Revision 1 Advanced Investment Appraisal
Chapter 6 International Investment and Financing Decisions
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1. Effects of Exchange Rate Assumptions on Project Values
1.1 Purchasing power parity
(Dec 08, Dec 11, Dec 13)
|1.2.1 |Purchasing Power Parity |
| |PPP claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective |
| |countries. In equilibrium, identical goods must cost the same, regardless of the currency in which they are sold. |
| | |
| |PPP predicts that the country with the higher inflation will be subject to a depreciation of its currency. |
| | |
| |Formally, if you need to estimate the expected future spot rates, PPP can be expressed in the following formula: |
| |[pic] |
| |Where: S0 = Current spot rate |
| |S1 = Expected future rate |
| |hb = Inflation rate in country for which the spot is quoted (base country) |
| |hc = Inflation rate in the other country (country currency). |
1.2 Interest rate parity
|1.2.1 |Interest Rate Parity (IRP) |
| |The IRP claims that the difference between the spot and the forward exchange rates is equal to the differential between |
| |interest rates available in the two currencies. |
| | |
| |IRP predicts that the country with the higher interest rate will see the forward rate for its currency subject to a |
| |depreciation. |
| | |
| |If you need to calculate the forward rate in one year’s time: |
| |[pic] |
| |Where: F0 = Forward rate |
| |S0 = Current spot rate |
| |ib = interest rate for base currency |
| |ic = interest rate for counter currency |
1.3 International Fisher Effect
|1.3.1 |International Fisher Effect |
| |According to the International Fisher effect, interest rate differentials between countries provide an unbiased predictor |
| |of future changes in spot exchange rates. |
| | |
| |The currency of countries with relatively high interest rates is expected to depreciate against currencies with lower |
| |interest rates, because the higher interest rates are considered necessary to compensate for the anticipated currency |
| |depreciation. |
| | |
| |The International Fisher effect can be expressed as: |
| |[pic] |
| |Where: ic = the nominal interest rate in country c |
| |ib = the nominal interest rate in country b |
| |hc = the inflation rate in country c |
| |hb = the inflation rate in country b |
1.4 Expectations theory
|1.4.1 |Expectations theory |
| |The expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in |
| |the future. |
| | |
| |The formula for expectation theory is: |
| |[pic] |
2. NPV for International Projects
2.1 Calculating NPV for international projects
2.1.1 There are two alternative approaches for calculating the NPV from an overseas project.
2.1.2 First approach (commonly used in examination):
(Dec 08, Dec 11, Dec 13, Jun 15)
(a) Forecast foreign currency cash flows including inflation
(b) Forecast exchange rates and therefore translate the foreign currency cash flows into the home currency cash flows
(c) Discount home currency cash flows at the domestic cost of capital
2.1.3 Second approach:
(a) Forecast foreign currency cash flows including inflation
(b) Discount at foreign currency cost of capital and calculate the foreign currency NPV
(c) Convert into a home currency NPV at the spot exchange rate
2.2 The effect of exchange rates on NPV
2.2.1 When there is a devaluation of the domestic currency relative to a foreign currency, then the domestic currency value of the net cash flows increases and thus the NPV increases.
2.2.2 The opposite happens when the domestic currency appreciates. In this case the domestic currency value of the cash flows decline and the NPV of the project in home currency declines.
3. Forecasting Cash Flows from Overseas Project
3.1 Effect on exports
3.1.1 When a multinational company sets up a subsidiary in another country, to which it already exports, the relevant cash flows for the evaluation of the project should take into account the loss of export earnings in the particular country. The NPV of the project should take explicit account of this potential loss.
3.2 Taxes
3.2.1 Taxes play an important role in the investment appraisal as it can affect the viability of a project. The main aspects of taxation in an international context are:
(a) Corporate taxes in the host country
(b) Investment allowances in the host country
(c) Withholding taxes in the host country
(d) Double taxation relief in the home country
(e) Foreign tax credits in the home country
3.3 Inter-company cash flows
3.3.1 Inter-company cash flows, such as transfer prices, royalties and management charges, can also affect the tax computations.
3.3.2 Although complex in reality, in the exam:
(a) Assume inter-company cash flows are allowable for tax unless the question says otherwise
(b) If an inter-company cash flow is allowable for tax relief overseas, there will be a corresponding tax liability on the income in the home country
(c) Assume that the tax authorities will only allow arm’s length / open market prices for tax relief and will not allow an artificially high or low transfer price.
3.4 Remittance restrictions
3.4.1 Remittance restrictions occur where a foreign government places a limit on the funds that can be repatriated back to the holding company. This restriction may change the cash flows that are received by the holding company.
3.4.2 The actual amount received by the parent company (and therefore the shareholders) is the relevant cash flow for the NPV purposes.
3.5 Working capital
3.5.1 It is normally assumed that the working capital requirement for the foreign project will increase by the annual rate of inflation in that country.
4. Types of Foreign Currency Risk
4.1 Currency risk
4.1.1 Currency risk occurs in three forms: transaction exposure (short-term), economic exposure (effect on present value of longer term cash flows) and translation exposure (book gains or losses).
4.2 Transaction risk
(Dec 12)
4.2.1 Transaction risk is the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion. It arises primarily on import and exports.
4.2.2 As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury management.
4.3 Economic risk
(Dec 12)
4.3.1 Economic risk is the variation in the value of the business (i.e. the present value of future cash flows) due to unexpected changes in exchange rates. It is the long-term version of transaction risk.
4.4 Translation risk
(Dec 12)
4.4.1 This is the risk that the organization will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency. Translation losses can result, for example, from restating the book value of a foreign subsidiary’s assets at the exchange rate on the statement of financial position date.
5. Choosing Finance for Overseas Investment
5.1 Financing an overseas subsidiary
5.1.1 The main reason for wanting to borrow in a foreign currency is to fund a foreign investment project or foreign subsidiary. The foreign currency borrowing provides a hedge of the value of the project or subsidiary to protect against changes in value due to currency movements.
5.2 Choice of finance for an overseas investment
5.2.1 The choice of the source funds will depend on:
(a) The local finance costs, and any subsidies which may be available
(b) Taxation systems of the countries in which the subsidiary is operating. Different tax rates can favour in high tax regimes, and no borrowing elsewhere
(c) Any restrictions on dividend remittances
(d) The possibility of flexibility in repayments which may arise from the parent / subsidiary relationship
5.2.2 Parent companies should also consider the following factors:
(a) Reduced systematic risk – There may be a small incremental reduction in systematic risk from investing abroad due to the segmentation of capital markets.
(b) Access to capital – Obtaining capital from foreign markets may increase liquidity, lower costs and make it easier to maintain optimum gearing.
6. Costs and Benefits of Alternative Sources of Finance for MNCs
6.1 International borrowing
6.1.1 Companies are able to borrow long-term funds on the Eurocurrency (money) markets and on the markets for Eurobonds. These markets are collectively called Euromarkets.
6.1.2 Large companies can also borrow on the syndicated loan market where a syndicate of banks provides medium to long-term currency loans.
6.1.3 If a company is receiving income in a foreign currency or has a long-term investment overseas, it can try to limit the risk of adverse exchange rate movements by matching. It can take out a long-term loan and use the foreign currency receipts to repay the loan.
6.2 Syndicated loans
(Dec 08, Dec 09)
6.2.1 A syndicated loan is a loan put together by a group of lenders (a ‘syndicate’) for a single borrower.
6.2.2 Banks or other institutional lenders may be unwilling (due to excessive risk) or unable to provide the total amount individually but may be willing to work as part of a syndicate to supply the requested funds.
6.2.3 Given that many syndicated loans are for very large amounts, the risk of even one single borrower defaulting could be disastrous for an individual lender. Sharing the risk is likely to be more attractive for investors.
6.2.4 Originally syndicated loans were limited to international organisations for acquisitions and other investments of similar importance and amounts. This was mainly due to the following:
(a) Elimination of foreign exchange risk – borrowers may be able to reduce exchange rate risk by spreading the supply of funds between a number of different international lenders.
(b) Speed – in normal circumstances it may take some time to raise very large amounts of money. The efficiency of the syndicated loans market means that large loans can be put together very quickly.
(c) Lower costs of issue – it has lower initial set up costs because, unlike the bond issue, it may not involve the high underwriting costs.
6.2.5 However, it may be that the best offer would entail accepting a variable rate based on LIBOR (for example) which would have to be swapped out if a company wishes to minimize interest rate risk.
6.3 Advantages of borrowing internationally
6.3.1 There are three main advantages from borrowing for international capital markets, as opposed to domestic capital markets:
(a) Availability. Domestic financial markets, with the exception of the large countries and the Euro zone, lack the depth and liquidity to accommodate either large debt issues or issues with long maturities.
(b) Lower cost of borrowing. In Eurobond markets interest rates are normally lower than borrowing rates in national markets
(c) Lower issue costs. The cost of debt issuance is normally lower than the cost of debt issue in domestic markets.
6.4 Risks of borrowing internationally
6.4.1 A multinational company has three options when financing an overseas project by borrowing.
(a) The first is to borrow in the same currency as the inflows from the project.
(b) The second option is borrowing in a currency other than the currency of the inflows but with a hedge in place and
(c) The third option is borrowing in a currency other than the currency of the inflows but without hedging the currency risk. The last case exposes the company to exchange rate risk which can substantially change the profitability of a project.
Question 1
You are the Chief Financial Officer of Moose Co. Moose Co is a manufacturer of cleaning equipment and has an international market for its products. Your company places a strong emphasis on innovation and design with patent protection across all its product range.
The company has two principal manufacturing centres, one in Europe which has been reduced in size in recent years because of high labour costs and the other in South East Asia. However, Moose Co’s development has relied upon ready access to the debt market both in Europe and in South East Asia and the company is planning significant expansion with a new manufacturing and distribution centre in South America. Your company is highly profitable with strong cash flows although in the last two quarters there has been a downturn in sales in all markets as the global recession has begun to take effect.
Since August 2007, credit conditions have deteriorated across all of the major economies as banks have curtailed their lending following the down rating of US asset-backed securities. In 2008 and 2009 many banks recorded significant multibillion dollar losses as they attempted to sell off what had become known as ‘toxic debt’, leading to a further collapse in their value. In response many banks also attempted to repair their balance sheets by rights and other equity issues.
The founder and executive chairman of the company, Alan Bison, is planning a round of meetings with a number of investment banks in leading financial centres around the world to explore raising a $350 million dollar loan for the new development. It has already been suggested that a loan of this size would need to be syndicated or alternatively raised through a bond issue.
In preparation for those meetings he has asked you to provide him with some briefing notes.
Required:
(a) Given conditions in the global debt market as described above, advise on the likely factors banks will consider in offering a loan of this size. (7 marks)
(b) Assess the relative advantages of loan syndication versus a bond issue to Moose Co. (7 marks)
(c) Assess the relative advantages and disadvantages of entering into a capital investment of this scale at this stage of the global economic cycle. (6 marks)
(20 marks)
(ACCA P4 Advanced Financial Management December 2009 Q4)
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