BD 506839 ppt31 Student

Chapter 31
International
Corporate Finance
Chapter Outline
31.1 Internationally Integrated Capital Markets

31.2 Valuation of Foreign Currency Cash Flows
31.3 Valuation and International Taxation
31.4 Internationally Segmented Capital Markets
31.5 Capital Budgeting with Exchange Risk
Copyright 2007 Pearson 31-2

Learning Objectives
1. Discuss the condition necessary for

internationally integrated capital markets.
2. Describe two methods that can be used to value
foreign currency cash flows; use those methods
to value those flows.
3. Calculate foreign and domestic WACCs, using
equation 31.7, given three out of the four inputs.

Learning Objectives (cont'd)
4. Identify which tax rate (the foreign or the

domestic) a U.S. corporation will pay on its
foreign project.
5. Discuss the implications of the possibility that
capital markets are internationally segmented.
6. Value a project when it has inputs and outputs in
different currencies.

31.1 Internationally Integrated
Capital Markets
Consider a risky foreign asset that is expected to

pay the cash flow, CFC, in one period.
In a normal market, the price of this asset in a foreign
market is:

CFC / (1 r ) FC

Capital Markets (cont'd)
A U.S. investor who wants to purchase this asset

in dollars will have to pay:
CFC
S
(1 rFC )
Where S is current spot exchange rate in dollars per
foreign currency

A U.S. investor who actually purchased this

security would have to convert the future cash
flow into dollars, so the payoff to such an investor
is the dollar cash flow it produces.

To value this cash flow, assume that the U.S.

investor contracts today to convert the expected
cash flow in one period at the forward rate, F,
quoted as dollars per foreign currency.
The U.S. investors expected dollar cash flow is F CFC

If r*$ is the cost of capital for U.S. investor, the

present value of this expected cash flow is:
F CFC
(1 r$ )

By the Law of One Price, this value must be equal

to what the U.S. investor paid for the security:
CFC F CFC
S

(1 rFC ) (1 r$ )
Which simplifies to
(1 r$ )
F
S
(1 rFC ) Equation
This is simply covered interest parity.

Internationally Integrated Capital Markets

Define: ______________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________

Example 31.1

Example 31.1 (cont'd)

Alternative Example 31.1
Problem
You are an American who is trying to calculate the
present value of a 25 million cash flow that will occur
one year in the future.
You know that the spot exchange rate is
S = $1.9397 and the one-year forward rate is
F = $1.9581 .

Problem (continued)
You also know that the appropriate dollar cost of capital
for this cash flow is 6.25% and that the appropriate
pound cost of capital for this cash flow is 5.25%.
What is the present value of the 25 million cash
flow from the standpoint of a British investor, and
what is the dollar equivalent of this amount?

Problem (continued)
What is the present value of the 25 million cash flow
from the standpoint of a U.S. investor who first converts
the 25 million into dollars and then applies the dollar
discount rate?

Solution
For the British investor:

Solution
For the U.S. investor:

31.2 Valuation of Foreign Currency
Cash Flows
In an internationally integrated capital market, two

equivalent methods are available for calculating
the NPV of a foreign project.
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________

WACC Valuation Method
in Domestic Currency
Converting the cash flows of the foreign project

into the local currency and then calculating the
NPV of these cash flows is the equivalent of
converting the expected dollar value of the foreign
currency cash flows and then proceeding to value
the project as if it were a domestic project.

Application: Ityesi, Inc.
Ityesi, Inc., wants to apply the WACC technique to

value a project in the United Kingdom.
The project will be completely self-contained in the
United Kingdom, such that all revenues are generated
and all costs are incurred there.

Application: Ityesi, Inc. (cont'd)
The technology used in the new products will be

obsolete after four years.
Annual sales are expected to be 37.5 million
per year.
Manufacturing costs and operating expenses are
expected to total 15.625 million and 5.625
million per year, respectively.

Developing the product will require an upfront

investment of 15 million in capital equipment that
will be obsolete in four years and an initial
marketing expense of 4.167 million.
Ityesi pays a corporate tax rate of 40% no matter
in which country it manufactures its products.

Table 31.1

Forward Exchange Rates

The current spot exchange rate, S, is $1.60/. Assume
the risk-free rate on dollars, r$, is 4% and the risk-free
interest rate on pounds, r, is 7%.

Forward Exchange Rates

Using the covered interest parity condition:
(1 r$ ) (1.04)
F1 S ($1.60 / ) $1.5551/
(1 r ) (1.07)
(1 r$ ) 2 (1.04) 2
F2 S ($1.60 / ) $1.5115/
(1 r ) 2
(1.07) 2
(1 r$ )3 (1.04)3
F3 S ($1.60 / ) $1.4692/
(1 r ) 3
(1.07) 3
(1 r$ ) 4 (1.04) 4
F4 S ($1.60 / ) $1.4280/
(1 r ) 4
(1.07) 4
Solution

Free Cash Flow Conversion

Using these forward exchange rates, the expected free
cash flows in dollars can be calculated by multiplying
the expected cash flows in pounds by the forward
exchange rate:

Table 31.2

The Value of Ityesis Foreign Project with WACC

With the cash flows of the U.K. project now expressed
in dollars, the foreign project can be valued as if it were
a domestic U.S. project.

Table 31.3


Ityesis WACC is calculated as:
E D
rwacc rE rD (1 C )
E D E D
(0.5)(10.0%) (0.5)(6.0%)(1 40%) 6Solution
.8%
Note: Ityesis net debt is the $320 million in debt minus the
$20 million in cash for a net debt of $300 million.


The present value of the future free cash flows is:
17.495 17.004 16.528 16.065
2
3
4
$57.20 million
1.068 1.068 1.068 1.068 Solution
Given the upfront cost of launching the product line

in dollars is only $28 million, the net present value is:

Using the Law of One Price as a
Robustness Check
Ityesi could have computed the foreign NPV by

discounting the foreign cash flows at the foreign
cost of capital and converting this result to a
domestic NPV using the spot rate.
Determining the NPV requires knowing the foreign cost
of capital.

Robustness Check (cont'd)
The foreign cost of capital must satisfy the Law of

One Price:
S
(1 r )
(1 r$ )
F
and
S 1 r

F 1 r$

Robustness Check (cont'd)
The foreign cost of capital must satisfy the Law of

One Price:
The foreign cost of capital in terms of the domestic cost
of capital and interest rates is:
The Foreign-Denominated Cost of Capital
1 r
r
(1 r$ ) 1
1 r$

Example 31.2


31.3 Valuation and International Taxation
Repatriated
Define: ______________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________

Single Foreign Project with Immediate
Repatriation of Earnings
The general international arrangement for the

taxation of corporate profits is that the host
country gets the first opportunity to tax income
produced within its borders.
The home government must establish a tax policy
specifying its treatment of foreign income and foreign
taxes paid on that income.

Single Foreign Project with Immediate
Repatriation of Earnings (cont'd)
U.S. tax policy requires U.S. corporations to pay

taxes on their foreign income at the same rate as
profits earned in the United States.
However, a full tax credit is given for foreign taxes paid
up to the amount of the U.S. tax liability.

Multiple Foreign Projects and Deferral of
Earnings Repatriation
Pooling Multiple Foreign Projects

Under U.S. tax law, multinational corporations may use
any excess tax credits generated in high-tax foreign
countries to offset their net U.S. tax liabilities on
earnings in low-tax foreign countries.

Multiple Foreign Projects and Deferral of
Earnings Repatriation
Deferring Repatriation of Earnings

A U.S. tax liability is not incurred until the profits are
brought back home if the foreign operation is set up as
a separately incorporated subsidiary (rather than as a
foreign branch).
If a company chooses not to repatriate, it effectively
reinvests those earnings abroad and defers its
U.S. tax liability.

31.4 Internationally Segmented
Capital Markets
Segmented Capital Markets

Define: ______________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________

Differential Access to Markets
Firms may face differential access to markets if

there is any kind of _______________________.
For example, Ityesi may be well known in the United
States but not be equally well known in the United
Kingdom, thus increasing their WACC in the U.K.
Ityesi would then view the foreign project as less valuable if
it raises capital in the United Kingdom rather than in the
United States.

Differential Access to Markets
Differential access to national capital markets is

common enough that it provides the best
explanation for the existence of ______________.
Define: ______________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________
____________________________________________

Macro-Level Distortions
Important macroeconomic reasons for segmented

capital markets include _____________ and
______________ that create barriers to
international capital flows and thus segment
national markets.
Political, legal, social, and cultural characteristics that
differ across countries may require compensation in the
form of a country risk premium.

Example 31.3


Problem
In March 2007, the spot Canadian dollar
(CAN$)U.S. dollar (US$) exchange rate
of CAN$1.1740 / US$.
At the time, the yield on one-year Canadian
government bonds was about 4%, while the
comparable one-year yield on U.S. Treasury
securities was 5%.
Using the covered interest parity relationship,
calculate the implied one-year forward rate.

Solution
(1 rCAN $ ) 1.04
F S 1.1740 1.1628
(1 rUS $ ) 1.05 Solution

Implications
Firms may be able to benefit from a segmented

international financial market if one country or
currency has a higher rate of return than another
country or currency, when the two rates are
compared in the same currency.

Example 31.4



31.5 Capital Budgeting
with Exchange Risk
The final issue that arises when a firm is

considering a foreign project is that the cash
flows of the project may be affected by exchange
rate risk.
The working assumption made thus far is that the
projects free cash flows are uncorrelated with the spot
exchange rates.

with Exchange Risk (cont'd)
Reconsider what happens if the Ityesi project in

the United Kingdom imports some materials from
the United States.
In this case, the projects pound free cash flows will be
correlated with exchange rates.

If the value of the dollar appreciates against

the pound, the pound cost of these materials
will increase, thereby reducing the pound free
cash flows.
If the dollar depreciates, then the pound free
cash flows will increase.
The assumption that changes in the free cash flows
are uncorrelated with changes in the exchange rate
is violated.

Whenever a project has cash flows that depend

on the values of multiple currencies, the most
convenient approach is to separate the cash
flows according to the currency they depend on.

Assume 5.625 million of Ityesis costs are

denominated in pounds, and an additional $16
million (or 10 million at the current exchange
rate of $1.60/) is for inputs whose price
fluctuates with the value of the dollar.
Ityesis pound-denominated free cash flows excluding
these dollar-based costs would be:

Table 31.4

If the revenues and costs on the previous slide

are not affected by changes in the spot
exchange rates, it can be assumed that changes
in the free cash flows are uncorrelated with
changes in the spot exchange rates.
The pound denominated free cash flows can be
converted to equivalent dollar amounts using the
forward exchange rate:

Table 31.5

The previous slide also adds the dollar-based

cash flows to determine the projects aggregate
free cash flow in dollar terms.
Note: Ityesis dollar-denominated costs are deducted
and the tax shield associated with these costs is
added in.

Given the dollar-denominated free cash flow, the

NPV of the investment using Ityesis dollar
WACC is:
17.225 16.473 15.744 15.033
2
3
4
28.000 $27.05 million
1.068 1.068 1.068 1.068 Solution

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Chapter 31

31.1 Internationally Integrated Capital Markets

Copyright 2007 Pearson 31-2

1. Discuss the condition necessary for

Copyright 2007 Pearson 31-3

4. Identify which tax rate (the foreign or the

Copyright 2007 Pearson 31-4

Consider a risky foreign asset that is expected to

Copyright 2007 Pearson 31-5

A U.S. investor who wants to purchase this asset

Copyright 2007 Pearson 31-6

A U.S. investor who actually purchased this

Copyright 2007 Pearson 31-7

To value this cash flow, assume that the U.S.

Copyright 2007 Pearson 31-8

If r*$ is the cost of capital for U.S. investor, the

Copyright 2007 Pearson 31-9

By the Law of One Price, this value must be equal

This is simply covered interest parity.

Copyright 2007 Pearson 31-10

Internationally Integrated Capital Markets

Copyright 2007 Pearson 31-11

Copyright 2007 Pearson 31-12

Copyright 2007 Pearson 31-13

Copyright 2007 Pearson 31-14

Copyright 2007 Pearson 31-15

Copyright 2007 Pearson 31-16

Copyright 2007 Pearson 31-17

Copyright 2007 Pearson 31-18

In an internationally integrated capital market, two

Copyright 2007 Pearson 31-19

Converting the cash flows of the foreign project

Copyright 2007 Pearson 31-20

Ityesi, Inc., wants to apply the WACC technique to

Copyright 2007 Pearson 31-21

The technology used in the new products will be

Copyright 2007 Pearson 31-22

Developing the product will require an upfront

Copyright 2007 Pearson 31-23

Copyright 2007 Pearson 31-24

Forward Exchange Rates

Copyright 2007 Pearson 31-25

Forward Exchange Rates

Copyright 2007 Pearson 31-26

Free Cash Flow Conversion

Copyright 2007 Pearson 31-27

Copyright 2007 Pearson 31-28

The Value of Ityesis Foreign Project with WACC

Copyright 2007 Pearson 31-29

Copyright 2007 Pearson 31-30

The Value of Ityesis Foreign Project with WACC

Copyright 2007 Pearson 31-31

The Value of Ityesis Foreign Project with WACC

Given the upfront cost of launching the product line

Copyright 2007 Pearson 31-32

Ityesi could have computed the foreign NPV by

Copyright 2007 Pearson 31-33

The foreign cost of capital must satisfy the Law of

Copyright 2007 Pearson 31-34

The foreign cost of capital must satisfy the Law of

Copyright 2007 Pearson 31-35

Copyright 2007 Pearson 31-36

Copyright 2007 Pearson 31-37