International Finance FIN456 ♦ Spring 2013 Michael Dimond

Michael Dimond School of Business Administration Sustaining & transferring Competitive Advantage In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market In order to sustain a competitive advantage it must be: Firm-specific Transferable Powerful enough to compensate the firm for the extra difficulties of operating abroad Some of the competitive advantages enjoyed by MNCs are: Economies of scale and scope Managerial and marketing expertise Advanced technology Financial strength Differentiated products Competitiveness of the their home market

Michael Dimond School of Business Administration Sustaining & Transferring Competitive Advantage

Michael Dimond School of Business Administration Multinational Investment Decisions Two related behavioral theories behind FDI that are most popular are Behavioral approach to FDI International network theory Behavioral Approach – Observation that firms tended to invest first in countries that were not too far from their country in psychic terms This included cultural, legal, and institutional environments similar to their own International network theory – As MNCs grow they eventually become a network, or nodes that operate either in a centralized hierarchy or a decentralized one Each subsidiary competes for funds from the parent It is also a member of an international network based on its industry The firm becomes a transnational firm, one that is owned by a coalition of investors located in different countries

Michael Dimond School of Business Administration Alternative investments for expansion Exporting vs. production abroad Licensing/management contracts versus control of assets abroad Joint ventures versus wholly owned subsidiary Greenfield investment versus acquisition A greenfield investment is establishing a facility “starting from the ground up” Usually require extended periods of physical construction and organizational development Here, a cross-border acquisition may be better because the physical assets already exist, shorter time frame and financing exposure However, problems with integration, paying too much for acquisition, post-merger management, and realization of synergies all exist

Michael Dimond School of Business Administration

When making FDI decisions, cost of capital is key There are two alternatives in valuing foreign projects: Adjusting the discount rate to accommodate risk Adjusting the cash flows to accommodate risk Adjusting the discount rate is simpler, but the approach can be over-simplified and lead to poor decisions (& agency cost) Adjust with a risk premium Adjust with a risk model

Michael Dimond School of Business Administration Refresher on WACC Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity. If Corcovado’s beta is estimated at 0.8, what is its weighted average cost of capital?

Michael Dimond School of Business Administration Refresher on Beta You should be familiar with some of this… β i = ρ im σ i / σ m β f = ρ fd σ f / σ d β project = β f β i

Michael Dimond School of Business Administration Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity. If Corcovado’s beta is estimated at 0.8, what is its weighted average cost of capital? Assume the beta of the foreign market vs the domestic market is What is the WACC for Corcovado to engage in a project in this foreign economy?

Michael Dimond School of Business Administration Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects Capital budgeting follows same framework as domestic budgeting –Identify initial capital invested or put at risk –Estimate cash inflows, including a terminal value or salvage value of investment –Identify appropriate discount rate for PV calculation –Apply traditional analysis Budgeting for Foreign Projects

Michael Dimond School of Business Administration Cementos Mexicanos (Cemex) is considering construction of plant in Indonesia (Semen Indonesia) as a Greenfield project Cemex is listed on both US and Mexican markets but most of its capital is US dollar denominated so evaluation of project is in US dollars FDI Example: Cemex enters Indonesia

Michael Dimond School of Business Administration Financial assumptions –Capital Investment – cost to build plant estimated at $150/tonne but Cemex believes it can build the plant at a cost of $110/tonne Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is estimated at Rp22 trillion With straight line depreciation on equipment values at Rp17.6 trillion costing 1.76 trillion per year –Financing – plant would be financed with 50% equity (all from Cemex) and 50% debt Debt is broken down, with Cemex providing 75% and a bank consortium providing the remaining 25% Cemex’s WACC (in US dollars) is 11.98% For the local project (in rupiah) the WACC is % Cemex enters Indonesia

Michael Dimond School of Business Administration Investment & Financing of Semen Indonesia All figures in 000s unless stated otherwise

Michael Dimond School of Business Administration More financial assumptions –Revenues – sales are based on export and the plant will operate at 40% capacity producing 8 million tonnes per year Cement will be sold in export market at $58/tonne –Costs – cost per ton is estimated at Rp115,000 in 1999 and rising at the rate of inflation (30%) per year For export costs, loading costs of $2.00/tonne and shipping costs of $10/tonne must also be added Cemex enters Indonesia

Michael Dimond School of Business Administration Expected Debt Service & Exchange Gain/Loss

Michael Dimond School of Business Administration Pro Forma Income Statement

Michael Dimond School of Business Administration Semen Indonsia’s free cash flows are found by looking at EBITDA and not EBT Taxes are calculated based on this amount Terminal value is calculated for the continuing value of the plant after year 5 –TV is calculated as a perpetual net operating cash flow after year 5 Project Viewpoint Capital Budget

Michael Dimond School of Business Administration $1,925 is Cemex’s capital investment, NOT the total capital invested: $1,100MM equity + $825MM Debt Remittance of income to parent (MM rupiah & $)

Michael Dimond School of Business Administration Now cash flows estimates are constructed from parent’s viewpoint Cemex must now use it’s cost of capital and not the project’s Recall that Cemex’s WACC was 11.98% However, Cemex requires an additional yield of 6% for international projects, thus the discount rate will be 17.98% This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint Parent Viewpoint Capital Budget

Michael Dimond School of Business Administration Political risk – biggest risk is blocked funds or expropriation –Analysis should build in these scenarios and answer questions such as how, when, how much, etc. Foreign exchange risk –Analysis should also consider appreciation or depreciation of the US dollar Sensitivity Analysis: Project Viewpoint

Michael Dimond School of Business Administration When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways; –Adjusting the discount rates –Adjusting the cash flows Sensitivity Analysis: Parent Viewpoint

Michael Dimond School of Business Administration Adjusting discount rates –The first method is to treat all foreign risk as a single problem, by adjusting the discount rate applicable to foreign projects relative to the rate used for domestic projects to reflect the greater foreign exchange risk, political risk, agency costs, asymmetric information and other uncertainties –However, adjusting the discount rate applied to a foreign project’s cash flow to reflect these uncertainties does not penalize NPV in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time Adjusting cash flows –In the second method, we incorporate foreign risks in adjustments to forecasted cash flows of the project –The discount rate for the foreign project is risk-adjusted only for overall business and financial risk, in the same manner as for domestic projects –It is important to remember that the process of forecasting cash flows is extremely subjective. Document all assumptions. Sensitivity Analysis: Parent Viewpoint

Michael Dimond School of Business Administration In many cases, neither adjusting the discount rate nor adjusting cash flows is optimal For example, political uncertainties are a threat to the entire investment, not just the annual cash flows Apart from anticipated political and foreign exchange risks, MNCs sometimes worry that taking on foreign projects may increase the firm’s overall cost of capital because of investor’s perceptions of foreign risk; in these cases diversification is a risk mitigant Shortcomings of Adjustments

Michael Dimond School of Business Administration

Scenario: Alpha Tile Co. (U.S.) is considering a capital expenditure of Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years the subsidiary would be sold to Indian investors for Rs100,000,000 above the value of the NWC tied up in the project. There wll be no capital gains tax on the final sale. The assumptions is sales revenue will be Rs30,000,000 next year, with sales growing 5% per year and 57% of sales required for cash operating expenses. There will be Rs1,000,000 annual depreciation expenses. Initial Net Working Capital needs will be Rs3 million, and are expected to be 12% of sales for each subsequent year. Alpha uses a 14% cost of capital on domestic investments, and will add 6 percentage points for the Indian investment because of perceived greater risk. The initial investment will be made on December 31, 2013, and cash flows will occur on December 31st of each succeeding year. Indian tax rate = 50%. What is the net present value, internal rate of return and payback period of this investment?

Michael Dimond School of Business Administration Parent cash flows must be distinguished from project Parent cash flows sometimes change based on the form of financing, and one cannot clearly separate cash flows from financing Additional cash flows from new investment may in part or in whole take away from another subsidiary; possibly negate the value to entire organization Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. Managers must anticipate differing rates of national inflation which can affect differing cash flows Use of segmented national capital markets may create opportunity for financial gain or additional costs Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC Managers must evaluate political risk Terminal value is more difficult to estimate because potential purchasers have widely divergent views Complexities of Budgeting for Foreign Projects

Michael Dimond School of Business Administration Most firms evaluate foreign projects from both parent and project viewpoints –The parent’s viewpoint analyses investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments Project valuation provides closer approximation of effect on consolidated EPS The parent’s viewpoint gives results closer to “proper” NPV capital budgeting analysis Project Valuation vs Parent Valuation

Michael Dimond School of Business Administration Further Details Annual cash dividends to the parent company from India will equal 75% of after tax profit (Indian corporate tax rate is assumed at 50%). The U.S. corporate tax rate is 40%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Alpha will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Alpha forecasts the rupee exchange rate as follows:

Michael Dimond School of Business Administration

The proposed greenfield investment in Indonesia by Cemex was analyzed within the traditional capital budgeting framework (base case) The foreign complications were introduced to the analysis, including foreign exchange and political risks Parent cash flows must be distinguished from project cash flows. Each of these two types of flows contributes to a different view of value Parent cash flows often depend on the form of financing. Thus, cash flows cannot be clearly separated from financing decisions, as is done in domestic capital budgeting Remittance of funds to the parent must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in how financial markets and institutions function Cash flows from subsidiaries to parent can be generated by an array of nonfinancial payments, including payment of license fees and payments for imports from the parent Summary

Michael Dimond School of Business Administration Summary Differing rates of national inflation must be anticipated because of their importance in causing changes in competitive position, and thus in cash flows over a period of time When a foreign project is analyzed from the project’s point of view, risk analysis focuses on the use of sensitivities, as well as consideration of foreign exchange and political risks associated with the project’s execution over time When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways, adjusting the discount rates or adjusting the cash flows