9. International Corporate Finance Chap 22

• Lecture 9 is about International Corporate Finance
• The key topics are foreign exchange, exchange rate risk, international capital markets, valuation of foreign currencies, and international taxation

Foreign Exchange Basics

• Foreign exchange rate refers to the price of a currency in terms of another currency
• The Foreign Exchange (FX) or FOREX market facilitates currency trading without a central physical location
• It has a daily turnover of over $5 trillion USD
• International banks, large multinational firms, and government central banks are key players
• Most traded currencies include USD, Euro, Japanese Yen, British Pound Sterling and Swiss Franc
• Example: if 1 peso = $0.0667, then $1/$0.0667/peso = 14.9925 pesos

Exchange Rate Risk Factors

• Exchange rate risk is influenced by exchange rate fluctuations
• Floating exchange rates constantly change based on supply and demand
• Supply and demand are driven by firms trading goods, investors trading securities, and central bank actions
• Companies risk losing money if exchange rates rise or fall after prices are set
• Currency forward contracts can be used for hedging, setting a currency exchange rate in advance of a future exchange

Exchange Rate Risk Example

• Manzini ordered parts for next year's production from Campagnolo in January 2009, when the exchange rate was $1.30 per euro
• They agreed to a price of 500,000 euros, to be paid when the parts were delivered one year later
• The exchange rate one year later was $1.45 per euro
• Manzini had to pay ($1.45/euro) × (500,000 euros) = $725,000
• This cost is $75,000, or about 12%, higher than if the price had been set in dollars
• If the price had been set in dollars, Manzini would have paid $650,000, which would have been worth only 448,276 euros to Campagnolo, or about 10% less
• Since neither party knows ahead of time who will suffer the loss, each has an incentive to hedge

Hedging with Forward Contracts

• Hedging can be done with currency forward contracts that defines the exchange rate for a future date
• If Manzini locked in an exchange rate of $1.29/€ then Manzini will be able to buy 500,000 euros for $1.29/€
• Even if the exchange rate rose to $1.45/€, Manzini would obtain the 500,000 euros using the forward contract at the forward exchange rate of $1.29/€
• Manzini must pay 500,000 euros x $1.29/euros = $645,000
• Manzini gives the bank $645,000, and the bank pays Campagnolo 500,000 euros
• A forward contract would have been a good deal
• Without the hedge, Manzini would have had to exchange dollars for euros at the prevailing rate of $1.45/€, raising its cost to $725,000
• A forward contract locks in eliminating the risk whether the movement of the exchange rate is favorable or unfavorable

Hedging Risk and Forward Contracts

• Initially, the risk passes to the bank that has written the forward contract
• Banks will often enter into another forward contract that offsets the risk

Hedging Exchange Rates with Options

• Currency options give the holder the right, but not the obligation, to exchange currency at a given exchange rate
• Currency forward contracts allow firms to lock in a future exchange rate, they must pay the rate it locks in, whether advantageous or not
• Currency Options insure firms against the exchange rate moving beyond a certain level, allows them to pay the current rate or rate in the option contract, whichever is better
• Option holders can always sell the position at a gain rather than demanding delivery of the currency
• Options benefit holders if the exchange rate moves in their favor
• Allows them to walk away from the exchange if there is an unfavorable rate

Capital Markets and Valuation

• Internationally integrated capital markets allow investors to exchange currencies in any amount at the spot or forward rates
• Investors are free to purchase or sell any security in any amount in any country at its current market prices
• The Valuation Principle suggests that the dollar present value of the expected cash flow must be equal to what the U.S. investor paid for the security

International Capital Markets

• Using r$* for dollar discount rate and rFC* for foreign currency discount rate, the equation is: Forward$/FC Rate = (1+r$) / (1+rFC) x Spot $/FC Rate

International Capital Markets - Example

• Calculating the present value of a ¥10 million cash flow that will occur one year in the future
• The spot exchange rate is ¥110/$ and the one-year forward rate is ¥105.8095/$
• The appropriate dollar cost of capital for this cash flow is r$* = 5% and the appropriate JPY cost of capital for this cash flow is r¥* =1%
• For the Japanese investor, compute the present value of the future yen cash flow at the yen discount rate, then use the spot exchange rate to convert that amount to dollars
• For the U.S. investor, convert the future yen cash flow to dollars at the forward rate and compute the present value using the dollar discount rate
• Because U.S. and Japanese capital markets are internationally integrated, both methods produce the same result

NPV of a Foreign Project

• Calculate the NPV in the foreign country and convert it to the local currency at the spot rate
• Convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows
• These equivalent methods are used to calculate the NPV of a foreign project in internationally integrated capital market.

Example Ityesi Inc.

• Ityesi, Inc., headquartered in the United States, wants to apply the WACC technique to value a project in the United Kingdom
• Ityesi is considering introducing a new line of packaging in the United Kingdom
• The marketing group expects annual sales of £37.5 million per year for this product line
• Manufacturing costs and operating expenses are expected to total £15.625 million and £5.625 million per year, respectively
• Developing the product will require an upfront investment of £15 million in capital equipment that will be obsolete in four years
• An initial marketing expense of £4.167 million is also required
• Ityesi pays a corporate tax rate of 40% no matter in which country it manufactures its products
• The current spot exchange rate is $1.60/£ and the yield curve in both countries is flat
• The risk-free rate on dollars is 4%, and the risk-free interest rate on pounds, is 7%
• Ityesi has built up $20 million in cash for investment needs and has debt of $320 million, so its net debt is D = $320 - $20 = $300 million
• This amount is equal to the market value of its equity, implying a (net) debt-equity ratio of 1
• Ityesi intends to maintain a similar (net) debt-equity ratio for the foreseeable future
• The WACC thus assigns equal weights to equity and debt

Ityesi Inc. - Value of Foreign Project

• Value the foreign project with WACC
• The value of Ityesi’s foreign project with WACC should be undertaken because the net present value equals $29.20 million
• WACC equals 6.8%
• Ityesi’s current market value balance sheet and cost of capital without the U.K. project: Wacc = =(0.5)(10.0%) + (0.5)(6.0%)(1 - 40%) =6.8%

Valuation and International Taxation Considerations

• Repatriated refers to the profits from a foreign project that a firm brings back to its home country
• Canada's tax policy requires Canadian corporations to pay taxes on their foreign income at the same rate as profits earned in Canada
• A full tax credit is given for foreign taxes paid up to the amount of the Canadian tax liability

Multiple Foreign Projects and Taxation

• Multinational corporations may use any excess tax credits generated in high-tax foreign countries to offset their net Canadian tax liabilities on earnings in low-tax foreign countries
• Canadian tax liability is not incurred until the profits are brought back home if the foreign operation is set up as a separately incorporated subsidiary (rather than as a foreign branch)

Segmented Capital Markets

• Segmented capital markets are not internationally integrated, making decisions complex
• Firms may face differential access to markets with information asymmetry
• Using currency swaps firms can borrow in the market where it has the best access to capital, and then "swap" the coupon and principal payments to whichever currency it would prefer to make payments in

Macro Level Distortions

• Some countries regulate or limit capital inflows or outflows, often restricting free currency conversion into dollars which segments capital markets
• Differing political, legal, social, and cultural characteristics may necessitate compensation through a country risk premium
• If return differences stem from market frictions like capital controls, corporations can exploit these by setting up projects in high-return countries/currencies and raising capital in low-return ones

Summary of Key points

• A currency exchange rate is a price of one currency denominated in another currency
• Firms can manage exchange rate risk by using currency forward contracts or using currency options
• When markets are internationally integrated, two methods can be used to calculate foreign currency cashflows
• Capital markets are not always internationally integrated – they can be segmented