CASE STUDY

In the remaining sections of this article we use a case study to explore further the issues raised in
previous sections. The case involves an international company investing in a (fictitious)
developing country. It also deals with the capital budgeting decision, method of financing and
the problem of determining a discount rate for international investment decisions.
Background
Zenobia is a developing country situated on the coast of Africa. Its government, now
democratically elected, has produced a programme of economic reforms aimed at promoting
investment in the country and reducing its dependence on foreign aid.
A major feature of this programme is the privatisation of companies and corporations which are
currently 100% owned by the government, e.g. hotels, breweries and coffee production. For the
time being, the government is not considering privatising services such as post, railways or the
provision of basic telecommunications (this is mainly the fixed-line, voice telephony service).
It does, however, wish to attract private capital to provide new services such as cellular (mobile)
telephones and data communication.
Global Telecommunications Inc (GTI) is a company registered in the USA but with global
business interests. Its shares are not listed on a stock exchange, but industry sources estimate that
it could command a market capitalisation of around US$200m. It has established itself as a
specialist in the provision of mobile telephone (cellular) services. It is currently negotiating with
the government of Zenobia (GoZ) for a licence to provide such services in the country and has
already spent US$O.5m in surveys and miscellaneous expenses. If GTI were successful in the
negotiations, it would be the company's first experience of working in a developing country.
Forecast cash flows
Based on a recent World Bank report, GTI estimates that there is a market for between 10,000
and 15,000 customers in a rectangular geographical area bounded by the capital city and three
other main towns. The proposed cellular service will operate in this relatively prosperous `urban
rectangle' but the poorer, rural areas outside the rectangle will not be covered.
The market for 10,000 lines is, apart from potential disasters, virtually guaranteed. GTI estimates
that the initial investment for this number of lines will be US$25m. The company has asked the
GoZ for a five-year exclusivity period (a period when no other company will be allowed to enter
the market to compete). Net operating cash flows, based on a network of 10,000 lines, are
forecast to be:
Year: 1 2 3 4 5

Net operating cash flows (US$m): 3.5 4.8 5.6 6.8 7.2
In year 6, competitors are likely to enter the market and cash flows are expected to fall to around
US$6m per annum. For the purposes of evaluation, GTI assumes this annual net cash flow will
be maintained indefinitely from year 6 onwards on a network of 10,000 lines. The figures are, of
course, an extreme simplification of what would be a complex appraisal.
Cash flows would arise in both local currency and US$ (the `home' currency in this case).
Forecasting the cash flows would be extremely difficult in the circumstances. However,
forecasting cash flows in any currency is fraught with difficulty and the procedure has not been
covered in detail here as it is not the main purpose of the article.
Discount rate
There is some dispute about the discount rate to be used for the evaluation of this project. The
company's cost of capital is 15% per annum constant, and this is the rate which is being
suggested. However, the managing director thinks this is a particularly risky project. Although
all calculations and negotiations with the GoZ are in US$, much of the cash inflow will be in
local currency. The technical director says that, as the project increases international
diversification, it actually reduces the company's risk, so a lower rate should be used. The
finance director notes that the cash flows for each year are highly correlated with those of the
previous and subsequent years and this also will affect risk.
Method of financing
GTI is at present all equity financed. The company has sufficient cash flows from other projects
to enable it to finance the Zenobia deal internally. However, the IFC is prepared to offer 10%
fixed interest rates on loans of up to US$20m for investments of this nature. Capital is repaid at
the end of the loan period, which must be a minimum of five years. Interest is paid annually. No
early repayment of the loan is permitted without severe financial penalties. If GTI were to raise a
similar amount of debt in the capital markets, it would currently be obliged to pay 12.5%
interest. GTI will be eligible for tax relief at 40% on loan interest payments.
Case discussion
As noted earlier, two methods exist to calculate the net present value of international investment
decisions. In the investment decision in a developing country, neither of these methods is ideal.
Forecasting foreign exchange rates is extremely difficult in countries where exchange rates are
highly volatile. It is also difficult to estimate the cost of capital in a developing country.
It is assumed that the company uses the first method noted above for evaluating investments of
this type (i.e. it has converted all currency cash flows from the project into US$ and will discount
them at a US$-denominated discount rate to generate a US$ NPV). The choice of this method is
common in such circumstances.
Implicit in the calculations is a suggestion that charges for telecommunication services will be
increased in local currency terms to allow for inflation and devaluation. Technically this is quite
acceptable, but there is a political risk that the government may not wish to see big increases in
telecommunication charges. However, what is being offered here is a cellular service, where the
market is likely to be with expatriates, diplomats and wealthy local businessmen. Tariffs are
therefore unlikely to be subject to the same amount of political pressure.
The volatility of exchange rates adds to project risk. Thus a project in a country whose currency
has been highly volatile against the US dollar would carry more risk than a similar project in a
country whose currency is pegged to the dollar. Expropriation risk, which can never be ignored
in developing countries, is difficult to diversify and even more difficult to assess, and companies
tend to stay out of countries where such risk is high. However, as with all high-risk projects, the
rewards should be high enough to compensate.
The technical director is in principle correct in that international diversification will reduce
overall risk. However, for a US company to diversify internationally in, for example, Western
Europe, is a very different proposition from diversifying into a developing country with a very
short history of political and economic reforms.
Inter-temporal correlations (the correlation of one year's cash flows with the previous year's)
affect the standard deviations of the net present value and internal rate of return and hence the
project's stand-alone risk. Generally, projects having cash flows with zero inter-temporal
correlations have lower standalone risk than projects with high correlations. This is because low
correlation means that a less-than-expected cash flow in one year can be offset by greater-than-
expected cash flow in the next. Very few projects have zero inter-temporal correlations, and most
of them are dependent to some extent on what has happened in a previous year.
In theory, projects should be evaluated using a specific risk-adjusted discount rate which reflects
the risk of that project. In order to determine a discount rate for a project we should use a `proxy'
company's beta and include this in the capital asset pricing model. In practice this is almost
impossible to do, particularly in a developing country. Even if we assume that: (i) the
government of Zenobia has agreed to allow GTI to increase prices in line with depreciation of
the local currency; (ii) it can be trusted not to prevent expropriation of profits and dividends; and
(iii) GTI accepts there will be no political interference in its operations, three risks remain.
Risk 1: Demand is at the level forecast by the World Bank.
Risk 2: Installation of the network does not meet geographical problems which were not
foreseen.
Risk 3: Civil disturbances.
The board of directors of GTI can only take a view on this type of risk, and it is almost
impossible to quantify a discount rate using any formal model such as CAPM.
GTI is currently all equity financed and therefore has substantial debt capacity. Even though it is
a service company, it will own a number of assets for the provision of telecommunications
services. It will also own the right to future income generation on networks which it has
installed, within the terms of its licences and agreements. On the face of it, GTI would be
sensible to take the IFC offer of a loan fixed at 10%, as this would release internally generated
cash flows to earn money in other areas, which should earn a return of the 15% cost of capital in
projects of lower risk than that in Zenobia. The disadvantages could be as follows:
1. The interest rate is fixed. If interest rates are expected to fall GTI could be locked to a
high-interest loan for between five and ten years. The capital is not repaid until the end of
the loan period therefore interest is payable on the full amount each year of the loan.
2. The maximum amount of the loan of US$20m will not be sufficient to fund the project.
The company will therefore have to provide a further US$5m from internally generated
funds at the beginning of the project.
The main advantages and disadvantages of taking out a loan of this type may be in the small
print. It is possible that the IFC will offer some inbuilt insurance that if Zenobia was subject to
civil disturbance, the loan becomes non-repayable. A disadvantage might be that taking out this
loan for Zenobia could preclude GTI's borrowing money from the IFC for other projects in the
future which may turn out to be less risky and more profitable.
Project cash flows

0 1 2

Initial investment -25.0

Net operating cash flows 3.5 4.8
Terminal value (6m/0.2)
Discount factor (at 20%) 1 0.83 0.69
Discounted cash flows -25.0 2.9 3.3
Cumulative DCFs -25.0 -22.1 -18.8
 3 4 5

Initial investment
Net operating cash flows 5.6 6.8 7.2
Terminal value (6m/0.2) 30.0[*]
Discount factor (at 20%) 0.58 0.48 0.40
Discounted cash flows 3.2 3.3 14.9
Cumulative DCFs -15.5 -12.2 2.7

[*] The terminal value is calculated as a perpetuity, i.e. we

assume year 5's cash flows will continue indefinitely and the
discount rate of 20% also remains constant
This proposal suggests that the project is just about viable using a discount rate for 20%, the
internal rate of return being around 23.5%. The undiscounted payback period is just under five
years. It is not possible to work out the discounted payback period without doing calculations on
cash flows beyond year 6. This has not been provided at this stage. However, if this proposal is
unacceptable to the GoZ it can only be used as a benchmark against which alternative options
may be compared.
The key to the acceptability of the project is GTI's attitude to risk. Telecommunications is a high-
technology industry and accustomed to certain levels of risk, but developing a new network in a
developing country, and in a country in which the company has no previous knowledge, is
compounding the risk factors. As noted earlier, the main risks may be summarised as follows:
Currency risk. Unless GTI has built into its licence a Tight to increase tariffs when the Zenobia
currency depreciates.
Political risk. That the government will honour its agreement in the licence and will allow the
company to remit profits and dividends as promised.
SUMMARY
As companies take a more global perspective to their trading activities, investing overseas and
the financing of such operations will be given greater consideration. The ability to raise capital,
and the cost of that capital, will remain important but is is also important to be aware of the risks
involved.
In this article we have identified the main types of foreign exchange risk, which may have an
impact on the method of financing overseas operations.
When appraising overseas projects, two equivalent approaches may be used. The project's
currency cash flows can be converted into sterling and appraised using a sterling discount rate.
Alternatively, the cash flows in the overseas currency can be discounted at a discount rate
appropriate to that currency. The NPV so produced can then be converted into a sterling NPV by
converting at the spot rate of exchange.
A case study was used to provide a real world situation around which a discussion of risk,
discount rate to be used and financing of risky overseas investments could be focused.
(*) The theory of interest rate parity says that interest rates are determined in the market by
supply and demand (although note political interference). There is a relationship between foreign
exchange and money markets. Other things being equal the currency with the higher interest rate
will sell at a discount in the forward market against the currency with the lower interest rate.