International Capital Budgeting

Driving the NPV of Free Cash Flow

• Incremental profit --> free cash flow represents the incremental profit of the project, as investors interested in how much new cash is coming into the firm in return. 
• Export cannibalisation: losing profit from export sales to foreign market due to establishing new plant in foreign country.
• Forecast of revenue --> depend on the corporate future economic environment, demand: company's pricing and advertising policies. Also, future exchange rates.
• Forecast of costs --> measures as the cost of goods sold (COGS)
• Depreciation --> legal tax shield; subtracted out before taxes are calculated.
• Capital expenses --> money spent on property, plant and equipment (PPE).
• Net working capital --> inventory and cash on hand to run business.

Financial side effects:

• The cost of issuing securities: monetary fee (compensation to financial intermediaries in issuing securities), underwriting discount (the spread between what the firm receives from issuing securities and what the public pays for the securities).
• Tax shield for certain securities: interest tax shield (the value of the ability to deduct interest expense for tax purposes)
• The proper discount rate: rate should reflect the appropriate riskiness of the project's cash flows.
• Cost of financial distress: Direct costs (legal consulting and accounting fees -- 3%); indirect costs (loss of value due to the expectation of failure) -- creditors unwilling to extend more credit, inability to attract skilled labor. 

Pros and Cons of alternative approach to capital budgeting

• WACC predict the project will perpetually provide the expected level of CFs.
• D/VL constant
• ANPV Pro: allows managers to make informed decisions about the economic profitability of a project versus other sources of value.
• ANPV Pro: works well for international projects and nicely with hedging foreign exchange risk.
• ANPV Con: problematic if D/E ratio os going to be held constant.
• WACC and FTE Con: problematic if D/E ratio is going to change.

Tax implication of borrowing in a foreign currency (FC):

• If the borrowed (foreign currency) strengthens against domestic currency, borrower owes more.
• If the foreign currency weakens against domestic currency, borrower owes less.
• Because high interest rate currencies are expected to depreciate relative to lower interest rate currencies, the borrower expects to have a capital gain on the repayment of the principal.
• Capital gain tax offsets the higher interest tax shield and prevents the existence of a tax incentive to borrow in high interest rate currencies.

Conflicts between bondholders and stockholders

• The incentives to take risks: stockholders have the incentives to take on risk.
• Bondholders want low variance projects.
• Equity holders want high variance projects.
• The underinvestment problems: no incentives to take +NPV project, because bondholders will get all of the value.
• Other managerial problems: cash distribution for shareholders and misrepresentation of earnings.

International Capital Market Equilibrium

Two risks of investing abroad:

• Return of the international asset in its local currency.
• Variations in the value of the foreign currency relative to investor's currency.
• Return of investment = return of asset + return of currency

Sharpe ratios:

• measured as the average excess return relative to the volatility of the return.
• Risk adjusted excess return.

Nonsystematic variance = idiosyncratic variance (changes over time --> implication on how many firms it takes to diversify)
Systematic variance = Beta.
p < 1; the lower the better, firms more diversify.

What drive correlation of returns?

• Trade
• Geographic proximity
• Industrial structure: firms in the same industry --> buffeted by the same shocks, their systematic risk also move together.
• Irrational investors : contagion phenomenon.

Investment hurdle rates --> lowest possible expected return that allows for an improvement in the Sharpe ratio when they invest in that foreign market.

Risk premium of the market --> how much the market compensates investors for systematic risk.

Home bias --> local investors hold a disproportionately large share of local assets compared to global assets.

• Issues: Investors should not hold foreign equities because they are more volatile and have been yielding lower return than US stocks. --> False. 
• You should add foreign equities as soon as the foreign sharpe ratio exceeds the American sharpe ratio times the correlation between US portfolio and foreign security retun.
• Issues: Home bias arises because investors face an additional risk when investing internationally - currency risk. Because currency risk makes return more volatile but does not lead to a higher expected return, investing more in domestic assets is rational.
• Issues: Home bias arises because investors have a non-traded domestic assets that they care about as well - namely human capital. The returns to this asset can be thought of as labor income.