Foreign investment decisions

• Why firms invest abroad– Comparative costs – least cost location– Scale economies – spread fixed costs especially R&D– Avoid transport costs– Restore/maintain growth in mature products– Lack of domestic capacity– Overcome trade barriers– Use of retained profits difficult to repatriate– Local inducements

• tax breaks, cheap loans, etc– To avoid FX risks.

Foreign direct investment (FDI)

FDI not the only means of serving foreign markets. Grant distinguishes between:

• Transactions-based methods– Exporting via agents, direct exporting, franchising,

licensing• Investment-based methods

– Joint ventures, acquisitions, direct investment• Choice depends on

– Cost– Source of advantage – ownership- or location-based– Ease of appropriation of technology.

Methods of market entry

The Switch Model

Exporting vs. FDI Source: Buckley and Casson (1981).

Foreign Direct Investment

Four difficulties not present in domestic project appraisal

1. Overseas cash flow’s are exposed to the risk of adverse FXmovements

2. The ‘host’ government have a variety of ways to take actions which adversely discriminates against an overseas project once the project is undertaken (imposing penal rate of taxation; restricting the remittance of project net cash flows

3. Problems related to estimating systematic risk and required rate of return of the project in an international rather than domestic context

4. Finding a correct project appraisal procedure. Especially: the viewpoint problem

The basic approach

UK Parent

NPV

USA

1. The project’s US dollar cash flows are discounted at the dollar discount rate to generate a $NPV. This can then be converted at the $/£ spot rate to a given sterling NPV

2. The project’s dollar cash flows are converted to sterling cash flows. These sterling cash flows are then discounted at the sterling discount rate to generate a sterling NPV

The viewpoint problem

Should the project’s net cash flows be viewed from the standpoint of the project itself, or from the standpoint of the parent? In other words: is it theyear-to-year net cash flows of the project, or is it the project’s cash flowsavailable to be remitted back to the parent that is to be evaluated?

ExampleRush plc is undertaking a project in an overseas country whose currency is US$. The project’snet cash flow are:

Year $M0 -101 +82 +43 +3.5

The current $/£ spot rate is 2.5000. Given the systematic risk involved, r = 20%. The companyfollows a policy paying out all of each year’s net cash flow as dividend.

The host country’s laws permit foreign projects to remit back to their parents a maximumannual cash flow equal to 10% of the project’s cost. Blocked funds have to be placed onspecial deposit at an interest rate of 5%. All blocked funds are released at the end of the project’s life.

From the viewpoint of the project…

Year $M PVF 20% Sum

0 -10 * 1 = -10

1 +8 * 0.8333 = +6.67

2 +4 * 0.6944 = +2.78

3 +3.5 * 0.5787 = +2.02

+$1.47

$1.47 / 2.5000 = £0.588M (NPV)

From the viewpoint of the parent…

Year 1 2 3

+project cash flow +8 +4 +3.5

Blocked funds 7 10.35

Interest +0.35 +0.52

Total cash flow +8 +11.35 +14.37

Repatriated c/f -1 -1 -14.37

Blocked funds +7 +10.35

Year $M 20%disc Sum0 -10 1 -101 +1 0.8333 +0.832 +1 0.6944 +0.693 +14.37 0.5787 +8.32

$ -0.16

-$0.16 / 2.5000 = -£64 000

There is little point inundertaking this if the

investors cannotenjoy its benefits

Managing Currency Risk

Foreign exchange markets (FX)

a) the ’spot’ FX marketb) the ’forward’ FX market (fixed f. contracts; time option f. contracts)

Existance iif there is sufficient demand

Where a forward market exist, just how far forward you can dealdepends upon the level of demand (the dept…)

’Standard periods of time are one month and three months. Otherforward rate has to be specifically quoted by the banks

Discounts….

$/£ spot 1.5840-1.5860

$/£ 1 month forward 1.6290-1.6335

$/£ 3 months forward 1.6525-1.6560

$/£ spot 1.5840-1.5860

$/£ 1 month forward 4.50c-4.75c discount (= ”add”)

$/£ 3 months forward 6.85c-7.00c discount

What does a discount imply w r t the relative exchange rate?

The first currency is ____________ against the second of the pairof currencies

buy

sell

Notice that the spread widens…Why?

…. and premiums

$/£ spot 1.8240-1.8260

$/£ 1 month forward 0.85c-0.75c premium (=”subtract”)

and so: spot 1.8240-1.8260

-premium 0.85 – 0.75

1 month forward 1.8155 – 1.8185

The first currency is now ____________ against the second of the pair of currencies

Rates of depreciation and appreciation

Spot $ 1.5210

12 months forward 8.65c discount

Spot $/£ $ 1.5210

+ discount +0.0865

12 months forward $ 1.6075

Suppose that the $/£ buying rates are given as:

Express the amont of discount as a percentage of the spot rate:

= 0.0569 or 5.69 percent

As a result, the forward rate can be calculated as:

spot: $ 1.5210*(1+0.0569) = $1.6075

Determinants of FX rates

three main questions to address:1. What causes foreign exchange rates to move?2. What determines forward exchange rates?3. What determines future spot rates?

What causes foreign exchange rates to move?= Supply and demand forces

Two (three) principal sources of market forces: (a) speculators and speculation, so-called ’hot money’(b) international trade and ’real’ investments(c) international finance

What determines forward exchange rates?

- The answer lies with the interest rate parity theorem (IRPT)

ExampleIn our example, spot $/£ is 1.5840-1.5860 and 12-month forward $/£ is 1.5370-1.5400. Suppose that the rate of interest on UK Treasury Bills is 8% and on US Treasury Bills 5%. You wish to place£ 10000 on deposit, risk free, for one year. Should you invest in UK T-bills and get 8%, or in US T-bills and get only 5%. IRPT says it doesn’t matter – either way will yield exactly the same return.

Example cont…

Invest (deposit) now £10000, receive back £10800 in 12 month’s time.-----------------------------------------------------------------------------------------------

Or sell £10000 spot for US dollars, receive £10000*1.5840 = $15840.

Place these on a US deposit for a year to produce $15840*(1+0.05) = $16632.

To avoid risk, sell the $’s for pounds at the 12-month forward rate of 1.5400 to yield $16632/1.5400 = £10800-------------------------------------------------------------------------------------------------------------------------------------------------

See this: Forward exchange rate are set as to effectively bring about parity between interest rates in different currencies.

The precise rate of change:

$ in theon appreciati 2.78% aor 0278.201.08

0.08-0.05

exampleour in Therefore,

$ in the change %rateinterest Sterling 1

rateinterest Sterling - rateinterest $

Spot $/£: 1.5840*(1-0.0278) = 1.5400: 12-month forward $/£

An important point that is often misunderstood:

Spot $/£: 1.5840*(1-0.0278) = 1.5400: 12-month forward $/£

This 12-month rate is technically an ‘unbiased estimator’ of what will bethe $/£ spot rate in 12 month’s time.

In reality this is seldom true. Why?

The actual spot rate will also be affected by supply and demandmarket forces at that time

What determines future spot rates?

-The answer lies with the purchasing power parity theorem (PPPT)

Exchange rates move to effectively bring about purchasing power parity between the currencies of different countries.

- PPPT is not as robust as IRPT. Because IRPT determines forward rates almost precisely.- PPPT rest on ‘the law of one price’.- In contrast, PPPT will be a major influence behind FX rates, but not the only one.

The law of one price:

Suppose that a particular lap-top PC costs £3000 in the UK and the $/£ spot rate is 1.7000.The US price would then have to be £3000*1.7000 = $5100.

What could happen if you could buy the PC in the US for $4250?

Buy for $4250/1.7000= £2500

Sell for =£

Profit =£

Does the law of one price apply to all goods?

There are two requirements for the LOP to operate effectively:

a) ________________________

b) ________________________

The transportation cost of the good concerned must be small relative to the good’s value

The goods must be physically capable of being traded internationally

What does b) exclude?

The LOP example continued:

Assume that the annual rates of inflation over the next 12 months in the UK and in the USare 4% and 6% respectively.

The lap-top cost £3000*(1+0.04) = £3120 in the UK in 12-months timeThe lap-top cost $5100*(1+0.06) = $5406 in the UK in 12-months time

Therefore, in order to maintain the LOP, this implies that the $/£ spot rate in 12 month’s timewill be 1.7327 (= 5406/3120), so that £3120*1.7327 = $5406.

Thus exchange rates move to maintain the LOP.

The answer to our question:The currency of the country with the higher rate of inflation will depreciate against the currencyof the country with the lower rate of inflation by approximately the inflation differential.

The precise rate of change in exchange is:

onappreciati -

ondepreciati $ in the change %

rateinflation UK 1

rateinflation UK - rateinflation US

Current spot: 1.7000*(1+0.01923) = 1.7327: estimated future spot

Interlocking theories in international economics

OFT = Diff between interest rates on similar bonds represents the market’s estimate of the future changes in theexchange rates over the period of the bond. (1.05/1.12)*1.61 (spot$/£) = 1.5 forward $/£ (A GBP Bond is 12% p.a.)

(1+M)=(1+P)(1+I)?

• IRP almost always holds• PPP generally applies long-term but we see

substantial short-term deviations• Fisher and IFE effects distorted by government

interference– apply long-term but with short-term deviations

• Expectations theory– F/w is unbiased predictor of future spot in long-term – F/w rates seem to undervalue short-term future spot

when spot rate is increasing, and vice versa.

What do we know ??

• If the theories work, should firms hedge FX exposure?– Inflation differences drive FX rate differences – why? – Inflation differences drive interest rate differences (Fisher),

which drive spot/forward differences (IRP), which predict changes in spot rates (UBFR)

• Why firms should not sell F/w their export receipts– forward rate = expected future spot rate – so, price according to FX F/w rate ruling at delivery

date - look at the market rates– may win or lose in practice but should expect to break-even

over time – the essential skills are to identify the assetsand cash flows that are at risk and to devise suitable means of hedging the risks...

How does it help?

Foreign exchange hedging

Risk = uncertainty of outcome, hence FX risk refers to uncertaintyof outcome that arises because exchange rates move unpredictably

Three types of FX risk:

1. transactions risk2. translation risk3. economic risk

import and export trade

‘real’ investments in a foreign country

borrowing denominated in f. currency

The focus here will be on the problem of FX transaction risk, andparticularly the risk faced by importers and exporters

An interesting point as far as financing is concerned…

- Should we ignore the financing cash flows in calculating a project’s NPV?

Example:Buy a machine for £1000. Operating net c/f = £450 /year over 3 years. No scarp value.Systematic risks involved gives r = 15%.

The machine is fully financed by a 3-year loan at 10%

NPV = -1000 + 450*AF(3y,15%) = 27.44

NPV(loan) = – 100*(0.9091) – 100*(0.8264) – 1000*(0.7513) = -1000

Therefore, in entering the project’s outlay of £1000 in the NPV analysis we are implicitly enteringthe present value of the financing cash flows involved in the project.

Miller-Modigliani separation theorem. But this does not mean that financing cash flows are excluded. They are just implicit…

The viewpoint problem in joint ventures or where funds are raised overseas

Go back to the Rush plc example. (Project NPV = £0.588M; Parent NPV = -£64 000.)The $10M investment is now financed by a joint venture with investors in the host country (50%), and via the export of £2M (=$5M).

Year 1 2 3

+project cash flow +8 +4 +3.5

-foreign dividends -4 -2 -1.75

Blocked funds +3 +4.15

Interest +0.15 +0.21

Total cash flow +4 +5.15 +6.11

Repatriated c/f -1 -1 -6.11

Blocked funds +3 +4.15

NPV (at r= 20%)

= -5*1 + 1*0.8333 + 1*0.6944 + 6.11*0.5787 = $0.06M = £24 000

Project discount rate

What would happen in the Rush plc example if the company hadoriginally intended to finance the project by exporting £4M, of which£2M would be in form of retained earnings and the other £2M would be raised via a three-year term loan?

The £ discount rate would have been the project’s WACC

However, what if Rush plc instead decided to raise the three-year term loan in the US in dollars?

As far as the project appraisal from the parent’s viewpoint is concernedit is the cash flows available for repatriation back to the parent that isof relevance.

The discount rate should then reflect the project’s business risk plusthe financial risk that arises from the leverage – the cost of equity capital

Example – Rush plc

Project’s asset beta = 1.6US government bond return =12% (the risk-free interest rate)Return on NYSE index =17%

CAPM then gives r = 12% + (17%-12%)*1.6 = 20%

Suppose now that the $10M project is financed by exporting £ (50%), and then through a three-year $5M term loan (interest 12%)

2.31

26.1

then

E

A

A

E

assetsequity

equityassets

rE=12%+(17%-12%)*3.2

= 28%

The project appraisal analysis is now:

Year 1 2 3

Project cash flow +8 +4 +3.5

- Interest payments -0.6 -0.6 -0.6

- loan -5

+ blocked funds +6.4 +9.12

+ interest +0.32 +0.46

Total cash flow +7.4 +10.12 +7.48

Repatriated c/f -1 -1 -7.48

Blocked funds +6.4 +9.12 -

NPV (r=28%) = -5*1 + 1*0.7812 + 1*0.6103 + 7.48*0.4768 = - $ 0.04M /2.5000 = -£16 000

We have left tax considerations…;)

Translation risk

The risk a company is exposed to through movements in FX rates whenit hold medium- to long-term assets and liabilities in an overseascurrency.

At each year-end their values have to be translated into the domestic currency for inclusion in the parent company’s balance sheet.

A UK company undertakes a project in the US, costing $10M. It is financed via a £5M loan.The $/£ exchange rate is 2.0000.

Opening balance

$ Asset: £5M £ loan: £5M $ Asset: £3.33M £ loan: £5Mless FX loss: (£1.67M)

Ending balance 12 month ahead

$/£=3.0000

How do we overcome thistranslation risk?

Problems in dealing with translation risk

Many governments insist that a minimum proportion of a project’s outlayis financed directly by the parent company

The standard financing advice for overseas projects is:

a) the project’s property fixed assets: finance with a foreign currency loan

b) the project’s non-property fixed assets: finance through exporting own c.

c) working capital requirements: finance with a foreign currency loan

a) and c) are not capable of being physically traded internationally,so these asset categories need to be protected against FX risk through matching.

What explains the strategy for b)?

Economic risk – the risk of unexpected changes in FX rates- is this risk systematic or unsystematic?- or does/should it exist at all?

A US project costs $1M. It has a life of three years and results in an annual production of 1000 units. The net after-tax cash flow is $0.5M in current terms. This cash amount is expectedto increase in line with the average US inflation rate (8% per year).

The project will be entirely financed by £, and there is no restrictions on remittance. A similar-risk UK project would be expected to produce an annual return of 16%.

The current $/£ spot exchange rate is 1.9000, and the UK inflation rate is expected to 5%per year.

Estimate the $/£ FX rate of change through the PPPT:

(0.08-0.05)/1.05 = +0.0286

and so, using the IRPT: $discount rate = (0.0286*1.16) = 19.3%

The project can now be evaluated:

Year $M PVF(19.3%) PV0 -1 1 -11 +0.54 0.8382 +0.4532 +0.583 0.7026 +0.4103 +0.630 0.5889 +0.371

$+0.234 (NPV)

If the firm the undertakes the project, the $/£ FX rates that they are expecting over the next three years can be found from the PPPT:

Spot: 1.9000 (given)Year 1: 1.9000*(1.0286) = 1.9543Year 2: 1.9543*(1.0286) = 2.0102Year 3: 2.0102*(1.0286) = 2.0677

Thus, the firm should expect the following sterling cash flow from the project:

Year $M $/£ £M0 -1 1.9000 -0.5261 +0.54 1.9543 +0.2762 +0.583 2.0102 +0.2903 +0.630 2.0677 +0.305

This cash flow has an NPV of £123 000 at r=16%

However, suppose that US inflation turns out to be higher than expected,say 12% rather than 8%. It means that the future exchange rates will alsodiffer:

Rate of change in $: (0.12-0.05)/1.05 = +0.067

Year 1: 1.9000*(1.067) = 2.0273Year 2: 2.0273*(1.067) = 2.1631Year 3: 2.1631*(1.067) = 2.3081

Will the UK parent suffer from this unexpected, adverse movement in the $/£ exchange rates?

Year $M $/£ £M0 -1 1.9000 -0.5261 +0.56 2.0273 +0.2762 +0.627 2.1631 +0.2903 +0.702 2.3081 +0.304

Again, NPV = £123 000 (at r =16%)

Hence, the UK parent doesn’t suffer; the reason being that the increasedUS inflation should result in increased dollar cash flows from the projectwhich now will inflate up at 12% rather that 8%.

Life does not work quite so perfectly!

The risk of unexpected FX movements does exist for firmsinvesting overseas!

Is this risk wholly systematic or unsystematic or partly both?

The answer is uncertain and depends partly upon if country capitalmarkets are segmented (independent) or integrated.

Solve the FX risk problem by selling forward the project’s expectedforeign currency net cash flow

These are only expected

What if a forward market does notexist?

Country/ Political risk

Source: Euromoney, September 2004 (www.euromoney.com).