INTERNATIONAL FINANCE

IAME International Academy of

Management & Entrepreneurship
Shashank BP
Module 05

Assignment 4
Discuss Long and Short Position with respect
to Derivatives.
Team 01 - Akash, Ram Naveen, Vandana,
Saddam
Team 02 - Kavya, Sharath, Shupriya, Sneha,
Snehitha
Team 03 - Vaishali, Manohar, Sasikumar,
Rashmi
Team 04 - Valentine, Pinky, Surendra,
Pushpamani
2

Assignment 4
Each group should come up with one example
of Long and Short Position w.r.t. Derivatives.
Example should be related clearly to
derivatives.
PowerPoint presentation or White Board
presentation in class on 26 August 2015.
Each group presentation should be completed
in less than 5 minutes.
No two groups should present the same
example, else they both will be downgraded.
3

Long Position
When a trader is long, he/she wins when the
price increases, and loses when the price
decreases.
When a trader buys an option contract that
he/she is not short, he/she is said to be
opening a long position.
When a trader sells an option contract that
he/she is already long, he/she is said to be
closing a long position.
4

Short Position
When a trader is short, he/she wins when
the price decreases, and loses when the price
increases.
When a trader sells an option contract that
he/she is not long, he/she is said to be
opening a short position.
When a trader buys an option contract that
he/she is already short, he/she is said to be
closing a short position.
5

Cost of Capital for Foreign

Investment
Concepts to know:
Deregulation of international financial
markets
Liberalization of cash flows
Optimal capital structure and capital cost
How is optimal capital structure achieved
by MNCs?
MNCs and their cost of capital advantage
due to size and economies of scale (large
scale operations)
6

Cost of Capital for Foreign

Investment
Concepts to know:
Practical framework of capital structure in
MNCs
Pecking order finance: No special
attention to theories
Empirical evidence on capital structures
and MNC preferences of mix

Cost of Capital for Foreign

Investment
With the developing countries liberalizing
their economies, MNCs have got more
opportunities to invest in those countries.
Each country has different economic
characteristics and business environment.
Each country has different sectors which are
liberalized.
One country may at one particular time treat
a particular sector as priority and provide
incentives for investment in that sector.
8

Cost of Capital for Foreign

Investment
India at this point of time gives top
preference to infrastructure sector.
MNCs might get much higher rate of return in
such sector investments.
The first step for MNCs is to determine the
capital mix and cost of capital.
Capital mix could have debt, equity and other
sources.

Cost of Capital for Foreign

Investment
Depending on prevailing conditions, higher
debt than equity may bring down the cost of
capital in certain cases. In other cases, it may
be vice versa.
A single rate of return cannot be used by
MNCs for all their projects in various countries.
The determination of cost of capital in
international finance is a complex issue.
10

Cost of Capital for Foreign

Investment
MNCs have advantages/disadvantages
because of their characteristics, that
differentiate them from large domestic firms,
like:
Size of the firm
Foreign exchange risk
Access to international capital market
International diversification
Political risk
Country risk
11

Cost of Capital for Foreign

Investment
Size of the firm: MNCs are large, and have
economies of large scale negotiation. They also
have possibilities of reducing the various
transaction costs and brokerage expenses.
They get preferential treatment from credit
agencies.

12

Cost of Capital for Foreign

Investment
Foreign exchange risk: A firm more exposed
to the foreign exchange rate fluctuations
would have wider spread of possible cash
flows in future periods.
Exposure to exchange rate fluctuations could
lead to higher cost of capital.
At times, fluctuations also give advantage to
the MNCs, when currency depreciation takes
place.
13

Cost of Capital for Foreign

Investment
Access to international capital market: This
could result in the subsidiary getting local
funds at lower rate than parent company.
International diversification: This gives MNCs
lower cost of capital because they get cash
flows from various businesses & countries.
Note that diversification gives stability to the
cash flow. Diversification also lowers
systematic (market related) risk, lowers beta
coefficient and thus lowers the cost of equity.
14

Cost of Capital for Foreign

Investment
Political risk: Political risk is likely to be
greater in the later years of a project because
of the length of time. This increases the cost of
capital because of an arbitrary risk premium.
Country risk: This is unique due to the
adverse impact of a countrys environment.
There are serious risks like bankruptcy of a
country, evacuation of foreigners and foreign
firms etc. For example, in Cuba in 1959, there
was mass scale expropriation of US firms.
15

Cost of Capital for Foreign

Investment
Risk free rate, tax laws, demographics,
monetary policy and economic conditions vary
from country to country. Due to these factors,
risk premium on debt also varies.
Capital structure decisions (whether to use
more debt or more equity capital) for
subsidiaries ultimately are dependent on the
corporate culture and circumstances such as
stable cash flows, low credit risk etc.
16

Cost of Capital for Foreign

Investment
Empirical studies of various MNCs reveal that
the parent company never wants a subsidiary
to be a defaulter, and so they adapt a practical
framework of capital structure, independent of
all theories. This policy is called Pecking Order
of Financing.

17

Cost of Capital for Foreign

Investment
Empirical studies reveal that MNCs go in for
local debt or equity issues as a last resort. They
prefer own generated funds (retentions).
Empirical studies also show that MNC firms
are often thought to be reluctant to explicitly
guarantee the debt of their subsidiaries. They
rather leave subsidiaries to their merit.

18

Cost of Capital for Foreign

Investment
The foreign creditors, investors and
shareholders of MNCs prefer global target
capital structure rather than local capital
structure because they would have better
understanding and control over financial
operations at the macro level than at the micro
level.

19

Case Study: Pharma Firms

Debt Equity Trend of Parent Companies and
Indian Subsidiaries
Company

Year 1

Year 2

Year 3

Year 4

Glaxo India

0.433

0.894

0.336

0.346

Glaxo Wellcome

2.860

2.670

2.140

1.680

Smithkline Beecham UK

0.441

0.408

0.386

0.269

Novartis India

0.385

0.116

0.099

0.045

Novartis AG, Switzerland

0.460

0.460

0.410

0.280

Pfizer, India

0.143

0.265

0.019

0.112

Pfizer, US

0.075

0.091

0.077

0.089

Smithkline Beecham India

Comment on the capital structure practices of

the four companies.

20

Case Study (Contd.): Pharma Firms

Glaxo Wellcome uses debt significantly
internationally, but rather conservatively in
Glaxo India.
Smithkline Beecham takes no debt in India
and is an extreme case. It uses only retentions
from Smithkline Beecham UK.
Novartis does not believe much in borrowing
either in the parent or in India. So is the case
with Pfizer.
21

Case Study (Contd.): Pharma Firms

It can thus be concluded that these
international pharmaceutical firms run on
retained earnings than on borrowings,
especially in subsidiaries.

22

WACC formula for MNCs

To compute the WACC for a multinational firm
with a foreign project, the following formula is
used:
Ko = (1-L)Ke + LKd(1-t)
Ko = Weighted Average Cost of Capital for the
multinational parent and the project
L = Parents debt ratio (or debt to assets ratio) interpreted as the proportion of a companys
assets that are financed by debt.
Ke = Cost of equity capital
Kd(1-t) = After tax cost of debt

23

WACC formula for MNCs

The WACC Ko is used as the discount rate in
evaluating the specific foreign investment. Note
that Ke is the required return on the firms stock
at the particular debt ratio selected.
Both project risk and project financial structure
can vary from the corporate norm because of the
projects different debt capacity. In such a case,
the projects WACC will be:
Ko = (1-L)Ke + LKd(1-t)
24

WACC formula for MNCs

Ko = WACC of the foreign project
L = Debt ratio of the foreign project
Ke = Cost of equity capital of the foreign project
Kd = Cost of debt of the foreign project

25

Cost of Capital Example

Lexon PLC, a successful UK-based MNC, is
considering how to obtain funding for a
project in Argentina during the next year. It
considers the following information:
UK risk free rate = 6%
Argentine risk free rate = 10%
Risk premium on Pound debt by UK
creditors = 3%
Risk premium on Peso debt by Argentine
creditors = 5%
26

Cost of Capital Example

Beta of Project = 1.5

Expected UK market return = 14%
UK corporate tax rate = 30%
Argentine corporate tax rate = 30%
Creditors will allow maximum of 50% debt

Calculate Cost of Capital of each

component for Lexon PLC.
(Contd..)
27

Cost of Capital Example

Answer:
Cost of Pound denominated debt in UK
= (Rf + Rp)(1 T) where Rf = Risk free rate, Rp =
Risk premium, T is the Tax rate.
= (6% + 3%)(1 0.3) = 6.3%
Cost of Peso denominated debt in Argentina
= (10% + 5%)(1 0.3) = 10.5%

28

Cost of Capital Example

Answer (Contd.):
Cost of Pound denominated Equity
= Rf + Beta(Rm Rf) where Rf = Risk free rate,
Beta is market sensitivity, Rm = Market return
= 6% + [1.5 * (14% - 6%)] = 18%

29

Cost of Capital Example

Now, you are expected to calculate the WACC
for Lexon PLC for 4 different scenarios as
follows:
30% UK debt, 70% UK equity
50% UK debt, 50% UK equity
20% UK debt, 30% Argentine debt, 50% UK
equity
50% Argentine debt, 50% UK equity
30

Cost of Capital Example:

WACC Formula

Where:
Re = cost of equity; Rd = cost of debt
E = market value of the firms equity
D = market value of the firms debt
V = E + D = total market value of the firms financing
(equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

31

Cost of Capital Example:

WACC Calculation
30% UK debt, 70% UK equity
WACC = (30% * 6.3%) + (70% * 18%) = 14.49%
50% UK debt, 50% UK equity
WACC = (50% * 6.3%) + (50% * 18%) = 12.15%
20% UK debt, 30% Argentine debt, 50% UK
equity
WACC = (20% * 6.3%) + (30%* 10.5%) + (50% *
18%) = 1.26% + 3.15% + 9% = 13.41%
50% Argentine debt, 50% UK equity
WACC = (50% * 10.5%) + (50% * 18%) = 14.25%

32

Cost of Capital Example: Risk Premium

Lexon estimated WACC at 12.15% if 50% UK
debt & 50% UK equity.
But Argentine project is exposed to Exchange
Rate Risk.
Lexon decides to add Risk Premium of 6%
points to the estimated WACC.
Thus, the required rate of return would be
12.15% + 6% = 18.15%.
33

Cost of Capital Example: NPV

Lexon PLC worked out the NPV for 2 of the 4
scenarios:
50% UK debt, 50% UK equity
WACC = 12.15%
NPV = -1.42 millions
50% Argentine debt, 50% UK equity
WACC = 14.25%
NPV = 1.26 millions
50% Argentine debt, 50% UK equity has higher
WACC but positive NPV!!
34

Cost of Debt Example

How is the cost of debt computed in
international finance?
This can be explained using an example. Consider
Embraer, the Brazilian aerospace company. To
estimate Embraers cost of debt, we first
estimate a synthetic rating for the firm. Based
upon its operating income of $810 million and
interest expenses of $28 million in year 2000, we
arrive at an interest coverage of 28.93, and thus
an AAA rating. The default spread for AAA rated
bonds is only 0.75%.
35

Cost of Debt Example

Now, Embraer is a Brazilian firm. The Brazilian
government bond traded at a spread of 5.37%,
and so it could be argued that every Brazilian
company should pay this premium, in addition to
its own default spread. With this reasoning the
pretax cost of debt for Embraer in US$ (assuming
a treasury bond rate of 5%) can be calculated as
follows:

36

Cost of Debt Example

Cost of Debt = Risk Free rate + Default spread for
country + Default spread for firm
= 5% + 5.37% + 0.75% = 11.12%
Now, using a marginal tax rate of 33%, we can
estimate the after-tax cost of debt for Embraer:
After-tax Cost of Debt
= Pre tax cost of debt * (1 Tax rate)
= 11.12% * (1 0.33) = 7.45%
Hence, the after-tax cost of debt for Embraer is
7.45%.
37

Managing Political Risk

Concepts to know:
Types of Political Risk
Techniques to assess political risk /
indicators of political risk
How MNCs can manage political risk
Case Study: Discuss the steps taken to
attract FDI by the present Indian
Government.

38

Managing Political Risk

Since investing in a foreign country and
putting a subsidiary up involves time factor
spanning generations, the first thing an MNC
assesses is the Political Risk.
Political risks are indicated through various
socio-political and historical events.
There are specialists who can read trends on:
the political parties and their philosophy
stability of local governments
consensus of various political parties on
priorities especially economic priorities.
39

Managing Political Risk

There are specialists who can read trends on:
attitude towards foreigners and foreign
investments
war and other extreme calamities
military role in politics
mechanism to express discontent and
anger
respect to democracy and democratic
institutions
past history for a long period (like a
century) on tolerance and empathy.
40

Managing Political Risk

Political risk is divided into:
Macro risk war, revolt, upheaval,
expropriation, insurrection
Micro risk partisanship to certain
sectors, corruption, prejudicial actions
Risk hotspots certain regions within the
country
Certain times entering business with high
political risk countries can be very lucrative.
In some countries, political risk insurance is
available.

41

Managing Political Risk

Political risk consultants (Moodys, Standard
& Poors, McKinsey) and specialists are
available.
MNCs do get caught unawares on rare
occasions.
MNCs do not explicitly announce exit policy
but might keep an exit plan at the back of
the mind unwritten, but fully conscious.

42

Managing Political Risk

MNCs contribution to local society, economy
and countrys overall growth is always keenly
observed by various activists, social
organizations and power groups.
At times, this results in forced withdrawals
as it happened in many countries.
We have cases like the exit of Enron from
India, which was before its full-fledged entry
into the country.
43

Managing Political Risk

We also have cases like the one-time forced
exit of Coca Cola from India, after it was fully
established in the country.
Fair trade policies, human rights
considerations, foreign policy of the country
these are some of the other factors that could
be classified under Political Risk.
Generally, political risk comes to light by
studying historical data and evolutionary
events. So these risks do not spring a surprise.
44

Managing Political Risk

Wherever there is Communist rule, or
opposite geo-political environment, MNCs
from UK or USA may not be interested in
putting up capital investments, since political
risk multiplies.
When geo-political developments take place,
MNCs keep a watch for stability in political
atmosphere, and then invest heavily like in the
case of China and Vietnam.
45

Managing Political Risk

Business and Politics are separate
philosophies in theory. However, in reality,
MNCs have to contribute to the host countries
and societys stated and desired goals.
Note that certain unforeseen events could
trigger into political risk. A product quality
issue like Nestles Maggi in India (2015) could
turn into a socio-political issue. Before the
issue escalates, MNCs use social interest and
technology to get over such situations.
46

Political Risk: Expropriation

What is expropriation?
The act of taking privately owned property by
a government to be used for the benefit of the
public is Expropriation. In the US, the Fifth
Amendment to the Constitution provides that
private property will not be taken for public use
without just compensation. While there is
compensation, the expropriation occurs without
the property owners consent.
47

Political Risk: Expropriation

What is expropriation?
Many, but not all, countries support the theory
that the expropriating country should pay
adequate, timely and effective compensation to
the involved party.
Countries can expropriate foreign businesses
located within the country. Former socialist
Chilean President Salvador Allende expropriated
US businesses located in Chile in the early 1970s.
48

Managing Political Risk

What is Host Government take over?
The most severe country risk is a take over of an
MNCs local operations by the host government.
This type of take over may result in major losses,
especially when the MNC does not have any
power to negotiate with the host government.
The most common strategies used to reduce
exposure to a host government take over are:
(a) concentrate on recovering cash flow quickly,
(Contd.)
49

Managing Political Risk

(b) rely on unique supplies or technology that
cannot be duplicated locally so that the host
government cannot do without those supplies
or technology,
(c) hire local labor,
(d) borrow local funds,
(e) purchase country risk insurance,
(f) use project finance to finance the project
heavily with credit. Project finance is based on
future cash flows from the project and
separates the MNC from the project.
50

Case Study: Venezuela

Assume you are CFO of a Cement Company
operating in Venezuela. You are planning a
major expansion in view of increasing
demand. The Venezuelan President has
threatened that if prices are not brought
down by cement manufacturers, he would
nationalize all the companies, including
foreign companies operating there.
51

Case Study: Venezuela

How would you assess the political risk for
your project?
What threats do you expect for your project in
future?

52

Case Study: Venezuela - Answer

This is a clear case of Host Government Take
Over.
This will result in major losses in case of take
over.
As CFO, I would focus on recovering cash flow
quickly.
I would also hire more local labour and
borrow more local funds.
53

Case Study: Venezuela - Answer

If possible, I would purchase country risk
insurance.
Also if possible I would separate the project in
Venezuela from the rest of the MNC.
I would use internally generated cash flows
from the project to fund the projects future
working capital and investment needs.
This is also called using project finance to
run the project.
54

Case Study: Venezuela - Answer

I will surely be cautious about increasing my
or my MNCs exposure in Venezuela since the
threat of Host Government Take Over is very
real.
I will run the Venezuelan operation from the
parent office overseas.

55

Case Study: India

Since 1991, by liberalizing its economy, India
has been struggling to gain a firm position in
the global economy. Though it has attracted
many foreign investors, it has not succeeded in
retaining them. Most of the companies have
left the country either because of the
infrastructure, which has to go a long way
before they meet the international standards
or because of the government policies, which
are not favorable for carrying out business in
India
(Contd..)
56

Case Study: India

The basic requirements for carrying on any
business like power, telecommunications,
roads, etc. are not up to the mark.

Question: Describe the various steps taken by

the present Indian government in the last one
year to attract more foreign players.

57

Case Study: India - Answer

Strong steps in foreign affairs: Political and
Economic relationship with SAARC, other Asian
countries.
PM visits Japan, Germany, USA
Make in India initiative, Smart City
programme
Ease of business reduced red tape
Transparency, Openness and Political stability
Control of rampant corruption
58

Case Study: India - Answer

Policy changes Centre and states with stable
majority have new industrial policies
Liberalized investment norms in Railway and
Defense ancillaries, Insurance
Reduction of interest rates
Encouragement of savings from the poorest
of the poor
Subsidies only to Below Poverty Line people

59

Case Study: India - Answer

Other positive factors:
Largest democracy in the world
Peaceful general elections always
No military coups or military juntas ever,
like in some Asian countries
Political stability of the highest order
Mature political parties
Excellent banking and financial systems
Mature stock and financial markets
Steady exports
60