Topic 6 | BBMF3183 Strategic Financial Management
TOPIC 6: APPRAISAL OF OVERSEAS INVESTMENT
DECISIONS
Interpret FOREX
1. Assess the impact of a project on a firm’s exposure to translation, transaction
and economic risk.
2. Assess and advise upon the costs of alternative sources of finance available
within the international equity and bond markets.
3. Purchasing Power Parity
 Exchange rate between two currencies is the same in equilibrium when the
purchasing power of currency is the same in each country.
S1 = S0 ×
1+hc 
1+hb 
Example 6.1 (BPP94)
4. Absolute purchasing parity theory
 Prices of products in different countries will be the same when expressed in
the same currency
5. Alternative purchasing power parity relationship (also known as relative PPP)
 Changes in exchange rates are due to differences in the expected inflation
rates between countries
6. Interest rate parity
 Difference between two countries’ interest rates should offset difference
between spot rate and forward rate
f0 = S0
1+ic 
1+ib 
Example 6.2
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Topic 6 | BBMF3183 Strategic Financial Management
7. International Fisher Effect
 With no trade or capital flows restrictions, real interest rates in different
countries will be expected to be the same
 Differences in interest rates reflect differences in inflation rates
Example 6.3
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Topic 6 | BBMF3183 Strategic Financial Management
8. Example 6.4
The exchange rate in January 2007 was 1.95 $ to the £; inflation in the US was
2.1% and 2.7% in the UK.
The exchange rate in January 2007 was 0.67 £ to the euro; inflation in Europe
was 2.1% and 2.7% in the UK.
Required
(a) What is the forecast spot rate in each of the next three years for the $ to
the £?
Year 1
1.95 × 1.021/1.027 = $1.939
Year 2
1.939 × 1.021/1.027 = $1.928
Year 3
1.928 × 1.021/1.027 = $1.917
1.021 1
1.95 × (
) = $1.939
1.027
1.021 2
1.95 × (
) = $1.928
1.027
1.021 3
1.95 × (
) = $1.917
1.027
This is good news for a UK firm investing in the US.
(b) What is the forecast spot rate in each of the next three years for the £ to
the €?
Year 1
0.67 × 1.027/1.021 = £0.674
Year 2
0.674 × 1.027/1.021 = £0.678
Year 3
0.678 × 1.027/1.021 = £0.682
1.027 1
0.67 × (
) = £0.674
1.021
1.027 2
0.67 × (
) = £0.678
1.021
1.027 3
0.67 × (
) = £0.682
1.021
9. Evaluating foreign investment (Example refer to BPP115 ebook Bromwich)
(a) Method 1
Forecast foreign cash flows including
inflation
Forecast exchange rates and convert
to local cash flows year by year
Discount at a local cost of capital
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Topic 6 | BBMF3183 Strategic Financial Management
(b) Method 2
Forecast foreign cash flows including
inflation
Discount at a foreign cost of
capital
Convert to local NPV at current
spot exchange rate
10. Example 6.5
A professional accountancy institute in the United Kingdom is evaluating an
investment project overseas – in Eastasia, a politically stable country. The project
will cost an initial 2.5 million Eastasian dollars (EA$) and it is expected to earn
nominal post-tax cash flows as follows.
Year
1
Cash flow (EA$'000) 750
2
950
3
4
1,250 1,350
(a) The expected inflation rate in Eastasia is 3% a year, and 5% in the UK.
(b) The current spot rate is EA$ 2 per £1 Sterling.
(c) The company requires a sterling return from this project of 16%.
Required
(a) Calculate the £ Sterling net present value of the project by discounting
nominal annual cash flows in £ Sterling.
Answer:
Calculate exchange rate for each year.
Year 0
Year 1
Year 2
Year 3
Year 4
0
1
2
3
1.03
1.03
1.03
1.03
1.03 4
2×(
) 2×(
) 2×(
) 2×(
) 2×(
)
1.05
1.05
1.05
1.05
1.05
EA$ 2
EA$ 1.9619 EA$ 1.9245 EA$ 1.8878 EA$ 1.8518
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Topic 6 | BBMF3183 Strategic Financial Management
Calculate NPV
In ’000
Year 0
Year 1
Year 2
Year 3
Year 4
Cash flow in EA$ (2,500)
750
950
1,250
1,350
Exchange rate
EA$ 2 EA$ 1.9619 EA$ 1.9245 EA$ 1.8878 EA$ 1.8518
Cash flow in £
(1,250)
382
494
662
729
0
-1
-2
-3
Discount Factor £
1.16
1.16
1.16
1.16
1.16-4
Present Value
(1,250)
329
367
424
402
NPV = £272,000
(b) Calculate the £ Sterling net present value of the project by discounting
nominal annual cash flows in Eastasian $.
Answer:
Calculate the cost of capital in EA$
1.03
EA$ Discount factor = [1.16 × (
)] − 1 = 𝟏𝟑. 𝟕𝟗%
1.05
Calculate NPV
In ’000
Year 0
Year 1
Year 2
Year 3
Year 4
Cash flow in EA$
(2,500)
750
950
1,250
1,350
Discount Factor EA$ 1.13790 1.1379-1 1.1379-2 1.1379-3 1.1379-4
Present Value
(2,500)
659
733
848
804
NPV = EA$544,000
EA$2
: £1
EA$544,000 : £272,000
Evaluating foreign investments
1. Effect of exchange rates on NPV
 When there is a devaluation of home currency relative to a foreign currency,
the home currency value of cash flows and NPV increase
 The opposite happens when the home currency appreciates
2. Effect on exports
 A multinational company sets up a subsidiary in another country in which it
already exports
 The relevant cash flows for evaluation of the project should account for loss
of export earnings in the particular country
3. Impact of transaction costs
 Transaction costs are incurred when companies invest abroad due to currency
conversion or other administrative expenses
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Topic 6 | BBMF3183 Strategic Financial Management
 These should also be taken into account
4. Taxes in Foreign country
 Corporate taxes
 Investment allowances
 Withholding taxes
5. Taxes in Home country
 Double taxation relief
 Foreign tax credits
6. Tax haven characteristics
 Low tax on foreign investment or sales income earned by resident companies
 Low withholding tax on dividends paid to the parent
 Stable government and currency
 Adequate financial services support facilities
7. Subsidies
 The benefit from concessionary loans should be included in the NPV
calculation as:
 The difference between repayment of borrowing under market conditions and
repayment under the concessionary loan
8. Transaction exposure
 The risk of adverse exchange rate movements between the date the price is
agreed and the date cash is received/paid
 Arising during normal international trade
 Factors that contribute towards to the level of transaction risk to which a
company is exposed.
 Size of transaction – the larger the monetary value of the transaction,
the greater the transaction exposure.
 Length of transaction – if a company is investing in a long-term overseas
project, there will be greater scope for being exposed to exchange rate
movements.
 Currency to which the company is exposed – if the exchange rate has
been traditionally volatile, transaction risk is likely to be high.
9. Translation exposure
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Topic 6 | BBMF3183 Strategic Financial Management
 Risk that organisation will make exchange losses when accounting results of
foreign branches/subsidiaries are translated
 Translation losses can arise from restating the book value of a foreign
subsidiary’s assets at the exchange rate on the statement of financial position
date – only important if changes arise from loss of economic value
10. Economic exposure
 The risk that the present value of a company’s future cash flows might be
reduced by adverse exchange rate movements
 Can be longer-term (continuous currency depreciation)
 Can arise even without trade overseas (effects of pound strengthening)
11. Operating Exposure (How to manage?)
 Operating strategies
 Matching cash inflows with outflows by sourcing components and other
inputs or open an operating subsidiary in the country where sales are made
 Where MNC operates in multiple locations, rescheduling production
between the different locations or exploiting product price changes for
greater profits or altering the procurement of raw materials between
different locations (i.e. the portfolio effect of diversifying into multiple
markets)
 Financial strategies
 Borrow in the same currency as that of cash inflows
 Pay suppliers in other countries using the currency received from sales (also
called currency switching)
 Use parallel matching, i.e. matching of currencies that tend to move
together (e.g. US and Canadian dollars)
International Financing
1. International borrowing options
 Borrow in the same currency as the inflows from the project.
 Borrow in a currency other than the currency of the inflows, with a hedge in
place.
 Borrow in a currency other than the currency of the inflows, without hedging
the currency risk. This option exposes the company to exchange rate risk
which can substantially change the profitability of a project.
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Topic 6 | BBMF3183 Strategic Financial Management
2. Advantages of international borrowing
 Availability
 Many smaller domestic financial markets might lack the depth and liquidity
to accommodate large or long-maturity debt issues
 Lower cost of borrowing in Eurobond markets
 Interest rates are normally lower than borrowing rates in national markets
 Lower issue costs
 Cost of debt issuance is normally lower than the cost of debt issue in
domestic markets
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