Week 1
Lecture 1 – Introduction intermediate corporate finance
Corporate finance topics
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Making investment decisions: Capital expenditures and M&A
Financing these investments
Corporate governance
Corporate finance – tools
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DFC valuation
MM-theorem
Agency costs
Corporations with international activities
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Investment and M&A around the globe: How to assess risk and returns?
Financing in international markets: Do global capital markets add value?
Effects on tools: valuation of cash flows in multiple currencies and global cost of
capital? Optimal financing with segmented international markets, international taxes,
etc.?
New dimension: Measuring exposure to risk and using derivative instruments for risk
management (treasury management of financial risk)
Chapter 1 – multinational firms
Why do corporations internationalize?
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Find raw materials (took root in the early 1600’s EIC, VOC …) :
 Not all raw materials exist domestically
Find new markets (starts 1800’s, Colt corporation, Singer corporation …) :
 Main motive of modern MNC
Reduce costs (starting in 1960’s, starts manufacturing abroad for lower labor costs) :
 Take advantage of lower overhead, taxes, labor, and environmental costs and lower
levels of regulation.
Other reasons
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Seeking knowledge
 Labs, universities
Moving with domestic customers
 Banks, marketing agencies
Arbitrage
 Exploiting inefficiencies in financial markets and regulation
How do firms become MNCs
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Mostly begin as purely domestic businesses
They become MNCs in phases over time
 Begin with simple, low-risk, low-return strategies
 Progress to sophisticated, high-risk, high-return strategies
Early phase
 Exporting
Intermediate phase
 Foreign sales office
 Service facilities
 Distribution systems
Advanced phase
 Overseas production
Why MNCs
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The goal of a corporation is to maximize the value of the shareholder’s investment (not
profit maximization)
Other stakeholders exist and are important
 Which stakeholder is the most important is irrelevant
 Fiduciary obligation of managers is to act in the best interest of shareholders
One germane issue: what behavior minimizes social waste
 Value maximization yields this behavior
Criticism of shareholder model
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Opponents to the shareholder model make the following criticisms:
 It is short-sighted and ignores long-term consequences of present decisions
 Shareholders are enriched at expense of other stakeholders
The above criticisms are erroneous
 Confuses profit maximization with value maximization
 Subject to zero-sum game fallacy (one person’s gains is necessarily another
person’s loss)
 Assumes managers directly control stock price
What about the negative externalities?
 MNCs may privatize benefits while socializing costs:
 Environmental damages
 Labour practices
 Health effects
Key premises
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Globalization
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 A growing, win-win model that boosts interconnected growth
 However, may cause negative externalities; neoliberal world order is shifting
Arbitrage
 Mispricing attracts arbitrage (risk-free or risky), pushing prices toward equilibrium
 However: arbitrage opportunities can be limited by constraints
Market efficiency
 With sufficient arbitrage, markets prices reflect available information
 However: not guaranteed – herd behavior and optimism can drive bubbles
Capital asset pricing model (CAPM)
 Prices reflect systematic risk (market-related) but ignore unsystematic risk (firmspecific)
 However: total risk still matters – e.g., due to bankruptcy or financial distress
Why do nations trade
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Can be answered by The law of comparative advantage (Ricardo)
 A nation should produce goods and services in which it has a comparative
advantage
 All other goods and services should be imported
What are the benefits of trade
 Nations grow wealthier together
 Trade as the antidote to war
High level of globalization associated with:
 More civil liberties (more freedom)
 More political rights (less corrupt governments)
Forces of globalization
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Massive deregulation
The fall of the communist bloc
Revolution in information technologies
Dramatic decrease in the cost of transportation
The sale of state-owned firms around the world
The rise of the market for corporate control and private equity
Dominant use of English as the Lingua Franca of business
Criticism of globalization
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A major criticism is:
 Globalization is source of job exportation
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What is the evidence?
 Nation that trade, grow richer together
 Error in criticism: zero-sum game fallacy
However! MNC arbitrage in several ways
 Reduce taxes, wages, costs of pollution
 Moreover, being MNC gives the opportunity to make deals with national governments
Is there a “method in madness”
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Stephen Miran’s & Scott Bessent strategy
 High tariffs
 Push for U.S. manufacturing revival
 “forced” currency adjustments
 Bilateral deals with preferential partners over global trade pacts
Underlying motivation
 Neoliberal world order (which US helped create) deemed unsustainable
 Currency manipulation by China
 Trump administration sees little benefit in providing international security
Threats to economic system?
 Risks trade wars & supply chain shocks
 Undermines multilateral institutions & promotes regional fragmentation
 Could raise consumer costs
Not supported by economic theory
 Seems largely based on work of Peter Navarro (UC Irvine professor)
Chapter 4 – Forex parities
What are exchange rates?
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Identify factors that cause exchange rates to change
What is an exchange rate?
 Price of one currency in terms of another currency
 An exchange rate is a price
Determined by supply and demand
Exchange rates are simply prices of foreign currencies
Exchange rates are quoted in two ways:
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Direct quote: 1 euro = 1.20 dollar
Indirect quote: 1 dollar = 0.83 euro
Economics of exchange rates
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Determinants of currency values:
 Increase in relative inflation (-)
 Increase in relative real interest rates (+)
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 Increase in relative economic growth (+ in short run; - in long run)
 Increase in relative risk (economic & political stability) (-)
 Improvement in relative central bank reputation (+)
IMPORTANT – in reality exchange rates are affected by expectation of these variables
What are parity conditions
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Parity relationships link various international markets together
 Spot exchange rate, forward exchange rate, interest rates, and real markets
Parity conditions are…
 Relationships based on the law of one price and are ideally enforced by arbitrage
 Identical assets must sell at
same price in different
countries
Parity relations
1. Purchasing power parity (PPP)
2. Fisher Effect (FE)
3. International Fisher Effect (IFE)
4. Interest rate parity (IRP)
5. Unbiased Forward Rates
(UFR)
Purchasing power parity (PPP)
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There are two versions of PPP
 Absolute PPP
 “What should the current exchange rate be?” (price level, S0)
 Relative PPP:
 “How should the exchange rate change?” (S1 – S0 = ΔS)
Absolute version of PPP
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A particular good must have the same price in different countries when priced in a
common currency. With free-trade prices will equalize otherwise arbitrage opportunities
will exist.
Notation:
 PH = price of good in terms of home currency ($)
 Pf = price of goods in foreign country
Price parity:
 PH = e0Pf
Example: Big Mac Index
Relative PPP
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Relative PPP is a dynamic version of absolute PPP. It says:
 Exchange rates will change to offset changes in inflation (thereby equalizing
purchasing power)
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Notation:
 E(et) = expected spot exchange rate at some future time t (direct quote)
 e0 = today’s spot exchange rate (direct quote)
 ih = home country inflation rate
 if = foreign country inflation rate
Relative PPP can be written:
\
Relative PPP intuition
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Suppose:
 I$ = 5%
 IYen = 1 %
US goods are more expensive
Consumers switch to Japanese goods
Causing Japanese Yen to increase against the $US
How much will yen increase?
 Until the Japanese goods are no longer cheaper in U.S. dollar terms: roughly 4%
Approximate relative PPP relation
Empirical evidence on PPP
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Absolute PPP does not hold
 Risk and costs of shipping goods internationally, tariffs and other trade barriers
prevent the law of one price from taking hold
 An iPhone X in Hungary is USD 1,455 and USD 995 in Japan
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Relative PPP does not hold in the short-run
 Exchange rates change quickly
 Prices of goods are “sticky” Exchanges rates follow with lag
 Differently constructed price indices and nontraded goods and services
Relative PPP holds in the long-run
 There is a clear relationship between relative inflation rates and changes in
exchange rates
Fisher effect – terminology
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Nominal rate of return
 Percentage change in wealth from an investment (change in number of dollars)
Real rate of return
 Percentage change in purchasing power from an investment (change in what you
can buy with those dollars)
Fisher effect
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Says nominal interest rates consist of 2 parts
 The real rate of return
 Expected inflation rate
Notation:
 r = nominal rate of return
 a = real rate of return
 i = expected inflation rate
The Fisher Effect
(1 + r) = (1 + a)(1 + i)
 A useful approximation of the fisher effect:
r≈a+i
Generalized Fisher effect:
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Real returns are equalized across countries (home h and foreign f)
ah = af
Why? If real rates were higher in one country capital would flow exclusively to it until the
rates equalized.
That is that the nominal interest rate differential must equal the anticipated inflation
differential
An intuitive approximation
International Fisher Effect (IFE)
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Is similar to Relative PPP except it uses interest rates to explain exchange rates rather
than inflation rates
Remember that (1) PPP says that a currency with higher inflation will decrease in value.
And (2) the FE says that currencies with higher inflation will have higher nominal rates. If
we combine (1) and (2) we get the IFE: Currencies with higher nominal interest rates will
decrease in value.
International Fisher Effect is expressed as:
An intuitive approximation
Does the IFE work
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Nominal interest rates change for 2 reasons
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(1) Changes in real interest rates
(2) Changes in inflation
If interest rates differ due to changes in real rates, the nation with the higher real rates
will experience currency appreciation
 In this case the predictions of IFE do not hold
If interest rates differ due to changes in inflation, then the nation with the greater inflation
will experience a currency depreciation
 In this case the prediction of IFE will hold
Interest rate parity – terminology
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Interest rate parity ties the spot rate with the forward rate
The spot rate is today’s exchange rate for immediate delivery
The forward rate is today’s exchange rate for delivery in the future
Example:
 The EUR/USD spot rate is $1.0873
 Today I can receive 1 euro by spending today $1.087
 The EUR/USD 3-month forward rate is $1.0900
 In 3-months, I can receive 1 euro by spending today $1.0900
Interest rate parity (IRP)
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The forward rate premium or discount to the spot rate is related to the interest rate
differential through arbitrage
The arbitrage is known as the covered interest arbitrage or covered interest parity
arbitrage (CIP)
This ensures that there is no money machine possible by borrowing in one country and
investing in the other at no risk (having a hedged position)
Illustration
No Arbitrage condition
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Funds will flow from the home to the foreign country if and only if:
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The converse will happen if
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The no arbitrage condition is
An intuitive approximation
Forward rate Unbiasedness (UFR)
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Consider IFE and IRP:
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Since the RHS of each equation is equal
Empirical Evidence
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Is the forward rate unbiased?
 The evidence suggests not
The evidence suggests that there is a risk premium:
 Where RP can be positive or negative
The fact that UFR does not always hold should not be a surprise…
 It assumes that IFE holds, which we saw does not always hold
Week 2