Education Course Notes [Session 5 & 6]
ACCA P4
Advanced Financial Management
Education Class 3
Session 5 and 6
Chapter 6
Patrick Lui
Chapter 6 International Investment and Financing Decisions
1. Assess the impact upon the value of a project of alternative exchange rate assumptions.
2. Forecast project or organization free cash flows in any specific currency and determine the project’s net present value or organization value under differing exchange rate, fiscal and transaction cost assumptions.
3. Evaluate the significance of exchange controls for a given investment decision and strategies for dealing with restricted remittance.
4. Assess the impact of a project upon an organization’s exposure to translation, transaction and economic risk.
5. Assess and advise upon the costs and benefits of alternative sources of finance available within the international equity and bond markets.
1. Effects of Exchange Rate Assumptions on Project Values
1.1 Introduction
1.1.1 When a project in a foreign country is assessed, we must take into account some specific considerations such as local taxes, double taxation agreements, and political risk that affect the present value of the project.
1.1.2 The main consideration of course in an international project is the exchange rate risk, that is the risk that arises from the fact that the cash flows are denominated in a foreign country.
1.2 Purchasing power parity
(Dec 08, Dec 11, Dec 13)
1.2.1 / Purchasing Power ParityPPP claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. In equilibrium, identical goods must cost the same, regardless of the currency in which they are sold.
PPP predicts that the country with the higher inflation will be subject to a depreciation of its currency.
Formally, if you need to estimate the expected future spot rates, PPP can be expressed in the following formula:
Where: S0 = Current spot rate
S1 = Expected future rate
hb = Inflation rate in country for which the spot is quoted (base country)
hc = Inflation rate in the other country (country currency).
Example 1
An item costs $3,000 in the US.
Assume that sterling and the US dollar are at PPP equilibrium, at the current spot rate of $1.50/£, i.e. the sterling price x current spot rate of $1.50 = dollar price.
The spot rate is the rate at which currency can be exchanged today.
The US market / The UK market
Cost of item now / $3,000 / $1.50 / £2,000
Estimated inflation / 5% / 3%
Cost in one year / $3,150 / £2,060
The law of one price states that the item must always cost the same. Therefore in one year:
$3,150 must equal £2,060, and also the expected future spot rate can be calculated:
$3,150 / £2,060 = $1.5291/£
By formula:
1.3 Interest rate parity
1.3.1 / Interest Rate Parity (IRP)The IRP claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the two currencies.
IRP predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation.
If you need to calculate the forward rate in one year’s time:
Where: F0 = Forward rate
S0 = Current spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
Example 2
UK investor invests in a one-year US bond with a 9.2% interest rate as this compares well with similar risk UK bonds offering 7.12%. The current spot rate is $1.5/£.
When the investment matures and the dollars are converted into sterling, IRP states that the investor will have achieved the same return as if the money had been invested in UK government bonds.
In 1 year, £1.0712 million must equate to $1.638 million so what you gain in extra interest, you lose on an adverse movement in exchange rates.
The forward rates moves to bring about interest rate parity amongst different currencies:
$1.638 ÷ £1.0712 = $1.5291
By formula:
1.4 International Fisher Effect
According to the International Fisher effect, interest rate differentials between countries provide an unbiased predictor of future changes in spot exchange rates.
The currency of countries with relatively high interest rates is expected to depreciate against currencies with lower interest rates, because the higher interest rates are considered necessary to compensate for the anticipated currency depreciation.
The International Fisher effect can be expressed as:
Where: ic = the nominal interest rate in country c
ib = the nominal interest rate in country b
hc = the inflation rate in country c
hb = the inflation rate in country b
Example 3
The nominal interest rate in the US is 5% and inflation is currently 3%. If inflation in the UK is currently 4.5%, what is its nominal interest rate? Would the dollar be expected to appreciate or depreciate against sterling?
Solution:
The dollar is the base currency.
The dollar would be expected to appreciate against sterling as it has a lower interest rate. According to the International Fisher effect, the currency of a country with a lower interest rate will appreciate against the currency of a country with a higher interest rate.
1.5 Expectations theory
1.5.1 / International Fisher EffectThe expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future.
The formula for expectation theory is:
2. NPV for International Projects,
(Dec 08, Dec 11, Dec 13, Jun15)
2.1 Calculating NPV for international projects
2.1.1 There are two alternative approaches for calculating the NPV from an overseas project.
2.1.2 First approach:
(a) Forecast foreign currency cash flows including inflation
(b) Forecast exchange rates and therefore the home currency cash flows
(c) Discount home currency cash flows at the domestic cost of capital
2.1.3 Second approach:
(a) Forecast foreign currency cash flows including inflation
(b) Discount at foreign currency cost of capital and calculate the foreign currency NPV
(c) Convert into a home currency NPV at the spot exchange rate
Example 4ABC Inc, a US company, is considering undertaking a new project in the UK. This will require initial capital expenditure of £1,250 million, with no scrap value envisaged at the end of the five year lifespan of the project. There will also be an initial working capital requirement of £500 million, which will be recovered at the end of the project. The initial capital will therefore be £1,750 million. Pre-tax net cash inflows of £800 million are expected to generate each year from the project.
Company tax will be charged in the UK at a rate of 40%, with depreciation on a straight-line basis being an allowable deduction for tax purposes. Tax is paid at the end of the year following that in which the taxable profits arise.
There is a double taxation agreement between the US and UK, which means that no US tax will be payable on the project profits.
The current spot rate is £0.625 = $1. Inflation rates are 3% in the US and 4.5% in the UK. A project of similar risk recently undertaken by ABC Inc in the US had a required post-tax rate of return of 10%.
Required:
Calculate the PV of the project using each of the two alternative approaches.
Solution:
Method 1 – convert sterling cash flows into $ and discount at $ cost of capital
Firstly we have to estimate the exchange rate for each of years 1 – 6. This can be done using purchasing power parity.
Year / £/$ expected spot rate
1 / 0.625 × 1.045/1.03 / 0.634
2 / 0.634 × 1.045/1.03 / 0.643
3 / 0.643 × 1.045/1.03 / 0.652
4 / 0.652 × 1.045/1.03 / 0.661
5 / 0.661 × 1.045/1.03 / 0.671
6 / 0.671 × 1.045/1.03 / 0.681
Method 2 – discount sterling cash flows at adjusted cost of capital
When we use this method we need to find the cost of capital for the project in the host country. If we are to keep the cash flows in £ they need to be discounted at a rate that takes account of both the US discount rate (10%) and different rates of inflation in the two countries. This is an application of the International Fisher effect.
where ic is the UK discount rate
1 + ic = 1.116, therefore ic is approximately 12%
Translating this present value at the spot rate gives
NPV = £709 / 0.625 = $1,134m
Note that the two answers are almost identical (with differences being due to rounding). In the first approach the dollar is appreciating due to the relatively low inflation rate in the US (not good news when converting sterling to $). In the second approach the UK discount rate is higher due to the relatively high inflation rate in the UK (again this is bad news as the NPV of the project will be lower).
2.2 The effect of exchange rates on NPV
2.2.1 When there is a devaluation of the domestic currency relative to a foreign currency, then the domestic currency value of the net cash flows increases and thus the NPV increases.
2.2.2 The opposite happens when the domestic currency appreciates. In this case the domestic currency value of the cash flows decline and the NPV of the project in home currency declines.
3. Forecasting Cash Flows from Overseas Project
3.1 Effect on exports
3.1.1 When a multinational company sets up a subsidiary in another country, to which it already exports, the relevant cash flows for the evaluation of the project should take into account the loss of export earnings in the particular country. The NPV of the project should take explicit account of this potential loss.
3.2 Taxes
3.2.1 Taxes play an important role in the investment appraisal as it can affect the viability of a project. The main aspects of taxation in an international context are:
(a) Corporate taxes in the host country
(b) Investment allowances in the host country
(c) Withholding taxes in the host country
(d) Double taxation relief in the home country
(e) Foreign tax credits in the home country
Example 5 – Different tax rate in home and foreign countriesWhat will be the rate of tax on a project carried out in the US by a UK company in each of the following scenarios?
UK tax / US tax
(a) / 33% / 40%
(b) / 33% / = / 33%
(c) / 33% / 25%
Solution:
(a) No further UK tax to pay on the project’s $ profits. Profits taxed at 40% in the US.
(b) No further UK tax to pay on the project’s $ profits. Profits taxes at 33% in the US.
(c) Project’s profit would be taxed at 33% => 25% in the US and a further 8% tax payable in the UK.
Example 6 – Withholding tax
ABC Inc is considering whether to establish a subsidiary in France at a cost of €20,000,000. The subsidiary will run for four years and the net cash flows from the project are show below.
Net cash flow (€)
Project 1 / 3,600,000
Project 2 / 4,560,000
Project 3 / 8,400,000
Project 4 / 8,480,000
There is a withholding tax of 10 percent on remitted profits and the exchange rate is expected to remain constant at €1.50 = $1. At the end of the four year period the Slovenian government will buy the plant for €12,000,000. The latter amount can be repatriated free of withholding taxes.
If the required rate of return is 15 percent what is the present value of the projects?
Solution:
Remittance / DF at 15% / PV
€ / $ / $
3,600,000 × 90% = 3,240,000 / 2,160,000 / 0.870 / 1,879,200
4,560,000 × 90% = 4,104,000 / 2,736,000 / 0.756 / 2,068,416
8,400,000 × 90% = 7,560,000 / 5,040,000 / 0.658 / 3,316,320
(8,480,000 × 90% + 12,000,000) = 19,632,000 / 13,088,000 / 0.572 / 7,486,336
14,750,272
Less: Initial investment (€20,000,000 ÷ 1.5) / 13,333,333
NPV / 1,416,939
Example 7
ABC plc is considering whether to establish a subsidiary in the USA, at a cost of $2,400,000. This would be represented by non-current assets of $2,000,000 and working capital of $400,000. The subsidiary would produce a product which would achieve annual sales of $1,600,000 and incur cash expenditures of $1,000,000 a year.
The company has a planning horizon of four years, at the end of which it expects the realisable value of the subsidiary's fixed assets to be $800,000.
It is the company's policy to remit the maximum funds possible to the parent company at the end of each year.
Tax is payable at the rate of 35% in the USA and is payable one year in arrears. A double taxation treaty exists between the UK and the USA and so no UK taxation is expected to arise.
Tax allowable depreciation is at a rate of 25% on a straight line basis on all non-current assets. The tax allowable depreciation can first be claimed one year after the investment i.e. at t1.
Because of the fluctuations in the exchange rate between the US dollar and sterling, the company would protect itself against the risk by raising a eurodollar loan to finance the investment. The company's cost of capital for the project is 16%.
Calculate the NPV of the project.
Solution:
3.3 Inter-company cash flows
3.3.1 Inter-company cash flows, such as transfer prices, royalties and management charges, can also affect the tax computations.
3.3.2 Although complex in reality, in the exam:
(a) Assume inter-company cash flows are allowable for tax unless the question says otherwise
(b) If an inter-company cash flow is allowable for tax relief overseas, there will be a corresponding tax liability on the income in the home country