Financing International Projects Capital Budgeting Capital budgeting requires estimation of a project’s incremental cash flows - which are determined by estimating worldwide cash flows with and without the project. There are two main methods of international capital budgeting, centralized and decentralized Centralized requires exchange rate forecasts Decentralized requires a local-currency cost of capital. The method a firm selects should depend on its comparative advantage in estimating each. Cost of Capital I CAPM determines a project’s equity cost of capital it prices only the systematic risk of the project. If risk premia are identical and uncovered interest parity holds, the only difference between home and foreign costs of capital will be anticipated exchange rate changes. In this case, centralized and decentralized capital budgeting will deliver identical results - the foreign cost of capital will perform dual roles of discounting and adjusting for anticipated exchange rate changes. Cost of Capital II If anticipated deviations from uncovered interest parity exist, centralized capital budgeting will deliver higher returns when deviations are positive and lower when negative. Centralized is also easier to implement if UIP fails. If investors do not hold worldwide market portfolio, decentralized capital budgeting will raise real capital costs and thereby lower project NPVs because foreign investor portfolios will co-vary more with project returns than home country investor portfolios. Country Specfic Risk Adjusted Present Value If incentives exist to finance with debt - tax shields or interest subsidies - Adjusted Present Value (APV) should be used. If tax treatments are symmetric, and if uncovered interest parity is expected to hold, tax shields will have identical value whether debt is raised in host or home country. Low capital gains taxes, high deductibility of interest payments, negative failure of UIP, and subsidized interest rates will all favor financing in depreciating currencies. Political Risk Centralized capital budgeting requires expected cash flows to be adjusted for political risk - not cost of capital. Foreign political risk is unlikely to be systematic to the risks of domestic shareholder portfolios. Sensitivity analysis is an alternative to calculation of exact political risk probabilities: solve for probability that sets NPV=0 and then ask whether it’s reasonable - if so, NPV is quite possibly negative. Financing Foreign Projects Financing Internal External Financing Foreign Projects Financing Internal Debt External Equity Debt Equity Financing Foreign Projects Financing Internal Debt External Equity Debt Home Currency Equity Foreign Currency Financing Foreign Projects Financing Internal Debt External Equity Debt Home Currency Equity Foreign Currency Home Currency Foreign Currency Internal Debt vs. Internal Equity The primary tradeoffs between internal debt and internal equity center around taxes. If internal debt is used, interest payments made from the subsidiary to the parent are treated on a pre-tax basis in the host country. If internal equity is used, dividends repatriated from the subsidiary to the parent are treated on a post-tax basis. Generally, home country gives a tax-credit on foreign taxes paid on repatriated dividends of up to (but no more than) the home country tax bill on the dividends. Internal Debt vs. Internal Equity MNCs using internal financing will have greater incentives to use debt: 1. The more volatile are parent earnings: higher probability of negative parent earnings means better chance interest payments will be untaxed. 2. The less volatile are subsidiary earnings: lower probability of negative subsidiary earnings means less chance subsidiary will be forced to make interest payments out of negative earnings that are taxed at the parent. 3. The larger the host country tax rate compared to the home country: larger host country tax rate means larger potential tax shield. Financing Foreign Projects Financing Internal External External vs. Internal Financing The tradeoffs between external and internal financing will be largely similar to those in a domestic context: - issuance costs - asymmetric information costs Financing Foreign Projects Financing Internal External Debt Equity External Debt vs. External Equity - tax shields - interest subsidies Additionally, the monitoring benefits debt may add over equity addressed in traditional finance settings will be applicable here. Financing Foreign Projects Financing Internal Debt External Equity Debt Equity Home Currency Foreign Currency Home vs. Host Country Equity Home and host currency costs of equity capital would be identical if uncovered interest parity held and if all investors held diversified world market portfolio. Where investors hold domestically-biased assets, host country cost of capital is likely to be higher. The project will likely have higher correlation between its returns and the local economy. From the host country investor perspective, the project will contain more systematic risk. Home vs. Host Country Equity From a political risk standpoint, issuing host country equity is likely to have two divergent effects: - political risks (i.e. probability of expropriation) are likely to be reduced. - political risks are likely to be more systematic to risks of host country shareholders’ portfolios. Financing Foreign Projects Financing Internal Debt External Equity Debt Home Currency Equity Foreign Currency International Debt Financing I Debt denomination decision is often cast in the same terms as international capital budgeting: centralized vs. decentralized debt finance. An MNC which borrows primarily in the home country is said to centralize debt finance (though an MNC certainly can centralize debt finance in any single country). An MNC which undertakes borrowing in countries where operations are located is said to decentralized debt finance. International Debt Financing II Ex-ante deviations from UIP make centralizing debt finances attractive. If a given currency’s low interest rates are not expected to be offset by appreciation of that currency, firms that can access the low interest rates and centralize debt finance there will profit. Even if UIP holds ex-ante, MNCs will generally have differential access to markets. Put simply, domestic firms usually enjoy lower interest rates in home-country debt markets than foreign firms. The Debt Denomination Decision If a firm borrows in domestic rather the local currency, it faces greater exchange rate risk. The cost of financing in the local currency will consist (approximately) of the local currency interest rate premium and the expected exchange rate change. The differential can be interpreted as the extent to which the firm accesses a home-currency financing advantage in excess of anticipated exchange rate changes. This will be traded-off against the larger exchange rate risk of home-currency financing. Example: GM and AutoZAZ GM will invest $500 million in AutoZAZ, an auto plant located in Zaporizha, Ukraine. With the investment, AutoZAZ will produce 250,000 cars for domestic sale annually. GM expects to receive a return of $300 per car. The Ukrainian Karbovan currently trades at $0.741/Karb. Ukrainian inflation is 35%. Ukrainian interest rates are 40%. U.S. interest rates are 5%. GM accesses Ukrainian debt markets by a factor of 7% above risk-free rates and accesses U.S. debt markets by a factor of 5% above risk-free. Should GM finance with Karbovan or Dollar debt? Key Points 1. Primary tradeoff of internal debt vs. equity is between the tax-shield benefit of debt and the flexibility of equity dividend repatriation. 2. Firms will tend to favor debt when parent earnings are volatile, subsidiary earnings are certain, and subsidiary tax rates are high. 3. With external financing, debt provides advantages over equity to the extent it offers tax shields, interest subsidies, and monitoring benefits. Key Points 4. When financing with external equity, firms will likely face higher equity costs of capital in the host country market. 5. Local equity will also often alter the magnitudes and pricing of political risks associated with the project. 6. In the debt denomination decision, an MNC which centralizes borrowing in home country is likely to get more-favorable rates. Key Points 7. MNCs which borrow in the currency of the project produce a natural hedge, offsetting project returns with debt obligations, and hence facing less exchange rate and political risk.