Valuation Models for a MNC and a Global Investor Combined with Observations on Exchange Rate Impacts

Objective of Lecture 1 In order to understand and appreciate the international forces which multinational firms and global investors face, we need to develop valuation models for global companies and investors. The models which we will develop are patterned after the Anglo-Saxon model of corporate behavior and investment valuations.

Valuation Concepts Anglo-Saxon Approach: – Firm Evaluation: Consider the value of the firm and corporate behavior in terms of (maximizing) the market value of the firm for shareholders. Capital budgeting techniques evaluate projects and corporate investments on the basis of present value of their cash flows. – Financial Asset Evaluation: Consider the present value of the anticipated future income stream from a particular financial asset.

4 Anglo-Saxon Valuation Model for Corporation: Present Value of Future Cash Flow $,t Where E(CF $,t ) represents expected cash flows to be received at the end of period t, N represents the number of periods into the future in which cash flows are received, and K represents the required rate of return by investors. Note: Changes in V occur because of changes in E(CF $,t ) and/or changes in K

5 Measuring the International Cash Flows for a U.S. Based MNC Where CF j,t represents the amount of cash flow denominated in a particular foreign currency j at the end of period t, Where S j,t represents the exchange rate at which the foreign currency can be converted into U.S. dollars at the end of period t. – Measured in U.S. dollars per unit of the foreign currency.

Changes in the Value of a MNC Valuation ModelV changes result from: Changes in foreign market conditions: Will impact on foreign currency earnings and thus on foreign currency cash flows (CF). Changes in political environment and political risk (policy of foreign government towards MNC): Will impact on foreign currency earnings and thus on foreign currency cash flows (CF). Changes in the MNC’s cost of capital, i.e., the required return (k). Changes in the exchange rate resulting from exposure to exchange rate risk (S); noting that: – Stronger foreign currency will increase U.S. dollar equivalent of cash flows. – Weaker foreign currency will decrease U.S. dollar equivalent of cash flows.

Exchange Rate Impacts on Operating Profits Japanese Multinationals Sony, which generates more than 70 percent of revenue outside of Japan, says it loses about 2 billion yen of annual operating profit for each yen gain against the U.S. currency. Toyota notes that every one- yen gain in the Japanese currency against the dollar reduces Toyota’s annual operating profit by 30 billion yen. Yen in 2010

Valuation Models for Financial Assets Bonds: Present value of: – Coupon payments + Par Value (face or maturity value) In U.S., par value = $1,000 Discount rate (k) is adjusted for opportunity cost and risk adjustments. Stocks: Present value of: – Future cash flow (Dividends, earnings) Foreign currency denominated financial assets: Valuation model adjustment needs to be made for changes in exchange rates.

Do Exchange Rates Affect Equity Returns? For an investor in the United States investing foreign stock market: YearLocal Currency Return Return in U.S. Dollars 2009 Japan+21.1%+18.5% Germany+25.4%+29.8% France+24.9%+29.2% Australia+35.2%+75.4% Canada+32.9%+58.6% 2008 Japan-39.6%-27.4% Germany-38.8%-42.9% Canada-34.1%-45.3% Venezuela- 7.1%-58.7%

Exchange Rate Adjusted Equity Returns in 2010 PeriodLocal Currency Return Return in U.S. Dollars Dec 31, 2009 – Aug 18, 2010 Japan-8.0%+0.4% United Kingdom-2.0%-5.4% Canada+0.3%+1.9% Germany+3.8%-7.0% France-7.3% -17.0% Czech Republic+6.0%+1.2% Singapore+0.8%+4.7% Malaysia+8.9% +18.1% Hong Kong-3.9%-4.1%

Exchange Rates in 2010 JPY (Equity Market: -LC8.0%; +$0.4%) GBP (Equity Market: -LC2.0%; -$5.4%)

Exchange Rates in 2010 EUR (German Equity Market: +LC3.8%; -$7.0% HKD (Equity Market: -LC3.9%; -$4.1% (a pegged currency)

Do Exchange Rates Affect Bond Returns?

Exchange Rate Adjusted Bond Returns Return on German Bonds, Exchange Rate Adjusted Returns on Government Bonds, 2005 YearLocal Market% ChangeUSD Return Return*in Local Currency** %11.8%10.0% %9.6%25.9% %-7.7%-0.4% %-15.2%-9.0% %8.9%19.8% %-14.3%-16.4% * = Interest (coupon payment) +/- Change in market price ** : % change in Deutschmark; 1999 % change in Euro