International Finance Lecture 11 Page 1 International

International Finance Lecture 11 Page 1

International Finance • Course topics – Foundations of International Financial Management – World Financial Markets and Institutions – Foreign Exchange Exposure – Financial Management for a Multinational Firm 2

Financial Management for a Multinational Firm • Foreign direct investment • International Capital Structure, Cost of Capital • International Capital Budgeting 3

Cost of Capital • For a levered firm, the financing costs can be represented by the weighted average cost of capital: • K = (1 – )ke + (1 – t)i • Where K = ______ average cost of capital ke = cost of equity capital for a levered firm i = pretax cost of debt = % of debt, debt to total market value ratio t = _______ corporate income tax rate 4

The Firm’s Investment Decision and the Cost of Capital reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders. cost of capital (%) • A firm that can • Internationalizing the firm’s cost of capital is one such policy. 5 Investment ($)

Cost of Capital in Segmented vs. Integrated Markets • The cost of equity capital (ke) of a firm is the expected return on the firm’s stock that investors require. • This return is frequently estimated using the Capital Asset Pricing Model (CAPM): where 6

Segmented vs. Integrated Markets • If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. versus Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. 7

Does the Cost of Capital Differ among Countries? • There do appear to be differences in the cost of capital in different countries. – Local rates for debt and equity capital may differ – Leverage ratio may differ across countries • In US, Canada, UK leverage _____, on average • In Europe, Japan leverage _______, on average • When markets are imperfect, international financing can lower the firm’s cost of capital. • One way to achieve this is to internationalize the firm’s ownership structure. 8

Example: Novo Industri 9

Cross-Border Listings of Shares • Cross-border listings of stocks have become quite _____ among major corporations. • The largest contingent of foreign stocks are listed on the ______ Stock Exchange. • U. S. exchanges attracted the next largest contingent of foreign stocks. 10

Cross-Border Listings of Shares • Cross-border listings of stocks benefit a company in the following ways. – The company can ____ its potential investor base, which will lead to a higher stock price and lower cost of capital. – Cross-listing creates a _______ market for the company’s shares, which facilitates raising new capital in foreign markets. – Cross-listing can enhance the ______ of the company’s stock. – Cross-listing enhances the ______ of the company’s name and its products in foreign marketplaces. 11

Cross-Border Listings of Shares • Cross-border listings of stocks have costs. – It can be ______ to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. – Once a company’s stock is traded in overseas markets, there can be volatility _____ from these markets. – Once a company’s stock is make available to foreigners, they might acquire a ______ interest and challenge the domestic control of the company. 12

Cross-Border Listings of Shares • Cross-border listings of stocks do carry costs. – Daimler Benz’s net profit/loss (DM bn) German Vs American Accounting rules 13

Cross-Border Listings of Shares Selected Foreign Firms listed on the NYSE 14

The Effect of Foreign Equity Ownership Restrictions • While companies have ________ to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners. • In some countries, there are legal ______ on the percentage of a firm that foreigners can own. • These restrictions are imposed as a means of ensuring domestic ______ of local firms. 15

Pricing-to-Market Phenomenon • Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm. • But they are constrained by ownership constraints imposed on foreigners to purchase at most 20 percent. • Because this constraint is effective in ____ desired foreign ownership, foreign and domestic investors face different market share prices. • This dual pricing is the pricing-to-market phenomenon. 16

Foreign Ownership Restrictions: Nestlé • Nestlé used to issue two different classes of common stock: bearer shares and registered shares. – Foreigners were only allowed to buy ______ shares. – Swiss citizens could buy ______ shares. – The bearer stock was __________ • On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. 17

SF Nestlé’s Foreign Ownership Restrictions 12, 000 10, 000 8, 000 6, 000 4, 000 2, 000 0 11 20 31 9 Source: Financial Times, November 26, 1988 p. 1. Adapted with permission. 18 18 24

Foreign Ownership Restrictions: Nestlé • Following this, the price spread between the two types of shares ______ dramatically. – This implies that there was a major _______ of wealth from foreign shareholders to Swiss shareholders. – The price of bearer shares declined about 25 percent. – The price of registered shares rose by about 35 percent. 19

Foreign Ownership Restrictions: Nestlé • Because registered shares represented about two-thirds of the market capitalization, the total value of Nestlé _______ substantially when it internationalized its ownership structure. • Nestlé’s cost of capital therefore _____. 20

Foreign Ownership Restrictions: Nestlé • Foreigners holding Nestlé bearer shares were exposed to _____ risk in a country that is widely viewed as a haven from such risk. • The Nestlé episode illustrates – The importance of considering market imperfections. – The peril of political risk. – The benefits to the firm of internationalizing its ownership structure. 21

The Financial Structure of Subsidiaries. There are three different approaches to determining the subsidiary’s financial structure. 1. Conform to the parent company's norm. 2. Conform to the local norm of the country where the subsidiary operates. 3. Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risk, and take advantage of various market imperfections. • 22

Financial Management for a Multinational Firm • Foreign direct investment • International Capital Structure, Cost of Capital • International Capital Budgeting 23

Review of Capital Budgeting • The basic net present value equation is Where: CFt = expected incremental after-tax cash flow in year t, TVT = expected after tax cash flow (terminal value) in year T, including return of net working capital, C 0 = initial investment at inception, K = weighted average cost of capital. T = economic life of the project in years. 24

Review of Capital Budgeting • Cash flow estimation Rt is incremental revenue OCt is incremental operating cost Dt is incremental depreciation It is incremental interest expense is the marginal tax rate 25

Review of Capital Budgeting • Various ways to represent CF 26

Review of Capital Budgeting • We can use to rewrite the NPV equation as: 27

The Adjusted Present Value Model • Can be converted to adjusted present value (APV) 28

The Adjusted Present Value Model • The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually. • Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow. 29

Domestic APV Example • Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: -$1, 000 0 30 $125 $250 $375 1 2 The unlevered cost of equity is r 0 = 10%: $500 3 4

Domestic APV Example • Now, imagine that the firm finances the project with $600 of debt at r = 8%. • Pearson’s tax rate is 40%, so they have an interest tax shield worth t×I =. 40×$600×. 08 = $19. 20 each year. · The net present value of the project under leverage is: 31

Domestic APV Example • Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan: 32

Capital Budgeting from the Parent Firm’s Perspective • Donald Lessard (1985) developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment. 33

APV Example • A US-based International Diesel Corporation (IDS-US) is evaluating whether to build a diesel engine plant in the UK (IDS-UK). The estimated project after tax operating cash flows in millions GBP are below. YEAR 0 1 2 3 4 5 5+ -26. 5 2. 2 3. 3 5. 6 6. 3 19. 0 The optimal capital structure is 80% equity and 20% debt. GBP is expected to depreciate by 2% per year vis-à-vis USD. Depreciation is 5 million GBP during first 5 years. Today's exchange rate is USD/GBP $2. 00. The applicable marginal tax rate in the UK and US 40%, borrowing rate in USD is 8% and 10% in GBP, the unlevered cost of equity is 12%. IDS borrows in the US market to finance the project. • Should IDS undertake the project? • 34

APV Example • Exchange rates. FX(t+1)=0. 98*FX(t) YEAR 0 1 2 3 4 5 5+ $2. 00 • $ cash flows. $CF = FX(t) * GBP CF(t) YEAR 0 1 2 3 4 Present value. Use CF and NPV worksheets. • Present value = • 35 5 5+

APV Example • Depreciation tax shield = D(t) * tax * FX(t). PV @ 8% = YEAR 0 1 2 n/a • Interest write-off tax shield • 36 3 4 5

Risk Adjustment in the Capital Budgeting Process • Clearly risk and return are correlated. • ______ risk may exist along side of business risk, necessitating an adjustment in the discount rate. – Systematic risk is reflected by Kud. Therefore, if a project is riskier than average firm’s project, _____ Kud, or if less risky, _____ Kud by 2 -3% or so. 37

Sensitivity Analysis • In the APV model, each cash flow has a probability distribution associated with it. • Hence, the realized value may be different from what was expected. • In sensitivity analysis, ______ estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment. 38

Real Options • The application of options pricing theory to the evaluation of investment options in real projects is known as real options. – A timing option is an option on when to make the investment. – A growth option is an option to increase the scale of the investment. – A suspension option is an option to temporarily cease production. – An abandonment option is an option to quit the investment early. 39