B5. International investment and financing decisions Flashcards
Motives for international investment:
- Company – expansion strategy may create economies of scale
- Country – access cheap labour and government grants. Local investment may be needed to overcome trade barriers
- Customer – locate close to international customers so that shorter lead times can be offered
- Competition – some international markets have weaker competition.
Investment decision - exchange rate risk.
As with any investment, international investments will need to be carefully scrutinised to identify relevant business risks and to put in place appropriate risk management strategies. International investments will create a variety of transactions in foreign currency and parent will need to convert home currency to meet foreign obligations – transaction risk. Cost of foreign obligations could rise as a result of weaker domestic currency or domestic value of foreign revenues could depreciate as a result of a stronger home currency. Remitted dividends to the parent will need conversion to home currency.
If there is a long-term decline in the value of the foreign currency after an international investment has been made, then the NPV of the project in the domestic currency may fall. This is an aspect of economic risk. So, before an international investment proceeds, the risk of the foreign currency falling in value should be carefully assessed. One of the causes of long-term decline in the value of a foreign currency is if the rate of inflation in the foreign country is higher than it is in domestic.
PPP theory
PPPT claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. It suggests that the impact of higher inflation is to decrease the purchasing power of the foreign currency which over time will reduce its value on foreign currency markets.
The PPP can be used to forecast exchange rate movements, based on predicted future inflation rates.
S_1=S_0×((1+h_c))/((1+h_b))
Where:
S0 = Exchange rate today S1 = Exchange rate in 1 year hb = Inflation rate in base currency hc = Inflation rate in foreign currency
PPP and international Fisher effect.
The interest rates can be used instead of inflation rates in PPP formula, on assumption that interest rate differentials between economies of similar risk are simply a reflection of different expectations of inflation. The idea that if long-term ($) interest rates are higher this is an indication that ($) inflation will be higher, is the International Fisher effect, because it is an extension of the Fisher formula.
PPE and base currency.
The base currency is the currency that is quoted to 1 unit.
PPE and economic risk.
Higher inflation has two-fold effect:
• Higher inflation increases cash inflows (good)
• Higher inflation weakens the value of the foreign currency (bad)
So, the cash inflows are affected by the inflation in exactly the same way as the exchange rate a weaker exchange rate due to higher inflation may not matter. In reality cash flows will inflate at different rates and so some impact on NPV from inflation is likely.
Danger signals for international investment
Other danger signals. Apart from inflation, other danger signals in a country being considered for international investment, that indicate that a fall in the value of foreign currency is likely include:
• Weak economic growth – this will reduce investment inflows into the foreign country and reduce the demand for the foreign currency
• High balance of payments deficit – if import exceed exports for a long period in the foreign country, this will increase the supply of foreign currency on the foreign exchange markets (as result of paying for imported goods and services) and can decrease its value.
• High government deficit – debt repayments increase the supply of the foreign currency on foreign exchange markets and this can decrease its value.
Interest rate parity theory.
Under interest rate parity the difference between spot and forward rates reflects differences in interest rates. It can be used to compute the effective cost of foreign loans (by comparing translated amount now and on repayment). F_0=S_0×((1+i_c))/((1+i_b)) Where: F0 = Forward rate S0 = Exchange rate today (spot) ib = interest rate for base currency ic = interest rate for foreign currency
International investment appraisal
International investment appraisal will normally require to estimate the overseas cash flows of a project and then to use forecast exchange rate to convert these into the domestic currency before discounting at a suitable (domestic) cost of capital.
Investment appraisal for overseas investments is similar to domestic investment appraisal. It includes the following steps:
• Identification of relevant cash flows.
• Dealing with inflation to assess real or nominal cash flows.
• Dealing with tax, including the tax savings on capital allowances.
• Dealing with inter-company transactions, such as management charges and royalties and cash flow remittance restrictions.
• Estimating future exchange rates (spot rates).
• Dealing with double taxation arrangements.
• Estimating the appropriate cost of capital (discount factor).
International investment appraisal
Taxation.
Taxation. To prevent double taxation, most governments give a tax credit for foreign tax paid on overseas profits. The home country will only charge the company the difference between tax paid overseas and the tax due in the home country. This extra tax will appear as an extra cashflow in the project NPV. The following procedure can be applied:
• Allow for host country investment incentives (capital allowance) before applying the local tax rate to local taxable cash flows.
• Apply the relevant parent company rate of tax to the taxable/remitted cash flows.
• Adjust point 2 above for any double taxation agreement.
International investment appraisal
Intercompany transactions.
Companies may charge their overseas subsidiaries for royalties and components supplied. These charges will affect taxable profit, and therefore the tax paid, in the foreign country. Domestic may also be payable on the profits from these transactions.
International investment appraisal
Project discount rates.
In the same way as for domestic capital budgeting, project cash flows should be discounted at a rate that reflects their systematic risk. Many firms assume that overseas investment must carry more risk than comparable domestic investment and therefore increase discount rates accordingly. This assumption, however, is not necessarily valid. Although the total risk of an overseas investment may be high, in the context of a well-diversified parent company portfolio much of the risk may be diversified away.
Because of the lack of correlation between the performance of some national economies, the systematic risk of overseas investment projects may in fact be lower than that of comparable domestic projects. It must therefore be realised that the automatic addition of a risk premium simply because a project is located overseas does not always make sense, and any increase in the discount rates used for foreign projects should be viewed with caution.
International investment appraisal
Forecasting project cash flows.
Forecasting project cash flows. 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 be:
Sum of discounted (net cash flows – exports) + discounted terminal value – initial investment
The appropriate discount rate will be WACC.
Exchange controls and strategies to overcome
Some countries impose delays on the payment of a dividend from an overseas investment. These exchange controls create liquidity problems and add to exchange rate risk because the exchange rate may have worsened by the time that dividends are permitted. The impact of delay in the timing of remittances may have to be incorporated into the international project appraisal.
Different strategies to overcome exchange controls:
• Transfer pricing – the parent can charge artificially higher prices for goods or services supplied to the subsidiary as a means of drawing cash out. This method is often prohibited by the foreign tax authorities.
• Management Charges - the parent company can impose a charge on subsidiary for the general management services provided each year. The fees would normally be based on the number of management hours committed by the parent on the subsidiary’s activities.
• Royalties - the parent company can charge the subsidiary royalties for patent, trade names or know-how. Royalties may be paid as a fixed amount per year or varying with the volume of output.
• Loans – if the parent company makes a loan to a subsidiary, a higher rate of interest on a loan may be charged.
When a firm starts trading in a different country, it is exposed to three types of risk:
When a firm starts trading in a different country, it is exposed to three types of risk: transaction, economic and translation risk.
Undertaking a new, foreign currency, project affects the firm’s exposure to these risks as follows:
• Transaction risk. Individual receipts and payments which arise during the new project’s life will be subject to transaction risk, in that the value of the transactions will initially be calculated using the forecast rate of exchange which may differ from the actual rate on the transaction date. Firms can use hedging methods to eliminate this transaction risk.
• Economic risk. The project NPV is initially calculated using forecast exchange rates. A change in these forecasts over the life of the project will increase or decrease the project NPV, and hence the gain to shareholders.
• Translation risk. Undertaking a foreign project often involves setting up a foreign based subsidiary, whose financial statements will have to be translated back into the home currency for the purposes of group accounting(consolidation). A change in exchange rates from one year to the next will cause the value of the subsidiary to fluctuate when its results are translated.
Economic risk.
Economic risk is the risk that arises from changes in economic policies or conditions in the host country that affect the macroeconomic environment in which a multinational company operates. Examples of economic risk include:
• Government spending policy.
• Economic growth or recession.
• International trading conditions.
• Unemployment levels.
• Currency inconvertibility for a limited time.
Hedging economic risk.
Actions that can reduce economic risk:
• Matching assets and liabilities. A foreign subsidiary can be financed, as far as possible, with a loan in the currency of the country in which the subsidiary operates. A depreciating currency results in reduced income but also reduced loan service costs.
• Diversifying the supplier and customer base. If currency of one of the supplier countries strengthens, purchasing can be switched to a cheaper source.
• Diversifying operations worldwide. On the principle that companies which confine themselves to one country suffer from economic exposure, international diversification is a method of reducing such exposure.
Translation risk
Translation risk – exchange rate change causing a fall in the book value of foreign assets or an increase in the book value of liabilities. Translation risk does not involve cashflows, so there is doubt as to whether it matters. However, if write-offs result in changes to gearing that affect a borrowing covenant there may be real economic consequences from translation risk. Also, if it affects reported profits it may cause a change in the share price. Using international debt finance reduces the net assets in foreign currency resulting from an overseas investment and reduces translation risk.
Exchange rate risk.
Changes in exchange rates can cause considerable variation in the amount of funds received by the parent company. In theory this risk could be taken into account in calculating the project’s NPV, either by altering the discount rate or by altering the cash flows in line with forecast exchange rates. Virtually all authorities recommend the latter course, as no reliable method is available for adjusting discount rates to allow for exchange risk.
Political risk.
Political risk. This relates to the possibility that the NPV of the project may be affected by host country government actions. These actions can include:
• Expropriation of assets (with or without compensation!);
• Blockage of the repatriation of profits;
• Suspension of local currency convertibility;
• Requirements to employ minimum levels of local workers or gradually to pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their possible occurrence must be considered when evaluating new investments.
Techniques to limit political risk
High levels of political risk will usually discourage investment altogether, but in the past certain multinational enterprises have used various techniques to limit their risk exposure and proceed to invest. These techniques include the following:
• Structuring the investment in such a way that it becomes an unattractive target for government action. For example, overseas investors might ensure that manufacturing plants in risk-prone countries are reliant on imports of components from other parts of the group, or that the majority of the technical “know-how” is retained by the parent company. These actions would make expropriation of the plant far less attractive.
• Borrowing locally so that in the event of expropriation without compensation, the enterprise can offset its losses by defaulting on local loans.
• Prior negotiations with host governments over details of profit repatriation, taxation, etc, to ensure no problems will arise. Changes in government, however, can invalidate these agreements.
• Attempting to be “good citizens” of the host country so as to reduce the benefits of expropriation for the host government. These actions might include employing large numbers of local workers, using local suppliers, and reinvesting profits earned in the host country.
Fiscal risk.
Fiscal risk. Fiscal risk is the risk that the host country may increase taxes or changes the tax policies after the investment in the host country is undertaken. Examples of fiscal risk include:
• An increase in corporate tax rate.
• Cancellation of capital allowances for new investment.
• Changes in tax law relating to allowable and disallowable tax expenses.
• Imposition of excise duties on imported goods or services.
• Imposition of indirect taxes.
Regulatory risk.
Regulatory risk. Regulatory risk is a risk that arises from changes in the legal and regulatory environment which determines the operation of a company. Examples are: • Anti-monopoly laws. • Health and safety laws. • Copyright laws. • Employment legislation.
Financing overseas projects.
Financing overseas projects. The chief sources of long-term finance are the following: • Equity. • Eurocurrency Loan • Government grants. • Intercompany accounts. • Eurobond. • Euro equity.
