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BUSINESS FINANCE
FINS3616
Tutorial
Week 10
CONTACT DETAILS
Your Tutor:
Peter Andersen
peter.andersen@unsw.edu.au
2
FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 1
You work for an Israeli company that is considering an investment in
China. The investment yields after‐tax Chinese Yuan cash flows (in
millions) as follows:
OUTLAY YEAR 1 YEAR 2 YEAR 3
‐CNY 600 CNY 200 CNY 500 CNY 300
The required return for this risk class is iILS = 15% in Israel new Shekels
and 11.745% in Yuan.
Expected inflation is 6% in shekels and 3% in Yuan. Risk‐free
government bonds yield 8.12% in shekels. China Construction Bank
bonds are risky and yield 6.09% in Yuan.
The spot exchange rate is S0 = ILS 0.5526/CNY.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 1
Assume the international parity conditions hold. Calculate the
present value of the investment by using the Chinese discount rate
and then converting into Shekels at the current spot rate.
CNY194.39m
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 1
Q. Assume the international parity conditions hold. Convert the
cash flows at expected future spot rates, and then find the
present value using the Israeli discount rate.
A. First, calculate the expected future spot rates
1
1 ρ
ILS
0.5526 1.06 1.03 ILS 0.5687/CNY
1
E[S1 ] S
ILS/CNY
0 CNY
1 ρ
5
FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 1
Once we have the expected spot rates, we find the expected ILS value
of the cash flows.
t = 0 t = 1 t = 2 t = 3
CFs in CNY –CNY 600 +CNY 200 +CNY 500 +CNY 300
St / E[St] ILS 0.5526/CNY ILS 0.5687/CNY ILS 0.5853/CNY ILS 0.6023/CNY
CFs in ILS –ILS 331.56 +ILS 113.74 +ILS 292.63 +ILS 180.69
And then we find the present value…
6
FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15— CONCEPTUAL QUESTION 2
Q. Discuss each cell in Figure 14.5. What should (or shouldn’t) a
firm do when faced with a foreign project that fits the
description in each cell?
A. The answer to this question is probably one of the most
important things you can get out of Chapter 15 of the textbook.
The NPV calculations themselves are straightforward enough
(especially when they give us the same conclusion because the
parity conditions hold), but our choices when the two NPV
methods conflict is less intuitive.
Read the textbook section on this thoroughly and in its entirety,
rather than rely on a summary by me.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
You currently live in the Land‐of‐Leisure (currency is the “L”), and you are
considering investment in a shop in a foreign country called Land‐of‐Work (currency
is “W”). Financial markets are perfect and the international parity conditions hold.
The investment will be funded with 100% equity. We have the following
information.
LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
The spot exchange rate is W100/L.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
a) What is the nominal required return on print‐shop projects in L. And in W?
i Lnom 1 i real
L
1 ρL 1 1 0.10 1 0.00 1 0.10 or 10%
W
i nom 1 i 1 ρ 1
W
real
W
1 0.10 1 0.50 1 0.65 or 65%
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
LEISURE WORK
Nominal Risk Free 0% 50%
Real Required Return on Risk Free 0% 0%
Expected inflation 0% 50%
Real Required Return on Shops 10% 10%
b) Identify the expected future spot rates for the next two years.
t
1 ρ W
E S W/L
t
S W/L
0 L
1 ρ
1
E S
W/L
W100/L 1.50 W150/L W150/L
1 1.00
2
E S W/L
W100/L 1.50 W225/L W225/L
2 1.00
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
c) We have the following information about the project:
• It will last two years
• The land for the shop costs W200,000 and will maintain its real value, before
being sold at the end of the project.
• Building the shop will cost another W200,000, which will be straight‐line
depreciated over two years to a salvage value of zero. The shop will have zero
market value at the end of two years.
• No investment in working capital is necessary.
• Diplomas sell for W200 each and will maintain their real value. 2,000 will be
sold per year.
• Variable costs are 20% of sales. Fixed costs are W45,000 in the first year and
grow with inflation.
• Income and capital gains taxes in both countries are 50%.
• Assume all operating cash flows occur at the end of the year.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
Identify the expected future cash flows in W on the investment
project. Discount them using the W discount rate and convert them
back at the spot rate.
To do this, we need:
• Investment cash flows (initial outlays)
• Operating cash flows
• Terminal cash flows
12
FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
OCF Calculation: YEAR 1 YEAR 2
Revenue 600,000 900,000
Less: Variable Costs 120,000 180,000
Less: Fixed Costs 45,000 67,500
Less: Depreciation 100,000 100,000
= EBIT 335,000 552,000
Less: Tax @ 50% 167,500 276,250
= NOPAT 167,500 276,250
Add Back: Depreciation 100,000 100,000
= Operating Cash Flows W267,500 W376,250
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
YEAR 0 YEAR 1 YEAR 2
Investment Cash Flows (Land) –200,000
Investment Cash Flows (Plant) –200,000
Operating Cash Flows 267,500 376,250
Terminal Cash Flows (Land) 450,000
Terminal Cash Flows (Tax on Land) –125,000
Net Cash Flow in W –W400,000 W267,500 W701,250
267,500 701,250
NPV | i W400,000
W W
1 0.65 1 0.65
0 1 2
W19, 697
W19,697 W19,697
NPV | i
L
0
W
W/L
L197
S0 W100 / L
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 14 — PROBLEM 3
YEAR 0 YEAR 1 YEAR 2
Investment Cash Flows (Land) –200,000
Investment Cash Flows (Plant) –200,000
Operating Cash Flows 267,500 376,250
Terminal Cash Flows (Land) 450,000
Terminal Cash Flows (Tax on Land) –125,000
Net Cash Flow in W –W400,000 W267,500 W701,250
Spot / Expected Spot W100/L W150/L W225/L
Net Cash Flow converted to L –L4,000 L1,783.33 L3,116.66
L1,783.33 L3,116.66
NPV | i L4,000
L L
1 0.10 1 0.10
0 1 2
=L197
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15— CONCEPTUAL QUESTION 2
Q. What distinguishes an integrated from a segmented capital
market?
A. In an integrated market, real after‐tax required returns on
equivalent assets are the same everywhere the assets are traded.
If real after‐tax rates of return are different in a particular market,
then that market is at least partially segmented from other
markets.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15— CONCEPTUAL QUESTION 3
Q. What factors could lead to capital market segmentation?
A. Violations of any of the perfect market conditions can lead to
capital market segmentation.
These factors include:
• prohibitive transactions costs
• differing legal and political systems
• regulatory interference (e.g., barriers to financial flows or to
financial innovation)
• differential taxes or tax regimes,
• informational barriers such as disclosure requirements, home
asset bias, and differential investor expectations.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15— CONCEPTUAL QUESTION 4
Q. Does the required return on a project depend on who is
investing the money or on where the money is being invested?
A. The required return on an investment project should be an asset‐
specific discount rate that reflects the opportunity cost of capital
on the project.
That is, it depends on where the money is going and not from
where it came.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15— CONCEPTUAL QUESTION 5
Q. Does the value of a foreign project depend on the way it is
financed?
A. Yes.
Additional debt brings additional tax shields from the tax
deductibility of interest payments as well as additional costs of
financial distress.
The adjusted present value approach to project valuation
attempts to separate the value of the unlevered project from the
value of these financial side‐effects.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 3a
Q. Find Oilily’s WACC in France under this following scenario.
• Oilily has a market value debt‐to‐value ratio of 40%.
• Their pre‐tax borrowing cost on new long‐term debt is 7% in France
• Their beta relative to the French stock market is 1.4
• The risk‐free rate in France is 5% and the market risk premium is 6%.
• Interest is deductible in France and the tax rate is 33%.
E D
WACC re rd 1 TC
V V
A. We have everything but E/V and re. How do I find them?
E D E D
1 1 1 0.40 0.60
V V V V
re rf β rm rf 5% 1.4 6% 13.4%
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 3a
E D
WACC re rd 1 TC
V V
WACC 9.916%
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 3b
Q. Find Oilily’s WACC under this second scenario.
• Oilily can borrow in the Europound market at a pretax cost of 6%
• International investors will tolerate a 50% debt‐to‐value mix.
• With that debt‐to‐value ratio, their beta against the world market is 1.2.
• The required return on the world market portfolio is 12%.
• The risk‐free rate is still 5%.
• We have everything but E/V and r
re 5% 1.2 12% 5% 13.4%
e. How do I find them?
• 1 – D/V = E/V 1 – 0.4 = 0.6 = E/V
E D
WACC re rd 1 TC
V V
WACC 0.5 13.4% 0.5 6% 1 0.33
WACC 8.710%
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 3c
Q. Find the value of Oilily using the WACCs calculated in parts A
and B and the following information:
• The firm will generate after‐tax operating cash flows of CF1 = EUR 10
million in the coming year.
• This cash flow is expected to grow at 4% in perpetuity.
Oilily can increase its value by over 25% by financing in international markets
because of this market’s higher tolerance for debt and lower required
returns.
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 5a
Q. Suppose Oilily uses an APV approach to valuation.
• Oilily’s latest investment proposal is for a chain of retail stores in the
United Kingdom.
• Initial investment will be €100m and will produce a single after‐tax cash
flow of €12m after one year.
• The chain is expected to be sold to a U.K. company for €100m (after tax)
at the end of the year.
• Oilily has an all‐equity discount rate of 10%.
• What is the value of Oilily's project as an all‐equity investment?
EUR112m
EUR100m EUR 1,818,182
1 0.10
1
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
CHAPTER 15 — PROBLEM 5b
Q. Again, suppose Oilily uses an APV approach to valuation.
• Now suppose the project can support up to €50m in debt at a pre‐tax cost
of 6%.
• Principal and interest (as well as the interest tax shield) are due in one
year.
• The corporate tax rate is 33%.
• What is the value of the tax shield from the use of the debt?
• Ignoring other financial side effects (costs of distress, etc), what is the
value of Oilily’s project as a levered investment?
TC i b B1 0.33 €3m
Tax Shield 0 €933,962
1 i b 1 0.06
1 1
CF1
APVUnlevered VU CF0 Initial Investment
iU ib B Interest Payment1
€12m 0.06 €50m €3m
€100m €20m
0.10
TC ib B
Tax Shield 0 TC B 0.33 €50m €16.5m
ib
APVLevered APVUnlevered Tax Shield 0 €20m €16.5m €36.5m
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FINS3616 — Peter Kjeld Andersen (2012‐S2)
THE END
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FINS3616 — Peter Kjeld Andersen (2012‐S2)