1. Page 1 International Finance Lecture 11

2. Page 2 International Finance Course topics –Foundations of International Financial Management –World Financial Markets and Institutions –Foreign Exchange Exposure –Financial Management for a Multinational Firm

3. Page 3 Financial Management for a Multinational Firm Foreign direct investment International Capital Structure, Cost of Capital International Capital Budgeting

4. Page 4 Cost of Capital For a levered firm, the financing costs can be represented by the weighted average cost of capital: K = (1 – )k e + (1 –  )i Where K = ___________ average cost of capital k e = cost of equity capital for a levered firm i = pretax cost of debt = % of debt, debt to total market value ratio  = _____________ corporate income tax rate

5. Page 5 The Firm’s Investment Decision and the Cost of Capital A firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders. Internationalizing the firm’s cost of capital is one such policy. cost of capital (%) Investment ($)

6. Page 6 Cost of Capital in Segmented vs. Integrated Markets The cost of equity capital (k e ) of a firm is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Model (CAPM): where

7. Page 7 Segmented vs. Integrated Markets If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. versus Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital.

8. Page 8 Does the Cost of Capital Differ among Countries? There do appear to be differences in the cost of capital in different countries. –Local rates for debt and equity capital may differ –Leverage ratio may differ across countries In US, Canada, UK leverage _____, on average In Europe, Japan leverage _______, on average When markets are imperfect, international financing can lower the firm’s cost of capital. One way to achieve this is to internationalize the firm’s ownership structure.

9. Page 9 Example: Novo Industri

10. Page 10 Cross-Border Listings of Shares Cross-border listings of stocks have become quite _________ among major corporations. The largest contingent of foreign stocks are listed on the ___________ Stock Exchange. U.S. exchanges attracted the next largest contingent of foreign stocks.

11. Page 11 Cross-Border Listings of Shares Cross-border listings of stocks benefit a company in the following ways. –The company can ________ its potential investor base, which will lead to a higher stock price and lower cost of capital. –Cross-listing creates a _____________ market for the company’s shares, which facilitates raising new capital in foreign markets. –Cross-listing can enhance the ____________ of the company’s stock. –Cross-listing enhances the ___________ of the company’s name and its products in foreign marketplaces.

12. Page 12 Cross-Border Listings of Shares Cross-border listings of stocks have costs. –It can be ____________ to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. –Once a company’s stock is traded in overseas markets, there can be volatility __________ from these markets. –Once a company’s stock is make available to foreigners, they might acquire a ___________ interest and challenge the domestic control of the company.

13. Page 13 Cross-Border Listings of Shares Cross-border listings of stocks do carry costs. –Daimler Benz’s net profit/loss (DM bn) German Vs American Accounting rules

14. Page 14 Cross-Border Listings of Shares Selected Foreign Firms listed on the NYSE

15. Page 15 The Effect of Foreign Equity Ownership Restrictions While companies have _______________ to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners. In some countries, there are legal ____________ on the percentage of a firm that foreigners can own. These restrictions are imposed as a means of ensuring domestic ___________ of local firms.

16. Page 16 Pricing-to-Market Phenomenon Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm. But they are constrained by ownership constraints imposed on foreigners to purchase at most 20 percent. Because this constraint is effective in ________ desired foreign ownership, foreign and domestic investors face different market share prices. This dual pricing is the pricing-to-market phenomenon.

17. Page 17 Foreign Ownership Restrictions: Nestlé Nestlé used to issue two different classes of common stock: bearer shares and registered shares. –Foreigners were only allowed to buy ______ shares. –Swiss citizens could buy ____________ shares. –The bearer stock was ____________________ On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.

18. Page 18 Nestlé’s Foreign Ownership Restrictions 12,000 10,000 8,000 6,000 4,000 2,000 0 11203191824 Source: Financial Times, November 26, 1988 p.1. Adapted with permission. SF

19. Page 19 Foreign Ownership Restrictions: Nestlé Following this, the price spread between the two types of shares ___________ dramatically. –This implies that there was a major _______ of wealth from foreign shareholders to Swiss shareholders. –The price of bearer shares declined about 25 percent. –The price of registered shares rose by about 35 percent.

20. Page 20 Foreign Ownership Restrictions: Nestlé Because registered shares represented about two-thirds of the market capitalization, the total value of Nestlé ______________ substantially when it internationalized its ownership structure. Nestlé’s cost of capital therefore _________.

21. Page 21 Foreign Ownership Restrictions: Nestlé Foreigners holding Nestlé bearer shares were exposed to __________ risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates –The importance of considering market imperfections. –The peril of political risk. –The benefits to the firm of internationalizing its ownership structure.

22. Page 22 The Financial Structure of Subsidiaries. There are three different approaches to determining the subsidiary’s financial structure. 1. Conform to the parent company's norm. 2. Conform to the local norm of the country where the subsidiary operates. 3. Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risk, and take advantage of various market imperfections.

23. Page 23 Financial Management for a Multinational Firm Foreign direct investment International Capital Structure, Cost of Capital International Capital Budgeting

24. Page 24 Review of Capital Budgeting The basic net present value equation is Where: CF t = expected incremental after-tax cash flow in year t, TV T = expected after tax cash flow (terminal value) in year T, including return of net working capital, C 0 = initial investment at inception, K = weighted average cost of capital. T = economic life of the project in years.

25. Page 25 Review of Capital Budgeting Cash flow estimation R t is incremental revenue OC t is incremental operating cost D t is incremental depreciation I t is incremental interest expense  is the marginal tax rate

26. Page 26 Review of Capital Budgeting Various ways to represent CF

27. Page 27 Review of Capital Budgeting We can use to rewrite the NPV equation as:

28. Page 28 The Adjusted Present Value Model Can be converted to adjusted present value (APV)

29. Page 29 The Adjusted Present Value Model The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually. Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.

30. Page 30 Domestic APV Example Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: 01 2 3 4 -$1,000$125 $250 $375 $500 The unlevered cost of equity is r 0 = 10%:

31. Page 31 Domestic APV Example Now, imagine that the firm finances the project with $600 of debt at r = 8%. Pearson’s tax rate is 40%, so they have an interest tax shield worth t×I =.40×$600×.08 = $19.20 each year.  The net present value of the project under leverage is:

32. Page 32 Domestic APV Example Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:

33. Page 33 Capital Budgeting from the Parent Firm’s Perspective Donald Lessard (1985) developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.

34. Page 34 APV Example A US-based International Diesel Corporation (IDS-US) is evaluating whether to build a diesel engine plant in the UK (IDS-UK). The estimated project after tax operating cash flows in millions GBP are below. YEAR 0123455+ -26.52.23.35.66.3 19.0 The optimal capital structure is 80% equity and 20% debt. GBP is expected to depreciate by 2% per year vis-à-vis USD. Depreciation is 5 million GBP during first 5 years. Today's exchange rate is USD/GBP $2.00. The applicable marginal tax rate in the UK and US 40%, borrowing rate in USD is 8% and 10% in GBP, the unlevered cost of equity is 12%. IDS borrows in the US market to finance the project. Should IDS undertake the project?

35. Page 35 APV Example Exchange rates. FX(t+1)=0.98*FX(t) YEAR 0123455+ $2.00 $ cash flows. $CF = FX(t) * GBP CF(t) YEAR 0123455+ Present value. Use CF and NPV worksheets. Present value =

36. Page 36 APV Example Depreciation tax shield = D(t) * tax * FX(t). PV @ 8% = YEAR 012345 n/a Interest write-off tax shield

37. Page 37 Risk Adjustment in the Capital Budgeting Process Clearly risk and return are correlated. ____________ risk may exist along side of business risk, necessitating an adjustment in the discount rate. –Systematic risk is reflected by K ud. Therefore, if a project is riskier than average firm’s project, __________ K ud, or if less risky, _________ K ud by 2-3% or so.

38. Page 38 Sensitivity Analysis In the APV model, each cash flow has a probability distribution associated with it. Hence, the realized value may be different from what was expected. In sensitivity analysis, ___________ estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.

39. Page 39 Real Options The application of options pricing theory to the evaluation of investment options in real projects is known as real options. –A timing option is an option on when to make the investment. –A growth option is an option to increase the scale of the investment. –A suspension option is an option to temporarily cease production. –An abandonment option is an option to quit the investment early.