Financing International Projects

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Financing International Projects
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Capital Budgeting
Capital budgeting requires estimation of a
projects incremental cash flows - which are
determined by estimating worldwide cash flows
with and without the project. There are two main
methods of international capital budgeting,
centralized and decentralized Centralized
requires exchange rate forecasts Decentralized
requires a local-currency cost of capital. The
method a firm selects should depend on its
comparative advantage in estimating each.
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Cost of Capital I
CAPM determines a projects equity cost of
capital - it prices only the systematic risk of
the project. If risk premia are identical and
uncovered interest parity holds, the only
difference between home and foreign costs of
capital will be anticipated exchange rate
changes. In this case, centralized and
decentralized capital budgeting will deliver
identical results - the foreign cost of capital
will perform dual roles of discounting and
adjusting for anticipated exchange rate changes.
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Cost of Capital II
If anticipated deviations from uncovered
interest parity exist, centralized capital
budgeting will deliver higher returns when
deviations are positive and lower when
negative. Centralized is also easier to implement
if UIP fails. If investors do not hold worldwide
market portfolio, decentralized capital budgeting
will raise real capital costs and thereby lower
project NPVs because foreign investor portfolios
will co-vary more with project returns than home
country investor portfolios.
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Country Specfic Risk
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Adjusted Present Value
If incentives exist to finance with debt - tax
shields or interest subsidies - Adjusted Present
Value (APV) should be used. If tax treatments are
symmetric, and if uncovered interest parity is
expected to hold, tax shields will have identical
value whether debt is raised in host or home
country. Low capital gains taxes, high
deductibility of interest payments, negative
failure of UIP, and subsidized interest rates
will all favor financing in depreciating
currencies.
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Political Risk
Centralized capital budgeting requires expected
cash flows to be adjusted for political risk -
not cost of capital. Foreign political risk is
unlikely to be systematic to the risks of
domestic shareholder portfolios. Sensitivity
analysis is an alternative to calculation of
exact political risk probabilities solve for
probability that sets NPV0 and then ask whether
its reasonable - if so, NPV is quite possibly
negative.
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Financing Foreign Projects
Financing
Internal
External
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
Debt
Equity
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
Debt
Equity
Foreign Currency
Home Currency
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
Debt
Equity
Foreign Currency
Home Currency
Foreign Currency
Home Currency
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Internal Debt vs. Internal Equity
The primary tradeoffs between internal debt and
internal equity center around taxes. If internal
debt is used, interest payments made from the
subsidiary to the parent are treated on a pre-tax
basis in the host country. If internal equity is
used, dividends repatriated from the subsidiary
to the parent are treated on a post-tax basis.
Generally, home country gives a tax-credit on
foreign taxes paid on repatriated dividends of
up to (but no more than) the home country tax
bill on the dividends.
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Internal Debt vs. Internal Equity
MNCs using internal financing will have greater
incentives to use debt 1. The more volatile are
parent earnings higher probability of negative
parent earnings means better chance interest
payments will be untaxed. 2. The less volatile
are subsidiary earnings lower probability of
negative subsidiary earnings means less chance
subsidiary will be forced to make interest
payments out of negative earnings that are taxed
at the parent. 3. The larger the host country
tax rate compared to the home country larger
host country tax rate means larger potential tax
shield.
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Financing Foreign Projects
Financing
Internal
External
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External vs. Internal Financing
The tradeoffs between external and internal
financing will be largely similar to those in a
domestic context - issuance costs - asymmetric
information costs
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
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External Debt vs. External Equity
- tax shields - interest subsidies Additionally,
the monitoring benefits debt may add over equity
addressed in traditional finance settings will be
applicable here.
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
Debt
Equity
Foreign Currency
Home Currency
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Home vs. Host Country Equity
Home and host currency costs of equity capital
would be identical if uncovered interest parity
held and if all investors held diversified world
market portfolio. Where investors hold
domestically-biased assets, host country cost of
capital is likely to be higher. The project will
likely have higher correlation between its
returns and the local economy. From the host
country investor perspective, the project will
contain more systematic risk.
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Home vs. Host Country Equity
From a political risk standpoint, issuing host
country equity is likely to have two divergent
effects - political risks (i.e. probability of
expropriation) are likely to be reduced. -
political risks are likely to be more systematic
to risks of host country shareholders portfolios.
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Financing Foreign Projects
Financing
Internal
External
Debt
Equity
Debt
Equity
Foreign Currency
Home Currency
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International Debt Financing I
Debt denomination decision is often cast in the
same terms as international capital budgeting
centralized vs. decentralized debt finance. An
MNC which borrows primarily in the home country
is said to centralize debt finance (though an MNC
certainly can centralize debt finance in any
single country). An MNC which undertakes
borrowing in countries where operations are
located is said to decentralized debt finance.
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International Debt Financing II
Ex-ante deviations from UIP make centralizing
debt finances attractive. If a given currencys
low interest rates are not expected to be offset
by appreciation of that currency, firms that can
access the low interest rates and centralize debt
finance there will profit. Even if UIP holds
ex-ante, MNCs will generally have differential
access to markets. Put simply, domestic firms
usually enjoy lower interest rates in
home-country debt markets than foreign firms.
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The Debt Denomination Decision
If a firm borrows in domestic rather the local
currency, it faces greater exchange rate risk.
The cost of financing in the local currency will
consist (approximately) of the local currency
interest rate premium and the expected exchange
rate change. The differential can be interpreted
as the extent to which the firm accesses a
home-currency financing advantage in excess of
anticipated exchange rate changes. This will be
traded-off against the larger exchange rate risk
of home-currency financing.
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Example GM and AutoZAZ
GM will invest 500 million in AutoZAZ, an auto
plant located in Zaporizha, Ukraine. With the
investment, AutoZAZ will produce 250,000 cars for
domestic sale annually. GM expects to receive a
return of 300 per car. The Ukrainian Karbovan
currently trades at 0.741/Karb. Ukrainian
inflation is 35. Ukrainian interest rates are
40. U.S. interest rates are 5. GM accesses
Ukrainian debt markets by a factor of 7 above
risk-free rates and accesses U.S. debt markets by
a factor of 5 above risk-free. Should GM finance
with Karbovan or Dollar debt?
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Key Points
1. Primary tradeoff of internal debt vs. equity
is between the tax-shield benefit of debt and the
flexibility of equity dividend repatriation. 2.
Firms will tend to favor debt when parent
earnings are volatile, subsidiary earnings are
certain, and subsidiary tax rates are high. 3.
With external financing, debt provides advantages
over equity to the extent it offers tax shields,
interest subsidies, and monitoring benefits.
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Key Points
4. When financing with external equity, firms
will likely face higher equity costs of capital
in the host country market. 5. Local equity will
also often alter the magnitudes and pricing of
political risks associated with the project. 6.
In the debt denomination decision, an MNC which
centralizes borrowing in home country is likely
to get more-favorable rates.
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Key Points
7. MNCs which borrow in the currency of the
project produce a natural hedge, offsetting
project returns with debt obligations, and hence
facing less exchange rate and political risk.