Lecture 11 Capital Budgeting. Lecture Review Foreign Direct Investment Motives for DFI...

Lecture 11Capital Budgeting

Lecture Review• Foreign Direct Investment • Motives for DFI• Revenue-Related Motives• Cost-Related Motives• Benefits of International Diversification• The Form Of FDI: Acquisitions Versus Greenfield

Investments• The Shift To Services• Types Foreign Direct Investment?• Political Ideology And Foreign Direct Investment• Pragmatic Nationalism• Shifting Ideology • Benefits And Costs Of FDI• Host-Home Country Benefits & Cost

Capital Budgeting

Capital Budgeting defined

• Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.

• It is budget for major capital, or investment, expenditures.

Capital Budgeting

• Capital Budgeting is the process by which the firm decides which long-term investments to make.

• Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years.

• The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost.

Methods for Capital Budgeting

• Accounting rate of return

• Payback period

• Net present value

• Profitability index

• Internal rate of return

• Modified internal rate of return

• Equivalent annuity

• Real options valuation

Subsidiary versus Parent Perspective

• Should the capital budgeting for a multi-national project be conducted from the viewpoint of the subsidiary that will administer the project, or the parent that will provide most of the financing?

• The results may vary with the perspective taken because the net after-tax cash inflows to the parent can differ substantially from those to the subsidiary.


The difference in cash inflows is due to :

• Tax differentials– What is the tax rate on remitted funds?

• Regulations that restrict remittances

• Excessive remittances– The parent may charge its subsidiary very high

administrative fees.

• Exchange rate movements

Remitting Subsidiary Earnings to the Parent

After-Tax Cash Flows Remitted by Subsidiary

Cash Flows Generated by Subsidiary

After-Tax Cash Flows to Subsidiary

Cash Flows Remitted by Subsidiary

Withholding Tax Paid to Host Government

Retained Earningsby Subsidiary

Corporate Taxes Paid to Host Government

Conversion of Fundsto Parent’s Currency

Parent

Cash Flows to Parent


• A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive net present value for the parent should enhance the firm’s value.

• However, one exception to this rule may occur when the foreign subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting

The following forecasts are usually required:1.Initial investment2.Consumer demand3.Product price4.Variable cost5.Fixed cost6.Project lifetime7.Salvage (liquidation) value

The following forecasts are usually required:

Input for Multinational Capital Budgeting

9.Tax laws10.Exchange rates11.Required rate of return

8.Fund-transfer restrictions

Multinational Capital Budgeting

• Capital budgeting is necessary for all long-term projects that deserve consideration.

• One common method of performing the analysis is to estimate the cash flows and salvage value to be received by the parent, and compute the net present value (NPV) of the project.

NET Present Value (NPV)

• The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

Multinational Capital Budgeting

• NPV = – initial outlay n

+ cash flow in period t

t =1 (1 + k )t

+ salvage value

(1 + k )n

k = the required rate of return on the projectn = project lifetime in terms of periods

• If NPV > 0, the project can be accepted.

Lecture Review

• Capital Budgeting

• Subsidiary versus Parent Perspective

• Remitting Subsidiary Earnings to the Parent

• Input for Multinational Capital Budgeting

• Multinational Capital Budgeting

• Multinational Capital Formula

Lecture 12

Lecture Review







Capital Budgeting Analysis Period t

1.Demand (1)2.Price per unit (2)3.Total revenue (1)(2)=(3)4.Variable cost per unit (4)5.Total variable cost (1)(4)=(5)6.Annual lease expense (6)7.Other fixed periodic expenses (7)8.Noncash expense (depreciation) (8)9.Total expenses (5)+(6)+(7)+(8)=(9)10.Before-tax earnings of subsidiary (3)–(9)=(10)11.Host government tax tax rate(10)=(11)12.After-tax earnings of subsidiary (10)–(11)=(12)

Capital Budgeting Analysis Period t

13.Net cash flow to subsidiary (12)+(8)=(13)14.Remittance to parent (14)15.Tax on remitted funds tax rate(14)=(15)16.Remittance after withheld tax (14)–(15)=(16)17.Salvage value (17)18.Exchange rate (18)19.Cash flow to parent (16)(18)+(17)(18)=(19)20.Investment by parent (20)

21. Net cash flow to parent (19)–(20)=(21)22. PV of net cash flow to parent (1+k)

- t(21)=(22)23.Cumulative NPV PVs=(23)

Factors to Consider in Multinational Capital Budgeting

Exchange rate fluctuations. Different scenarios should be considered together with their probability of occurrence.

Inflation. Although price/cost forecasting implicitly considers inflation, inflation can be quite volatile from year to year for some countries.


Financing arrangement. Financing costs are usually captured by the discount rate. However, many foreign projects are partially financed by foreign subsidiaries.

Blocked funds. Some countries may require that the earnings be reinvested locally for a certain period of time before they can be remitted to the parent.


Uncertain salvage value. The salvage value typically has a significant impact on the project’s NPV, and the MNC may want to compute the break-even salvage value.

Impact of project on prevailing cash flows. The new investment may compete with the existing business for the same customers.

Host government incentives. These should also be considered in the analysis.

Adjusting Project Assessment for Risk

• If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its assessment for this risk.

• One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that is applied.

• Many computer software packages are also available to perform sensitivity analysis and simulation.

Lecture Review







Lecture Review

• Capital Budgeting Analysis

• Factors to Consider in Multinational Capital Budgeting

• Adjusting Project Assessment for Risk

Multinational RestructuringMultinational Restructuring

1515

Chapter

Chapter

South-Western/Thomson Learning © 2003

See c15.xls for spreadsheets to accompany this chapter.

Chapter Objectives• To introduce international acquisitions

by MNCs as a form of multinational restructuring;

• To explain how MNCs conduct valuations of foreign target firms;

• To explain why the valuations of a target firm may vary among MNCs; and

• To identify other methods of multinational restructuring.

Multinational Restructuring• Building a new subsidiary, acquiring a

company, selling an existing subsidiary, downsizing operations, or shifting production among subsidiaries, are all forms of multinational restructuring.

• MNCs continually assess possible forms of multinational restructuring to capitalize on changing economic, political, and industrial conditions across countries.

• What are the economic, political, and industrial changes for various countries?

Online Application

¤ Consult the Country Commercial Guides prepared by embassy staff at http://www.usatrade.gov/website/ccg.nsf/ccghomepage?openform.

¤ Refer to the CIA’s World Factbook at http://www.odci.gov/.

http://www.usatrade.gov/website/ccg.nsf/ccghomepage?openform

http://www.usatrade.gov/website/ccg.nsf/ccghomepage?openform#Capital%20Budgeting%20defined



http://www.odci.gov/

International Acquisitions• Through an international acquisition, a firm

can immediately expand its international business since the target is already in place, and benefit from already-established customer relationships.

• However, establishing a new subsidiary usually costs less, and there will not be a need to integrate the parent management style with that of the acquired company.

Value of International Acquisitions

0

50

100

150

200

250

300

350

1988 1990 1992 1994 1996 1998 2000

(billions)$

Foreign Acquisitionsof U.S. Firms

U.S.Acquisitionsof Foreign Firms

0

200

400

600

800

1000

1200

1400

1988 1990 1992 1994 1996 1998 2000

(billions)$

World-wideCross-BorderAcquisitions

Value of International Acquisitions

• Like any other long-term project, capital budgeting analysis can be used to determine whether a firm should be acquired.

• Hence, the acquisition decision can be based on a comparison of the benefits and costs as measured by the net present value (NPV).

International Acquisitions

• NPV = – initial outlay n

+ cash flow in period t

t =1 (1 + k )t

+ salvage value

(1 + k )n

k = the acquisition’s required rate of returnn = the lifetime of the acquired firm

• If NPV > 0, the firm can be acquired.


• Note that the relevant exchange rate, taxes, and blocked-funds restriction, should be taken into account.

• The cost of overcoming the barriers that may be imposed by the government agencies that monitor mergers and acquisitions should be taken into consideration too.


• Examples of such barriers include laws against hostile takeovers, restricted foreign majority ownership, “red tape,” and special requirements.


• In the U.S., mergers and acquisitions are monitored by two agencies:

Online Application

¤ Department of Justice (Antitrust Division)http://www.usdoj.gov/atr/

¤ Federal Trade Commissionhttp://www.ftc.gov/

http://www.usdoj.gov/atr/

http://www.ftc.gov/

• While the Asian crisis had devastating effects, it created an opportunity for some MNCs to pursue new business in Asia.

• In Asia, property values had declined, the currencies were weakened, many firms were near bankruptcy, and the governments wanted to resolve the crisis.

• However, these MNCs must not ignore the lowered economic growth in Asia too.


• In Europe, the adoption of the euro as the local currency by several countries simplifies the analysis that an MNC has to perform when comparing various possible target firms in the participating countries.


• For news and comments on recent international mergers and acquisitions, check out:– http://surveys.ft.com/intmergers2001/

– http://www.mergerstat.com/

Online Application

http://surveys.ft.com/intmergers2001/

http://www.mergerstat.com/

Factors that Affect the ExpectedCash Flows of the Foreign Target

Target-Specific FactorsTarget’s previous cash flows. These may serve

as an initial base from which future cash flows can be estimated.

Managerial talent of the target. The acquiring firm may allow the acquired firm to be managed as it was before the acquisition, downsize the firm, or restructure its operations.

Country-Specific FactorsTarget’s local economic conditions. Demand is

likely to be higher when the economic conditions are strong.

Target’s local political conditions. Cash flow shocks are less likely when the political conditions are favorable.


Target’s currency conditions. A currency that is expected to strengthen over time will usually be preferred.


Target’s industry conditions. Industries with high growth potential and non-excessive competition are preferred.

Country-Specific Factors

Taxes applicable to the target. What matters to the acquiring firm is the after-tax cash flows that it will ultimately receive in the form of remitted funds.


Target’s local stock market conditions. When the local stock market prices are generally low, the target’s acceptable bid price is also likely to be low.

Country-Specific Factors

The Valuation Process• Prospective targets are first screened to

identify those that deserve a closer assessment.

• Capital budgeting analysis is then applied to each of the targets that passed the initial screening process.

• Only those targets that are priced lower than their perceived net present values may be worth acquiring.

Why Valuations of a TargetMay Vary Among MNCs

Estimated cash flows of the foreign target.– Different MNCs will manage the target’s

operations differently.

– Each MNC may have a different plan for fitting the target within the structure of the MNC.

– Acquirers based in certain countries may be subjected to less taxes on remitted earnings.


Exchange rate effects on remitted funds.– Different MNCs have different schedules for

remitting funds from the target to the acquirer.


Required rate of return of the acquirer.– Different MNCs may have different plans for the

target, such that the perceived risk of the target will be different.

– The local risk-free interest rate may differ for MNCs based in different countries.

International Partial Acquisitions

• An MNC may purchase a substantial portion of the existing stock of a foreign firm, so as to gain some control over the target’s management and operations.

• The valuation of the firm depends on whether the MNC plans to acquire enough shares to control the firm (and hence influence its cash flows).

Other Types ofMultinational Restructuring

International Acquisitions of Privatized Businesses

• Many MNCs have acquired businesses from foreign governments.

• These businesses are usually difficult to value because the transition entails many uncertainties - cash flows, benchmark data, economic and political conditions, exchange rates, financing costs, etc.


International Alliances

• MNCs commonly engage in alliances, such as joint ventures and licensing agreements, with foreign firms.

• The initial outlay is typically smaller, but the cash flows to be received will typically be smaller too.


International Divestitures

• An MNC should periodically reassess its DFIs to determine whether to retain them or to sell (divest) them.

• The MNC can compare the present value of the cash flows from the project if it is continued, to the proceeds that would be received (after taxes) if it is divested.


Restructuring DecisionsAs Real Options

• Restructuring decisions may involve real options, or implicit options on real assets.

• If a proposed project carries an option to pursue an additional venture, then the project has a call option on real assets.

• If a proposed project carries an option to divest part or all of itself, then the project has a put option on real assets.

• The expected NPV of a project with real options may be estimated as the sum of the products of the probability of each scenario and the respective NPV for that scenario.

E(NPV) = pi NPVi i pi = probability of scenario i

NPVi = NPV for scenario i

Restructuring DecisionsAs Real Options

Impact of Multinational Restructuringon an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Multinational Restructuring Decisions

• Introduction to Multinational Restructuring

• International Acquisitions– Trends in International Acquisitions

– Model for Valuing a Foreign Target

– Barriers to International Acquisitions

– Assessing Potential Acquisitions in Asia and Europe

Chapter Review

Chapter Review

• Factors that Affect the Expected Cash Flows of the Foreign Target – Target-Specific Factors

– Country-Specific Factors

• The Valuation Process– International Screening Process

– Estimating the Target’s Value

Chapter Review

• Why a Target’s Value May Vary Among MNCs– Expected Cash Flows of the Target

– Exchange Rate Effects on Remitted Funds

– Required Return of the Acquirer

Chapter Review

• Other Types of Multinational Restructuring– International Partial Acquisitions

– International Acquisitions of Privatized Businesses

– International Alliances

– International Divestitures

Chapter Review

• Restructuring Decisions as Real Options– Call and Put Options on Real Assets

• Impact of Multinational Restructuring on an MNC’s Value

Country Risk AnalysisCountry Risk Analysis

1616

Chapter

Chapter

South-Western/Thomson Learning © 2003

See c16.xls for spreadsheets to accompany this chapter.

Chapter Objectives• To identify the common factors used by

MNCs to measure a country’s political risk and financial risk;

• To explain the techniques used to measure country risk; and

• To explain how the assessment of country risk is used by MNCs when making financial decisions.

Country Risk Analysis

• Country risk represents the potentially adverse impact of a country’s environment on the MNC’s cash flows.

Country Risk Analysis

• Country risk can be used:– to monitor countries where the MNC is presently

doing business;

– as a screening device to avoid conducting business in countries with excessive risk; and

– to improve the analysis used in making long-term investment or financing decisions.

Political Risk Factors• Attitude of Consumers in the Host Country

– Some consumers may be very loyal to homemade products.

• Attitude of Host Government– The host government may impose special

requirements or taxes, restrict fund transfers, subsidize local firms, or fail to enforce copyright laws.

Political Risk Factors• Blockage of Fund Transfers

– Funds that are blocked may not be optimally used.

• Currency Inconvertibility– The MNC parent may need to exchange earnings

for goods.

• War– Internal and external battles, or even the threat of

war, can have devastating effects.

• Bureaucracy– Bureaucracy can complicate businesses.

• Corruption– Corruption can increase the cost of conducting

business or reduce revenue.

Political Risk Factors

Corruption Perceptions IndexThe index, which is published by Transparency International, reflects the degree to which corruption is perceived to exist among public officials and politicians.In 2001, 91 countries are ranked on a clean score of 10.

Rank Country Score1 Finland 9.93 New Zealand 9.44 Singapore 9.27 Canada 8.9

13 U.K. 8.314 Hong Kong 7.916 Israel 7.616 U.S.A. 7.618 Chile 7.520 Germany 7.421 Japan 7.1

Rank Country Score23 France 6.726 Botswana 6.027 Taiwan 5.938 South Africa 4.842 South Korea 4.246 Brazil 4.051 Mexico 3.757 Argentina 3.557 China 3.579 Russia 2.388 Indonesia 1.9

Financial Risk Factors• Current and Potential State of the Country’s

Economy– A recession can severely reduce demand.

– Financial distress can also cause the government to restrict MNC operations.

• Indicators of Economic Growth– A country’s economic growth is dependent on

several financial factors - interest rates, exchange rates, inflation, etc.

Types of Country Risk Assessment• A macro-assessment of country risk is an

overall risk assessment of a country without consideration of the MNC’s business.

• A micro-assessment of country risk is the risk assessment of a country as related to the MNC’s type of business.

Types of Country Risk Assessment• The overall assessment of country risk thus

consists of : Macro-political risk Macro-financial risk Micro-political risk Micro-financial risk

• Note that the opinions of different risk assessors often differ due to subjectivities in:– identifying the relevant political and financial

factors,

– determining the relative importance of each factor, and

– predicting the values of factors that cannot be measured objectively.

Types of Country Risk Assessment

Techniques of Assessing Country Risk

• A checklist approach involves rating and weighting all the identified factors, and then consolidating the rates and weights to produce an overall assessment.

• The Delphi technique involves collecting various independent opinions and then averaging and measuring the dispersion of those opinions.


• Quantitative analysis techniques like regression analysis can be applied to historical data to assess the sensitivity of a business to various risk factors.

• Inspection visits involve traveling to a country and meeting with government officials, firm executives, and/or consumers to clarify uncertainties.

• Often, firms use a variety of techniques for making country risk assessments.

• For example, they may use a checklist approach to develop an overall country risk rating, and some of the other techniques to assign ratings to the factors considered.


Developing A Country Risk Rating

• A checklist approach will require the following steps: Assign values and weights to the political risk

factors. Multiply the factor values with their respective

weights, and sum up to give the political risk rating.

Derive the financial risk rating similarly.


Multiply the ratings with their respective weights, and sum up to give the overall country risk rating.

Assign weights to the political and financial ratings according to their perceived importance.

• A checklist approach will require the following steps:


• Different country risk assessors have their own individual procedures for quantifying country risk.

• Although most procedures involve rating and weighting individual risk factors, the number, type, rating, and weighting of the factors will vary with the country being assessed, as well as the type of corporate operations being planned.


• Firms may use country risk ratings when screening potential projects, or when monitoring existing projects.

• For example, decisions regarding subsidiary expansion, fund transfers to the parent, and sources of financing, can all be affected by changes in the country risk rating.

Comparing Risk RatingsAmong Countries

• One approach to comparing political and financial ratings among countries is the foreign investment risk matrix (FIRM ).

• The matrix measures financial (or economic) risk on one axis and political risk on the other axis.

• Each country can be positioned on the matrix based on its political and financial ratings.

UnclearZone

AcceptableZone

UnacceptableZone

Financial Risk RatingP

olit

ical

Ris

k R

atin

gAcceptable Unacceptable

Stab

le U

nsta

ble

The Foreign Investment Risk Matrix (FIRM)

Actual Country Risk Ratings Across Countries

• Some countries are rated higher according to some risk factors, but lower according to others.

• On the whole, industrialized countries tend to be rated highly, while emerging countries tend to have lower risk ratings.

• Country risk ratings change over time in response to changes in the risk factors.

Incorporating Country Risk in Capital Budgeting

• If the risk rating of a country is in the acceptable zone, the projects related to that country deserve further consideration.

• Country risk can be incorporated into the capital budgeting analysis of a project by adjusting the discount rate, or by adjusting the estimated cash flows.

• Adjustment of the Discount Rate– The higher the perceived risk, the higher the

discount rate that should be applied to the project’s cash flows.

• Adjustment of the Estimated Cash Flows– By estimating how the cash flows could be

affected by each form of risk, the MNC can determine the probability distribution of the net present value of the project.

Incorporating Country Risk in Capital Budgeting

Applications ofCountry Risk Analysis

• Alerted by its risk assessor, Gulf Oil planned to deal with the loss of Iranian oil, and was able to avoid major losses when the Shah of Iran fell four months later.

• However, while the risk assessment of a country can be useful, it cannot always detect upcoming crises.

Applications ofCountry Risk Analysis

• Iraq’s invasion of Kuwait was difficult to forecast, for example. Nevertheless, many MNCs promptly reassessed their exposure to country risk and revised their operations.

• The 1997-98 Asian crisis also showed that MNCs had underestimated the potential financial problems that could occur in the high-growth Asian countries.

Reducing Exposureto Host Government Takeovers

• The benefits of DFI can be offset by country risk, the most severe of which is a host government takeover.

• To reduce the chance of a takeover by the host government, firms often use the following strategies:

Use a Short-Term Horizon– This technique concentrates on recovering cash

flow quickly.


Rely on Unique Supplies or Technology– In this way, the host government will not be able to

take over and operate the subsidiary successfully.

Hire Local Labor– The local employees can apply pressure on their

government.

Borrow Local Funds– The local banks can apply pressure on their

government.

Purchase Insurance– Investment guarantee programs offered by the

home country, host country, or an international agency insure to some extent various forms of country risk.


• Why Country Risk Analysis Is Important

• Political Risk Factors– Attitude of Consumers in the Host Country

– Attitude of Host Government

– Blockage of Fund Transfers

– Currency Inconvertibility

– War

– Bureaucracy

– Corruption

Chapter Review

Chapter Review

• Financial Risk Factors– Current and Potential State of the Country’s

Economy

– Indicators of Economic Growth

• Types of Country Risk Assessment– Macro-Assessment of Country Risk

– Micro-Assessment of Country Risk

Chapter Review

• Techniques of Assessing Country Risk– Checklist Approach

– Delphi Technique

– Quantitative Analysis

– Inspection Visits

– Combination of Techniques

Chapter Review

• Developing a Country Risk Rating– Example of Measuring Country Risk

– Variation in Methods of Measuring Country Risk

– Using the Country Risk Rating for Decision-Making

• Comparing Risk Ratings Among Countries

• Actual Country Risk Ratings Across Countries

Chapter Review

• Incorporating Country Risk in Capital Budgeting– Adjustment of the Discount Rate

– Adjustment of the Estimated Cash Flows

• Applications of Country Risk Analysis

Chapter Review

• Reducing Exposure to Host Government Takeovers– Use a Short-Term Horizon

– Rely on Unique Supplies or Technology

– Hire Local Labor

– Borrow Local Funds

– Purchase Insurance

• Impact of Country Risk on an MNC’s Value

Multinational Cost of Capital& Capital Structure

Chapter Objectives• To explain how corporate and country

characteristics influence an MNC’s cost of capital;

• To explain why there are differences in the costs of capital across countries; and

• To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure.

Cost of Capital• A firm’s capital consists of equity (retained

earnings and funds obtained by issuing stock) and debt (borrowed funds).

• The cost of equity reflects an opportunity cost, while the cost of debt is reflected in interest expenses.

• Firms want a capital structure that will minimize their cost of capital, and hence the required rate of return on projects.

• A firm’s weighted average cost of capital

kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + E

where D is the amount of debt of the firmE is the equity of the firmkd is the before-tax cost of its debtt is the corporate tax rateke is the cost of financing with equity

Cost of Capital

• The interest payments on debt are tax deductible. However, as interest expenses increase, the probability of bankruptcy will increase too.

• It is favorable to increase the use of debt financing until the point at which the bankruptcy probability becomes large enough to offset the tax advantage of using debt.

Cost of Capital

Debt’s Tradeoff

Cost of Capital

Cos

t of

Cap

ital

Debt Ratio

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.



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 capital asset pricing model (CAPM) can be used to assess how the required rates of return of MNCs differ from those of purely domestic firms.

• According to CAPM, ke = Rf + (Rm – Rf )

where ke = the required return on a stock

Rf = risk-free rate of return

Rm = market return

= the beta of the stock


• A stock’s beta represents the sensitivity of the stock’s returns to market returns, just as a project’s beta represents the sensitivity of the project’s cash flows to market conditions.

• The lower a project’s beta, the lower its systematic risk, and the lower its required rate of return, if its unsystematic risk can be diversified away.


• An MNC that increases its foreign sales may be able to reduce its stock’s beta, and hence the return required by investors. This translates into a lower overall cost of capital.

• However, MNCs may consider unsystematic risk as an important factor when determining a foreign project’s required rate of return.


• Hence, we cannot be certain if an MNC will have a lower cost of capital than a purely domestic firm in the same industry.


Costs of Capital Across Countries

• The cost of capital may vary across countries, such that: MNCs based in some countries may have a

competitive advantage over others; MNCs may be able to adjust their international

operations and sources of funds to capitalize on the differences; and

MNCs based in some countries may have a more debt-intensive capital structure.


• The cost of debt to a firm is primarily determined by the prevailing risk-free interest rate of the borrowed currency and the risk premium required by creditors.

• The risk-free rate is determined by the interaction of the supply and demand for funds. It may vary due to different tax laws, demographics, monetary policies, and economic conditions.


• The risk premium compensates creditors for the risk that the borrower may be unable to meet its payment obligations.

• The risk premium may vary due to different economic conditions, relationships between corporations and creditors, government intervention, and degrees of financial leverage.


• Although the cost of debt may vary across countries, there is some positive correlation among country cost-of-debt levels over time.


0

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4

6

8

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Canada

U.S.

GermanyJapan

Cos

ts o

f Deb

t (%

)


• A country’s cost of equity represents an opportunity cost – what the shareholders could have earned on investments with similar risk if the equity funds had been distributed to them.

• The return on equity can be measured by the risk-free interest rate plus a premium that reflects the risk of the firm.


• A country’s cost of equity can also be estimated by applying the price/earnings multiple to a given stream of earnings.

• A high price/earnings multiple implies that the firm receives a high price when selling new stock for a given level of earnings. So, the cost of equity financing is low.


• The costs of debt and equity can be combined, using the relative proportions of debt and equity as weights, to derive an overall cost of capital.

Using the Cost of Capital for Assessing Foreign Projects

• Foreign projects may have risk levels different from that of the MNC, such that the MNC’s weighted average cost of capital (WACC) may not be the appropriate required rate of return.

• There are various ways to account for this risk differential in the capital budgeting process.

Using the Cost of Capital for Assessing Foreign Projects

Derive NPVs based on the WACC.– The probability distribution of NPVs can be

computed to determine the probability that the foreign project will generate a return that is at least equal to the firm’s WACC.

Adjust the WACC for the risk differential. – The MNC may estimate the cost of equity and the

after-tax cost of debt of the funds needed to finance the project.

The MNC’sCapital Structure Decision

• The overall capital structure of an MNC is essentially a combination of the capital structures of the parent body and its subsidiaries.

• The capital structure decision involves the choice of debt versus equity financing, and is influenced by both corporate and country characteristics.


Corporate Characteristics

• Stability of cash flows. MNCs with more stable cash flows can handle more debt.

• Credit risk. MNCs that have lower credit risk have more access to credit.

• Access to retained earnings. Profitable MNCs and MNCs with less growth may be able to finance most of their investment with retained earnings.


• Agency problems. Host country shareholders may monitor a subsidiary, though not from the parent’s perspective.

• Guarantees on debt. If the parent backs the subsidiary’s debt, the subsidiary may be able to borrow more.

Corporate Characteristics

Country Characteristics

• Stock restrictions. MNCs in countries where investors have less investment opportunities may be able to raise equity at a lower cost.

• Interest rates. MNCs may be able to obtain loanable funds (debt) at a lower cost in some countries.


• Country risk. If the host government is likely to block funds or confiscate assets, the subsidiary may prefer debt financing.


• Strength of currencies. MNCs tend to borrow the host country currency if they expect it to weaken, so as to reduce their exposure to exchange rate risk.

Country Characteristics

• Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate, withholding tax rate, etc.) are higher.

The MNC’sCapital Structure DecisionCountry Characteristics

Interaction Between Subsidiary and Parent Financing DecisionsIncreased debt financing by the subsidiary A larger amount of internal funds may be

available to the parent. The need for debt financing by the parent may

be reduced.

• The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk.

Interaction Between Subsidiary and Parent Financing DecisionsReduced debt financing by the subsidiary A smaller amount of internal funds may be

available to the parent. The need for debt financing by the parent may

be increased.

• The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk.

Amount of Internal Amount ofLocal Debt Funds Debt

Host Country Financed by Available FinancedConditions Subsidiary to Parent by Parent

Higher Country Risk Higher Higher Lower

Lower Interest Rates Higher Higher Lower

Expected Weakness Higher Higher Lowerof Local Currency

Blockage of Funds Higher Higher Lower

Higher Taxes Higher Higher Lower

Interaction Between Subsidiary and Parent Financing Decisions

Using a Target Capital Structure on a Local versus Global Basis

• An MNC may deviate from its “local” target capital structure as necessitated by local conditions.

• However, the proportions of debt and equity financing in one subsidiary may be adjusted to offset an abnormal degree of financial leverage in another subsidiary.

• Hence, the MNC may still achieve its “global” target capital structure.


• Note that a capital structure revision may result in a higher cost of capital.

• Hence, an unusually high or low degree of financial leverage should only be adopted if the benefits outweigh the overall costs.

• The volumes of debt and equity issued in financial markets vary across countries, indicating that firms in some countries (such as Japan) have a higher degree of financial leverage on average.

• However, conditions may change over time. In Germany for example, firms are shifting from local bank loans to the use of debt security and equity markets.


• Introduction to the Cost of Capital– Comparing the Costs of Equity and Debt

• Cost of Capital for MNCs• Size of Firm

• Access to International Capital Markets

• International Diversification

• Exposure to Exchange Rate Risk

• Exposure to Country Risk

Chapter Review

Chapter Review

• Cost of Capital for MNCs … continued

– Cost of Capital Comparison Using the CAPM

– Implications of the CAPM for an MNC’s Risk

Chapter Review

• Costs of Capital Across Countries– Country Differences in the Cost of Debt

– Country Differences in the Cost of Equity

– Combining the Costs of Debt and Equity

• Using the Cost of Capital for Assessing Foreign Projects– Derive NPVs Based on the WACC

– Adjust the WACC for the Risk Differential

Chapter Review

• The MNC’s Capital Structure Decision– Influence of Corporate Characteristics

– Influence of Country Characteristics

• Interaction Between Subsidiary and Parent Financing Decisions– Impact of Increased Debt Financing by the

Subsidiary

– Impact of Reduced Debt Financing by the Subsidiary

Chapter Review

• Using a Target Capital Structure on a Local versus Global Basis– Offsetting a Subsidiary’s Abnormal Degree of

Financial Leverage

– Limitations of Offsets

– Differences in Financing Tendencies Among Countries

• Impact of Capital Structure Decisions on an MNC’s Value

Part VShort-Term Asset and Liability Management

Subsidiariesof MNC withExcess Funds

Subsidiariesof MNC withDeficient Funds

InternationalCommercialPaper Market

Eurobanks inEurocurrencyMarket

MNCParent

Deposits Purchase

Securities

Provisionof Loans

Provisionof Loans

DepositsPurchaseSecurities

BorrowFunds

BorrowFunds

BorrowFunds

BorrowFunds

Borrow Funds Borrow Funds

Financing International Trade

Chapter Objectives• To describe the methods of payment for

international trade;

• To explain common trade finance methods; and

• To describe the major agencies that facilitate international trade with export insurance and/or loan programs.

Payment Methodsfor International Trade

• In any international trade transaction, credit is provided by either – the supplier (exporter), – the buyer (importer), – one or more financial institutions, or – any combination of the above.

• The form of credit whereby the supplier funds the entire trade cycle is known as supplier credit.


Method : Prepayments• The goods will not be shipped until the buyer

has paid the seller.

• Time of payment : Before shipment

• Goods available to buyers : After payment

• Risk to exporter : None• Risk to importer : Relies completely on

exporter to ship goods as ordered

Payment Methods for International Trade

Method : Letters of credit (L/C)• These are issued by a bank on behalf of the

importer promising to pay the exporter upon presentation of the shipping documents.

• Time of payment : When shipment is made• Goods available to buyers : After payment• Risk to exporter : Very little or none• Risk to importer : Relies on exporter to ship

goods as described in documents


Method : Drafts (Bills of Exchange)• These are unconditional promises drawn by

the exporter instructing the buyer to pay the face amount of the drafts.

• Banks on both ends usually act as intermediaries in the processing of shipping documents and the collection of payment. In banking terminology, the transactions are known as documentary collections.


• Time of payment : On presentation of draft• Goods available to buyers : After payment• Risk to exporter : Disposal of unpaid goods• Risk to importer : Relies on exporter to ship


Method : Drafts (Bills of Exchange)

• Sight drafts (documents against payment) : When the shipment has been made, the draft is presented to the buyer for payment.


• Time of payment : On maturity of draft• Goods available to buyers : Before payment• Risk to exporter : Relies on buyer to pay• Risk to importer : Relies on exporter to ship


Method : Drafts (Bills of Exchange)

• Time drafts (documents against acceptance) : When the shipment has been made, the buyer accepts (signs) the presented draft.


Method : Consignments• The exporter retains actual title to the goods

that are shipped to the importer.• Time of payment : At time of sale to third party

• Goods available to buyers : Before payment

• Risk to exporter : Allows importer to sell inventory before paying exporter

• Risk to importer : None


Method : Open Accounts• The exporter ships the merchandise and

expects the buyer to remit payment according to the agreed-upon terms.

• Time of payment : As agreed upon• Goods available to buyers : Before payment• Risk to exporter : Relies completely on buyer

to pay account as agreed upon• Risk to importer : None

Trade Finance MethodsAccounts Receivable Financing

– An exporter that needs funds immediately may obtain a bank loan that is secured by an assignment of the account receivable.

Factoring (Cross-Border Factoring)– The accounts receivable are sold to a third party

(the factor), that then assumes all the responsibilities and exposure associated with collecting from the buyer.

Trade Finance MethodsLetters of Credit (L/C)

– These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation of the shipping documents.

– The importer pays the issuing bank the amount of the L/C plus associated fees.

– Commercial or import/export L/Cs are usually irrevocable.

Trade Finance Methods

– Sometimes, the exporter may request that a local bank confirm (guarantee) the L/C.

Letters of Credit (L/C)¤ The required documents typically include a

draft (sight or time), a commercial invoice, and a bill of lading (receipt for shipment).

Sample Letter of Credit (Confirmation)Advice Number: BA000000094 Amount: April 17, 2002Issue Bank Ref: 1234/LMC/5678 US$: Advice Date: 21 March 2002Beneficiary: ABC Company, Inc. Applicant: XYZ Company, Inc. Expire Date: 21 July 2002

5278 S. Motorized Blvd 25 Rising Sun WayDetroit, MI 48210 Tokyo, Japan 120-113000-000-0000 +000-0000-0000

We have been requested to advise you of the following letter of credit issued by: First Bank of Japan123 Cherry Blossom DrTokyo, Japan

Please be guided by its terms and conditions and by the following: Credit is available by negotiation of your draft(s) in duplicate at sight for 100% of invoice value drawn on us accompanied by the following documents:

1. Signed commercial invoice, one (1) original and three (3) copies.2. Full set ocean bills of lading consigned to the order of First Bank of Japan, Japan notify applicant and marked

freight collect.3. Packing list, two (2) copies.

Evidencing Shipment of: 20,000 motorized tooth brushes FOB San FranciscoShipment From: Detroit, MI through San Francisco, CA Shipment To: Tokyo, JapanPartial Shipments not allowed. All banking charges outside Japan are for beneficiary's account. Documents must be presented within 21 days from BILL date.At the request of our correspondent, we confirm this credit and engage with you that all drafts drawn under and in compliance with the terms of this credit will be duly honored by us.Please examine this instrument carefully. If you are unable to comply with the terms or conditions, please communicate with your buyer to arrange for an amendment.Sincerely,Jill MoneybagsAccount Manager

International Banking Group • Jack and Jill Bank Corp. • P.O. Box 1234 • Detroit, MI 48201

Documentary Credit Procedure

Buyer(Importer)

Sale Contract Seller(Exporter)

Deliver Goods

Requestfor Credit

Importer’s Bank(Issuing Bank)

Documents& Claim forPayment

PresentDocuments

DeliverLetter ofCredit

PresentDocuments

Send Credit

Exporter’s Bank(Advising Bank) Payment


– Variations include• standby L/Cs : funded only if the buyer does not pay

the seller as agreed upon • transferable L/Cs : the first beneficiary can transfer

all or part of the original L/C to a third party• assignments of proceeds under an L/C : the original

beneficiary assigns the proceeds to the end supplier

Letters of Credit (L/C)

Trade Finance MethodsBanker’s Acceptance (BA)

– This is a time draft that is drawn on and accepted by a bank (the importer’s bank). The accepting bank is obliged to pay the holder of the draft at maturity.

– If the exporter does not want to wait for payment, it can request that the BA be sold in the money market. Trade financing is provided by the holder of the BA.


– In general, all-in-rates are lower than bank loan rates. They usually fall between the rates of short-term Treasury bills and commercial papers.

Banker’s Acceptance (BA)¤ The bank accepting the drafts charges an all-

in-rate (interest rate) that consists of the discount rate plus the acceptance commission.

Life Cycle of a Typical Banker’s Acceptance

8. Pay Discounted Value of BA

1 - 7 : Prior to BA

1. Purchase OrderImporter Exporter

5. Ship Goods

Importer’sBank

2. Applyfor L/C

11.ShippingDocuments

14. PayFace Valueof BA

10. SignPromissoryNote to Pay

6.ShippingDocuments& TimeDraft

4. L/CNotification

9. PayDiscountedValue ofBA

7. Shipping Documents &Time Draft

Exporter’sBank

3. L/C

12. BA

Money Market Investor

13. Pay Discounted Value of BA

16. Pay Face Value of BA

15. Present BA at Maturity

14 - 16 : When BAmatures

8 - 13 : When BAis created

Trade Finance MethodsWorking Capital Financing

– Banks may provide short-term loans that finance the working capital cycle, from the purchase of inventory until the eventual conversion to cash.

Trade Finance MethodsMedium-Term Capital Goods Financing

(Forfaiting)– The importer issues a promissory note to the

exporter to pay for its imported capital goods over a period that generally ranges from three to seven years.

– The exporter then sells the note, without recourse, to a bank (the forfaiting bank).

Trade Finance MethodsCountertrade

– These are foreign trade transactions in which the sale of goods to one country is linked to the purchase or exchange of goods from that same country.

– Common countertrade types include barter, compensation (product buy-back), and counterpurchase.

– The primary participants are governments and multinationals.

Agencies that Motivate International Trade

• Due to the inherent risks of international trade, government institutions and the private sector offer various forms of export credit, export finance, and guarantee programs to reduce risk and stimulate foreign trade.


Overseas Private Investment Corporation (OPIC)

• OPIC is a U.S. government agency that assists U.S. investors by insuring their overseas investments against a broad range of political risks.

• It also provides financing for overseas businesses through loans and loan guaranties.


• Beyond insurance and financing, the U.S. has tax provisions that encourage international trade.

• The FSC Repeal and Extraterritorial Income Exclusion Act of 2000, which replaced the 1984 Foreign Sales Corporation provisions in response to WTO concerns, excludes certain extraterritorial income from the definition of gross income for U.S. tax purposes.

Chapter Review

• Payment Methods for International Trade– Prepayments

– Letters of Credit

– Sight Drafts and Time Drafts

– Consignments

– Open Accounts

Chapter Review

• Trade Finance Methods– Accounts Receivable Financing

– Factoring

– Letters of Credit

– Banker’s Acceptances

– Working Capital Financing

– Medium-Term Capital Goods Financing (Forfaiting)

– Countertrade

Lecture 11 Capital Budgeting. Lecture Review Foreign Direct Investment Motives for DFI...

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