Exam Prep Flashcards
- What is the difference between a direct and an indirect intervention in the FX market
Direct intervention occurs when a central bank such as the Fed, intervenes in the foreign exchange market by buying or selling its own currency to influence value. The central bank might sell its currency to depreciate its value or buy it to appreciate its value. The effectiveness of a bank’s intervention depends on the number of reserves it can use. Direct intervention is also more likely to be affective if coordinated by multiple central banks.
Indirect intervention involves affecting the currency value through other economic factors such as adjusting interest rates or imposing foreign exchange controls. They achieve this through using monetary policy, which affects the currency’s value by changing the underlying conditions that determine exchange rates.
What are the implications of a direct intervention by the central bank and how might these effects be mitigated?
Key Implications of Direct Intervention:
- Exchange Rate Movements: Interventions can immediately impact exchange rates, affecting exports, imports, inflation, and growth. However, effects may be temporary if not backed by strong economic fundamentals, risking speculator challenges.
- Foreign Reserve Depletion: Frequent interventions risk depleting reserves, which could reduce currency stability and market confidence. A large reserve buffer and careful intervention use can help.
- Market Signaling: Interventions signal desired exchange rate levels. Market confidence hinges on the central bank’s credibility—weak interventions can encourage speculative opposition.
- Trade and Inflation Impacts: Currency depreciation can improve trade balance by making exports cheaper, but it may also drive inflation due to higher import costs.
Mitigating Negative Effects:
- Coordinated Interventions: Collaborating with other central banks can amplify intervention effectiveness, as seen in the Plaza Accord.
- Sterilization: Sterilized interventions, using open market operations, neutralize changes in the money supply, mitigating deflation risks.
- Transparent Communication: Clear explanations of intervention goals can boost market confidence, manage expectations, and reduce intervention frequency.
What are agency costs? and the types
Agency costs are the costs of ensuring that managers maximise shareholder wealth. These costs are higher for MNCs than for domestic firms due to a few reasons. These include monitoring managers of overseas subsidiaries are difficult. The cultural differences of foreign subsidiaries and the larger size of MNCs can also increase the agency costs of a business.
Types of Agency Costs:
1. Monitoring Costs: Costs incurred by shareholders to oversee managers, like audits and governance mechanisms.
o Examples: Hiring auditors, setting up audit committees.
2. Bonding Costs: Costs incurred by managers to assure shareholders of their alignment, often through performance-based contracts.
o Examples: Performance-based pay, stock options.
3. Residual Losses: Inefficiencies due to unresolvable conflicts between managers’ and shareholders’ interests.
o Examples: Managers avoiding high-risk projects or using excessive perks.
what are the causes of agency costs and how to reduce them
Causes of Agency Costs:
* Separation of Ownership and Control: Managers may prioritize personal goals over shareholders’ interests.
* Information Asymmetry: Managers often have more firm-specific information, leading to potential self-interest.
* Risk Preferences: Managers may avoid risks that shareholders would prefer.
* Moral Hazard: Lack of full oversight may lead managers to act in self-interest.
Reducing Agency Costs:
1. Performance-Based Compensation: Aligns manager and shareholder interests.
2. Board Oversight: Independent boards ensure management acts in shareholders’ interests.
3. Corporate Governance: Mechanisms like shareholder rights plans improve accountability.
4. Market for Corporate Control: Threat of takeovers pressures managers to maximize value.
5. Transparency: Improved reporting reduces information asymmetry.
4o
What are the factors that affect a MNC’s valuation of a foreign target?
When an MNC evaluates the acquisition of a foreign target, several factors influence this valuation.
Factors such as:
- currency exchange risks: Exchange rate fluctuations can impact future cash flows, as depreciating foreign currencies can lead to reduced revenues after conversion.
- country-specific political: Country risk such as political instability can lead to higher discount rates, lowering the valuation.
- economic conditions: MNC’s must assess the risks and benefits from strategies such as transfer pricing.
- tax considerations: Additionally, tax laws such as corporate taxes can affect the valuation.
Other key factors affecting a foreign target’s valuation include: - local competitive environment
- regulatory frameworks
- cultural fit.
- Profits decrease and compliance costs increase in highly competitive and regulated markets.
- A strong financial structure and aligned management team can increase valuation, while high debt or repatriation limitations may reduce it.
What are the factors that affect foreign currency option pricing? How do these factors affect the pricing of foreign currency options?
Foreign currency options, which give the holder the right but not the obligation to buy or sell a specified amount of foreign currency at a pre-agreed price (strike price), are influenced by several key factors. The factors include spot exchange rate, strike price, time to expiry, currency volatility and interest rate differentials.
- The spot exchange rate and strike price determine the intrinsic value of the option.
Spot rate > strike price = call option increases in value
Spot rate < strike price = put option increases in value
- Longer time to expiry generally increases the options value due to higher possibility of favourable movements in the exchange rate
- High currency volatility increases option value due to high chance of extreme movements -> higher payoffs.
- Interest rate differentials between the domestic and foreign countries play a role.
Rise in domestic interest rates relative to foreign rates increases the value of call options and decreases the value of put options.
Why might a firm use forecasting of FX values? What are the different forms of forecasting techniques used? How are these forms affected by market efficiency?
A firm uses FX forecasting to manage risk, optimise financial decisions and plan for investments and financing. Forecasting helps to mitigate exchange rate risks and improves decision making for transactions, budgeting and earnings remittances.
- Technical Forecasting: using historical data but is limited to short term predictions
- Fundamental forecasting: relies on economic variables but can be uncertain due to timing and data reliability
- Market-based forecasting: uses spot and forward rates as forecasts based on market expectations.
- Mixed forecasting: combines multiple methods for a more balanced forecast.
Weak-form efficiency: historical data already priced in, limiting technical forecasting.
Semi-strong/strong-from efficiency: public/private info reflected, making it difficult to outperform the market.
Why might a firm choose to hedge FX exposures
Choose to hedge FX exposures:
- Reduce the risk of adverse currency movements that could negatively affect its cash flows, profitability or overall financial performance.
- Hedging allows for stabilisation of firm cash flows -> predictable costs/revenues -> protection from currency fluctuations that can occur due to international operations.
- Forward contracts, options and futures allow for exchange rates to be locked in to provide more certainty in financial planning.
Why might a firm choose not to hedge FX exposures?
Choose not to hedge FX exposures:
- Cost of hedging, options involve upfront costs that do not justify potential benefits.
- Firms rely on natural hedging through diversified operations or income streams, reducing need for financial hedging.
- Firms believe currency movements will offset over time or speculate on favourable exchange rate movements rather than hedge.
- Limitations of hedging include risk of over/under hedging due to uncertainty in the timing or amount of foreign currency flows.
financial intermediation
What is the difference between financial intermediation and disintermediation?
Financial intermediation is the process of raising debt finance through an intermediary. Banks, insurance companies and investment funds can connect borrowers with lenders. Key characteristics:
- Risk management: Intermediaries help mitigate risk by pooling resources and spreading exposure across multiple borrowers.
- Liquidity: They provide liquidity to savers by offering products like deposits that can be easily withdrawn, while also providing long-term capital to borrowers.
- Expertise: Financial intermediaries have specialized knowledge in assessing risk and allocating capital efficiently.
- Examples: Banks offering loans, mutual funds pooling investments, and insurance companies managing pooled premiums for coverage.
disintermediation
What is the difference between financial intermediation and disintermediation?
Disintermediation refers to raising debt directly from the market by issuing securities to debt holders, which bypasses intermediaries, reducing costs and increasing flexibility.
- Cost reduction: By cutting out intermediaries, firms may reduce the costs associated with borrowing, such as interest margins or intermediary fees.
- Increased control: Borrowers may gain more flexibility and control over their financing options.
- Higher risk for investors: Without an intermediary, investors face more risk, as there is no institution to assess or guarantee the borrower’s creditworthiness.
- Examples: Firms issuing bonds directly to investors, crowdfunding platforms, or companies conducting initial public offerings (IPOs) to raise capital from the public
What are Eurocurrencies? What are the advantages of using international money markets to raise capital?
Eurocurrencies refer to deposits of a currency held in a bank located outside the home country of that currency. For example, U.S. dollars deposited in a bank in London are considered Eurodollars, and similarly, yen deposited outside Japan would be Euroyen.
- Eurodollars: U.S. dollars deposited in foreign banks or in the international branches of U.S. banks.
- Euroyen: Japanese yen deposited in banks outside Japan.
- Eurocurrency market: The market in which Eurocurrencies are traded and deposited.
Eurocurrencies are offshore deposits held outside their home country’s regulations. Key advantages of using international money markets include access to a larger capital pool, lower borrowing costs due to fewer regulations, and flexibility in borrowing currencies. Firms can diversify funding sources, meet short-term financing needs efficiently, and benefit from highly liquid and less regulated markets, reducing costs and increasing transaction speed.
What does it mean for markets to be either segmented or integrated?
A segmented market is one where securities are price based on domestic standards due to barriers such as government regulations or investor perceptions. Can result from imperfections like political risk or insider trading regulations. Capital flows are restricted by barriers like regulatory controls, leading to price inefficiencies, higher capital costs and limited diversification. Local risk factors dominate asset pricing, as seen in historically segmented markets like China or India.
An integrated market refers to the absence of such barriers, where securities are priced uniformly on a global scale. Capital moves freely, assets of similar risk have uniform returns, and prices reflect global risk factors. There are no significant barriers to capital flow, leading to efficient pricing and global diversification opportunities, such as in the Eurozone.
What are swap transactions, and how are they instituted? What are the potential benefits arising from swaps transactions? What conditions create these potential opportunities?
Swap transactions are derivative contracts in which two parties agree to exchange cash flows or other financial instruments at specified intervals, based on predefined terms.
Swaps can include
- currency swaps, where parties exchange currencies at specified rates and dates.
- interest rate swaps, where fixed interest payments are exchanged for floating one.
The benefits of swaps include managing exposure to interest rate or currency risks, reducing borrowing costs, and gaining access to foreign markets.
Opportunities arise from comparative advantage, market segmentation, or mispricing of risks.
What are the different forms of available international equity financing? What are the characteristics of these forms?
The different forms of equity financing include:
- Domestic equity offerings: MNC raise capital by issuing equity in their home country. The funds are in local currency and offering follows regulatory guidelines of home market.
- Global equity offering: issuing shares in multiple countries simultaneously. Acces to domestic and international capital market at the same time.
- Public or private placement of equity: public issues involve offering shares to the public and listing them on stock exchanges. Private placements involve offering equity to a select group of institutional investors.
- Yankee stock offerings: refers to non-US firm issuing equity in the US. These firm issue shares directly in the US capital markets to raise large amounts of funds from US investors.
- American Depository Receipts: certificates representing shares of a foreign company, traded on the US exchanges. These certificates are issued by US banks and represent a bundle of the company’s actual shares.
- Euro-equity Issues: involves a company issuing equity across multiple foreign equity markets, outside its home country. They are underwritten by financial institutions and can be done simultaneously with a domestic offering.
Why might a firm seek to raise capital internationally rather than purely domestically?
- Access larger capital markets: By raising capital internationally, firms can tap into a broader investor base across multiple countries, providing access to deeper and more liquid capital markets.
- Reduce cost of capital: Raising capital internationally can lower a firm’s weighted average cost of capital (WACC) by reducing borrowing costs or attracting equity investors willing to accept lower returns. International markets offer lower interest rates for companies.
- Hedge against economic/political risk: By raising capital internationally, firms can hedge against economic or political risks in their home country. Domestic financial markets may be vulnerable to political instability, inflation, regulatory changes, or economic crises that could disrupt a firm’s access to capital.
- Benefit from lower regulatory requirements: Some international markets offer more favorable regulatory environments or tax incentives that reduce the overall cost of raising capital. For example, certain countries or financial centers provide tax breaks or incentives to foreign firms issuing bonds or equity in their markets.
What is political risk?
Political risk refers to the potential for losses or adverse effects on business operations, investments, or profitability due to political events or actions by governments or other political forces. Political risk can arise from various factors, including changes in government policies, regulatory shifts, political instability, civil unrest, corruption, and geopolitical tensions
How can we measure political risk?
- Country risk ratings and indices country risk ratings: provided by agencies that assess overall political, economic and financial stability of a country. Institutions provide ratings that assess political risk, such as Political Risk Services Group and Economist Intelligence Unit.
- Sovereign credit ratings: (AAA, AA, A) provided by agencies such as Moody’s, Standard & Poor (S&P) to reflect a country’s ability to meet debt obligations, ratings incorporate political risk.
- Political risk insurance premiums: cost of political risk insurance offered by agencies reflects the perceived level of political risk.
- Political risk analysis (qualitative): involves examining a country’s political environment, government stability, policies and potential for conflict.
- Sovereign bond spreads: the spread between a country’s sovereign bonds and the bonds of a stable benchmark country such as US treasury bonds, provides an indication of political risk.
- Market-based indicators: financial markets often respond quickly to political events and certain indicators can provide insight into political risk.
What actions can firms take to alter the political risks that they face?
- Political risk insurance: protects firms against specific types of political risks such as expropriation, currency inconvertibility, political violence and breach of contract by foreign government. Reduces the risk as firms transfer part of their political risk to the insurer.
- Diversification of investments: across multiple countries or regions to reduce exposure to political risks in one market. Political risk is country specific so spreading the exposure reduces the impact of political event in one country.
- Joint ventures and partnerships with local firms: local partners have better knowledge of political landscape and stronger relationships with local stakeholders. Foreign companies may gain local government favour, reduce the risk of expropriation and improve ability to navigate foreign regulatory environments.
- Localisation of operations: localisation involves adapting firms operations, workforce and decision making to align more closely with the host country’s culture values and practises. Firms that localise their operations are less likely to be seen as foreign entities exploiting local resources.
- Negotiating stabilisation clauses in contracts: Stabilization clauses are legal provisions that protect foreign investors from adverse changes in the host country’s laws or regulations after the investment has been made. Stabilization clauses reduce the risk of regulatory changes, such as new taxes or unfavourable laws, that could negatively affect the profitability of an investment
business risk
What is the difference between business risk and financial leverage risk?
Business risk refers to the inherent risk associated with a company’s operations and environment, independent of its financial structure or how it is financed. It stems from the uncertainty in the company’s ability to generate revenues and profits due to external and internal factors. Business risk is primarily influenced by factors related to the company’s industry, competition, operational efficiency, and market demand for its products or services.
- Demand Risk: The risk that changes in consumer demand will affect revenues.
- Supply Chain Risk: The risk that disruptions in the supply chain will impact production or sales.
- Competitive Risk: The risk that competitors may reduce market share or pressure prices.
- Technological Risk: The risk that technological changes or innovations may render a company’s products or services obsolete.
finanical leverage risk
What is the difference between business risk and financial leverage risk?
Financial leverage risk, or financial risk, is the added risk a company faces due to debt financing. It arises from the capital structure’s reliance on debt over equity, increasing obligations for fixed interest payments. This amplifies the risk of default or bankruptcy if cash flows fall short.
- Interest Rate Risk: The risk that rising interest rates will increase the cost of servicing debt.
- Credit Risk: The risk that the company may be unable to meet its debt obligations, leading to default.
- Refinancing Risk: The risk that a company may be unable to refinance its debt at favorable terms when it matures.
- Bankruptcy Risk: The risk that financial distress could lead to insolvency and bankruptcy if the company cannot meet its debt obligations.
What is Foreign Direct Investment?
Foreign Direct Investment (FDI) is when a company or individual from one country invests in business interests in another country, often establishing ownership or control over the foreign company. Unlike portfolio investments, FDI involves a significant influence on the operations.
Key Characteristics of FDI:
- Ownership and Control: FDI typically involves acquiring a substantial ownership stake (usually 10% or more), giving the investor control over the foreign company’s operations and policies.
- Long-Term Commitment: FDI is a sustained investment aimed at creating productive operations, like factories or acquisitions, as opposed to short-term financial gains.
- Forms of FDI:
o Greenfield Investments: Building new facilities from scratch.
o Brownfield Investments: Merging with or acquiring existing foreign companies for quicker entry.
o Joint Ventures: Partnering with local firms to share risks and access local expertise. - Capital and Technology Transfer: FDI often involves transferring not only capital but also technology, management, and expertise, enhancing the host country’s capabilities.
- Direct Participation: FDI entails active involvement in management and decision-making, with the investor invested in the success of the foreign venture.
What conditions make investments likely to be expropriated?
Expropriation is when a government seizes foreign-owned assets, often without adequate compensation. Certain conditions make expropriation more likely:
- Political Instability: Frequent government changes, weak legal systems, and anti-foreign sentiment increase expropriation risks.
- Economic Crisis: Governments may seize profitable foreign assets during recessions or financial crises to generate revenue or prevent capital flight.
- Resource Nationalism: Countries rich in resources may nationalize foreign-owned assets, especially when commodity prices are high, to capture economic benefits.
- Ideological Shifts: Socialist or protectionist regimes, as well as populist governments, may expropriate foreign investments to fulfill ideological goals or campaign promises.
- Strategic Industries: Investments in critical sectors like energy, telecom, or defense face higher risks due to national security concerns.
- Deterioration of Foreign Relations: Diplomatic tensions, sanctions, and geopolitical conflicts can prompt retaliatory expropriation.
- Weak Investment Protections: Lack of investment treaties or weak investor protection laws increase the vulnerability of foreign assets.
- Unmet Local Expectations: If foreign investors fail to meet job creation, environmental, or social commitments, governments may seize assets under public interest claims.
Why might a firm cross list?
Cross-listing refers to the practice of a company listing its shares on multiple stock exchanges in different countries. Firms may choose to cross-list their shares for several strategic, financial, and operational reasons.
Firms may cross-list for several reasons:
- Access to Capital: Cross-listing expands a firm’s access to foreign investors and capital, especially beneficial when the domestic market is small or illiquid.
- Increased Liquidity: Listing on multiple exchanges enhances share liquidity, as shares are available to a larger investor pool across different time zones.
- Enhanced Visibility: Cross-listing on prestigious exchanges boosts global visibility and credibility, attracting international investors, customers, and partners.
- Improved Governance: Cross-listing often requires adherence to stricter governance and disclosure standards, which can improve investor confidence.
- Lower Cost of Capital: By increasing investor demand and diversifying funding sources, cross-listing can reduce a firm’s cost of capital.
- Diverse Shareholder Base: It allows firms to attract foreign investors, reducing reliance on domestic investors and mitigating risks from local economic shocks.
- Currency Matching: Firms can raise capital in the currency of their foreign revenues, providing a natural hedge against currency risk.
Can cross listings overcome barriers to capital flows? Is there any evidence to support this?
Can Cross-Listings Overcome Barriers to Capital Flows? Yes, cross-listing can help overcome capital flow barriers by:
- Reducing Information Asymmetry: Stricter reporting standards improve transparency, making foreign investors more confident in investing.
- Overcoming Home Bias: Cross-listing makes it easier for foreign investors to buy shares, reducing the preference for domestic investments.
- Enhanced Investor Protection: Listing in countries with strong legal protections can attract more foreign investors.
- Lowering Market Segmentation: Aligning with international standards facilitates capital flow and market integration.
Evidence Supporting Cross-Listing Benefits:
- Higher Liquidity & Lower Cost of Capital: Cross-listed firms often see increased liquidity and lower capital costs due to a larger investor base and reduced home bias.
- Improved Valuation: Cross-listed firms typically have a valuation premium due to increased investor protection and visibility.
- Reduced Information Asymmetry: Stricter disclosure requirements improve investor confidence.
- Global Diversification: Cross-listed firms experience lower volatility by spreading risk across global markets.
What are the different forms of cross-listings into US capital markets that are available?
Foreign firms seeking access to U.S. capital markets have several cross-listing options, each differing in regulatory demands, investor reach, and integration:
- American Depositary Receipts (ADRs)
ADRs allow foreign firms to trade on U.S. exchanges in dollars.
Level I: Traded OTC with minimal disclosure, limited access, used by smaller firms for U.S. exposure.
Level II: Listed on major exchanges, requires SEC filings (Form 20-F), more investor access; used by firms like BP for visibility without raising capital.
Level III: Full IPO on U.S. exchanges, maximum investor access, full SEC compliance; used by firms like Alibaba to raise capital.
Direct Listings: Direct listing on exchanges (NYSE/Nasdaq) without ADRs, requiring full SEC compliance, provides strong U.S. market presence; used by large firms like Unilever.
- Global Depositary Receipts (GDRs): Similar to ADRs but accessible in multiple markets (U.S., Europe, Asia), enhancing global liquidity; used by firms like Gazprom.
- Private Placements (Rule 144A): For institutional investors only, allows raising capital without SEC registration, less disclosure; suitable for firms avoiding public listing costs.
- Over-the-Counter (OTC) Trading: Lower regulatory requirements, limited access and liquidity; allows small foreign firms exposure to U.S. investors without full exchange listing.
Why might ownership concentration levels differ between countries?
Ownership concentration, or the extent to which a company’s shares are held by a small number of shareholders, varies across countries due to legal, economic, cultural, and governance factors:
- Legal and Regulatory Frameworks: Strong shareholder protections encourage dispersed ownership, as seen in the U.S. and U.K., while weak protections, common in emerging markets, lead to higher concentration as large shareholders maintain control to safeguard interests.
- Capital Market Development: Well-developed markets with broad access to equity financing, like in the U.S. and U.K., have more dispersed ownership. Underdeveloped markets rely on large shareholders, such as families or governments, leading to concentration.
- Cultural and Historical Factors: Countries with a tradition of family-owned businesses, like Italy and South Korea, exhibit higher concentration. In contrast, the Anglo-American model favors dispersed ownership through public equity.
- Role of Institutional Investors: High institutional investor presence, as in the U.S., diversifies ownership, while countries with fewer institutional investors have concentrated ownership among families or state entities.
- Government Ownership: High government stakes, common in strategic industries in China and Russia, result in concentration. Privatized economies like the U.S. see more dispersed ownership.
Is capital structure relevant?
The relevance of capital structure addresses whether a firm’s debt-equity mix impacts its value, cost of capital, and risk. Key theories provide perspectives:
- M&M Irrelevance Theory: Modigliani and Miller (1958) argued that in a world without taxes or bankruptcy costs, capital structure doesn’t impact a firm’s value; investors can replicate any leverage through “homemade leverage.”
- M&M with Taxes: Accounting for taxes (1963), M&M proposed that debt financing adds value through tax-deductible interest, suggesting firms benefit from a tax shield, increasing the firm’s value.
- Trade-Off Theory: This theory balances the tax benefits of debt with bankruptcy costs. An optimal capital structure exists where tax shields and distress costs are balanced, maximizing firm value.
- Pecking Order Theory: Firms prefer financing through retained earnings, then debt, and issue equity as a last resort, due to information asymmetry. This order minimizes capital costs and adverse signals to the market.
- Agency Costs Theory: Debt can limit managerial misuse of free cash flow, acting as a control on agency costs. However, too much debt may lead to conflicts between shareholders and creditors, as shareholders may favor riskier investments.
These theories illustrate that capital structure is generally relevant, as it affects a firm’s tax benefits, control costs, and overall financial strategy.
Are the observed rights accruing to security holders the same across different legal structures?
No, the rights accruing to security holders (such as shareholders and bondholders) are not the same across different legal structures. Security holder rights vary across countries due to legal, governance, and regulatory differences:
- Legal Traditions:
o Common Law (e.g., U.S., U.K.): Strong protections for shareholders, robust voting rights, transparency, and legal recourse. Bondholders have clear bankruptcy rights.
o Civil Law (e.g., Germany, France): Weaker protections with concentrated ownership and limited shareholder influence, often controlled by families or the state. - Corporate Governance
o Unitary Board (Common Law): Single board structure, enhancing shareholder control.
o Dual Board (Civil Law): Separate supervisory and management boards reduce shareholder power. - Regulatory Influence
o Common Law: Active regulators protect investors through strict oversight.
o Civil Law: Less regulatory enforcement, limiting shareholder rights.
In essence, common law favors shareholder rights, while civil law emphasizes broader stakeholder interests.
What is information asymmetry and how can it be reduced?
Information asymmetry occurs when one party in a transaction or business relationship has more or better information than the other party. In corporate finance, it typically refers to the disparity in the amount of information available to managers (insiders) and shareholders or potential investors (outsiders). Managers have access to detailed internal information about the company’s operations, strategy, and financial condition, while shareholders and investors must rely on publicly available information, which may be incomplete or less timely.
- Improving Financial Disclosure: Provide detailed financial statements and forward-looking guidance to enhance transparency and build investor trust.
- Adopting Accounting Standards (IFRS/U.S. GAAP): Use recognized accounting standards for consistent and comparable financial reporting across firms.
- Earnings Guidance and Conference Calls: Host quarterly calls to discuss financial results and outlook, aligning investor expectations and reducing uncertainty.
- Corporate Governance Enhancements: Strengthen board independence and establish audit committees to increase confidence in financial disclosures and mitigate manipulation risks.
- Insider Trading Regulations: Enforce strict rules against insider trading to promote market fairness and ensure equal access to information for all investors.
When is it appropriate to use the firm’s WACC in the evaluation of a new project?
The Weighted Average Cost of Capital (WACC) is used in capital budgeting to evaluate if a project can generate returns above the firm’s overall cost of capital. WACC is appropriate for a project when:
- Project Risk Matches Firm Risk: The project’s risk profile aligns with the firm’s overall risk, such as a similar industry and operational characteristics.
- Firm’s Capital Structure Used: The project uses the same debt-equity mix as the firm’s existing capital structure.
- Cash Flows in Same Currency and Market: Project cash flows are in the same currency and market as the firm’s current operations, with similar interest rates and inflation.
- Firm’s Overall Beta Unchanged: The project does not significantly affect the firm’s beta or market risk exposure.
- Project Duration Matches Existing Projects: The project has a similar duration to the firm’s typical financing strategy.
When Not to Use WACC: Avoid using WACC if the project has a different risk profile (e.g., new industry or country) or alters the firm’s leverage, currency, or risk exposure. In such cases, a project-specific cost of capital is more appropriate.
What is a Global Capital Asset Pricing Model? Under what situations might we use a Global Capital Asset Pricing Model as opposed to a domestic model?
The Global Capital Asset Pricing Model (GCAPM) extends the traditional CAPM by accounting for global risks like international market volatility, currency fluctuations, and country-specific risks. GCAPM is used to estimate the expected return on investments in a globally interconnected market, where the risks go beyond domestic factors.
When to Use GCAPM vs. Domestic CAPM:
- Multinational Firms: For global operations exposed to international risks, GCAPM better reflects global economic factors.
- Foreign/Emerging Market Investments: Accounts for country-specific risks, such as political instability or currency risks.
- Cross-Border M&A: Captures the risks associated with foreign markets in M&A transactions.
- Global Portfolios: Reflects the risks of diversified portfolios exposed to international markets.
- Currency Risk: Useful for firms facing exchange rate fluctuations affecting revenues.
- Globally Integrated Industries: For industries (e.g., tech, energy) impacted by global economic trends.
- Hedging Global Risks: Evaluates strategies for managing currency or commodity price fluctuations.
Why might the cost of capital vary between a parent and a subsidiary?
The cost of capital between a parent company and its subsidiary may differ due to factors including country-specific risks, currency risk, business risk profiles, capital structure, credit ratings, market access, tax policies, regulatory differences, and governance structures.
Key Factors:
- Country-Specific Risks: Subsidiaries in riskier countries face higher costs due to political, economic, and currency risks.
- Currency and Exchange Rate Risk: Subsidiaries exposed to volatile currencies face higher capital costs.
- Business Risk Profiles: Different industries or markets can lead to varying risk levels, impacting capital costs.
- Capital Structure Differences: Varying debt-to-equity ratios affect the weighted average cost of capital (WACC) based on risk exposure.
- Creditworthiness: Subsidiaries with weaker credit ratings or less market access incur higher borrowing costs.
key differences
Why might the cash flows used in project evaluation viewed from either the parent or the subsidiary’s perspective differ? In what situations does this matter?
Cash flows in project evaluation can vary between a parent and subsidiary due to factors like currency exchange, tax differences, transfer pricing, repatriation policies, and distinct financial goals. These factors lead each entity to view project cash flows differently, impacting decisions in project viability, capital allocation, and risk management.
Key Differences in Cash Flow Perspectives:
- Currency and Exchange Rate Risk: Subsidiaries calculate cash flows in local currency, while the parent values cash flows in home currency, affected by exchange rate fluctuations.
- Taxation: Local taxes affect subsidiary cash flows, while the parent considers additional repatriation and home-country taxes.
- Transfer Pricing: Prices for intercompany goods/services impact cash flows; inflated transfer prices can reduce the subsidiary’s cash flow but enhance the parents.
- Repatriation Policies: Some countries restrict profit repatriation, reducing cash flow accessibility for the parent.
- Financing Differences: Subsidiaries financing locally may incur higher interest expenses, unlike parent-funded projects with potentially lower costs.
situation where this matters
Why might the cash flows used in project evaluation viewed from either the parent or the subsidiary’s perspective differ? In what situations does this matter?
Situations Where This Matters:
- Project Evaluation: Projects profitable locally might be less attractive to the parent due to repatriation costs or currency risks.
- Capital Allocation: Parents may prioritize subsidiaries with favorable repatriation rules, even if local cash flows are lower.
- Transfer Pricing and Tax Optimization: Adjustments in transfer pricing can shift cash flows to low-tax jurisdictions.
- Risk Management: Different currency risk perceptions lead to varied hedging or financing strategies.
- Dividends and Repatriation: Local regulations on dividend payments may limit the parent’s cash flow access, affecting capital planning.
