1. “International Finance and Payments” Lecture V “Cost of International Capital” Lect. Cristian PĂUN Email: cpaun@ase.ro cpaun@ase.rocpaun@ase.ro URL: http://www.finint.ase.ro Academy of Economic Studies Faculty of International Business and Economics

2. Course 2: International Financial Markets and Institutions 2 International portfolio theory - review the difference between certainty, risk and uncertainty in international financing; investment decision is based on risk and return profile; investors expectations in terms of return are based on their risk assessment (direct relationship); investors associate an utility function to their expected returns; we have different risk attitudes; modern portfolio theory: Markovitz – efficient frontier CAPM (W. Sharpe) – beta and market portfolio APT (S. Ross) – arbitrage and market equilibrium active and passive portfolio management.

3. Course 2: International Financial Markets and Institutions 3 Interest rate and market equilibrium interest rate = compensation required by the investors because they lend money for a determined period of time; interest rate = market equilibrium between demand and supply of money; Supply curveDemand curve 950 $5.3% 900 $ 11.1% i=RET=(FV-P)/P Quantity of bonds 750 $ 33 % 100 bil. 500 bil. 850 $ 17.6% E 300 bil. Interest rate Security price

4. Course 2: International Financial Markets and Institutions 4 Shifts in the demand for bonds Wealth; Expected returns on bonds relative to alternative assets; Expected inflation Risk of bonds relative to alternative assets; Liquidity of bonds relative to alternative assets. Shifts in the supply for bonds Expected profitability of investment opportunities (increase); Expected inflation (real cost of financing is falling down); Government activities (public deficits). Fisher effect: when expected inflation rises, interest rates will rise Liquidity preference framework: B D +M D =B S +M S (Keynes) (no real assets)

5. Course 2: International Financial Markets and Institutions 5 Shifts in the demand for money Income level (increase); Price level (increase); Shifts in the supply for money Central Bank expansionary monetary policy; 2. Interest rate and rate of return - Zero-cupon bond: i=RET=(FV-IP)/IP - RET=(P t+1 -P t +I)/P t = current yield + capital gain RET – return for holding a security from time t to time t+1 P t, P t+1 – prices at moment t and t+1 Interest payments (Coupon or Dividends)

6. Course 2: International Financial Markets and Institutions 6 Real and Nominal Interest Rate Simple and Compounded Interest Rate Risk Free Interest Rate I nominal =I real +Inflation (1+I nominal )=(1+I real )x(1+p) - Fisher Effect RFR=(FV T-Bills -IP T-Bills )/IP T-Bills 100 USD = IP110 USD = FV

7. Course 2: International Financial Markets and Institutions 7 Risk Structure of Interest Rate - Default risk = the chance that the issuer of the bond will be unable to make interest payments or pay off the face value at the maturity; Aaa  Baa  Caa (Moody’s) AAA  BBB  CCC  D (S&P) Ex: B Companies: Mariott, Revlon AA Companies: McDonalds, Mobil Oil AAA Companies: General Electric, Wisconsin Bell - Liquidity = the capacity of a security to be cheaply and quickly converted into cash - Income Tax Consideration: in case of Municipal Bonds vs. T-Bonds

8. Course 2: International Financial Markets and Institutions 8 Term Structure of Interest Rate - Securities with identical risk, liquidity and income tax characteristics may have different interest rates because the maturity is different - Yield Curve plots the yields on bonds with different terms to maturity but identical risk, liquidity and tax characteristics US Treasury Yield Curve / November 2004 Date1 mo3 mo6 mo1 yr2 yr3 yr5 yr7 yr10 yr20 yr 11/01/041.791.992.202.342.612.893.363.764.114.84 11/02/041.861.972.192.332.602.863.343.754.104.84 11/03/041.831.962.182.322.602.853.353.744.094.83 Maturity Yield Yield Curve Securities with longer maturities usually have a higher yield. If short term securities offer a higher yield, then the curve is said to be inverted.

9. Course 2: International Financial Markets and Institutions 9 Cost of International Capital Current Yield = Current Yield = 9.04% Step 1: Determine the proportions of each source to be raised as capital. Step 2: Determine the marginal cost of each source. Step 3: Calculate the weighted average cost of capital.

10. Course 2: International Financial Markets and Institutions 10 Cost of International Capital – Time Value of Money - Translating a value back in time -- referred to as discounting -- requires determining what a future amount or cash flow is worth today.discounting A1A1 A2A2 A3A3 A4A4 A5A5 Financing Decision Moment EX: 1000 USD  1100 USD after 1 y Inflation rate of 20% 1100 USD = 1100 / (1+p) = 916.6. USD in present

11. Course 2: International Financial Markets and Institutions 11 Present Value, Net Present Value, Internal Rate of Return IRR = k  NPV = 0 Inflation rate Interest rate Estimated profit for an investment project Discounted rate Expectations in terms of

12. Course 2: International Financial Markets and Institutions 12 Present Value, Net Present Value, Internal Rate of Return Conclusion 1: Internal Rate of Return is the best measure for the marginal cost of international financing (real cost is 17.80 instead 10% or 8.89%)

13. Course 2: International Financial Markets and Institutions 13 Comparing credits in different currencies using NPV Method I: - Estimating k(euro) - Estimating k(USD) - NPV euro x spot 0 = NPV euro USD

14. Course 2: International Financial Markets and Institutions 14 Comparing credits in different currencies using NPV Method II: - Estimating k(euro) - Estimating exchange rate - Transforming An from USD in € - Comparing NPV

15. Course 2: International Financial Markets and Institutions 15 Comparing credits in different currencies using NPV Method III (best accuracy): - Estimating k(euro) - Estimating k(USD) - Estimating an average FX rate - Transforming NPV from USD in € - Comparing NPV

16. Course 2: International Financial Markets and Institutions 16 Comparing credits in different currencies using IRR Method I: Comparing IRR obtained on initial An expressed in different currencies Method II: Transforming An from USD to Euro and calculating IRR We have the same IRR (= 17.8%) We have different IRR:

17. Course 2: International Financial Markets and Institutions 17 NPV Criteria in International Financing - Easier to be calculated than IRR - It is difficult to estimate different discount rates for different financial markets; - We should take into consideration the exchange rate when we compare different NPVs; - NPV encourage big investment projects and discourage big financing projects. IRR Criteria in International Financing Independent from FX rate; It is quite complicated to be estimated; In some cases we can’t calculate it (symmetric annuities, positive annuities). CONCLUSION 2: When compare different financing alternatives we should use both two criteria: NPV and IRR

18. Course 2: International Financial Markets and Institutions 18 Cost of Equity Scenario A: - Buy – back of stocks after 5 years: NPV = 0  K stocks Scenario B: no buy - back K stocks = (D 0 /IP)+g (Gordon – Shapiro Model)

19. Course 2: International Financial Markets and Institutions 19 International Financing Plan - summary WACC = 13.27%

20. Course 2: International Financial Markets and Institutions 20 Global CAPM and WACC RfRf RmRm EiEi Beta β i =1 Risk premium Securities with a higher risk than market risk Securities with a lower risk than market risk Note: the company has the same risk as the global market has WACC RmRm

21. Course 2: International Financial Markets and Institutions 21 Capital Structure Optimization trying to find new financing resources with a lower cost according to the risk level of the borrower modifying the credit condition in terms of reimbursement, renouncing to the no – payment periods; modifying the capital structure; different maturities; diversifying international your financing; search to issue more fixed income instruments.