Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter 13: transaction exposure management

When a firm faces contractual cash flows denominated in foreign currencies then it has transaction exposure. When a firms does nothing about the exposure, it is effectively speculating on the future course of the exchange rate. Thus, whenever a firm has foreign-currency-denominated receivables or payables, it has transaction exposure as the firm’s cash flows in its home currency would be affected by the exchange rate at the settlement of these contracts. With increasing globalization of business, such foreign-currency-denominated contracts have become quite common and the importance of managing transaction exposure has increased further. Transaction exposure is well defined as the magnitude of transaction exposure is the same as the amount of foreign currency receivable or payable.

Financial contracts:

• Forward market hedge

• Money market hedge

• Option market hedge

• Swap market hedge

Operational techniques:

• Choice of the invoice currency

• Lead/lag strategy

• Exposure netting

The most common way of hedging transaction exposure is by currency forward contracts. The firm may sell (buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. E.g. when a company sells forward its receivables, the gain will be positive as long as the forward exchange rate is greater than the spot rate on the maturity date, that is F > S_T, and the gain will be negative if the opposite holds. However, no one knows for sure what the future spot rate will be beforehand. The firm must decide whether to hedge or not to hedge ex ante.

There are three alternative scenarios:

Appendix 1

In scenario 1, the expected gains or losses are approximately zero. But forward hedging eliminated exchange exposure. The firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale. Under this scenario, the firm would be inclined to hedge as long as it is averse to risk.

In scenario 2, the firm expects a positive gain from forward hedging. Here the firm is even more inclined to hedge under this scenario than under scenario 1. This scenario implies that the firm’s management dissents from the market’s consensus forecast of the future spot exchange rate as reflected in the forward rate.

In scenario 3, the firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds from foreign sale. The firm would be less inclined to hedge under this scenario, ceteris paribus. Despite lower expected dollar proceeds, however, the firm may still end up hedging: this depends on the degree of risk aversion. The more risk averse the firm is, the more likely it is to hedge. From the perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an insurance premium paid for avoiding the hazard of exchange risk.

A futures contract is not as suitable as a forward contract for hedging purposes for two reasons (that allow the firm only hedge approximately)

• Unlike forward contracts that are tailor-made to the firm’s specific needs, futures contracts are standardized instruments in terms of contract size, delivery date, etc.

• Due to the marking-to-market property, there are interim cash flows prior to the maturity date of the futures contract that may have to be invested at uncertain interest rates.

Lending and borrowing in the domestic and foreign money markets can also hedge transaction exposure. The firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. The fist important step in money market hedging is to determine the amount of foreign currency to borrow/lend. Apart from transaction costs, the money market hedge is fully self-financing.

Shortcoming of forward and money market hedges is that these methods completely eliminate exchange exposure. Consequently, the firm has to forgo the opportunity to benefit from favourable exchange rates. To solve this, one can use an option market hedge: currency options provide a flexible optional hedge against exchange exposure. In general, a firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables). Options hedge allows the firm to limit the downside risk while preserving the upside potential. However, the firm has to pay for this flexibility in terms of the option premium. Note that neither the forward nor the money market hedge involves any upfront costs. When a firm has an account payable rather than a receivable, in term of a foreign currency, the firm can set a ceiling for the future dollar cost of buying the foreign currency amount by using a call option on the foreign currency amount. A break-even analysis suggests that if the firm’s expected future spot rate is greater (less) than the break-even rate, then the options (forward) hedge might be preferred. Unlike for the forward contract, for the options contract there are multiple exercise exchange rates (prices). Choice of the exercise price for the options contract ultimately depends on the extent to which the firm is willing to bear exchange risk. For instance, if the firm’s objective is only to avoid very unfavourable exchange rates, then it should consider buying an out-of-money put option with a low exercise price, saving option costs.

If a firm has receivables/payables in major currencies, then it can easily use forward, money market, or option contracts to manage its exchange risk exposure. In contrast, if the firm has positions in less liquid currencies, it may be either very costly or just impossible to use financial contracts in these currencies. This is because financial markets of developing countries are relatively underdeveloped and often highly regulated. Facing this situation, the firm may consider using cross-hedging techniques to manage its minor currency exposure. Cross-hedging involves hedging a position in one asset by taking a position in another asset. Also, commodities futures contracts may be used effectively to cross-hedge some minor currency exposures, e.g. a firm can sell (buy) oil futures if it has Mexican peso receivables (payables) – note that Mexico is a major exporter of oil. The effectiveness of cross-hedging techniques depend on the strength and stability of the relationship between the exchange rate and the commodity futures prices.

Option contracts can also provide an effective hedge against what might be called contingent exposure, i.e. a situation in which the firm may or may not be subject exchange exposure.

Firms often deal with a sequence of accounts payable/receivable in terms of a foreign currency. Such recurrent cash flows in a foreign currency can best be hedged using a currency swap contract, which is an agreement to exchange one currency for another at a predetermined exchange rate – that is, the swap rate, on a sequence of future dates. As such, a swap contract is like a portfolio of forward contracts with different maturities.

A firm can also hedge through the choice of invoice currency, which is an operational technique. The firm can shift, share, or diversify exchange risk by appropriately choosing the currency of invoice. Currency basket units can be a useful hedging tool, especially for long-term exposure for which no forward or options contracts are readily available.

Leading and lagging foreign currency receipts and payments is another operational technique the firm can use to reduce transaction exposure.

• To lead means to pay or collect early;

• To lag means to pay or collect late.

The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and the benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the lead/lag strategy, the transaction exposure the firm faces can be reduced. The lead/lag strategy can be employed more effectively to deal with intra-firm payables and receivables, such as the material costs, rents, royalties, interest, and dividends, among subsidiaries of the same multinational corporation. Since management of various subsidiaries of the same firm are presumably working for the good of the entire corporation, the lead/lag strategy can be applies more aggressively.

When a firm has both receivables and payables in a given foreign currency, it should consider hedging only its net exposure. In reality, a typical multinational firm is likely to have a portfolio of currency positions. If the firm has a portfolio of currency positions, it makes sense to hedge residual exposure rather than hedge each currency position separately. If the firm would like to apply exposure netting aggressively, it helps to centralize the firm’s exchange exposure management function in one location. Many multinational corporations are using a reinvoice centre, a financial subsidiary, as a mechanism for centralizing exposure management functions. All the invoices arising from intra-firm transactions are sent to the reinvoice centre, where exposure is netted. Once the residual exposure is determined, then foreign exchange experts at the centre determine optimal hedging methods and implement them.

In a perfect capital market where stockholders can hedge exchange exposure as well as the firm it is difficult to justify exposure management at the corporate level. In reality, capital markets are far from perfect, and the firm often has advantages over the stockholders in implementing hedging strategies. Thus, there exists room for corporate exposure management to contribute to the firm’s value.

Chapter 18: Management of multinational cash

Cash management refers to the investment the firm has in transaction balances to cover scheduled outflows of funds during a cash budgeting period and the funds the firm has tied up in precautionary cash balances – which are necessary in case the firm has underestimated the amount needed to cover transactions. Good cash management also encompasses investing excess funds at the most favourable rate and borrowing at the lowest rate when the firm is short on cash. The foundation of any cash management system is its cash budget – that is, a plan detailing the time and size of expected cash receipts and disbursements.

The benefits of centralized cash management are:

1. A multilateral netting system is beneficial in reducing the number of and the expense associated with interaffiliate foreign exchange transactions

2. A centralized cash pool assists in reducing the problem of mislocated funds and in funds mobilization. A central cash manager has a global view of the most favourable borrowing rates and the most advantageous investment rates;

3. A centralized cash management system with a cash pool can reduce the investment the MNC has in precautionary cash balances, saving the firm money.

Under a bilateral netting system, each pair of affiliates determines the net amount due between them, and only the net amount is transferred. Bilateral netting can reduce the number of foreign exchange transactions among the affiliates to N (N – 1)/2, or less. Under a multilateral netting system, each affiliate nets all its interaffiliate receipts against all its disbursements. It then transfers or receives the balance, respectively, if it is a net payer or receiver. Under a multilateral netting system, the net funds to be received by the affiliates will equal the net disbursements to be made by the affiliates. Also, it reduces foreign exchange risk because currency flows are reduced. In a typical multilateral netting operation, it is common to cut FX volume and expense by up to 70 percent. A multilateral netting system requires a certain degree of administrative structure. At the minimum, there must be a netting centre manager who has an overview of the interaffiliate cash flows from the cash budget. The netting centre manager determines the amount of the net payments and which affiliates are to make or receive them. A netting centre does not imply that the MNC has a central cash manager.

Under a centralized cash management system, unless otherwise instructed, all interaffiliate payments will flow through the central cash depository. The benefits of this depository derive mainly from the business transactions the affiliates have with external parties. With such depository, excess cash is remitted to the central cash pool. Analogously, the central cash manager arranges to cover shortages of cash and has a global view of the MNC’s overall cash position and needs. Consequently, there is less of a chance for mislocated funds – that is, there is less chance for funds to be denominated in the wrong currency. A centralized system facilitates funds mobilization, where system-wide cash excesses are invested at the most advantageous rates and cash shortages are covered by borrowing at the most favourable rates.

An additional benefit of a centralized cash depository is that the MNC’s investment in precautionary cash balances can be substantially reduced without a reduction in its ability to cover unforeseen expenses. The larger the precautionary cash balance, the grater is the firm’s ability to meet unexpected expenses, and the less is the risk of financial embarrassment and loss of credit standing. In the event one of the affiliates experiences a cash shortage, funds are wired from precautionary cash held in the central cash pool.

Chapter 19: Imports & Exports

In a consignment sale, the exporter retains title to the merchandise that is shipped. The importer only pats the exporter one he sells the merchandise. If he cannot sell it, he returns it to the exporter. Obviously, the exporter bears all the risk in a consignment sale. In a shipment on credit, the payment is not made in advance for an order that might not ever be received.

A letter of credit (L/C) is a guarantee from the importer’s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant document specified in the L/C are presented according to the terms of the L/C. in essence, the importer’s bank is substituting its creditworthiness for that of the unknown US importer.

A time draft is written order instructing the importer or his agent, the importer’s bank, to pay the amount specified on its face on a certain date – that is, the end of the credit period in a foreign trade transaction. A bill of lading (B/L) is a document issued by the common carrier specifying that it has received the goods for shipment; it can serve as title to the goods. The exporter’s bank presents the shipping documents and the time draft to the importer’s bank. After taking title to the goods via the bill of lading, the importer’s bank accepts the time draft, creating at this point a banker’s acceptance (B/A), a negotiable money market instrument for which a secondary market exists. The importer’s bank charges an acceptance commission, which is deducted at the time of final settlement. The acceptance commission is based on the term-to-maturity of the time draft and the creditworthiness of the importer. Several things can happen with the B/A. it can be returned to the exporter, who will present it at for payment to the importer’s bank at maturity. Should the exporter suddenly find he needs funds prior to the maturity date, than the B/A can be sold at rates similar to rates for negotiable bank certificates of deposit. Since their risks are similar, banker’s acceptances trade at rates similar to rates for negotiable bank certificates of deposit. Alternatively, the exporter could instruct its bank to have the B/A discounted by the importer’s bank and pay that amount to it. Analogously, the exporter’s bank may decide to hold the B/A to maturity as an investment, and pay the exporter the discounted equivalent. If the B/A is not held by the exporter or the exporter’s bank, the importer’s bank may hold it to maturity when it will collect the face value from the importer via the promissory note. The importer’s bank may sell the B/A in the money market to an investor at a discount from face value.

Forfaiting is a type of medium-term trade financing used to finance the sale of capital goods. It involves the sale of promissory notes signed by the importer in favour of the exporter. The forfeit, usually a bank, buys the notes at a discount from face value from the exporter. The exporter receives payment for the export and does not have to carry the financing. The promissory notes are typically to extend out in a series over a period from three to seven years, with a note in the series maturing every six months.

The purpose of the Export-Import Bank (Ex-Im Bank) of the United States is to provide financing in situations where private financial institutions are unable or unwilling to because

1. The loan maturity is too long;

2. The amount of the loan is too large;

3. The loan risk is too great;

4. The importing firm has difficulty obtaining hard currency for payment.

Through its medium and long-term loan program, he bank will facilitate direct credit to foreign buyers of US exports. The long-term program covers repayment terms in excess of seven years and a loan amount greater than $10 million. The medium-term program covers repayment terms of seven years or less and loan amounts of $10 million or less. Both cover financing up to 85% of the export contract value. The private export funding corporation (PEFCO) frequently cooperates in loans with the Ex-Im Bank under these programs by providing liquidity via the purchase of notes issued by Ex-Im Bank to finance the loans. Through the export and credit insurance program the bank helps US exporters develop and expand their overseas sales by protecting them against loss should a foreign buyer or other foreign debtor default for political or commercial reasons.

Countertrade is an umbrella term used to describe many different types of transactions, each in which the seller provides a buyer with goods/services and promises in return to purchase goods/services from the buyer. It may or may not involve the use of money. Six forms of countertrade are identified:

1. Barter;

2. Clearing arrangement;

3. Switch trading;

4. Buy-back;

5. Counterpurchase;

6. Offset.

The first three do not involve the use of money, whereas the latter three do.

Barter is the direct exchange of goods between two parties. it fosters bilateral trade which, in turn, under mercantilist economies and imperialistic policies, fostered a tight system of colonial dependency with protected markets and captive sources of raw materials.

A clearing arrangement is a form of a barter in which the counterparties (governments) contract to purchase a certain amount of goods and services from another. Both parties set up accounts with each other that are debited whenever one country imports from the other. At the end of an agreed-upon period of time, any account imbalances are settled for hard currency, or by the transfer of goods.

Switch trade is the purchase by a third party of one country’s clearing agreement imbalance for hard currency, which is in turn resold. The second buyer uses the account balance for to purchase foods and services from the original clearing agreement counterparty who had the account imbalance.

Buy-back transaction involves a technology transfer via the sale of a manufacturing plant. As part of the transaction, the seller agrees to purchase a certain portion of the plant output one it is constructed. The plant buyer borrows hard currency in the capital market to pay the seller for the plant. The plant seller agrees to purchase enough of the plant output over a period of time to enable the buyer to pay back the borrowed funds. A buy-back transaction can be viewed as a form of direct investment in the purchasing country.

Counterpurchase is similar to a buy-back transaction, but with some notable differences. Usually, the two counterparties are a Eastern importer and a Western exporter of technology. The major difference between a buy-back and a counterpurchase transaction is that in the latter, the merchandise by the Western seller agrees to purchase is unrelated and has not been produced on the exported equipment. The seller agrees to purchase goods from a list drawn up by the importer at prices set by the importer. Goods on the list are frequently items for which the buyer does not have a ready market.

An offset transaction can be seen as a counterpurchase trade agreement involving the aerospace/defence industry. They are reciprocal trade agreements between an industrialized country and a country that has defence and/or aerospace industries.

Negative incentives of countertrade are those that are forced upon a country or corporation whether or not it desires to engage in countertrade. They include the conservation of cash and hard currency, the improvement of trade imbalances, and the maintenance of export prices. Positive reasons include enhanced economic development, increased employment, technology transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus goods from inventory, and the development of marketing expertise. Those against countertrade claim that such transactions tamper with the fundamental operation of free markets, and, therefore, resources are used inefficiently. Opponents claim that transaction costs are increased, that multilateral trade is restricted by fostering bilateral trade agreements, and that, in general, transaction that do not make use of money represent a step backward in economic development.

Chapter 15: FDI

Firms become multinational when they undertake foreign direct investment (FDI). It often involves the establishment of new production facilities in foreign countries, but it may also involve mergers and acquisitions of existing foreign business. Whether FDI involves a greenfield investment – that is, building brand-new production facilities – or cross-border mergers and acquisitions, it affords the multinational corporation (MNC) a measure of control. Therefore, FDI represents an internal organizational expansion by MNCs. The recent trends in FDI flows are presented in exhibit 15.1 & 15.2. FDI stocks are the accumulation of previous FDI flows. The overall cross-border production activities of MNCs are best captured by FDI stocks (exhibit 15.3).

Many of the existing theories explaining the key motivating forces driving FDI emphasize various market imperfections – that is, imperfections in product, factor, and capital markets. Some key factors are important in firms’ decisions to invest overseas:

• Trade barriers;

• Imperfect labour market;

• Intangible assets;

• Vertical integration;

• Product life cycle;

• Shareholder diversification services.

Trade barriers. Government may impose tariffs, quotas, and other restrictions on exports and imports of goods and services, hindering the free flow of these products across national boundaries. Sometimes, governments may even impose complete bans on the international trade of certain products. Governments regulate international trade to raise revenue, protect domestic industries, and pursue other economic policy objectives. Facing these barriers to exporting its products to foreign markets, a firm may decide to move production to foreign countries as a mean of circumventing the trade barriers. Trade barriers also arise naturally from transaction costs. Such products as mineral ore and cement that are bulky relative to their economic values may not be suitable for exporting because high transportation costs will substantially reduce profit margins. In these cases, FDI can be made in the foreign markets to reduce transportation costs.

Imperfect labour market. Labour services in a country can be severely under-priced relative to their productivity because workers are not allowed to freely move across national boundaries to seek higher wages. Among all factor markets, the labour market is the most imperfect. Severe imperfections in the labour market lead to persistent wage differentials among countries. When workers are not mobile because of immigration barriers, firms themselves should move to the workers in order to benefit from the underpriced labour services (where labour is underpriced relative to their productivity).

Intangible assets. MNCs may undertake overseas investment projects in a foreign country, despite the fact that local firms may enjoy inherent advantages. This implies that MNCs should have significant advantages over local firms. Indeed, MNC often enjoy comparative advantages due to special intangible assets they possess. These assets are often hard to package and sell to foreigners. In addition, the property rights in intangible assets are difficult to establish and protect, especially in foreign countries where legal resource may not be readily available. According to the internalization theory of FDI, firms that have intangible assets with a public good property tend to invest directly in foreign countries in order to use these assets on a larger scale and, at the same time, avoid the misappropriations of intangible assets that may occur while transacting in foreign markets through a market mechanism.

Vertical integration. MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable price. Furthermore, if MNCs have monopolistic / oligopolistic control over the input market, this can serve as a barrier to entry to the industry. Many MNCs involves in extractive / natural resources industries tend to directly own oil fields, mine deposits, and forests for this reason. Also, MNCs often find it profitable to locate manufacturing / processing facilities near the natural resources in order to save transportation costs. It would be costly to bring bulky bauxite ore to the home country and then extract the aluminium. Although the majority of vertical FDIs are backward in that FDI involves and industry abroad that produces inputs for MNCs, foreign investment can take the form of forward vertical FDI when they involve an industry abroad that sells a MNC’s outputs.

Product life cycle. Firms undertake FDI at a particular stage in the life cycle of products that they initially introduced. As demands for the new product develops in foreign countries, the pioneering firm begins to export to those countries. As foreign demand continues to grow, the firms may be induced to start production in foreign countries to serve local markets. As the product becomes standardized and mature, it becomes important to cut the cost of production to stay competitive. FDI takes place when the product reaches maturity and cost becomes an important consideration. Thus, FDI can be interpreted as a defensive move to maintain the firm’s competitive position against its domestic and foreign rivals. See also exhibit 15.6.

Shareholder diversification services. If investors cannot effectively diversify their portfolio holdings internationally because of barriers to cross-border capital flows, firms may be able to provide their shareholders with indirect diversification services by making direct investment in foreign countries. When a firm holds assets in many countries, the firm’s cash flows are internationally diversified. Therefore, shareholders of the firm can indirectly benefit from international diversification even if they are not directly holding foreign shares. Capital market imperfections thus may motivate firms to undertake FDI. Although shareholders of MNCs may indirectly benefit from corporate international diversification, it is not clear that firms are motivate to undertake FDI for the purpose of providing shareholders with diversification services.

Mergers and acquisitions (M&A) are a popular mode of investment for firms wishing to protect, consolidate, and advance their global competitive positions, by selling off divisions that fall outside the scope of their core competence and acquiring strategic assets that enhance their competitiveness. For those firms, ownership assets acquired from another firm, such as technical competence, established brand names, and existing supplier networks and distribution systems can be put to immediate use toward better serving global customers, enhancing profits, expanding market share, and increasing corporate competitiveness by employing international production networks more efficiently.

Cross-border acquisitions of businesses are a politically sensitive issue, as most countries prefer to retain local control of domestic firms. As a result, although countries may welcome greenfield investments, as they are viewed as representing new investment and employment opportunities, foreign firms’ bids to acquire domestic firms are often resisted and sometimes even resented. Whether or not cross-border acquisitions produce synergistic gains and how such gains are divided between acquiring and target firms are thus important issues form the perspective of shareholder welfare and public policy. Synergistic gains are obtained when the value of the combined firm is greater than the stand-alone valuation of the individual (acquiring and target) firms. Synergistic gains may or may not arise from cross-border acquisitions, depending on the motive of the acquiring firms. In general, gains will result when the acquirer is motivated to take advantage of the market imperfections. In other words, firms may decide to acquire firms to take advantage of mispriced factors of production and to cope with trade barriers.

In the backward-internalization case, the acquirer seeks to create wealth by appropriating the rent generated from the economy of scale obtained from using the target’s intangible assets on a global bass. The internalization thus may proceed forward to internalize the acquirer’s assets, or backward to internalize the target’s assets.

Political risk refers to the potential losses to the parent firm resulting from adverse political developments in the host country. Political risks range from the outright expropriation of foreign assets to unexpected changes in the tax laws that hurt the profitability of foreign projects. Political risk that firms face can differ in terms of the incidence as well as the manner in which political events affect them. Depending on the incidence, political risk can be classified into two types:

1. Macro risk, where all foreign operations are affected by adverse political developments in the host country.

2. Micro risk, where only selected areas of foreign business operations or particular foreign firms are affected.

Depending on the manner in which firms are affected, political risk can be classified into three types:

1. Transfer risk, which arises form uncertainty about cross-border flows of capital, payments, know-how, and the like. Examples include the unexpected imposition of capital controls, inbound or outbound, and withholding taxes on dividend and interest payments.

2. Operational risk, which is associated with uncertainty about the host country’s policies affecting the local operations of MNCs. Examples include unexpected changes in environmental policies, sourcing / local content requirements, minimum wage law, and restriction on access to local credit facilities.

3. Control risk, which arises from uncertainty about the host country’s policy regarding ownership and control of local operations. Examples include restrictions imposed on the maximum ownership share by foreigners, mandatory transfer of ownership to local firms over a certain period of time (fade-out requirements), and the nationalization of local operations of MNCs.

Experts of political risk analysis evaluate, often subjectively, a set of key factors such as:

• The host country’s political and government system. Whether the host country has a political and administrative infrastructure that allows for effective and streamlined policy decisions has important implications for political risk. If a country has too many political parties and frequent changes in government, government policies may become inconsistent and discontinuous, creating political risk.

• Track records of political parties and their relative strength. Examination of the ideological orientations and historical track records of political parties would reveal a great deal about how they would run the economy. If a party has a strong nationalistic ideology and/or social beliefs, it may implement policies that are detrimental to foreign interests. On the other hand, a party that subscribes to a liberal and market-oriented ideology is not very likely to take actions to damage the interests of foreign concerns. If the former party is more popular than the latter party, and thus more likely to win the next general election, MNCs will bear more political risk.

• Integration into the world system. If a country is politically and economically isolated and segmented from the rest of the world, it would be less willing to observe the rules of the game. If a country is a member of major international organizations, such as the EU, OECD, and WTO, it is more likely to abide by the rules of the game, reducing political risk.

• The host country’s ethnic and religious stability. Domestic peace can be shattered by ethnic and religious conflicts, causing political risk for foreign business.

• Regional security. Real and potential aggression from a neighbouring country is obviously a major source of political risk.

• Key economic indicators. Often political events are triggered by economic situations. Political risk is therefore not entirely independent of economic risk. Severe inequality in income distribution and deteriorating living standards can cause major political disturbances.

Euromoney provides country ratings by political risk, credit rating, economic performance, and other factors (exhibit 15.12). it also provides the overall country risk ranking based on a opinion poll of economists and political analysts, plus market data and debt figures. Country risk is a broader measure of risk than political risk, as the former encompasses political risk, credit risk and other economic performances.

How to manage political risk?

1. MNCs can take a conservative approach to foreign investment projects when faced with political risk. When a foreign project is exposed to political risk, the MNC can explicitly incorporate political risk into the capital budgeting process and adjust the projects NPV accordingly. The firm may do so either by reducing expected cash flows or by increasing the cost of capital. The MNC may undertake the foreign project only when the adjusted NPV is positive. To the extent that political risk is diversifiable, a major adjustment to the NPV may not be necessary. This consideration also suggests that MNCs can use geographic diversification of foreign investments as a means of reducing political risk.

2. One a MNC decides to undertake a foreign project, it can take various measures to minimize its exposure to political risk. The idea is that the project is partially owned by a local company, the foreign company may be less inclined to expropriate it since the action will hurt the local company as well as the MNC. The MNC may also consider forming a consortium of international companies to undertake the foreign project. In that case, the MNC can reduce its exposure to political risk, and, at the same time, make expropriation more costly to the host government. Alternatively, MNCs can use local debt to finance the foreign project. In that case, the MNC has an option to repudiate its debt if the host government takes actions to hurt its interests.

3. MNC may purchase insurance against the hazard of political risk. Such insurance policies, which are available in many advanced countries, are especially useful for small firms that are less well equipped to deal with political risk on their own. In the US, the Overseas Private Investment Corporation (OPIC) offers insurance against

   1. The inconvertibility of foreign currencies

   2. Expropriation of US-owned assets overseas;

   3. Destruction of US-owned physical properties due to war, revolution, and other violent political events in foreign countries;

   4. Loss of business income due to political violence.

Chapter 16: costs of capital & international capital structure

Internationalizing the capital structure has affects the firm’s cost of capital and market value. The cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. Id the return on an investment project is equal to the cost of capital, undertaking the project will leave the firm’s value unaffected. When a firm identifies and undertakes an investment project that generates a return exceeding its cost of capital, the firm’s value will increase. Therefore, it is important for a value-maximizing firm to try to lower its cost of capital.

When a firm has both debt and equity in its capital structure, its financing cost can be represented by the weighted average cost of capital, which can be computed by weighting the after-tax borrowing cost of the firm and the cost of equity capital, using the capital structure ratio as the weight. Specifically:

Appendix 2

Generally, both K_l and i increase as the proportion of debt in the firm’s capital structure increases. At the optimal combination of debt and equity financing, however, the weighted average cost of capital (K) will be the lowest. Firms may have an incentive to use debt financing to take advantage of the tax deductible, unlike dividend payments. However, debt financing should be balanced against possible bankruptcy costs associated with higher debt. A trade-off between the tax advantage of debt and potential bankruptcy costs is thus a major factor in determining the optimal capital structure.

The choice of optimal capital structure is important, since a firm that desires to maximize shareholder wealth will finance new capital expenditures up to the point where the marginal return on the last unit of new invested capital equals the weighted marginal cost of capital of the last unit of new financing to be raised. Consequently, for a firm confronted with a fixed schedule of possible new investments, any policy that lowers the firm’s cost of capital will increase the profitable capital expenditures the firm takes on and increase the wealth of the firm’s shareholders. Internationalizing the firm’s cost of capital is one such policy. See also figure 16.1: the value-maximizing firm would undertake an investment project as long as the internal rate of return (IRR) on the project exceeds the firm’s cost of capital. The firm’s optimal capital expenditure will be determined at the point where the IRR schedule intersects the cost of capital.

The main difficulty in computing the financing cost (K) of a firm is related to the cost of equity capital (K_e). The cost of equity capital is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Model (CAPM), which states that the equilibrium expected rate of return on a stock is a linear function of the systematic risk inherent the security. Specifically, the CAPM-determined expected rate of return for the ith security is:

Appendix 3

If international financial markets are segmented, investors can only diversify domestically. In this case, the market portfolio (M) in the CAPM formula would represent the domestic market portfolio. In segmented capital markets, the same future cash flows are likely to be priced differently across countries, as they would be viewed as having different systematic risks by investors from different countries. On the other hand, when international financial markets are fully integrated, investors can diversify internationally. The market portfolio in the CAPM formula will be the world market portfolio comprising all assets in the world. The relevant risk measure then should be the beta measured against the world market portfolio. In integrated international financial markets, the same future cash flows will be priced in the same way everywhere. Investors would require, on average, lower expected return on securities under integration than under segmentation because they can diversify risk better under integration.

Integration or segmentation of international financial markets has major implications for determining the cost of capital. However, empirical evidence on the issue is less than clear-cut. Studies suggest that international financial markets are certainly not segmented anymore, but still are not fully integrated. If international financial markets are less than fully integrated, which may be the case, there can be systematic differences in the cost of capital among countries.

The home bias of a country is the difference between the percentage of domestic mutual funds’ holdings in domestic securities in a country and the country’s weight in the world stock market capitalization. If a country’s weight in the world market capitalization is 6% and domestic mutual funds collectively invest more than 6% of their investment funds in domestic securities, then the country is judged to exhibit a home bias. The implicit cost of capital (ICOC) is a proxy for the country’s cost of capital. ICOC is based on four different models, as implied by the current stock price and earning forecasts, and then take the average of the four estimates. In perfect markets, firms would be indifferent between raising funds abroad or at home. When markets are imperfect, international financing can lower the firm’s cost of capital.

Cross-listing is the act of directly listing securities on foreign financial exchanges. Cross-listing will require meeting the listing and disclosure standards of foreign exchanges. In general, a company can benefit from cross-border listings of its shares in the following ways:

1. The company can expand its potential investor base, which will lead to a higher stock price and a lower cost of capital;

2. Cross-listing creates a secondary market for the company’s shares, which facilitates raising new capital in foreign markets;

3. Cross-listing can enhance the liquidity of the company’s stock;

4. Cross-listing enhances the visibility of the company’s name and its products in foreign marketplaces;

5. Cross-listed shares may be used as the acquisition currency for taking over foreign companies;

6. Cross-listing may improve the company’s corporate governance and transparency.

Despite the potential benefits, not every company seeks overseas listings because of the costs:

1. It can be costly to meet disclosure and listing requirements imposed by the foreign exchange and regulatory authorities;

2. Controlling insiders may find it difficult to continue to derive private benefits once the company is cross-listed on foreign exchanges;

3. Once a company’s stock is traded in overseas markets, there can be volatility spillover from those markets;

4. Once a company’s stock is made available to foreigners, they might acquire a controlling interest and challenge the domestic control of the company.

Surveys show that disclosure requirements appear to be the most significant barrier to overseas listings. In the light of the cost and benefits of overseas listings, a foreign listing should be viewed as an investment project to be undertaken if it is judged to have a positive net present value (NPV) and thus adds to the firm’s value. Another survey shows, among other things, that

1. The share price reacts favorably to cross-border listings;

2. The total post-listing trading volume increases on average, and for many issues, home-market trading volume also increases;

3. Liquidity of trading in shares improves overall;

4. The stock’s exposure to domestic market risk is significantly reduced and is associated with only a small increase in the global market risk;

5. Cross-border listings resulted in a net reduction in the cost of equity of 114 basis points on average;

6. Stringent disclosure requirements are the greatest impediment to cross-border listings.

Another study confirms that dual listing can mitigate barriers to international capital flows, resulting in a higher stock price and a lower cost of capital. Considering these findings, cross-border listings of stocks seem to have been, on average, positive NPV projects.

When you assume that cross-listed assets are internationally tradable assets while all other assets are internationally nontradable assets we can recalibrate the CAPM formula, to eventually derive an International Asset Pricing Model (IAPM). Restating the CAPM formula gives:

Appendix 4

This equation indicates that, given investors’ aggregate risk-aversion measure, the expected rate of return on an asset increases as the asset’s covariance with the market portfolio increases.

In a completely segmented capital market assets will be priced according to their country systematic risk. For domestic country assets, the expected asset return is calculated as:

Appendix 5

The asset pricing relationship becomes more complicated in partially integrated world financial markets where some assets are more internationally tradable while others are non-tradable. Internationally tradable assets will be priced as if world financial markets were completely integrated. Non-tradable assets will be priced according to a world systematic risk, reflecting the spillover effect generated by the traded assets, as well as a country-specific systematic risk. Due to the pricing spillover effect, non-tradable assets will not be prices as if world financial markets were completely segmented. For non-tradable assets of the domestic country, the pricing relationship is give by:

Appendix 6

The IAPM has a few interesting implications:

1. International listing (trading) of assets in otherwise segmented markets directly integrates international capital markets by making these assets tradable;

2. Firms with non-tradable assets essentially get a free ride from firms with tradable assets in the sense that the former indirectly benefit from international integration in terms of a lower cost of capital and higher assets prices, without incurring any associated costs.

To maximize the benefits from partial integration of capital markets, a country should choose to internationally cross-list those assets that are most highly correlated with the domestic market portfolio.

While companies have incentives to internationalize their ownership structure to lower the cost of capital and increase their market values, they may be concerned at the same time with possible loss of corporate control to foreigners. Consequently, governments in both developing and developed countries sometimes impose restrictions on the maximum percentage ownership of local firms by foreigners. These countries want to make sure that foreigners do not acquire majority stakes in local companies. If the ownership constraints imposed on foreigners is effective in limiting desired foreign ownership, foreign and domestic investors may face different market share prices. In other words, shares can exhibit a dual pricing or pricing-to-market (PTM) phenomenon due to legal restrictions imposed on foreigners.

Assume there are two countries in the world, the domestic and the foreign country. Also, assume that the foreign country imposes an ownership constraint on investors from the domestic country, but that the domestic country does not impose any constraints on investor of the foreign country. Consequently, domestic country investors are restricted to holding most of a certain percentage of the shares of any foreign firms, whereas foreign country investors are not restricted in any way from investing in the domestic country. For foreign shares, the PTM phenomenon applies. Investors from the domestic country will pay a premium above and beyond the perfect market price that would prevail in the absence of restrictions, whereas investors from the foreign country will receive a discount from the perfect market price. This implies that the domestic investors would require a lower return on foreign country shares than the foreign investors do.

Eun & Janakiramanan (1986) offer the following solutions for the equilibrium rates of return for foreign asset i from the domestic and the foreign country investors’ perspectives, respectively:

Appendix 7

There are three different approaches to determine a 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 risks, and take advantage of various market imperfections.

Which approach is used depends largely on whether and to what extent the parent company is responsible for the subsidiary's financial obligations. The subsidiary’s financial structure should be chosen so that the parent’s overall cost of capital can be minimized. Neither the first nor the second approach determining the financial structure of the subsidiary can be deemed appropriate. The first approach is not necessarily consistent with minimizing the parent’s overall cost of capital. The second approach calls for adopting the local financing norm. by following the local norm, the firm can reduce the chance of being singled out for criticism. This approach only makes sense when the parent is not responsible for the subsidiary’s obligation, and the subsidiary has to depend on local financing due to, say, segmentation of financial markets. Otherwise, it does not make much sense. The third approach seems to most reasonable and consistent with the goal of minimizing the firm’s overall cost of capital. The subsidiary should take advantage of subsidized loans as much as possible whenever available. It should also take advantage of tax deductions of interest payments in borrowing more heavily than is implied by the parent’s norm when the corporate income tax rate is higher in the host country than in the home country, unless foreign tax credits are useful. Political risk is another factor that should be considered in choosing the method of financing the subsidiary. When the choice is between external debt and equity financing, political risk tends to favor the former, because the host government tolerates repatriation of funds in the form of interest much better than dividends.

Since the parent company is responsible, legally and/or morally, for its subsidiary’s financial obligations, it has to decide the subsidiary’s financial structure considering the latter’s effect on the parent’s overall financial structure. The subsidiary, however, should be allowed to take advantage of any favorable financing opportunities available in the host country, because that is consistent with the goal of minimizing the overall cost of capital of the parent. If necessary, the parent can adjust its own financial structure to bring about the optimal overall financial structure.

Chapter 17: International Capital Budgeting

The basic net present value (NPV) capital budgeting equation can be states as:

Appendix 8

The NPV of a capital project is the present value of all cash inflows, including those at the end of the project’s life, minus the present value of all cash outflows. The NPV rule is to accept a project if NPV ≥ 0 and to reject if NPV < 0.

The internal rate of return (IRR), the payback method, and the profitability index are 3 additional methods for analyzing a capital expenditure. The IRR method solves for the discount rate, that is the project’s IRR, that causes the NPV to equal zero. In many situations a project will have only a single IRR, and the IRR decision rule is to select the project if the IRR ≥ K. the profitability index is competed by dividing the present value of cash inflows by the initial outlay; the larger the ratio, the more acceptable is the project. This may give some frictions between the outcomes of the profitability index and the NPV rule. Overall, the NPV decision is considered the superior framework for analyzing a capital budgeting expenditure.

In capital budgeting, out concern is only with the change in the firm’s total cash flows that are attributable to the capital expenditure. CF_t represents the incremental change in total firm cash flow for year t resulting from the capital project.

Appendix 9

The first equation presents a very detailed expression for incremental cash flow that is worth learning so that we can easily apply the model. The first term in the second equation is expected income, NI_t, which belongs to the equity holders of the firm. Incremental NI_t is calculated as the after-tax value of the change in the firm’s sales revenue, R_t, generated from the project, minus the corresponding operating costs, OC_t, minus project depreciation, D_t, minus interest expense, I_t. the second term represents the fact that depreciation is a noncash expense, that is, D_t is subtracted in the calculation of NI_t only for tax purposes. It is added back because this cash did not actually flow out of the firm in year t.

Appendix 10

Modigliani & Miller (1963) derived a theoretical statement for the market value of a levered firm (V_l) versus the market value of an equivalent unlevered firm (V_u), and they showed that

Appendix 11

The APV model is a value-additivity approach to capital budgeting, meaning that each cash flow that is a source of value is considered individually. In the APV model, each cash flow is discounted at a rate of discount consistent with the risk inherent in that cash flow. It is suggested that the tax savings due to depreciation, , also be discounted at I because these cash flows are relatively less risky than operating cash flows if tax laws are not likely to change radically over economic life of the project.

The APV model is useful for a domestic firm analyzing a domestic capital expenditure. If APV ≥ 0, the project should be accepted. Otherwise, when APV < 0, the project should be rejected. Therefore, the model is useful for a MNC for analyzing one of its domestic expenditures or for a foreign subsidiary of the MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint.

The next APV model is suitable for a MNC to use in analyzing a foreign capital expenditure. The model recognizes that the cash flows will be denominated in a foreign currency, and will have to be converted into the currency of the parent. Additionally, it incorporates special cash flows that are frequently encountered in foreign project analysis. Using the basic structure of the APV model developed before, Lessard’s model can be stated as:

Appendix 12

Several points are noteworthy about this equation:

• The cash flows are assumed to be denominated in the foreign currency and converted to the currency of the parent at the expected spot exchange rates, , applicable for year t. the marginal corporate tax rate, τ, is the larger of the parent’s or the foreign subsidiary’s because the model assumes that the tax authority in the parent firm’s home country will give a foreign tax credit for foreign taxes paid up to the amount of the tax liability in the home country. Therefore, if the parent’s tax rate is the larger of the two, additional taxes are due in the home country, which equals the difference between the domestic tax liability and the foreign tax credit. If it is the other way around, the foreign tax credit more than offsets the domestic tax liability, so no additional taxes are due.

• The OCF_t represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm. Cash flows earned in the foreign country that are blocked by the host government from being repatriated do not provide any benefits to the stockholders of the parent firm and are not relevant to the analysis. Additionally, cash flows that are repatriated through circumventing restrictions are not included here.

• It is important to include only incremental revenues and operating costs in calculating the OCF_t. Incremental revenue is not the total sales revenue. However, if the sales would be lost regardless, say because a competitor who is better able to satisfy local demand is gearing up, then the entire sales revenue of the new foreign manufacturing facility is incremental sales revenue.

• The equation includes additional terms representing cash flows frequently encountered in foreign projects. The term S₀RF₀ represents the value of accumulated restricted funds (of amount RF₀) in the foreign country from existing operations that are freed up by the proposed project. These funds become available only because of the proposed project and are therefore available to offset a portion of the initial capital outlay. RF₀ equals the difference between the face value of these funds and their present value used in the next best alternative.

• The term (appendix 13) denotes the present value in the currency of the parent firm of the benefit of below-market-rate borrowing in foreign currency. In certain cases, a concessionary loan (of amount CL₀) at a below-market rate of interest may be available to the parent firm if the proposed capital expenditure is made in the foreign land. The benefit to the MNC is the difference between the face value of the concessionary loan converted into the home currency and the present value of the similarly converted concessionary loan payments (LP_t) discounted at the MNC’s normal domestic borrowing rate (i_d). The loan payments will yield a present value less than the face amount of the concessionary loan when they are discounted at the higher normal rate. This difference represents a subsidy the host country is willing to extend to the MNC if the investment is made.

• It is necessary to know the firm’s optimal debt ratio. When the asset base increases because a capital project is undertaken, the firm can handle more debt in its capital structure – the borrowing capacity of the firm has increased because of the project. Nevertheless, the investment and financing decisions are separate. What is important is that in the long run the firm does not stray too far from its optimal capital structure so that overall the firm’s assets are financed at the lowest cost. Thus the interest tax term (Appendix 14) in the APV model recognizes the tax shields of the borrowing capacity created by the project regardless of how the project is financed.

One of the major benefits of the APV framework is the ease with which difficult cash flow terms, such as tax savings or deferrals and the repatriation of restricted funds, can be handles. Additional cash flow terms do not need to be explicitly considered unless the APV is negative. If it is turns out negative, the analyst can calculate how large the cash flows from other sources need to be make the APV positive, and then estimate whether these other cash inflows will likely be that large.

The financial manager must estimate the future expected exchange rates (Appendix 15), in order to implement the APV framework. One quick and simple way to do this, is to rely on PPP and estimate the future expected spot rate for year t as:

Appendix 16

Risk adjustment in capital budgeting:

1. The risk-adjusted discount method requires adjusting the discount rate upward or downward for increases or decreases, respectively, in the systematic risk of the project relative to the firm as a whole.

2. The certainty equivalent method extracts the risk premium from the expected cash flows to convert them into equivalent riskless cash flows, which are then discounted at the risk-free rate of interest.

The more risky the cash flow, the smaller is the certainty-equivalent factor. In general cash flows ten to be more risky the further into the future they are expected to be received. We favor the risk–adjusted discount rate method over the certainty-equivalent approach because we find that it is easier to adjust the discount rate than it is to estimate the appropriate certainty-equivalent factors.

In a sensitivity analysis, different scenarios are examined by using different exchange rate estimates, inflation rate estimates, and cost and pricing estimates in the calculation of the APV. In essence, the sensitivity analysis allows the financial manager a means to analyze the business risk, economic exposure, exchange rate uncertainty, and political risk inherent in the investment. Sensitivity analysis puts financial managers in a position to more thoroughly understand the implications of the planned expenditures. Also, it forces them to consider in advance actions that can be taken should an investment not develop as anticipated.

The APV methodology we developed assumes that PPP holds and that future expected exchange rages could be forecasted accordingly. Relying on PPP assumption is a common and a conceptually satisfying way to forecast future exchange rates.

Option pricing theory is useful for evaluating investment opportunities in real assets as well as financial assets, such as foreign exchange. The application of option pricing theory to the evaluation of investment options in real projects is known as real options. The firm is confronted with many possible real options over the life of a capital asset.

• Timing option about when to make the investment;

• Growth option to increase the scale of the investment;

• Suspension option to temporarily cease production;

• Abandonment option to quit the investment early.

Uncertainties (such as political uncertainty) make real option analysis ideal for use in evaluating international capital expenditures. Real option analysis, however, should be thought of as an extension of discounted cash flow analysis, not as a replacement of it.

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