1 Overview

Many of the projects that companies are appraising may have an international dimension. For example,
the assumption can be made that part of the production from a project may be exported. In appraising
a tourist development, a company may be making assumptions about the number of tourists from
abroad who may be visiting. Imported goods and materials could be a factor in the determination of
cash flows. All these examples show that exchange rates will have an influence on the cash flows of the
company.
Companies that undertake overseas projects are exposed, in addition to exchange rate risks, to other
types of risk such as exchange control, taxation or political risks. The latter is particularly true in
countries with undemocratic regimes that may be subject to changes in a rather disorderly fashion.
Capital budgeting techniques for multinational companies therefore need to incorporate these
additional complexities in the decision making process. These can be based on similar concepts to
those used in the purely domestic case which we have examined. Special considerations, examples of
which were given above, may apply.

2 Effects of exchange rate assumptions on project values

Changes in exchange rates are as important as the underlying profitability in selecting an overseas
project.
In a domestic project the NPV is the sum of the discounted cash flows plus the terminal value
(discounted at the WACC) less the initial investment.
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. 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 currency. An
appraisal of an international project requires estimates of the exchange rate. In the rest of this section
we discuss some fundamental relationships that help the financial manager form views about exchange
rates.

2.1 Purchasing power parity

Purchasing power parity theory states that the exchange rate between two currencies is the same
in equilibrium when the purchasing power of currency is the same in each country.
Purchasing power parity theory predicts that the exchange value of foreign currency depends on the
relative purchasing power of each currency in its own country and that spot exchange rates will
vary over time according to relative price changes.
Formally, purchasing power parity can be expressed in the following formula.

Where S1 = expected spot rate

S0 = current spot rate
hc = expected inflation rate in country c
hb = expected inflation rate in country b
Note that the expected future spot rate will not necessarily coincide with the 'forward exchange rate'
currently quoted.

2.1.1 Example: Purchasing power parity

The spot exchange rate between UK sterling and the Danish kroner is 1 = 8.00 kroners. Assuming that
Denmark. Over the next year, price inflation in Denmark is expected to be 5% while inflation in the UK
is expected to be 8%. What is the 'expected spot exchange rate' at the end of the year?

Using the formula above:

Future (forward) rate, S1 = 8 1.05
1.08
= 7.78
This is the same figure as we get if we compare the inflated prices for the commodity. At the end of the
year:
UK price = 110 1.08 = 118.80
Denmark price = Kr880 1.05 = Kr924
St = 924 118.80 = 7.78
In the real world, exchange rates move towards purchasing power parity only over the long term.
However, the theory is sometimes used to predict future exchange rates in investment appraisal
problems where forecasts of relative inflation rates are available.

Case Study
An amusing example of purchasing power parity is the Economist's Big Mac index. Under PPP
movements in countries' exchange rates should in the long-term mean that the prices of an identical
basket of goods or services are equalised. The McDonalds Big Mac represents this basket.
The index compares local Big Mac prices with the price of Big Macs in America. This comparison is used
to forecast what exchange rates should be, and this is then compared with the actual exchange rates
to decide which currencies are over and under-valued.

2.2 Interest rate parity

Under interest rate parity the difference between spot and forward rates reflects differences in interest
rates.
Interest rate parity predicts foreign exchange rates based on the hypothesis that the difference
between two countries interest rates should offset the difference between the spot rates and the
forward exchange rates over the same period.
Under interest rate parity the difference between spot and forward rates reflects differences in interest
rates. If this was not the case then investors holding the currency with the lower interest rate would
switch to the other currency, ensuring that they would not lose on returning to the original currency by
fixing the exchange rate in advance at the forward rate. If enough investors acted in this way, forces of
supply and demand would lead to a change in the forward rate to prevent such risk-free profit making.
The principle of interest rate parity links the foreign exchange markets and the international money
markets. The principle can be stated using the following formula which is given in the exam formula
sheet.

where Fo is the forward rate

So is the spot rate
ic is the interest rate in the country overseas
ib is the interest rate in the base country
This equation links the spot and forward rates to the difference between the interest rates.

Example
A US company is expecting to receive Zambian kwacha in one years time. The spot rate is US$1 =
ZMK4,819. The company could borrow in kwacha at 7% or in dollars at 9%. There is no forward rate for
one years time.
Estimate the forward rate in one years time.

Solution
2

The base currency is dollars therefore the dollar interest rate will be on the bottom of the fraction.

However this prediction is subject to considerable inaccuracy as future events can result in large
unexpected currency rate swings that were not predicted by interest rate parity. In general interest rate
parity is regarded as less accurate than purchasing power parity for predicting future exchange rates.

2.2.1 Use of interest rate parity to compute the effective cost of foreign currency
loans

Loans in some currencies are cheaper than in others. However when the likely strengthening of the
exchange rate is taken into consideration, the cost of apparently cheap international loans becomes
much more expensive.

Example
Cato, a Polish company, needs a one year loan of about 50 million zlotys. It can borrow in zlotys at
10.80% pa but is considering taking out a sterling loan which would cost only 6.56% pa. The current
spot exchange rate is zloty/ 5.1503. The company decides to borrow 10 million at 6.56% per annum.
Converting at the spot rate, this will provide zloty51.503 million. Interest will be paid at the end of one
year along with the repayment of the loan principal.
Assuming the exchange rate moves in line with interest rate parity, you are required to show the zloty
values of the interest paid and the repayment of the loan principal. Compute the effective interest rate
paid on the loan.

Solution
By interest rate parity, the zloty will have weakened in one year to:

This rate would have to be incorporated into the discount rate for any investment projects financed by
this loan. As the discount rate would now be higher than originally anticipated, the NPV of the project
will be lower (which may result in the project being unviable).

2.3 International Fisher effect

The International Fisher effect states that currencies with high interest rates are expected to depreciate
relative to currencies with low interest rates.
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. Given free movement of capital internationally, this idea suggests that the real rate of
return in different countries will equalise as a result of adjustments to spot exchange rates.

The International Fisher effect can be expressed as:

Where ia is the nominal interest rate in country c

ib is the nominal interest rate in country b
ha is the inflation rate in country c
hb is the inflation rate in country b

Example
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 depreciate 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 depreciate
against the currency of a country with a higher interest rate.

Question

Forecasting exchange rates

Suppose that the nominal interest rate in the UK is 6 percent and the nominal interest rate in the US is
7 percent. What is the expected change in the dollar/sterling exchange rate?

Answer
Since
It means that

And the implication is that the dollar will depreciate by 1 percent.

2.4 Expectations theory

Expectations theory looks at the relationship between differences in forward and spot rates and the
expected changes in spot rates.
The formula for expectations theory is:
Spot
=
Spot
Forward
Expected future spot
.

2.5 Calculating NPV for international projects 12/11

The NPV of an international project can be calculated either by converting the cash flows or the NPV.
There are two alternative approaches for calculating the NPV from a overseas project.
1st 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
2nd 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

Question

Overseas investment appraisal

Bromwich 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 be generated 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. Portuguese 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 the UK, which means that no US tax will be
payable on the project profits.
The current $/ spot rate is $1 = 0.625. Inflation rates are 3% in the US and 4.5% in the UK.A project
of similar risk recently undertaken by Bromwich Inc in the US had a required post-tax rate of return of
10%.
Required
Calculate the present value of the project using each of the two alternative approaches.

Answer
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
0
1
2
3
4
5
6

0.625
0.634
0.643
0.652
0.661
0.671

x
x
x
x
x
x

(1.045/1.03)
(1.045/1.03)
(1.045/1.03)
(1.045/1.03)
(1.045/1.03)
(1.045/1.03)

$/ expected spot rate

0.625
0.634
0.643
0.652
0.661
0.671
0.681

Method 2 discount sterling cash flows at adjusted cost of capital

When we use the 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.

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).

2.6 The effect of exchange rates on NPV

6

Now that we have created a framework for the analysis of the effects of exchange rate changes on the
net present value from an overseas project we can use the NPV equation to calculate the impact of
exchange rate changes on the sterling denominated NPV of a project.
NPV = the sum of the discounted domestic cash flows
Add: discounted domestic terminal value
Less: initial domestic investment (converted at spot rate)
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. 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 sterling declines. The relationship between NPV in sterling and the
exchange rate is shown in the diagram below

Question

Effect of changes in the exchange rate

Calculate the NPV for the UK project of Bromwich Inc under three different scenarios.
(a) The exchange rate remains constant at $1 = 0.625 for the duration of the project
(b) The dollar appreciates by 1.5% per year (as per the original question)
(c) The dollar depreciates by 1.5% per year

Answer
If the dollar depreciates by 1.5% each year the exchange rates are as follows:
Year
Exchange rate ($/)
0
0.625
1
0.625/1.015
0.616
2
0.616/1.015
0.607
3
0.607/1.015
0.598
4
0.598/1.015
0.589
5
0.589/1.015
0.580
6
0.580/1.015
0.571
The NPV under the three scenarios is given in the table below. Cash flows are discounted at 10%.

3 Forecasting cash flows from overseas projects

3.1 Forecasting project cash flows and APV

The calculation of cash flows for the appraisal of overseas projects requires a number of other factors
to be taken into account.

3.2 Effect on exports

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 and it should be written as
Sum of discounted (net cash flows exports) + discounted terminal value initial investment
The appropriate discount rate will be WACC.

3.3 Taxes
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:
Corporate taxes in the host country.
Investment allowances in the host country
Withholding taxes in the host country
Double taxation relief in the home country
Foreign tax credits in the home country
The importance of taxation in corporate decision making is demonstrated by the use of tax havens by
some multinationals as a means of deferring tax on funds prior to their repatriation or reinvestment. A
tax haven is likely to have the following characteristics.
(a) Tax on foreign investment or sales income earned by resident companies, and withholding tax on
dividends paid to the parent, should be low.
(b) There should be a stable government and a stable currency.
(c) There should be adequate financial services support facilities.

For example suppose that the tax rate on profits in the Federal West Asian Republic is 20% and the UK
corporation tax is 30%, and there is a double taxation agreement between the two countries. A
subsidiary of a UK firm operating in the Federal West Asian Republic earns the equivalent of 1 million
in profit, and therefore pays 200,000 in tax on profits. When the profits are remitted to the UK, the UK
parent can claim a credit of 200,000 against the full UK tax charge of 300,000, and hence will only
pay 100,000.

Question

International investment I

Flagwaver Inc is considering whether to establish a subsidiary in Slovenia at a cost of 20,000,000. The
subsidiary will run for four years and the net cash flows from the project are shown 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 = 1.50. 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 project?

Answer

3,240,000
4,104,000
7,560,000
19,632,000

Remittance
Discounted
$
2,160,000
2,736,000
5,040,000
13,088,000

Discount factor (15%)

0.870
0.756
0.658
0.572

$
1,879,200
2,068,416
3,316,320
7,486,336
14,750,272

The NPV is $14,750,272 - EUR20,000,000

1.50
= $1,416,939

Question

International investment 2

Goody 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 ie at t 1.

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.
The annual writing down allowance (WDA) is 25% of US$2,000,000 = $500,000, from which the annual
tax saving would be (at 35%) $175,000.

* Non-current assets realisable value $800,000 plus working capital $400,000

** It is assumed that tax would be payable on the realisable value of the non-current assets, since the
tax written down value of the assets would be zero. 35% of $800,000 is $280,000.
The NPV is negative and so the project would not be viable at a discount rate of 16%.

3.4 Subsidies
Many countries offer concessionary loans to multinational companies in order to entice them to invest
in the country. The benefit from such concessionary loans should be included in the NPV calculation.
The benefit of a concessionary loan is the difference between the repayment when borrowing under
market conditions and the repayment under the concessionary loan. For a UK company this benefit is
calculated as

3.5 Exchange restrictions

In calculating the NPV of an overseas project only the proportion of cash flows that are expected to be
repatriated should be included in the calculation of the NPV.

3.6 Impact of transaction costs on NPV for international projects

Transaction costs are incurred when companies invest abroad due to currency conversion or other
administrative expenses. These should also be taken into account.

3.7 A general model using adjusted present value

3.7.1 A recap of the APV approach

The APV method of investment appraisal was introduced earlier in the context of domestic
investments. Just to recap, there are three steps.

Step 1

Estimate NPV assuming that the project is financed entirely by equity.

10

Step 2
Step 3

Estimate the effects of the actual structure of finance (for example, tax effects of borrowing)
Add the values from steps 1 and 2 to obtain the APV.

3.7.2 APV in the international context

You should follow the normal procedure of estimating the relevant cash flows and discounting them at
an appropriate cost of capital. However you must also take account of the international dimension of
the project, so that the steps become as follows.

Step 1

As the initial NPV assumes that the project is financed entirely by equity, the appropriate cost
of capital is the cost of equity (allowing for project risk but excluding financial risk).

Step 2

Make adjustments for:

Tax effects of debt and debt issue costs
Any finance raised in the local markets
Restrictions on remittances
Subsidies from overseas governments

Step 3

Add the values from the first two steps to obtain the APV
The steps for calculating the APV of an international project are essentially the same as for domestic
projects, although more care has to taken with the extra adjustments

4 The impact of exchange controls

4.1 The nature of exchange controls
Exchange controls restrict the flow of foreign exchange into and out of a country, usually to defend
the local currency or to protect reserves of foreign currencies. Exchange controls are generally more
restrictive in developing and less developed countries although some still exist in developed countries.
These controls take the following forms:
Rationing the supply of foreign exchange. Anyone wishing to make payments abroad in a foreign
currency will be restricted by the limited supply, which stops them from buying as much as they want
from abroad.
Restricting the types of transaction for which payments abroad are allowed, for example by
suspending or banning the payment of dividends to foreign shareholders, such as parent companies in
multinationals, who will then have the problem of blocked funds.

4.2 Impact of exchange controls on investment decisions

In order to investigate the impact of exchange rate controls we can use the basic equation for the NPV.

Step 1 Convert net cash flows to home currency and discount at WACC
Step 2 Convert terminal value to home currency and discount at WACC
Step 3 Add the values from Steps 1 and 2 and deduct the initial investment

(converted to home

currency)
Assuming that no repatriation is possible until period N, when the life of the project will have been
completed then the NPV will be calculated as follows.

Step
Step
Step
Step
Step

1
2
3
4
5

Add all net cash flows together and then add the terminal value
Convert the value from Step 1 to home currency
Discount the value from Step 2 at WACC
Convert initial investment to home currency
Deduct the value from Step 4 from the value in Step 3 to obtain NPV

11

The above formula assumes that non repatriated funds are not invested. If in fact we assume that the
cash flow is invested each period and earns a return equal to i, then the NPV will be calculated as
follows.

Step 1

Convert terminal value to home currency and discount at WACC

Step 2

Convert net cash flows to home currency, gross up for interest and add together, before
discounting the total using WACC

Step 3

Convert initial investment to home currency and deduct from the sum of the values in Steps
1 and 2
The impact will depend on the interest rate earned and the cost of capital. An example will illustrate
how this may be calculated.

Question

Exchange controls

Consider again the case of Flagwaver Inc, and its proposed subsidiary in Slovenia in question
International Investment 1.
Now assume that no funds can be repatriated for the first three years, but all the funds are allowed to
be remitted to the home market in year 4. The funds can be invested at a rate of 5 percent per year. Is
the project still financially viable?

Answer

The first payment represents the initial profit of 3,600,000 + 3 years investment interest of 5% that is:
3,600,000 x 1.053 = 4,167,150
(1)

The second payment includes 2 years investment interest and the 3 rd payment one years investment
interest.
Total net cash flow receivable in Year 4 is $15,896,910. When the salvage value of $8,000,000
(20,000,000/1,50) is included, total cash receivable is $23,896,910. Discounted at 15% (discount
factor at year 4 = 0.572), the present value is $13,669,033.
Net present value = $13,669,033 (20,000,000/1.5) = $335,700
Note that the exchange controls have reduced the NPV of the project by 76% (original NPV =
$1,416,939) but the project is still financially viable.

4.3 Strategies for dealing with exchange controls

Multinational companies have used many different strategies to overcome exchange controls the most
common of which are
Transfer pricing where the parent company sells goods or services to the subsidiary and obtain
payment. The amount of this payment will depend on the volume of sales and also on the transfer price
for the sales.

12

Royalty payments when a parent company grants a subsidiary the right to make goods protected
by patents. The size of any royalty can be adjusted to suit the wishes of the parent company's
management.
Loans by the parent company to the subsidiary. If the parent company makes a loan to a subsidiary,
it can set the interest rate high or low, thereby affecting the profits of both companies. A high rate of
interest on a loan, for example, would improve the parent company's profits to the detriment of the
subsidiary's profits.
Management charges may be levied by the parent company for costs incurred in the management
of international operations.

5 Transaction, translation and economic risks

The main risks faced by companies dealing with foreign currencies are transaction, translation and
economic risks.
Exposure to foreign exchange risk can occur in a variety of ways. Most companies and certainly
multinational corporations are affected by movements in exchange rates. Generally, exposure to
foreign exchange risk can be categorised as transaction exposure, translation exposure and
economic exposure.

5.1 Transaction exposure

Transaction risk is the risk of adverse exchange rate movements occurring in the course of normal
international trading transactions.
Transaction exposure occurs when a company has a future transaction that will be settled in a foreign
currency. Such exposure could arise for example as the result of a US company operating a foreign
subsidiary. Operations in foreign countries encounter a variety of transactions for example, purchases
or sales or financial transactions that are denominated in a foreign currency. Under these
circumstances it is often necessary for the parent company to convert the home currency in order to
provide the necessary currency to meet foreign obligations. This necessity gives rise to a foreign
exchange exposure. The cost of foreign obligations could rise as a result of a domestic currency or the
domestic value of foreign revenues could depreciate as a result of a stronger home currency. Even
when foreign subsidiaries operate independently of the parent company, without relying on the parent
company as a source of cash, they will ultimately remit dividends to the parent in the home currency.
Once again, this will require a conversion from foreign to home currency.
Transaction risk and its management will be covered in greater detail in a later handout when we look
at hedging foreign currency exposure.

5.2 Translation exposure

Translation risk is the risk that the organisation will make exchange losses when the accounting
results of its foreign branches or subsidiaries are translated into the home currency.
Translation exposure occurs in multinational corporations that have foreign subsidiaries with assets and
liabilities denominated in foreign currency. Translation exposure occurs because the value of these
accounts must eventually be stated in domestic currency for reporting purposes in the company's
financial statements. In general, as exchange rates change, the home currency value of the foreign
subsidiaries' assets and liabilities will change. Such changes can result in translation losses or gains,
which will be recognised in financial statements. The nature and structure of the subsidiaries' assets
and liabilities determine the extent of translation exposure to the parent company.
Translation losses can also result from, for example, restatingthe book value of a foreign subsidiarys
assets at the exchange rate on the date of the statement of financial position. Such losses will not have
an impact on the firms cash flow unless the assets are sold. This could influence investors and
lenders attitudes to the financial worth and creditworthiness of the company. Such risk can be reduced
if assets and liabilities denominated in particular currencies can be held in balanced accounts.
For example, suppose a UK firm has a European subsidiary that has a European bank deposit of 1
million and payable of 1 million. Also, suppose the exchange rate between the and sterling is 1.10

13

per . The sterling value of the subsidiary's position in these two accounts is 909,090 in both cases. If
sterling was to suddenly appreciate against the , say to 1.15/ the asset and the liability accounts
would lose sterling value in the same amount. Both would be revalued in sterling at 869,565.
However, there would be no loss to the UK parent, since the sterling loss on the bank deposit is exactly
offset by the sterling gain on the payable. In essence, these two accounts hedged each other from
translation exposure to exchange rate changes.

Case Study
In 2011, Coca Cola used 73 functional currencies in addition to the US dollar. As Coca Colas
consolidated financial statements are presented in US dollars, revenues, income and expenses,
together with assets and liabilities, must be translated into US dollars at the prevailing exchange rates
at the end of the financial year. Increases or decreases in the value of the US dollar against other major
currencies will affect reported figures in the financial statements.
Although Coca Cola hedges against currency fluctuations it states in its annual 10K return that it cannot
guarantee that currency fluctuations will not have a material effect on its reported figures. In 2011
Coca Cola made a foreign exchange loss of $73 million.
In 2010, Coca Cola made a loss of $103 million as a result of the Venezuelan government devaluing the
bolivar as a response to hyperinflation. This loss was based on the carrying value of Coca Colas assets
and liabilities that were denominated in Venezuelan bolivar.

5.3 Economic exposure

Economic risk is the risk that exchange rate movements might reduce the international
competitiveness of a company. It is the risk that the present value of a companys future cash flows
might be reduced by adverse exchange rate movements.
Economic exposure is the degree to which a firm's present value of future cash flows is affected by
fluctuations in exchange rates.
Economic exposure differs from transaction exposure in that exchange rate changes may affect the
value of the firm even though the firm is not involved in foreign currency transactions.

Example
Trends in exchange rates
Suppose a US company sets up a subsidiary in an Eastern European country. The Eastern European
countrys currency depreciates continuously over a five year period. The cash flows remitted back to
the US are worth less in dollar terms each year, causing a reduction in the investment project.
Another US company buys raw materials which are priced in euros. It converts these materials into
finished products which it exports mainly to Singapore. Over a period of several years the US dollar
depreciates against the euro but strengthens against the Singapore dollar. The US dollar value of the
companys income declines whilst the US dollar value of its materials increases, resulting in a drop in
the value of the companys net cash flows.
The value of a company depends on the present value of its expected future cash flows. If there
are fears that a company is exposed to the type of exchange rate movements described above, theis
may reduce the companys value. Protecting against economic exposure is therefore necessary to
protect the companys share price.
A company need not even engage in any foreign activities to be subject to economic exposure. For
example, if a company trades only in the UK but sterling strengthens significantly against other world
currencies, it may find that it loses UK sales to an overseas competitor who can now afford to charge
cheaper sterling prices.
One-off events
As well as trends in exchange rates, one-off events such as a major stock market crash or disaster such
as the attacks on 9/11 may administer a shock to exchange rate levels.

14

Assessing the impact of economic risks

None of the above examples are as simple as they seem however due to the compensating actions of
economic forces. For example, if the exchange rate of an Eastern European depreciates significantly it
is probably because of its high inflation rates.
So if the Eastern European subsidiary of a US company increases its prices in line with inflation, its
cash flows in the local currency will increase each year. These will be converted at the depreciating
exchange rate to produce a fairly constant US dollar value of cash flows. Therefore what is significant
for companies is the effect on real cash flows, after the effects of inflation have been removed. In
order for there to be real operating risk there must be relative price changes between countries.

5.3.1 Hedging economic risks

Various actions can reduce economic exposure, including the following.
(a) Matching assets and liabilities
A foreign subsidiary can be financed, as far as possible, with a loan in the currency of the country in
which the subsidiary operates. A depreciating currency results in reduced income but also reduced loan
service costs. A multinational will try to match assets and liabilities in each country as far as possible.
Matching will be discussed in a later handout.
(b) Diversifying the supplier and customer base
For example, if the currency of one of the supplier countries strengthens, purchasing can be switched
to a cheaper source.
(c) Diversifying operations world-wide
On the principle that companies which confine themselves to one country suffer from economic
exposure, international diversification is a method of reducing such exposure.
(d) Change prices
The amount of scope a company has to change its prices in response to exchange movements will
depend on its competitive position. If there are numerous domestic and overseas competitors, an
increase in prices may lead to a significant fall in demand.

6 Issues in choosing finance for overseas investment

6/12

As part of the fulfilment of the performance objective evaluate potential business/investment

opportunities and the required finance options you are expected to be able to identify and apply
different finance options to single and combined entities in domestic and multinational business
markets. This section and Section 7 look at the financing options available to multinationals which you
can put to good use if you work in such an environment.

6.1 Financing an overseas subsidiary

Once the decision is taken by a multinational company to start overseas operations in any of the forms
that have been discussed in the previous section, there is a need to decide on the source of funds for
the proposed expansion. There are some differences in methods of financing the parent company
itself, and the foreign subsidiaries. The parent company itself is more likely than companies which
have no foreign interests to raise finance in a foreign currency, or in its home currency from foreign
sources.
The need to finance a foreign subsidiary raises the following questions.
(a) How much equity capital should the parent company put into the subsidiary?
(b) Should the subsidiary be allowed to retain a large proportion of its profits, to build up its equity
reserves, or not?
(c) Should the parent company hold 100% of the equity of the subsidiary, or should it try to create a
minority shareholding, perhaps by floating the subsidiary on the country's domestic stock exchange?

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(d) Should the subsidiary be encouraged to borrow as much long-term debt as it can, for example by
raising large bank loans? If so, should the loans be in the domestic currency of the subsidiary's country,
or should it try to raise a foreign currency loan?
(e) Should the subsidiary be listed on the local stock exchange, raising funds from the local equity
markets?
(f) Should the subsidiary be encouraged to minimise its working capital investment by relying heavily
on trade credit?
The method of financing a subsidiary will give some indication of the nature and length of time of
the investment that the parent company is prepared to make. A sizeable equity investment (or longterm loans from the parent company to the subsidiary) would indicate a long-term investment by the
parent company.

6.2 Choice of finance for an overseas investment

The choice of the source of funds will depend on:
(a) The local finance costs, and any subsidies which may be available
(b) Taxation systems of the countries in which the subsidiary is operating. Different tax rates can
favour borrowing in high tax regimes, and no borrowing elsewhere.
(c) Any restrictions on dividend remittances
(d) The possibility of flexibility in repayments which may arise from the parent/subsidiary
relationship
Tax-saving opportunities may be maximised by structuring the group and its subsidiaries in such a
way as to take the best advantage of the different local tax systems.
Because subsidiaries may be operating with a guarantee from the parent company, different gearing
structures may be possible. Thus, a subsidiary may be able to operate with a higher level of debt that
would be acceptable for the group as a whole.
Parent companies should also consider the following factors.
(a) Reduced systematic risk. There may be a small incremental reduction in systematic risk from
investing abroad due to the segmentation of capital markets.
(b) Access to capital. Obtaining capital from foreign markets may increase liquidity, lower costs and
make it easier to maintain optimum gearing.
(c) Agency costs. These may be higher due to political risk, market imperfections and
complexity,leading to a higher cost of capital.
You must be prepared to answer questions about various methods of financing an overseas subsidiary.

7 Costs and benefits of alternative sources of finance for

MNCs
Multinational companies will have access to international debt facilities, such as Eurobonds and
syndicated loans.
Multinational companies (MNCs) fund their investments from retained earnings, the issue of new equity
or the issue of new debt. Equity and debt funding can be secured by accessing both domestic and
overseas capital markets. Thus multinational companies have to make decisions not only about their
capital structure as measured by the debt/equity, but also about the source of funding, that is whether
the funds should be drawn from the domestic or the international markets.

7.1 International borrowing

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Borrowing markets are becoming increasingly internationalised, particularly for larger companies.
Companies are able to borrow long-term funds on the eurocurrency (money) markets and on the
markets for eurobonds. These markets are collectively called 'euromarkets'. Large companies can
also borrow on the syndicated loan market where a syndicate of banks provides medium to longterm currency loans.
If a company is receiving income in a foreign currency or has a long-term investment overseas, it can
try to limit the risk of adverse exchange rate movements by matching. It can take out a long-term
loan and use the foreign currency receipts to repay the loan.

7.2 Eurocurrency markets

A UK company might borrow money from a bank or from the investing public, in sterling. However it
might also borrow in a foreign currency, especially if it trades abroad, or if it already has assets or
liabilities abroad denominated in a foreign currency. When a company borrows in a foreign currency,
the loan is known as a eurocurrency loan. (As with euro-equity, it is not only the euro that is involved,
and so the 'euro-' prefix is a misnomer.) Banks involved in the euro currency market are not subject
to central bank reserve requirements or regulations in respect of their involvement.
The eurocurrency markets involve the depositing of funds with a bank outside the country of the
currency in which the funds are denominated and re-lending these funds for a fairly short term,
typically three months, normally at a floating rate of interest. Eurocredits are medium to long-term
international bank loans which may be arranged by individual banks or by syndicates of banks.
Syndication of loans increases the amounts available to hundreds of millions, while reducing the
exposure of individual banks.

7.3 Syndicated loans

A syndicated loan is a loan offered by a group of lenders (a syndicate) to a single borrower. A
syndicated loan is a loan put together by a group of lenders (a syndicate) for a single borrower. Banks
or other institutional lenders may be unwilling (due to excessive risk) or unable to provide the total
amount individually but may be willing to work as part of a syndicate to supply the requested funds.
Given that many syndicated loans are for very large amounts, the risk of even one single borrower
defaulting could be disastrous for an individual lender. Sharing the risk is likely to be more attractive for
investors.
Each syndicate member will contribute an agreed percentage of the total funds and receive the same
percentage of the repayments.
Originally syndicated loans were limited to international organisations for acquisitions and other
investments of similar importance and amounts. This was mainly due to the following:
(a) Elimination of foreign exchange risk borrowers may be able to reduce exchange rate risk by
spreading the supply of funds between a number of different international lenders.
(b) Speed in normal circumstances it may take some time to raise very large amounts of money. The
efficiency of the syndicated loans market means that large loans can be put together very quickly.
Syndicated loans are now much more widely available, with small and medium sized organisations now
making use of such provision of funds. These loans can also be made on a best efforts basis that is,
if a sufficient number of investors cannot be found the amount the borrower receives will be lower than
originally anticipated.

7.4 The advantages of borrowing internationally

There are three main advantages from borrowing for international capital markets, as opposed to
domestic capital markets
(a) Availability. Domestic financial markets, with the exception of the large countries and the Euro
zone, lack the depth and liquidity to accommodate either large debt issues or issues with long
maturities.

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(b) Lower cost of borrowing. In Eurobond markets interest rates are normally lower than borrowing
rates in national markets
(c) Lower issue costs. The cost of debt issuance is normally lower than the cost of debt issue in
domestic markets.

7.5 The risks of borrowing internationally

A multinational company has three options when financing an overseas project by borrowing. The first
is to borrow in the same currency as the inflows from the project. The second option is borrowing in a
currency other than the currency of the inflows but with a hedge in place and the third option is
borrowing in a currency other than the currency of the inflows but without hedging the currency risk.
The last case exposes the company to exchange rate risk which can substantially change the
profitability of a project.

Question

International investment 3

Donegal plc manufactures Irish souvenirs. These souvenirs are exported in vast quantities to the USA
to the extent that Donegal is considering setting up a manufacturing and commercial subsidiary there.
After undertaking research, it has been found that it would cost $6m, comprising $5m in non-current
assets and $1m in working capital. Annual sales of the souvenirs have been estimated as $4m and they
would cost $2.5m per annum to produce. Other costs are likely to be $300,000 per annum.
Tax rates are as follows.
Ireland
23%

USA

25%

Tax is payable in the year of occurrence in both countries. Assume there is no double tax relief. Capital
allowances at a rate of 20% reducing balance are available. Balancing allowances or balancing charges
should also be accounted for at the end of the projects life.
The maximum possible funds will be remitted to the home country (Ireland) at the end of each year.
The exchange rate is $1 = 0.71. It is assumed that this rate will remain constant over the projects
life.
The project is being appraised on a five year time span. The non-current assets will be sold for an
expected $2.5m at the end of the projects life.
Donegal uses a cost of capital of 12% on all capital investment projects.
Required
Calculate the NPV of the proposed project and recommend to the Board of Directors of Donegal
whether the US subsidiary should be set up.

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