FOREIGN INVESTMENT ANALYSIS

1. FOREIGN INVESTMENT ANALYSIS TWO METHODS OF INTERNATIONAL CAPITAL BUDGETING THE COST OF CAPITAL (COC), COC PARITY SOURCES OF INVESTMENT FUNDS SIGNIFICANCE OF SEGMENTED CAPITAL MARKETS

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

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

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

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

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

7. Sales Creation • The opposite of cannibalization. • Same problem: Difficult to estimate. International Financing

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 International Financing

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. International Financing

10. Intangible Benefits • Difficult to measure. • Efficiency • Brand Name Presence In Foreign Country • Improved Supplier Networks International Financing

11. CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION Multinational corporations have more opportunities but also face many problems that domestic businesses do not have to worry about

12. 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 International Financing

13. 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. International Financing

14. What Explains Locational Patterns of FDI? What are some reasons certain countries are chosen over others as targets for multinational investment? International Financing

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

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

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

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

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

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

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

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

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

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

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

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 in the market – e.g. industry specific risk. That this is diversifiable means CAPM assumes it is zero Variations explained by variations in the market International Financing

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

28. How can overall risk change? • Example: • If the number of investment opportunities increases -> increased diversification opportunities -> • Expected returns and project specific risk areunchanged, but • -> less risky in CAPM terminology International Financing

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

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

31. Discount rate for foreign investments First a little intuition:

32. 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!! International Financing

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

34. Estimating foreign project discount rates. Key: Historical data to estimate the betas are not available. -> We need some kind of proxy firm.

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 portfolio 3) which market should the premium be based on? 4) How do we measure country risk? International Financing

36. 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. International Financing

37. 2) Using an adjusted domestic proxy Problems: ->Industries might have higher correlation than markets ->Should there be an additional risk premium for country risk….? International Financing

38. Country specific risk International Financing

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

40. Which risk premium to use! • The US market has the best data! International Financing

41. The final model. Ri = Rf + risk premium ·Bi + (add. premium) observed Constructed from historic data – assumed constant in the long run Many Suggestions. e.g. the difference between the domestic and the foreign interest rate. • Blocal proxy • Rlocal proxy · Bcountry • GCAPM International Financing

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

43. Cost of Debt

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 International Financing

45. Cost of Debt - International Scenario • Use of Sovereign Risk Spreads Cost of Debt = Treasury bond yield + the country risk premium International Financing

46. International Financing

47. Capital Structure of Multinational Corporation and its Foreign Affiliates

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 International Financing

49. World Capital Structure

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. International Financing