1. FOREIGN INVESTMENTFOREIGN INVESTMENT ANALYSISANALYSIS TWO METHODS OF INTERNATIONAL CAPITAL BUDGETING THE COST OF CAPITAL (COC), COC PARITY SOURCES OF INVESTMENT FUNDS SIGNIFICANCE OF SEGMENTED CAPITAL MARKETS

2. www.StudsPlanet.com 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 projects 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 doesnt preempt a more attractive project should be pursued. Generally, the source of financing is irrelevant to the investment decision. 3. www.StudsPlanet.com Upside to NPV Evaluates investment in the same manner as a companys shareholders. Focuses in on cash and not accounting profits Emphasizes the opportunity cost of the money invested. 4. www.StudsPlanet.com 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. 5. www.StudsPlanet.com 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. 6. www.StudsPlanet.com Cannibalization When a new product takes sales from a companys existing products. Sometimes difficult to assess the magnitude of cannibalization that will occur. 7. www.StudsPlanet.com Sales Creation The opposite of cannibalization. Same problem: Difficult to estimate. 8. www.StudsPlanet.com 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 9. www.StudsPlanet.com Competition Ignore it and youll lose. Key question to be asked! What will happen if we dont 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. 10. www.StudsPlanet.com Intangible Benefits Difficult to measure. Efficiency Brand Name Presence In Foreign Country Improved Supplier Networks 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 12. www.StudsPlanet.com 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 13. www.StudsPlanet.com 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 latters 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. 14. www.StudsPlanet.com What Explains Locational Patterns of FDI? What are some reasons certain countries are chosen over others as targets for multinational investment? 15. www.StudsPlanet.com 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 16. www.StudsPlanet.com 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?) 17. www.StudsPlanet.com 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. 18. www.StudsPlanet.com 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? 19. www.StudsPlanet.com Three Stage Approach Project cash flows are computed either from the subsidiarys standpoint and PV converted to home currency at spot rate or future values are converted to home currency and PV calculated from the parents 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. 20. www.StudsPlanet.com First Stage of this Approach Decentralized assessment: Project cash flows are computed from the subsidiarys standpoint (using the subsidiarys 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 parents standpoint (using the parents project- specific COC). 21. www.StudsPlanet.com 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. 22. www.StudsPlanet.com Political Risk You face risks you dont 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 firms stock.to induce investors to buy or hold the firms stock. 24. www.StudsPlanet.com 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? 25. www.StudsPlanet.com 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: 26. www.StudsPlanet.com 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 27. www.StudsPlanet.com 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 !! 28. www.StudsPlanet.com 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 29. www.StudsPlanet.com 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. 30. www.StudsPlanet.com 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: 32. www.StudsPlanet.com 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!! 33. www.StudsPlanet.com 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. 35. www.StudsPlanet.com 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? 36. www.StudsPlanet.com 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. 37. www.StudsPlanet.com 2) Using an adjusted domestic proxy Problems: ->Industries might have higher correlation than markets ->Should there be an additional risk premium for country risk.? 38. www.StudsPlanet.com Country specific risk 39. www.StudsPlanet.com 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. 40. www.StudsPlanet.com Which risk premium to use! The US market has the best data! 41. www.StudsPlanet.com 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. 42. www.StudsPlanet.com 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! 43. Cost of DebtCost of Debt 44. www.StudsPlanet.com 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 45. www.StudsPlanet.com Cost of Debt - International Scenario Use of Sovereign Risk Spreads Cost of Debt = Treasury bond yield + the country risk premium 46. www.StudsPlanet.com 47. Capital Structure ofCapital Structure of Multinational CorporationMultinational Corporation and its Foreign Affiliatesand its Foreign Affiliates 48. www.StudsPlanet.com 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 49. World Capital StructureWorld Capital Structure 50. www.StudsPlanet.com 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 MNCs cost of capital. 51. www.StudsPlanet.com 52. www.StudsPlanet.com 53. www.StudsPlanet.com 54. www.StudsPlanet.com Political Risk Management Currency Risk Management 55. www.StudsPlanet.com Leverage and foreign tax credits Leasing and Tax credits 56. www.StudsPlanet.com Joint Ventures 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 58. www.StudsPlanet.com 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 59. www.StudsPlanet.com 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 60. www.StudsPlanet.com 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 61. www.StudsPlanet.com 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 62. www.StudsPlanet.com 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 63. www.StudsPlanet.com 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. 64. www.StudsPlanet.com 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. 65. www.StudsPlanet.com 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. 66. www.StudsPlanet.com 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). 67. www.StudsPlanet.com 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. 68. www.StudsPlanet.com 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. 69. www.StudsPlanet.com 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). 70. www.StudsPlanet.com 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. 71. www.StudsPlanet.com 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. 72. www.StudsPlanet.com 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. 73. www.StudsPlanet.com 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. 74. www.StudsPlanet.com THE EUROMARKETS I. THE EUROCURRENCY MARKETS II. EUROBONDS III.NOTE ISSUANCE FACILITIES AND EURONOTES IV.EUOR COMMERCIAL PAPER 75. www.StudsPlanet.com 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$ 76. www.StudsPlanet.com 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. 77. www.StudsPlanet.com Eurodollar Creation involves 1. A chain of deposits 2. Changing control/usage of deposit 78. www.StudsPlanet.com 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. 79. www.StudsPlanet.com Multi-currency Clauses a. Clause gives borrower option to switch currency of loan at rollover. b. Reduces exchange rate risk 80. www.StudsPlanet.com Domestic vs. Eurocurrency Markets 1. Closely linked rates by arbitrage 2. Euro rates: tend to lower lending, higher deposit 81. www.StudsPlanet.com 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 82. www.StudsPlanet.com 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: Moodys, Standard & Poor 8. Rationale For Market Existence a. Eurobonds avoid government regulation b. May fade as financial markets deregulate 83. www.StudsPlanet.com 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 84. www.StudsPlanet.com Note Issuance Facility (NIF) 1. Low-cost substitute for loan 2. Allows borrowers to issue own notes 3. Placed/distributed by banks 85. www.StudsPlanet.com NIFs vs. Eurobonds 1. Differences: a. Notes draw down credit as needed b. Notes let owners determine timing c. Notes must be held to maturity 86. www.StudsPlanet.com 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.