International Valuation and Capital Budgeting

Important Equations

I. Parity Conditions

1. Fisher Effect: Nominal Interest Rates are a combination of Real Interest Rates
(productivity) and expected inflation. No-arbitrage condition between real
and nominal (financial) assets.

R$ = r$ + E(ΠUS)

where R$ is the nominal interest rate or the risk-free rate, r$ is the real
interest rate and E(ΠUS) is the expected inflation rate in the US.
Relationship between real rates, nominal rates and expected inflation applies
to all countries-country-specific subscripts and supercripts.

2. Uncovered Interest Parity (UIP): Nominal interest rate differentials across

countries will be offset by exchange rate changes. No-arbitrage condition
between international bond markets.

%Δst,t+1 = Rt,t+1 - R*t,t+1

where Rt,t+1 and R*t,t+1 are nominal risk-free interest rates in the home and
foreign country, respectively. %Δst,t+1 is the expected percent change in the
spot rate.

3. Purchasing Power Parity (PPP): Expected inflation differentials will be offset

by exchange rate changes. No-arbitrage condition between international
goods (product) markets.

%Δst,t+1 = E(Πt,t+1) – E(Π*t,t+1)

where E(Πt,t+1) and E(Π*t,t+1)are expected inflation rates in the home and
foreign country, respectively. %Δst,t+1 is the expected percent change in the
spot rate.

II. Parity conditions give us two ways of forecasting exchange rates if real interest
rates are assumed equal across countries.

1) UIP: st,t+n = st*(1+ Rt,t+n/1+ R*t,t+n)t+n

2) PPP: st,t+n = st*(1+ E(Πt,t+n) /1+ E(Π*t,t+n))t+n

III. International Valuation

1) Approach #1: Decentralized Method

𝑛
𝐸(𝐶𝐹𝑡 )
𝑁𝑃𝑉 = −𝐼0 + 𝑆0 ∗ ∑
(1 + 𝐶𝑂𝐶 ∗ )𝑡
𝑡=1

2) Approach #2: Centralized Method

𝑛
𝐸(𝐶𝐹𝑡 ∗ 𝑆𝑡 )
𝑁𝑃𝑉 = −𝐼0 + ∑
(1 + 𝐶𝑂𝐶)𝑡
𝑡=1

IV. Parity Conditions can also help with Cost of Capital Calculations if we only have
information about the parent (headquarter) company’s discount rate.

1) Discount rate (parent) multiplied by UIP parity factor (1+ Rt,t+1/1+ R*t,t+1)
2) Discount rate (parent) multiplied by UIP parity factor (1+ E(Πt,t+1) /1+
E(Π*t,t+1))

V. We can use the CAPM to estimate the cost of capital in different countries as well.