FOREIGN INVESTMENT ANALYSIS

FOREIGN INVESTMENT FOREIGN INVESTMENT ANALYSISANALYSIS

• TWO METHODS OF INTERNATIONAL CAPITAL BUDGETING

• THE COST OF CAPITAL (COC), COC PARITY

• SOURCES OF INVESTMENT FUNDS• SIGNIFICANCE OF SEGMENTED CAPITAL

MARKETS

Fred Thompson International Financing 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.


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.


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.


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.


Cannibalization

• When a new product takes sales from a company’s existing products.– Sometimes difficult to assess the magnitude of

cannibalization that will occur.


Sales Creation

• The opposite of cannibalization.– Same problem: Difficult to estimate.


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


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.


Intangible Benefits

• Difficult to measure.

• Efficiency

• Brand Name Presence In Foreign Country

• Improved Supplier Networks

CAPITAL BUDGETING FOR CAPITAL BUDGETING FOR THE MULTINATIONAL THE MULTINATIONAL

CORPORATIONCORPORATION

Multinational corporations have more opportunities but also face many

problems that domestic businesses do not have to worry about


Why FDI over Portfolio or Intermediated Investment?

For FDI to be considered, the foreign investor must

view: r*FDI > r*PI,II

From the perspective of the host country, it must be the case that:

r*FDI > r*local investment

But these inequalities are the same, since local investors will equate:

r*PI, II = r*local investment


What Makes the Return on FDI greater than that on PI or II?

In other words, how do foreign corporations outperform domestic ones on the latter’s home turf?

Especially considering the foreign firm must incur additional 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 has over domestic competition, making returns to FDI greater than those to Portfolio or Intermediated Investment.


What Explains Locational Patterns of FDI?

What are some reasons certain countries are chosen over others as targets for multinational investment?



1. Labor costs

2. Access to resources

3. Government policies

4. Expanding markets/transport costs

5. Currency values

6. Tax advantages

7. Investment climates



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?)


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.


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?


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.


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).


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.


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.

Cost of capitalCost of capital

the minimum (required) rate of return necessary the minimum (required) rate of return necessary to induce investors to buy or hold the firm’s stock.to induce investors to buy or hold the firm’s stock.


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?


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:


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 explained by variations in the market

Variations not explained by variations in the market – e.g. industry specific risk.

That this is diversifiable means CAPM assumes it is zero


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 !!


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


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.


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.

Discount rate for foreign Discount rate for foreign investmentsinvestments

First a little intuition:


Intuition using S&P as the market PF

The 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!!


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!

Estimating foreign project Estimating foreign project discount rates.discount rates.

Key: Historical data to estimate the betas are not available.

-> We need some kind of proxy firm.


The key questions about the proxy firm!

1) Should the proxy firm be domestic or foreign?

2) What should be used for the market portfolio

3) which market should the premium be based on?

4) How do we measure country risk?


3 methods for estimating proxy betas

1) 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.


2) Using an adjusted domestic proxy

Problems:->Industries might have higher correlation than markets

->Should there be an additional risk premium for country risk….?


Country specific risk


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.


Which risk premium to use!

• The US market has the best data!


The final model.

Ri = Rf + risk premium ·Bi + (add. premium)

observed

Constructed from historic data – assumed constant in the long run

1) B local proxy

2) R local proxy · B country

3) GCAPM

Many Suggestions. e.g. the difference between the domestic and the foreign interest rate.


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!

Cost of DebtCost of Debt


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


Cost of Debt - International Scenario

• Use of Sovereign Risk Spreads

Cost of Debt = Treasury bond yield +

the country risk premium


Capital Structure of Capital Structure of Multinational Corporation Multinational Corporation and its Foreign Affiliatesand its Foreign Affiliates


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

World Capital StructureWorld Capital Structure


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.





• Political Risk Management

• Currency Risk Management


• Leverage and foreign tax credits

• Leasing and Tax credits


Joint Ventures

INTERNATIONAL FINANCING INTERNATIONAL FINANCING AND NATIONAL FINANCIAL AND NATIONAL FINANCIAL

MARKETSMARKETS• 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


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


Securitization

Twenty years ago, commercial banks handle most short- and medium-term financing

Now corporations borrow low-cost funds directly from lenders, primarily in the form of commercial paper marketed by investment banks rather than by commercial banks


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


Financing Practices among Countries Have Consequences

Differences in the role of banks and permissible banking activities

» Differences in national financing patterns

» Differences in profitability and growth among national firms


Convergence of Financing Practices among Countries

Convergence in the role of banks and permissible banking activities

» Convergence in national financing patterns

» Convergence in profitability and growth among national firms


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.


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.


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.


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).


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.


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.


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).


Bond owners and traders today have an enormous collective influence over a nation's

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 nation's access to capital on favorable terms.


Why are large multinational corporations located in 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.


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 firm's name in local markets and increase its sales overseas.


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 Portugal's 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.


THE EUROMARKETS

I. THE EUROCURRENCY MARKETS

II. EUROBONDS

III.NOTE ISSUANCE FACILITIES AND EURONOTES

IV. EUOR COMMERCIAL PAPER


THE EUROCURRENCY MARKETS

The most important international financial markets today

A.The Eurocurrency Market1. Created after WWII2. Composed of eurobanks who

accept/maintain deposits of foreign currency

3. Dominant currency: US$


Growth of Eurodollar Market

Caused by restrictive US government policies, especially1. Reserve requirements on deposits2. Special charges and taxes3. Required concessionary loan rates4. Interest rate ceilings5. Rules which restrict bank competition.


Eurodollar Creation involves

1. A chain of deposits2. Changing control/usage of deposit


Eurocurrency loans

a. Use London Interbank Offer Rate [LIBOR] as basic rate

b. Six month rollovers

c. Risk indicator: size of margin between cost and rate charged.


Multi-currency Clauses

a. Clause gives borrower option to switch currency of loan at rollover.

b. Reduces exchange rate risk


Domestic vs. Eurocurrency Markets

1. Closely linked rates by arbitrage

2. Euro rates: tend to lower lending, higher deposit


DEFINITION OF EUROBONDS

Bonds 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 banks4. Currency Denomination

a. Most often US$b. “Cocktails” allow a basket of currencies


EUROBONDS (cont.)

5. Eurobond Secondary Market -- result of rising investor demand6. Retirement

a. sinking fund usuallyb. some carry call provisions

7. Ratingsa. According to relative riskb. Rating Agencies: Moody’s, Standard & Poor

8. Rationale For Market Existencea. Eurobonds avoid government regulationb. May fade as financial markets deregulate


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


Note Issuance Facility (NIF)

1. Low-cost substitute for loan

2. Allows borrowers to issue own notes

3. Placed/distributed by banks


NIFs vs. Eurobonds

1. Differences:

a. Notes draw down credit as needed

b. Notes let owners determine timing

c. Notes must be held to maturity


SHORT-TERM FINANCING

A. Euronotes and Euro-Commercial Paper1. 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-CPs2. Secondary market for Euro; not U.S. CPs.3. Smaller fraction of Euro use credit rating services to rate.

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FOREIGN INVESTMENT ANALYSIS

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