CAPITAL BUDGETING ISSUES IN FAST-GROWING ECONOMIES COST OF CAPITAL

Plan NPV is the sum of discounted cash flows Cash flows come from capital budgeting Where do discount rates come from? Cost of capital cost of equity cost of debt weighted average cost of capital practitioner approach (country risks)

How to value business opportunities? Examples Boeing considers building a component assembly plant in Sao Paulo. The plant would import components from Canada, employ Brazilian workers to assemble the components into modules, and re-exports all of its production back to Bombardier’s facilities in US. Google analyzes entering the Russian portal market via a joint venture with Yandex search engine.

How to value business opportunities? Project valuation in emerging markets can be challenging how would you go about valuing each investments? would you construct your cash flow projections in Brazilian Real or Canadian dollars? Then, how would you convert between different currencies? how would you measure country risks (political risk, corruption) and how would you adjust your cost of capital for country risks? what about industry characteristics (e.g., aviation vs. internet access)?

Main issues Main issues arising when investing in EM recognizing costs and revenues in multiple currencies assessing country risk and incorporating them into discount rate country risk includes macroeconomic volatility, potential regulatory or political change, poorly defined property rights and enforcement mechanisms accounting for business volatility which is different from that of developed economy accounting for potential events, e.g., expropriation or currency devaluation These issues make project valuation in EM an art than a science

Basic idea Basic Principles inflation and risk erode purchasing power of money. Hence, dollar received at 2011 will have different purchasing power from the same dollars received at 2012 we have to discount future cash flows with appropriate discount rates as future cash flows are also exposed to uncertainty, we calculate expected value of cash flows at each time in the future before discounting Present Value of Investment where CFi is the expected cash flow at future year i and DR a discount rate that reflects the risk of the investment

NPV Basic Idea Net Present Value is the Present Value of an investment project, “net” of initial investment to start the project positive NPV indicates that the present value of the cash flows of the project outweighs the necessary investments; a negative NPV indicates the opposite Net Present Value of Investment If NPV > 0  Invest; If NPV < 0  Do not invest. If NPVi > NPVj  Invest in i; If NPVi < NPVj  Invest in j.

Steps Project value determining steps Forecasting investment requirements and expected free cash flows from a project Determining the rate at which to discount the cash flows from the project (cost of capital) Using the discount rate to calculate the net present value (NPV) of the project Performing sensitivity analysis

Currency conversion Foreign exchange terminology and economic relationships spot rate forward rate for any two countries and any two periods, the expected change in the exchange rate is equal to the difference in nominal interest rates, which is equal to the expected difference in inflation rates what happens if the equality does not hold?  Currency arbitrage

Revenues and costs in multiple currencies Capital budgeting with multiple currencies – two approaches Local currency NPV project value is primarily determined by the events within the host country revenues and costs occur primarily in local currency, when investment capital is raised locally and free cash flow is reinvested locally pros: don’t need to forecast exchange rates cons: local cost of capital can be severely distorted, especially due to hyperinflation or government’s interest rate manipulation when there is (dis) advantage against foreign firms accessing local financing, this approach can (over) undervalue the project, compared to local firms 11

Revenues and costs in multiple currencies Capital budgeting with multiple currencies – two approaches Period-by period conversion produce local currency projections, then convert the period-by period cash flows into home country currency using forward rates or projected exchange rates resulting home country cash flows are then discounted at a rate derived from the home country discount rate. pros: analyst can explicitly consider how shifts in the exchange rate affect project cons: few forward rates are available beyond one year forecasting can be complicated when local governments intervenes in credit or foreign exchange market 12

Cost of capital Intuitive definition minimum return required from the projects invested by a company average cost of financing a company it is the minimum required rate of return on an investment project that keeps the present wealth of the shareholders constant it is also a discount rate used to determine how favorable an investment project is 13

Equity cost of capital The Capital Asset Pricing Model (CAPM) is a practical way to estimate. The cost of capital of any investment opportunity equals the expected return of available investments with the same beta. The estimate is provided by the Security Market Line equation: Risk Premium for Security i

Example Suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson &Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk? If the risk-free interest rate is 4% and you estimate the market’s expected return to be 12%, calculate the equity cost of capital for Wal-Mart and Johnson & Johnson. Which company has a higher cost of equity capital?

Market indexes Report the value of a particular portfolio of securities. Examples: S&P 500 A value-weighted portfolio of the 500 largest U.S. stocks Wilshire 5000 A value-weighted index of all U.S. stocks listed on the major stock exchanges Dow Jones Industrial Average (DJIA) A price weighted portfolio of 30 large industrial stocks

Market portfolio Most practitioners use the S&P 500 as the market proxy, even though it is not actually the market portfolio.

Market risk premium Determining the Risk-Free Rate The yield on U.S. Treasury securities Surveys suggest most practitioners use 10 to 30 year treasuries Where to obtain? The Historical Risk Premium Estimate the risk premium (E[RMkt]-rf) using the historical average excess return of the market over the risk-free interest rate

Historical Excess Returns of the S&P 500 Compared to One-Year and Ten-Year U.S. Treasury Securities

Beta estimation Estimating Beta from Historical Returns Recall, beta is the expected percent change in the excess return of the security for a 1% change in the excess return of the market portfolio. Consider Cisco Systems stock and how it changes with the market portfolio.

Monthly Returns for Cisco Stock and for the S&P 500, 1996–2009

Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 1996–2009

Beta estimation Estimating Beta from Historical Returns As the scatterplot on the previous slide shows, Cisco tends to be up when the market is up, and vice versa. We can see that a 10% change in the market’s return corresponds to about a 20% change in Cisco’s return. Thus, Cisco’s return moves about two for one with the overall market, so Cisco’s beta is about 2.

Beta estimation Estimating Beta from Historical Returns Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess returns versus the market excess return.

Using linear regression The statistical technique that identifies the best-fitting line through a set of points. αi is the intercept term of the regression. βi(RMkt – rf) represents the sensitivity of the stock to market risk. When the market’s return increases by 1%, the security’s return increases by βi%. εi is the error term and represents the deviation from the best-fitting line and is zero on average.

Using linear regression Since E[εi] = 0: αi represents a risk-adjusted performance measure for the historical returns. If αi is positive, the stock has performed better than predicted by the CAPM. If αi is negative, the stock’s historical return is below the SML.

Using linear regression Given data for rf , Ri , and RMkt , statistical packages for linear regression can estimate βi. A regression for Cisco using the monthly returns for 1996–2009 indicates the estimated beta is 1.80. The estimate of Cisco’s alpha from the regression is 1.2%.

Practical considerations, comparables approach All-equity comparables Find an all-equity financed firm in a single line of business that is comparable to the project. Complications there are few firms without debt creates problems for both your company and finding comparable companies Leverage would increase your company’s cost of equity!

Equity cost of capital Leverage makes equity riskier Debt Betas One can estimate the debt cost of capital using the CAPM. Debt betas are difficult to estimate because corporate bonds are traded infrequently. One approximation is to use estimates of betas of bond indices by rating category.

Average Debt Betas by Rating and Maturity

Equity cost of capital We often assume that debt beta is zero Levered equity beta is then Intuitively, beta of equity of a levered company is higher for more levered company Even further simplifications assume no tax shield effect

Industry Betas

Debt cost of capital Debt Yields Yield to maturity is the IRR an investor will earn from holding the bond to maturity and receiving its promised payments. If there is little risk the firm will default, yield to maturity is a reasonable estimate of investors’ expected rate of return.

Financing and the Weighted Average Cost of Capital How might the project’s cost of capital change if the firm uses leverage to finance the project? Perfect capital markets In perfect capital markets, choice of financing does not affect cost of capital or project NPV Taxes – A Big Imperfection When interest payments on debt are tax deductible, the net cost to the firm is given by: Effective after-tax interest rate = r(1-τC)

Weighted Average Cost of Capital Weighted Average Cost of Capital (WACC) Given a target leverage ratio:

Example

Notes on beta 37 Which factors influence β ? cyclicality of revenues, leverage low β firms : utilities, food retailers, low fixed cost firms, low levered firms high β firms : high tech or homebuilders why is β of homebuilder high? homebuilder’s revenue is more sensitive to business cycle why is β of low levered firm low? firms with debt should make interest payments regardless of sales or profits 37

Accounting for country risk What is country risk? ability to service its debt and to support the conversion of local earnings into home country currency How to measure country risk? yield on sovereign debt debt yield reflects two risk factors country risk exchange risk premium 38

Accounting for country risk How to measure cost of equity in EM? add country premium Equity Cost of Capital = (Rf + country premium) + β·(Rm – Rf) country premium of developing economies