Ifm Lecture 09 Bps

8/19/2019 Ifm Lecture 09 Bps

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INTERNATIONAL FINANCEIAME – International Academy of

Management & Entrepreneurship

Shashank BP

Module 05

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Assignment 4

•

Discuss “Long and Short Position with respectto Derivatives”.

• Team 01 - Akash, Ram Naveen, Vandana,

Saddam

• Team 02 - Kavya, Sharath, Shupriya, Sneha,

Snehitha

•

Team 03 - Vaishali, Manohar, Sasikumar,Rashmi

• Team 04 - Valentine, Pinky, Surendra,

Pushpamani2


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Assignment 4

•

Each group should come up with one exampleof “Long and Short Position w.r.t. Derivatives”.

• Example should be related clearly to

derivatives.

• PowerPoint presentation or White Board

presentation in class on 26 August 2015.

•

Each group presentation should be completedin less than 5 minutes.

• No two groups should present the same

example, else they both will be downgraded.3


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Long Position

• When a trader is “long”, he/she wins when theprice increases, and loses when the pricedecreases.

• When a trader buys an option contract thathe/she is not short, he/she is said to beopening a long position.

•

When a trader sells an option contract thathe/she is already long, he/she is said to beclosing a long position.

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Short Position

• When a trader is “short”, he/she wins whenthe price decreases, and loses when the priceincreases.

• When a trader sells an option contract thathe/she is not long, he/she is said to beopening a short position.

•

When a trader buys an option contract thathe/she is already short, he/she is said to beclosing a short position.

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Cost of Capital for Foreign

Investment• Concepts to know:

Deregulation of international financial

markets

Liberalization of cash flows Optimal capital structure and capital cost

How is optimal capital structure achieved

by MNCs? MNCs and their cost of capital advantage

due to size and economies of scale (large

scale operations)


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Investment• Concepts to know:

Practical framework of capital structure in

MNCs

Pecking order finance: No specialattention to theories

Empirical evidence on capital structures

and MNC preferences of mix


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Investment• With the developing countries liberalizing

their economies, MNCs have got more

opportunities to invest in those countries.

• Each country has different economiccharacteristics and business environment.

• Each country has different sectors which are

liberalized.• One country may at one particular time treat

a particular sector as priority and provide

incentives for investment in that sector.


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Investment• India at this point of time gives top

preference to infrastructure sector.

• MNCs might get much higher rate of return in

such sector investments.• The first step for MNCs is to determine the

capital mix and cost of capital.

•

Capital mix could have debt, equity and othersources.


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Investment• Depending on prevailing conditions, higher

debt than equity may bring down the cost of

capital in certain cases. In other cases, it may

be vice versa.• A single rate of return cannot be used by

MNCs for all their projects in various countries.

• The determination of cost of capital ininternational finance is a complex issue.


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Investment• MNCs have advantages/disadvantages

because of their characteristics, that

differentiate them from large domestic firms,

like: Size of the firm

Foreign exchange risk

Access to international capital market International diversification

Political risk

Country risk


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Investment• Size of the firm: MNCs are large, and have

economies of large scale negotiation. They also

have possibilities of reducing the various

transaction costs and brokerage expenses.They get preferential treatment from credit

agencies.


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Investment• Foreign exchange risk: A firm more exposed

to the foreign exchange rate fluctuations

would have wider spread of possible cash

flows in future periods.• Exposure to exchange rate fluctuations could

lead to higher cost of capital.

•

At times, fluctuations also give advantage tothe MNCs, when currency depreciation takes

place.


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Investment• Access to international capital market: Thiscould result in the subsidiary getting local

funds at lower rate than parent company.

• International diversification: This gives MNCslower cost of capital because they get cash

flows from various businesses & countries.

•

Note that diversification gives stability to thecash flow. Diversification also lowers

systematic (market related) risk, lowers beta

coefficient and thus lowers the cost of equity.


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Investment• Political risk: Political risk is likely to begreater in the later years of a project because

of the length of time. This increases the cost of

capital because of an arbitrary risk premium.• Country risk: This is unique due to the

adverse impact of a country’s environment.

There are serious risks like bankruptcy of acountry, evacuation of foreigners and foreign

firms etc. For example, in Cuba in 1959, there

was mass scale expropriation of US firms.


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Investment• Risk free rate, tax laws, demographics,

monetary policy and economic conditions vary

from country to country. Due to these factors,

risk premium on debt also varies.• Capital structure decisions (whether to use

more debt or more equity capital) for

subsidiaries ultimately are dependent on thecorporate culture and circumstances such as

stable cash flows, low credit risk etc.


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Investment• Empirical studies of various MNCs reveal that

the parent company never wants a subsidiary

to be a defaulter, and so they adapt a practical

framework of capital structure, independent ofall theories. This policy is called “Pecking Order

of Financing”.


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Investment• Empirical studies reveal that MNCs go in forlocal debt or equity issues as a last resort. They

prefer own generated funds (retentions).

• Empirical studies also show that MNC firms

are often thought to be reluctant to explicitly

guarantee the debt of their subsidiaries. They

rather leave subsidiaries to their merit.


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Investment• The foreign creditors, investors andshareholders of MNCs prefer “global” target

capital structure rather than “local” capital

structure because they would have betterunderstanding and control over financial

operations at the macro level than at the micro

level.


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Case Study: Pharma Firms

Company Year 1 Year 2 Year 3 Year 4

Glaxo India 0.433 0.894 0.336 0.346

Glaxo Wellcome 2.860 2.670 2.140 1.680

Smithkline Beecham India 0 0 0 0

Smithkline Beecham UK 0.441 0.408 0.386 0.269

Novartis India 0.385 0.116 0.099 0.045

Novartis AG, Switzerland 0.460 0.460 0.410 0.280

Pfizer, India 0.143 0.265 0.019 0.112

Pfizer, US 0.075 0.091 0.077 0.089

Debt – Equity Trend of Parent Companies and

Indian Subsidiaries

Comment on the capital structure practices of

the four companies.


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Case Study (Contd.): Pharma Firms

•

Glaxo Wellcome uses debt significantlyinternationally, but rather conservatively in

Glaxo India.

• Smithkline Beecham takes no debt in India

and is an extreme case. It uses only retentions

from Smithkline Beecham UK.

• Novartis does not believe much in borrowing

either in the parent or in India. So is the casewith Pfizer.


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Case Study (Contd.): Pharma Firms

•

It can thus be concluded that theseinternational pharmaceutical firms run on

retained earnings than on borrowings,

especially in subsidiaries.


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To compute the WACC for a multinational firm

with a foreign project, the following formula is

used:

Ko = (1-L)Ke + LKd(1-t)

Ko = Weighted Average Cost of Capital for themultinational parent and the project

L = Parent’s debt ratio (or debt to assets ratio) -

interpreted as the proportion of a company’sassets that are financed by debt.

Ke = Cost of equity capital

Kd(1-t) = After tax cost of debt

WACC formula for MNCs


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The WACC Ko is used as the discount rate in

evaluating the specific foreign investment. Note

that Ke is the required return on the firm’s stock

at the particular debt ratio selected.

Both project risk and project financial structure

can vary from the corporate norm because of the

project’s different debt capacity. In such a case,the project’s WACC will be:

Ko’ = (1-L’)Ke’ + L’Kd’(1-t)



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Ko’ = WACC of the foreign project

L’ = Debt ratio of the foreign project

Ke’ = Cost of equity capital of the foreign project

Kd’ = Cost of debt of the foreign project



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Cost of Capital Example• Lexon PLC, a successful UK-based MNC, is

considering how to obtain funding for a

project in Argentina during the next year. It

considers the following information:

– UK risk free rate = 6%

– Argentine risk free rate = 10%

– Risk premium on Pound debt by UK

creditors = 3%

– Risk premium on Peso debt by Argentine

creditors = 5%26


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Cost of Capital Example

–

Beta of Project = 1.5 – Expected UK market return = 14%

– UK corporate tax rate = 30%

– Argentine corporate tax rate = 30% – Creditors will allow maximum of 50% debt

• Calculate Cost of Capital of each

component for Lexon PLC.

(Contd..)

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Answer:• Cost of Pound denominated debt in UK

= (Rf + Rp)(1 – T) where Rf = Risk free rate, Rp =

Risk premium, T is the Tax rate.= (6% + 3%)(1 – 0.3) = 6.3%

• Cost of Peso denominated debt in Argentina

= (10% + 5%)(1 – 0.3) = 10.5%

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Answer (Contd.):• Cost of Pound denominated Equity

= Rf + Beta(Rm – Rf) where Rf = Risk free rate,

Beta is market sensitivity, Rm = Market return= 6% + [1.5 * (14% - 6%)] = 18%

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• Now, you are expected to calculate the WACC

for Lexon PLC for 4 different scenarios as

follows:

– 30% UK debt, 70% UK equity

– 50% UK debt, 50% UK equity

– 20% UK debt, 30% Argentine debt, 50% UK

equity

– 50% Argentine debt, 50% UK equity

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Cost of Capital Example:

WACC Formula

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Where:

Re = cost of equity; Rd = cost of debtE = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D = total market value of the firm’s financing

(equity and debt)

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate



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WACC Calculation

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• 30% UK debt, 70% UK equity

WACC = (30% * 6.3%) + (70% * 18%) = 14.49%


WACC = (50% * 6.3%) + (50% * 18%) = 12.15%• 20% UK debt, 30% Argentine debt, 50% UK

equity

WACC = (20% * 6.3%) + (30%* 10.5%) + (50% *18%) = 1.26% + 3.15% + 9% = 13.41%

• 50% Argentine debt, 50% UK equity

WACC = (50% * 10.5%) + (50% * 18%) = 14.25%


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Cost of Capital Example: Risk Premium

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• Lexon estimated WACC at 12.15% if 50% UKdebt & 50% UK equity.

• But Argentine project is exposed to Exchange

Rate Risk.• Lexon decides to add Risk Premium of 6%

points to the estimated WACC.

• Thus, the required rate of return would be12.15% + 6% = 18.15%.


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Cost of Capital Example: NPV

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•

Lexon PLC worked out the NPV for 2 of the 4scenarios:


WACC = 12.15%

NPV = -£1.42 millions

• 50% Argentine debt, 50% UK equity

WACC = 14.25%

NPV = £1.26 millions

• 50% Argentine debt, 50% UK equity has higherWACC but positive NPV!!


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Cost of Debt Example• How is the cost of debt computed in

international finance?

This can be explained using an example. Consider

Embraer, the Brazilian aerospace company. To

estimate Embraer’s cost of debt, we firstestimate a synthetic rating for the firm. Based

upon its operating income of $810 million and

interest expenses of $28 million in year 2000, wearrive at an interest coverage of 28.93, and thus

an AAA rating. The default spread for AAA rated

bonds is only 0.75%.


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Cost of Debt Example

Now, Embraer is a Brazilian firm. The Brazilian

government bond traded at a spread of 5.37%,

and so it could be argued that every Brazilian

company should pay this premium, in addition to

its own default spread. With this reasoning thepretax cost of debt for Embraer in US$ (assuming

a treasury bond rate of 5%) can be calculated as

follows:


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Cost of Debt Example

Cost of Debt = Risk Free rate + Default spread for

country + Default spread for firm

= 5% + 5.37% + 0.75% = 11.12%

Now, using a marginal tax rate of 33%, we can

estimate the after-tax cost of debt for Embraer:After-tax Cost of Debt

= Pre tax cost of debt * (1 – Tax rate)

= 11.12% * (1 – 0.33) = 7.45%Hence, the after-tax cost of debt for Embraer is

7.45%.


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Managing Political Risk

• Concepts to know:

Types of Political Risk

Techniques to assess political risk /

indicators of political risk

How MNCs can manage political risk Case Study: Discuss the steps taken to

attract FDI by the present Indian

Government.

M i P liti l Ri k


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Managing Political Risk• Since investing in a foreign country and

putting a subsidiary up involves time factorspanning generations, the first thing an MNC

assesses is the Political Risk.

•

Political risks are indicated through varioussocio-political and historical events.

• There are specialists who can read trends on:

the political parties and their philosophy

stability of local governments consensus of various political parties on

priorities – especially economic priorities.

M i P liti l Ri k


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Managing Political Risk• There are specialists who can read trends on:

attitude towards foreigners and foreigninvestments

war and other extreme calamities

military role in politics mechanism to express discontent and

anger

respect to democracy and democratic

institutions past history for a long period (like a

century) on tolerance and empathy.


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• Political risk is divided into:

Macro risk – war, revolt, upheaval,

expropriation, insurrection

Micro risk – partisanship to certain

sectors, corruption, prejudicial actions Risk hotspots – certain regions within the

country

•

Certain times entering business with highpolitical risk countries can be very lucrative.

• In some countries, political risk insurance is

available.


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•

Political risk consultants (Moody’s, Standard& Poor’s, McKinsey) and specialists are

available.

• MNCs do get “caught unawares” on rare

occasions.

• MNCs do not explicitly announce “exit policy”

but might keep an “exit plan” at the back of

the mind – unwritten, but fully conscious.


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• MNCs contribution to local society, economy

and country’s overall growth is always keenly

observed by various activists, social

organizations and power groups.

• At times, this results in “forced withdrawals”as it happened in many countries.

• We have cases like the exit of Enron from

India, which was before its full-fledged entryinto the country.


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• We also have cases like the one-time forced

exit of Coca Cola from India, after it was fully

established in the country.

• Fair trade policies, human rights

considerations, foreign policy of the country – these are some of the other factors that could

be classified under “Political Risk”.

• Generally, political risk comes to light by

studying historical data and evolutionary

events. So these risks do not spring a surprise.


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•

Wherever there is Communist rule, oropposite geo-political environment, MNCs

from UK or USA may not be interested in

putting up capital investments, since political

risk multiplies.

• When geo-political developments take place,

MNCs keep a watch for stability in political

atmosphere, and then invest heavily like in thecase of China and Vietnam.


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• Business and Politics are separate

philosophies in theory. However, in reality,

MNCs have to contribute to the host countries

and society’s stated and desired goals.

• Note that certain unforeseen events couldtrigger into political risk. A product quality

issue like Nestle’s Maggi in India (2015) could

turn into a socio-political issue. Before theissue escalates, MNCs use social interest and

technology to get over such situations.


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Political Risk: Expropriation

• What is expropriation?

The act of taking privately owned property by

a government to be used for the benefit of the

public is Expropriation. In the US, the Fifth

Amendment to the Constitution provides thatprivate property “will not be taken for public use

without just compensation”. While there is

compensation, the expropriation occurs withoutthe property owner’s consent.


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Political Risk: Expropriation

• What is expropriation?

Many, but not all, countries support the theory

that the expropriating country should pay

adequate, timely and effective compensation to

the involved party. Countries can expropriate foreign businesses

located within the country. Former socialist

Chilean President Salvador Allende expropriatedUS businesses located in Chile in the early 1970s.


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• What is Host Government take over?

The most severe country risk is a take over of an

MNC’s local operations by the host government.

This type of take over may result in major losses,

especially when the MNC does not have anypower to negotiate with the host government.

The most common strategies used to reduce

exposure to a host government take over are:(a) concentrate on recovering cash flow quickly,

(Contd.)


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(b) rely on unique supplies or technology that

cannot be duplicated locally so that the host

government cannot do without those supplies

or technology,

(c) hire local labor,(d) borrow local funds,

(e) purchase country risk insurance,

(f) use project finance to finance the projectheavily with credit. Project finance is based on

future cash flows from the project and

separates the MNC from the project.


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Case Study: Venezuela

• Assume you are CFO of a Cement Company

operating in Venezuela. You are planning a

major expansion in view of increasing

demand. The Venezuelan President hasthreatened that if prices are not brought

down by cement manufacturers, he would

nationalize all the companies, includingforeign companies operating there.

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Case Study: Venezuela

• How would you assess the political risk for

your project?

• What threats do you expect for your project in

future?

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Case Study: Venezuela - Answer

• This is a clear case of “Host Government Take

Over”.

• This will result in major losses in case of take

over.

• As CFO, I would focus on recovering cash flow

quickly.

• I would also hire more local labour and

borrow more local funds.

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• If possible, I would purchase “country risk

insurance”.

• Also if possible I would separate the project in

Venezuela from the rest of the MNC.

• I would use internally generated cash flows

from the project to fund the project’s future

working capital and investment needs.

• This is also called using “project finance” to

run the project.54


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• I will surely be cautious about increasing my

or my MNC’s exposure in Venezuela since the

threat of Host Government Take Over is very

real.• I will run the Venezuelan operation from the

parent office overseas.

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Case Study: India


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Case Study: India• Since 1991, by liberalizing its economy, India

has been struggling to gain a firm position inthe global economy. Though it has attracted

many foreign investors, it has not succeeded in

retaining them. Most of the companies have

left the country either because of the

infrastructure, which has to go a long way

before they meet the international standards

or because of the government policies, whichare not favorable for carrying out business in

India… (Contd..)

Case Study: India


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Case Study: IndiaThe basic requirements for carrying on any

business like power, telecommunications,roads, etc. are not up to the mark.

Question: Describe the various steps taken by

the present Indian government in the last one

year to attract more foreign players.


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Case Study: India - Answer

• Strong steps in foreign affairs: Political and

Economic relationship with SAARC, other Asian

countries.

• PM visits Japan, Germany, USA

• “Make in India” initiative, “Smart City”programme

• Ease of business – reduced red tape

• Transparency, Openness and Political stability• Control of rampant corruption


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• Policy changes – Centre and states with stable

majority have new industrial policies

• Liberalized investment norms in Railway and

Defense ancillaries, Insurance

• Reduction of interest rates• Encouragement of savings from the poorest

of the poor

• Subsidies only to Below Poverty Line people


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• Other positive factors:

Largest democracy in the world

Peaceful general elections always

No military coups or military juntas ever,

like in some Asian countries Political stability of the highest order

Mature political parties

Excellent banking and financial systems Mature stock and financial markets

Steady exports

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