2.
Chapter Outline <ul><li>31.1 Internationally Integrated Capital Markets </li></ul><ul><li>31.2 Valuation of Foreign Currency Cash Flows </li></ul><ul><li>31.3 Valuation and International Taxation </li></ul><ul><li>31.4 Internationally Segmented Capital Markets </li></ul><ul><li>31.5 Capital Budgeting with Exchange Risk </li></ul>
3.
Learning Objectives <ul><li>Discuss the condition necessary for internationally integrated capital markets. </li></ul><ul><li>Describe two methods that can be used to value foreign currency cash flows; use those methods to value those flows. </li></ul><ul><li>Calculate foreign and domestic WACCs, using equation 31.7, given three out of the four inputs. </li></ul>
4.
Learning Objectives (cont'd) <ul><li>Identify which tax rate (the foreign or the domestic) a U.S. corporation will pay on its foreign project. </li></ul><ul><li>Discuss the implications of the possibility that capital markets are internationally segmented. </li></ul><ul><li>Value a project when it has inputs and outputs in different currencies. </li></ul>
5.
31.1 Internationally Integrated Capital Markets <ul><li>Consider a risky foreign asset that is expected to pay the cash flow, C FC , in one period. </li></ul><ul><ul><li>In a normal market, the price of this asset in a foreign market is: </li></ul></ul>
6.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>A U.S. investor who wants to purchase this asset in dollars will have to pay: </li></ul><ul><ul><li>Where S is current spot exchange rate in dollars per foreign currency </li></ul></ul>
7.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>A U.S. investor who actually purchased this security would have to convert the future cash flow into dollars, so the payoff to such an investor is the dollar cash flow it produces. </li></ul>
8.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>To value this cash flow, assume that the U.S. investor contracts today to convert the expected cash flow in one period at the forward rate, F , quoted as dollars per foreign currency. </li></ul><ul><ul><li>The U.S. investor’s expected dollar cash flow is F × C FC </li></ul></ul>
9.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>If r* $ is the cost of capital for U.S. investor, the present value of this expected cash flow is: </li></ul>
10.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>By the Law of One Price, this value must be equal to what the U.S. investor paid for the security: </li></ul><ul><ul><li>Which simplifies to </li></ul></ul><ul><ul><li>This is simply covered interest parity. </li></ul></ul>
11.
31.1 Internationally Integrated Capital Markets (cont'd) <ul><li>Internationally Integrated Capital Markets </li></ul><ul><ul><li>When any investor can exchange currencies in any amount at the spot or forward rates and is free to purchase or sell any security in any amount in any country at its current market prices </li></ul></ul><ul><ul><ul><li>With internationally integrated capital markets, the value of an investment does not depend on the currency used. </li></ul></ul></ul>
14.
Alternative Example 31.1 <ul><li>Problem </li></ul><ul><ul><li>You are an American who is trying to calculate the present value of a ₤25 million cash flow that will occur one year in the future. </li></ul></ul><ul><ul><li>You know that the spot exchange rate is S = $1.9397/₤ and the one-year forward rate is F = $1.9581/₤. </li></ul></ul>
15.
Alternative Example 31.1 <ul><li>Problem (continued) </li></ul><ul><ul><li>You also know that the appropriate dollar cost of capital for this cash flow is 6.25% and that the appropriate pound cost of capital for this cash flow is 5.25%. </li></ul></ul><ul><ul><li>What is the present value of the ₤25 million cash flow from the standpoint of a British investor, and what is the dollar equivalent of this amount? </li></ul></ul>
16.
Alternative Example 31.1 <ul><li>Problem (continued) </li></ul><ul><ul><li>What is the present value of the ₤25 million cash flow from the standpoint of a U.S. investor who first converts the ₤25 million into dollars and then applies the dollar discount rate? </li></ul></ul>
17.
Alternative Example 31.1 <ul><li>Solution </li></ul><ul><ul><li>For the British investor: </li></ul></ul><ul><ul><ul><li>The present value of the pound cash flow is: </li></ul></ul></ul><ul><ul><ul><ul><li>₤25 million ÷ 1.0525 = ₤23,752,969 </li></ul></ul></ul></ul><ul><ul><ul><li>The dollar equivalent is: </li></ul></ul></ul><ul><ul><ul><ul><li>₤23,752,969 × $1.9397/₤ = $46,073,634 </li></ul></ul></ul></ul>
18.
Alternative Example 31.1 <ul><li>Solution </li></ul><ul><ul><li>For the U.S. investor: </li></ul></ul><ul><ul><ul><li>The present value of the converting the ₤25 million to dollars using the forward rate and then applying the dollar cost of capital is: </li></ul></ul></ul><ul><ul><ul><ul><li>(₤25 million × $1.9581/₤) ÷ 1.0625 = $46,072,941 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Note: The $693 difference is rounding error. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>$46,073,634 − $46,072,941 = $693 </li></ul></ul></ul></ul></ul>
19.
31.2 Valuation of Foreign Currency Cash Flows <ul><li>In an internationally integrated capital market, two equivalent methods are available for calculating the NPV of a foreign project. </li></ul><ul><ul><li>Calculate the NPV in the foreign country and convert it to the local currency at the spot rate </li></ul></ul><ul><ul><li>Convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows </li></ul></ul>
20.
WACC Valuation Method in Domestic Currency <ul><li>Converting the cash flows of the foreign project into the local currency and then calculating the NPV of these cash flows is the equivalent of converting the expected dollar value of the foreign currency cash flows and then proceeding to value the project as if it were a domestic project. </li></ul>
21.
Application: Ityesi, Inc. <ul><li>Ityesi, Inc., wants to apply the WACC technique to value a project in the United Kingdom. </li></ul><ul><ul><li>The project will be completely self-contained in the United Kingdom, such that all revenues are generated and all costs are incurred there. </li></ul></ul>
22.
Application: Ityesi, Inc. (cont'd) <ul><li>The technology used in the new products will be obsolete after four years. </li></ul><ul><li>Annual sales are expected to be £37.5 million per year. </li></ul><ul><li>Manufacturing costs and operating expenses are expected to total £15.625 million and £5.625 million per year, respectively. </li></ul>
23.
Application: Ityesi, Inc. (cont'd) <ul><li>Developing the product will require an upfront investment of £15 million in capital equipment that will be obsolete in four years and an initial marketing expense of £4.167 million. </li></ul><ul><li>Ityesi pays a corporate tax rate of 40% no matter in which country it manufactures its products. </li></ul>
25.
Application: Ityesi, Inc. (cont'd) <ul><li>Forward Exchange Rates </li></ul><ul><ul><li>The current spot exchange rate, S , is $1.60/£. Assume the risk-free rate on dollars, r $ , is 4% and the risk-free interest rate on pounds, r £ , is 7%. </li></ul></ul>
26.
Application: Ityesi, Inc. (cont'd) <ul><li>Forward Exchange Rates </li></ul><ul><ul><li>Using the covered interest parity condition: </li></ul></ul>
27.
Application: Ityesi, Inc. (cont'd) <ul><li>Free Cash Flow Conversion </li></ul><ul><ul><li>Using these forward exchange rates, the expected free cash flows in dollars can be calculated by multiplying the expected cash flows in pounds by the forward exchange rate: </li></ul></ul>
28.
Table 31.2 Spreadsheet Expected Dollar Free Cash Flows from Ityesi’s U.K. Project
29.
Application: Ityesi, Inc. (cont'd) <ul><li>The Value of Ityesi’s Foreign Project with WACC </li></ul><ul><ul><li>With the cash flows of the U.K. project now expressed in dollars, the foreign project can be valued as if it were a domestic U.S. project. </li></ul></ul>
30.
Table 31.3 Ityesi’s Current Market Value Balance Sheet ($ millions) and Cost of Capital Without the U.K. Project
31.
Application: Ityesi, Inc. (cont'd) <ul><li>The Value of Ityesi’s Foreign Project with WACC </li></ul><ul><ul><li>Ityesi’s WACC is calculated as: </li></ul></ul><ul><ul><ul><li>Note: Ityesi’s net debt is the $320 million in debt minus the $20 million in cash for a net debt of $300 million. </li></ul></ul></ul>
32.
Application: Ityesi, Inc. (cont'd) <ul><li>The Value of Ityesi’s Foreign Project with WACC </li></ul><ul><ul><li>The present value of the future free cash flows is: </li></ul></ul><ul><ul><ul><li>Given the upfront cost of launching the product line in dollars is only $28 million, the net present value is $29.20 million. </li></ul></ul></ul><ul><ul><ul><ul><li>$57.20 – $28 = $29.20 </li></ul></ul></ul></ul>
33.
Using the Law of One Price as a Robustness Check <ul><li>Ityesi could have computed the foreign NPV by discounting the foreign cash flows at the foreign cost of capital and converting this result to a domestic NPV using the spot rate. </li></ul><ul><ul><li>Determining the NPV requires knowing the foreign cost of capital. </li></ul></ul>
34.
Using the Law of One Price as a Robustness Check (cont'd) <ul><li>The foreign cost of capital must satisfy the Law of One Price: </li></ul><ul><ul><li>and </li></ul></ul>
35.
Using the Law of One Price as a Robustness Check (cont'd) <ul><li>The foreign cost of capital must satisfy the Law of One Price: </li></ul><ul><ul><li>The foreign cost of capital in terms of the domestic cost of capital and interest rates is: </li></ul></ul><ul><ul><ul><li>The Foreign-Denominated Cost of Capital </li></ul></ul></ul>
38.
Alternative Example 31.2 <ul><li>Problem </li></ul><ul><ul><li>Sky Motors, based in Austin, TX, is considering opening a manufacturing plant in Mexico. Sky’s weighted average cost of capital in the U.S. is 12%. The current risk-free rate is 2% in the U.S. and 8% in Mexico. What is the firm’s peso WACC? </li></ul></ul>
39.
Alternative Example 31.2 (cont’d) <ul><li>Solution </li></ul><ul><ul><li>Using Equation 31.7: </li></ul></ul>
40.
31.3 Valuation and International Taxation <ul><li>Repatriated </li></ul><ul><ul><li>Refers to the profits from a foreign project that a firm brings back to its home country </li></ul></ul><ul><ul><ul><li>If the foreign project is a separately incorporated subsidiary of the parent, the amount of taxes a firm pays generally depends on the amount of profits repatriated. </li></ul></ul></ul>
41.
Single Foreign Project with Immediate Repatriation of Earnings <ul><li>The general international arrangement for the taxation of corporate profits is that the host country gets the first opportunity to tax income produced within its borders. </li></ul><ul><ul><li>The home government must establish a tax policy specifying its treatment of foreign income and foreign taxes paid on that income. </li></ul></ul>
42.
Single Foreign Project with Immediate Repatriation of Earnings (cont'd) <ul><li>U.S. tax policy requires U.S. corporations to pay taxes on their foreign income at the same rate as profits earned in the United States. </li></ul><ul><ul><li>However, a full tax credit is given for foreign taxes paid up to the amount of the U.S. tax liability. </li></ul></ul>
43.
Multiple Foreign Projects and Deferral of Earnings Repatriation <ul><li>Pooling Multiple Foreign Projects </li></ul><ul><ul><li>Under U.S. tax law, multinational corporations may use any excess tax credits generated in high-tax foreign countries to offset their net U.S. tax liabilities on earnings in low-tax foreign countries. </li></ul></ul>
44.
Multiple Foreign Projects and Deferral of Earnings Repatriation <ul><li>Deferring Repatriation of Earnings. </li></ul><ul><ul><li>A U.S. tax liability is not incurred until the profits are brought back home if the foreign operation is set up as a separately incorporated subsidiary (rather than as a foreign branch). </li></ul></ul><ul><ul><ul><li>If a company chooses not to repatriate, it effectively reinvests those earnings abroad and defers its U.S. tax liability. </li></ul></ul></ul>
45.
31.4 Internationally Segmented Capital Markets <ul><li>Segmented Capital Markets </li></ul><ul><ul><li>Capital markets that are not internationally integrated </li></ul></ul>
46.
Differential Access to Markets <ul><li>Firms may face differential access to markets if there is any kind of asymmetry with respect to information about them. </li></ul><ul><ul><li>For example, Ityesi may be well known in the United States but not be equally well known in the United Kingdom, thus increasing their WACC in the U.K. </li></ul></ul><ul><ul><ul><li>Ityesi would then view the foreign project as less valuable if it raises capital in the United Kingdom rather than in the United States. </li></ul></ul></ul>
47.
Differential Access to Markets <ul><li>Differential access to national capital markets is common enough that it provides the best explanation for the existence of currency swaps. </li></ul><ul><ul><li>Currency Swaps </li></ul></ul><ul><ul><ul><li>A contract in which parties agree to exchange coupon payments and a final face value payment that are in different currencies </li></ul></ul></ul><ul><ul><ul><ul><li>Currency swaps allow firms to mitigate their exchange rate risk exposure while still making investments and raising funds in the most attractive locales. </li></ul></ul></ul></ul>
48.
Macro-Level Distortions <ul><li>Important macroeconomic reasons for segmented capital markets include capital controls and foreign exchange controls that create barriers to international capital flows and thus segment national markets. </li></ul><ul><ul><li>Political, legal, social, and cultural characteristics that differ across countries may require compensation in the form of a country risk premium. </li></ul></ul>
51.
Alternative Example 31.3 <ul><li>Problem </li></ul><ul><ul><li>In March 2007, the spot Canadian dollar (CAN$)–U.S. dollar (US$) exchange rate was CAN$1.1740 / US$. </li></ul></ul><ul><ul><li>At the time, the yield on one-year Canadian government bonds was about 4%, while the comparable one-year yield on U.S. Treasury securities was 5%. </li></ul></ul><ul><ul><li>Using the covered interest parity relationship, calculate the implied one-year forward rate. </li></ul></ul>
52.
Alternative Example 31.3 <ul><li>Solution </li></ul><ul><ul><li>The implied one-year forward rate is CAN$1.1628 / US$. </li></ul></ul>
53.
Implications <ul><li>Firms may be able to benefit from a segmented international financial market if one country or currency has a higher rate of return than another country or currency, when the two rates are compared in the same currency. </li></ul>
57.
31.5 Capital Budgeting with Exchange Risk <ul><li>The final issue that arises when a firm is considering a foreign project is that the cash flows of the project may be affected by exchange rate risk. </li></ul><ul><ul><li>The working assumption made thus far is that the project’s free cash flows are uncorrelated with the spot exchange rates. </li></ul></ul>
58.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>Reconsider what happens if the Ityesi project in the United Kingdom imports some materials from the United States. </li></ul><ul><ul><li>In this case, the project’s pound free cash flows will be correlated with exchange rates. </li></ul></ul>
59.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>If the value of the dollar appreciates against the pound, the pound cost of these materials will increase, thereby reducing the pound free cash flows. </li></ul><ul><li>If the dollar depreciates, then the pound free cash flows will increase. </li></ul><ul><ul><li>The assumption that changes in the free cash flows are uncorrelated with changes in the exchange rate is violated. </li></ul></ul>
60.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>Whenever a project has cash flows that depend on the values of multiple currencies, the most convenient approach is to separate the cash flows according to the currency they depend on. </li></ul>
61.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>Assume £5.625 million of Ityesi’s costs are denominated in pounds, and an additional $16 million (or £10 million at the current exchange rate of $1.60/£) is for inputs whose price fluctuates with the value of the dollar. </li></ul><ul><ul><li>Ityesi’s pound-denominated free cash flows excluding these dollar-based costs would be: </li></ul></ul>
63.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>If the revenues and costs on the previous slide are not affected by changes in the spot exchange rates, it can be assumed that changes in the free cash flows are uncorrelated with changes in the spot exchange rates. </li></ul><ul><ul><li>The pound denominated free cash flows can be converted to equivalent dollar amounts using the forward exchange rate: </li></ul></ul>
64.
Table 31.5 Spreadsheet Expected Dollar Free Cash Flows from Ityesi’s U.K. Project
65.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>The previous slide also adds the dollar-based cash flows to determine the project’s aggregate free cash flow in dollar terms. </li></ul><ul><ul><li>Note: Ityesi’s dollar-denominated costs are deducted and the tax shield associated with these costs is added in. </li></ul></ul>
66.
31.5 Capital Budgeting with Exchange Risk (cont'd) <ul><li>Given the dollar-denominated free cash flow, the NPV of the investment using Ityesi’s dollar WACC is: </li></ul>
67.
Discussion of Data Case Key Topic <ul><li>How would your answer change if the investment were to be made in Great Britain rather than in Australia? </li></ul><ul><ul><li>Hint: You will first need to convert the capital investment and cash flows from Australian dollars to British pounds. </li></ul></ul><ul><ul><li>www. bloomberg .com </li></ul></ul>
68.
Chapter Quiz <ul><li>What implication do internationally integrated capital markets have for the value of the same asset in different countries? </li></ul><ul><li>Explain two methods we use to calculate the NPV of a foreign project. </li></ul><ul><li>What tax rate should we use to value a foreign project? </li></ul><ul><li>What is the main implication for international corporate finance of a segmented financial market? </li></ul><ul><li>How do we make adjustments when a project has inputs and outputs in different currencies? </li></ul>
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