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CAPITAL BUDGETING ISSUES IN FAST- GROWING ECONOMIES
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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 Bombardier’s facilities in Montreal.
Google analyzes entering the Russian portal market via a joint venture with Yandex.
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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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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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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 CFi is the expected cash flow at future year i and DR a discount rate that reflects the risk of the investment
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 NPVi > NPVj Invest in i; If NPVi < NPVj Invest in j.
NPV
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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
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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
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Time DimensionC
urr
ency
Dim
ensi
on
$
FC
t t+nBorrow $
Borrow FC
Lend FC
Lend $ S
ell
FC
Sp
ot
Bu
y F
C S
po
t
Se
ll F
C
Bu
y F
C
Spot, Forward, and Money Markets
A
B C
D
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EXAMPLES
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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
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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: don’t need to forecast exchange rates
• cons:
• local cost of capital can be severely distorted, especially due to hyperinflation or government’s 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
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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
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Revenues and Costs in Multiple Currencies
EXAMPLE
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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)
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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 = Rf + β·(Rm- Rf )
where Rf = risk free rate
(Rm- Rf ) = 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 security’s or the project’s return
Risk Free Rates (Rf) approximated with the yield to maturity on government bonds (e.g., U.S. T-bonds)
10-year yield is widely used
Cost of Capital
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Betas (β) usually estimated on the basis of five years or monthly returns
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Cost of Capital
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? homebuilder’s 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
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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
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How to measure cost of equity in EM? add country premium
Equity Cost of Capital = (Rf + country premium) + β·(Rm – Rf)
country premium of developing economies
Accounting for Country Risk
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