International Financial Management

P G Apte

The Eclectic Paradigm:The why, where and how of the

MNC

Why Ownership-specific (O) advantages

Where Location-specific (L) advantages

How Market internalization (I) advantages

Ownership-specific (O) advantages

The why of the multinational corporation

• Ownership-specific (O) advantages are brand names, patents, copyrights, proprietary technology or technological processes, and marketing and management expertise

• Ownership-specific advantages can lead to sustainable competitive advantages

Location-specific (L) advantagesThe where of the multinational

corporation

• Location-specific (L) advantages include location-specific natural resources, man-made resources, low taxes, low wage costs, high labor productivity, or state-supported monopolies

• Location-specific advantages can lead to sustainable competitive advantages

Market internalization (I) advantages

The how of the multinational corporation

• Ownership-specific and location-specific advantages by themselves are not sufficient to ensure the success of the multinational corporation over local firms

• Market internalization (I) advantages accrue to the multinational corporation as it exploits its ownership- specific advantages in local and international markets

The life cycle of the multinational corporation

• Infancy: developing ownership-specific advantages

• Growth: seeking new markets

• Maturity: milking the cash cow– defensive strategies to preserve revenues– defensive strategies to reduce operating costs– financial considerations

• Decline? or Renewal?

Introduction• Why can’t the local reproduce or nullify the ownership- specific or location-specific advantages of MNCs?

• Many activities are internalized within a firm and carried out within the framework of internal contractual arrangements rather than by means of contracts with independent external agents.

• Through vertical integration, exclusive supply contracts, patents and copyrights MNCs attempt to protect their proprietary technologies or access to cheap, high-quality inputs.

• The sheer scale of their operations and ability to centralize many tasks allow them to achieve scale economies which their smaller local competitors cannot avail of

• MNCs can minimize tax burden by means of transfer pricing and location in tax havens

Foreign market entry

• Export entry– agents/distributors (foreign or domestic)– foreign sales branches and subsidiaries

• Contract-based entry– licensing and franchising

• Investment-based entry– foreign direct investments– cross-border mergers and acquisitions– joint ventures

Investment-based entry• Foreign direct investment

– relatively slow entry– maintains control over production, distribution, and

intellectual property

• Cross-border mergers and acquisitions– relatively rapid entry– price of entry (acquisition premium) can be high

• Cross-border joint ventures– may avoid investment restrictions– less exposure to political/cultural risks– risk losing control of intellectual properties– risk creating a competitor

• Since foreign direct investment is the most important avenue for achieving multinational presence, it is important to understand how MNCs might be evaluating such investment proposals – sole ownership as well as joint ventures

• The NPV based approach to project appraisal has to be extended to projects based outside the firm’s own country.

Review of the NPV Approach

• The well known Net Present Value (NPV) formula widely used in evaluating domestic investment projects

)k + (1

CF + C - = NPVw

tt

T=t

1=t0

C0: Initial capital cost; CFt : Periodic cash flows

kw : Weighted average cost of capital defined by

kw = ke + (1-)(1 - )kd

Where ke is cost of equity capital, kd cost of debt capital, the

proportion of equity in project funding and c the tax rate

Review of the NPV Approach

There are two implicit assumptions.

(1) The project being appraised has the same business risk as the portfolio of the firm's current activities

(2) The debt:equity proportion in financing the project is same as the firm's existing debt:equity ratio.

An alternative formula for cost of capital allows for differences in the debt:equity ratio :

kw = ke(1-) where ke is the "all equity" required rate of

return reflecting the project's business risk.

If the project's business risk differs from the existing portfolio of projects, one must estimate the project's beta and the required "all equity" return from some version of CAPM

 

Cost of Capital for MNCs

• The cost of capital for MNCs may differ from that for domestic firms because of the following differences.

Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors. They can usually achieve smaller per unit flotation costs too.

Acess to International Capital Markets. MNCs are normally able to obtain funds through international capital markets, where the cost of funds may be lower.

International Diversification. M NCs may have more stable cash inflows due to international diversification, such that their probability of bankruptcy may be lower.

Cost of Capital for MNCs

Exposure to Exchange Rate Risk. MNCs may be more exposed to exchange rate fluctuations, such that their cash flows may be more uncertain and their probability of bankruptcy higher.

Exposure to Country Risk. M NCs that have a higher percentage of assets invested in foreign countries are more exposed to country risk.

Cost of Capital for MNCs

Cost of Capital for MNCs

Possible access to low-

cost foreign financing

Preferential treatment from

creditorsGreater access to international capital markets

Larger size

International diversification

Exposure to exchange rate

risk

Exposure to country risk

Cost of capital

Probability of bankruptcy

THE ADJUSTED PRESENT VALUE (APV) FRAMEWORK

(1) In the first step, evaluate the project as if it is financed entirely by equity. The rate of discount is the required rate of return on equity corresponding to the risk class of the project.

 (2) In the second step, add the present values of any cashflows arising out of special financing features of the project such as external financing, special subsidies if any and so forth. The rate of discount used to find these present values should reflect the risk associated with each of the cash flows.

(3) Tax benefits of debt:

Additional borrowing capacity : B = TDEGPV

Tax savings : (RD )B = (RD )(TDE GPV)

RD : Pre-tax Cost of Debt : Tax Rate

Discount using RD

The APV Approach Add PV of any other cash flows on account of subsidies,

concessional finance etc.

Two assumptions:

(1) Firm will be able to utilize the interest tax shield fully in every year. If not, carrying it forward involves loss of time value

(2) The benefit of tax shield is fully appropriated by the firm i.e. by the shareholders

In general, the calculation of the interest tax shield as presented here probably represents an overestimate of the true benefit from added borrowing capacity.

Cross-Border Projects

The main added complications which distinguish a foreign project from a domestic project can be summarized as follows :

Exchange Risk and Capital Market Segmentation

Political or "Country" Risk

International Taxation

Blocked Funds

In addition, like in domestic projects, we must be careful to take account of any interactions between the new project and some existing activities of the firm - e.g. local production will usually mean loss of export sales.

The APV Approach for Cross-Border Projects

1. First treat the project as a branch operation of the parent company. All the cash flows generated by the project belong by definition to the parent since the project has no distinct identity. This allows us to focus on the pure economics of the project.

 2. Next, consider the project as a fully equity financed, wholly owned subsidiary of the parent, incorporated under the host country laws, having a distinct legal identity. Now we focus on the various financial arrangements between the parent and the subsidiary and consider what means are available to the parent to increase the cashflow transfers between the subsidiary and the parent and minimise the overall tax burden.

 3. Finally, as in the case of a domestic project, incorporate the effects of external financing such as the interest tax shield.

Valuing Foreign Currency Cash-Flows

First consider the problem of valuing risk-free cash flows in foreign currency. There are three possible methods :

(1) Find the present value of the cashflows in terms of foreign currency and translate at today's spot rate. Thus if FCFt is the

cashflow at time t and rF is the risk-free foreign currency

discount rate, the home currency PV is

  [FCFt/(1+rF)t]S0

(2) Translate each cashflow FCFt at the forward rate F0,t and

discount at the home currency risk-free discount rate. The PV is given by

  (F0,t)(FCFt)/(1+rH)t

 

Valuing Foreign Currency Cashflows

(3) Translate at the expected spot rate E0(St) and discount at a

home currency discount rate that reflects exchange risk

E0 (St)](FCFt)/(1+rH)t

All the three methods would yield identical results if the home and host country capital and money markets are free and integrated When the markets are segmented (1) and (2) cannot be used. It may happen that a project which is financially viable when evaluated from the local point of view is not acceptable from the parent point of view or vice versa – a project may not be viable from the local point of view but appears acceptable from the parent point of view.

Example

(a) Consider first the case where global capital markets are fully integrated, investors are risk neutral and all the parity conditions – Purchasing Power Parity (PPP), Covered Interest Parity (CIP) and Uncovered Interest Parity (UIP) – hold continuously. Suppose an Indian firm is considering a project in Shangrila with the following cash flows measured in Shangrila dollars (SGD) million

Year 0 1 2

Cash Flow -50 40 60

 Suppose the risk free real rates in India and Shangrila are 5% p.a., the inflation rate in India is 5% p.a. while inflation in Shangrila is 10% p.a. The nominal risk free rates are 10.25% in India and 15.50% in Shangrila.

Example …

The current SGD/INR exchange rate is 0.2000 (i.e. 5.00 SGD per INR) while the one and two year forward rates are 0.1909 and 0.1822. These in turn equal the spot rates expected at the end of year 1 and 2 respectively. The project evaluated from a local point of view yields an NPV of

 SGD {-50 + (40.0/1.1550) + [60.0/(1.1550)2] } million

= SGD 29.61 million

 Translated into parent currency using the current spot rate this gives an NPV of INR 5.92 million.

Now translate SGD cash flows into their INR equivalent using the appropriate forward rates which also equal the expected spot rate at the relevant time and discount these using the risk free nominal rate in India.

Example …

This yields an NPV of

 { (-50.0/5.0) + [(40.0 0.1909)/(1.1025)]

+ [(60.0 0.1822)/(1.1025)2]}

= INR 5.92 million

 This shows that when global capital markets are perfectly integrated and all the parity conditions are satisfied, evaluation of projects can be done from either local or parent perspective.

Example …

(b) Now consider the case when there are capital controls in place which segment the international capital markets. In particular, suppose the government of Shangrila has imposed capital controls which raise the real rate of interest in Shangrila. The inflation rates in India and Shangrila are, as before, 5% and 10% p.a., the real risk free rate in India is 5% but that in Shangrila is 10%. The risk free nominal rates are therefore 10.25% in India and 26.50% in Shangrila. The forward rates are 0.1743 and 0.1519. However, due to capital controls and intervention on the part of Shangrila’s central bank the SGD is expected to remain at 0.20 INR. Consider a project in Shangrila with the following net cash flows (SGD Million):

  Year 0 1 2

  -50 30 40

Example …

Using a discount rate of 26.50%, the NPV of these cash flows is {-50 + (30/1.2650) + [40/(1.2650)2]}m SGD = -1.29m SGD

Now translate these SGD cash flows into their INR equivalents using the expected spot rate of 0.20 INR per SGD through the life of the project and discount the resulting INR cash flows using a discount rate of 10.25%. The cash flows are ( -10, 6, 8) million INR and the NPV is INR 2.02 million. Thus it appears that the project is acceptable from parent perspective.

Is this a correct conclusion? If not what is the correct approach?

Are there any reasons why MNCs might wish to undertake such projects?

Example …

(c) The opposite case is easy to construct. Consider a Shangrila firm contemplating a direct investment project in India under the same cicumstances as in case (b) above. Suppose the cash flows from the project are (-10, 6, 8) million INR. With a discount rate of 10.25%, this yields an NPV of INR 2.02 million from the local perspective – which now is the Indian perspective. Translated into SGD at the expected spot rate of 0.2000 INR per SGD, these cash flows would be (-50, 30,40) million SGD. With a discount rate of 26.50%, the NPV works out to be –1.29 million SGD. It appears that the project is viable from the local point of view but not from parent point of view. What should the Shangrila firm do?

Example …

It should try to acquire local financing for the project. Suppose it can borrow INR 12.02 million at 10.25% in India. It can finance the project construction with INR 10 million out of this and immediately remit the rest to the parent company. It invests the first year’s net cash flow at 10.25%. At the end of two years it has INR 14.61 million, which is enough to pay off its two year loan.

When global capital markets are segmented and parity conditions are violated, the correct procedure is to value the project from parent perspective allowing explicitly for exchange rate risk. Also this example had assumed away the project’s business risks by assuming the projects cash flows in local currency to be risk free. The problem becomes more complicated when the firm must take into account project-specific risks in addition to the exchange rate risk.

Valuing Risky Cashflows

____________________________________________________

  After-Tax Cashflow(Z$ Million)

Boom Recession

(prob.=0.6) (prob.=0.40)

13.8 10.5

____________________________________________________

  Cashflow Translated to Rupees(Million)

 Z$/Rs. 7.5 103.5 78.75

(prob.=0.5) (prob.=0.1) (prob.=0.3)

 Z$/Rs. 5.5 75.9 57.75

(prob.=0.5) (prob.=0.5) (prob.=0.1)

____________________________________________________

Valuing Risky Cashflows …

Once again, with integrated capital markets and validity of parity conditions, we can discount the expected foreign currency cashflow, Zimbabwe dollars [0.613.8+0.410.5] million, using a discount rate which equals the rate of return required by Zimbabwean investors from similar projects and translate into rupees at the current spot rate. In obtaining this discount rate we must employ the international CAPM which takes account of the covariance of the project with the world market portfolio and the Rs/Z$ exchange rate.

If host and home country capital markets are segmented this procedure cannot be employed. The expected value in home currency, of a risky foreign currency cashflow at a future date is given by

Et(CFHT) = Et(CFFT)Et(ST) + cov[CFFT,ST]

Valuing Risky Cashflows …

In the example given above the expected value is

(103.50.1)+(75.90.5)+(78.750.3)+(57.750.1)

= Rs.77.7 million

To estimate this, we need forcasts of future spot rate and an estimate of the covariance between the spot rate and the foreign currency cashflow. This has to be discounted at a rate equal to the rate of return required by home currency investors on similar projects. This must be estimated with a single-country CAPM augmented by exchange risk.

Degree of capital market integration is the crucial issue. Integration is far from complete. This raises difficult issues.

Difficulties in Incorporating Exchange Rate Risk and Choice of Discount Rates• Reliable exchange rate forecasts are notoriously difficult to obtain.

• Linking the performance of the project with the exchange rate is no less difficult. If the project is intended to serve not only the host country market but also third-country markets, the issues are still more complex since the performance of the project now depends upon several exchange rates and not just the home country-host country exchange rate.

• The appropriate risk premium to be added for exchange risk is far from easy to estimate in practice.

• The international CAPM is hard to operationalize.

International taxation introduces further complications.

• Treatment of dividend income by home country government

• Withholding taxes,

• Treatment (by host and home country tax authorities) of other forms of transfers such as interest, royalties etc. between the subsidiary and the parent.

• Existence or otherwise of double taxation avoidance agreements and their scope.

• The possibility of using transfer prices which are different from arms-length prices.

• These are all highly complex issues best left to the specialists in this area.

    

In practice, firms use their all-equity required rate of return and add a risk premium which is supposed to reflect not only exchange risk but also other risks such as political or country risk and in some cases also the fact that the firm may be totally unfamiliar with the host country and may have to incur additional costs. This is a rather arbitrary procedure.

• Some risks should be accounted for by adjusting cash flows

• Some risks are insurable – deduct premium payments from cash flows

• Exchange risks are to some extent diversifiable.

An arbitrary risk premium may err on the conservative side and result in the parent firm foregoing potentially high NPV projects.

THE PRACTICE OF CROSS-BORDER DIRECT INVESTMENT APPRAISAL

(1) A large majority of practitioners employ DCF as at least one of the methods for valuation.

 (2) Most practitioners are de facto multi-factor model adherents. More segmented the market under consideration greater is the number of additional factors used in valuation. Even those who claimed to use the single factor CAPM include more than one risk factor proxies.

(3)The use of local market portfolio as the sole risk factor is less frequent when the evaluator is dealing with countries which are not well integrated into the global capital markets. However, they then add other risk factors rather than using the global market portfolio. For integrated markets such as the US or the UK, global market portfolio is used more frequently.

THE PRACTICE OF CROSS-BORDER DIRECT INVESTMENT APPRAISAL …

(4) In the case of less integrated markets like Sri Lanka or Mexico, exchange risk, political risk (e.g. expropriation), sovereign risk (e.g. Government defaulting on its obligations) and unexpected inflation are considered to be important risk factors in addition to market risk.

(5) Most practitioners adjust for these added risks by adding ad-hoc risk premia to discount rates derived from some asset pricing model rather than incorporating them in estimates of cash flows. This goes against the spirit of asset pricing models which are founded on the premise that only non-diversifiable risks should be incorporated in the discount rate.

Practice of Cross-Border Project Appraisal

The Goldman-Sachs Model:

(1) Identify an existing firm in an identical/similar business in the host country.

(2) Regress its returns on S&P500 to obtain its beta.

(3) Required return on equity for the project:

R = Rf(US) + RS&P500 + Country Spread

Country Spread is defined as :Country spread = Yield on the host country government’s bonds denominated in USD – yield on US treasuries

Practice of Cross-Border Project Appraisal …

The CSFB Model

R = RBB + d {E [RUSM – Rf(US)] Ad } Kd

RBB : Yield on Brady bonds

RUSM : US market portfolio (e.g.S&P500) return

Rf(US) : US risk free return

Ad : Ratio of coefficient of variation of the country market

index to coefficient of variation of US market index

Kd : An adjustment factor to allow for correlation between risk

free rate and risk premium (set at 0.60).

Practice of Cross-Border Project Appraisal …

The Godfrey-Espinosa Model (Journal of Applied Corporate Finance Vol.9, No.3, Fall 1996, 80-89)

R = Rf (US) + Country Spread

+ (d/ US)(US or World Market Excess Return)

Here d and US are volatilities of the host country and US

indices respectively.

All these models attempt to capture covariance risk with world/US markets and exchange rate and political risk in a CAPM like framework. The country spread is taken to capture the exchange rate and political risk and the beta term the covariance risk.

INTERNATIONAL JOINT VENTURES

• Over and above the pure economics of the joint venture project, the most crucial issue is the sharing of the synergy gains between the partners.

• Two or more partners join in a venture only because they have strengths that complement each other, in terms of technology, distribution, market access, brand equity and so forth.

• The joint venture is expected to yield gains over and above the sum of the gains each partner can obtain on its own.

• How should these extra gains be shared between the partners?

INTERNATIONAL JOINT VENTURES …

Game-theoretic models of bargaining suggest that the synergy gains should be split equally.

• One way of achieving this is proportional sharing of project cash-flows. Thus of the two partners, A brings in 30% of the investment and B the remaining 70%, cash-flows should be shared in the same proportion.

• This conclusion however needs modification when the two partners are subject to different tax regimes and tax rates.

    

INTERNATIONAL JOINT VENTURES …

Fair sharing of synergy gains can also be achieved by other means.

• Thus a properly designed license contract wherein the joint venture pays one of the partners a royalty or license fee for "know-how" can achieve the same result as proportional sharing of cash-flows.

• Alternatively, one of the partners brings in some intangible asset (e.g. a brand name) the value of which is negotiated between the partners.

Joint Ventures

Modes of allocation of cash flows among partners

(A)Pure-Equity Contract: Partners share cash flows in proportion to their shareholding

(B) License Contract: JV pays royalty to one partner; subtracted from operating cash-flows; residual cash-flows shared pro-rata

(C) One partner brings an intangible asset at a negotiated value. This plus his shareholding determines his share in cash-flows.

JVs subject to many restrictions.

Joint Ventures …

1. Restrictions on foreign equity holding

2. Ceilings on royalty payments

3. Different tax rates

4. Differential tax treatment of dividend payments vs. royalty payments

Bargaining theory suggests equal sharing of synergy gains.

Pure equity contracts achieve this; other arrangements canbe designed to achieve this.

Three step approach: Joint branch mode valuation; adjustfor non-proportional sharing; adjust for external financing

Joint Ventures …

• NPVA and NPVB are A and B’s best alternative on their own. Both know these and other relevant data. Each could go ahead on its own, find another partner.

• These are their “threat points” – neither will accept less than its best alternative.

• Nash, Rubinstein, Sutton : Equal sharing

A’s gain = B’s gain > 0

A’s gain : NPV of A’s cash flow from JV – NPVA

B’s gain : NPV of B’s cash flow from JV – NPVB

Joint Ventures ..

Case I : Neutral taxes, integrated capital markets, simple pro-rata sharing

NPVJV : NPV of joint venture : A’s share (1- ) : B’s share

Equal gain rule: NPVJV – NPVA = (1 - ) NPVjv – NPVB

= 0.5 + [(NPVA – NPVB) / 2 NPVJV

If NPVA > NPVB (A’s threat stronger than B’s), A obtains a larger share.

Each NPV viz. NPVA, NPVB, NPVJV computed as in a wholly owned subsidiary.

NPVJV must be larger than (NPVA + NPVB)

Joint Ventures …

Case II : Different tax rates and/or discount rates. Suppose B is host country. A is subject to higher taxes. B’s capital market is segmented. B investors demand a higher rate of return.

NPV of A’s cash flows = PV of A’s share of operating cash flows – PV of A’s tax liability on A’s share of taxable income – A’s share in initial investment

= PV[ a (REV-OPEX)] – PV[a (SALES-COST) TA] – aI0

= a(NPVJV, A)

(NPVJV, A) = PV[REV-OPEX] – PV[(SALES-COST)TA] – I0

Where a is A’s share in initial investment and JV cash flows, I0 initial investment, TA is A’s tax rate (including host and home country taxes).

Joint Ventures…

Similarly,

NPV of B’s cash flows

= (1-a) NPVJV,B

(NPVJV, B) = PV[REV-OPEX] – PV[(SALES-COST)TB] – I0

Equal gain rule

a (NPVJV,A) – NPVA = (1-a) (NPVJV,B) – NPVB

a = [NPVJV,B/(NPVJV,A+ NPVJV,B)]

+ [(NPVA-NPVB) /(NPVJV,A+ NPVJV,B)]

A > 0.5 even if NPVA = NPVB. A has to be compensated for

higher taxes.

Joint Ventures …

Case III : Unbundled JV with a license contract or a management contract

Some popular arrangements:

* Royalty paid to one partner, tied to sales.

* An up-front license fee

* Periodic license fee

* One partner brings “know-how” as equity-in-kind

* One partner brings a tangible asset as equity-in-kind and is allowed to value it above market

Joint Ventures …

Many decision variables: Profit share, royalty %, lump-sum fee, valuation of intangible asset. Some of these may be restricted by host country laws.

What motivates license contracts?

• Licensor wants a low-risk income stream

• Information asymmetry: Better informed partner (local partner) accepts a bigger share of business risk; allows the other a low-risk cash flow

• Restrictions on equity share

• Tax factors : License fees are tax deductible; branch profits or foreign dividends may be subject to heavy host country taxes. However, relative tax rates and presence/absence of DTAA’s must be considered

Joint Ventures …

Equal Gains Rule with License Contracts

y : Royalty % (of sales) received by A

Lt : Lumpsum fee received by A in year t

LPt = y(Sales) + Lt

TAD : A’s effective tax rate on dividends

TAL : A’s effective tax rate on license fee

TBD : B’s effective tax rate on dividends

Cash flow from JV accruing to A at time t

= LPt(1-TAL) + a(REVt-OPEXt-LPt) – a(SALESt-COSTt-LPt)TAD

Joint Ventures …

= a [REVt – OPEXt – (SALESt – COSTt) TAD]

+ LPt[(1-TAL) – a (1-TAD)]

NPV of A’s cash flows

= PVA(LP) [(1-TAL) – a (1-TAD)]

+ a{PVA [REVt – OPEXt – (SALESt – COSTt) TAD] – I0}

= PVA(LP) [(1-TAL) – a (1-TAD)] + a NPVJV,A

PVA(LP) = y PVA(SALES) + PVA(L)

PVA(SALES) : PV of sales using a discount rate that reflects riskiness of sales from A’s stockholders’ point of view.

PVA(L) : PV of lump-sum payments

Joint Ventures…

NPV of B’s cash flows

= (1-a) NPVJV,B – (1-a) PVB(LP) (1 – TBD)

Equal gain rule

(1-a) NPVJV,B – (1-a) PVB(LP) (1 – TBD) – NPVB

= PVA(LP) [(1-TAL) – a (1-TAD)] + a NPVJV,A – NPVA

(1) Fix y, Lt and determine a to satisfy equal gains rule

(2) Fix a, Lt, find y

etc.