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1 CAPITAL BUDGETING ISSUES IN FAST- GROWING ECONOMIES

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2 How to value business opportunities? Examples Bombardier considers building a component assembly plant in Sao Paulo. The plant would import components from Canada, employ Brazilian workers to assemble the components into modules, and re-exports all of its production back to Bombardiers facilities in Montreal. Google analyzes entering the Russian portal market via a joint venture with Yandex.

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3 Project valuation in emerging markets can be challenging how would you go about valuing each investments? would you construct your cash flow projections in Brazilian Real or Canadian dollars? Then, how would you convert between different currencies? how would you measure country risks (political risk, corruption) and how would you adjust your cost of capital for country risks? what about industry characteristics (e.g., aviation vs. internet access)? How to Value Business Opportunities?

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4 Main Issues Main issues arising when investing in EM recognizing costs and revenues in multiple currencies assessing country risk and incorporating them into discount rate country risk includes macroeconomic volatility, potential regulatory or political change, poorly defined property rights and enforcement mechanisms accounting for business volatility which is different from that of developed economy accounting for potential events, e.g., expropriation or currency devaluation These issues make project valuation in EM an art than a science

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5 Basic Idea Basic Principles inflation and risk erode purchasing power of money. Hence, dollarreceived at 2010 will have different purchasing power from the same dollars received at 2011 we have to discount future cash flows with appropriate discount rates as future cash flows are also exposed to uncertainty, we calculate expected value of cash flows at each time in the future before discounting Present Value of Investment - where CF i is the expected cash flow at future year i and DR a discount rate that reflects the risk of the investment

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Basic Idea Net Present Value is the Present Value of an investment project, net of initial investment to start the project positive NPV indicates that the present value of the cash flows of the project outweighs the necessary investments; a negative NPV indicates the opposite Net Present Value of Investment If NPV > 0 Invest; If NPV < 0 Do not invest. If NPV i > NPV j Invest in i; If NPV i < NPV j Invest in j. NPV 6

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Steps Project value determining steps 1. Forecasting investment requirements and expected free cash flows from a project 2. Determining the rate at which to discount the cash flows from the project (cost of capital) 3. Using the discount rate to calculate the net present value (NPV) of the project 4. Performing sensitivity analysis 7

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Currency Conversion Foreign exchange terminology and economic relationships spot rate forward rate for any two countries and any two periods, the expected change in the exchange rate is equal to the difference in nominal interest rates, which is equal to the expected difference in inflation rates what happens if the equality does not hold? Currency arbitrage 8

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Time Dimension Currency Dimension $ FC tt+n Borrow $ Borrow FC Lend FC Lend $ Sell FC Spot Buy FC Spot Sell FC Buy FC Spot, Forward, and Money Markets A BC D 9

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EXAMPLES 10

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Relative Inflation Rates Forward Exchange Rates Relative Interest Rates Key International Relationships Uncovered Interest Parity Unbiased Forward Rate Covered Interest Parity Purchasing Power Parity Exchange Rate Change Fisher Effect and Real Interest Parity 11

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Revenues and Costs in Multiple Currencies Capital budgeting with multiple currencies – two approaches Local currency NPV project value is primarily determined by the events within the host country revenues and costs occur primarily in local currency, when investment capital is raised locally and free cash flow is reinvested locally pros: dont need to forecast exchange rates cons: local cost of capital can be severely distorted, especially due to hyperinflation or governments interest rate manipulation when there is (dis) advantage against foreign firms accessing local financing, this approach can (over) undervalue the project, compared to local firms 12

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Capital budgeting with multiple currencies – two approaches Period-by period conversion produce local currency projections, then convert the period-by period cash flows into home country currency using forward rates or projected exchange rates resulting home country cash flows are then discounted at a rate derived from the home country discount rate. pros: analyst can explicitly consider how shifts in the exchange rate affect project cons: few forward rates are available beyond one year forecasting can be complicated when local governments intervenes in credit or foreign exchange market 13 Revenues and Costs in Multiple Currencies

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EXAMPLE 14

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Cost of Capital Intuitive definition minimum return required from the projects invested by a company average cost of financing a company it is the minimum required rate of return on an investment project that keeps the present wealth of the shareholders constant it is also a discount rate used to determine how favorable an investment project is Example suppose a firm finances only with debt and equity. Its cost of capital is where,, required return on market value of debt (equity) 15

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Difference between cost of debt and equity cost of debt is easily observable, while cost of equity needs to be estimated Cost of equity = R f + β· ( R m - R f ) where R f = risk free rate ( R m - R f ) = market risk premium β = project beta which measures how project returns vary with market returns What do β = 0.5 or 2.0 mean? β = 0.5 (2.0) means that a 1% change in market implies an expected 0.5% (2.0%) move in the securitys or the projects return Risk Free Rates ( R f ) approximated with the yield to maturity on government bonds (e.g., U.S. T-bonds) 10-year yield is widely used Cost of Capital 16

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Betas (β ) usually estimated on the basis of five years or monthly returns 17 Cost of Capital

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Which factors influence β ? cyclicality of revenues, leverage low β firms : utilities, food retailers, low fixed cost firms, low levered firms high β firms : high tech or homebuilders why is β of homebuilder high? homebuilders revenue is more sensitive to business cycle why is β of low levered firm low? firms with debt should make interest payments regardless of sales or profits Cost of Capital 18

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What is country risk? ability to service its debt and to support the conversion of local earnings into home country currency How to measure country risk? yield on sovereign debt debt yield reflects two risk factors 1) country risk 2) exchange risk premium Accounting for Country Risk 19

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How to measure cost of equity in EM? add country premium Equity Cost of Capital = ( R f + country premium ) + β· ( R m – R f ) country premium of developing economies Accounting for Country Risk 20

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