country risk & topics in international corporate finance · 2021. 4. 14. · - optimal...

4/14/2021

1

Country Risk & Topics in International Corporate Finance

(for private use, not to be posted/shared online)

• Last Class

• Economic exposure (EE): Risk associated with a change in the NPV of afirm's expected cash flows, due to changes in St.

• Tools to Manage EE:

- Operational Hedging: Matching inflows in FC & outflows in FC

- Diversification

- Financial Hedging, for firms that cannot use operational hedging(mainly exporting & importing firms)

• Asset Allocation in International Markets:

- Passive vs Active allocations.

- Decompose performance of active managers into segments thatmeasure skills in picking stocks and market weights

- Performance metrics, incorporating risk-return trade-off.

- Optimal Portfolio Construction: Maximizing RVOL

4/14/2021

2

• This Class

• Case 3 (Templeton Fund Case)

• Country Risk and Project (Country Report. See class homepage. To bediscussed in second hour.)

• Topics in International Corporate Finance: DFI, MNC Capital Budgeting& Capital Structure.

Country Analysis

• Active allocation strategy requires the forecast of changes in macroeconomic variables: currencies, interest rates, & stock markets.

Key variable: Choice of a country (currency).

But currency forecasting is difficult.

• Q: How do we select a country?

To help this process, economists monitor a large number of variables:

- anticipated real growth (probably major influence on a national mkt.)

- monetary and fiscal policy

- wage and employment rigidities

- social and political situations

- competitiveness

4/14/2021

3

• Investment banks and consulting firms produce “Country Reports,” trying to summarize all the relevant information that an investor/firm needs to make an investment decision in a given country.

• Country reports are brief and they give an investor an overall idea of the business, political, and economic climate.

• This is the Class Project: Write a professional country report.

Country Risk

Definition: Country Risk

Country risk (CR) is the risk attached to a borrower or an investment by virtue of its location in a particular country.

Example: ConocoPhillips invested in Venezuela in the 1990s to help develop the Petrozuata, Hamaca and Coroco projects, it added an additional risks to its investment portfolio: Venezuelan country risk.

Country Risk? In 2007, the Venezuelan government expropriated all ConocoPhillips investments without fair compensation. ¶

Note: CR is different than FX risk. CR risk can be zero and FX can be huge for a given country. The reverse, though unusual, can also happen.

4/14/2021

4

• CR reflects the (potentially) negative impact of a country’s economic and political situation on an MNC’s or an investor’s cash flows.

• CR is a broad risk concept. It includes economic risk, financial risk, political risk, etc.

• Situations that can affect MNC’s Cash flows:

- Nationalization of subsidiaries or joint ventures.

- Labor strikes in an industry.

- Recession or a big macroeconomic shock.

- A political scandal that introduces new laws or regulations.

- New trade restrictions, limiting imports or exports.

Q: Does country risk analysis matter?

A: Look at companies investing in Ukraine & Russia in 2014, Greece in 2011 or Argentina in 2020. Value of affected assets went down significantly.

International Crisis Are Not Rare

Graph X.1Sovereign External Debt1800 - 2006 – Taken from Reinhart and Rogoff (2011)

.

This graphs describes sovereign crises, with the associated risk, sovereign risk.

4/14/2021

5

• Measures to reduce country risk:

- A cap on the total amount invested in a particular country.

- Diversification.

- Credit/Political Risk Derivatives

Diversification and Country Risk (From The Economist, Sep 20, 2014)

After China’s revolution in 1949 HSBC, then a purely Asian bank, lost half its business. Iran’s nationalization in 1951 of the Anglo-Iranian Oil Company’s assets devastated the firm, a precursor of BP.

Modern episodes:

• Repsol (Spain), fell in love with Argentina, leaving it vulnerable when YPF, the firm it bought there, was nationalized in 2012.

• First Quantum, (Canada), had made a third of its profits from a mine that the Democratic Republic of Congo nationalized in 2009.

Remark: Ben van Beurden, the boss of Royal Dutch Shell, recently said diversification is “the only way to inoculate yourself”.

• Quantifying CR

CR is an important component of the Multinational Capital Budgeting process.

- MNCs make decisions on DFI projects on the basis of NPVs.

- MNCs use discount rates to establish NPV for projects (the higher thediscount rate, the lower the chances of a project to have a NPV > 0).

Q: Where do discount rates come from?

A: For projects abroad, a key element is Country risk (CR). We need to quantify this risk.

4/14/2021

6

• Simple Idea

Many factors affect a country’s economy: political, economic, social, etc.

We want to create a global indicator that assesses the likelihood of a (negative) change in a given country’s economic policy.

This indicator, reported as a single number, is called country risk (CR).

• Similar to credit risk ratings, CR is usually measured as a letter: A=excellent, B =good, C=bad Letter = Grade

• Ideally, CR gives companies and lenders a very good indicator of a country’s likelihood of default.

• Credit and Interest Rate Risk for Bonds: Brief Review

Bonds are subject to two types of risk:

1) Interest rate risk: Risk associated to changes in interest rates.

2) Credit/default risk: Risk associated to the probability of default (& not receiving principal and interest payments after default)

Credit rating agencies describe/measure the risk with a credit rating (a letter).

Implication: The higher the grade, the lower the yield (YTM) of the bond

YTM = A spread over risk-free rate (usually, in bps).

Note: For us, risk-free rate = YTM of government bonds.

4/14/2021

7

• General Idea

From a big data set (with a lot of economic, socioeconomic and political variables), we produce a single measure (a letter).

• Two approaches to measure CR (and get a grade)

(1) Qualitative – collect data, get opinions from “experts” consensus grade.

(2) Quantitative – collect data, process data with a computer model grade.

(1) Qualitative Approach: Talk to experts (politicians, union members, economists, etc.) to form a consensus opinion about the risk of a country. Consensus opinion = The final grade.

(2) Quantitative Approach: Start with some quantifiable factors that affect CR. Use a formula to determine numerical scores for each factor. Calculate a weighted average of the factors’ numerical scores.

Weighted average of scores = The final grade.

(1) Qualitative Approach is considered “subjective.”

(2) Quantitative Approach is considered “objective.”

We will emphasize the Quantitative Approach.

• Pros

- It is simple

- It allows cross-country and across time comparison.

• Cons

- It is too simple.

- In practice, ratings tend to converge (herding).

- Not a lot of predictive power.

Note: Ideally, rating companies are independent. But, they have incentives to accommodate clients (countries).

4/14/2021

8

CR: Is it really a good indicator of economic problems/default?

The lack of predictive power for many crisis is a major criticism.

Example: A month before the 1997 Asia crisis, South Korea was rated as Italy and Sweden. Then, Fitch went from rating Korea as AA- (investment grade) to B- (junk) in one month. Other rating agencies replicated the same dramatic sudden change in Korea’s CR rating.

In early 1998, Fitch justified the situation:

“There were no early warnings about Korea from us or, to the best of our knowledge, from other market participants, and our customers should expect a better job from us.” ¶

Similar sudden downgrades occurred during the 2009-2013 European debt crisis with Greece, Ireland, Italy, Portugal, and Spain (PIIGS).

• Practical use of CR

• We will associate CR to the spread over a base, global risk-free rate, say U.S. T-bills. We call the spread, CR spread or CR premium. That is, CR influences the interest on the debt issued by a government of a country (& the discount rate on foreign projects!).

Example: Setting yields for Mexico (actually, the Mexican government)

YieldMex = US Treasuries + CR spread (or CR premium, a function of CR)

Data:

Mexico’s grade: BBB -a CR spread of 140 bps (1.40%) over US Treasuries

Yield (US Treasuries yield): 4%

YieldMex = 4% + 1.40% = 5.40%

Note: This is a USD yield. To translate it to MXN, we use linear IFE:

YieldMex (MXN) ≈ YieldMex (USD) + E[st+T].

4/14/2021

9

Example (continuation):

YieldMex (MXN) ≈ YieldMex (USD) + E[st+T].

To calculate E[st+T], we can use linearized PPP. Data:

E[IMEX] = 7%

E[IUS] = 2% E[st+T] = E[IMEX] - E[IUS] = 5%

YieldMex (MXN) ≈ 5.40% + 5% = 10.40%.

• YieldMex (MXN) becomes the risk-free rate for projects in Mexico, used to the discount CFs in MXN. That is:

Discount Rate ProjectMex = YieldMex + project’s risk premium.

Suppose an oil company is investing in a project in Mexico and sets a 3% project’s risk premium. Then,

Discount Rate Oil ProjectMex = 10.40% + 3% = 13.40%.

The MXN CFs will be discounted using 13.40% as the discount rate. ¶

Very different yields. All countries share the same currency: FX Risk plays no role in explaining the yields.

Q: What explains the difference in yields? Country Risk

• We can calculate CR spreads, relative to Germany.

Effect of CR in Yields

4/14/2021

10

Risk Rating Method (Check list)

• Weighted average of grades for four major aspects of a country:

- Economic Indicators (financial condition)

- Debt management (ability to repay debt)

- Political factors (political stability)

- Structural factors (socioeconomic conditions)

The grades (between 0 and 100) for each factor are a function of “fundamental data.” For example, the economic indicator’s grade depends on GDP per capita, GDP growth, inflation, interest rates, etc.

A specific formula is used to compute the grades. For example,

Score(EI) = α0 + α1 GDP growth + α2 Inflation + α3 Productivity + ....

Regressions and experience will determine the coefficients (α0, α1, α2,...). We expect GDP growth & inflation to have α1>0 and α2<0.

Risk Rating Method (Check list)

• Final score (& CR letter) will be determined by a weighted average:

Final Score = wEI Score(EI) + wDM Score(DM) + wPF Score(PF) + wSF Score(SF)

Note: Weights should be non-negative and add up to 1:

∑J wJ = 1, –i.e., wEI + wDM + wPF + wSF = 1.

Q: Where are the weights and the formulae for the grades coming from?

A: This method seems more “objective,” because it is based on hard economic data, but weights and formula for grades may be “subjective.”

CR is more an art, than a science.

• CR is a broad concept. It is possible to treat political risk as a separate risk. Why? Political risk can be insured (many governments subsidize it) & if political risk is independent of systematic risk, it does not affect discount rates.

4/14/2021

11

The model can deliver different forecasts:

- Short-term

- Medium-term

- Long-term

Weights and grades can change depending on your horizon.

For example:

(a) Short-term: More weight to debt management and political factors.

(b) Long-term: More weight to economic indicators and structural factor.

Each grade is associated with a spread in basis points (bps) over base rate, usually a risk free rate.

Note I: A rating of BBB or better is considered “investment grade.”

Note II: A rating of BB or less is considered “junk.” In the U.S., the usual spread of junk debt is between 400 to 600 bps over 1-yr T-bills. Range is very wide: Spreads can go over 2600 bps.

Note III: As time to maturity increases, the spread (in bps) also increases.

TABLE 16.1 Conversion Table of a Country's Grade into a Rating and Spreads over US Treasuries Overall grade Rating Interpretation Spread (in bps) Average 91-100 AAA Excellent 10-70 50 81-90 AA 50-100 70 71-80 A 80-130 100 61-70 BBB Average risk 110-220 160 51-60 BB 190-300 240 41-50 B 270-410 350 31-40 CCC Excessive risk 360-490 450 21-30 CC 450-700 570 10-20 C 700+ 800 0-10 D In Default (debt in arrears)

4/14/2021

12

Example: Spread on government European bonds: Nov 11. 2014.

Higher risk (PIIGS), higher spread! ¶

From MTS Indices: http://www.mtsindices.com/european-bond-spreads.

Higher spreads

Example: But, not always.

10-year government bonds: Q4 2016 (from Euromoney).

Note: ECR = Euromoney country risk.

• Ratings tend to converge (herding?); but they do not necessarily have the same impact on yields.

4/14/2021

13

Example: Bertoni Bank evaluates the country risk of country DX.

Short-term Horizon Medium-term HorizonFactor Weight Grade Weight Grade

Economic .3 80 24 .3 70 21Debt managt .3 90 27 .2 70 14Political .3 67 20.1 .2 50 15Structural .1 75 7.5 .3 60 12Total 78.6 63Short-term ranking: A Medium-term ranking: BBB

Short-term debt (in USD) of country DX gets a spread in the 80-130 bpsrange, say 93 bps over US Treasuries; while medium-term debt gets a higherspread, say 128 bps.

Suppose the short-term US Treasuries yield 4% (s.a.). Then,YTMDX (short-term, in USD) = 4% (s.a.) + 0.93% (s.a.) = 4.93% (s.a.). ¶

Example: Country Risk in PracticeEuromoney produces semi-annual CR analysis of 189 countries using a panelof 400+ experts. Euromoney rates 6 categories with a score (ECR, from 0 to100).

• Categories and weights:

Economic performance -30%

Political Risk -30%

Structural assessment -10%

Debt indicators: Debt/GDP; Debt service/X; & X-M/GDP -10%

Credit rating: Moody’s or S&P’s or Fitch IBCA’s rating -10%

Access to bank finance/Capital markets: Grade from 0 to 10 -10%

The first three categories are (mainly) qualitative and the last three categories are (mainly) quantitative.

Based on the weighted average for each country, each country is placed on a Tier, with Tier 1 = AAA (80 - 100); and Tier 5 = C (0 - 35.9). ¶

4/14/2021

14

Example: Country Risk in PracticeEuromoney’s experts evaluate each category for each country and grade themfrom 0 to 100. For example, they look at the category Debt Indicator (10%weight) and grade it:

<= Very Bad, low score

<= Very Good, high score

Example: Euromoney, World Country Risk February 21, 2018World Country Risk weighted average: 42.77 (B rating or Tier 4)

4/14/2021

15

Example: World Composite Risk 2017


4/14/2021

16



4/14/2021

17

Example: Country Risk in Practice

• Euromoney CR ratings

- Congo (2017: 29.31)2011: 28.89 (World ranking: 139. In 2001, Congo ranked 180th.)

- Romania (2017: 53.18 – World Ranking: 59)2011: 49.09 (World ranking: 72. In 2001, Romania ranked 89th.)

- China (2017: 58.50 - World Ranking: 43)2011: 63.55 (World ranking: 40. In 2001, China ranked 45th.)

- Taiwan (2017: 73.40)2011: 80.04 (World ranking: 18. In 2001, Taiwan ranked 28th.)

- Singapore (2017: 88.53 - World Ranking: 1)2011: 87.48 (World ranking: 6. In 2001, Singapore ranked 14th.)

• As expected, there is a wide dispersion of CR across countries. Ratingstend to be persistent over time.

• Other Maps: Coface 2020

4/14/2021

18

• Other Maps: Euler Hermes 2019

• Other Maps: Marsh Political Risk 2019

4/14/2021

19

Other Country Risk Indicators

• Given the lack of predictive power of CR, a single indicator may not be enough. There are other indexes that may be also signal the true riskiness of a country –i.e., they can be correlated with the CR.

• Popular indicators

- A.T. Kearny: Globalization Index (it measures a country’s global links) -A.T. Kearny: FDI confidence index (survey of MNCs indicating the likelihood of investment in specific markets).

- World Economic Forum: Global competitiveness index (it uses indexes to rate growth environment and opportunities).

- Institute for Management Development World Competitiveness index.

- PWC: Opacity Index (it measures the adverse impact of opacity of capital -the cost of borrowing funds- in different countries).

- Heritage Foundation: Index of economic freedom (absence of government obstructions).


• Popular indicators

- Fraser Institute: Index of Economic Freedom

- UNDP: Human Development Index (HDI is a composite index measuring average achievement in life expectancy, education, and standard of living).

- Nord Sud Export (NSE) index (market potential assessment for foreign investor

4/14/2021

20


• Popular indicators: Summary

In general, we see countries’ rankings moving in a similar range (say, Japan is between 9 and 28; USA between 1 and 15); but not always.

The economic freedom rankings of Brazil and China create huge intervals for these countries, far away from the others.

Country Euromoney (2011)

Global’n (2007)

GCI -WEF(2011)

WCI -IMD(2011)

Opacity(2009)

Economic Freedom

(2011)

Brazil 41 67 53 44 28 99

China 40 66 26 19 45 138

Japan 25 28 9 26 16 22

UK 17 12 10 20 2 14

USA 15 7 5 1 6 10

Country Risk : Implications

• Country/Political risk affects the expected cash flows of an investment. MNCs need to account for this type of political risk when evaluating international projects.

• In general, companies try to adjust the expected cash flows by decreasing them by an amount that reflects the probability of a loss due to country/political risk.

• It is complicated how to calculate the probability distribution associated with country/political risk.

4/14/2021

21

Example: Suppose HAL, a U.S. MNC, is considering a project in Hong Kong with an initial investment of USD 10 million and a duration of 4 years with the following expected cash flows (in USD):

Year 1 Year 2 Year 3 Year 4

Free CF 1.114M 1.486M 1.811M 13.524M

The MNC uses a 15% discount rate. Then,

NPV (in M) = -10 + {1.114/1.15 + 1.486/1.152 + 1.811/1.153 + 13.524/1.154}

= USD 1.0155 M > 0 Yes, the MNC undertakes the project.

But, we have ignored political risk. Suppose the MNC thinks there is a Pi

probability of expropriation every year. Assume, for simplicity, that after expropriation the CFs = 0 –that is, there is no recovery.

P1

P4

P2

P3

1 - P1

1 - P2

1 - P3

0 1.114M

0

0

0

1 - P4

1.811M

1.486M

13.524M

CFs for the next 4 year are given by the following diagram:

Assume that Pi = P –that is, a constant– and set P = 5%. Then,

NPV = -10 +{1.114/1.15*.95 + 1.486/1.152 *.952 + 1.811/1.153*.953 + 13.524/1.154*.954}= - USD 0.746653M < 0 The U.S. MNC will reject the project. ¶

4/14/2021

22

In practice, it is difficult to compute the Pi’s in the previous Example.

Sometimes, it is easier to calculate break-even probabilities and, then, compare them with other the probabilities used in other projects or with the experience of a company or expert.

In the previous example, the break-even probabilities, pBE, can be derived from solving the following equation:

NPV = -10 + {1.114/1.15 * (1 – pBE) + 1.486/1.152 * (1 – pBE)2 +

+ 1.811/1.153 * (1 – pBE)3 + 13.524/1.154 * (1 – pBE)4} = 0.

Example: Using trial and error (or Excel or R), HAL determines

pBE = 0.027964

MNC’s rule: If pBE < .03 The U.S. MNC undertakes the project. ¶

Country Risk : Insurance

• NPV calculations are easier if there is insurance: MNC just adjust the expected cash flows by the cost of insurance and proceed as usual.

• There is an active market for Country Risk Insurance.

- Sovereign Risk can be insured by the private market or CDS (swaps).

- Political Risk can be insured by international organizations (World Bank), governments and private insurance companies (AIG, Zurich, etc.)

• Political risk is available for different events:

⋄ Political violence: Revolution, civil unrest, terrorism, war, etc.

⋄ Expropriation or confiscation of assets.

⋄ Repudiation of contracts.

⋄ Cancellation of credit or guarantees.

⋄ Business interruptions.

⋄ Currency inconvertibility, blockage of funds.

4/14/2021

23

Country Risk: Insurance

• Political risk insurance policies tend to be standardized, but can be adapted for specific situations. For larger investments or complex situations, tailor-made policies are common, with a syndicate of several insurers providing coverage.

• The private market is usually used for complex investments that require a great deal of customization.

• The U.S. government, through the Overseas Private Investment Corporation (OPIC) has been providing political risk insurance to U.S. international investors since 1971.

• The World Bank also offers political risk insurance through its Multilateral Investment Guarantee Agency (MIGA), which was established in 1988.


Example: Suppose HAL gets fully insured against political risk. It insured the full amount for each year. The premium is 1.5% annual. That is,

NPV (USD M) = -10 + {1.114 * .985 /1.15 + 1.486 * .985 /1.152 + + 1.811 * .985 /1.153 + 13.524 * .985 /1.154}

= USD 0.8502 > 0 HAL undertakes the project. ¶

• The example is very simple. In practice, MNCs cannot get insurance for 100% of cash flows, usually they can get covered from 50% to 90%.

Example (continuation): Now, HAL gets insurance against political risk for 70% of the CFs. The premium is 1.5% annual and P = 5%. That is,

NPV (USD M) = -10 + {1.114 * .985 /1.15 + 1.486 * .985 /1.152 + + 1.811 * .985 /1.153 + 13.524 * .985 /1.154} * .70 +

+ {1.114/1.15 * .95 + 1.486/1.152 * .952 + 1.811/1.153 * .953 + + 13.524/1.154 * .954} *. 30 = USD 0.37122 > 0 YES! ¶

4/14/2021

24


In many situations, once expropriation happens, the company files a claim and the company gets a one-time payment.

Country Report

4/14/2021

25

Country Report: Due on April 15

Goal: Learn about investment environment in a country.Target of Report: A busy U.S. investor.

Usual style: (1) Very brief historical & current political details of chosen country. (2) Description of economic, financial environment, & investment

opportunities (usually, competitive sectors). (3) Based on analysis, a couple of recommendations.

A. Necessary Information• Anticipated GDP or GNP growth.• Monetary policy: Evaluation of inflationary prospects and interest rates.• Wages & employment conditions: Productivity and Health of economy.• Social and political situation: Goal is to evaluate political/country risk.• Sector analysis: Competitiveness of sectors in world/region.• Fiscal situation and taxes: Implications government budget situation.

Country Report

B. Figures or Graphs

1. Macroeconomic Indicators (4 years of history + forecasts):GDP growth (GDP forecast is a must) + sector analysis

• Inflation

• Trade Account (imports, exports and current account balance)

• Exchange rate against the USD

• Unemployment

2. Market Indicators (4 years of history + forecasts, if available):

• Stock Market Index (level, returns, P/E, if available)

• Government Bond yields (short-term and long-term)

3. Stocks (4 years of history for individual stocks + analysts' forecasts, if available):10 largest stocks (price, PE or EPS, if available)

4/14/2021

26

Country Report

C. TextReport should include:• Current events• Macroeconomics (economic growth, monetary policy, government deficit, labor markets, etc.)• Sectorial analysis• Country risk• Taxes• Exchanges rates• Equilibrium P/E (fair valuation)

D. Practical Issues• The text cannot have more than five pages.• Do not include irrelevant information as appendices. • There are over 3,000 ADRs in the U.S.• Need to include fair P/E Valuation• Provide and justify a recommendation.

Country Report

E. Some Grading IssuesMaximum Grade: 5 points.

• Incomplete discussion will be penalized. (Up to 2 points off.)

• Incomplete information -info suggested above-- up to 2 points off.

• Irrelevant information will be penalized. (1/2 point off).

• Current data is a must. If your latest data is from 2017, you lost 1 point.

• If current news is important (covid-19 or a recent devaluation), you should include it in your report. (Up to 1 point off.)

• If no equilibrium P/E calculated included, you'll lose 1/2 point.

• Long papers are penalized (1/2 point off, though if the paper is long because of irrelevant info, you'll be penalized only once.)

• Recommendations should come out logically from your country analysis.

• Copying a professionally written report is considered cheating.

4/14/2021

27

TOPICS IN INTERNATIONAL CORPORATE FINANCE

I. DFIDefinition: A Direct Foreign Investment (DFI) is a controlling ownership in a business enterprise in one country by an entity based in another country. Also called FDI.

- Controlling ownership: 10%+ of voting stock (World Bank/OECD).

- DFI is different from portfolio investing abroad.

- DFIs: Greenfield investments (building a new operational facility), mergers & acquisitions, a joint venture, etc.

• According to UNCTAD (a U.N. agency), total DFI in 2019 was USD 1.5 trillion. In 2020 (pandemic year), DFI was down 49%.

- U.S. biggest recipient of DFI, followed by China, HK, & Brazil.

- High income countries receive almost half DFI flows.

4/14/2021

28

Figure X.1: Global DFI Flows

(Annual Data 2018)

Figure X.2: DFI Flows to U.S.

(Quarterly Data, as a percentage of GDP, 2019)

4/14/2021

29

• Factors behind DFI:

According to the annual DFI survey of A.T. Kearney, the main drivers are regulatory transparency/lack of corruption, taxes, and labor costs.

• A domestic firm can sell a product abroad by:

- Producing at home and exporting production.

- Producing abroad (& do a DFI) and selling abroad.

• Q: Why DFI instead of exports?

A: Usual reasons:

⋄ Access to cheap inputs (labor, energy, etc.)

⋄ Avoid tariffs, quotas & reduce transportation costs

⋄ Local management

⋄ Take advantage of government subsidies

⋄ Access to new technology

⋄ Access to local expertise (including: contacts, red tape, etc.)

⋄ Real option (investment today to make investments elsewhere later).

⋄ Reduce economic exposure

⋄ Diversification

4/14/2021

30

• Diversification through DFI

MNCs have many DFI projects. MNCs select the project that improves their risk-reward profile.

• Popular risk-adjusted performance measures (RAPM):

Reward to variability (Sharpe ratio): RVAR = E[rt – rf]/SD.

Reward to volatility (Treynor ratio): RVOL = E[rt – rf]/Beta.

Risk-adjusted ROC (BT): RAROC = Return/Capital-at-risk.

Jensen’s alpha measure: Estimated constant (α) on a CAPM-like linear regression

• We focus on RVAR & RVOL to evaluate projects.

Note: RVAR & RVOL can produce different rankings.

• Diversification through DFI: RVAR and RVOL

• Compute E[r] & Var[r] for a portfolio, compose by X & Y, as:

E[rp=+y] = wx * E[rx] + (1 - wx) * E[ry]

Var[rp=x+y] = σ2x+y = wx

2 * σx2 + wy

2 * σy2 + 2 wx wy x,y σx σy

RVARp = (rp - rf) / σp.

• Compute of the X+Y portfolio:

p=x+y = wx * x + (1 - wx) * y

RVOLp = (rp - rf) / ßp.

Note: If project is added, MCN becomes X+Y

Y = Project MNC is considering

X = Existing portfolio of MNC –i.e., the “rest of the MNC.”

4/14/2021

31

• Diversification through DFI: RVAR and RVOL

RVAR = E[ri – rr]/ σi = Sharpe Ratio (SR)

RVOL = E[ri – rf]/ ßi = Treynor Ratio (TR)

• Q: RVAR or RVOL?

- RVAR (SR) uses total risk (σ); appropriate for undiversified portfolios.

When asset i is a small part of a diversified portfolio; σ is inappropriate.

- RVOL (TR) emphasizes systematic risk, appropriate measure of risk, according to the CAPM, when a portfolio is diversified.

Example: A US company considers two DFIs: Colombia & Brazil.

The firm has the following data, assuming rf = 3%:

wCol = .30, (1 – wcol) = wEP = .70

wBrazil = .35, (1 – wBrazil) = wEP = .65

Q: Which project is better? Calculate a RAPM for each project:

- SR = E[ri – rr]/ σi = RVAR

- TR = E[ri – rf]/ ßi = RVOL

For the US company:

SREP = (.13 – .03)/.12 = .833

TREP = (.13 – .03)/.90 = .111

E[ri] SD[ri] = σi i US,i Weight

US firm (EP) 13% 12% .90 - -

Colombia 18% 25% .60 0.40 .30

Brazil 23% 30% .30 0.05 .35

4/14/2021

32


• Colombia – Calculation of SR and TR

E[rEP+Col - rf] = wEP * E[rEP – rf] + (1 – wEP) * E[rcol - rf]

= .70 * .10 + .30 * .15 = 0.115

σ2EP+Col = wEP

2 (σEP2) + wCol

2 (σCol2) + 2 wEP wCol EP,Col σEP σCol

= (.70)2 * ( .12 )2 + ( .30 )2 * (.25)2 + 2*.70*.30*0.40*.12*.25 = 0.017721

σEP+Col = (σ2EP+Col)1/2 = (0.017721)1/2 = 0.1331

EP+Col = wEP * EP + wCol * Col = .70 * .90 + .30 * .60 = 0.81

⋄ SREP+Col = E[rEP+Col – rr]/ σEP+Col = 0.115/0.1331 = 0.8640

⋄ TREP+Col = E[rEP+Col – rr]/ βEP+Col = 0.115/0.81 = 0.14198


• Colombia – Interpretation of Ratios:

⋄ SREP+Col = E[rEP+Col – rr]/ σEP+Col = 0.115/0.1331 = 0.8640

Interpretation of SR: An additional unit of total risk (1%) increases returns by .864%.

⋄ TREP+Col = E[rEP+Col – rr]/ βEP+Col = 0.115/0.81 = 0.14198

Interpretation of TR: An additional unit of systematic risk increases returns by .142%.

4/14/2021

33


• Brazil

E[rEP+Brazil – rf] = 0.135

σEP+Brazil = 0.1339

EP+Brazil = 0.69

SREP+Brazil = 0.135/0.1339 = 1.0082 > SREP+Col = 0.8640

TREP+Brazil = 0.135/0.69 = 0.19565 > TREP+Col = 0.14198

Under both measures, Brazilian project is superior.

• Existing portfolio of the company (to compare to Brazilian project):

SREP = (.13 - .03)/.12 = .833 < SREP+Brazil = 1.0082

TREP = (.13 - .03)/.90 = .111 < TREP+Brazil = 0.19565

Using both measures, diversify internationally!

Q: Why? Because it improves the risk-reward profile for the company.

II. Multinational Capital Budgeting

• Q: How to evaluate a project?

A: NPV. The evaluation of MNC’s projects is similar to a domestic one.

• Data Needed for Multinational Capital Budgeting:

1. CFs (Revenues[P & Q] and Costs[VC & FC])

2. Maturity (T)

3. Salvage Value (SVT)

4. Depreciation

5. Taxes (local and foreign, withholding, tax credits, etc.)

6. Exchange Rates (St)

7. Required Rate of Return (k)

8. Restrictions to Capital Outflows

4/14/2021

34

• Data Needed for Multinational Capital Budgeting:

- Taxes.

MNCs pay taxes twice: - Local level

- Parent level.

Different rules and tax treaties are in place to avoid double taxation –i.e., paying taxes for the same income twice.

- CF Uncertainty.

CFs are difficult to estimate. A point estimate (a single number) is usually submitted by subsidiary. Then, Parent “adjusts” for CFs uncertainty.

Usual adjustment: Discounting at rate k: CF’s uncertainty ↑, higher k ↑.

2.A International Taxation

Taxes on Investments

1. Capital gains,

2. Income (dividends, etc.),

3. Transactions.

• Key question for international investors:

Q: Do they tax foreigners? If so, what are the withholding taxes?

Two Tax principles

- Residence: Residents taxed on their worldwide income.

- Source: Only income earned inside the country is taxed.

4/14/2021

35

When entire income is earned in the country of residence, both principles agree. Otherwise, principles do not agree.

Example:

Situation: A U.S. consultant works 3 months a year in Greece.

Residence principle: She pays taxes on her Greek income in the U.S.

Source principle: She pays taxes on her Greek income in Greece.

Greek income can be taxed twice. ¶

• Foreign investments may be taxed in two locations:

1. the investor's country,

2. the investment's country

Convention: Make sure that taxes are paid in at least one country.

This is why withholding taxes are levied on dividend payments.

Tax Neutrality

Tax neutrality: No tax penalties associated with international business.

Two approaches:

(1) Capital import neutrality

(2) Capital export neutrality.

(1) Capital Import Neutrality

– No penalty/advantage attached to foreign-owned capital

– Foreign and domestic capital compete on equal basis.

Local taxes exempt foreign-source income from local taxes.

For U.S. MNC: Exclusion of foreign branch profits from U.S. taxable income (Exclusion method).

4/14/2021

36

(2) Capital Export Neutrality

– No tax incentive for firms to export capital to a low tax country.

– Same overall tax whether capital remains in the country or not.

Local authorities "gross up" the after-tax income with all foreign taxes; then, apply home-country tax rules to that income, with credit for foreign taxes paid.

For U.S. MNC: Inclusion of "pre-tax" foreign branch profits in U.S. taxable income. A tax credit is given for foreign paid taxes (Credit method).

Example: Bertoni Bank, a U.S. bank, has a branch in Hong Kong.Hong Kong branch income: USD 100.U.S. tax rate: 35%Hong Kong tax rate: 17%

Double Exclusion CreditTaxation Method Method

• Hong KongBranch profit 100 100 100(17% tax) (i) 17 17 17Net profit 83 83 83

• U.S.Net Hong Kong profit 83 83 83Gross up 0 0 17Taxable income 83 0 100(35% tax) 29.05 0 35Tax credit 0 0 (17)Net Tax due (ii) 29.05 0 18

Total taxes (i)+(ii) 46.05 17 35

4/14/2021

37

• Agency Problem: Subsidiary vs Parent

In general, CFs are difficult to estimate. Point estimates (a single estimated number) is usually submitted by the subsidiary. The Parent will attempt to adjust for CFs uncertainty.

Usually, this is done through the discount rate, k. But, many other methods can be used.

Typical problem for an MNC: Agency Problem - Subsidiary vs. Parent.

- Subsidiary wants to undertake more projects.

- Parent only cares about Profitability.

Subsidiary can misstate Revenues, VC, and SV.

• Agency Problem

Example: Project in Hong Kong (Data provided in HKD)

T = 4 years

CF0= HKD 70M (=USD 10M)

Revenue: Year 1 (Price per unit (HKD), Quantity)) - 20; 1.00M = 20M

Year 2 (25; 0.95M) = 23.75M

Year 3 (30; 0.90M) = 27M

Year 4 (35; 0.85M) = 29.75M

Cost - VC = HKD 5/unit

- FC = HKD 3M

Depreciation = 10% of initial outlay (HKD 7M/year)

St = 7 HKD/USD (use RW to forecast future St’s)

Taxes: - Income: HK 17%, US 35% (Gross-up, Credit for foreign taxes)

- Withholding tax (in Hong Kong) = 10%

Note: U.S. collects taxes based on worldwide income.

4/14/2021

38


SV4 = HKD 25M

k = 15%

1. Subsidiary’s NPV (in HKD including local taxes)

T=1 2 3 4

Revenues 20M 23.75M 27M 29.75M

Cost 5M 4.75M 4.5M 4.25M

3M 3M 3M 3M

Profit 12M 16M 19.5M 22.5M

Dep. 7M 7M 7M 7M

EBT 5M 9M 12.5M 15.5M

Taxes .85M 1.53M 2.125M 2.635M

EAT 4.15M 7.47M 10.375M 12.865M

Free CF +SV 11.15M 14.47M 17.375M 44.865M

Example: (continuation)

T=1 2 3 4

Free CF +SV 11.15M 14.47M 17.375M 44.865M

NPV (in HKD) = -70M + 11.15M/1.15 + 14.47M/1.152 + + 17.375M/1.153 + 44.865M/1.154 = - HKD 12.2869M < 0

Note: If SV4 is changed to HKD 80M, then NPV = 19.16M > 0!

Subsidiary would submit the project.

• Subsidiary never submits a project with NPV<0. SV is important!

4/14/2021

39

Year 1 Year 2 Year 3 Year 4

CFs to be remitted (HKD)

11.15M 14.47M 17.375M 19.865M+25M

St = 7 HKD/USD

CFs in USD 1.59M 2.067M 2.48M 2.84M+3.57MWithholding (.159M) (.2067M) (.248M) (.284M)CFs remitted 1.431M 1.86M 2.3M 2.56M+3.57M(US Tax) (.6M) (.8M) (.975M) (1.125M)Tax Credit .281M .425M .552M .376MNet Tax (.319M) (.425M) (.423M) (.749M)EAT 1.114M 1.486M 1.811M 2.09M+3.57M

2. MNC’s NPV (in USD, including all taxes)

NPV = - USD 10M + 6.5195M = - USD 3.48M < 0. No!

Note: Subsidiary will never submit a project like this! Subsidiary will inflate some numbers, for example, SVT.

If SVT = HKD 80M, then

NPV (USD M) = -10 + {1.114/1.15 +1.486/1.152 +1.811/1.153

+ (2.095 + 80/7)/1.154} = USD 1.01181 M > 0 Yes. ¶

4/14/2021

40

• Real Options View

Original HK project has NPV<0. Usual view: MNC rejects project.

But, MNCs may undertake NPV<0 projects if there are future benefits associated with them. For example, an expansion, development of contacts, power to influence future political events, etc.

An MNC may view the DFI as an option –a real option. The initial investment plays the role of a premium paid:

p = NPVInitial Investment < 0

The MNC sets some targets for initial investments (revenue, market share, etc.) that play role of a strike price, X:

If Realized Target > X Expand (exercise real option).

• Real Options View

Overall, MNC undertakes project if

E[NPV] = NPVInitial Investment + Option Value of Expansion

• Think of a real option as a two-phase project:

1) First phase: Test the Market

2) If test is successful: Expand

In many applications, the initial investment also gives a company the option to delay further investments. These options have value.

Financial options are not complicated to value, inputs (Pt, X, σ) are easy to get. In general, these inputs are not very precise value for real options.

Real options tend to be difficult to value. Simulations are used.

4/14/2021

41

Example: Malouf Coffee considers expansion to Mexico with two stores:

S & B.

♦ Expansion is done simultaneously (S&B together)

- Upfront investment is 230.

- Probability of failure (F) = 70%

- k = .15:

- CFs for S: 60 (if F) & 140 (if not F)

- CFs for B: 120 (if F) & 280 (if not F).

E[NPV] = -230 + [(.70)*(60+120) + (.30)*(140+280)]/1.15 = -10.87 < 0.

No!


♦ CFs for a 2-phase expansion (1st S; 2nd B):

- Initial Investment = 100

- Expansion Investment = 70 if X (CFs) > 120.

- Probability of failure (F) for S = P1 = .70%

- Probability of failure (F) for B = P2 = .50;

- k = .15

Learning: Lower expansion investment & lower P2.

P1

P2

1- P1

1- P2

60

120

140

280

• If S (1st-phase) is valued individually:E[NPV1st-phase] = -100 + [(.70)*60 + (.30)*140]/1.15 = -26.96 < 0 No!

4/14/2021

42


• If we evaluate 2-phase investment:

E[NPV] = -100 + (.70) * 60/1.15 + (.30) * {(140-70)/1.15 +

+ [(120)*.50 + (280)*.50]/1.152} = 0.1512 > 0 YES!

Higher valuation when real option (flexibility) is introduced.

Technical Note: Discount rate in 2nd-phase should be lower! ¶

• Technical Issues: Not easy to determine P1 & P2, and future CFs.

• Value of the Real Option: Firm learns from 1st-phase & adapts (expand, delay, or close the project). Limiting downside.

• Many MNCs went to China in the early 1990s with NPV<0 projects. Years later, some expanded, some closed projects and left market.

• Adjusting Project Risk

MNCs have many ways methods to adjust for CF uncertainty.

• Adjusting discount rate, kIn general, CF’s uncertainty is incorporated through the discount rate, k: Higher uncertainty, k↑ .

k also incorporates economic & political uncertainty in local country.

But k is a point estimate, an average risk. An average risk may cost an MNC: It may wrongly reject projects that have a below average risk.

An MNC may use a range for k, say {kLB, kUB}.

4/14/2021

43

Using a range {kLB, kUB}, creates a range for {NPV(kLB), NPV(kUB)}.

Example: Based on {kLB, kUB} for the HK project, MNC builds an NPV range

Range for k : {kLB = .135, kUB = .165} (with SV4 = HKD 80M, NPV > 0)

Range for NPV: {USD 0.535M; USD 1.519M}.

Note: Range is always positive. Good for a project. ¶

• Sensitivity Analysis/Simulation

MNCs can use sensitivity analysis to evaluate proposals.

1) Sensitivity Analysis of the impact of CFs on the NPV of project

⋄ Play with different scenarios/Simulation

Steps: a. Assign a probability to each scenario

b. Get an NPV for each scenario.

c. Calculate a weighted average (weight=probability) NPV E[NPV]

d. If possible, use a risk-reward measure (say, a Sharpe Ratio).

⋄ Breakeven Analysis (same as what we do below for SV).

4/14/2021

44


Example: Compute E[NPV] & SD[NPV] for HK project

We create different scenarios for CFs (as a % of submitted CFs)

% of CFs Probability NPV (in M)0.60 0.01 -0.779180.64 0.025 -0.600090.68 0.05 -0.420990.72 0.075 -0.241890.76 0.09 -0.062790.80 0.10 0.1163130.84 0.125 0.2954120.88 0.15 0.4745120.92 0.15 0.6536110.96 0.125 0.832711

1 0.10 1.01181

E[NPV] 0.35541SD[NPV] 0.64477Prob[NPV<0] 0.25


• Descriptive StatsE[NPV] = USD 0.355411 MSD[NPV] = USD 0.644769 MProb[NPV < 0] = 0.250000SR = E[.]/SD[.] = 0.55122195% C.I. (Normal): (-0.90834M; 1.61916M)

4/14/2021

45

• Sensitivity Analysis/Simulation - Decisions

Parent can base a decision on some risk-reward rule. For example, a firm may look at the SR (using E[NPV] and SD[NPV]), a range, establishing some ad-hoc tolerable level for the probability of negative NPV, etc.

• Decisions

Rule: Among projects with E[NPV] > 0, Parent compares the SRs (or CIs) for different projects. Then, select project with higher SR (or the CI with the smallest negative part).


2) Sensitivity Analysis of the impact of SV on NPV

⋄ Different scenarios based on original SV. For example:

% of SVs (in HKD) Probability NPV (in M)0.60 (=HKD 48) 0.05 -1.601920.64 (=HKD 51.2) 0.065 -1.340550.68 (=HKD 54.4) 0.085 -1.079170.72 (=HKD 57.6) 0.1 -0.81780.76 (=HKD 60.8) 0.125 -0.556430.80 (=HKD 64) 0.15 -0.295050.84 (=HKD 67.2) 0.125 -0.033680.88 (=HKD 70.4) 0.1 0.2276920.92 (=HKD 73.6) 0.085 0.4890640.96 (=HKD 76.8) 0.065 0.7504371.00 (=HKD 80) 0.05 1.01181

E[NPV] -0.29505SD[NPV] 0.866876Prob[NPV<0] 0.70

4/14/2021

46


⋄ Breakeven Analysis: Calculate SVBE, such that NPV(SVBE) = 0.

SVBE = {IO – Σt CFt/(1+k)t} * (1+k)T

The higher SVBE, the more dependent project is on an uncertain SV: To make the NPV > 0, we need SVT > SVBE. (Not good!)

Q: Is the SVT reasonable? SVBE helps to answer this question.

Example: Calculate SVBE for HK project.

SVBE = {10M - {1.114M/1.15 + 1.486M/1.152 + 1.811M/1.153 +

+ 2.09M/1.154} * 1.154 = USD 9.65891 (or HKD 67.61236M)

Check:

NPV(USD M) = -10 + {1.114/1.15 + 1.486/1.152 + 1.811/1.153 +

+ (2.09 + 67.61236/7)/1.154} = 0.

A parent company compares the SVBE with the reported SV value:

SVBE = HKD 67.61236M < SV4 = HKD 80M. (Too big!) ¶

Note: If SVBE < 0 Good for project. Profitability does not depend onSV.

4/14/2021

47

• Judgment call

In practice, there is a lot of subjective judgment.

Experience (MNC’s own and consultants) also are incorporated.

Example: Ad-hoc decision

Based on past experience, Parent requires:

(1) E[NPV] > 0

(2) Prob[NPV < 0] < 30%.

In HK example, Prob[NPV < 0] = 25% Accept!

Note: This ad-hoc rule double counts risk, since NPV is calculated using risk-adjusted discount rates! ¶

country risk & topics in international corporate finance · 2021. 4. 14. · - optimal...

Documents