International Finance
Lecture 11
Page 1
International Finance
• Course topics
– Foundations of International Financial
Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure
– Financial Management for a Multinational
Firm
Page 2
Financial Management for a
Multinational Firm
• Foreign direct investment
• International Capital Structure, Cost of Capital
• International Capital Budgeting
Page 3
Cost of Capital
• For a levered firm, the financing costs can be
represented by the weighted average cost of
capital:
• K = (1 – )ke + (1 – t)i
• Where
K = ___________ average cost of capital
ke = cost of equity capital for a levered firm
i = pretax cost of debt
 = % of debt, debt to total market value ratio
t = _____________ corporate income tax rate
Page 4
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.
Page 5
Investment ($)
Cost of Capital in Segmented vs.
Integrated Markets
• The cost of equity capital (ke) 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):
ke, company i  R f  βi ( R M  R f )
where
Page 6
Cov( Ri , RM )
βi 
Var( RM )
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.
Ri 
versus
CAN
Rf

CAN
βi ( RTSX
CAN
 Rf )
World
World
Ri  RWorld

β
(
R

R
)
MSCI World
f
i
f
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
Page 7
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.
Page 8
Example: Novo Industri
Page 9
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.
Page 10
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.
Page 11
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.
Page 12
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
Page 13
Cross-Border Listings of Shares
Selected Foreign Firms listed on the NYSE
Page 14
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.
Page 15
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.
Page 16
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.
Page 17
SF
Nestlé’s Foreign Ownership
Restrictions
12,000
10,000
8,000
6,000
4,000
2,000
0
11
20
31
9
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
Page 18
18
24
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.
Page 19
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 _________.
Page 20
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.
Page 21
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.
•
Page 22
Financial Management for a
Multinational Firm
• Foreign direct investment
• International Capital Structure, Cost of Capital
• International Capital Budgeting
Page 23
Review of Capital Budgeting
• The basic net present value equation is
T
CFt
TVT
NPV  

 C0
t
T
(1  K )
t 1 (1  K )
Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow (terminal value) in year T,
including return of net working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
Page 24
Review of Capital Budgeting
• Cash flow estimation
CFt  ( Rt  OCt  Dt  I t )(1  τ )  Dt  I t (1  τ )
Rt is incremental revenue
OCt is incremental operating cost
Dt is incremental depreciation
It is incremental interest expense
t is the marginal tax rate
Page 25
Review of Capital Budgeting
• Various ways to represent CF
CFt  ( Rt  OCt  Dt  I t )(1  τ )  Dt  I t (1  τ )
 NI t  Dt  I t (1  τ )
 ( Rt  OCt  Dτ )(1  τ )  Dt
 NOI t (1  τ )  Dt
 ( Rt  OCt )(1  τ )  τDt
 OCFt (1  τ )  τDt
Page 26
Review of Capital Budgeting
• We can use
CFt  OCFt (1  τ )  τDt
to rewrite the NPV equation
T
CFt
TVT
NPV  

 C0
t
T
(1  K )
t 1 (1  K )
as:
OCFt (1  τ )  τDt
TVT
NPV  

 C0
t
T
(1  K )
(1  K )
t 1
T
Page 27
The Adjusted Present Value Model
 OCFt (1  τ )
τDt

NPV 

t
 (1  K ) t
(
1

K
)
t 1 
T


TVT

 (1  K )T  C0

• Can be converted to adjusted present
value (APV)
 OCFt (1  τ ) τDt
τI
t
APV  


t
t
 (1  K ) t
(
1

i
)
(
1

i
)
u
t 1 
T

Page 28

TV
T

 C0
T
 (1  K )
u

The Adjusted Present Value Model
T
APV 

t 1
OCFt (1  τ )
(1  K u )
t
T

T
τDt
τI t
 (1  i)   (1  i)
t 1
t
t 1
t

TVT
(1  K u )
T
 C0
• 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.
Page 29
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:
-$1,000
0
$125
$250
$375
1
2
The unlevered cost of equity is r0 = 10%:
Page 30
$500
3
4
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:
APV  NPVunlevered  PVtax shield
4
APV  $56 .50 
 (1  0.08)
t 1
Page 31
$19 .20
t
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:
$600  .08  (1  .4)
$600
 $600  

t
4
(
1
.
08
)
(
1
.
08
)
t 1
 $63.59
4
NPVloan
NPVloan
APV  NPVunlevered  NPVloan
Page 32
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.
T
St OCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(
1

K
)
(
1

i
)
(
1

i
)
t 1
t 1
t 1
ud
d
d
T
T
St LPt
ST TVT

 S 0C0  S 0 RF0  S 0CL0  
T
t
(1  K ud )
t 1 (1  id )
Page 33
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
0
1
2
3
4
5
5+
-26.5
2.2
3.3
5.6
6.3
6.3
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?
•
Page 34
APV Example
•
Exchange rates. FX(t+1)=0.98*FX(t)
YEAR
0
1
2
3
4
5
5+
$2.00
•
$ cash flows. $CF = FX(t) * GBP CF(t)
YEAR
0
1
2
3
4
Present value. Use CF and NPV worksheets.
• Present value =
•
Page 35
5
5+
APV Example
•
Depreciation tax shield = D(t) * tax * FX(t). PV @ 8% =
YEAR
0
1
2
n/a
•
Interest write-off tax shield
•
Page 36
3
4
5
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 Kud.
Therefore, if a project is riskier than
average firm’s project, __________ Kud, or
if less risky, _________ Kud by 2-3% or so.
Page 37
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.
Page 38
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.
Page 39