Financing International

Projects
 Capital Budgeting
Capital budgeting requires estimation of a project’s
incremental cash flows - which are determined
by estimating worldwide cash flows with and
without the project.
There are two main methods of international capital
budgeting, centralized and decentralized
Centralized requires exchange rate forecasts
Decentralized requires a local-currency cost of
capital.
The method a firm selects should depend on its
comparative advantage in estimating each.
 Cost of Capital I
CAPM determines a project’s equity cost of capital -
it prices only the systematic risk of the project.
If risk premia are identical and uncovered interest
parity holds, the only difference between home
and foreign costs of capital will be anticipated
exchange rate changes.
In this case, centralized and decentralized capital
budgeting will deliver identical results - the
foreign cost of capital will perform dual roles of
discounting and adjusting for anticipated
exchange rate changes.
 Cost of Capital II
If anticipated deviations from uncovered interest
parity exist, centralized capital budgeting will
deliver higher returns when deviations are
positive and lower when negative.
Centralized is also easier to implement if UIP fails.
If investors do not hold worldwide market portfolio,
decentralized capital budgeting will raise real
capital costs and thereby lower project NPVs
because foreign investor portfolios will co-vary
more with project returns than home country
investor portfolios.
Country Specfic Risk
 Adjusted Present Value

If incentives exist to finance with debt - tax shields

or interest subsidies - Adjusted Present Value
(APV) should be used.
If tax treatments are symmetric, and if uncovered
interest parity is expected to hold, tax shields
will have identical value whether debt is raised in
host or home country.
Low capital gains taxes, high deductibility of interest
payments, negative failure of UIP, and
subsidized interest rates will all favor financing
in depreciating currencies.
 Political Risk

Centralized capital budgeting requires expected

cash flows to be adjusted for political risk - not
cost of capital.
Foreign political risk is unlikely to be systematic
to the risks of domestic shareholder portfolios.
Sensitivity analysis is an alternative to calculation of
exact political risk probabilities: solve for
probability that sets NPV=0 and then ask
whether it’s reasonable - if so, NPV is quite
possibly negative.
Financing Foreign Projects
Financing

Internal External
 Financing Foreign Projects
Financing

Internal External

Debt Equity Debt Equity

 Financing Foreign Projects
Financing

Internal External

Debt Equity Debt Equity

Home Foreign
Currency Currency
 Financing Foreign Projects
Financing

Internal External

Debt Equity Debt Equity

Home Foreign Home Foreign

Currency Currency Currency Currency
 Internal Debt vs. Internal Equity
The primary tradeoffs between internal debt and
internal equity center around taxes.
If internal debt is used, interest payments made from
the subsidiary to the parent are treated on a pre-tax
basis in the host country.
If internal equity is used, dividends repatriated from
the subsidiary to the parent are treated on a post-tax
basis. Generally, home country gives a tax-credit on
foreign taxes paid on repatriated dividends of up to
(but no more than) the home country tax bill on the
dividends.
 Internal Debt vs. Internal Equity
MNCs using internal financing will have greater incentives
to use debt:
1. The more volatile are parent earnings: higher
probability of negative parent earnings means better
chance interest payments will be untaxed.
2. The less volatile are subsidiary earnings: lower
probability of negative subsidiary earnings means less
chance subsidiary will be forced to make interest
payments out of negative earnings that are taxed at the
parent.
3. The larger the host country tax rate compared to the
home country: larger host country tax rate means larger
potential tax shield.
Financing Foreign Projects
Financing

Internal External
 External vs. Internal Financing

The tradeoffs between external and internal

financing will be largely similar to those in a
domestic context:
- issuance costs
- asymmetric information costs
Financing Foreign Projects
Financing

Internal External

Debt Equity
External Debt vs. External Equity
- tax shields
- interest subsidies
Additionally, the monitoring benefits debt may add
over equity addressed in traditional finance
settings will be applicable here.
 Financing Foreign Projects
Financing

Internal External

Debt Equity Debt Equity

Home Foreign
Currency Currency
 Home vs. Host Country Equity
Home and host currency costs of equity capital
would be identical if uncovered interest parity held
and if all investors held diversified world market
portfolio.
Where investors hold domestically-biased assets,
host country cost of capital is likely to be higher.
The project will likely have higher correlation
between its returns and the local economy.
From the host country investor perspective, the
project will contain more systematic risk.
 Home vs. Host Country Equity
From a political risk standpoint, issuing host
country equity is likely to have two divergent
effects:
- political risks (i.e. probability of
expropriation) are likely to be reduced.
- political risks are likely to be more
systematic to risks of host country
shareholders’ portfolios.
 Financing Foreign Projects
Financing

Internal External

Debt Equity Debt Equity

Home Foreign
Currency Currency
 International Debt Financing I
Debt denomination decision is often cast in the
same terms as international capital budgeting:
centralized vs. decentralized debt finance.
An MNC which borrows primarily in the home
country is said to centralize debt finance (though an
MNC certainly can centralize debt finance in any
single country).
An MNC which undertakes borrowing in countries
where operations are located is said to decentralized
debt finance.
 International Debt Financing II
Ex-ante deviations from UIP make centralizing debt
finances attractive. If a given currency’s low
interest rates are not expected to be offset by
appreciation of that currency, firms that can access
the low interest rates and centralize debt finance
there will profit.
Even if UIP holds ex-ante, MNCs will generally have
differential access to markets.
Put simply, domestic firms usually enjoy lower
interest rates in home-country debt markets
than foreign firms.
 The Debt Denomination Decision

If a firm borrows in domestic rather the local

currency, it faces greater exchange rate risk.
The cost of financing in the local currency will
consist (approximately) of the local currency
interest rate premium and the expected exchange
rate change.
The differential can be interpreted as the extent to which
the firm accesses a home-currency financing advantage
in excess of anticipated exchange rate changes. This will
be traded-off against the larger exchange rate risk of
home-currency financing.
 Example: GM and AutoZAZ

GM will invest $500 million in AutoZAZ, an auto

plant located in Zaporizha, Ukraine. With the
investment, AutoZAZ will produce 250,000 cars for
domestic sale annually.
GM expects to receive a return of $300 per car.
The Ukrainian Karbovan currently trades at
$0.741/Karb. Ukrainian inflation is 35%. Ukrainian
interest rates are 40%. U.S. interest rates are 5%.
GM accesses Ukrainian debt markets by a factor of
7% above risk-free rates and accesses U.S. debt
markets by a factor of 5% above risk-free.
Should GM finance with Karbovan or Dollar debt?
 Key Points

1. Primary tradeoff of internal debt vs. equity is

between the tax-shield benefit of debt and the
flexibility of equity dividend repatriation.
2. Firms will tend to favor debt when parent
earnings are volatile, subsidiary earnings are
certain, and subsidiary tax rates are high.
3. With external financing, debt provides
advantages over equity to the extent it offers tax
shields, interest subsidies, and monitoring
benefits.
 Key Points

4. When financing with external equity, firms will

likely face higher equity costs of capital in the
host country market.
5. Local equity will also often alter the magnitudes
and pricing of political risks associated with the
project.
6. In the debt denomination decision, an MNC
which centralizes borrowing in home country is
likely to get more-favorable rates.
 Key Points

7. MNCs which borrow in the currency of the project

produce a natural hedge, offsetting project
returns with debt obligations, and hence facing
less exchange rate and political risk.