Yale School of Management 1 Emerging Market Finance: Lecture 8: Project Valuation in Emerging Markets

Yale School of Management 2 The Textbook Approach to Capital Budgeting The standard approach involves calculating a Net Present Value (NPV): 1. Forecast Investment requirements and expected free cash flows from a project. 2. Determine the rate at which to discount the cash flows from the project. 3. Use the project discount rate to discount future cash flows and determine the project NPV. 4. Perform sensitivity analysis around key variables to determine how NPV varies with changes in these variables

Yale School of Management 3 Shortcuts for Valuation in Emerging Markets Approach 1: Valuation using multiples of easily observed asset values.  Most straight forward approach is to value an investment opportunity as a multiple of some important operating asset – such as oil reserves, brewing capacity, or potential cellular phone subscribers.  Start with the “asset multiple” that prevails in developed countries, and adjust it to account for uncertainty in the local business environment.

Yale School of Management 4 Shortcuts for Valuation in Emerging Markets Approach 2: Revenue/Operating Profit Multiples.  Forecast revenues or operating profits and value the potential investment as a multiple of this flow.  Make conservative estimations about capacity utilization, pricing and margins. This approach allows to sidestep the challenge of predicting exchange rates, determining a cost of capital, or explicitly valuing the potential for follow-on investments.

Yale School of Management 5 Approach 3: Hard currency projections and discount rates: Foreign Exchange Terminology A foreign exchange rate is simply the value of one currency in terms of another. The rate available on a particular day is referred to as the spot rate. For major currencies it is also possible to observe forward rates. Spot and Forward rates are closely related to differences in interest rates and inflation rates (assuming neither exchange rates or interest rates are controlled). In fact, 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. If this relationship did not hold, profitable arbitrage opportunities would arise.

Yale School of Management 6 Capital Budgeting with Multiple Currencies Two approaches to valuing projects with cash inflows and outflows in more than one currency:  Local Currency NPV  Period-by Period Conversion

Yale School of Management 7 International Capital Budgeting: Example Arctis, a canadian manufacturer of heating equipment, considers building a plant in Japan. The plant would cost Yen1.3m to build and would produce cash flows of Yen200,000 for the next 7 years. Other data are:  Yen interest rate:2.9%  C$ interest rate: 8.75%  Spot rate: Yen/C$:  Assumption: the investment is risk free How should you calculate the NPV?

Yale School of Management 8 Two Ways of Calculating NPV Method I: local currency NPV Step 1: Forecast cash flows in Yen Step 2: Discount at interest rate for Yen; gives NPV in Yen Step 3: Convert NPV in Yen into Canadian dollars at spot exchange rate, gives NPV in C$ Method II: period-by-period Conversion Step 1: Forecast cash flows in Yen Step 2: Convert cash flows into C$ using implied forward rate Step 3: Discount C$ cash flows using the interest rate for C$, gives NPV in C$.

Yale School of Management 9 Results for Two Methods Method I: Present value = -Yen 49,230 Method II: Present value = -C$ 590 = -Yen (590*83.86)=-Yen49,230 Both methods yield the same result!  Why is this necessary?

Yale School of Management 10 Alternative Exchange Rate Forecast Suppose the corporate treasurer argues that the true value of the investment is understated, because the market is too pessimistic about the Yen  Assume the Yen appreciates 2.5% p. a. faster than anticipated by the market  Now the PV with Method II becomes C$ 976 or Yen 81,840 Now the project looks profitable, should you take it?

Yale School of Management 11 Local Currency NPV It assumes that the project value is determined primarily by events within the host country. Appropriate for projects whose revenues and costs will occur primarily in local currency, when investment capital is raised locally, and when free cash flow will be reinvested locally. Shortcomings:  Local cost of capital is severely distorted in many countries, particularly in those with hyperinflation or those with foreign exchange controls.

Yale School of Management 12 Period-by Period Conversion Produce local currency projections and to convert the period-by period cash flows into home country currency using forward rates or projected exchange rates. The resulting home country cash flows are then discounted at a rate derived from the home country discount rate, with appropriate adjustments for country and project risks.

Yale School of Management 13 Period-by Period Conversion Advantages:  Consider explicitly how shifts in the exchange rate affect project economics. Useful for sensitivity analysis.  Explicit also about how a discount rate is chosen. Drawback:  Project exchange rates over the life of the project. For some countries, publicly quoted forward rates are available for up to a year, but few forward rates are available beyond that. Long-term currencies forecasts are available from a variety of sources, but these often vary widely. For floating currencies interest rate differentials and PPP are used.

Yale School of Management 14 Symmetrical and Asymmetrical Risks These are non-exchange rate risks. Symmetrical risks are those that might turn out either better or worse than the analysts expected value.  Country and Commercial Risk.  Lead to an increase in required returns and should be accounted for by increasing the discount rate. Asymmetric risks are those whose variance is primarily in one direction from the expected value.  Appropriation and follow-on investments.  Should be accounted for by using probability-weighted scenario analysis.

Yale School of Management 15 Shortcuts for Valuation in Emerging Markets Approach 4: Adding fixed markups to the home country cost of capital.

Yale School of Management 16 Approach 4: Adjusting the emerging-market cost of capital The term country risk is used to refer to a host country’s ability to service its debt and to support the conversion of local earnings into home country currency. One convenient measure of country risk is provided by yields on sovereign debt. The difference in the yields on the public debt of two countries reflects two factors: a country risk premium and the expected shift in the exchange rate.

Yale School of Management 17 Country or Sovereign Risk It is difficult to disentangle both effects. However, if both countries have issued sovereign debt in a common currency, the currency effect is eliminated and differences in yield represents the market’s assessment of the relative likelihood of losses due to rescheduling or default. Example: In this case country risk is considered constant and should be added to the risk free rate: Equity Cost of Capital = (Rf + country premium) + B * (Rm-Rf)

Yale School of Management 18 Country or Sovereign Risk

Yale School of Management 19 The International Cost of Capital Goldman-Integrated Model Estimate market beta on the S&P 500 Beta times historical US premium Add sovereign yield spread Goldman model only useful if you have sovereign yield spread

Yale School of Management 20 The International Cost of Capital CSFB E[r]=SY+ß{E[r-RF] x A} x K SY= Brady bond yield (or use fitted from EHV) ß= beta of a stock against a local index A= the coefficient of variation (CV) in the local market divided by the CV of the US market, where CV= standard deviation/mean K is an adjustment factor to allow for correlation between risk free and risk premium (set=0.6)

Yale School of Management 21 Business Risk Business risk reflects the volatility of the business environment. It is attributable to microeconomic factors such as rapid entry and exit rates, changing consumer preferences, industry structural change, and the possibility of regulatory change. If the business environment is highly volatile, the market risk premia should be adjusted to reflect this:  Project discount rate = (risk free rate + country risk premium) + (relative risk) * equity mkt premium

Yale School of Management 22 Business Risk Two approaches to calculate relative business risk:  Calculate country “betas” by regressing the equity returns from the individual countries against a world equity portfolio (Lessard 1996). Many countries with high volatility relative to the U.S. market have low betas because these country’s equity market performance has low correlation with the U.S. market. These projects contribute little to the volatility of a firm’s cash flows and Lessard argues that the discount rate applied to a project in such a country might be close to, or even below, the home country cost of capital.

Yale School of Management 23 Business Risk Second Approach bye Godfrey and Espinosa (1996).  Argue that statistical CAPM beta estimates understate the risk of emerging market projects. They note that managers perceive such projects to have much higher risks than home country projects and that a higher proportion of project risks are outside manager’s control.  They use “Total Return Volatility”. It is simply the ratio of a country’s equity volatility and world equity volatility The average “TRV” beta for Emerging Markets was 2.5 times as volatile as developed countries. Based on an equity premium of 6%, this would imply and average 15% adjustment to the home country cost of capital.