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  2. 2. Net Present Value (NPV)• NPV is the present value of future cash flows minus the initial net cash outlay for the project discounted at the project’s cost of capital.• Assuming the goal of maximizing shareholder wealth, any project with a positive NPV that cannot be delayed or can be undone (at low or no cost) and that doesn’t preempt a more attractive project should be pursued.• Generally, the source of financing is irrelevant to the investment decision. International Financing 2
  3. 3. Upside to NPV• Evaluates investment in the same manner as a company’s shareholders. – Focuses in on cash and not accounting profits – Emphasizes the opportunity cost of the money invested. International Financing 3
  4. 4. Downside to NPV• The project with highest NPV may also consume the most resources.• Therefore, you should look to the best combination of positive NPV projects that yield the highest NPV given your investment constraints. International Financing 4
  5. 5. Difficulties with NPV• Estimating cash flows. – The cost of the project – The cash inflows during the life of the project (especially hard where there are relevant spillovers -- cannibalization or sales creation) – The terminal or ending values of the project. International Financing 5
  6. 6. Cannibalization• When a new product takes sales from a company’s existing products. – Sometimes difficult to assess the magnitude of cannibalization that will occur. International Financing 6
  7. 7. Sales Creation• The opposite of cannibalization. – Same problem: Difficult to estimate. International Financing 7
  8. 8. Opportunity Cost• Project costs must include the true economic cost of any resource required for the project. – Example: IBM in Brazil• Transfer Pricing – The prices at which goods and services are traded internally within an organization. – Example: Ford motors Fred Thompson International Financing 8
  9. 9. Competition• Ignore it and you’ll lose.• Key question to be asked! – What will happen if we don’t make this investment?• The rule is simple: – If you must be the victim of a cannibal, make sure the cannibal is a member of your family. Fred Thompson International Financing 9
  10. 10. Intangible Benefits• Difficult to measure.• Efficiency• Brand Name Presence In Foreign Country• Improved Supplier Networks International Financing 10
  11. 11. CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATIONMultinational corporations have more opportunities but also face manyproblems that domestic businesses do not have to worry about
  12. 12. Why FDI over Portfolio or Intermediated Investment?For FDI to be considered, the foreign investor mustview: r*FDI > r*PI,IIFrom the perspective of the host country, it must bethe case that: r*FDI > r*local investmentBut these inequalities are the same, since localinvestors will equate: r*PI, II = r*local investment International Financing 12
  13. 13. What Makes the Return on FDI greater than that on PI or II?In other words, how do foreign corporationsoutperform domestic ones on the latter’s home turf?Especially considering the foreign firm must incuradditional costs of travel, communication, and monitoring......and the foreign firm must contend with unfamiliar legal,distributing, and accounting systems.Thus, an understanding of FDI must identify what‘overcompensating advantage’ a foreign firm hasover domestic competition, making returns to FDIgreater than those to Portfolio or IntermediatedInvestment. International Financing 13
  14. 14. What Explains Locational Patterns of FDI?What are some reasons certain countries arechosen over others as targets for multinationalinvestment? International Financing 14
  15. 15. What Explains Locational Patterns of FDI? 1. Labor costs 2. Access to resources 3. Government policies 4. Expanding markets/transport costs 5. Currency values 6. Tax advantages 7. Investment climates International Financing 15
  16. 16. What Explains Locational Patterns of FDI? 1. Labor costs (home or foreign? make or buy? Where?) 2. Access to resources (where?) 3. Government policies (where?) 4. Expanding markets/transport costs (how?) 5. Currency values (home or foreign? What?) 6. Tax advantages (home or foreign? Where? What?) 7. Investment climates (where?) International Financing 16
  17. 17. Growth Options• Growth Options vary in value depending on: – The length of time the project can be deferred. The more time increases odds of a positive turn of events. – The risk of the project. The riskier the project the more valuable the option is. – The level of interest rates. High interest rates generally raise the value of options because of the reduction of the present value of the cash outlay needed to exercise an option. – The proprietary nature of the option. The greater the percentage of ownership the more valuable to the owner. International Financing 17
  18. 18. Issues in Foreign Investment Analysis• Should cash flows be measured from the viewpoint of the subsidiary or that of the parent?• Should the additional economic and political risks that are uniquely foreign be reflected in cash-flow or discount-rate adjustments? International Financing 18
  19. 19. Three Stage Approach• Project cash flows are computed either from the subsidiary’s standpoint and PV converted to home currency at spot rate or future values are converted to home currency and PV calculated from the parent’s standpoint.• The indirect benefits and costs that the investment confers on the rest of the system are accounted for.• Headquarters determines amounts, timing, and form of actual transfers and tax payments. International Financing 19
  20. 20. First Stage of this Approach• Decentralized assessment: Project cash flows are computed from the subsidiary’s standpoint (using the subsidiary’s project-specific COC) to PV, which is converted to home currency at spot rate• Centralized assessment: Future project cash flows are converted to home currency at the expected exchange rates and PV calculated from the parent’s standpoint (using the parent’s project- specific COC). International Financing 20
  21. 21. Political & Economic Risk Analysis• The three main methods for incorporating additional Political and Economic Risk – Shortening the minimum payback period. – Raising the required rate of return (Note: Our former colleague, Professor Marc Choate, claimed there is some curse that befalls all managers who choose this option.) – Adjusting cash flows to reflect the specific impact of a given risk. International Financing 21
  22. 22. Political Risk• You face risks you don’t even know about.• Expropriation – Where a government seizes your assets.• Blocked Funds – Where a government changes exchange controls. International Financing 22
  23. 23. Cost of capital the minimum (required) rate of return necessaryto induce investors to buy or hold the firm’s stock.
  24. 24. Is it different where foreign investments are concerned?• Cost of capital needed to calculate NPV!• Foreign Investments: – Opportunity for further diversification! – But also further risk exposure – country specific risk. – The question is: how do we measure country specific risk? International Financing 24
  25. 25. Traditionally:• CAPM Assumes: COCi = Ri + Bi (RM-Ri) – Where Bi = Cov(COCi,RM)/var[RM ] Assumptions: All the traditional – risk adverse investors, equilibrium, perfect markets etc. But in this context the most important is: International Financing 25
  26. 26. All unsystematic risk is diversifiable• Risk is measured by the standard deviation and we assume the following decomposition is possible:• Risk = systematic risk + unsystematic risk Variations not explained by Variations explained by variations in the market – e.g. variations in the market industry specific risk. That this is diversifiable means CAPM assumes it is zero International Financing 26
  27. 27. How do you diversify?There are two ways: 1) increase the variety of assets in a portfolio 2) choose the right mix or variety of assets !! International Financing 27
  28. 28. How can overall risk change?• Example:• If the number of investment opportunities increases -> increased diversification opportunities -> – Expected returns and project specific risk are unchanged, but – -> less risky in CAPM terminology International Financing 28
  29. 29. Important!!• The beta we need is the project beta reflecting the risk of the project not the beta of the company reflecting the risk of the entire firm. International Financing 29
  30. 30. WACC• Is the discount factor! It is calculated as a weighted average of cost of debt and the cost of equity using the ratios of the market values of debt and equity to the total firm value as weights.• -> This is how we evaluate domestic investments!!! -> We now expand this to evaluating foreign investments as well. International Financing 30
  31. 31. Discount rate for foreign investmentsFirst a little intuition:
  32. 32. Intuition using S&P as the market PFThe two effects:->Naturally the correlation between returns on foreign investments and S&P are less than for domestic investments -> suggesting lower B s-> Project specific risk might also vary between countries -> can have both a positive and negative effect. However often country specific risk is unsystematic risk -> diversifiable!! International Financing 32
  33. 33. Important assumption:• MNCs have better diversification opportunities than their shareholders. Otherwise the share holders could just as well do the diversification.• Supported empirically by investors’ home bias! International Financing 33
  34. 34. Estimating foreign project discount rates.Key: Historical data to estimate the betas are not available. -> We need some kind of proxy firm.
  35. 35. The key questions about the proxy firm!1) Should the proxy firm be domestic or foreign?2) What should be used for the market portfolio3) which market should the premium be based on?4) How do we measure country risk? International Financing 35
  36. 36. 3 methods for estimating proxy betas1) Use a local company beta.• Problem: Such a company (industry) might not exist and at least not with the necessary historic data.• However, this is the optimal choice, if it is possible. International Financing 36
  37. 37. 2) Using an adjusted domestic proxyProblems: ->Industries might have higher correlation than markets ->Should there be an additional risk premium for country risk….? International Financing 37
  38. 38. Country specific risk International Financing 38
  39. 39. 3) The Global CAPM• Instead of using foreign/domestic market portfolios use a global market portfolio!• This is a good choice if you look at the world as one market!• The problem is that you assume implicitly that stock holders hold well diversified portfolios not just domestic but global. This is not empirically supported.• If GCAPM is used for foreign investments it should also be used for domestic investments. International Financing 39
  40. 40. Which risk premium to use!• The US market has the best data! International Financing 40
  41. 41. The final model.Ri = Rf + risk premium ·Bi + (add. premium)observedConstructed from historic data– assumed constant in the Many Suggestions. e.g. thelong run difference between the domestic and the foreign interest rate. 1) B local proxy 2) R local proxy · B country 3) GCAPM International Financing 41
  42. 42. A comment on the additional premium• Instead of adjusting the discount rate, treat the investment like a real option: add more scenarios, which will change the expected cash flows! International Financing 42
  43. 43. Cost of Debt
  44. 44. Cost of Debt - Basic Concepts• Debt Traded in the Market Price = Ct/(1+Kd)t• Debt Not traded in the Market YTM of US treasury + Prevailing spread Fred Thompson International Financing 44
  45. 45. Cost of Debt - International Scenario • Use of Sovereign Risk Spreads Cost of Debt = Treasury bond yield + the country risk premium Fred Thompson International Financing 45
  46. 46. Fred Thompson International Financing 46
  47. 47. Capital Structure ofMultinational Corporationand its Foreign Affiliates
  48. 48. Capital Structure - Domestic Theories• M&M Corporate Tax Model• Agency Cost of Under Investment• Static Trade off Model• Types of Companies• Jensen theory of Agency cost of Free Cash Flows• Theory of Managerial behavior, agency cost and capital structure• Pecking Order Theory Fred Thompson International Financing 48
  49. 49. World Capital Structure
  50. 50. Capital Structure of Foreign Affiliates• Conform to the capital structure of Parent Company.• Reflect the capitalization norm of each foreign country• Vary to take advantage of opportunities to minimize the MNC’s cost of capital. Fred Thompson International Financing 50
  51. 51. Fred Thompson International Financing 51
  52. 52. Fred Thompson International Financing 52
  53. 53. Fred Thompson International Financing 53
  54. 54. • Political Risk Management• Currency Risk ManagementFred Thompson International Financing 54
  55. 55. • Leverage and foreign tax credits• Leasing and Tax creditsFred Thompson International Financing 55
  56. 56. Joint VenturesFred Thompson International Financing 56
  57. 57. INTERNATIONAL FINANCING AND NATIONAL FINANCIAL MARKETS• Financial markets are increasingly global• Old kinds of debt are being made into new kinds of securities• The distinction between commercial and investment banks is breaking down
  58. 58. Globalization of Financial Firms• 1960s: Banks develop global branch networks for loans, payments, clearings, and foreign exchange trading• 1970-80s: Securities firms operate abroad, first in London with Eurobond market, then other markets, Tokyo, Hong Kong, and Singapore; foreign commercial banks and securities houses expand to the United States• Now: To thrive in any leading financial markets, a firm must have a significant presence in them all Fred Thompson International Financing 58
  59. 59. SecuritizationTwenty years ago, commercial banks handle most short- and medium-term financingNow corporations borrow low-cost funds directly from lenders, primarily in the form of commercial paper marketed by investment banks rather than by commercial banks Fred Thompson International Financing 59
  60. 60. Diminished Distinctions among Kinds of Financial Firms• Firms want to be in all profitable product lines and have flexibility to shift to more promising ones• In US & Japan, law separates commercial banking from investment banking• Commercial banking less profitable than some kinds of investment banking -- commercial banks have circumvent prohibition• Investment banks encroach upon commercial banks’ traditional areas of activity -- money market mutual funds drew billions of dollars from banks in the late 1970s and early 1980s Fred Thompson International Financing 60
  61. 61. Financing Practices among Countries Have ConsequencesDifferences in the role » Differences in national of banks and financing patterns permissible banking activities » Differences in profitability and growth among national firms Fred Thompson International Financing 61
  62. 62. Convergence of Financing Practices among CountriesConvergence in the role » Convergence in of banks and national financing permissible banking patterns activities » Convergence in profitability and growth among national firms Fred Thompson International Financing 62
  63. 63. What are the basic differences between the financing practices of US and Japanese firms? What might account for these differences?Answer. The two main differences are: 1. Source of financing -- internal versus external; 2. Composition of external finance -- bank borrowing versus debt securities.Historically, U.S. companies have received 60% to 70% of funds from internal sources. Japanese companies have relied heavily on external funds to finance a strategy of of massive investment and pursuit of market share -- often at the expense of profitability.Japanese firms also rely heavily on bank borrowing, while U.S. firms raise more money directly from financial markets by the sale of securities. Fred Thompson International Financing 63
  64. 64. What is securitization?Answer. Instead of raising money in the form of non-marketable loans, securitization means selling negotiable instruments directly to savers. By contrast, financial intermediation involves the use of financial institutions such as banks and thrifts to bring together borrowers and savers. These institutions make a large number of loans and fund them by issuing liabilities (e.g., deposits) in their own name.Securitization reflects reductions in the cost of using financial markets and increases in the cost of bank borrowing. Fred Thompson International Financing 64
  65. 65. Why is bank lending on the decline worldwide?Answer.(1) Banks face higher capital requirements and, therefore, costs.(2) Banks have responded to greater interest rate volatility by cutting back on loan commitments, thereby reducing the value of a banking relationship to corporate customers.(3) Banks have moved away from relationship lending making them more vulnerable to adverse selection. Fred Thompson International Financing 65
  66. 66. How have banks responded to their loss of market share?Answer. Banks have responded to their loss of market share by eliminating unprofitable aspects of the traditional lending (retention of loans on the balance sheet) while retaining the element crucial to the borrower (access to funds). Thus origination of loans for sale has emerged as a new business line.Banks have also expanded nonlending services that produce fee income and are not (yet) covered by capital requirements: underwriting commercial paper, foreign exchange trading, arranging swaps, advising on mergers and acquisitions, and issuing letters of credit and debt guarantees (credit enhancement). Fred Thompson International Financing 66
  67. 67. What is meant by the globalization of financial markets?Answer. Globalization integrates national financial markets across space and time, thereby eliminating barriers that separate domestic from foreign capital markets. The process is driven by investors seeking the best combination of risk and return for their money and by companies trying to get it for the best terms and conditions.It will be complete only when the price of risk and the time value of money are identical worldwide.Markets for US government securities and certain stocks, foreign exchange trading, inter-bank borrowing and lending -- to cite a few examples -- already operate around the clock and the world. Fred Thompson International Financing 67
  68. 68. How has technology affected the process of globalization?Answer. Improvements in such areas as data manipulation and telecommunications have greatly reduced the costs of gathering, processing, and acting on information from anywhere in the world.This has facilitated the process of arbitrage across financial markets, which has brought prices of securities with similar risks and returns closer in line with each other and turned the world into a much more interconnected market. Fred Thompson International Financing 68
  69. 69. How has globalization affected government regulation of national capital markets?Answer. National systems of supervision and regulation were not designed for a worldwide marketplace. Governments that restrict domestic financial institutions will often provide foreign firms with a competitive advantage. Similarly, restrictions on domestic financial markets will often drive business overseas. The net result will be increased pressure for loosening controls on domestic financial institutions and markets to enable them to be more competitive, which will tend to speed the process of financial deregulation (with respect to entry and pricing and choice of business partners). Fred Thompson International Financing 69
  70. 70. Bond owners and traders today have an enormous collective influence over a nations economic policies, why?Answer. Bond owners and traders influence national access to capital markets. To the extent that a nation requires this access (and most do, at least at some point in time), this exerts a strong disciplinary effect on the types of economic policies a nation is likely to select. A policy perceived as being economically harmful will restrict the nations access to capital on favorable terms. Fred Thompson International Financing 70
  71. 71. Why are large multinational corporations locatedin small countries (Sweden, Holland, Switzerland) interested in developing a global investor base?Answer. Large MNCS located in these small countries need to raise substantial amounts of capital to grow. Often, the domestic market cannot provide this amount of capital on reasonable terms (portfolio theory). Borrowing abroad means a lower cost of capital for these MNCs (and hence a higher market value).In addition, developing a global investor base gives them access to capital when events (most likely political) restrict the ability of MNCs to raise capital locally regardless of price. Fred Thompson International Financing 71
  72. 72. Why are many U.S. multinationals listing their shares on foreign stock exchanges?Answers.• Diversification of equity funding risk: A pool of funds from a diversified shareholder base insulates a company from the vagaries of a single national market.• Increase stock price: By selling stock overseas, a company can expand its investor base, thereby lowering its cost of equity capital and increasing its market value.• Boost foreign sales: An international stock offering can spread the firms name in local markets and increase its sales overseas. Fred Thompson International Financing 72
  73. 73. Many governments withhold income taxes on interest payments, returning them to foreigners where they have double-taxation treaties with the foreigners’ governments. Often, however, repayment is delayed. What are the likely consequences of eliminating withholding from interest payments to foreigners under such circumstances?Answer. This actually happened in Portugal. The OECD reports that Portugal discovered that charging foreigners withholding tax on interest payments due on government bonds deterred them from buying its debt rather than bringing in more revenues, thereby raising its cost of capital.The fact that foreign investors had to wait so long to claim back a portion of the tax led them to price Portugals debt as if they had to pay all of the tax.Moreover, because bond markets that charge foreigners withholding tax tend to be less liquid, investors demanded an extra premium. The higher interest rates that Portugal had to pay more than offset its income from withholding tax.After scrapping its withholding tax, the yield spread between 10-year Portuguese government bonds and corresponding German government bonds narrowed significantly. Fred Thompson International Financing 73
  75. 75. THE EUROCURRENCY MARKETSThe most important international financial markets todayA.The Eurocurrency Market 1. Created after WWII 2. Composed of eurobanks who accept/maintain deposits of foreign currency 3. Dominant currency: US$Fred Thompson International Financing 75
  76. 76. Growth of Eurodollar MarketCaused by restrictive US government policies, especially 1. Reserve requirements on deposits 2. Special charges and taxes 3. Required concessionary loan rates 4. Interest rate ceilings 5. Rules which restrict bank competition. Fred Thompson International Financing 76
  77. 77. Eurodollar Creation involves1. A chain of deposits2. Changing control/usage of deposit Fred Thompson International Financing 77
  78. 78. Eurocurrency loansa. Use London Interbank Offer Rate [LIBOR] as basic rateb. Six month rolloversc. Risk indicator: size of margin between cost and rate charged. Fred Thompson International Financing 78
  79. 79. Multi-currency Clausesa. Clause gives borrower option to switch currency of loan at rollover.b. Reduces exchange rate risk Fred Thompson International Financing 79
  80. 80. Domestic vs. Eurocurrency Markets1. Closely linked rates by arbitrage2. Euro rates: tend to lower lending, higher deposit Fred Thompson International Financing 80
  81. 81. DEFINITION OF EUROBONDSBonds sold outside the country of currency denomination. 1. Recent Substantial Market Growth -- due to use of swaps [a financial instrument which gives 2 parties the right to exchange streams of income over time.] 2. Links to Domestic Bond Markets -- arbitrage has eliminated interest rate differential. 3. Placement underwritten by syndicates of banks 4. Currency Denomination a. Most often US$ b. “Cocktails” allow a basket of currencies Fred Thompson International Financing 81
  82. 82. EUROBONDS (cont.)5. Eurobond Secondary Market -- result of risinginvestor demand6. Retirement a. sinking fund usually b. some carry call provisions7. Ratings a. According to relative risk b. Rating Agencies: Moody’s, Standard & Poor8. Rationale For Market Existence a. Eurobonds avoid government regulation b. May fade as financial markets deregulate Fred Thompson International Financing 82
  83. 83. Eurobond vs. Eurocurrency Loans 1. Five Differences a. Eurocurrency loans use variable rates b. Loans have shorter maturities c. Bonds have greater volume d. Loans have greater flexibility e. Loans obtained faster Fred Thompson International Financing 83
  84. 84. Note Issuance Facility (NIF)1. Low-cost substitute for loan2. Allows borrowers to issue own notes3. Placed/distributed by banks Fred Thompson International Financing 84
  85. 85. NIFs vs. Eurobonds1. Differences: a. Notes draw down credit as needed b. Notes let owners determine timing c. Notes must be held to maturity Fred Thompson International Financing 85
  86. 86. SHORT-TERM FINANCINGA. Euronotes and Euro-Commercial Paper 1. Euronotes » Unsecured short-term debt securities denominated in US$ and issued by corporations and governments. 2. Euro-commercial paper(CP) » Euronotes not bank underwrittenB. U.S. vs. Euro-CPs 1. Average maturity longer (2x) for Euro-CPs 2. Secondary market for Euro; not U.S. CPs. 3. Smaller fraction of Euro use credit rating services to rate. Fred Thompson International Financing 86