The objective underlying hedging should be made explicit.
Trying to manage accounting exposure is inconsistent with empirical evidence; since it
doesnt affect cashflows, it amounts to assuming that investors cannot see beyond financial
statements.
If this assumption is false, hedging for this purpose would have positive costs and no
benefits.
Selective hedging may end up increasing cashflow variances, rather than reduce them, if the
firm has no predictive abilities.
All costs of hedging should be taken into account. For example, the cost of increasing LC
borrowings is the cost of the LC loan less the profit generated from those funds, such as prepaying a
hard currency loan. Interest rates on loans in local currencies may be higher because of anticipated
devaluations
Forward Market Hedge
A company that is long (short) a foreign currency will sell (buy) the foreign currency forward.
Suppose GE expects to received 10m. from the sale of turbines in 1 year.
Suppose the current spot price is $1.00/ and the forward price is $0.957/.
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A forward sale of 10m. For delivery in one year will yield GE $9.57m on Dec. 31.
Without hedging, GE will have a 10m asset, whose value will fluctuate with the euro. With the
hedge, the value is fixed at $9.57m
Hedging with forward contracts eliminates the forward risk at the expense of forgoing the upside
potential.
Money Market Hedge
A money market hedge involves simultaneous borrowing and lending in two different currencies
to lock in the dollar value of a future foreign currency flow.
Suppose Euro and US dollar interest rates are 15% and 10% resply.
GE can borrow (10/1.15)m = 8.7m in the spot market and invest it for one year.
On 12/31, GE will get (1.1)(8.7) = $9.57m
GE will use the 10m from its euro receivable to repay the euro loan.
The payoff in one year should be the same with the forward hedge or the money market hedge
provided interest rate parity holds.
Exposure Netting
This refers to offsetting exposures in one currency with exposures in the same or other currency,
where exchange rates are expected to move in such a way that loss on the first exposed position
are offset by gains on the second exposure. This assumes that the net gain or loss on the entire
currency exposure portfolio is what matters.
This can be achieved in one of three ways:
A firm can offset a long position in a currency with a short position in that same
currency.
If the exchange rate movements of two currencies are positively correlated, then the firm
can offset a long position in one currency with a short position in the other.
If the currency movements are negatively correlated, then short (or long) positions can be
used to offset each other.
Such offset of exposures does not require actual netting (bilateral or multilateral). Rather, if there
is the potential for actual netting, then there is no real exchange exposure, whether or not the
netting is actually done.
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However, it may be useful to do the actual netting one to reduce costs, and two, to have better
control of how much hedging is actually necessary.
Reinvoicing centers and in-house factoring can also procure the same result.
Cross Hedging
Hedging with futures is similar to hedging with forwards.
However, it is very difficult to find a futures contract that matches the needs of the hedger in
currency, maturity and amount simultaneously.
As long as the futures price on the futures contract that is available is positively correlated with
the exposure being hedged, the company can obtain some protection. Such use of futures
contracts is called cross-hedging.
Suppose a US firm has a Danish Krone receivable, but it wants to use euro futures to hedge.
Then, the slope coefficient from the regression of changes in the DK/$ rate against changes in the
/$ rate is the number of euros it should sell forward per DK.
Foreign Currency Options
Using forwards/futures or currency collars makes sense if the extent of the exposure is known.
However, at times, a firm might want to hedge against a future exposure that might or might not
materialize.
In this case, using forwards might not be a good idea. If the exposure does materialize, well and
good. However, if the exposure does not materialize, then the firm would end up with an
unwanted exposure, once again.
One way around this would be to buy an option. This is more like insurance.
Internal hedging techniques
Internal hedging means using techniques available within the company or group to manage
exchange-rate risks. These techniques do not operate through the foreign exchange markets and
therefore they avoid the associated costs. However, this does not mean they are costless.
- Invoicing in the home currency
Here, the company simply invoices in its own currency. The exchange rate risk is not avoided, it
is merely transferred to the customer. This technique may not always be possible, given that the
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company may well be competing with local industries invoicing in the local currency, and, as
such, the overseas quote may become uncompetitive.
- Bilateral and multilateral netting
This is a form of matching appropriate for multinational groups or companies with subsidiaries
or branches in a number of overseas countries. Bilateral netting applies where pairs of companies
in the same group net off their own positions regarding payables and receivables, often without
the involvement of a central treasury department. Multilateral netting is performed by a central
treasury department where several subsidiaries are involved and interact with head ofce. The
process is based on determining a base currency, for example, sterling or US dollars, so that the
intra-group transactions are recorded only in that currency; each group company reports its
obligations to other group companies to a central, say UK, treasury department, which then
informs each subsidiary of the net receipt or payment needed to settle their foreign exchange
intra-group positions. While this procedure undoubtedly reduces transaction costs by reducing
the number of transactions and also reduces exchange-rate risk by reducing currency ows, the
difculties are that there are regulations in certain countries which severely limit or even prohibit
netting, and there may also be cross-border legal and taxation problems to overcome as well as
the extra administrative costs of the centralised treasury operation.
- Hedging with Forwards
Hedging refers to managing risk to an extent that makes it bearable. In international trade and
dealings foreign exchange play an important role. Fluctuations in the foreign exchange rate can
have significant impact on business decisions and outcomes. Many international trade and
business dealings are shelved or become unworthy due to significant exchange rate risk
embedded in them. Historically, the foremost instrument used for exchange rate risk
management is the forward contract. Forward contracts are customized agreements between
two parties to fix the exchange rate for a future transaction. This simple arrangement would
easily eliminate exchange rate risk, but it has some shortcomings, particularly getting a counter
party who would agree to fix the future rate for the amount and time period in question may not
be easy. In Malaysia many businesses are not even aware that some banks do provide forward
rate arrangements as a service to their customers. By entering into a forward rate agreement
with a bank, the businessman simply transfers the risk to the bank, which will now have to bear
this risk. Of course the bank in turn may have to do some kind of arrangement to manage this
risk. Forward contracts are somewhat less familiar, probably because there exists no formal
trading facilities, building or even regulating body.
- Hedging with Futures
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Noting the shortcomings of the forward market, particularly the need and the difficulty in finding
a counter party, the futures market came into existence. The futures market basically solves
some of the shortcomings of the forward market. A currency futures contract is an agreement
between two parties a buyer and a seller to buy or sell a particular currency at a future date, at
a particular exchange rate that is fixed or agreed upon today. This sounds a lot like the forward
contract. In fact the futures contract is similar to the forward contract but is much more liquid.
It is liquid because it is traded in an organized exchange the futures market (just like the stock
market). Futures contracts are standardized contracts and thus are bought and sold just like
shares in the stock market. The futures contract is also a legal contract just like the forward, but
the obligation can be removed before the expiry of the contract by making an opposite
transaction. As for hedging with futures, if the risk is an appreciation of value one needs to buy
futures and if the risk is depreciation then one needs to sell futures. Consider our earlier
example, instead of forwards, Company A could have thus sold Rupee futures to hedge against
Rupee depreciation. Lets assume accordingly that Company A sold Rupee futures at the rate
RM0.10 per Rupee. Hence the size of the contract is RM1,000,000. Now say that Rupee
depreciates to RM0.07 per Rupee the very thing Company A was afraid of. Company A would
then close the futures contract by buying back the contract at this new rate. Note that in essence
Company A basically bought the contract for RM0.07 and sold it for RM0.10. This would give a
futures profit of RM300,000 [(RM0.10-RM0.07) x 10,000,000]. However in the spot market
Company A gets only RM700,000 when it exchanges the 10,000,000 Rupees contract value at
RM0.07. The total cash flow however, is RM1,000,000 (RM700,000 from spot and RM300,000
profit from futures). With perfect hedging the cash flow would be RM1 million no matter what
happens to the exchange rate in the spot market. One advantage of using futures for hedging is
that Company A can release itself from the futures obligation by buying back the contract
anytime before the expiry of the contract. To enter into a futures contract a trader needs to pay a
deposit (called an initial margin) first. Then his position will be tracked on a daily basis so much
so that whenever his account makes a loss for the day, the trader would receive a margin call
(also known as variation margin), i.e. requiring him to pay up the losses.
- Hedging using Options
A currency option may be defined as a contract between two parties a buyer and a seller -
whereby the buyer of the option has the right but not the obligation, to buy or sell a specified
currency at a specified exchange rate, at or before a specified date, from the seller of the option.
While the buyer of option enjoys a right but not obligation, the seller of the option nevertheless
has an obligation in the event the buyer exercises the given right. There are two types of options:
Call options gives the buyer the right to buy a specified currency at a specified exchange rate,
at or before a specified date.
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Put options gives the buyer the right to sell a specified currency at a specified exchange rate,
at or before a specified date. Of course the seller of the option needs to be compensated for
giving such a right.
The compensation is called the price or the premium of the option. Since the seller of the option
is being compensated with the premium for giving the right, the seller thus has an obligation in
the event the right is exercised by the buyer. For example assume a trader buys a September
RM0.10 Rupee call option for RM0.01. This means that the trader has the right to buy Rupees
for RM0.10 per Rupee anytime till the contract expires in September. The trader pays a
premium of RM0.01 for this right. The RM0.10 is called the strike price or the exercise price. If
the Rupee appreciates over RM0.10 anytime before expiry, then the trader may exercise his right
and buy it for RM0.10 per Rupee. If however Rupee were to depreciate below RM0.10 then the
trader may just let the contract expire without taking any action since he is not obligated to buy it
at RM0.10. If he needs physical Rupee, then he may just buy it in the spot market at the new
lower rate. In hedging using options, calls are used if the risk is an upward trend in price and puts
are used if the risk in a downward trend in price. In our Company A example, since the risk is a
depreciation of Rupees, Company A would need to buy put options on Rupees. If Rupees were
to actually depreciate by the time Company A receives its Rupee revenue then Company A
would exercise its right and exchange its Rupees at the higher exercise rate. If however Rupees
were to appreciate instead, Company A would just let the contract expire and exchange its
Rupees in the spot market for the higher exchange rate. Therefore the options market allows
traders to enjoy unlimited favourable movements while limiting losses. This feature is unique to
options, unlike the forward or futures contracts where the trader has to forego favourable
movements and there is also no limit to losses.
Options are particularly suited as a hedging tool for contingent cash flows, for example like in
bidding processes. When a firm bids for a project overseas, which involves foreign exchange
risk, it may quote its bidding price and at the same time protect itself from foreign exchange risk
by buying put options. If the bidding was successful, the firm will be protected from a
depreciation of the foreign currency. However, if the bidding was unsuccessful and the currency
appreciated, then the firm may just let the contract expire. In this case the firm loses the
premium paid, which is the maximum loss possible with options. If the bidding was
unsuccessful and the currency depreciated, the firm may exercise its right and make some profits
from this favourable movement. In the case of hedging with forward or futures, the firm would
be automatically placed in a speculative position in the event of an unsuccessful bid, without a
limit to its downside losses.
SWAPS
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Swaps literally mean exchange.
An agreement between the two parties to exchange a series of payments the terms of which are
predetermined can be considered as financial swap.
Financial swap are broadly classified into
Interest Rate Swaps
Currency rate Swaps
Interest Rate Swaps
In the interest rate swaps or the plain vanilla swap the fixed rate obligations are exchanged for
floating rate obligations over a specified period of time for a notional principal.
Let us assume that X & Y enter the interest rate swap agreement wherein X lends to Y at LIBOR
and Y lends to X at fixed rate 10% .
The net cost of funds to X and Y using the swap agreement can be seen by examining their cash
flows.
Currency Swaps
Currency swaps involve three steps, although the first step may be notional.
- Intial exchange of principal
- Exchange of interest rates
- Re-exchange of principal at the end of the contract.
Generally this is known as cross- currency swaps
A cross-currency swap is an interest rate swap in which the cash flows are in different
currencies. Upon initiation of cross currency swap, the counterparties make the initial exchange
of the notional principals in the two currencies. During the life of the swap, each party pays
interest( in the currency of the principal received) to the other. And at the maturity of the swap,
the parties make a final exchange of the initial principal amounts, reversing the initial exchange
at the same spot rate.
Generic cross currency swap: A 5 year EUR/USD example (Spot =1.30)
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The figure above illustrates a structure in which the company receives USD interest and pays
EUR interest. The front and back exchanges of principal amounts are based on the current spot
rate. The grey Euro cash flows are economically equivalent to issuing a Euro bond; the USD
cashflows are equivalent to investing in a USD bond. If paired with a USD borrowing, the CCS
converts the USD borrowings into a synthetic EUR one; if paired with a EUR investment, the
CCS converts the EUR asset into a synthetic USD one.
Country Risk Analysis
A collection of risks associated with investing in a foreign country. These risks include political
risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of
capital being locked up or frozen by government action. Country risk varies from one country to
the next. Some countries have high enough risk to discourage much foreign investment.
Country risk can reduce the expected return on an investment and must be taken into
consideration whenever investing abroad. Some country risk does not have an effective hedge.
Other risk, such as exchange rate risk, can be protected against with a marginal loss of profit
potential.
The United States is generally considered the benchmark for low country risk and most nations
can have their risk measured as compared to the U.S. Country risk is higher with longer term
investments and direct investments, which are investments not made through a regulated market
or exchange.
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Country risk refers to the risk of investing in a country, dependent on changes in the business
environment that may adversely affect operating profits or the value of assets in a specific
country. For example, financial factors such as currency controls, devaluation or regulatory
changes, or stability factors such as mass riots, civil war and other potential events contribute to
companies' operational risks. This term is also sometimes referred to as political risk; however,
country risk is a more general term that generally refers only to risks affecting all companies
operating within a particular country.
Political risk analysis providers and credit rating agencies use different methodologies to assess
and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative
econometric models and focus on financial analysis, whereas political risk providers tend to use
qualitative methods, focusing on political analysis. However, there is no consensus on
methodology in assessing credit and political risks.
MNCs constantly assess business environments of countries they operate in, as well as the ones
they are considering investing in. Similarly, private and public investors are interested in
determining which countries offer the best opportunities for sound investments.
This is the area of country risk analysis --- assessing the potential risks and rewards associated
with making investments and doing business in a country.
MNCs are interested in the economic policies of these countries, because economic policies
determine the business environment. However, country risk assessment cannot be only economic
in nature. It is also important to consider the political factors that lead to economic policies. This
interaction of politics and economics is the subject area of political economy.
Key Indicators
Expropriation (nationalization) is the most extreme form of political risk. However, there are
other levels and forms of political risk, including currency and trade controls, changes in tax or
labor laws, regulatory restrictions, and requirements for additional local production.
Political risk can be assessed from a country-specific (macro or country risk analysis) and a firm-
specific (micro or firm risk analysis) perspective. A useful indicator of the degree of political risk
is the seriousness of capital flight. Capital flight refers to the export of savings by a nations
citizens because of fears about the safety of their capital.
We now turn to some key indicators of the general level of risk in the country as a whole
termed country risk. Some of the common characteristics of country risk are:
i) A large government deficit relative to GDP
ii) A high rate of money expansion, especially if it is combined with a relatively fixed
exchange rate
iii) Substantial government expenditures yielding low rates of return
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iv) Price controls, interest rate ceilings, trade restrictions, rigid labor laws, and other
government-imposed barriers to the smooth adjustment of the economy to changing relative
prices
v) High tax rates that destroy incentives to work, save, and invest
vi) Vast state-owned firms run for the benefit of their managers and workers
vii) a citizenry that demands, and a political system that accepts, government responsibility
for maintaining and expanding the nations standard of living through public-sector spending and
regulations (the less stable the political system, the more important this factor will likely be.)
viii) Pervasive corruption that acts as a large tax on legitimate business activity, holds back
development, discourages foreign investment, breeds distrust of capitalism, and weakens the
basic fabric of society
ix) the absence of basic institutions of government a well-functioning legal system, reliable
regulation of financial markets and institutions, and an honest civil service
Alternatively, indicators of a nations long-run economic health include the following:
a) A structure of incentives that rewards risk taking in productive ventures
b) A legal structure that stimulates the development of free markets
c) Minimal regulations and economic distortions
d) Clear incentives to save and invest
e) An open economy
f) Stable macroeconomic policies
In summary, from the standpoint of an MNC, country risk analysis is the assessment of factors
that influence the likelihood that a country will have a healthy investment climate. Several costly
lessons have led to a new emphasis on country risk analysis in international banking as well.
From the banks standpoint, country risk the credit risk on loans to a nation is largely
determined by the real cost of repaying the loan versus the real wealth that the country has to
draw on. These parameters, in turn, depend on the variability of the nations terms of trade and
the governments willingness to allow the nations standard of living to adjust rapidly to
changing economic fortunes.
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Module VIII
International Capital Budgeting
Concept, Evaluation of a project, Factors affecting, Risk Evaluation, Impact on Value,
Adjusted Present Value Method
Concept
Capital budgeting (or investment appraisal) is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth the funding of cash through
the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures. One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.
Many formal methods are used in capital budgeting, including the techniques such as
- Accounting rate of return
- Payback period
- Net present value
- Profitability index
- Internal rate of return
- Modified internal rate of return
- Equivalent annuity
- Real options valuation
These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.
In International capital budgeting multinational firms engaged in evaluating foreign projects face
a number of complexities, many of which are not there in the domestic capital budgeting process.
International capital budgeting is more complicated than domestic capital budgeting.
International capital budgeting involves substantial spending(capital investment) in projects that
are located in foreign(host) countries, rather than in the home country of the MNC.
Foreign-exchange rates, interest rates, and inflation are three external factors that affect
multinational companies (MNCs) and their markets. Changes in these three factors stem from
several sources, such as economic conditions, government policies, monetary systems, and
political risks. Each factor is a significant external variable that affects areas such as policy
decisions, strategic planning, profit planning, and budget control. To minimize the possible
negative impact of these factors, MNCs must establish and implement policies and practices that
recognize and respond to their influences.
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These three factors exchange rates, interest rates, and inflation affect sales budgets, expense
budgets, capital budgeting, and cash budgets. However, they are particularly useful when
evaluating international capital budgeting alternatives.
Foreign-exchange rates have the most significant effect on the capital budgeting process. A
foreign investment project will be affected by exchange rate fluctuations during the life of the
project, but these fluctuations are difficult to forecast. There are methods of hedging against
exchange rate risks, but most hedging techniques are used to cover short-term positions.The cost
of capital is used as a cutoff point to accept or reject a proposed project. Because the cost of
capital is the weighted average cost of debt and equity, interest rates play a key role in a capital
expenditure analysis. Most components of project cash flows revenues, variable costs, and
fixed costs are likely to rise in line with inflation, but local price controls may not permit
internal price adjustments. A capital expenditure analysis requires price projections for the entire
life of the project. In some The basic principles of analysis are the same for foreign and domestic
investment projects. However , a foreign investment decision results from a complex process,
which differs, in many aspects, from the domestic investment decision.
Relevant cash flows are the dividends and royalties that would be repatriated by each subsidiary
to a parent firm. Because these net cash flows must be converted into the currency of a parent
company, they are subject to future exchange rate changes. Moreover, foreign investment
projects are subject to political risks such as exchange controls and discrimination. Normally, the
cost of capital for a foreign project is higher than that for a similar domestic project. Certainly,
this higher risk comes from two major sources, political risk and exchange risk.
Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the
cash inflows and outflows associated with prospective long-term (foreign) investment projects.
The basic steps are:
Identify the initial capital invested
Estimate cash flows to be derived from the project over time, including an estimate of the
terminal value of the investment
Identify the appropriate discount rate to use in valuation
Apply traditional capital budgeting decision criteria such as Net Present Value (NPV) and
Internal Rate of Returns (IRR)
Alternative, Adjusted Present Value (APV).
Evaluation of a project
In sum, the capital budgeting process is the tool by which a company administers its investment
opportunities in additional fixed assets by evaluating the cash inflows and outflows of such
opportunities. Once such opportunities have been identified or selected, management is then
tasked with evaluating whether or not the project is desirable.
Depending on the business, the competitive environment and industry forces, companies will
certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember
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that the capital budgeting process involves two sets of decisions, investment decisions and
financial decisions; given the unique business and market environments that exist at the time,
each decision may not initially be seen as worthwhile individually, but could be worthwhile if
both were to be undertaken.
Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks
announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million.
The offer price for Teavana represented a 50% premium over the then market value of Teavana.
Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana.
Looking at this capital investment today, one can suggest that the financial decision paying
$620 million for a company that generated $167 and $18 million in sales and profits in 2011
was not a desirable one for Starbucks.
On the other hand, from an investment perspective, Starbucks is paying $620 million for
ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the
fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks
approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality
tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a
purely financial perspective, the decision would have ignored that highly-valuable benefit of
combining the most well-known coffee brand with the highest-quality tea brand.
Generally speaking however, businesses will consider the following questions when evaluating
whether or not a project is desirable and should be pursued.
What Will the Project Cost?
This is the first and most basic question a company must answer before pursuing a project.
Identifying the cost, which includes the actual purchase price of the assets along with any future
investment costs, determines whether or not the business can afford to take on such a project.
How Long Will It Take to Re-coup the Investment?
Once the costs have been identified, management must determine the cash return on that
investment. An affordable project that has little chance of recouping the initial investment, in a
reasonable period of time, would likely be rejected unless there were some unique strategic
decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is
matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related
projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that
management's forecast will prove accurate or correct; nevertheless, forecasting future cash
inflows and outflows are a vital exercise in the capital budgeting process.
Mutually Exclusive or Independent?
All investment projects are considered to be mutually exclusive or independent. An independent
project is one where the decision to accept or reject the project has no effect on any other
projects being considered by the company. The cash flows of an independent project have no
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effect on the cash flows of other projects or divisions of the business. For example the decision
to replace a company's computer system would be considered independent of a decision to build
a new factory.
A mutually-exclusive project is one where acceptance of such a project will have an effect on the
acceptance of another project. In mutually exclusive projects, the cash flows of one project can
have an impact on the cash flows of another. Most business investment decisions fall into this
category. Starbucks decision to buy Teavana will most certainly have a profound effect on the
future cash flows of the coffee business as well as influence the decision making process of other
future projects undertaken by Starbucks.
Factors affecting International Capital Budgeting
Exchange Rate fluctuations
Inflation
Financing Arrangements
Subsidiary financing
Parent financing
Financing with other subsidiarys Retained Earnings
Blocked funds
In some cases, the host country may block funds that the subsidiary attempts to send to
the parent. Some countries require that earnings generated by the subsidiary be
reinvested locally for at least 3 years before they can be remitted. Political coditions in
the host country and restrictions that may be imposed by a countrys host govt. needs to
be considered.
Uncertain salvage value
Impact of project on prevailing cash flows
Host govt. incentives
Real options
A real option is an option on specified real assets such as machinery or a facility.
Some capital budgeting projects contain rel option in that they may allow
oppurtunities to obtain or eliminate real assets. Since these opportunities can
generate cash flows, they can enhance value of the project.
Risk Evaluation
Project Risk
Some of the risk you face from a long-term investment is from the project itself. Project risk
approximates the chance that the project will not be as profitable as expected due to errors from
the company or from the project's initial evaluation. Project risk is increased when a company
invests in a business that is not in its area of expertise. This increases the chance that
management will not be able to properly value the project's cash flows and that the company will
make errors while running the business.
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Market Risk
Market risk measures the part of a project's risk from macroeconomic factors such as inflation
and interest rates. Market risk is increased during a weak economy. A poor economy can
decrease demand for a product, potentially turning a project unprofitable. Banks may be more
reluctant to lend in a weak economy, raising the cost of capital for the project. High inflation can
also be a problem at it weakens the long-term real return of the project. These factors increase
the market risk of a project and contribute higher total risk.
International Risk
If a company's capital budget project will involve another country, it will be exposed to
international risk. This entails political and exchange-rate risk of the project. If a project is based
in a country with an unstable political structure, civil or political unrest could cause the entire
investment to be lost. If currency rates move in an unfavorable direction, the company could face
higher relative costs and lower relative gains. Domestic projects are completely devoid of this
type of risk.
Methods commonly used to adjust the evaluation of risk:
Risk-adjusted discount Rate
Sensitivity analysis
Simulation
Adjusted Present Value Method
The APV model is a value-additivity approach to capital budgeting. That is, each cash flow that
is a source of value is considered individually. Note that in the APV model, each cash flow is
discounted at a rate of discount consistent with the risk inherent in that cash flow. The OCFt and
TVT are discounted at Ku. The firm would receive these cash flows from a capital project
regardless of whether the firm was levered or unlevered. The tax savings due to interest, It, are
discounted at the before-tax borrowing rate, i, as in equation 8b. It is suggested that the tax
savings due to risky than operating cash flows if tax laws are not likely to change radically over
the 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. If APV < 0, the project should be rejected. Thus, the model is
useful for a MNC for analyzing one of its domestic capital expenditures or for a foreign
subsidiary of the MNC analyzing a proposed capital expenditure from the subsidiarys
viewpoint.