Weeks 9-12 Flashcards

Question

Control Decisions as Real Options

Answer 1

**Real Assets** * Physical / Tangible assets **Real Options on Real Assets** * Management decision-making flexibility * Can be seen as the ability to defer / gather information **Call option on real assets** * Expansion: Represents a proposed project that contains an option of pursuing an additional venture. **Put option on real assets** * Abandonment: Represents a proposed project that contains an option of divesting part, or all, of the project.

Answer 2

A partial international acquisition requires less funds because only a portion of the foreign target’s shares are purchased. Issues * Reliance on local management * Unable to fully integrate / standardise * Conflicting interests * Dividend policies * Lack of liquidity in minority stakes * Lack of knowledge sharing When an MNC considers a partial acquisition, it must take the perspective of a passive investor rather than as a decision maker

Answer 3

* Potential conflict between government control and acquirers may exist * Political conditions can be volatile * Economic conditions are uncertain in transitional economies * Future cash flows are uncertain due to potential introduction of competition * Exchange rate forecasting * Taxation / Legal system differences * Privatised businesses – Data regarding value and benchmarks are limited * Unanticipated business integration challenges

Answer 4

The valuation of a proposed international divestiture requires comparing the present value of the cash flows if the project is continued to the proceeds that would be received (after taxes) if the project is divested. External forces that could reduce the present value: * a weakening economy in the host country could reduce expected cash flows to be generated by the subsidiary * a reduction in the foreign currency could reduce the exchange rate at which cash flows are converted to the home currency * higher taxes imposed by the host government would reduce the expected cash flows of the subsidiary * an increase in the MNC parent’s cost of capital would increase the discount rate at which expected future cash flows are discounted when determining the present value of the subsidiary

Answer 5

The system of controls, regulations and incentives designed to control corporations across countries. **Legal Framework Emphasis** * Shareholders v Stakeholder Balanced Approach v CSR * Compliance: Sarbanes-Oxley & EU Directives **Governance by Board Members** * Board members who are employees of a foreign subsidiary may maximise the benefits to the subsidiary **Governance by Institutional Investors** * Institutional investors commonly hold a large proportion of a firm’s shares (incentives to be active) **Cultural Differences** * Attitudes towards authority, collectivism and individualism.

Answer 6

If managers make decisions that destroy value, the MNC could be subject to takeover, and managers could lose their jobs. * Hostile takeovers are a governance mechanism **Barriers to International Corporate Control** * Anti-takeover amendments implemented by target: Target may implement an anti-takeover amendment that requires a large proportion of shareholders to approve the takeover. * Poison pills implemented by target: Grants special rights to managers or shareholders under specified conditions. * Host government barriers: Governments of some countries restrict foreign firms from taking control of local firms, or they may allow foreign ownership of local firms only if specific guidelines are satisfied.

Answer 7

* Domestic Equity Offering (public) – MNCs can engage in a domestic equity offering in their home country in which the funds are denominated in their local currency. * Global Equity Offering (public) – Some MNCs pursue a global equity offering in which they can simultaneously access equity from multiple countries. * Private Placement (domestic / international) – Offer a private placement of equity to financial institutions / private investors in their home country or in the foreign country where they are expanding.

Answer 8

* Domestic Bond Offering – MNCs commonly engage in a domestic bond offering in their home country in which the funds are denominated in their local currency. * Global Bond Offering – MNCs can engage in a global bond offering, in which they simultaneously sell bonds denominated in the currencies of multiple countries. * Private Placement of Bonds – MNCs may offer a private placement of bonds to financial institutions in their home country or in the foreign country where they are expanding. * Loans from Financial Institutions – An MNC’s parent commonly borrows funds from financial institutions.

Answer 9

* What factors influence capital structure? * component costs of capital * taxes * interactions of components * The Goal: * to determine the mix of debt and equity that maximises shareholder wealth * But is capital structure relevant?

Answer 10

1. The irrelevancy statement (MM1) The market value of any firm is independent of its capital structure 2. The cost of capital (MM2)

Answer 11

Optimal capital structure considers: 1.Financial Distress Financial Distress *Loss of value caused by the risk of bankruptcy. *Bankruptcy itself is an additional cost.

Answer 12

Optimal capital structure considers: 1.Financial Distress 2.Agency costs Agency cost is roughly defined as “difference between the value of the firm in what would be an ideal contracting situation and what is viable through negotiation” Amaro de Matos, J., Theoretical Foundations of Corporate Finance (Princeton University, Press, Princeton NJ, 2001), p. 61.

Answer 13

Optimal capital structure considers: 1. Financial Distress 2. Agency costs 3. Costs due to information asymmetry Information asymmetry comes about when parties have different information. It is normally assumed that managers (insiders) have the best information about the firm.

Answer 14

**EQUITY (Ownership / Control)** MNC’s parent: – may invest its own cash into the subsidiary. – The cash infusion in the subsidiary represents an equity investment by the parent, so that the parent is the sole owner of the subsidiary. MNC Subsidiary: – An alternative method by which the subsidiary can build more equity is to offer its own stock to the public. **DEBT (Is the Parent Responsible?)** – Fully responsible * Overall Financial Structure – Prepared to allow default * Subsidiaries Financial Structure * Consequences?

Answer 15

Conform to the capital structure of the parent company * Financial structures are generally not independent * This approach is not consistent with minimising the parent’s overall cost of capital Reflect the capitalisation norms in each foreign country * Not consistent with a strategic approach * May reduce criticism if doing as everyone else does * but doesn’t exploit MNC’s comparative advantages in financing Implication: * Vary judiciously

Answer 16

Some subsidiaries are subject to conditions that favour debt financing, while other subsidiaries are subject to conditions that favour equity financing. **Impact of Increased Subsidiary Debt Financing** * When a subsidiary relies heavily on debt financing, its need for internal equity financing (retained earnings) is reduced. **Impact of Reduced Subsidiary Debt Financing** * The subsidiary will need to use more internal financing, will remit fewer funds to the parent, and will reduce the amount of internal funds available to the parent. **Limitations in Offsetting a Subsidiary’s Leverage** * Foreign creditors may charge higher loan rates to a subsidiary that uses a highly leveraged local capital structure because they believe that the subsidiary may be unable to meet repayments.

Answer 17

**▪ MNC’s Cash Flow Stability** — MNCs with more stable cash flows can handle more debt because there is a constant stream of cash inflows to cover periodic interest payments on debt. **▪ MNC’s Credit Risk **— MNCs that have lower credit risk have more access to credit. **▪ MNC’s Access to Retained Earnings** — Highly profitable MNCs may be able to finance most of their investment with retained earnings and therefore use an equity-intensive capital structure. **▪ MNC’s Guarantees on Debt **— If the parent backs the debt of its subsidiary, the subsidiary’s borrowing capacity might be increased. **▪ MNC’s Agency Problems** — If a subsidiary in a foreign country cannot easily be monitored by investors from the parent’s country, agency costs are higher => incentives to use debt financing

Answer 18

▪ Potential for Blocked Funds ▪ Equity Valuations ▪ Interest Rates in Host Countries ▪ Strength of Host Country Currencies ▪ Expected weakness => borrow locally ▪ Expected appreciation => retain / reinvest earnings ▪ Country Risk in Host Countries ▪ Higher expropriation risk => local debt financing ▪ Tax Laws in Host Countries ▪ e.g. withholding taxes

Answer 19

* The argument depends on – Market integration * Difficult issue as to whether this is the case * No barriers to transfer of funds between countries – Is this true? – Home country bias * Integration of capital markets (pre-tax resolution)

Answer 20

A tax-based explanation. * Stulz considered an investment in Germany that is risk-free – U.S. company with 36% tax rate – Liechtenstein company with 0% tax rate * U.S. company would seek 100% debt funding, but the Liechtenstein company would not * Tax may explain capital structure * Risk effect on the use of debt? – Alternative tax shields? Note: This does not explain differences in required compensation for risk.

Answer 21

* Traditional NPV analysis assumes – Managers seek to maximise shareholder wealth – Ignores costs of managerial discretion * Myers and Majluf (1984) – Pecking order hypothesis * Issuing equities makes investors suspicious, lowering value of the company. If relying on equity, some projects may not go ahead (costs too high). * Internal funds have intrinsic value. No agency costs and all positive NPV projects could proceed. – No information transfer costs * Jensen (1986) – “free-cash” flow undesirable – Investors prefer high debt and low cash levels

Answer 22

Stulz concludes that “neo-classical” cost of capital should not differ but “agency adjusted” cost of capital differs. Testable hypotheses: 1. An increased ability to monitor will reduce cost of capital. 2. Managers can reduce cost of capital by reducing agency problems.

Answer 23

1. Civil law (Romano- Germanic) a) French b) German c) Scandinavian 2. Common-law countries * These countries give strongest protection to creditors and shareholders

Answer 24

1. Laws differ markedly around the world 2. Investors seem better protected in common law countries 3. Concentration of ownership is a compensation for poorer protection. 4. Law enforcement is critical * Accounting standards are important in this respect * The richer you are, the better the laws are enforced 5. There is a link between legal systems and economic development

Answer 25

*** MNC’s Cost of Debt:** – An MNC’s cost of debt is dependent on the interest rate that it pays when borrowing funds. *** MNC’s Cost of Equity:** – An MNC creates equity by retaining earnings or by issuing new stock. An MNC’s cost of equity contains a risk premium (above the risk-free interest rate) that compensates the equity investors for their willingness to invest in the equity.

Answer 26

* There is an advantage to using debt rather than equity as capital because the interest payments on debt are tax deductible. * The greater the use of debt, however, the greater the interest expense and the higher the probability that the firm will be unable to meet its expenses. * As an MNC increases its proportion of debt, the rate of return required by potential new shareholders or creditors will increase to reflect the higher probability of bankruptcy.

Answer 27

May differ because of: *** Size of firm** – An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital. *** Access to international capital markets** – MNC’s access to the international capital markets may allow it to obtain funds at a lower cost than that paid by domestic firms. *** International diversification** – If a firm’s cash inflows come from sources all over the world, those cash inflows may be more stable because the firm’s total sales will not be highly influenced by a single economy. *** Exposure to exchange rate risk** – An MNC’s cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk. *** Exposure to country risk** – An MNC that establishes foreign subsidiaries is subject to the possibility that a host country government may seize a subsidiary’s assets.

Answer 28

**Differences in the risk-free rate** – The risk-free rate is the interest rate charged on loans to a country’s government that is perceived to have no risk of defaulting on the loans. **Differences in the Credit Risk Premium** – The credit risk premium paid by an MNC must be large enough to compensate creditors for taking the risk that the MNC may not meet its payment obligations. **Comparative costs of debt across countries** – There is some positive correlation between country cost-of-debt levels over time

Answer 29

* Capital asset pricing model * International capital asset pricing model * Global capital asset pricing model * Dividend discount model * Gordon growth model * Fama-French three-factor model * Arbitrage pricing theory model

Answer 30

* We’re operating in a global economy * CAPM: * How can the Capital Asset Pricing Model be used to determine the cost of capital in an international setting?

Answer 31

Implications of the CAPM for an MNC’s risk: * MNC may be able to reduce its beta by increasing its international business. Implications of the CAPM for an MNC’s projects: * For MNC with many projects in foreign countries, their cash flows are less sensitive to general home market conditions leading to lower project betas.

Answer 32

Country differences in the cost of equity * Differences in the risk-free rate – When the country’s risk-free interest rate is high, local investors would only invest in equity if the potential return is sufficiently higher than that they can earn at the risk-free rate. * Differences in the Equity Risk Premium – Based on investment opportunities in the country of concern; a second factor that can influence the equity risk premium is the country risk.

Answer 33

* Beta represents systematic risk * Measure of risk that cannot be diversified – compare with unsystematic risk * you can remove unsystematic risk by diversification * Beta Source – History – Proxy

Answer 34

1 Foreign Proxy Companies 2 Home proxy companies Correlation foreign vs. home market Upwardly biased estimate 3 Foreign proxy industries 4 Adjusted home industry beta

Answer 35

* Segmented Markets – Market Imperfections * Government constraints * Investor Perceptions & Regulations * Integrated Markets – Assets priced by un-diversifiable world risk => Use Global CAPM

Answer 36

* Stulz considers the cost of capital in smaller, but globally integrated markets – he focuses on Switzerland, but the case could be made for Australia, Singapore etc… – Does the U.S. have to worry about this problem? * the U.S. market is closely correlated with the World Index anyway

Answer 37

* Segmented market – Less diversification – C. of C. will be higher (relative to the world) – Lower share prices – Domestic CAPM assumes segmentation * Integrated market – Applying CAPM with a World Market Index: – Use world, rather than local, market as the benchmark (even Americans!)

Answer 38

Dealing with additional risk: View 1 Extra Premium View 2 Global CAPM not applicable

Answer 39

Firm comes across a new project * What discount is used for evaluation? Discount rate k reflects: 1. Operating (business) risk of the project 2. Capital structure (financing)

Answer 40

Basic Scenarios: 1. Expansion Project (Same risk) + Same Capital Structure 2. Expansion Project (Same risk) + Change in Cap Structure 3&4. Project of Different Risk (Same / Different Cap Structure)

Answer 41

* assume that – the risk of the foreign project is no different from the risk of other projects being undertaken by the parent – the capital structure of the company (the mixture of debt and equity) remains the same and they continue to use domestic funds solution * the international WACC

Answer 42

* assume that – the risk of the foreign project is no different from the risk of other projects being undertaken by the parent – the company uses new sources of funds * for example, local currency (LC) debt solution: kI = discount rate for international project

Answer 43

Adjusting Measured Risk * Use an all-equity beta to estimate discount rate reflective of business risk Direct use of CAPM inputting a beta reflective of the foreign subsidiary’s risk * Financing effects are placed in the cash flows!

Answer 44

Traditional finance ▪The analysis of business proposals ▪To accept projects that add value

Answer 45

Financial Metrics ▪Internal rate of return ▪Payback period ▪Discounted payback period ▪Accounting rate of return average profit / average investment ▪Net present value

Answer 46

Challenges ▪Unequal Lives ▪Leasing ▪Real Options Assumptions ▪Base Case ▪Fisher’s separation theorem ◦ Independence from consumption preferences ◦ Independence from financing decisions

Answer 47

In imperfect markets firm can generate projects with positive NPVs from competitive advantages Imperfections ▪High barriers to entry ▪Economies of scale ▪Product differentiation / premium pricing ▪Competitor cost disadvantages ▪Exclusive access to distribution channels ▪Favourable government policy

Answer 48

Sunk costs ▪Irrecoverable past expenses, excluded from future project decisions Initial outlay ▪The upfront cash investment required to start the project Working capital ▪Funds required for daily operations, often fluctuating throughout the project. ▪Some working capital may be recovered at project termination

Answer 49

General costs ▪ Variable-cost forecasts can be developed from costs of components and depend on the level of output. ▪ Fixed costs can be estimated without an estimate of consumer demand. ▪ Beware allocated overhead costs, which may not represent additional cash flows e.g. Management salaries may not be an extra expense Depreciation and Tax ▪ Tax is a cash flow ▪ Depreciation reduces taxable inco

Answer 50

Potential Benefits ▪ Future demand is usually influenced by uncertain economic conditions Salvage (Liquidation) Values ▪ Depends on several factors, including the success of the project and the attitude of the host government toward the project. ▪ Consider scenario analysis to estimate NPV at various salvage values. ▪ Consider estimating break-even salvage value at zero NPV. Opportunity costs ▪ Include opportunity costs, the value of the next best alternative. ▪ Can be difficult to estimate – market price as a benchmark

Answer 51

Shorten payback period ▪ Shortening the payback period reduces the project’s exposure to long-term uncertainties in high-risk countries Adjust the discount rate ▪ Higher country risk increases the uncertainty of future cash flows, justifying a higher discount rate to account for that risk ▪ The greater the uncertainty the larger should be the discount rate applied to cash flows ▪ Estimating an appropriate discount rate can be challenging ▪ Fluctuations in country risk over time can lead to inconsistencies in applying the discount rate

Answer 52

▪ Sensitivity analysis ◦ Examines how variables impact project outcomes ◦ More useful than simple point estimates because it reassesses the project based on various circumstances that may occur ▪ Simulation ◦ Simulations generate a range of possible outcomes for NPV by modeling input variables. This technique is typically performed using specialized software to assess how changes in factors affect project viability

Answer 53

Project cash flows estimated from subsidiary’s viewpoint ▪ Treating the project as standalone helps to isolate cash flows directly attributable to the subsidiary’s operations, without considering broader corporate effects Examine project from parent’s viewpoint ▪ The parent must account for additional complexities, including foreign exchange fluctuations, tax implications, and potential repatriation issues, all of which can affect the overall cash flow Indirect benefits and costs ▪ Broader corporate effects, such as cannibalization of other revenue streams or potential synergy gains

Answer 54

Parent’s perspective ▪ The parent’s perspective is appropriate when evaluating a project since the parent’s shareholders are the owners, and any project should generate sufficient cash flows to the parent to enhance shareholder wealth Subsidiary perspective ▪ One exception is when the foreign subsidiary is not wholly owned by the parent and the foreign project is partially financed with retained earnings of the parent and of the subsidiary ▪ The subsidiary’s perspective may prioritise local market dynamics and operational needs, which can differ from the parent’s broader focus on shareholder value

Answer 55

Remitted Funds ▪ Remittance policies can affect cash flow timing and availability, potentially leading to delays or restrictions that impact the parent’s financial forecasts Cannibalisation ▪ Cannibalisation occurs when new projects reduce the sales or profitability of existing operations. For example, opening a subsidiary in a new region could reduce sales in the parent’s existing markets Sales Creation ▪ Sales creation occurs when the new project leads to increased sales for the parent company, such as when a new subsidiary boosts overall market share

Answer 56

Fees and Royalties ▪ If the parent company charges fees to the subsidiary, then a project may appear favourable from a parent perspective, but not from a subsidiary’s perspective Transfer Pricing ▪ Transfer pricing refers to the prices charged between related entities for goods, services, or intellectual property. ▪ It can influence cash flows, as companies may adjust transfer prices to optimize tax efficiency or manage profits across subsidiaries

Answer 57

Tax Issues ▪International tax effects must be determined on any proposed foreign projects ▪Withholding Taxes, Corporate Income Taxes, Tax Credits, Intercompany Transfers ▪Different tax rates may make a project feasible from a subsidiary’s perspective, but not from a parent’s perspective. ▪Tax treaties or double taxation agreements may mitigate the tax burden and affect the project's feasibility for both the subsidiary and the parent

Answer 58

Foreign Exchange Considerations ▪ Fluctuations in exchange rates can lead to a significant variance in cash flows, affecting profitability when converted to the parent’s currency. ▪ Foreign exchange forecasts required e.g. parity conditions ▪ Multinational capital budgeting analysis can incorporate potential scenarios for exchange rate movements ▪ Hedging Hedging allows companies to reduce the risk of currency fluctuations, which could affect project viability. If hedging is used, evaluate the project based on the hedged exchange rate

Answer 59

Blocked Funds ▪ In some cases, the host country may block funds that the subsidiary attempts to send to the parent ▪ Some countries require that earnings generated by the subsidiary be reinvested locally for at least 3 years before they can be remitted

Answer 60

Inflation ▪ Should affect both costs and revenues ▪ Highly inflated countries tend to weaken (FX) over time ▪ The impact of inflation and exchange rate fluctuations may be partially offsetting from the viewpoint of the parent Host Government Incentives ▪ Low-rate host government loans ▪ Reduced tax rates for subsidiary ▪ Government subsidies of initial investment Real Options ▪ Real options provide flexibility, allowing firms to make future investment decisions contingent on market developments