vis USD. Depreciation is 5 million GBP during first 5 years. Today's exchange rate is USD/GBP $2.00. The applicable marginal tax rate in the UK and US 40%, borrowing rate in USD is 8% and 10% in GBP, the unlevered cost of equity is 12%. IDS borrows in the US market to finance the project.
• Should IDS undertake the project?
Page 35
APV Example• Exchange rates. FX(t+1)=0.98*FX(t)
YEAR
0 1 2 3 4 5 5+
$2.00
• $ cash flows. $CF = FX(t) * GBP CF(t)
YEAR
0 1 2 3 4 5 5+
• Present value. Use CF and NPV worksheets.• Present value =
Page 36
APV Example• Depreciation tax shield = D(t) * tax * FX(t). PV @ 8% =
YEAR
0 1 2 3 4 5
n/a
• Interest write-off tax shield •
Page 37
Risk Adjustment in the Capital Budgeting Process
• Clearly risk and return are correlated.• ____________ risk may exist along side of
business risk, necessitating an adjustment in the discount rate.
– Systematic risk is reflected by Kud. Therefore, if a project is riskier than average firm’s project, __________ Kud, or if less risky, _________ Kud by 2-3% or so.
Page 38
Sensitivity Analysis
• In the APV model, each cash flow has a probability distribution associated with it.
• Hence, the realized value may be different from what was expected.
• In sensitivity analysis, ___________ estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.
Page 39
Real Options• The application of options pricing theory
to the evaluation of investment options in real projects is known as real options.– A timing option is an option on when to
make the investment.– A growth option is an option to increase
the scale of the investment.– A suspension option is an option to
temporarily cease production.– An abandonment option is an option to
quit the investment early.
