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Foreign investment decisions

Foreign investment decisions. Foreign direct investment (FDI). 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

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Foreign investment decisions

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  1. Foreign investment decisions

  2. Foreign direct investment (FDI) • 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.

  3. Methods of market entry • 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.

  4. The Switch Model Exporting vs. FDI Source: Buckley and Casson (1981).

  5. Foreign Direct Investment Four difficulties not present in domestic project appraisal • Overseas cash flow’s are exposed to the risk of adverse FX • movements 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

  6. The basic approach UK Parent USA NPV • 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

  7. 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 the year-to-year net cash flows of the project, or is it the project’s cash flows available to be remitted back to the parent that is to be evaluated? Example Rush plc is undertaking a project in an overseas country whose currency is US$. The project’s net cash flow are: Year$M 0 -10 1 +8 2 +4 3 +3.5 The current $/£ spot rate is 2.5000. Given the systematic risk involved, r = 20%. The company follows 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 maximum annual cash flow equal to 10% of the project’s cost. Blocked funds have to be placed on special deposit at an interest rate of 5%. All blocked funds are released at the end of the project’s life.

  8. From the viewpoint of the project… +$1.47 $1.47 / 2.5000 = £0.588M (NPV)

  9. From the viewpoint of the parent… There is little point in undertaking this if the investors cannot enjoy its benefits Year $M 20%disc Sum 0 -10 1 -10 1 +1 0.8333 +0.83 2 +1 0.6944 +0.69 3 +14.37 0.5787 +8.32 $ -0.16 -$0.16 / 2.5000 = -£64 000

  10. Managing Currency Risk • Foreign exchange markets (FX) • the ’spot’ FX market • 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 deal • depends upon the level of demand (the dept…) • ’Standard periods of time are one month and three months. Other • forward rate has to be specifically quoted by the banks

  11. buy sell Discounts…. Notice that the spread widens…Why? What does a discount imply w r t the relative exchange rate? The first currency is ____________ against the second of the pair of currencies

  12. …. and premiums The first currency is now ____________ against the second of the pair of currencies

  13. Rates of depreciation and appreciation 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

  14. Determinants of FX rates • three main questions to address: • What causes foreign exchange rates to move? • What determines forward exchange rates? • What determines future spot rates? • What causes foreign exchange rates to move? • = Supply and demand forces • Two (three) principal sources of market forces: • speculators and speculation, so-called ’hot money’ • international trade and ’real’ investments • international finance

  15. What determines forward exchange rates? - The answer lies with the interest rate parity theorem (IRPT) Example In 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.

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

  17. 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 be the $/£ 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 demand market forces at that time

  18. 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.

  19. 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: • ________________________ • ________________________ 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?

  20. The LOP example continued: Assume that the annual rates of inflation over the next 12 months in the UK and in the US are 4% and 6% respectively. The lap-top cost £3000*(1+0.04) = £3120 in the UK in 12-months time The 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 time will 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 currency of the country with the lower rate of inflation by approximately the inflation differential. The precise rate of change in exchange is: Current spot: 1.7000*(1+0.01923) = 1.7327: estimated future spot

  21. Interlocking theories in international economics ? (1+M)=(1+P)(1+I) OFT = Diff between interest rates on similar bonds represents the market’s estimate of the future changes in the exchange rates over the period of the bond. (1.05/1.12)*1.61 (spot$/£) = 1.5 forward $/£ (A GBP Bond is 12% p.a.)

  22. What do we know ?? • 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.

  23. How does it help? • 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 assets • and cash flows that are at risk and to devise suitable means of hedging the risks...

  24. Foreign exchange hedging Risk = uncertainty of outcome, hence FX risk refers to uncertainty of outcome that arises because exchange rates move unpredictably • Three types of FX risk: • transactions risk • translation risk • 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, and particularly the risk faced by importers and exporters

  25. 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 entering the 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…

  26. 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). NPV (at r= 20%) = -5*1 + 1*0.8333 + 1*0.6944 + 6.11*0.5787 = $0.06M = £24 000

  27. Project discount rate What would happen in the Rush plc example if the company had originally 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 concerned it is the cash flows available for repatriation back to the parent that is of relevance. The discount rate should then reflect the project’s business risk plus the financial risk that arises from the leverage – the cost of equity capital

  28. Example – Rush plc Project’s asset beta = 1.6 US 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%) rE=12%+(17%-12%)*3.2 = 28%

  29. The project appraisal analysis is now: 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…;)

  30. Translation risk The risk a company is exposed to through movements in FX rates when it hold medium- to long-term assets and liabilities in an overseas currency. 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 Ending balance 12 month ahead $ Asset: £5M £ loan: £5M £ loan: £5M less FX loss: (£1.67M) $ Asset: £3.33M How do we overcome this translation risk? $/£=3.0000

  31. Problems in dealing with translation risk • Many governments insist that a minimum proportion of a project’s outlay • is financed directly by the parent company • The standard financing advice for overseas projects is: • the project’s property fixed assets: finance with a foreign currency loan • the project’s non-property fixed assets: finance through exporting own c. • working capital requirements: finance with a foreign currency loan • 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)?

  32. 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 expected to 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%

  33. The project can now be evaluated: Year $M PVF(19.3%) PV 0 -1 1 -1 1 +0.54 0.8382 +0.453 2 +0.583 0.7026 +0.410 3 +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) = 1.9543 Year 2: 1.9543*(1.0286) = 2.0102 Year 3: 2.0102*(1.0286) = 2.0677

  34. Thus, the firm should expect the following sterling cash flow from the project: Year $M $/£ £M 0 -1 1.9000 -0.526 1 +0.54 1.9543 +0.276 2 +0.583 2.0102 +0.290 3 +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 also differ: Rate of change in $: (0.12-0.05)/1.05 = +0.067 Year 1: 1.9000*(1.067) = 2.0273 Year 2: 2.0273*(1.067) = 2.1631 Year 3: 2.1631*(1.067) = 2.3081

  35. Will the UK parent suffer from this unexpected, adverse movement in the $/£ exchange rates? Year $M $/£ £M 0 -1 1.9000 -0.526 1 +0.56 2.0273 +0.276 2 +0.627 2.1631 +0.290 3 +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 increased US inflation should result in increased dollar cash flows from the project which now will inflate up at 12% rather that 8%. Life does not work quite so perfectly!

  36. The risk of unexpected FX movements does exist for firms investing overseas! Is this risk wholly systematic or unsystematic or partly both? The answer is uncertain and depends partly upon if country capital markets are segmented (independent) or integrated. Solve the FX risk problem by selling forward the project’s expected foreign currency net cash flow These are only expected What if a forward market does not exist?

  37. Country/ Political risk Source: Euromoney, September 2004 (www.euromoney.com).

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