Chapter 13 Global Financial Management

1. Chapter 13 Global Financial Management

2. Key issues in global finance • Currency exchange variations • Strategic exposure (long -term ) • Transaction exposure (short-term) • Translation exposure (book valuation effect) • Investment • Project valuation • Financing • Equity financing and cross-listing • Debt financing • Trade financing • Project finance

3. Currency exchange variations

4. Strategic effects of forex variations Markets Markets Domestic Global Domestic Global Increases competitiveness of domesticaly produced products Increases competitiveness against imports Decreases competitiveness Decreases competitiveness Domestic Domestic Firms Firms Decreases competitiveness of products with high global content Increase competitiveness No effects No effects Global Global Effects of a ‘domestic’ revaluation Effects of a ‘domestic’ devaluation

5. Strategic effects: what to do? • Move production: • to low cost countries • to countries with weak currencies? • Differentiate to make products less price-sensitive • Balance production-sales by currency zones

6. Transaction exposure • Hedging techniques: • Forward contracts • Money markets contracts • Future contracts • Options • Swap • Netting • Leading and lagging

7. Hedging with forward contract Example: a US machinery company sells to a paper machine to a Finnish company for 10 million Euros payable in one year US interest rate: 1% Euro interest rate: 2% Spot exchange rate: 1.30 $/€ Forward rate (1 Year): 1.287$/£

8. Example: The paper machinery transaction Forward hedge Money market hedge

9. Netting Example: Cash receipts and disbursements matrix for Teltrex ($000) Teltrex’s interaffiliates foreign exchange transactions without netting (000 $) Bilateral netting of Teltrex’s interaffiliates foreign exchange transactions (000 $) +30 GER GER US +10 US +20 +15 +10 +30 +10 +25 +40 +10 +25 +35 +60 +20 +40 +20 AUS UK AUS UK +10 +30

10. Netting cont. Example +10 US GER +35 Intersubsidiaries netting +5 +40 +30 AUS UK +15

11. Global financing Cross-listing • If cost of capital is different (fragmented) across countries there is a potential advantage of arbitrage (assuming similar risks). • But also: • Higher liquidity • Larger investor base • Higher visibility • Less vulnerable to hostile take-over • However: • Costs of compliance • Higher dependance on volatility of international markets Source: Eun and Resnick: International Financial Management, 2001

12. Global financing cont. Source : NYSE Factbook, 1999.

13. Project finance ‘Financing of a particular economic unit in which the providers of funds look primarily to the cash flow from the project as the source of funds to service their loans or provide a return on equity and to the assets of the economic unit as collateral for the loans.’* • Involves: • Private sponsors • Multinational development agencies (IFC, ADB, EBRD, AFDB..) • Bilateral development agencies (CDC, AFD, Finnfunds, OECF..) • Commercial banks • Export credit agencies (Coface, Hermes, ECGD…) *Nevitt & Fabozzi (2000) and Finnerty (1996)

14. Project valuation Objectives • To look at the costs and benefits of a project from the point of view: • of the fund providers (financial risks and return) • of the stakeholders (economic and social risks and return) I.R.R E.R.R • This applies to: • Infrastructure projects • Industrial projects

15. The points of view of the providers of funds • Project cash flow based evaluation: • NPV • IRR • Pay back • Project sponsor • Other equity providers • Loan providers • Issues: • Evaluation of the risks for the funds providers • How to incorporate risks into the calculation

16. Risks in project evaluation Construction risks Operating risks Sovereign risks Technology Supply Expropriation Complexity or untested technology may lead to cost overruns or construction delays. Quantity and quality of resources Direct Creeping Market Legal Timing Price and quantity of output Lack of law enforcement Throughput Failure to complete on time may induce penalties and jeopardize cash flows Price control Efficiency of process Inflation Operating Costs Supporting industries Absence of qualified contractors and supporting services Staibilty of cost factors Foreign exchange Force majeure Convertibilty and transferability ‘Acts of god’ Environmental Wars, terrorism Logistics and red tape Difficulties in custom clearance transport of materials and personnel Disruption Strikes

17. Mitigating risks in projects Construction risks Operating risks Sovereign risks Supply Expropriation Technology Supplier training International suppliers Integrated projects (power, water, etc.) Multilateral agency as shareholder Host country assets in home country Proven technology Appropriate technology Experience in projects Project management Market Legal Take-off contracts Exports Timing Lobbying Throughput Project management Price control Proven process Experience Management Supporting industries Lobbying Suppliers training Piggy backing Inflation Operating costs Quality of management Long-term contracts Pricing Logistics and red tape Foreign exchange Force majeure Output priced in hard currency Insurance Local knowledge Disruption Convertibilty and transferability Fairness Human resource management Offshore proceeds account

18. Accounting for risks in projects evaluation 2 methods: Adjusting the cost of equity with a ‘risk’ premium • Country βeta (Lessard): • CoE= Risk free rate + country risk premium + asset βeta *market equity premium* Country βeta • Risk premium : • a) based on bond spread • = (yield on host country bonds - yield on home country bonds) • b) Export credits agency credit risk premium Adjusting the cash flows Adjust each element of cash flow according to expected occurrence of adverse events

19. Adjusting the cost of equity (Donald Lessard - MIT) • Calculate the risk premiumdue to market risk(offshore project βeta) to be included in the cost of equity • Offshore project βeta = βeta of comparable project in home country * country βeta • Where country βeta = volatility of the host country stock market (correlation of changes with home country) (or GDP)/ to the home country • Add a political risk premium • Bond risk premium • Adjust WACCaccordingly • Cost of equityin a foreign investment: • = Risk-free home country + country risk (bond risk premium) + market risk premium* • (company βeta * country market βeta)

20. Adjusting the cost of equity (Donald Lessard - MIT) cont. Example: Investment of Australian Mining Co. (AMC) in Brazil, entirely financed with equity Cash flow in Brazilian Real (BRL): (1 AUS$ = 1.9 BRL) (AMC cost of equity: 12% (5% risk free + 5% market risk + 2% company risk) 10 year government bond rates: Australia = 5.5%; Brazil= 12.4%) GDP variation βeta BRZ/AUS= 1.04 NPV without risks (cost of equity: 12%) = IRR = NPV with risks (cost of equity: 12% + (12.4% - 5.5%) + (5%*1.04) = IRR =

21. Adjusting the cash flows (Hawawini & Viallet - INSEAD) 1. Identify the elements of cash flow subject to country risk variation (revenues, costs) 2. Assign a probability of occurrenceto those elements 3. Take the expected value[likely cash flow * (1-probability of adverse event)] 4. Possibility to run a Monte Carlo simulationif various probabilities affect various elements 5. Calculate NPV with global cost of capital

22. Trade finance