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Net Present Value (NPV)
• NPV is the present value of future cash flows
minus the initial net cash outlay for the project
discounted at the project’s cost of capital.
• Assuming the goal of maximizing shareholder
wealth, any project with a positive NPV that cannot
be delayed or can be undone (at low or no cost) and
that doesn’t preempt a more attractive project
should be pursued.
• Generally, the source of financing is irrelevant to
the investment decision.
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Upside to NPV
• Evaluates investment in the same manner as
a company’s shareholders.
– Focuses in on cash and not accounting profits
– Emphasizes the opportunity cost of the money
invested.
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Downside to NPV
• The project with highest NPV may also
consume the most resources.
• Therefore, you should look to the best
combination of positive NPV projects that
yield the highest NPV given your
investment constraints.
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Difficulties with NPV
• Estimating cash flows.
– The cost of the project
– The cash inflows during the life of the project
(especially hard where there are relevant
spillovers -- cannibalization or sales creation)
– The terminal or ending values of the project.
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Cannibalization
• When a new product takes sales from a
company’s existing products.
– Sometimes difficult to assess the magnitude of
cannibalization that will occur.
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Opportunity Cost
• Project costs must include the true
economic cost of any resource required for
the project.
– Example: IBM in Brazil
• Transfer Pricing
– The prices at which goods and services are
traded internally within an organization.
– Example: Ford motors
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Competition
• Ignore it and you’ll lose.
• Key question to be asked!
– What will happen if we don’t make this
investment?
• The rule is simple:
– If you must be the victim of a cannibal, make
sure the cannibal is a member of your family.
11. CAPITAL BUDGETING FORCAPITAL BUDGETING FOR
THE MULTINATIONALTHE MULTINATIONAL
CORPORATIONCORPORATION
Multinational corporations have more
opportunities but also face many
problems that domestic businesses do
not have to worry about
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Why FDI over Portfolio or
Intermediated Investment?
For FDI to be considered, the foreign investor must
view: r*FDI> r*PI,II
From the perspective of the host country, it must be
the case that:
r*FDI> r*localinvestment
But these inequalities are the same, since local
investors will equate:
r*PI,II = r*local investment
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What Makes the Return on FDI
greater than that on PI or II?
In other words, how do foreign corporations
outperform domestic ones on the latter’s home turf?
Especially considering the foreign firm must incur
additional costs of travel, communication, and monitoring...
...and the foreign firm must contend with unfamiliar legal,
distributing, and accounting systems.
Thus, an understanding of FDI must identify what
‘overcompensating advantage’ a foreign firm has
over domestic competition, making returns to FDI
greater than those to Portfolio or Intermediated
Investment.
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What Explains Locational Patterns of
FDI?
1. Labor costs
2. Access to resources
3. Government policies
4. Expanding markets/transport costs
5. Currency values
6. Tax advantages
7. Investment climates
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What Explains Locational Patterns of
FDI?
1. Labor costs (home or foreign? make or buy? Where?)
2. Access to resources (where?)
3. Government policies (where?)
4. Expanding markets/transport costs (how?)
5. Currency values (home or foreign? What?)
6. Tax advantages (home or foreign? Where? What?)
7. Investment climates (where?)
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Growth Options
• Growth Options vary in value depending on:
– The length of time the project can be deferred. The
more time increases odds of a positive turn of events.
– The risk of the project. The riskier the project the more
valuable the option is.
– The level of interest rates. High interest rates generally
raise the value of options because of the reduction of
the present value of the cash outlay needed to exercise
an option.
– The proprietary nature of the option. The greater the
percentage of ownership the more valuable to the
owner.
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Issues in Foreign Investment
Analysis
• Should cash flows be measured from the
viewpoint of the subsidiary or that of the
parent?
• Should the additional economic and
political risks that are uniquely foreign be
reflected in cash-flow or discount-rate
adjustments?
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Three Stage Approach
• Project cash flows are computed either from the
subsidiary’s standpoint and PV converted to home
currency at spot rate or future values are converted
to home currency and PV calculated from the
parent’s standpoint.
• The indirect benefits and costs that the investment
confers on the rest of the system are accounted for.
• Headquarters determines amounts, timing, and
form of actual transfers and tax payments.
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First Stage of this Approach
• Decentralized assessment: Project cash flows are
computed from the subsidiary’s standpoint (using
the subsidiary’s project-specific COC) to PV,
which is converted to home currency at spot rate
• Centralized assessment: Future project cash flows
are converted to home currency at the expected
exchange rates and PV calculated from the
parent’s standpoint (using the parent’s project-
specific COC).
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Political & Economic Risk Analysis
• The three main methods for incorporating
additional Political and Economic Risk
– Shortening the minimum payback period.
– Raising the required rate of return
(Note: Our former colleague, Professor Marc Choate,
claimed there is some curse that befalls all managers
who choose this option.)
– Adjusting cash flows to reflect the specific
impact of a given risk.
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Political Risk
• You face risks you don’t even know about.
• Expropriation – Where a government seizes
your assets.
• Blocked Funds – Where a government
changes exchange controls.
23. Cost of capitalCost of capital
the minimum (required) rate of return necessarythe minimum (required) rate of return necessary
to induce investors to buy or hold the firm’s stock.to induce investors to buy or hold the firm’s stock.
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Is it different where foreign
investments are concerned?
• Cost of capital needed to calculate NPV!
• Foreign Investments:
– Opportunity for further diversification!
– But also further risk exposure – country
specific risk.
– The question is: how do we measure country
specific risk?
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Traditionally:
• CAPM Assumes:
COCi = Ri + Bi (RM-Ri)
– Where Bi = Cov(COCi,RM)/var[RM ]
Assumptions:
All the traditional – risk adverse investors,
equilibrium, perfect markets etc. But in this
context the most important is:
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All unsystematic risk is
diversifiable
• Risk is measured by the standard deviation
and we assume the following
decomposition is possible:
• Risk = systematic risk + unsystematic risk
Variations explained by
variations in the market
Variations not explained by
variations in the market – e.g.
industry specific risk.
That this is diversifiable means
CAPM assumes it is zero
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How do you diversify?
There are two ways:
1) increase the variety of assets in a
portfolio
2) choose the right mix or variety of
assets !!
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How can overall risk change?
• Example:
• If the number of investment opportunities
increases -> increased diversification
opportunities ->
– Expected returns and project specific risk are
unchanged, but
– -> less risky in CAPM terminology
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Important!!
• The beta we need is the project beta
reflecting the risk of the project not the beta
of the company reflecting the risk of the
entire firm.
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WACC
• Is the discount factor! It is calculated as a
weighted average of cost of debt and the cost of
equity using the ratios of the market values of debt
and equity to the total firm value as weights.
• -> This is how we evaluate domestic
investments!!! -> We now expand this to
evaluating foreign investments as well.
31. Discount rate for foreignDiscount rate for foreign
investmentsinvestments
First a little intuition:
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Intuition using S&P as the
market PF
The two effects:
->Naturally the correlation between returns on foreign
investments and S&P are less than for domestic
investments -> suggesting lower B s
-> Project specific risk might also vary between countries
-> can have both a positive and negative effect.
However often country specific risk is unsystematic
risk -> diversifiable!!
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Important assumption:
• MNCs have better diversification
opportunities than their shareholders.
Otherwise the share holders could just as
well do the diversification.
• Supported empirically by investors’ home
bias!
34. Estimating foreign projectEstimating foreign project
discount rates.discount rates.
Key: Historical data to estimate the betas
are not available.
-> We need some kind of proxy firm.
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The key questions about the proxy
firm!
1) Should the proxy firm be domestic or
foreign?
2) What should be used for the market
portfolio
3) which market should the premium be based
on?
4) How do we measure country risk?
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3 methods for estimating proxy betas
1) Use a local company beta.
• Problem: Such a company (industry) might
not exist and at least not with the necessary
historic data.
• However, this is the optimal choice, if it is
possible.
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2) Using an adjusted domestic proxy
Problems:
->Industries might have higher correlation
than markets
->Should there be an additional risk
premium for country risk….?
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3) The Global CAPM
• Instead of using foreign/domestic market
portfolios use a global market portfolio!
• This is a good choice if you look at the world as
one market!
• The problem is that you assume implicitly that
stock holders hold well diversified portfolios not
just domestic but global. This is not empirically
supported.
• If GCAPM is used for foreign investments it
should also be used for domestic investments.
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The final model.
Ri = Rf + risk premium ·Bi + (add. premium)
observed
Constructed from historic data
– assumed constant in the
long run
1) B local proxy
2) R local proxy · B country
3) GCAPM
Many Suggestions. e.g. the
difference between the domestic
and the foreign interest rate.
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A comment on the additional
premium
• Instead of adjusting the discount rate, treat
the investment like a real option: add more
scenarios, which will change the expected
cash flows!
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Cost of Debt - Basic Concepts
• Debt Traded in the Market
Price = Ct/(1+Kd)t
• Debt Not traded in the Market
YTM of US treasury + Prevailing spread
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Cost of Debt - International Scenario
• Use of Sovereign Risk Spreads
Cost of Debt = Treasury bond yield +
the country risk premium
47. Capital Structure ofCapital Structure of
Multinational CorporationMultinational Corporation
and its Foreign Affiliatesand its Foreign Affiliates
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Capital Structure - Domestic
Theories
• M&M Corporate Tax Model
• Agency Cost of Under Investment
• Static Trade off Model
• Types of Companies
• Jensen theory of Agency cost of Free Cash Flows
• Theory of Managerial behavior, agency cost and capital
structure
• Pecking Order Theory
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Capital Structure of Foreign
Affiliates
• Conform to the capital structure of Parent
Company.
• Reflect the capitalization norm of each
foreign country
• Vary to take advantage of opportunities to
minimize the MNC’s cost of capital.
57. INTERNATIONAL FINANCINGINTERNATIONAL FINANCING
AND NATIONAL FINANCIALAND NATIONAL FINANCIAL
MARKETSMARKETS
• Financial markets are increasingly global
• Old kinds of debt are being made into
new kinds of securities
• The distinction between commercial and
investment banks is breaking down
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Globalization of Financial Firms
• 1960s: Banks develop global branch networks for
loans, payments, clearings, and foreign exchange
trading
• 1970-80s: Securities firms operate abroad, first in
London with Eurobond market, then other markets,
Tokyo, Hong Kong, and Singapore; foreign
commercial banks and securities houses expand to
the United States
• Now: To thrive in any leading financial markets, a
firm must have a significant presence in them all
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Securitization
Twenty years ago, commercial banks handle
most short- and medium-term financing
Now corporations borrow low-cost funds
directly from lenders, primarily in the form
of commercial paper marketed by
investment banks rather than by commercial
banks
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Diminished Distinctions among
Kinds of Financial Firms
• Firms want to be in all profitable product lines and
have flexibility to shift to more promising ones
• In US & Japan, law separates commercial banking
from investment banking
• Commercial banking less profitable than some
kinds of investment banking -- commercial banks
have circumvent prohibition
• Investment banks encroach upon commercial
banks’ traditional areas of activity -- money
market mutual funds drew billions of dollars from
banks in the late 1970s and early 1980s
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Financing Practices among
Countries Have Consequences
Differences in the role
of banks and
permissible banking
activities
» Differences in national
financing patterns
» Differences in profitability and growth
among national firms
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Convergence of Financing
Practices among Countries
Convergence in the role
of banks and
permissible banking
activities
» Convergence in
national financing
patterns
» Convergence in profitability and growth
among national firms
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What are the basic differences between the
financing practices of US and Japanese firms?
What might account for these differences?
Answer. The two main differences are: 1. Source of
financing -- internal versus external; 2. Composition of
external finance -- bank borrowing versus debt securities.
Historically, U.S. companies have received 60% to 70% of
funds from internal sources. Japanese companies have
relied heavily on external funds to finance a strategy of of
massive investment and pursuit of market share -- often at
the expense of profitability.
Japanese firms also rely heavily on bank borrowing, while
U.S. firms raise more money directly from financial
markets by the sale of securities.
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What is securitization?
Answer. Instead of raising money in the form of
non-marketable loans, securitization means selling
negotiable instruments directly to savers
. By contrast, financial intermediation involves the use of financial institutions
such as banks and thrifts to bring together borrowers and savers. These
institutions make a large number of loans and fund them by issuing liabilities
(e.g., deposits) in their own name.
Securitization reflects reductions in the cost of using
financial markets and increases in the cost of bank
borrowing.
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Why is bank lending on the decline worldwide?
Answer.
(1) Banks face higher capital requirements and,
therefore, costs.
(2) Banks have responded to greater interest rate
volatility by cutting back on loan commitments,
thereby reducing the value of a banking
relationship to corporate customers.
(3) Banks have moved away from relationship
lending making them more vulnerable to adverse
selection.
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How have banks responded to their loss of
market share?
Answer. Banks have responded to their loss of market share
by eliminating unprofitable aspects of the traditional
lending (retention of loans on the balance sheet) while
retaining the element crucial to the borrower (access to
funds). Thus origination of loans for sale has emerged as a
new business line.
Banks have also expanded nonlending services that produce
fee income and are not (yet) covered by capital
requirements: underwriting commercial paper, foreign
exchange trading, arranging swaps, advising on mergers
and acquisitions, and issuing letters of credit and debt
guarantees (credit enhancement).
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What is meant by the globalization of
financial markets?
Answer. Globalization integrates national financial
markets across space and time, thereby
eliminating barriers that separate domestic from
foreign capital markets. The process is driven by
investors seeking the best combination of risk and
return for their money and by companies trying to
get it for the best terms and conditions.
It will be complete only when the price of risk and
the time value of money are identical worldwide.
Markets for US government securities and certain stocks, foreign exchange
trading, inter-bank borrowing and lending -- to cite a few examples -- already
operate around the clock and the world.
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How has technology affected the process of
globalization?
Answer. Improvements in such areas as data
manipulation and telecommunications have
greatly reduced the costs of gathering, processing,
and acting on information from anywhere in the
world.
This has facilitated the process of arbitrage across
financial markets, which has brought prices of
securities with similar risks and returns closer in
line with each other and turned the world into a
much more interconnected market.
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How has globalization affected government
regulation of national capital markets?
Answer. National systems of supervision and regulation were
not designed for a worldwide marketplace. Governments
that restrict domestic financial institutions will often
provide foreign firms with a competitive advantage.
Similarly, restrictions on domestic financial markets will
often drive business overseas. The net result will be
increased pressure for loosening controls on domestic
financial institutions and markets to enable them to be
more competitive, which will tend to speed the process of
financial deregulation (with respect to entry and pricing
and choice of business partners).
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Bond owners and traders today have an
enormous collective influence over a nation's
economic policies, why?
Answer. Bond owners and traders influence
national access to capital markets. To the
extent that a nation requires this access (and
most do, at least at some point in time), this
exerts a strong disciplinary effect on the
types of economic policies a nation is likely
to select. A policy perceived as being
economically harmful will restrict the
nation's access to capital on favorable
terms.
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Why are large multinational corporations located
in small countries (Sweden, Holland, Switzerland)
interested in developing a global investor base?
Answer. Large MNCS located in these small
countries need to raise substantial amounts of
capital to grow. Often, the domestic market cannot
provide this amount of capital on reasonable terms
(portfolio theory). Borrowing abroad means a
lower cost of capital for these MNCs (and hence a
higher market value).
In addition, developing a global investor base gives
them access to capital when events (most likely
political) restrict the ability of MNCs to raise
capital locally regardless of price.
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Why are many U.S. multinationals listing their
shares on foreign stock exchanges?
Answers.
• Diversification of equity funding risk: A pool of funds
from a diversified shareholder base insulates a company
from the vagaries of a single national market.
• Increase stock price: By selling stock overseas, a company
can expand its investor base, thereby lowering its cost of
equity capital and increasing its market value.
• Boost foreign sales: An international stock offering can
spread the firm's name in local markets and increase its
sales overseas.
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Many governments withhold income taxes on interest payments,
returning them to foreigners where they have double-taxation
treaties with the foreigners’ governments. Often, however, repayment
is delayed. What are the likely consequences of eliminating
withholding from interest payments to foreigners under such
circumstances?
Answer. This actually happened in Portugal. The OECD reports that
Portugal discovered that charging foreigners withholding tax on
interest payments due on government bonds deterred them from
buying its debt rather than bringing in more revenues, thereby raising
its cost of capital.
The fact that foreign investors had to wait so long to claim back a portion
of the tax led them to price Portugal's debt as if they had to pay all of
the tax.
Moreover, because bond markets that charge foreigners withholding tax
tend to be less liquid, investors demanded an extra premium. The
higher interest rates that Portugal had to pay more than offset its
income from withholding tax.
After scrapping its withholding tax, the yield spread between 10-year
Portuguese government bonds and corresponding German government
bonds narrowed significantly.
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THE EUROCURRENCY
MARKETS
The most important international financial
markets today
A.The Eurocurrency Market
1. Created after WWII
2. Composed of eurobanks who
accept/maintain deposits of foreign
currency
3. Dominant currency: US$
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Growth of Eurodollar Market
Caused by restrictive US government policies,
especially
1. Reserve requirements on deposits
2. Special charges and taxes
3. Required concessionary loan rates
4. Interest rate ceilings
5. Rules which restrict bank competition.
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Eurocurrency loans
a. Use London Interbank Offer Rate [LIBOR] as
basic rate
b. Six month rollovers
c. Risk indicator: size of margin between cost
and rate charged.
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DEFINITION OF EUROBONDS
Bonds sold outside the country of currency denomination.
1. Recent Substantial Market Growth -- due to use of swaps
[a financial instrument which gives 2 parties the right to
exchange streams of income over time.]
2. Links to Domestic Bond Markets -- arbitrage has
eliminated interest rate differential.
3. Placement underwritten by syndicates of banks
4. Currency Denomination
a. Most often US$
b. “Cocktails” allow a basket of currencies
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EUROBONDS (cont.)
5. Eurobond Secondary Market -- result of rising
investor demand
6. Retirement
a. sinking fund usually
b. some carry call provisions
7. Ratings
a. According to relative risk
b. Rating Agencies: Moody’s, Standard & Poor
8. Rationale For Market Existence
a. Eurobonds avoid government regulation
b. May fade as financial markets deregulate
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Eurobond vs. Eurocurrency Loans
1. Five Differences
a. Eurocurrency loans use variable
rates
b. Loans have shorter maturities
c. Bonds have greater volume
d. Loans have greater flexibility
e. Loans obtained faster
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SHORT-TERM FINANCING
A. Euronotes and Euro-Commercial Paper
1. Euronotes
» Unsecured short-term debt securities denominated in
US$ and issued by corporations and governments.
2. Euro-commercial paper(CP)
» Euronotes not bank underwritten
B. U.S. vs. Euro-CPs
1. Average maturity longer (2x) for Euro-CPs
2. Secondary market for Euro; not U.S. CPs.
3. Smaller fraction of Euro use credit rating services to rate.
Editor's Notes
1
discounted at the project’s cost of capital. Any project with a positive NPV is a possibility. Actually, theory says that any time you are confronted with a project offering positive NPV, you should grab it, as long as that project does not preclude a more attractive option. There are two further considerations, of course: delayability and irreversibility. If a project is a now or never choice and NPV is positive or if it can be costlessly undone down the road, you should invest now. If not, you should consider the value of retaining the option of investing later. NPV is simple to use even for those who might not be so good with numbers. Interesting observation; how come critic of continuous budgeting in public sector claim it is too hard for politicians to understand?
Management can only handle so many projects Liquidity and solvency constraints.
Makes us aware of our ignorance or uncertainty and the need to take it into consideration. Getting your cash flows right are the most important problem in capital budgeting. What some of the states of nature might be…..best case or lucky, moderately lucky, we go down in flames… Not a lot of difference between foreign and domestic but with domestic you have less variables. The more projects the more likely your cost of capital will go up….banks will often notice that you are over stretched before you do.
When Honda introduced Acura some customers switched from Honda to Acura
Example: Suppose IBM decides to build a new office building in Sao Paulo on land it bought 10 years ago. IBM must include the cost of the land in calculating the value of undertaking the project based on the current market value of the land, not the price it paid 10 years ago. Example: Ford raises the price of engines from the U.S. plant it increases profitability of the engine plant. But when it sells the engines to its English affiliate, the English affiliate’s profits decline. Move to opportunity cost slide!!!
Examples: GM small cars Kodak – Film Zenith – Televisions They thought overseas expansion was too risky or unattractive and the next thing they knew their domestic position was eroding.
Example: Investing in Japan makes you tough. Don’t leave intangibles out of the analysis, either up or down, but if they matter the right number is not 0. Accountants do this a lot and should be flogged for this mistake.
Problems that domestic firms do not have to worry about: Differences between local branch or subsidiary and parent company cash flows, foreign tax regulations, expropriation, blocked funds, exchange rate and inflation Project-specific financing and differences between the basic business risks of foreign and domestic projects.
Standpoint of sub means local cost of capital
Standpoint of sub means local cost of capital
Do political risks violate assumption of ergodicity? Can you diversify them away? Buy insurance?
