CH-13-14 International Portfolio Investment – Foundations of Multinational Financial Management : Book Guide

This Document Contains Chapters 13 to 14 CHAPTER 13 INTERNATIONAL PORTFOLIO INVESTMENT The basic message of this chapter is that international stock and bond diversification can provide substantially higher returns with less risk than investment in a single market. A major reason is that international investment offers a much broader range of opportunities than domestic investment alone, even in a market as large as the U.S. An investor restricted to the U.S. stock market, for example, is cut off, in effect, from about two thirds of the available investment opportunities. International diversification pushes out the efficient frontier – the set of portfolios that has the smallest possible standard deviation for its level of expected return and has the maximum expected return for a given level of risk allowing investors simultaneously to reduce their risk and increase their expected return. The chapter shows how to measure the total dollar return on foreign currency-denominated securities as well as how to estimate the risk return trade off associated with foreign portfolio investing. It does this by providing the formulas for the expected return and standard deviation for a portfolio consisting of a fraction a invested in U.S. stocks and the remaining fraction, 1 a, invested in foreign stocks. The chapter details the several ways in which U.S. investors can diversify into foreign securities: buying stocks of firms that have listed their securities on the New York Stock Exchange or the American Stock Exchange; buying American Depository Receipts or American shares; and buying shares in the growing number of internationally diversified mutual funds. SUGGESTED ANSWERS TO “DEUTSCHE BANK LISTS AS A GLOBAL SHARE” 1. List the pros and cons of Deutsche Bank listing on the NYSE as a global share instead of an ADR. Answer: Pros include the savings to U.S. investors in trading Deutsche Bank global shares as opposed to ADRs, the fact that it can be traded in dollars, and the increased expected demand for Deutsche Bank’s global shares given this greater trading convenience and lower trading costs. These features should translate into a higher issue price for Deutsche Bank’s global shares. Negatives include the higher costs to Deutsche Bank associated with a global share issue along with the need to coordinate clearing and settlement systems and regulatory issues between the U.S. and German markets. 2. Are these pros and cons of a GSR issue likely to change over time? In which direction? Answer: Yes. As markets increasingly move toward 24-hour-a-day trading, the necessary coordination of clearing and settlement systems will naturally occur. The result will be to lower the costs of global shares relative to ADRs. 3. What changes would increase the desirability of issuing global shares? Answer: Greater coordination of clearing and settlement systems across countries would increase the desirability of issuing global shares. In addition, greater harmonization of regulatory systems and rules would lower the cost and increase the desirability of global shares. SUGGESTED ANSWERS TO CHAPTER 13 QUESTIONS 1. What characteristics of foreign securities lead to diversification benefits for American investors? Answer: The two basic characteristics are: i) Many foreign securities are issued by companies that produce goods and services not available from U.S. companies. ii) All U.S. companies are more or less subject to the same cyclical economic fluctuations. Foreign securities by contrast involve claims on economies whose cycles are not perfectly in phase with the U.S. economic cycle. Thus, just as movements in different stocks partially offset one another in an all U.S. portfolio, so also movements in U.S. and non U.S. stocks cancel out each other somewhat. 2. Will increasing integration of national capital markets reduce the benefits of international diversifications? Answer: Despite increasing integration of national capital markets, they still don’t march in lock step. Some economies and, hence, their markets will do better than others at any given time, so having stakes in several countries still spreads risks. Nonetheless, increasing integration could lead to more co-movement in common risk factors (e.g., real interest rate changes). If so, this will increase the correlation of national markets and decrease the risk-reducing benefits of diversifying internationally. Ultimately, it’s an empirical issue, and one that should be addressed, as to whether the benefits of international investing are declining. My sense is that international investing can still reduce portfolio risk but the degree of risk reduction is less today than in the past. 3. Studies show that the correlations between domestic stocks are greater than the correlations between domestic and foreign stocks. Explain why this is likely to be the case. What implications does this fact have for international investing? Answer: Domestic stocks are more highly correlated because they are all subject in one way or another to the state of the domestic economy. The lower correlations between domestic and foreign stocks reflect the lower correlations between the domestic and foreign economies. These lower correlations also imply that international investing is likely to lead to greater diversification than just investing across industries within a country. As the text shows, these lower correlations appear to be persisting despite the greater integration of the global economy. 4. Who is likely to gain more from investing overseas, a resident of the U.S. or of Mexico? Explain. Answer: Mexican investors will gain much more from international investing. The size of the U.S. economy is such that the U.S. and world stock markets are highly correlated whereas the Mexican stock market, being much smaller, shows a much lower correlation with the world stock market. The result is greater diversification (and, hence, risk reduction) benefits for the Mexican investor than for the U.S. investor. In addition, the U.S. has a much greater range of industries than does Mexico, giving much more scope for industry diversification outside Mexico than would be true for a U.S. investor who has access to such a broad range of industries already. 5. Suppose Mexican bonds are yielding more than 100% annually. Does this high yield make them suitable for American investors looking to raise the return on their portfolios? Explain. Answer: These returns are denominated in nominal peso terms, subjecting them to currency risk. Nonetheless, holding a small percentage of your portfolio in Mexican bonds will reduce its risk, without sacrificing expected return. This is because arbitrage will equilibrate expected returns across countries at the same time that the actual returns from the Mexican peso bonds are relatively uncorrelated with returns on the U.S. stock market. Hence, the primary reason for holding Mexican bonds is to reduce risk, not raise expected return. 6. According to one investment advisor, “I feel more comfortable investing in Western Europe or Canada. I would not invest in South America or other regions with a record of debt defaults and restructuring. The underwriters of large new issues of ADRs of companies from these areas assure us that things are different now. Maybe, but who can say that a government that has defaulted on debt won't change the rules again?” Comment on this statement. Answer: True. A nation that has already defaulted on its debt is less trustworthy than one that never has. However, this possibility has already been factored into the prices of that nation’s bonds and stocks in the form of a large discount to what they would sell for absent that past experience. The important question is whether the discount is high enough to provide an expected return high enough to compensate for those risks. If so, Latin American stocks and bonds would be a reasonable investment since they would provide additional diversification benefits. 7. As noted in the chapter, from 1949 to 1990, the Japanese market rose 25,000%. 7.a. Given these returns, does it make sense for Japanese investors to diversify internationally? Answer: Note that the same argument could be made as to why non-Japanese investors should also invest all their money in Japan. Implicit in this argument is the expectation that historically high returns will persist into the future. Such an expectation is an unreasonable one in efficient markets. Thus, unless one unrealistically expects these superior returns to persist into the future, diversification would make sense for both Japanese and non-Japanese investors. The benefits of this diversification were pointed out in 1990, when the Tokyo Stock Exchange fell 35% in dollar terms (39% in yen), while the Morgan Stanley Capital International World Index fell by “just” 18.6% in dollar terms. 7.b. What arguments would you use to persuade a Japanese investor to invest overseas? Answer: Here are two arguments. First, you can’t expect stock markets to keep going up in a straight line. All markets entail risk, and one way to counter that risk is through diversification. This argument should by now be bolstered by the crash of the Japanese stock market in 1990. Second, to the extent that the Japanese investor consumes foreign goods and services, international investing can reduce the risk associated with the investor’s consumption stream by matching foreign currency inflows with foreign currency outflows. For example, if the yen depreciates, the higher yen cost of buying foreign goods and services will be offset by the higher yen value of foreign assets. 7.c. Why might Japanese (and other) investors still prefer to invest in domestic securities despite the potential gains from international diversification? Answer: If investors buy mostly domestic goods and services (or at least goods and services priced in a domestic context), investing overseas will expose them to currency risk that is not offset by gains on the consumption side. For example, if the yen appreciates, the yen value of dollar assets will decline. If the Japanese investor is not consuming much in the way of U.S. goods and services, the reduction in consumption costs will not offset the investment losses. 8. Because ADRs are denominated in dollars and are traded in the U.S., they present less foreign exchange risk to U.S. investors than do the underlying foreign shares of stock. Comment. Answer: The answer to this question depends on the distinction between the currency of denomination and the currency of determination. Although the ADR currency of denomination is the dollar, the currency of determination is the local currency (or whatever currency determines the cash flows of the stock). More specifically, the price of an ADR is the price of the share of stock in its foreign currency multiplied by the spot dollar value of the foreign currency. As the spot exchange rate changes, the dollar price of the ADR will also change (unless the foreign currency value of the stock changes in inverse proportion to the change in the spot price, an unlikely scenario). Hence, ADRs are as subject to exchange risk as the underlying shares of foreign stock. ADDITIONAL CHAPTER 13 QUESTIONS AND ANSWERS 1. An alternative to investing in foreign stocks is to invest in the shares of domestic multinationals. Are MNCs likely to provide a reasonable substitute for international portfolio investment? Answer: No. The empirical evidence clearly shows that multinationals cannot provide a substitute for international portfolio investment. The economic rationale for this is simple. Multinationals already comprise part of the domestic stock index. A subset of an index cannot provide diversification benefits that the full index cannot. If domestic multinationals could provide a reasonable substitute for foreign stocks, then international investing should provide minimal incremental diversification benefits. In fact, the evidence is that international diversification provides substantial risk reduction benefits. 2. Why did Latin American stocks perform so well in recent years? Is this performance likely to continue? Explain. Answer: Until recently, Latin American countries followed statist economic policies that shackled their economies, discouraged private initiative, and imposed high risks on private enterprise. Local stock prices discounted these high risks and the lack of profitable private sector growth opportunities. In recent years, Latin American governments have begun to dismantle many of their statist policies. Investors have responded to the resulting more favorable investment opportunities by reducing the discounts they had imposed on local stocks. The result was a jump in stock prices across Latin America. In an efficient market, stocks that are expected to earn excess returns in the future will see their prices jump immediately, thereby eliminating the expectation of future excess returns. The same holds true for stock markets. Current Latin American stock prices already reflect expectations of a more profitable future. Thus, in order for these stock prices to continue to grow as fast as they have in recent years, the future will have to turn out to be much more profitable than it is already expected to be. Since one cannot expect the future to be better than it is already expected to be, Latin American stocks can be expected to earn future returns that are just equal to their risk-adjusted cost of capital. Of course, if one believes that the Latin American future will turn out to be more bountiful than the expectations already embodied in Latin stock prices, then one can expect Latin American stocks to continue their superior performance. Then, however, the issue becomes whether one is privy to inside information or has better insight into economic trends than current investors do. 3. Would you expect emerging markets on average to outperform developed country markets in the future? Explain. Answer: As in the answer to question 7, in an efficient market, the performance of emerging markets should be about in line with expectations. This means that the expected risk-adjusted return on emerging markets should be just about equal to that on developed country markets. Emerging markets can be expected to outperform developed country markets only if investors perceive the former markets to be riskier and thereby demand a risk premium (relative to developed country markets) for investing in them. This situation may well be the case, leading to a higher expected return on emerging markets than on developed country markets. At the same time, the lower systematic risk of emerging markets may lead to a lower risk premium and lower future expected returns. 4. The Brazilian stock market rose by 165% during 1988. Are American investors likely to be pleased with that performance? Explain. Answer: These returns are stated in nominal cruzeiro terms. American investors are interested in dollar returns. Thus American pleasure with the Brazilian market’s performance depends on how much the cruzeiro devalued during the year. In fact, the cruzeiro (actually the cruzado then) devalued by about 90% during the year. Hence, the dollar return on the Brazilian market was approximately -74%. Not good enough to keep investors happy. 5. Persian Gulf countries receive virtually all their income from oil revenues denominated in dollars. At the same time, they buy substantial amounts of goods and services from Japan and Western Europe. Their investment portfolios are heavily weighted towards short term U.S. Treasury bills and other dollar denominated money market instruments. Comment on their asset allocation. Answer: Persian Gulf countries face exchange risk because of the currency mismatch between the dollar revenues they generate through oil sales and the nondollar costs they incur in buying goods and services from Japan and Western Europe. If the U.S. dollar devalues, for example, Persian Gulf oil revenues will buy fewer non-American goods and services. One way to hedge this risk is to hold a substantial fraction of the investment portfolio in nondollar-denominated assets. In this way, the very same event that reduced the purchasing power of their revenues would increase the purchasing power of their investment returns. But this is not the strategy they have been following. One possible reason for the divergence is that these countries prefer highly liquid – meaning dollar – assets. 6. In deciding where to invest your money, you read that Germany looks like it’s well positioned to capitalize on the opening of Eastern Europe. But Britain is troubled by weak growth and high inflation and interest rates. Which of these countries would it make sense to invest in? Explain. Answer: As noted in the answer to the previous question, investors have already factored these expectations into the prices of assets in these countries. As events diverge from the expected, stock prices will adjust to reflect these new expectations so that at any point in time the expected risk-adjusted return from investing in different countries and assets will be the same. And the fact that the risks noted in the question are likely to be uncorrelated with each other should raise the diversification benefits from investing in both nations simultaneously. 7. Does the high volatility of emerging markets lead to high expected returns for investors? Answer: Not necessarily. To the extent emerging markets are open to foreign investors, investors are likely to be the marginal investors in these markets. In that case, what matters is the systematic component of that volatility (systematic in the context of the globally-diversified portfolios of the foreign investors). 8. As more U.S. investors shift funds into emerging markets, what will drive expected returns? Answer: Historically, most foreign investors have stayed out of emerging markets because of local government regulations, various restrictions on foreign investors’ ability to own local stocks, high transaction costs, and the significant political and economic risks associated with these markets. The net result is that these markets have been largely segmented and their expected returns driven by the specific risks of those markets (because the marginal investor has not been well diversified). As U.S. and other foreign investors become more important, the expected returns in emerging markets will be based more on the contribution of those markets to the systematic risk of a globally-diversified portfolio. The initial reaction of these markets will be a price jump as expected future cash flows get capitalized at a lower rate. In the future, however, this will mean lower expected returns from investing in emerging markets. 9. During 1995, the Morgan Stanley Capital International world index of developed country stock markets rose by 18.7% in dollar terms. In contrast, the IFC emerging markets index fell by just over 17% in dollar terms. Many investment advisors point to this sorry performance of emerging markets as an expensive lesson to investors not to venture too far from home. Do the diverging performances of mature and emerging markets argue against investing in emerging markets? Answer: The experience of 1995 illustrates the riskiness of emerging markets. Paradoxically, however, the poor performance of emerging markets in a year when practically all developed country stock markets jumped is reassuring. By providing more evidence that emerging and mature markets move independently of each other, the diverging performances of these markets in 1995 bolster the case for diversifying across these different sets of markets. Indeed, the fact that practically all mature markets moved together in 1995 argues against putting all of one’s money in these markets. It makes sense for investors to hedge against risk by putting some of their money in markets that tend to move independently of their main investment markets, thereby making their overall portfolio less risky than it were fully invested in highly correlated markets. One who had followed this advice would have benefited in 1993, when emerging markets significantly outperformed mature ones. SUGGESTED SOLUTIONS TO CHAPTER 13 PROBLEMS 1. During the year the price of British gilts (government bonds) went from £102 to £106, while paying a coupon of £9. At the same time, the exchange rate went from £1:$1.76 to £1:$1.62. What was the total dollar return, in percent, on gilts for the year? Answer: Rewriting Equation 13.4, the one period total dollar return on a foreign bond investment r$ can be calculated as follows: where B(t) = local currency bond price at time t C = local currency coupon income G = percent change in dollar value of LC With an initial bond price of £102, coupon income of £9, end of period bond price of £106, and pound depreciation of (1.62 1.76)/1.76 = -7.95%, the total dollar return is 3.79%: r$ = [1 + (106 102 + 9)/102](1 .0795) 1= (1.1275)(0.9205) 1= 3.79% 2. Suppose during the first half of the year, government bonds yielded a local currency return of 1.6%. However, the Swiss franc rose by 8% against the dollar over this six month period. Corresponding figures for France were 1.8% and 2.6%. Which bond earned the higher U.S. dollar return? What was the return? Answer: The dollar return on Swiss bonds equaled (1 - .016)(1 + 0.08) - 1 = 6.27%. The return on French bonds was lower at (1.018)(1.026) - 1 = 4.45%. In this case, Swiss franc appreciation more than offset the lower local currency return on Swiss bonds. 3. During the year Toyota Motor Company shares went from ¥9,000 to ¥11,200, while paying a dividend of ¥60. At the same time, the exchange rate went from $1 = ¥145 to $1 = ¥120. What was the total dollar return, in percent, on Toyota stock for the year? Answer: Rewriting Equation 15.5, the one period total dollar return on a foreign stock investment R$ can be calculated as follows: where P(t) = local currency stock price at time t DIV = local currency dividend income Substituting in the numbers yields a total dollar return on Toyota stock for the year of 51.17%: R$ = [1 + (11,200 9,000 + 60)/9,000](1+.2083) 1 = (1.2511)(1.2083) 1 = 51.17% Note that yen appreciation during the year was (145 120)/120 = 20.83%. 4. During 1989, the Mexican stock market climbed 112%in peso terms while the peso depreciated by 28.6% against the U.S. dollar. What was the dollar return on the Mexican stock market during the year? Answer: According to these data, the dollar return on the Mexican stock market during 1989 was 51.37%: R$ = (1 + 1.12)(1 0.286) 1 = 51.37% 5. Suppose that the dollar is now worth €0.7423. If one-year German bunds are yielding 9.8% and one-year U.S. Treasury bonds are yielding 6.5%, at what end-of-year exchange rate will the dollar returns on the two bonds be equal? What amount of euro appreciation or depreciation does this equilibrating exchange rate represent? Answer: To begin, given that German bunds are yielding more than U.S. Treasuries, it is clear that for dollar returns on these two securities to equilibrate, the euro must depreciate against the dollar by about the interest differential, which is 3.3%. Using Equation 13.4, the expected dollar return on investing $1 in a bund (after first converting it into €0.7423) for a year can be found as 0.7423(1.098)e1 = 0.8150e1 where e1 is the unknown end-of-year exchange rate ($/€). Note that ex ante, one cannot anticipate any capital gains or losses on investing. Setting this figure equal to the $1.065 expected dollar return from investing one dollar in a Treasury bond yields the solution e1 = $1.3067, which converts into a direct quote for the dollar of €0.7653. This exchange rate entails a euro depreciation of (0.7423 – 0.7653)/0.7653 = -3.01% against the dollar. Alternatively, the dollar has appreciated against the euro by (0.7653 – 0.7423)/0.7423= 3.10%. 6. In 1992, the Brazilian market rose by 1,117% in cruzeiro terms, while the cruzeiro fell by 91.4% in dollar terms. Meanwhile, the U.S. market rose by 8.5%. 6.a. Which market did better? Answer: The dollar return on the Brazilian market can be calculated using Equation 15.5: R$ = (1 + 11.17)(1 - 0.914) - 1 = 4.66% The numbers reflect the fact that a return of 1,127% is equivalent to receiving an additional Cr11.17 for each Cr1 invested. Based on these figures, the U.S. market return of 8.5% bested the dollar return on the Brazilian market by almost 4 percentage points. 6.b. In 1993, the Brazilian market rose by 4,190% in cruzeiro terms, while the cruzeiro fell by 95.9% in dollar terms. Did the Brazilian market do better in dollar terms in 1992 or in 1993? Answer: Redoing the numbers in the answer to part a, we see that the Brazilian market did far better in 1993 than in 1992: R$ = (1 + 41.90)(1 - 0.959) - 1 = 75.89% In this case, the very large local currency return more than offset the dramatic devaluation of the cruzeiro. 7. In 1990, Matsushita bought MCA Inc. for $6.1 billion. At the time of the purchase, the exchange rate was about ¥145/$. By the time that Matsushita sold an 80% stake in MCA to Seagram for $5.7 billion in 1995, the yen had appreciated to a rate of about ¥97/$. 7.a. Ignoring the time value of money, what was Matsushita’s dollar gain or loss on its investment in MCA? Answer: If an 80% stake in MCA was worth $5.7 billion, then the entire firm was worth $7.125 billion. Based on this valuation, Matsushita actually made $1.025 billion on its purchase of MCA. That is, by buying MCA at a price of $6.1 billion and selling it for a price that valued the business at $7.125 billion, Matsushita made $1.025 billion. 7.b. What was Matsushita’s yen gain or loss on the sale? Answer: Taking into account the differences in exchange rates, Matshushita paid ¥884,500,000,000 (6,100,000,000 * 145) for MCA in 1990 and sold MCA in 1995 for a price that valued it at ¥691,125,000,000 (7,125,000,000 * 97). The net result was a loss for Matsushita of ¥193,375,000,000 on its purchase of MCA. 7.c. What did Matsushita's yen gain or loss translate into in terms of dollars? What accounts for the difference between this figure and your answer to part a? Answer: Matsushita’s yen loss converts into a dollar loss of $1,993,556,701 (193,375,000,000/97). This figure differs from the answer in part a because it takes into account the change in exchange rates between 1990 and 1995. In effect, it asks what would have happened if Matsushita had held onto its yen instead of converting them into a dollar asset that didn’t appreciate in line with the yen’s appreciation. In other words, this computed dollar loss represents an opportunity cost. 8. Suppose the standard deviations of the British and U.S. stock markets have risen to 38% and 22%, respectively, while the correlation between the U.S. and British markets has risen to 0.67. What is the new beta of the British market from a U.S. perspective? Answer: Using the following formula to calculate the beta of the British market, we can calculate the new British market beta from the perspective of a U.S. investor to be 0.67 * 38/22 = 1.16. 9. A portfolio manager is considering the benefits of increasing his diversification by investing overseas. He can purchase shares in individual country funds with the following characteristics: U.S. (%) U.K. (%) Spain (%) Expected Return Standard Deviation Correlation with U.S. 15 10 1.0 12 9 0.33 5 4 0.06 9.a. What is the expected return and standard deviation of return of a portfolio with 25% invested in the United Kingdom and 75% in the U.S.? Answer: Use the formulas rp = w1r1 + w2r2 and σp2 = w12σ12 + w22σ22 + 2w1w2r12σ1σ2 to calculate the means and standard deviations of the portfolios. % US %UK Expected Return Standard Deviation 25 50 75 75 50 25 12.75 13.50 14.25 7.93 7.75 8.51 9.b. What is the expected return and standard deviation of return of a portfolio with 25% invested in Spain and 75% in the U.S.? Answer: Using the same formulas as in the answer to part a, we can calculate the means and standard deviations of the various portfolios as follows: %US %Spain Expected Return Standard Deviation 25 50 75 75 50 25 7.50 10.00 12.50 4.02 5.50 7.63 9.c. Calculate the expected return and standard deviation of return of a portfolio with 50% invested in the U.S. and 50% in the United Kingdom. With 50% invested in the U.S. and 50% invested in Spain. 9.d. Calculate the expected return and standard deviation of return of a portfolio with 25% invested in the U.S. and 75% in the United Kingdom. With 25% invested in the U.S. and 75% invested in Spain. Answer: The answers to items a and b contain the answers to items c and d. 9.e. Plot these two sets of risk return combinations (a) through (d) as in Exhibit 15.5. Which leads to a better set of risk return choices, Spain or the United Kingdom? Answer: As the following diagram shows, Spain offers better diversification opportunities because its fund returns are less correlated with the U.S. market (correlation = 0.06) than U.K. funds (correlation = 0.33). However, it also obvious that investors are sacrificing a significant amount of expected return by choosing to add Spanish stocks to their portfolios. 9.f. How can you achieve an even better risk return combination? Answer: An investor can improve on the risk-return combination selected in the answer to part d by including the U.K. fund in the portfolio. You can never do worse by expanding the set of portfolio assets. The appropriate percent to invest in the U.K. fund depends on the correlation between the U.K. fund and the Spain fund, which we don’t know. 10. Suppose that the standard deviation of the return on Nestlé, a Swiss firm, in terms of Swiss francs is 19% and the standard deviation of the rate of change in the dollar-franc exchange rate is 15%. In addition, the estimated correlation between the Swiss franc return on Nestlé and the rate of change in the exchange rate is 0.17. Given these figures, what is the standard deviation of the dollar rate of return on investing in Nestlé stock? Answer: According to Equation 15.8 in the text, we can write the standard deviation of the dollar return, σ$, as σ$ = [σf2 + σg2 + 2σfσgσf,g]½ where σf2 = the variance (the standard deviation squared) of the foreign currency return σg2 = the variance of the change in the exchange rate σf,g = the correlation between the foreign currency return and the exchange rate change Applying this equation, the standard deviation of the dollar rate of return on investing in Nestlé stock is 27.33%: ADDITIONAL CHAPTER 13 PROBLEMS AND SOLUTIONS 1. On February 14, 1994, the dollar fell from ¥106.85 to ¥102.65. Meanwhile, the Tokyo stock market fell 1.63% as measured in yen. What was the one-day dollar return on the Tokyo stock market? Answer: On that day, the dollar value of the yen rose by (106..85 - 102.65)/102.65 = 4.09%. Using Equation 15.5 (see the answer to problem 3), the one-day return on the Tokyo Stock Exchange was R$ = (1 - 0.0163)(1.0409) - 1 = 2.39% 2. During 1997, the Korean Stock Exchange’s composite index fell by 42%, while the won lost half its value against the dollar. What was the combined effect of these two declines on the dollar return associated with Korean stocks during 1997? Answer: According to these data, the dollar return on the Korean Stock Exchange during 1997 was -71%: R$ = (1 - 0.42)(1 0.5) 1 = -71% 3. Here are data on stock market returns and exchange rate changes during 1988 for 12 stock markets. Country Return in Local Currency (%) LC Units/Dollar 12/31/87 LC Units/Dollars 12/31/88 Australia Belgium Canada France West Germany Holland Italy Japan Spain Sweden Switzerland United Kingdom 14.5 56.3 10.9 56.8 27.9 42.8 26.2 44.8 25.0 60.5 31.9 9.1 1.41 35.1 1.29 5.65 1.68 1.88 1230 129 114 6.03 1.37 0.56 1.17 38.8 1.20 6.31 1.85 2.09 1357 128 116 6.30 1.58 0.57 Determine the dollar return on each of these markets. Answer: Using Equation 15.5, here are the total dollar returns on these markets during 1988: Currency Gain (loss) (%) Total Dollar Return (%) Australia Belgium Canada France West Germany Holland Italy Japan Spain Sweden Switzerland United Kingdom 20.5 -9.5 7.5 -10.5 -9.2 -10.1 -9.4 0.8 -1.7 -4.3 -13.3 -1.8 38.0 41.4 19.2 40.4 16.2 28.5 14.4 45.9 22.8 53.6 14.4 7.2 4. Suppose over a ten-year period the annualized peseta return of a Spanish bond has been 12.1%. If a comparable dollar bond has yielded an annualized return of 8.3%, what cumulative devaluation of the peseta over this period would be necessary for the return on the dollar bond to exceed the dollar return on the Spanish bond? Answer: The answer to this question can be found by solving the following equation: (1.121)10(1 - d) = (1.083)10 where d is the cumulative peseta devaluation over the ten-year period. That is,, the dollar return on investing in the Spanish bond just equals the dollar return on investing in the comparable dollar-denominated bond. The solution to this equation is d = 0.2917, or a cumulative peseta devaluation of 29.17%. 5. The standard deviations of U.S. and Mexican returns over the period 1989-1993 were 12.7% and 29.7%, respectively. In addition, the correlation between the U.S. and Mexican markets over this period was 0.34. Assuming that these data reflect the future as well, what is the Mexican market beta relative to the U.S. market? Answer: Using the formula presented in the text, and substituting in the numbers in the problem, we have In other words, despite the much greater riskiness of the Mexican market relative to the U.S. market, the low correlation between the two markets led to a Mexican market beta (0.80) which is lower than the U.S. market beta (1.00). 6. In an attempt to diversify your portfolio internationally, you must decide how to invest in Brazil. You can invest in an index fund that replicates the Brazilian stock market, or you can buy shares of the Brazil Fund traded on the New York Stock Exchange. The covariance of dollar returns on the index with the S&P 500 is 0.02; the covariance of dollar returns on the Brazil Fund with the S&P 500 is 0.03; the variance of the S&P 500 index is 0.035; and the beta of the Brazil Fund with respect to the Brazilian index is 0.90. In addition, the Brazil Fund and the Brazilian index are expected to yield annual dollar returns of 21% and 19%, respectively, in contrast to expected annual returns of 18% from investing in the S&P 500. 6.a. Ignoring other considerations, should you buy the Brazil Fund or the Brazilian index fund? Answer: To answer this question, we need to determine which investment provides a better risk-return trade-off in the context of the U.S. market, which is represented here by the S&P 500. This means that we must calculate the beta for the Brazilian index with respect to the S&P 500, ßBrazilian index, and the corresponding beta for the Brazil Fund, ßBrazil Fund (the Brazil Fund’s beta relative to the Brazilian index is irrelevant). By definition, ßBrazilian index = 0.02/0.035, or 0.57, and ßBrazil Fund = 0.03/0.035, or 0.86. Given these betas and the 5% Treasury bill rate mentioned in Part b, the CAPM predicts an expected return on the Brazilian index of 5% + 0.57(18% - 5%) = 12.43% and an expected return on the Brazil Fund of 5% + .86(18% - 5%) = 16.14%. Given their actual expected returns 19% and 21%, respectively, both investments appear to offer excess risk-adjusted returns, but the excess return for the Brazilian index of 6.57% (19% - 12.43%) exceeds the Brazil Fund’s excess return of 4.86% (21% - 16.14%). Hence, the Brazilian index fund appears to provide a better risk-return trade-off than the Brazil Fund. 6.b. Suppose the U.S. Treasury bill rate is 5%. Assuming the S&P 500 has a beta of 1, plot the capital market line and show the positions of the Brazil Fund and the Brazilian stock index relative to the capital market line. Answer: The following chart shows the position of the Treasury bill, S&P 500, Brazil Fund, and Brazilian index relative to the capital market line. Notice that both the Brazil Fund and Brazilian index are above the capital market line. In other words, for the same degree of systematic risk, their expected return exceeds the return expected in the U.S. CHAPTER 14 CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION This chapter focuses on three aspects of foreign investment analysis that are infrequently considered in evaluating domestic projects: the difference between project and parent cash flows; incorporating political risks such as expropriation and currency controls; and factoring in inflation and exchange rate changes in cash flow estimates. It also evaluates the various methods used to incorporate in the investment analysis the additional risks encountered overseas. These points are brought out in the process of working through the International Diesel Corporation Case. The ability to perform a capital budgeting analysis is one of the most valuable skills we can provide our students; this case is designed to make them aware of many of the intricacies involved in doing such an analysis. SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS 1. A foreign project that is profitable when valued on its own will always be profitable from the parent firm’s standpoint. True or false. Explain. Answer: There are many reasons why project cash flows can diverge from the incremental cash flows accruing to the parent. Therefore, the correct answer is false. 2. Early results on the Lexus, Toyota’s upscale car, showed it was taking the most business from customers changing from either BMW (15%), Mercedes (14%), Toyota (14%), General Motors’ Cadillac (12%), and Ford’s Lincoln (6%). With what in the auto business is considered a high percentage of sales coming from its own customers, how badly is Toyota hurting itself with the Lexus? Answer: Toyota appears to be hurting itself with Lexus. But, in fact, Lexus is doing exactly what Toyota intended: retaining customers, since Toyota determined that many of its customers who switched to Lexus were ready to “trade up” to a luxury car. Now Toyota’s customers are trading up to a Lexus instead of a BMW or Mercedes. The key point is that the cannibalization is more apparent than real: If Toyota had not built the Lexus, it would have lost these customers anyway, but to another company. 3. What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be higher, lower, or the same as the cost of capital for a comparable domestic operation? Answer: Key factors include whether the cash flows of the affiliate are closely tied to the state of the local economy or to the world economy, the correlation between the local and domestic economies, and the volatility of the foreign affiliate’s cash flows relative to that of the domestic operation. The greater (lesser) each of these factors, the higher (lower) the foreign affiliate’s cost of capital relative to that of the domestic operation. In general, the closer these factors are to each other, the closer their costs of capital. 4. According to an article in Forbes, “American companies can and are raising capital in Japan at relatively low rates of interest. Dow Chemical, for instance, has raised $500 million in yen. That cost the company over 50% less than it would have at home.” Comment on this statement. Answer: Forbes is comparing apples with oranges. Borrowing in yen is not the same as borrowing in dollars. When converting from yen into dollars Dow faces the possibility that the yen will appreciate, wiping out its apparent cost savings. In fact, in less than one year after the article appeared, the yen had appreciated by over 35% relative to the dollar, raising the dollar cost of repaying that $500 million yen borrowing to over $675 million. 5. Boeing Commercial Airplane Co. manufactures all its planes in the U.S. and prices them in dollars, even the 50% of its sales destined for overseas markets. What financing strategy would you recommend for Boeing? What data do you need? Answer: Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from Airbus Industries, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those countries. However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed analysis, another suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of the currencies of its European competitors. ECU bonds would also provide a hedge against appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to move up and down together against the dollar (albeit imperfectly). 6. United Airlines recently inaugurated service to Japan and now wants to finance the purchase of Boeing 747s to service that route. The CFO for United is attracted to yen financing because the interest rate on yen is 300 basis points lower than the dollar interest rate. Although he doesn’t expect this interest differential to be offset by yen appreciation over the ten year life of the loan, he would like an independent opinion before issuing yen debt. 6.a. What are the key questions you would ask in responding to UAL’s CFO? Answer: What’s your business? Speculating on exchange rates or running an airline? Do you think you can profitably outguess the financial markets? How do your operating cash flows respond to changes in the dollar/yen exchange rate? 6.b. Can you think of any other reason for using yen debt? Answer: Another reason for preferring yen financing could be to use this financing to hedge operating cash flows on the Tokyo route against changes in the dollar/yen exchange rate. 6.c. What would you advise him to do, given his likely responses to your questions and your answer to part b? Answer: The professed reason for preferring yen financing runs afoul of the IFE. Yen interest rates are 300 basis points less than dollar interest rates because the market expects the dollar to depreciate by about 3% annually against the yen. This reason for borrowing yen is, therefore, a non starter assuming that the CFO does not assert the ability to outguess financial markets. If United’s dollar cash flow on its new route to Japan varies in line with the value of the dollar (that is, dollar cash flow drops when the dollar appreciates against the yen and vice versa when the dollar depreciates against the yen), then yen financing of its planes will reduce its exchange risk. Otherwise, dollar financing is the appropriate solution. It is difficult to say how United’s cash flow will be affected by the exchange rate. A rising dollar will reduce tourism from Japan to the U.S., but it might increase business travel involving purchases of less expensive Japanese products. Conversely, a falling dollar will stimulate Japanese tourist travel to the U.S., but could hurt business travel between the two countries. 7. Eastman Kodak’s CFO is thinking of borrowing Japanese yen because of the low interest rate, currently 4.5%. The interest rate on U.S. dollars is 9%. What is your advice to the CFO? Answer: My advice would be “don’t speculate.” The IFE says that the 450 basis point differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or operating exposure, it should stick to dollar financing. 8. Name some of the advantages and disadvantages of having highly leveraged foreign subsidiaries. Answer: A more highly leveraged subsidiary may also be a more efficient firm because management is unable to turn to the parent for help. The disadvantages of high leverage include the following: i) Local suppliers and customers may shy away from doing business with a new subsidiary operating on a shoestring if that subsidiary is receiving minimal financial backing from its parent. Having a balance sheet with more equity demonstrates that the unit has greater staying power. ii) The government might argue that the firm is overly leveraged and declare that certain debt payments are constructive dividends and impose taxes on those payments. 9. Compania Troquelados ARDA is a medium sized Mexico City auto parts maker. It is trying to decide whether to borrow dollars at 9% or Mexican pesos at 75%. What advice would you give it? What information would you need before you gave the advice? Answer: To begin, it is necessary to recognize that 75% in pesos is not the same as 9% in dollars. In the absence of government controls or access to subsidized financing, the expected before tax cost of the two loans should be about the same. If there is some tax asymmetry (e.g., foreign exchange losses are not tax deductible), then the expected after tax costs of the two loans could diverge. Regardless of the expected costs of the two loans, the risks for the firm are quite different. The dollar loan entails foreign exchange risk, while the peso loan entails inflation risk. A key question, therefore, is how does the return on the firm’s assets respond to inflation and changes in the dollar/peso exchange rate. The answer depends on where the firm sells (domestic or abroad) and whether it faces import competition on domestic sales. If the firm is selling in the U.S., the dollar loan will probably lower its exchange risk. If it is selling in Mexico without much import competition (because of trade barriers), its nominal operating profits will likely increase in line with inflation, making the peso loan the low risk loan. This assumes that the interest rate on the peso loan will adjust periodically. If the peso interest rate is fixed, then the peso loan is the low risk funding technique only if the firm’s real operating profits move inversely with Mexican inflation. Otherwise, the dollar loan is probably a lower risk bet. 10. What are the principal cash outflows associated with the IDC U.K. project? Answer: The principal cash outflows associated with the IDC U.K. project are i) The initial investment outlay, consisting of the plant purchase, equipment expenditures, and working capital requirements ii) Operating expenses iii) Later additions to working capital as sales expand iv) Taxes paid on its net income. 11. What are the principal cash inflows associated with the IDC U.K. project? Answer: The principal cash inflows associated with the IDC U.K. project include i) Cash inflows from sales in England and other EC countries ii) The tax shield provided by depreciation and interest charges iii) Interest subsidies iv) The terminal value of its investment, net of any capital gains taxes owed upon liquidation. This figure includes recapture of working capital. 12. In what ways do parent and project cash flows differ on the IDC U.K. project? Why? Answer: Parent and project cash flows differ on the IDC U.K. project in several ways: i) Funds remitted to IDC U.S. may lead to additional taxes paid to England or the U.S. These are cash outflows from the view of IDC U.S. but not IDC U.K. ii) IDC U.S. owes tax to the U.S. Internal Revenue Service on gains associated with the sale for $5 million of equipment having a book value of zero. iii) IDC U.S. receives licensing and overhead allocation fees each year, for which it incurs no additional expenses. These fees are costs to IDC U.K. iv) IDC U.S. also profits from exports to IDC-U.K. v) If sales of IDC U.K. just substitute for exports from IDC U.S., then IDC U.K.’s profits are overstated by an amount equal to the incremental cash flow that IDC U.S. would have earned on these lost exports. 13. Why are loan repayments by IDC U.K. to Lloyds and NEB treated as a cash inflow to the parent company? Answer: Loan repayments by IDC U.K. to Lloyds and NEB are treated as cash inflows to the parent because they reduce its outstanding consolidated debt burden and increase the value of its equity by an equivalent amount. Assuming that the parent would repay these loans regardless, then having IDC U.K. borrow and repay funds is equivalent to IDC U.S. borrowing the money, investing it in IDC U.K., and then using IDC U.K.’s higher cash flows (since it no longer has British loans to service) to repay IDC U.S.’s debts. 14. How sensitive is the value of the project to the threat of currency controls and expropriation? How can the financing be structured to make the project less sensitive to these political risks? Answer: Figures in Exhibit 13.6 reveal that the value of IDC’s English project is quite sensitive to the potential political risks of currency controls and expropriation. The project NPV does not turn positive until well after its fifth year of operation (assuming there are no lost sales). Should expropriation occur or exchange controls be imposed at some point during the first five years, the project is unlikely to ever be economically viable. In the face of these risks, the project is viable only if compensation is sufficiently great in the event of expropriation, or if unremitted funds can earn a return reflecting their opportunity cost to IDC U.S., with eventual repatriation, in the event of exchange controls. The project can be made less sensitive to political risks by using pound financing. Pound cash flows from the project can be used to service these debts. By borrowing from British banks, IDC will also have fewer assets at risk in the event of expropriation. In addition, the impact of potential currency controls can be minimized by setting high initial transfer prices on the sale of components to IDC U.K. by other units, by setting fees and royalties at a high initial level, and, to the extent possible, by investing parent funds as debt rather than equity. 15. What options does investment in the new British diesel plant provide to IDC U.S.? How can these options be accounted for in the traditional capital budgeting analysis? Answer: Here are some options IDC-U.S. will realize by investing in the British diesel plant: The plant’s output can be raised or lowered depending on current and expected future demand conditions, currency movements and other relative cost changes; the plant can be expanded or shut down, temporarily or permanently, again depending on future cost and market conditions (e.g., the success or failure of Europe 1992). Moreover, IDC has an enhanced market position in the EEC that can be used to expand its product offerings in the future, depending on demand conditions as well as the output of IDC’s R&D efforts. ADDITIONAL CHAPTER 14 QUESTIONS AND ANSWERS 1. Suppose the real value of the pound declines. How would this decline likely affect the economics of the IDC U.K. project? Answer: If the real value of the pound declines, the dollar value of revenues on sales in England will undoubtedly decline. At the same time, however, dollar costs of production will also decline. The net effect on IDC U.K. depends on what would have been done absent this project. If IDC U.S. would have continued to service the U.K. market, then any reduction in revenues from the pound devaluation is irrelevant since it would not be incremental from the project’s standpoint. In this case, we are left with the cost reduction and the net impact of pound devaluation on the project is unambiguously positive. In contrast, if export sales would have ceased in the absence of the IDC U.K. project, then the net impact of a pound devaluation must take into account both the revenue decline and the cost reduction. The net impact depends critically on the price elasticity of demand. The odds are that the impact will be negative but only slightly. The reason for the word "slightly" is that dollar costs of production decline on 100% of IDC U.K.’s output but sales of only half the output are affected by pound devaluation (the other half is sold to other EEC nations). 2. Describe the alternative ways to treat the interest subsidy provided by the British government. Answer: The interest subsidy provided by the British government can be incorporated in the investment analysis in one of two ways: i) Employ a weighted cost of capital, where the interest rate used is the subsidized rate; or ii) Explicitly include the subsidy (equal to the difference between the market interest rate and the subsidized rate multiplied by the subsidized principal amount) as one of the cash flows. 3. Under what circumstances should IDC U.S. earnings on lost export sales to the United Kingdom and the rest of the Common Market countries be treated as a cost of the project? Answer: IDC U.S. earnings on lost export sales to the U.K. and other EEC countries should be treated as a cost of the project if IDC U.S. had sufficient excess capacity to have continued selling in the EEC in the absence of the IDC U.K. project. 4. When should these lost export earnings be ignored when evaluating the project? Answer: The lost export earnings should be ignored when evaluating the project if the sales would have been lost anyway because (1) IDC U.S. no longer had sufficient capacity to service both the U.S. market and the European market or (2) import restrictions would have kept out exports otherwise. 5. Should the cost of capital for the IDC U.K. project be higher, lower, or the same as the cost of capital for a similar project to manufacture and sell diesel engines in the U.S.? Explain. Answer: There is no obviously correct Answer: However, three points that are relevant here. First, one of the major messages of modern financial theory is that the required return on a project depends on the riskiness of the project itself. Thus, the required return on the project should equal the required return on a similar investment undertaken in the U.S. only if the risks are the same. Second, the relevant risk that is priced and enters the cost of capital is the systematic risk of the project, not the project’s total risk. Third, returns on the U.S. plant are strongly affected by variations in the U.S. economy – a major element of systematic risk. By contrast, returns on IDC-U.S.’s British venture are primarily affected by the state of the European economy, which is less related to factors that systematically affect returns on a well-diversified U.S. or world portfolio. The net result of these three points is that the cost of capital for IDC-U.K. is most likely to be less than the cost of capital for a similar project in the U.S. 6. Some economists have stated that too many companies are not calculating the cost of not investing in new technology, world class manufacturing facilities, or market position overseas. What are some of these costs? How do these costs relate to the notion of growth options discussed in the chapter? Answer: The company that gets to market first often goes on to dominate it. Those companies that don’t invest early may quickly be out of the business altogether. They may also lose out on other opportunities that were not foreseen at the time of the investment decision, but that developed later. For example, a company that forgoes investment in a novel technology passes up the chance to explore its technical possibilities, market opportunities, development costs, and competitors’ strategies. In other words, initial expenditures on product and process technologies and market position should be viewed as investments in information and in the creation of options to utilize that information in ways that may not have been envisioned originally. For example, Merck, the pharmaceutical firm, decided to invest in an automated packaging and distribution plan, even though the labor savings didn’t justify the investment, in order to explore the potential benefits of plant automation. Results from the pilot project have clarified these benefits to the point that Merck is now expanding automation to its diverse manufacturing operations. Thus, firms that forgo investments in are passing up the chance to create and act on options. And the fact that a company passes up the chance to invest in options does not mean that its competitors will. For example, an auto maker may give up on ceramic engines, because technically they seem infeasible. But a rival who makes prosaic ceramic parts with the aim of one day using the knowledge to build a ceramic engine – as the Japanese are doing – can quickly change the competitive balance. Similarly, although liquid crystal displays (LCDs) are a U.S. invention (they were developed by RCA, which abandoned them as uneconomic), Japanese companies used them to make watches and small TVs; now they lead in LCD flat-panel computer screens. The ability to make these displays are a major reason Toshiba and other Japanese firms have won a large share of the laptop computer market. Moreover, the advanced display screens used in laptops not only are important as computer screens but also promise to open up huge markets in all types of display technology from cockpit, medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV. 7. Comment on the following statement that appeared in The Economist (August 20, 1988, p. 60): “Those oil producers that have snapped up overseas refineries – Kuwait, Venezuela, Libya, and, most recently, Saudi Arabia – can feed the flabbiest of them with dollar a barrel crude and make a profit. ... The majority of OPEC’s existing overseas refineries would be scrapped without its own cheap oil to feed them. Both Western European refineries fed by Libyan oil (in West Germany and Italy) and Kuwait’s two overseas refineries (in Holland and Denmark) would almost certainly be idle without it.” Answer: The statement is incorrect, assuming the author is referring to true economic profit. On an integrated basis, profits on the refinery are more than offset by losses on sales of the crude oil at subsidized prices. In fact, the oil producers are cross-subsidizing their refineries. They would be better off without the refineries and selling their oil on the open market. Investments should be evaluated taking into account the true opportunity costs of all the assets used. 8. In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian state owned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on the price GE paid). 8.a. What might account for GE’s decision to spend so much money to acquire such a dilapidated, inefficient manufacturer? Answer: Eastern Europe has the potential to be both a large market for Western goods and a low-cost manufacturing platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years’ experience in “they pretend to pay us and we pretend to work” can produce at the level and quality necessary to be competitive with their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern European market. It also is learning what it takes to install modern Western management methods in a former communist country and to use Hungary as a low-cost backdoor to Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak global presence. GE’s presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically it has dominated the U.S. market. Then came a highly successful raid on GE’s U.S. fortress by Philips, which is the world’s largest light bulb producer. GE fought back by storming Philips’ European base but was unable to acquire a controlling interest in any Western European firm and building a new plant would have cost at least $300 million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European market; (b) introducing new technologies and higher-priced products to Tungsram; and (c) a low-cost export platform. 8.b. A Hungarian light bulb worker earns about $170 a month in Hungary, compared with about $1,700 a month in the U.S. Do these figures indicate Tungsram will be a low cost producer? Answer: No. You must also know how productive these workers are. What matters is what you are getting relative to what you are paying for. In fact, GE estimates that the productivity of Hungarian workers is one-seventh that of its workers in the U.S. Since GE is paying only one-tenth the wages but getting one-seventh the productivity, these figures taken together indicate that Tungsram should produce a light bulb 30% cheaper than GE’s U.S. plants (1/10:1/7 = .70). In response, Philips recently took over Poland’s leading lamp producer and another Western European competitor, Siemens’ Osram unit, has acquired an East German producer. SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS 1. Suppose a firm projects a $5 million perpetuity from a $20 million investment in Spain. If the required return on this investment is 20%, how large does the probability of expropriation in year 4 have to be before the investment has a negative NPV? Assume that all cash inflows occur at the end of each year and that the expropriation, if it occurs, will occur prior to the year 4 cash inflow or not at all. There is no compensation in the event of expropriation. Answer: This problem can be solved by breaking the cash flow stream into two components – one component if expropriation takes place and the other if no expropriation takes. The expected value of these streams is found by multiplying the first component by the probability that expropriation will take place and the other component by the probability that expropriation will not take place. Note that the cash flow streams are identical prior to year 4. All numbers are in millions of dollars. Year 0 1 2 3 4 5+ Cash flow with expropriation Cash flow if no expropriation $20 20 $5 5 $5 5 $5 5 0 5 0 5 If the probability of expropriation in year 4 is p, then the expected cash flows associated with this investment are: Year 0 1 2 3 4 5+ -$20 $5 $5 $5 $5(1 - p) $5(1 - p) The net present value of these cash flows, discounted at a 20% required return, is 20 + 5/1.2 + 5/(1.2)2 + 5/(1.2)3 + 5(1 p)/(1.2)4 + ... + 5(1 p)/(1.2)t + ... = 20 + 5/.2 (5p/.2)/(1.2)3 = 20 + 25 14.68p Setting this quantity equal to 0 yields a solution of p = 34.1%. This means that the probability of expropriation has to be 34.1% before the investment no longer has a positive NPV. Note. The summation of the terms in the NPV equation uses the fact that the sum of an infinite annuity (a perpetuity) is a/r, where a is the annuity and r is the discount rate. Recognize also that the expected cash flow can be split into two annuities – one beginning in year 1 and equal to 5 per annum and the other beginning in year 4 and equal to 5p per annum. 2. Suppose a firm has just made an investment in France that will generate $2 million annually in depreciation, converted at today’s spot rate. Projected annual rates of inflation in France and in the U.S. are 7% and 4%, respectively. If the real exchange rate is expected to remain constant and the French tax rate is 50%, what is the expected real value (in terms of today’s dollars) of the depreciation charge in year 5, assuming that the tax write off is taken at the end of the year? Answer: If the real exchange rate is expected to remain constant, then the real dollar value of the euro is expected to decline at the same rate as the real euro value, namely the 7% French inflation rate. Hence, the real dollar value of the depreciation tax write off will decline at the rate of 7% per annum. If the French tax rate is 50%, then a depreciation charge of $2 million is worth $1 million in today’s dollars. If the real dollar value of this write off is declining at the rate of 7% annually, then its real value in year 5, given that the write off is taken at the end of the year, is $1,000,000/(1.07)5 = $712,986. 3. A firm with a corporate wide debt/equity ratio of 1:2, an after tax cost of debt of 7%, and a cost of equity capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12%. The after tax cost of debt is expected to remain at 7%. 3.a. What is the project’s weighted average cost of capital? How does it compare with the parent's WACC? Answer: The weighted average cost of capital for the project is kI = (1 w) * ke’ + w * id(1 t) where w is the ratio of debt to total assets, ke’ is the required risk adjusted return on project equity, and id(1 t) is the after tax cost of debt for the project. Substituting in the numbers provided yields kI = 2/3 * 12% + 1/3 * 7% = 10.33% 3.b. If the project’s equity beta is 1.21, what is its unlevered beta? Answer: The following approximation is usually used to unlever beta: Unlevered beta = levered beta/[1 + (1 t)D/E] where t is the firm’s marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm’s marginal tax rate, we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is Unlevered beta = 1.21/[1 + (1 0.4)0.25] = .93 4. Suppose that a foreign project has a beta of 0.85, the risk free return is 12%, and the required return on the market is estimated at 19%. What is the cost of capital for the project? Answer: The cost of capital for the project is k* = Rf + β*[E(Rm) Rf] where Rf is the risk free required return, β* is the project beta, and E(Rm) is the expected return on the market. Substituting in the numbers provided in the problem yields k* = 012 + 0.85(0.19 0.12) = 17.95% 5. IBM is considering having its German affiliate issue a 10-year, $100 million bond denominated in euros and priced to yield 7.5%. Alternatively, IBM’s German unit can issue a dollar-denominated bond of the same size and maturity and carrying an interest rate of 6.7%. 5.a. If the euro is forecast to depreciate by 1.7% annually, what is the expected dollar cost of the euro-denominated bond? How does this compare to the cost of the dollar bond? Answer: According to Chapter 14, the pre-tax dollar cost of borrowing in a foreign currency at an interest rate of rL, where the currency is expected to appreciate (depreciate) against the dollar at an annual rate of c, is rL(1 + c) + c. Substituting the numbers in the problem to this formula yields an expected dollar cost of borrowing euros of 5.67% [7.5% * (1 - 0.017) - 1.7%). This figure is substantially below the 6.7% cost of borrowing dollars. 5.b. At what rate of euro depreciation will the dollar cost of the euro-denominated bond equal the dollar cost of the dollar-denominated bond? Answer: The answer to this question is the solution to 7.5% * (1 + c) + c = 6.7%, or c = (6.7% - 7.5%)/1.075 = -0.74%. 5.c. Suppose IBM’s German unit faces a 35% corporate tax rate. What is the expected after-tax dollar cost of the euro-denominated bond? Answer: According to Chapter 14, the effective after-tax dollar cost of borrowing a local currency at an interest rate of rL, annual currency appreciation (depreciation) of c, and a corporate tax rate of ta, is r = rL(1 + c)(1 ta) + c. Substituting in the numbers from the question yields a solution of r = 7.5% * (1 - 0.017)(1 - 0.35) - 0.017 = 4.78%. 6. Suppose the cost of borrowing restricted euros is 7% annually, whereas the market rate for these funds is 12%. If a firm can borrow €10 million of restricted funds, how much will it save annually in before-tax franc interest expense? Answer: The annual interest savings on €10 million of restricted funds at 7% when the market rate is 12% equals €10,000,000(0.12 0.07) or €500,000. 7. Suppose one of the inducements provided by Taiwan to Xidex to set up a local production facility is a ten year, $12.5 million loan at 8%. The principal is to be repaid at the end of the tenth year. The market interest rate on such a loan is about 15%. With a marginal tax rate of 40%, how much is this loan worth to Xidex? Answer: By borrowing at 8% when the market rate is 15%, Xebec saves 8% annually. This translates into annual before tax savings of $12,500,000(0.15 0.08) = $875,000. With a marginal tax rate of 40%, this yields annual after tax savings of $525,000. The value of this ten year annuity, discounted at Xebec’s after tax debt cost of 9% (15% * 0.6), is $525,000 * 6.4177 = $3,369,293. 8. Jim Toreson, CEO of Xebec Corp., a California, manufacturer of disk drive controllers, must decide whether to switch to offshore production. Given Xebec’s well developed engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking advantage of low wage labor, tax holidays, low interest loans, and other government largess. Most of his competitors seem to be doing it. The faster he follows suit, the better off Xebec would be according to the conventional discounted cash flow analysis, which shows that switching production offshore is clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of certain intangible strategic benefits associated with domestic production. 8.a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its customers are all U.S. firms and that manufacturing technology – particularly automation skills – is key to survival in this business. Answer: Short run benefits include better quality control and communication with customers and the ability to adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a laboratory to apply the latest thinking about automated production. By working with the production process on a daily basis, Xebec would have a better sense of the technology’s wider potential. For example, running a highly automated production operation next door to the engineering group would enable Xebec to provide production related input in the early stages of product design – which offshore production managers can rarely do. With successfully automated production, Xebec’s new disk drives could be offered at a price and quality level to match those of potential competitors from Japan or anywhere else. By contrast, contracting to have its products built by a potential competitor in a country like Taiwan or Japan might cost Xebec both market share and its technological edge. The video recorder is an example of how production know how can yield important technical advances. Sony, along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professional use product from the U.S. costing $20,000 or more and turned it into a $1,500 home product with a relatively small market. Japanese designers then worked closely with Japanese factories to make every component smaller and less expensive. Cooperation between Matsushita’s design teams and employees on the shop floor eliminated more than three quarters of the product’s cost while dramatically improving its quality. In the process, the firm turned a niche product into the mass market success story of the 1980s. 8.b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing (which are intangible costs of offshore production) into the factory location decision? Answer: The intangible strategic benefits of domestic manufacturing can be factored into the factory location decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and benefit from expanding into new products or markets or new process technologies. Whether Xebec will exercise these growth options depends on what happens in the future, which is unknowable today. The value of these growth options depends on several factors: i) The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before responding to changes in the marketplace (since automation enables it to respond so quickly once it decides to). The investment in automation also provides Xebec with a set of long lasting skills. ii) The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in automation is likely to be especially valuable since it so risky. iii) The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options. iv) The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared with others. Learning about the automation process is clearly a proprietary skill and so more valuable than investing in a new piece of equipment that everyone has access to. Valuing an investment in automation that embodies discretionary follow up projects requires an expanded net present value rule that considers the attendant options. More specifically, the value of an option to undertake a follow up project equals the expected NPV from investing in the project using the conventional discounted cash flow analysis plus the value of the discretion associated with undertaking the project. 8.c. How would the possibility of radical shifts in manufacturing technology affect the production location decision? Answer: The possibility of radical shifts in manufacturing technology would increase the benefits from investing in factory automation in the U.S. The phrase “radical shifts” implies that the project is high risk, which increases the option component of value. For example, companies that in the mid 1970s made the transition from electro mechanical manually operated machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities – much higher performance at much lower cost – of the microprocessors and microcontrollers that became available in the early 1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when they became available. Companies that had deferred investment in the emerging electronic technology were not able to participate in the great technological advances in microelectronics; they had not acquired an option in this new process technology. 8.d. Xebec is considering producing more sophisticated drives that require substantial customization. How does this possibility affect its production decision? Answer: The more customization is required, the more important it is to work closely with the customer. To meet the exacting needs of customers, there must be close personal contract between Xebec’s engineering and production staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of the marketing, engineering, design, and manufacturing people when they are spread around the globe. The need for coordination increases the value of domestic production facilities. 8.e. Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to Xebec to build a factory there. The loan would be paid off in equal annual installments over a five year period. If the market interest rate for such an investment is 14%, what is the before tax value of the interest subsidy? Answer: Borrowing at 5% when the market rate of interest is 14% saves Xebec 9% annually on the principal balance. This leads to annual before tax savings and their associated present values as follows: Year Principal Interest Savings PV Factor (@ 14%) Present Value 1 2 3 4 5 $10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 $900,000 720,000 540,000 360,000 180,000 .8772 .7695 .6750 .5921 .5194 $789,480 554,040 364,500 213,156 93,492 Total $2,014,668 The value of this five year stream of cash, discounted at 14%, is $2,014,668. 8.f. Projected before tax income from the Taiwan plant is $1 million annually, beginning at the end of the first year. Taiwan’s corporate tax rate is 25%, and there is a 20% dividend withholding tax. However, Taiwan will exempt the plant’s income from corporate tax (but not withholding tax) for the first five years. If Xebec plans to remit all income as dividends back to the U.S., how much is the tax holiday worth? Answer: Very little. Assuming that Xebec doesn’t have any excess foreign tax credits (FTCs), it will owe the difference between the 20% withholding tax on dividends and the 34% rate levied by the IRS on its Taiwanese income. Xebec’s after tax income from Taiwan, with and without the tax holiday, will be: Taiwan No Tax Holiday Tax Holiday PBT PAT (tax @ 25%) Dividend Withholding tax (@ 20%) $1,000,000 750,000 750,000 150,000 PBT PAT (no tax) Dividend Withholding tax (@ 20%) $1,000,000 1,000,000 1,000,000 200,000 Net Dividend to Xebec $600,000 Net Dividend to Xebec $800,000 United States U.S. tax owed (@ 34%) Direct FTC Indirect FTC $340,000 150,000 250,000 U.S. tax owed (@ 34%) Direct FTC Indirect FTC $340,000 200,000 0 Net U.S. tax owed PAT to Xebec ($60,000) $600,000 Net U.S. tax owed PAT to Xebec $140,000 $660,000 Assuming that Xebec has no use for excess foreign tax credits, the calculations show that the value of the tax holiday to it is only about $60,000 annually. 8.g. An alternative sourcing option is to shut down all domestic production and contract to have Xebec’s products built for it by a foreign supplier in a country such as Japan. What are some of the potential advantages and disadvantages of foreign contracting vis á vis manufacturing in a wholly owned foreign subsidiary? Answer: Foreign contracting, where a company outsources production to a foreign supplier, presents a variety of advantages and disadvantages compared to manufacturing in a wholly owned foreign subsidiary. Here's a detailed look at both sides: Advantages of Foreign Contracting 1. Cost Savings: Contracting with a foreign supplier can significantly reduce labor and production costs due to lower wages and operational expenses in the supplier's country. 2. Flexibility: It allows for more flexibility in production volumes. Companies can scale up or down production without the need to invest heavily in new facilities or equipment. 3. Focus on Core Competencies: Outsourcing production enables the company to concentrate on its core activities such as research, development, marketing, and sales. 4. Reduced Capital Investment: There is no need to invest in the construction and maintenance of manufacturing facilities, which can lead to substantial capital savings. 5. Access to Expertise: Foreign suppliers often have specialized knowledge and expertise in production processes, which can lead to higher quality products. 6. Speed to Market: Utilizing established suppliers can lead to faster production start-ups and quicker time-to-market for products. Disadvantages of Foreign Contracting 1. Quality Control Issues: It can be challenging to maintain consistent quality standards when production is outsourced, particularly if the supplier does not adhere to the company’s quality expectations. 2. Loss of Control: There is less control over the production process, which can lead to issues with product specifications, delivery times, and compliance with safety and environmental standards. 3. Intellectual Property Risks: Outsourcing production may expose the company to risks related to intellectual property theft or infringement. 4. Dependence on Suppliers: Relying heavily on a foreign supplier can create dependency issues, which can be problematic if the supplier faces disruptions or decides to alter terms or pricing. 5. Political and Economic Risks: Outsourcing to a foreign country can expose the company to political instability, economic fluctuations, and changes in trade policies or tariffs. 6. Logistical Challenges: Managing logistics and supply chain complexities can become more challenging when dealing with international suppliers, including longer lead times and potential shipping delays. Advantages of a Wholly Owned Foreign Subsidiary 1. Complete Control: Owning the manufacturing facility provides full control over production processes, quality standards, and operational procedures. 2. Protection of Intellectual Property: A wholly owned subsidiary offers better protection for intellectual property and proprietary technology. 3. Integration: The subsidiary can be fully integrated into the company's global operations, ensuring consistency in culture, values, and business practices. 4. Direct Market Presence: Establishing a subsidiary can enhance the company’s presence and brand recognition in the foreign market. 5. Long-term Strategy: Investing in a subsidiary can be part of a long-term strategy to build a strong foothold in a strategic market. Disadvantages of a Wholly Owned Foreign Subsidiary 1. High Capital Investment: Establishing and maintaining a subsidiary requires significant capital investment in facilities, equipment, and local operations. 2. Complexity: Managing a foreign subsidiary can be complex and challenging, requiring knowledge of local regulations, business practices, and market conditions. 3. Longer Time to Set Up: Setting up a new manufacturing facility takes considerable time and effort, delaying the start of production. 4. Operational Risks: The company bears all operational risks, including local economic downturns, regulatory changes, and labor issues. 5. Cultural Differences: Managing a foreign workforce involves navigating cultural differences and potential misunderstandings, which can impact efficiency and morale. In summary, while foreign contracting offers cost advantages and flexibility, it comes with significant risks related to quality control and dependence on external suppliers. Conversely, a wholly owned foreign subsidiary provides greater control and integration but involves higher costs and complexity. The choice between these options depends on the company's strategic priorities, resources, and risk tolerance. Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954