CORPORATE FINANCE VIII ESCP-EAP - European Executive MBA 25&26 January 2006, Berlin I International Finance and Investment Decisions I. Ertürk Senior Fellow in Banking

INTERNATIONAL INVESTMENT DECISIONS METHOD 1 METHOD 2 STEP 1 ESTIMATE FUTURE ESTIMATE FUTURE CASH FLOW IN FCCASH FLOW IN FC STEP 2 CONVERT TO HCCALCULATE PV AT FORECASTED USING FC EXCHANGE RATES DISCOUNT RATE...STEP 3 CALCULATE PV CONVERT TO HC USING HC USING SPOT RATE DISCOUNT RATE HC: HOME CURRENCY FC: FOREIGN CURRENCY

EXAMPLE  US STEEL’S EXPECTED NET CASH FLOWS IN THOUSANDS OF EUROS YEAR CASH FLOW-1,  HOW MUCH ARE THESE CASH FLOWS WORTH TODAY IF OUTLAND WANTS 16% DOLLAR RETURN FROM ITS DUTCH INVESTMENT?

METHOD 2  NEED TO CALCULATE DUTCH RISK-ADJUSTED DISCOUNT RATE  US risk free rate= 8%Euro risk free rate=9%  (1 +U.S. RISK-ADJUSTED DISCOUNT RATE) = ( 1 + U.S. NOMINAL RISK-FREE INTEREST RATE) x (1 + RISK-PREMIUM) 1.16 = 1.08 x (1 + RISK-PREMIUM) (1 + RISK PREMIUM) =  (1 + DUTCH RISK-ADJUSTED DISCOUNT RATE)..= ( 1 +DUTCH NOMINAL RISK-FREE INTEREST RATE) x (1 + RISK-PREMIUM) = 1.09 x = OR 17.1%

METHOD 2  DISCOUNT EURO CASH FLOW AT EURO OPPORTUNITY COST OF CAPITAL – OBTAIN EURO PV OF CASH FLOWS – CONVERT TO DOLLARS AT SPOT RATE YEAR CASH FLOW-1, % = €588 CONVERT TO €1=$1.10$647

METHOD 1 -FORECAST EXCHANGE RATE -CONVERT FC CASHFLOW TO HC CASHFLOW -DISCOUNT AT HC COST OF CAPITAL TO FIND HC NPV YEAR €CASH FLOW-1, FX RATE $CASH FLOW-1, %$372

FORECASTING FX RATES & THREE PARITIES  INTEREST RATE PARITY – relates today’s spot exchange rate to today’s forward exchange rate – foreign exchange markets and money markets  INTERNATIONAL FISHER EFFECT – estimating future spot exchange rate from interest rate differentials in capital markets – foreign exchange markets and capital markets  PURCHASING POWER PARITY – estimating future spot exchange rate from inflation differentials – foreign exchange markets and goods markets

INTEREST RATES AND EXCHANGE RATES  €1MM TO BORROW FOR 1YEAR  CHOICE BETWEEN – EURO LOAN AT 7 5/8 % – SWISS FRANC LOAN AT 4 9/16 %  EURO LOAN – AT END OF YEAR 1,000,000 x 1,07625 = €1,076,250  SWISS FRANC LOAN – SPOT RATE SFr1.3125/€ – BORROW 1,000,000 x = SFr1,312,500 – AFTER 1 YEAR, PAY – 1,312,500 x = SFr1,372,383

COVERED INTEREST RATE ARBITRAGE  YOU WANT TO BE SURE OF THE EXCHANGE RATE YOU RECEIVE IN A YEAR’S TIME – YOU FIX TODAY THE PRICE AT WHICH YOU WILL BUY YOUR FRANCS AT END OF YEAR BY BUYING THEM FORWARD – 1-YEAR FORWARD RATE IS SFr1.275/€ – AFTER 1 YEAR, PAY 1,372,383/1.275 = €1,076,379  TWO INVESTMENTS OFFER (ALMOST) SAME RETURN  IF DOMESTIC INTEREST RATE DIFFERENT FROM COVERED FOREIGN INTEREST RATE – OPPORTUNITY FOR RISKLESS ARBITRAGE

INTEREST RATE PARITY  THE SWISS FRANC BORROWING GIVES YOU LOWER INTEREST RATE – BUT YOU LOSE BY BUYING FRANCS FORWARD – IN A YEAR’S TIME MORE EUROS NEEDED THAN TODAY f SFr/€ = s SFr/€ * (1 + r SFr ) / (1 + r € ) = SFr1,275/€  INTEREST RATE PARITY THEOREM – INTEREST RATE DIFFERENTIAL = DIFFERENTIAL BETWEEN FORWARD AND SPOT RATES

INTERNATIONAL FISHER EFFECT  CAPITAL FLOWS WHERE REAL RETURNS ARE GREATEST  IN EQUILIBRIUM – EXPECTED REAL RETURN ON CAPITAL SAME IN ALL COUNTRIES  FISHER EQUATION s t+1 = s t * (1 + r foreign ) / (1 + r home )

REAL INTEREST RATES AND CAPITAL MARKET EQUILIBRIUM  IN SHORT RUN – GOVERNMENTS HAVE CONTROL OVER INTEREST RATES – CAN ACHIEVE REAL INTEREST RATES BELOW OTHER COUNTRIES  BUT CANNOT MAINTAIN POSITION INDEFINITELY – INVESTORS WILL TRANSFER CASH TO HIGH REAL INTEREST COUNTRIES  COUNTRIES WITH HIGHEST INFLATION HAD HIGHEST INTEREST RATES  MUCH SMALLER DIFFERENCES BETWEEN REAL INTEREST RATES THAN BETWEEN NOMINAL RATES

GOODS MARKET AND FX MARKET  SAME FORCES THAT TEND TO MAKE PRICE LEVELS ROUGHLY SAME ACROSS SUPERMARKETS OFFERING SIMILAR SERVICES  CALLED – LAW OF ONE PRICE (TALKING ABOUT SINGLE GOOD) – PURCHASING POWER PARITY(TALKING ABOUT LEVEL OF PRICES IN GENERAL)  PPP IMPLIES THAT – ANY DIFFERENCES IN INFLATION BETWEEN THE TWO COUNTRIES – OFFSET BY CHANGE IN EXCHANGE RATE

PURCHASING POWER PARITY  IF INFLATION 4% IN EU, 1% IN SWITZERLAND – TO EQUALIZE EURO PRICES OF GOODS IN EU AND SWITZERLAND – NUMBER OF SWISS FRANCS YOU CAN BUY FOR A EURO MUST FALL BY (1.01/1.04) - 1 OR ABOUT 3% s t+1 = s t * (1 + i foreign ) / (1 + i home )

EXCHANGE RATES AND INFLATION  PLAZA ACCORD AND US DOLLAR DEVALUATION IN 1986  ERM CRISIS AND STERLING DEVALUATION IN 1992  MEXICAN PESO CRISIS IN 1994  FINANCIAL CRISIS IN THE FAR EAST IN 1997  ARGENTINA IN 2002 PPP WORKS IN THE LONGER TERM AS A TREND RATHER THAN ACCURATE POINT ESTIMATE TRADEABLE GOODS INDEX VS. CPI

INTERNATIONAL FINANCIAL MANAGEMENT  MANY COMPANIES DO BUSINESS OVERSEAS  SAME OBJECTIVES AS DOMESTIC FINANCE – BUT ADDITIONAL PROBLEMS  MULTIPLE CURRENCIES – HOW CAN FIRM PROTECT ITSELF AGAINST EXCHANGE RISKS?  DIFFERING INTEREST RATES ACROSS COUNTRIES

INTERNATIONAL FINANCIAL MANAGEMENT  SHOULD PARENT – PROVIDE FINANCING? – TRY TO FINANCE LOCALLY? – BORROW WHERE INTEREST RATES LOWEST?  HOW SHOULD INTERNATIONAL COMPANIES MAKE CAPITAL BUDGETING DECISIONS? – WHAT DISCOUNT RATE? – HOW DOES FINANCING METHOD AFFECT CHOICE OF PROJECT?

COST OF CAPITAL FOR FOREIGN INVESTMENT  THINK MORE CAREFULLY ABOUT RISK OF OVERSEAS PROJECT – WHAT RETURN DO INVESTORS REQUIRE FPR TAKING THIS RISK?  ANSWER DEPENDS ON OTHER SECURITIES INVESTOR HOLDS IN HER PORTFOLIO  CASE 1 – SINGLE WORLD CAPITAL MARKET INVESTORS FROM EACH COUNTRY HOLD WELL-DIVERSIFIED INTERNATIONAL PORTFOLIOS – RISK OF FOREIGN PROJECT IS PROJECT’S BETA RELATIVE TO WORLD MARKET PORTFOLIO – SAME BETA AS LOCAL COMPANY

COST OF CAPITAL FOR FOREIGN INVESTMENT  CASE 2  OTHER EXTREME  CAPITAL MARKETS COMPLETELY SEGMENTED  LOCAL INVESTORS HOLD ONLY LOCAL STOCKS – FOREIGN INVESTORS HOLD ONLY FOREIGN STOCKS  FOREIGN PROJECT AND A LOCAL COMPANY DO NOT FACE SAME RISK – LOCAL PLC’S RISK IS MEASURED BY ITS BETA RELATIVE TO LOCAL MARKET – MAY BE LOW RISK IF FOREIGN MARKET NOT CLOSELY CORRELATED WITH LOCAL MARKET – FOREIGN PLC MEASURES ITS RISK RELATIVE TO FOREIGN MARKET

COST OF CAPITAL FOR FOREIGN INVESTMENT SINGLE WORLD COMPLETELY SEGMENTED CAPITAL MARKET CAPITAL MARKETS INTERNATIONAL DOMESTIC DIVERSIFICATION DIVERSIFICATION RISK MEASURED RELATIVE RISK MEASURED RELATIVE TO WORLD MARKET INDEX TO DOMESTIC INDEX NO FURTHER GAINS FROM LARGE GAINS FROM INTERNATIONAL INTERNATIONAL DIVERSIFICATION DIVERSIFICATION LOCAL FIRM HAS SAME LOCAL FIRM HAS DIFFERENT COST OF CAPITAL AS COST OF CAPITAL THAN FOREIGN FIRM FOREIGN FIRM

COST OF CAPITAL FOR FOREIGN INVESTMENT  MARKETS PARTIALLY SEGMENTED  LOCAL INVESTORS FREE TO HOLD FOREIGN SHARES – BUT ONLY SMALL PART OF PORTFOLIO IN FOREIGN STOCKS – PERHAPS BECAUSE OF COSTS OF GETTING INFORMATION  WORLD IS CHANGING  LARGE INSTITUTIONAL INVESTORS INCREASING OVERSEAS INVESTMENTS  MUTUAL FUNDS INVESTING IN FOREIGN STOCKS FOR INDIVIDUAL INVESTORS – EVEN IN SMALLER STOCK MARKETS – INDIA – THAILAND – CHILE

FUDGE FACTORS  MANAGERS OFTEN MARK UP DOMESTIC COST OF CAPITAL BY A FUDGE FACTOR – WHEN CONSIDERING FOREIGN INVESTMENTS – PERHAPS TO COVER RISK OF EXPROPRIATION – FOREIGN EXCHANGE RESTRICTIONS  BETTER LEAVE DISCOUNT RATE ALONE – LIKELY TO BE UNSYSTEMATIC RISKS  REDUCE EXPECTED CASH FLOWS INSTEAD  SUPPOSE THERE IS A 10% CHANCE OF PLANT BEING SHUT DOWN BECAUSE OF POLITICAL UNREST – REDUCE EXPECTED CASH FLOW BY 10%  ADJUSTING CASH FLOWS BRINGS ASSUMPTIONS ABOUT POLITICAL RISK INTO THE OPEN

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