INTERNATIONAL BUSINESS FINANCE INTERNATIONAL BUSINESS FINANCE

FINS3616
Tutorial Tutorial
Week 9
CHAPTER 13 PROBLEM1 CHAPTER 13 PROBLEM1
Russia suffered a currency and stock crisis in 1998 that drove the dollar
value of Russian stocks down to 10% of their pre-crash value. The crash
caught investors by surprise, including hedge fund managers
specializing in emerging markets. One hedge fund manager was
quoted as saying:
If Russia had taken over a plant belonging to General Motors, the
government would have done something about it Essentially, the
Russian government has confiscated Western capital, and nobody is
doing anything about it
Is the risk of a market crash in an emerging economy a political risk or
a financial risk? Explain.
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CHAPTER 13 PROBLEM1 CHAPTER 13 PROBLEM1
There is not always a clear distinction between political and
financial risks. Indeed, financial risks often result from political
decisions.
In Russias case, the financial risks of investment in Russian have
been acerbated by the inability of the Russian government to
t bli h d f l d l ti f th d l d t establish and enforce laws and regulations for the orderly conduct
of business.
Organized crime and corruption have contributed to poor political Organized crime and corruption have contributed to poor political,
economic, financial country risk ratings in Russia.
Governments make a convenient scapegoats and this hedge fund Governments make a convenient scapegoats, and this hedge fund
manager clearly holds the Russian government responsible for his
losses. losses.
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CHAPTER 13 PROBLEM3 CHAPTER 13 PROBLEM3
Suppose the systematic risk of a domestic investment is:

i
=
iW
(
i
/
W
), where
iW
= 0.4 is the correlation between
domestic asset returns and world market returns,
i
= 0.2 is the ,
i
standard deviation of domestic asset returns, and
W
= 0.1 is the
standard deviation of the world market return.
A comparable foreign asset has
f
iW
= 0.3 and
f
i
= 0.3.
a) Is the total risk of the foreign asset more or less than that of a) Is the total risk of the foreign asset more or less than that of
the domestic asset?
b) What about the systematic risk? b) What about the systematic risk?
4 FINS3616 Peter Kjeld Andersen
CHAPTER 13 PROBLEM3 CHAPTER 13 PROBLEM3
a) Is the total risk of the foreign asset more or less than that of
the domestic asset?
More. Total risk is measured by standard deviation, and the y ,
foreign asset has the higher standard deviation.
b) What about the systematic risk?

foreign

f
(
f
/ ) (0 3)(0 3/0 1) 0 9
i
foreign
=
iW
f
(
i
f
/
W
) = (0.3)(0.3/0.1) = 0.9

i
domestic
=
iW
(
i
/
W
) = (0.4)(0.2/0.1) = 0.8.
Therefore, the foreign asset also has the higher systematic
risk.
5 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM1 CHAPTER 14 PROBLEM1
You work for an Israeli company that is considering an
investment in China. The investment yields after-tax Chinese
Yuan cash flows (in millions) as follows:
OUTLAY YEAR 1 YEAR 2 YEAR 3
-CNY 600 CNY 200 CNY 500 CNY 300
The required return for this risk class is i
ILS
= 15% in Israel new
Shekels and 11 745%in Yuan Shekels and 11.745% in Yuan.
Expected inflation is 6% in shekels and 3% in Yuan. Risk-free
government bonds yield 8 12%in shekels China Construction government bonds yield 8.12% in shekels. China Construction
Bank bonds are risky and yield 6.09% in Yuan.
Th t h t i S ILS 0 5526/CNY The spot exchange rate is S
0
= ILS 0.5526/CNY.
6 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM1 CHAPTER 14 PROBLEM1
Assume the international parity conditions hold. Calculate the
present value of the investment by using the Chinese discount
rate and then converting into Shekels at the current spot rate.
( ) ( ) ( )
CNY
0
1 2 3
200 500 300
600
1 0.11745 1 0.11745 1 0.11745
V = + + +
+ + +
CNY194.39m =
ILS CNY CNY ILS/CNY
0 0 0
| V i V S =
CNY194 39m ILS 0 5526 / CNY ILS107 42m = = CNY194.39m ILS 0.5526 / CNY ILS107.42m = =
7 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM1 CHAPTER 14 PROBLEM1
Q. Assume the international parity conditions hold. Convert
the cash flows at expected future spot rates, and then find
the present value using the Israeli discount rate.
A. First, calculate the expected future spot rates
1
| |
1
/
1 0
1
[ ]
1
ILS
ILS CNY
CNY
E S S

| |
+
= =
|
+
\ .
( )
1
0.5526 1.06 1.03 ILS 0.5687/CNY =
( )
2
2
[ ] 0.5526 1.06 1.03 ILS 0.5853/CNY E S = =
( )
3
3
[ ] 0.5526 1.06 1.03 ILS 0.6023/CNY E S = =
8 FINS3616 Peter Kjeld Andersen
( )
3
[ ]
CHAPTER 14 PROBLEM1 CHAPTER 14 PROBLEM1
Once we have the expected spot rates, we find the expected ILS
value of the cash flows.
t = 0 t = 1 t = 2 t = 3 t = 0 t = 1 t = 2 t = 3
CFs in CNY CNY 600 +CNY 200 +CNY 500 +CNY 300
S
t
/ E[S
t
] ILS 0.5526/CNY ILS 0.5687/CNY ILS 0.5853/CNY ILS 0.6023/CNY
And then we find the present value
CFs in ILS ILS 331.56 +ILS 113.74 +ILS 292.63 +ILS 180.69
And then we find the present value
( ) ( ) ( )
ILS
0
1 2 3
113.74 292.63 180.69
331.56
1 0 15 1 0 15 1 0 15
V = + + +
+ + +
( ) ( ) ( )
1 0.15 1 0.15 1 0.15 + + +
ILS 107.42 million =
9 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM3
You currently live in the Land-of-Leisure (currency is the L), and you are
considering investment in a shop in a foreign country called Land-of-Work
(currency is W). Financial markets are perfect and the international parity
conditions hold The investment will be funded with 100% equity We have conditions hold. The investment will be funded with 100% equity. We have
the following information.
LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
The spot exchange rate is W100/L.
Real Required Return on Shops 10% 10%
10 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM3
LEISURE WORK LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0% Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
a) What is the nominal required return on print-shop projects in L. And in
W?
( )( )
i 1 i 1 1
W?
( )( )
nom real
i 1 i 1 1 = + +
This is the Fisher equation.
( )( )
L L L
nom real
i 1 i 1 1 = + +
( )( )
1 0.10 1 0.00 1 = + +
0.10 or 10% =
( )( )
W W W
( )( )
11 FINS3616 Peter Kjeld Andersen
( )( )
W W W
nom real
i 1 i 1 1 = + +
( )( )
1 0.10 1 0.50 1 = + +
0.65 or 65% =
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM3
LEISURE WORK LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0% Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
b) Identify the expected future spot rates for the next two years.
t
W
1
(
+
W/L W/L
t 0
L
1
E S S
1
(
+
(
=
(

+

W150/L =
1
W/L
1
1.50
E S W100/L W150/L
1.00
(
(
= =


2
(
12 FINS3616 Peter Kjeld Andersen
2
W/L
2
1.50
E S W100/L W225/L
1.00
(
(
= =


W225/L =
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM3
c) We have the following information about the project:
It will last two years
The land for the shop costs W200,000 and will maintain its real value, before being
sold at the end of the project sold at the end of the project.
Building the shop will cost another W200,000, which will be straight-line
depreciated over two years to a salvage value of zero. The shop will have zero
market value at the end of two years.
No investment in working capital is necessary.
Diplomas sell for W200 each and will maintain their real value 2 000 will be sold Diplomas sell for W200 each and will maintain their real value. 2,000 will be sold
per year.
Variable costs are 20% of sales. Fixed costs are W45,000 in the first year and grow
with inflation.
Income and capital gains taxes in both countries are 50%.
Assume all opearting cash flows occur at the end of the year Assume all opearting cash flows occur at the end of the year.
13 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM3
Identify the expected future cash flows in W on the investment
project. Discount them using the W discount rate and convert
them back at the spot rate.
To do this, we need: To do this, we need:
Investment cash flows (initial outlays)
Operating cash flows Operating cash flows
Terminal cash flows
14 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM 3
OCF Calculation: YEAR 1
600,000
YEAR 2
900,000 Revenue
120,000
45,000
180,000
67,500
Less: Variable Costs
Less: Fixed Costs
100,000
335,000
167 500
100,000
552,000
276 250
Less: Depreciation
= EBIT
Less: Tax @50% 167,500
167,500
100,000
276,250
276,250
100,000
Less: Tax @ 50%
= NOPAT
Add Back: Depreciation
W267,500 W376,250 = Operating Cash Flows
15 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM 3
YEAR 0 YEAR 1 YEAR 2 YEAR 0 YEAR 1 YEAR 2
Investment Cash Flows (Land) 200,000
Investment Cash Flows (Plant) 200,000
Operating Cash Flows 267,500 376,250
Terminal Cash Flows (Land) 450,000
Terminal Cash Flows (Tax on Land) 125,000
Net Cash Flow in W -W400,000 W267,500 W701,250
267 500 701 250
( ) ( )
W W
0
1 2
267,500 701,250
V | i W400,000
1 0.65 1 0.65
= + +
+ +
W19 697 W19, 697 =
L W
0
W19,697
V | i L197 = =
16 FINS3616 Peter Kjeld Andersen
0
W/L
0
V | i L197
S
CHAPTER 14 PROBLEM3 CHAPTER 14 PROBLEM 3
YEAR 0 YEAR 1 YEAR 2 YEAR 0 YEAR 1 YEAR 2
Investment Cash Flows (Land) 200,000
Investment Cash Flows (Plant) 200,000
Operating Cash Flows 267,500 376,250
Terminal Cash Flows (Land) 450,000
Terminal Cash Flows (Tax on Land) 125,000
Net Cash Flow in W -W400,000 W267,500 W701,250
L1 783 33 L3 116 66
( ) ( )
L L
0
1 2
L1,783.33 L3,116.66
V | i L4,000
1 0.10 1 0.10
= + +
+ +
=L197
17 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 6
Q. Consider the investment in China from problem 14.1.
Suppose each cash flow generated by the project must be
loaned to the China Construction Bank for one year at a zero
percent interest rate?
At what yuan rate should you discount these blocked funds? y y
What is the present value of the blocked funds in yuan?
18 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 6
A. The funds are invested with the China Construction Bank, so the
appropriate opportunity cost of capital is the (risky) bank rate of 6 09 appropriate opportunity cost of capital is the (risky) bank rate of 6.09
percent.
It is easiest to focus on the funds that are blocked and exclude other cash It is easiest to focus on the funds that are blocked and exclude other cash
flows (in particular, the initial investment) from the analysis. Following the
threestep procedure from the text: p p
a) The present value of blocked funds assuming they are not blocked is:
CNY200m CNY500m CNY300m
PV + +
CNY 884 01m
b) Cash flows will not be received until one year later, so the present
( ) ( ) ( )
0
1 2 3
PV
1 0.0609 1 0.0609 1 0.0609
= + + =
+ + +
CNY 884.01m
b) Cash flows will not be received until one year later, so the present
value of blocked funds is really only:
CNY200m CNY500m CNY300m
PV = + + =
CNY 833 26m
19 FINS3616 Peter Kjeld Andersen
( ) ( ) ( )
0
2 3 4
PV
1 0.0609 1 0.0609 1 0.0609
= + + =
+ + +
CNY 833.26m
CHAPTER 14 PROBLEM 6
c) The opportunity cost of the blocked funds is the difference between
project value with and without the blocked funds project value with and without the blocked funds:
SIDE EFFECT PROJECT WITH SIDE EFFECT PROJECT WITHOUT SIDE EFFECT
V V V =
CNY 833.26m CNY 844.01m =
CNY 50.75m =
20 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 7
Q. Consider the investment in China from problem 14.1. China
Construction Bank is willing to provide you with a non-
amortizing loan of CNY 600m at their borrowing rate of
6.09% per annum payable over 3 years.
If you were to finance the project locally in China, your y p j y , y
borrowing rate would be 8.15% per annum.
What is the yuan value of this subsidized loan? Assume the What is the yuan value of this subsidized loan? Assume the
effective tax rate is 40% in both China and Israel.
21 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 7
A. There are several steps:
I. Work out how much cash interest expense you save per annum by
financing through the subsidy rather than through your actual
borrowing cost: borrowing cost:
(CNY600m)(0.08150.0609)(10.4) = CNY7.416 million.
II Work out what discount rate you would use to find the present value II. Work out what discount rate you would use to find the present value.
The after-tax market cost of debt is (8.15%)(10.4) = 4.89% in yuan.
III The present value of a three year annuity of CNY7 416 million III. The present value of a three-year annuity of CNY7.416 million
discounted at the after-tax yuan discount rate of 4.89% is:
( )
n
0
1 1 r
PV CF
r

(
+
= = (
(

( )
3
1 1 0.0489
7.416
0 0489

(
+
= (
(

CNY 20, 237, 306
22 FINS3616 Peter Kjeld Andersen
r
(

0.0489
(

CHAPTER 14 PROBLEM 8
Q. Consider AGAIN (omg!!!) the investment in China from
problem 14.1. The Chinese government insists that you build
an airport near this project at a cost of CNY 100million.
Should you still accept the project?
A. V
0
CNY
= CNY 194.39 million without the side effect.
The airport project reduces this value by CNY100 million, but the NPV with The airport project reduces this value by CNY100 million, but the NPV with
the side effect is still positive (CNY 94.39 million).
You should accept the project even if the Chinese authorities are not p p j
willing to renegotiate.
23 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 9
Q. Consider the investment in China from problem 14.1.
Suppose that in any given year there is a 10 % chance that
the Chinese government will expropriate your assets.
If your assets are expropriated in a particular year, then you
will not receive that years or any later years cash flow from y y y
your investment. This risk is diversifiable and hence does not
chance the discount rate. chance the discount rate.
What is the NPV of this asset in shekels, assuming the
international parity conditions hold and the required returns international parity conditions hold and the required returns
are i
ILS
= 15% and I
CNY
= 11.745% are the after-tax discount
rates.
24 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 9
A. The expropriation risk in Problem 14.9 differs from that in the
chapters Neverland project because there is a probability of
expropriation in each year, rather than just at the end of the
project.
Once expropriated, you will not receive any later cash flows p p , y y
from your investment. This can be represented with a decision
tree: tree:
25 FINS3616 Peter Kjeld Andersen
CHAPTER 14 PROBLEM 9
A.
( ) ( ) ( )
1 2 3
( )
( )
( )
( )
( )
( )
1 2 3
CNY
0
1 2 3
200 0.9 500 0.9 300 0.9
V 600
1 0.11745 1 0.11745 1 0.11745
= + + +
+ + +
CNY
0
V 42.15m =
( ) ( )
ILS CNY
0
V | i CNY 42.15m ILS 0.5526 / CNY = = ILS 23.29m
SIDE EFFECT PROJECT WITH SIDE EFFECT PROJECT WITHOUT SIDE EFFECT
V V V =
CNY 42 15m CNY 194 4m = CNY 42.15m CNY 194.4m
CNY 152.24m =
26 FINS3616 Peter Kjeld Andersen