1 CAPITAL BUDGETING ISSUES IN FAST- GROWING ECONOMIES.

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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

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Dim

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$

FC

t t+nBorrow $

Borrow FC

Lend FC

Lend $ S

ell

FC

Sp

ot

Bu

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C S

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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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