Revision Course Notes
Chapter 6 International Investment and Financing Decisions
1.
Effects of Exchange Rate Assumptions on Project Values
1.1
Purchasing power parity
(Dec 08, Dec 11, Dec 13)
1.2.1
Purchasing Power Parity
PPP claims that the rate of exchange between two currencies depends on the
relative inflation rates within the respective countries. In equilibrium, identical
goods must cost the same, regardless of the currency in which they are sold.
PPP predicts that the country with the higher inflation will be subject to a
depreciation of its currency.
Formally, if you need to estimate the expected future spot rates, PPP can be
expressed in the following formula:
S1 1  hc

S 0 1  hb
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).
1.2
1.2.1
Interest rate parity
Interest Rate Parity (IRP)
The IRP claims that the difference between the spot and the forward exchange rates
is equal to the differential between interest rates available in the two currencies.
IRP predicts that the country with the higher interest rate will see the forward
rate for its currency subject to a depreciation.
If you need to calculate the forward rate in one year’s time:
F0 1  ic

S 0 1  ib
Where: F0 = Forward rate
S0 = Current spot rate
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Revision Course Notes
ib = interest rate for base currency
ic = interest rate for counter currency
1.3
1.3.1
International Fisher Effect
International Fisher Effect
According to the International Fisher effect, interest rate differentials between
countries provide an unbiased predictor of future changes in spot exchange
rates.
The currency of countries with relatively high interest rates is expected to
depreciate against currencies with lower interest rates, because the higher
interest rates are considered necessary to compensate for the anticipated currency
depreciation.
The International Fisher effect can be expressed as:
1  ic 1  h c

1  ib 1  hb
Where: ic = the nominal interest rate in country c
ib = the nominal interest rate in country b
hc = the inflation rate in country c
hb = the inflation rate in country b
1.4
1.4.1
Expectations theory
International Fisher Effect
The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future.
The formula for expectation theory is:
Spot
Spot

Forward Expected future spot
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Revision Course Notes
2.
NPV for International Projects
2.1
Calculating NPV for international projects
2.1.1 There are two alternative approaches for calculating the NPV from an overseas
project.
2.1.2 First approach (commonly used in examination):
(a)
(b)
(Dec 08, Dec 11, Dec 13, Jun 15)
Forecast foreign currency cash flows including inflation
Forecast exchange rates and therefore translate the foreign currency cash
flows into the home currency cash flows
(c)
Discount home currency cash flows at the domestic cost of capital
2.1.3 Second approach:
(a)
Forecast foreign currency cash flows including inflation
(b)
Discount at foreign currency cost of capital and calculate the foreign
currency NPV
(c)
2.2
Convert into a home currency NPV at the spot exchange rate
The effect of exchange rates on NPV
2.2.1 When there is a devaluation of the domestic currency relative to a foreign currency,
then the domestic currency value of the net cash flows increases and thus the NPV
increases.
2.2.2 The opposite happens when the domestic currency appreciates. In this case the
domestic currency value of the cash flows decline and the NPV of the project in home
currency declines.
3.
Forecasting Cash Flows from Overseas Project
3.1
Effect on exports
3.1.1 When a multinational company sets up a subsidiary in another country, to which it
already exports, the relevant cash flows for the evaluation of the project should take
into account the loss of export earnings in the particular country. The NPV of the
project should take explicit account of this potential loss.
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Revision Course Notes
3.2
Taxes
3.2.1 Taxes play an important role in the investment appraisal as it can affect the viability of
a project. The main aspects of taxation in an international context are:
(a)
Corporate taxes in the host country
(b)
Investment allowances in the host country
(c)
Withholding taxes in the host country
(d)
Double taxation relief in the home country
(e)
Foreign tax credits in the home country
3.3
Inter-company cash flows
3.3.1 Inter-company cash flows, such as transfer prices, royalties and management
charges, can also affect the tax computations.
3.3.2 Although complex in reality, in the exam:
(a)
Assume inter-company cash flows are allowable for tax unless the question
says otherwise
(b)
If an inter-company cash flow is allowable for tax relief overseas, there will
be a corresponding tax liability on the income in the home country
Assume that the tax authorities will only allow arm’s length / open market
prices for tax relief and will not allow an artificially high or low transfer
price.
(c)
3.4
Remittance restrictions
3.4.1 Remittance restrictions occur where a foreign government places a limit on the funds
that can be repatriated back to the holding company. This restriction may change the
cash flows that are received by the holding company.
3.4.2 The actual amount received by the parent company (and therefore the shareholders)
is the relevant cash flow for the NPV purposes.
3.5
Working capital
3.5.1 It is normally assumed that the working capital requirement for the foreign project
will increase by the annual rate of inflation in that country.
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Revision Course Notes
4.
Types of Foreign Currency Risk
4.1
Currency risk
4.1.1 Currency risk occurs in three forms: transaction exposure (short-term), economic
exposure (effect on present value of longer term cash flows) and translation
exposure (book gains or losses).
4.2
Transaction risk
(Dec 12)
4.2.1 Transaction risk is the risk of an exchange rate changing between the transaction
date and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion. It arises primarily on import and exports.
4.2.2 As transaction risk has a potential impact on the cash flows of a company, most
companies choose to hedge against such exposure. Measuring and monitoring
transaction risk is normally an important component of treasury management.
4.3
Economic risk
(Dec 12)
4.3.1 Economic risk is the variation in the value of the business (i.e. the present value of
future cash flows) due to unexpected changes in exchange rates. It is the long-term
version of transaction risk.
4.4
Translation risk
(Dec 12)
4.4.1 This is the risk that the organization will make exchange losses when the accounting
results of its foreign branches or subsidiaries are translated into the home
currency. Translation losses can result, for example, from restating the book value of
a foreign subsidiary’s assets at the exchange rate on the statement of financial position
date.
5.
Choosing Finance for Overseas Investment
5.1
Financing an overseas subsidiary
5.1.1 The main reason for wanting to borrow in a foreign currency is to fund a foreign
investment project or foreign subsidiary. The foreign currency borrowing provides
a hedge of the value of the project or subsidiary to protect against changes in
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value due to currency movements.
5.2
Choice of finance for an overseas investment
5.2.1 The choice of the source funds will depend on:
(a)
(b)
The local finance costs, and any subsidies which may be available
Taxation systems of the countries in which the subsidiary is operating.
Different tax rates can favour in high tax regimes, and no borrowing elsewhere
(c)
(d)
Any restrictions on dividend remittances
The possibility of flexibility in repayments which may arise from the parent /
subsidiary relationship
5.2.2 Parent companies should also consider the following factors:
(a)
Reduced systematic risk – There may be a small incremental reduction in
systematic risk from investing abroad due to the segmentation of capital
markets.
(b)
Access to capital – Obtaining capital from foreign markets may increase
liquidity, lower costs and make it easier to maintain optimum gearing.
6.
Costs and Benefits of Alternative Sources of Finance for MNCs
6.1
International borrowing
6.1.1 Companies are able to borrow long-term funds on the Eurocurrency (money)
markets and on the markets for Eurobonds. These markets are collectively called
Euromarkets.
6.1.2 Large companies can also borrow on the syndicated loan market where a syndicate of
banks provides medium to long-term currency loans.
6.1.3 If a company is receiving income in a foreign currency or has a long-term
investment overseas, it can try to limit the risk of adverse exchange rate
movements by matching. It can take out a long-term loan and use the foreign
currency receipts to repay the loan.
6.2
Syndicated loans
(Dec 08, Dec 09)
6.2.1 A syndicated loan is a loan put together by a group of lenders (a ‘syndicate’) for a
single borrower.
6.2.2 Banks or other institutional lenders may be unwilling (due to excessive risk) or unable
to provide the total amount individually but may be willing to work as part of a
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syndicate to supply the requested funds.
6.2.3 Given that many syndicated loans are for very large amounts, the risk of even one
single borrower defaulting could be disastrous for an individual lender. Sharing the
risk is likely to be more attractive for investors.
6.2.4 Originally syndicated loans were limited to international organisations for acquisitions
and other investments of similar importance and amounts. This was mainly due to the
following:
(a)
Elimination of foreign exchange risk – borrowers may be able to reduce
exchange rate risk by spreading the supply of funds between a number of
different international lenders.
(b)
Speed – in normal circumstances it may take some time to raise very large
amounts of money. The efficiency of the syndicated loans market means that
large loans can be put together very quickly.
6.3
Advantages of borrowing internationally
6.3.1 There are three main advantages from borrowing for international capital markets, as
opposed to domestic capital markets:
6.4
(a)
Availability. Domestic financial markets, with the exception of the large
countries and the Euro zone, lack the depth and liquidity to accommodate
either large debt issues or issues with long maturities.
(b)
Lower cost of borrowing. In Eurobond markets interest rates are normally
lower than borrowing rates in national markets
(c)
Lower issue costs. The cost of debt issuance is normally lower than the cost
of debt issue in domestic markets.
Risks of borrowing internationally
6.4.1 A multinational company has three options when financing an overseas project by
borrowing.
(a)
(b)
(c)
The first is to borrow in the same currency as the inflows from the project.
The second option is borrowing in a currency other than the currency of
the inflows but with a hedge in place and
The third option is borrowing in a currency other than the currency of the
inflows but without hedging the currency risk. The last case exposes the
company to exchange rate risk which can substantially change the
profitability of a project.
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