International Finance

Lecture 11

Page 1
International Finance
• Course topics
– Foundations of International Financial
Management
– World Financial Markets and
Institutions
– Foreign Exchange Exposure
– Financial Management for a
Multinational Firm

Page 2
Financial Management for a
Multinational Firm
• Foreign direct investment
• International Capital Structure, Cost of
Capital
• International Capital Budgeting

Page 3
 Cost of Capital
• For a levered firm, the financing costs can be
represented by the weighted average cost of
capital:
• K = (1 – λ )ke + λ (1 – τ )i

• Where
K = ___________ average cost of capital
ke = cost of equity capital for a levered firm
i = pretax cost of debt
λ = % of debt, debt to total market value ratio
τ = _____________ corporate income tax rate
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The Firm’s Investment
Decision and the Cost of
Capital
• A firm that can reduce
its cost of capital will

cost of capital (%)

increase the profitable
capital expenditures
that the firm can take on
and increase the wealth
of the shareholders.

• Internationalizing the
firm’s cost of capital is
one such policy.

Investment ($)

Page 5
Cost of Capital in Segmented
vs. Integrated Markets
• The cost of equity capital (ke) of a firm is the
expected return on the firm’s stock that
investors require.
• This return is frequently estimated using the
Capital Asset Pricing Model (CAPM):

k e, c o m p a niy= R f + βi ( R M − R f )
Cov(Ri , RM )
where βi =
Var(RM )

Page 6
 Segmented vs. Integrated Markets
• If capital markets are segmented, then
investors can only invest domestically. This
means that the market portfolio (M) in the
CAPM formula would be the domestic
portfolio instead of the world portfolio.
Ri = R CAN
f + β CAN
i ( R TSX − R CAN
f )

versus Ri = RWf orld + βiW orld( R M SCIW orld − RWf orld)

Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
Page 7
Does the Cost of Capital Differ
among Countries?
• There do appear to be differences in the cost of capital in
different countries.
– Local rates for debt and equity capital may differ
– Leverage ratio may differ across countries
• In US, Canada, UK leverage _____, on average
• In Europe, Japan leverage _______, on average
• When markets are imperfect, international financing can
lower the firm’s cost of capital.
• One way to achieve this is to internationalize the firm’s
ownership structure.

Page 8
 Example: Novo Industri

Page 9
Cross-Border Listings of Shares
• Cross-border listings of stocks have
become quite _________ among major
corporations.
• The largest contingent of foreign
stocks are listed on the ___________
Stock Exchange.
• U.S. exchanges attracted the next
largest contingent of foreign stocks.

Page 10
Cross-Border Listings of Shares
• Cross-border listings of stocks benefit a
company in the following ways.
– The company can ________ its potential
investor base, which will lead to a higher stock
price and lower cost of capital.
– Cross-listing creates a _____________ market for
the company’s shares, which facilitates raising
new capital in foreign markets.
– Cross-listing can enhance the ____________ of
the company’s stock.
– Cross-listing enhances the ___________ of the
company’s name and its products in foreign
marketplaces.
Page 11
Cross-Border Listings of
Shares
• Cross-border listings of stocks have costs.
– It can be ____________ to meet the disclosure
and listing requirements imposed by the
foreign exchange and regulatory authorities.
– Once a company’s stock is traded in overseas
markets, there can be volatility __________
from these markets.
– Once a company’s stock is make available to
foreigners, they might acquire a ___________
interest and challenge the domestic control of
the company.

Page 12
Cross-Border Listings of Shares

• Cross-border listings of stocks do carry costs.

– Daimler Benz’s net profit/loss (DM bn) German
Vs American Accounting rules

Page 13
Cross-Border Listings of Shares
Selected Foreign Firms listed on the
NYSE

Page 14
The Effect of Foreign Equity
Ownership Restrictions
• While companies have _______________ to
internationalize their ownership structure to
lower the cost of capital and increase market
share, they may be concerned with the
possible loss of corporate control to foreigners.
• In some countries, there are legal ____________
on the percentage of a firm that foreigners can
own.
• These restrictions are imposed as a means of
ensuring domestic ___________ of local firms.

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Pricing-to-Market
Phenomenon
• Suppose foreigners, if allowed, would like to
buy 30 percent of a Korean firm.
• But they are constrained by ownership
constraints imposed on foreigners to
purchase at most 20 percent.
• Because this constraint is effective in
________ desired foreign ownership, foreign
and domestic investors face different
market share prices.
• This dual pricing is the pricing-to-market
phenomenon.
Page 16
 Foreign Ownership
Restrictions: Nestlé
• Nestlé used to issue two different classes
of common stock: bearer shares and
registered shares.
– Foreigners were only allowed to buy ______
shares.
– Swiss citizens could buy ____________ shares.
– The bearer stock was ____________________
• On November 18, 1988, Nestlé lifted
restrictions imposed on foreigners, allowing
them to hold registered shares as well as
bearer shares.
Page 17
 Nestlé’s Foreign
Ownership Restrictions
SF

12,000

10,000

8,000
6,000

4,000

2,000

0
11 20 31 9 18 24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
Page 18
Foreign Ownership Restrictions:
Nestlé

• Following this, the price spread between

the two types of shares ___________
dramatically.
– This implies that there was a major
_______ of wealth from foreign
shareholders to Swiss shareholders.
– The price of bearer shares declined
about 25 percent.
– The price of registered shares rose by
about 35 percent.
Page 19
Foreign Ownership Restrictions:
Nestlé

• Because registered shares represented about

two-thirds of the market capitalization, the
total value of Nestlé ______________
substantially when it internationalized its
ownership structure.
• Nestlé’s cost of capital therefore _________.

Page 20
 Foreign Ownership Restrictions:
Nestlé

• Foreigners holding Nestlé bearer shares

were exposed to __________ risk in a
country that is widely viewed as a haven
from such risk.
• The Nestlé episode illustrates
– The importance of considering market
imperfections.
– The peril of political risk.
– The benefits to the firm of
internationalizing its ownership
structure.
Page 21
The Financial Structure of
Subsidiaries.
• There are three different approaches to
determining the subsidiary’s financial
structure.
1. Conform to the parent company's norm.
2. Conform to the local norm of the country
where the subsidiary operates.
3. Vary judiciously to capitalize on
opportunities to lower taxes, reduce
financing costs and risk, and take
advantage of various market
imperfections.
Page 22
Financial Management for a
Multinational Firm
• Foreign direct investment
• International Capital Structure, Cost of
Capital
• International Capital Budgeting

Page 23
Review of Capital
Budgeting
• The basic net present value equation is
T
CFt TV T
NPV = ∑ + − C0
t =1 (1 + K ) (1 + K )
t T
Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow (terminal value) in year T,
including return of net working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
Page 24
Review of Capital
Budgeting
• Cash flow estimation

CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ )

Rt is incremental revenue
OCt is incremental operating cost
Dt is incremental depreciation
It is incremental interest expense
τ is the marginal tax rate

Page 25
Review of Capital
Budgeting
• Various ways to represent CF

CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ )

= NI t + Dt + I t (1 − τ )
= ( Rt − OCt − Dτ )(1 − τ ) + Dt
= NOIt (1 − τ ) + Dt
= ( Rt − OCt )(1 − τ ) + τDt
= OCFt (1 − τ ) + τDt
Page 26
Review of Capital
Budgeting
• We can use CFt = OCFt (1 − τ ) + τDt
to rewrite the NPV equation
T
CFt TVT
NPV = ∑ + − C0
t =1 (1 + K ) (1 + K )
t T

as:
OCFt (1 − τ ) + τDt
T
TVT
NPV = ∑ + − C0
t =1 (1 + K ) t
(1 + K ) T

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The Adjusted Present Value Model

 OCFt (1 − τ )
T
τDt  TVT
NPV = 
t =1 
∑
 (1 + K ) t +
(1 + K ) t
+
 (1 + K )T − C0

Can be converted to adjusted present value (APV)
•

 OCFt (1 − τ )
T
τD τI  TV
APV = 
t =1 
∑
 (1 + K ) t
u
+
(1 +
t
i ) t
+
(1 +
t
i ) t
+

T
 (1 + K )
u
T
− C0

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The Adjusted Present Value
Model
T T T
OCFt (1 − τ ) τDt τI t TVT
APV = ∑
t =1 (1 + K u ) t
+ ∑ (1 + i) + ∑ (1 + i)
t =1
t
t =1
t
+
(1 + K u ) T
− C0

• The APV model is a value additivity approach to

capital budgeting. Each cash flow that is a
source of value to the firm is considered
individually.
• Note that with the APV model, each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.

Page 29
 Domestic APV Example
• Consider a project of the Pearson Company, the timing and
size of the incremental after-tax cash flows for an all-equity
firm are:
-$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is r0 = 10%:

Page 30
 Domestic APV Example
• Now, imagine that the firm finances the project with $600 of debt at r
= 8%.
• Pearson’s tax rate is 40%, so they have an interest tax shield worth
t×I = .40×$600×.08 = $19.20 each year.
• The net present value of the project under leverage is:

APV = NPV unlevered +PV tax shield

4
$19 .20
APV = −$56 .50 + ∑(1 +0.08 )
t =1
t

Page 31
Domestic APV Example
• Note that there are two ways to calculate the NPV of
the loan. Previously, we calculated the PV of the
interest tax shields. Now, let’s calculate the actual
NPV of the loan:

4
$600 ×.08 × (1 − .4) $600
NPV loan = $600 − ∑ t
− 4
t =1 (1.08 ) (1 .08 )
NPV loan = $63 .59
APV = NPV unlevered + NPV loan

Page 32
Capital Budgeting from the
Parent Firm’s Perspective
• Donald Lessard (1985) developed an APV model for
a MNC analyzing a foreign capital expenditure. The
model recognizes many of the particulars peculiar to
foreign direct investment.

St OCFt (1 − τ ) T St τDt
T T
St τI t
APV = ∑ +∑ +∑
t =1 (1 + K ud ) t
t =1 (1 + id )
t
t =1 (1 + id )
t

T
ST TVT St LPt
+ − S 0C0 + S 0 RF0 + S 0CL0 + ∑
(1 + K ud ) T
t =1 (1 + id ) t

Page 33
APV Example
• A US-based International Diesel Corporation (IDS-US) is evaluating whether to
build a diesel engine plant in the UK (IDS-UK). The estimated project after tax
operating cash flows in millionsYEAR
GBP are below.

0 1 2 3 4 5 5+
-26.5 2.2 3.3 5.6 6.3 6.3 19.0

• The optimal capital structure is 80% equity and 20%

debt. GBP is expected to depreciate by 2% per year vis-à-
vis USD. Depreciation is 5 million GBP during first 5
years. Today's exchange rate is USD/GBP $2.00. The
applicable marginal tax rate in the UK and US 40%,
borrowing rate in USD is 8% and 10% in GBP, the
unlevered cost of equity is 12%. IDS borrows in the US
market to finance the project.
• Should
Page 34 IDS undertake the project?
APV Example
• Exchange rates. FX(t+1)=0.98*FX(t)
YEAR
0 1 2 3 4 5 5+
$2.00

• $ cash flows. $CF = FX(t) * GBP CF(t)

YEAR
0 1 2 3 4 5 5+

• Present value. Use CF and NPV worksheets.

• Present value =

Page 35
APV Example
• Depreciation tax shield = D(t) * tax * FX(t). PV @ 8% =
YEAR

0 1 2 3 4 5
n/a

• Interest write-off tax shield

•

Page 36
Risk Adjustment in the Capital
Budgeting Process
• Clearly risk and return are correlated.
• ____________ risk may exist along side of
business risk, necessitating an
adjustment in the discount rate.
– Systematic risk is reflected by Kud.
Therefore, if a project is riskier than
average firm’s project, __________ Kud,
or if less risky, _________ Kud by 2-3% or
so.

Page 37
 Sensitivity Analysis
• In the APV model, each cash flow has a
probability distribution associated with it.
• Hence, the realized value may be different from
what was expected.
• In sensitivity analysis, ___________ estimates are
used for expected inflation rates, cost and
pricing estimates, and other inputs for the APV
to give the manager a more complete picture of
the planned capital investment.

Page 38
 Real Options
• The application of options pricing theory
to the evaluation of investment options in
real projects is known as real options.
– A timing option is an option on when to
make the investment.
– A growth option is an option to increase
the scale of the investment.
– A suspension option is an option to
temporarily cease production.
– An abandonment option is an option to
quit the investment early.
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