International Short-Term Financing and Investment 251

(1 + e_y ⁾ > (1 + L ) 291

(1+f ) 300

(1+f ) 302

International Long-Term Financing, Capital Structure and the Cost of Capital 284

D = Z D, 283

E = Z 283

k = Z 289

International Long-Term Portfolio Investment 296

Rj,t = b 0,j + b 1, jR m,t + b 2,j$t + e j,t (11.40) 311

dL 319

dm ₁ -¹'—-¹'-²'"² --v-^"³ '-³ (1149) 319

+ 2ct(S 1, S ₄)w 4 +1 1 = 0 319

= 2w3 s ² (S3 ) + 2s(S 1 , S3 )w 1 + 2s(S2 , S3 )w2 320

+ 2s(S 3 , S₄ )w 4 +2 1 = 0 = 2w4 s ² (S4 ) + 2s(S 1 , S4 )w 1 + 2s(S 2 , S4 )w2 + 2s(S 3 , S4 )w 4 + 2 2 = 0 320

= w 1 + W2 + w 3 -1 = 0 320

w' = [w 1 w 2 w 3 w 4 2 1 2 2] and 331

Foreign Direct Investment 344

i 341

References 341

i 361

Index 363

0 0 0 0

w' = [w 1 w 2 w 3 w 4 2 1 2 2] and

(11.57)

(11.58)

C ' = [0 0 0 0 1 -1]

Therefore, the weights for a basket hedge are calculated by solving the matrix equation (11.55) to obtain

(11.59)

w

= B^-1C

Thus, the amount of currency yi (i = 1, 2, 3) sold forward is given by

(11.60)

wK

M; = -

F( x/yi )

where K is the x currency value of the portfolio. For more detail, see DeRosa (1991).

Hedging currency risk in international portfolios when the base currency is pegged to a basket

(11.61)

Suppose that the base currency, x, is pegged to a basket. Recall from Chapter 3 that a portfolio manager with securities denominated in k currencies will in this case give a total base currency rate of return that is given by

k

Rx =Z Aj + C j=1

where Aj is the rate of return on a yj-denominated currency and C is the currency factor (the foreign exchange gain/loss). If the portfolio is chosen such that: (i) the currencies denominating the securities are identical to those of which the basket consists (k = n); and (ii) the weights in the portfolio are identical to the weights in the basket (aj = bj for j = 1, 2, ..., n), it follows that C = 0 (see Chapter 3). In this case, the variance of R_x in equation (11.61) is determined entirely by the variance and covariances of the Ajs, which makes it independent of the currency factor. Thus, by constructing the international portfolio such that the weight of the secu­rity denominated in a particular currency is equal to the weight of the same currency in the basket, foreign exchange risk can be eliminated completely. Needless to say, this operation requires knowledge of the structure of the basket to which the base currency is pegged.

Empirical evidence

Domestic portfolio

Figure 11.1 demonstrates the effect of international diversification and that of currency hedging. In general, as the number of securities from which the

Rp /s Rp)

Hedged international portfolio

— Unhedged international portfolio

Number of securities

FIGURE 11.1 The effect of international diversification and currency hedging.

portfolio consists increases, the return-risk ratio improves, though at a decreasing rate. The effect of international diversification is to make it possible to obtain a higher return-risk ratio for any given number of securities. The effect of currency hedging is to boost the effect of international diversification, allowing the portfolio manager to obtain even higher return-risk ratios for the same number of securities. This is in theory, but what does the empirical evidence tells us?

Several studies have suggested that hedging foreign exchange risk can reduce the variability of returns on international portfolios while having little impact on or even enhancing returns. These studies include Madura and Reiff (1985), Eun and Resnick (1988), Perold and Schulman (1988), Eaker and Grant (1991), Glen and Jorion (1993) and Levich and Thomas (1993a). For example, Madura and Reiff (1985) estimated the returns on country stick indices to determine the degree of risk reduction resulting from currency hedging. They found that the hedged portfolio had half the variance of a corresponding unhedged portfolio for the same level of return. However, Abken and Shrikhande (1997) have produced results indicating that the dominance of hedged portfolios during the period 1980-85 was reversed during the period 1986-96, when the dollar was generally depreciating.

I

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CHAPTER 12

Foreign Direct Investment

12.1 DEFINITION AND CLASSIFICATION

Foreign direct investment (FDI) is the process whereby residents of one country (the source country) acquire ownership of assets for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country). The International Monetary Fund's Balance of Payments Manual defines FDI as "an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor's purpose being to have an effective voice in the management of the enterprise". The United Nation's 1999 World Invest­ment Report (UNCTAD, 1999) defines FDI as "an investment involving a long- term relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise, affiliate enterprise or foreign affiliate)". The term "long-term" is used in the last definition in order to distinguish FDI from port­folio investment, which we dealt with in the previous chapter. FDI does not have the portfolio investment characteristic of being short term in nature, involving a high turnover of securities.

The common feature of these definitions lies in words like "control" and "controlling interest", which represent the most important feature that distin­guishes FDI from portfolio investment, since a portfolio investor does not seek control or lasting interest. There is no agreement, however, on what constitutes a controlling interest, but most commonly a minimum of 10% shareholding is regarded as allowing the foreign firm to exert significant influence, either poten­tially or actually exercised, over the key policies of the underlying project. Many firms are unwilling to carry out foreign investment unless they have 100% equity ownership and control. Others refuse to make such investments unless they have at least majority control (that is, a 51% stake). In recent years, however, there has been a tendency for indulging in FDI cooperative arrangements where several firms participate and no single party holds majority control (for example, joint ventures).

Classification of FDI

FDI can be classified from the perspective of the investing firm and from the perspective of the host country (the recipient of FDI). From the perspective of the investor, it is possible to distinguish among horizontal FDI, vertical FDI and conglomerate FDI. Horizontal FDI is undertaken for the purpose of hori­zontal expansion to produce the same or similar kinds of goods abroad (in the host country) as in the home country. Hence product differentiation is the crit­ical element of market structure for horizontal FDI. More generally, horizontal FDI is undertaken to exploit more fully certain monopolistic or oligopolistic advantages such as patents or differentiated products, particularly if expan­sion at home were to violate anti-trust laws. Vertical FDI, on the other hand, is undertaken for the purpose of exploiting raw materials (backward vertical FDI) or to be nearer to consumers through the acquisition of distribution outlets (forward vertical FDI).

From the perspective of the host country, FDI can be classified into (i) import-substituting FDI, (ii) export-increasing FDI and (iii) government-initi­ated FDI. Import-substituting FDI involves the production of goods previ­ously imported by the host country, necessarily implying that imports by the host country and exports by the investing firm will decline. This type of FDI is likely to be determined by the size of the host country's market, transportation costs and trade barriers. Export-increasing FDI, on the other hand, is moti­vated by the desire to seek new sources of input, such as raw materials and intermediate goods. This kind of FDI is export-increasing in the sense that the host country will increase its exports of raw materials and intermediate prod­ucts to other countries, where the investing firm and its subsidiaries are located. Government-initiated FDI may be triggered, for example, when a government offers incentives to foreign investors in an attempt to eliminate a balance of payments deficit.

FDI may also be classified into expansionary and defensive types. Expan­sionary FDI seeks to exploit firm-specific advantages in the host country. This type of FDI has the additional benefit of contributing to sales growth of the investing firm at home and abroad. On the other hand, defensive FDI seeks cheap labour in the host country with the objective of reducing the cost of production.

FDI may take one of three forms: greenfield investment, cross-border mergers and acquisitions (M&As), and joint ventures. Greenfield investment occurs when the investing firm establishes new production, distribution or other facilities in the host country. Typically, host countries prefer greenfield investment because of the job-creating potential and value-added output. FDI may occur via an acquisition of, or a merger with, an established firm in the host country (the vast majority of M&As are indeed acquisitions rather than mergers). This mode of FDI has two advantages over greenfield investment: (i) it is cheaper, particularly if the acquired project is a loss-making operation that can be bought at a low price; and (ii) it allows the investor to get quick access to the market. Firms may be motivated to engage in cross-border acqui­sitions to bolster their competitive positions in the world market by acquiring special assets from other firms or by using their own assets on a larger scale. A large number of M&As fail in the sense that the firms engaging in this activity do not produce better results in terms of share prices and profitability than those firms that do not indulge in this activity.

FDI can also take the form of joint ventures either with a host country firm or with a government institution, as well as with another company that is foreign to the host country. One side normally provides the technical exper­tise and its ability to raise finance while the other side provides valuable input through its local knowledge of the bureaucracy as well as local laws and regulations.

What is a multinational firm?

Most FDI is carried out by multinational firms, but it is difficult to pinpoint what constitutes a multinational firm. The 1999 World Investment Report defines multinational firms (which it calls transnational corporations) as "incorporated or unincorporated enterprises comprising parent enterprises and their foreign affiliates". A parent enterprise or firm is defined as "an enter­prise that controls assets of other entities in countries other than its home country, usually by owning a certain equity capital stake". A foreign affiliate is defined as "an incorporated or unincorporated enterprise in which an investor, who is resident in another economy, owns a stake that permits a lasting interest in the management of that enterprise". Foreign affiliates may be subsidiaries, associates or branches. A subsidiary is an incorporated enter­prise in the host country in which another entity directly owns more than half of the shareholders' voting power and has the right to appoint or remove a majority of the members of the administrative, management or supervisory body. An associate is an incorporated enterprise in the host country in which an investor owns a total of at least 10%, but not more than half, of the share­holders' voting power. A branch is a wholly or jointly owned unincorporated enterprise in the host country, which may take the form of a permanent office of the foreign investor or an unincorporated partnership or a joint venture. A branch may also refer to land, structures, immovable equipment and mobile equipment (such as oil drilling rigs and ships) operating in a country other than the investor's country. Here, the term "subsidiary" is used as a generic term for the "foreign establishment" or "foreign arm" of a multinational firm.

Some attempts have been made to measure the extent of being "multina­tional" according to a set of indicators. Dorrenbacher (2000) proposes a measure based on the following indicators: (i) structural indicators, (ii) perfor­mance indicators and (iii) attitudinal indicators. Structural indicators include the number of countries where the firm is active, the number of foreign subsidiaries, the number of foreign employees and the number of stock markets on which the firm's shares are listed. Performance indicators include foreign sales and operating income of foreign subsidiaries. The attitudinal indicators include management style and the international experience of top management.

12.2 EXPLAINING FOREIGN DIRECT INVESTMENT

A number of theories have been put forward to explain FDI. In this section, we present these theories as a series of hypotheses.

Hypothesis 1: FDI depends on the rate of return on the underlying project

The differential rates of return hypothesis represents one of the first attempts to explain FDI flows. This hypothesis postulates that capital flows from coun­tries with low rates of return to countries with high rates of return move in a process that eventually leads to the equality of ex ante real rates of return. The hypothesis obviously assumes risk neutrality, making the rate of return the only variable upon which the investment decision depends. Risk neutrality in this sense implies that the investor considers domestic and foreign direct investments to be perfect substitutes, or in general that direct investment in any country, including the home country, is a perfect substitute for direct investment in any other country.

One problem with the differential rates of return hypothesis is that it is not consistent with the observation that countries simultaneously experience inflows and outflows of FDI. This is because a rate of return differential implies capital flows in one direction only, from the low-rate country to the high-rate country, and not vice versa. There is, obviously, something missing in this hypothesis. Furthermore, the validity of the differential rates of return hypothesis can be questioned on theoretical grounds. First of all, multina­tional firms may indulge in FDI for reasons other than profit, particularly in the short run and medium run. For example, the objective may be to maximise sales revenue in accordance with the market penetration objective. Or the objective may not be purely financial, but rather logistical and operational, such as the desire to circumvent trade barriers. In general, multinational firms are faced with a multiplicity of objectives for their international operations, and these objectives are likely to change with the passage of time. More impor­tantly, however, risk aversion implies that the FDI decision does not only depend on return but also on risk. Finally, the differential rates of return hypothesis does not explain why a firm indulges in FDI rather than portfolio investment.

Hypothesis 2: FDI depends on return and risk

When the assumption of risk neutrality is relaxed, risk becomes another vari­able upon which the FDI decision is made. If this proposition is accepted, then the differential rates of return hypothesis becomes inadequate, in which case we resort to the diversification (or portfolio) hypothesis to explain FDI. The choice among various projects is therefore guided not only by the expected rate of return, but also by risk. The same idea of reducing risk via diversifica­tion that is relevant to portfolio investment is used here. Because of risk aver­sion, a rate of return differential will not induce capital flows in one direction until the differential disappears via arbitrage. Rather, capital mobility will be constrained by the desire to minimise or reduce risk, which is achieved via diversification.

Hypothesis 3: FDI depends on market size

The volume of FDI in a host country depends on its market size. This hypoth­esis is particularly valid for the case of import-substituting FDI. As soon as the size of the market of a particular country has grown to a level warranting the exploitation of economies of scale, this country becomes a potential target for FDI inflows. The rationale for the hypothesis that firms increase their invest­ment in response to their sales is based on neoclassical domestic investment theories.

One way to test the market size hypothesis is to find out whether or not the share of FDI of a given country going to a group of host countries is correlated with the individual income level of the host country. The empirical studies using this testing approach seem to support the hypothesis that higher levels of sales and the host country's income are positively related to FDI.

Size does matter, according to a survey by A.T. Kearney, the results of which were summarised in the 17 February 2000 issue of The Economist. This survey is based on the views of 135 executives of the world's 1000 largest companies who gave marks on a scale of 0-3 for the likelihood of investing in a particular country. The top three countries favoured for investment turned out to be the USA, China and Brazil. Mexico was ranked sixth, whereas India was ranked seventh. Needless to say, the ranking of countries from the top to the bottom of the list did not exactly match the ranking of countries in terms of size, because of the influence of other determinants of FDI. For example, Japan was twentieth, whereas the UK was fourth.

Hypothesis 4: FDI can be explained in terms of firm-specific advantages

When a firm establishes a subsidiary in another country it faces several disad­vantages emanating from differences in language, culture and the legal system as well as other inter-country differences. If, in spite of these disadvan­tages, a firm engages in FDI, it must have some advantages arising from intan­gible assets such as a well-known brand name, patent-protected technology, managerial skills and other firm-specific factors. It is, therefore, firm-specific advantages that explain why a firm can compete successfully in a foreign market. This hypothesis, however, does not explain why a firm chooses to invest in country A rather than country B.

Hypothesis 5: FDI is triggered by the need for internalisation

According to the internalisation hypothesis, FDI arises from efforts by firms to replace market transactions with internal transactions. For example, if there are problems associated with buying oil products on the market, a firm may decide to buy a foreign refinery. These problems arise from imperfections and failure of markets for intermediate goods, including human capital, knowledge, marketing and management expertise. The advantages of internalisation are the avoidance of time lags, bargaining and buyer uncertainty. The internalisation hypothesis explains why firms use FDI in preference to exporting and importing from foreign countries. It also explains why they may shy away from licensing. Because of the significant time lags and transaction costs associated with market purchases and sales, firms replace some of the market functions with internal processes (that is, with intra-firm transactions).

Hypothesis 6: FDI exists because of the international immobility of factors of production

According to the location hypothesis, FDI exists because of the international immobility of some factors of production such as labour and natural resources. This immobility leads to location-related differences in the costs of factors of production. One form of location-related differences in the costs of factors of production is the locational advantage of low wages. Thus, the level of wages in the host country relative to wages in the home country is an important determinant of FDI. This is why countries like India attract labour-intensive production (such as footwear and textiles) from high-wage countries. It is also why multinational firms wanting to establish production facilities in North America choose Mexico in preference to Canada.

Locational advantages do not only take the form of low wages, as they are also applicable to other factors of production. For example, a firm may indulge in FDI by building a factory in a country where it is cheap to generate hydro­electric power. Similarly, a factory could be located near a copper mine in the host country if copper is an important input in the production process. This is a locational advantage because significant savings can be made on the cost of shipping copper from where it is produced to where it is used. Apart from these savings, the firm can avoid delays in the delivery of copper shipments arising from the time it takes to ship the metal and the red tape that may be involved in this operation. In general, the location hypothesis emphasises the importance of unavoidable government constraints such as trade barriers. Capital may also be the underlying factor of production, particularly if capital markets are segmented. The idea here is that FDI flows to countries where the cost of capital is low.

Hypothesis 7: The eclectic theory

The eclectic theory results from the integration of the industrial organisation hypothesis, the internalisation hypothesis and the location hypothesis without being too precise about how they interrelate. The eclectic theory aims at answering the following two questions. First, if there is demand for a partic­ular commodity in a particular country why is it not met by a local firm producing in the same country or by a foreign firm exporting from another country? Second, suppose that a firm wants to expand its operations, why does it not do so via other means, which include (i) producing in the home country and exporting to the foreign country; (ii) expanding into a new line of business within the home country; (iii) indulging in portfolio investment in the foreign country; and (iv) licensing its technology to foreign firms that can carry out the production.

Suppose that there is demand for a particular product in which a particular domestic firm has an ownership advantage. What happens depends on the internalisation and locational advantages. If there are no internalisation gains, the firm will license its ownership advantage to another firm, particularly if locational factors favour expansion abroad. If there are internalisation gains and if locational factors favour home expansion, the firm expands at home and exports. And, if there are internalisation gains and if locational factors favour foreign expansion, FDI will take place.

Hypothesis 8: The role of the product life cycle

According to the product life cycle hypothesis, products go through a cycle of initiation, exponential growth, slowdown and decline. The hypothesis postu­lates that firms indulge in FDI at a particular stage in the life cycle of the prod­ucts that they initially produce as innovations.

FDI takes place as the cost of production becomes an important consider­ation, which is the case when the product reaches maturity and standardisa­tion. FDI is thus a defensive move to maintain the firm's competitive position against its domestic and foreign rivals. The product life cycle hypothesis predicts that the home country where the innovative product first appears switches over time from an exporting to an importing country.

Hypothesis 9: The role of oligopolistic reaction

The oligopolistic reaction hypothesis postulates that FDI by one firm triggers a similar action by other leading firms in the industry in an attempt to maintain their market shares. An implication of the oligopolistic reaction hypothesis, which is incompatible with some stylised facts, is that the process of FDI is self- limiting, since the invasion of each other's home market leads to an increase in competition and a decline in the intensity of oligopolistic reaction. Moreover, this hypothesis also fails to identify the factors that trigger the initial investment.

Hypothesis 10: The role of internal financing

Internal financing refers to the utilisation of profit generated by a subsidiary to finance the expansion of FDI by a multinational firm in the same country where the subsidiary operates. The internal financing hypothesis postulates that multinational firms commit a modest amount of their resources to their initial direct investment, whereas subsequent expansions are financed by reinvesting the profits obtained from operations in the host country. It there­fore implies the existence of a positive relationship between internal cash flows and investment outlays, which is plausible because the cost of internal financing is lower. The hypothesis seems to be more appropriate for explaining FDI in developing countries for at least two reasons: (i) the pres­ence of restrictions on the movement of funds, and (ii) the rudimentary state and inefficiency of financial markets.

Hypothesis 11: The effect of exchange rates

The currency areas hypothesis postulates that firms belonging to a country with a strong currency tend to invest abroad, whereas firms belonging to a country with a weak currency do not have such a tendency. In other words, countries with strong currencies tend to be sources of FDI, whereas countries with weak currencies tend to be host countries or recipients of FDI. This hypothesis is based on capital market relationships, foreign exchange risk and the market's preference for holding assets denominated in strong currencies. It is arguable that a multinational firm in a hard currency area is able, based on reputation, to borrow at lower rates than local firms in a country that has a soft currency. In essence, the crucial assumption is that there is bias in capital markets, which arises because an income stream located in a country with a weak currency is associated with foreign exchange risk. Hence the view arises that a strong currency firm may be more efficient in hedging foreign exchange risk.

Froot and Stein (1991) have come up with a more elaborate theory based on market imperfections to explain the effect of exchange rates. They argue that a weak currency may be associated with FDI inflows owing to informational imperfections in the capital market and that these imperfections make the cost of external financing higher than the cost of internal financing.

Changes in exchange rates are theoretically bound to have an effect on FDI. First of all, depreciation of the domestic currency makes domestic assets more attractive for foreigners while foreign assets become more expensive for resi­dents in the home country. Thus FDI inflows will increase. This, according to Froot and Stein (1991), explains the increase in FDI in the US as a result of the depreciation of the US dollar that started in March 1985. But this argument can be dismissed as follows. In a world with mobile capital, risk-adjusted expected returns on all international assets will be equalised. For this equality to hold, depreciation of the domestic currency will result in a rise in the prices of domestic assets. The question that arises here is that if foreigners can buy domestic assets with an appreciating currency, why can't domestic residents with access to global capital markets borrow the foreign currency and take advantage of the situation just like the foreign investors? Still, Froot and Stein (1991) argue that "the view that exchange rates are irrelevant to FDI is at odds with more than just casual empiricism".

The effect of exchange rates on FDI may be ambiguous because the latter is affected by both the level and variability of exchange rates. Moreover, the effect of the level of the exchange rate depends on the destination of the goods produced. If the investor aims at serving the local market then FDI and trade are substitutes, in which case appreciation of the currency of the host country attracts FDI inflows. Alternatively, if FDI is aimed at re-exports then FDI and trade are complements. In this case appreciation of the currency of the host country reduces FDI inflows through lower competitiveness. The effect of exchange rate variability also depends on the objective of FDI. If the investor aims at serving the local market then exchange rate variability encourages FDI. If, however, the objective is to re-export then this benefit vanishes.

Hypothesis 12: Diversification with barriers to international capital flows

For international diversification to be carried out through firms, two condi­tions must hold: (i) there must exist barriers or costs to portfolio flows that are greater than those associated with direct investment, and (ii) investors must recognise that multinational firms provide diversification opportunities that are unavailable otherwise. It has been found that there is a systematic relation­ship between the extent of international involvement and excess market value. This relationship gets stronger in periods characterised by the presence of barriers to capital flows.

Hypothesis 13: The role of political risk and country risk

Lack of political stability discourages inflows of FDI. Political risk arises because unexpected modifications of the legal and fiscal frameworks in the host country may change the economic outcome of a given investment in a drastic manner. For example, a decision by the host government to impose restrictions on capital repatriation to the investor's home country will adversely affect the cash flows received by the parent company.

Hypothesis 14: The role of tax policies

Domestic and foreign tax policies affect the incentive to engage in FDI and the means by which it is financed. Tax policies affect the decisions taken by multi­national firms via three channels. First, the tax treatment of income generated abroad has a direct effect on the net return on FDI. Second, the tax treatment of income generated at home affects the net profitability of domestic invest­ment and the relative profitability of domestic and foreign investment. Third, tax policies affect the relative cost of capital of domestic and foreign investment.

Swenson (1994) empirically examined how taxes shape FDI and found that increased taxes boost inward FDI. While simple intuition might suggest that higher taxes should discourage both foreign and domestic investments, Scholes and Wolfson (1990) have shown that the general equilibrium effects on asset returns combined with a careful consideration of foreign tax systems reveals reasons for foreign investors to increase their investments in response to high taxes in the host country.

Hypothesis 15: The effect of trade barriers

FDI may be undertaken to circumvent trade barriers, such as tariffs, because FDI can be viewed as an alternative to trade. This means that open economies without many restrictions on international trade should receive less FDI flow. The surge in FDI in countries like Mexico and Spain is partly attributed to the desire of multinational firms to circumvent the trade barriers imposed by NAFTA and the EU. Sometimes, the threat of protectionism by the host government triggers FDI. Blonigen and Feenstra (1996) argue that the litera­ture on quid pro quo FDI suggests that FDI may be induced by the threat of protection and that FDI may be used as an instrument to defuse protectionist threats.

Hypothesis 16: The effect of government regulations

Most governments adopt policies aimed at both encouraging and discour­aging inward FDI by offering incentives on the one hand and disincentives (taking the form of restrictions on the activities of multinational firms) on the other. Typically, they offer incentives (such as financial and tax incentives as well as market preferences) while simultaneously placing restrictions on the activities of multinational firms.

One particular case of using incentives to offset disincentives is when the host government uses a package that includes trade-related investment performance (TRIP) requirements, which are seen by some as a significant obstacle to FDI. TRIP requirements include two components: (i) local content and (ii) export minima. These requirements should be viewed as disincentives to FDI because the local content requirements may lead to increased cost and decreased earnings, which makes the underlying project less competitive. Likewise, export minima may lead to lower earnings, adversely affecting the attractiveness of FDI. Normally, TRIP requirements are combined with incen­tives such as preferential tax status, access to foreign exchange and import protection.

Hypothesis 17: The role of strategic and long-term factors

Some strategic and long-term factors have been put forward to explain FDI. These factors include the following:

1. The desire on the part of the investor to defend existing foreign markets and foreign investments against competitors.

2. The desire to gain and maintain a foothold in a protected market or to gain and maintain a source of supply that may prove useful in the long run.

3. The need to develop and sustain a parent-subsidiary relationship.

4. The desire to induce the host country into a long commitment to a partic­ular type of technology.

5. The advantage of complementing another type of investment.

6. The economies of new product development.

7. Competition for market shares among oligopolists and the concern for strengthening bargaining positions.

12.3 INTERNATIONAL CAPITAL BUDGETING

Although the decision to invest abroad may be taken for non-financial reasons, it is imperative that the underlying project is financially viable. Capital budgeting (also called investment appraisal and project evaluation) is the technique (or techniques) used for evaluating the financial viability of a project.

International capital budgeting is more complicated than domestic capital budgeting because multinational firms are typically large and capital-inten­sive, and because the process involves a larger number of parameters and decision variables. In general, international capital budgeting involves a consideration of more risk than domestic capital budgeting. But like domestic capital budgeting, international capital budgeting involves the estimation of some measures or criteria that indicate the feasibility or otherwise of a project (a capital budgeting evaluation measure) such as the net present value (NPV). However, certain factors that are not considered in domestic capital budgeting should be taken into account in international capital budgeting because of the special nature of FDI projects. The estimation of NPV and similar criteria requires (i) the identification of the relevant expected cash flows to be used for the analysis of the proposed project; and (ii) the determination of the proper discount rate for finding the present value of the cash flows.

International capital budgeting involves substantial spending (capital investment) in projects that are located in foreign (host) countries, rather than in the home country of the multinational firm. Foreign projects differ from purely domestic projects with respect to a number of factors: the foreign currency dimension, different economic indicators (such as inflation) in different countries, and different risk characteristics with which the multina­tional firm is not as familiar as those pertaining to domestic projects. All of these differences lead to a higher level of risk in international capital budgeting than in domestic capital budgeting.

International capital budgeting involves a number of issues that do not appear in domestic capital budgeting. For example, a project may be feasible from the perspective of a subsidiary but not from the perspective of the parent firm. Measures of project feasibility, such as the NPV, can be calcu­lated from either perspective depending on whether the calculation is based on the cash flows received by the subsidiary or those remitted by the subsid­iary to the parent firm. One view is that it should be considered from the subsidiary's perspective, since the subsidiary will eventually be in charge of administering the project. It is also argued that projects should be evaluated from the subsidiary's perspective because the subsidiary belongs to the parent firm, which means that what is good for the subsidiary should be good for the parent firm.

One counterargument is that since the multinational firm is financing the project, it should be assessed from its perspective. This is more the case if the subsidiary is wholly owned by the parent firm. After all, the parent firm's objective is to enhance its net worth, which is what is expected by its share­holders. Hence, for a project (domestic or foreign) to be accepted by the parent firm, it must have a positive net present value from its perspective. An excep­tion would be when the subsidiary is not wholly owned by the parent firm. In this case the subsidiary would also have the objective of increasing its net worth as expected by the shareholders who are not shareholders of the multi­national firm. Hence the acceptability, or otherwise, of a project is determined by negotiation between the parent firm and the subsidiary.

Another argument for evaluating projects from the subsidiary's perspective is that there is a tendency for the subsidiaries not to appreciate fully the ways in which a project may benefit the parent firm. This tendency is reinforced by the practice of rewarding the subsidiary's management on the basis of its net income, not on its contribution to the consolidated performance of the parent firm.

What makes this matter important is that the net after-tax cash flows that accrue to the parent firm can be substantially different from those accruing to the subsidiary. The earnings of the subsidiary are subject to corporate income tax and withholding tax in the host country, and part of the after-tax earnings is kept by the subsidiary as retained earnings. Sometimes the whole amount is retained, in which case the parent firm gets nothing. The amount remitted to the parent firm is then converted to its base currency, and these earnings are subsequently taxed once more by the home government. Hence, what may look like an attractive project from the point of view of the subsidiary may be utterly unattractive to the multinational firm. Several reasons explain the difference between the cash flows accruing to the multi­national firm and to the subsidiary. Remember that the net present value and other measures of the feasibility of projects are calculated from the net after­tax cash flows.

The first reason for the difference between the cash flows received by the subsidiary and those received by the parent firm is tax differentials, arising when there is a difference between the tax rates in the host country and the home country. If the host government imposes a lower tax rate on earnings than the home government then the project may be feasible from the perspec­tive of the subsidiary but not from the perspective of the parent firm.

The second reason is restricted remittances. This occurs when the host govern­ment requires a certain percentage of the subsidiary's earnings to remain in the host country. Sometimes the earnings generated by the subsidiary are required to be reinvested in the host country for some years before they can be remitted to the multinational firm, giving rise to so-called "blocked funds". If there are restrictions on remittances, then the parent firm will not have access to these funds, and hence its after-tax cash flows will be lower than those of the subsidiary. Again, the project may not be feasible from the parent firm's perspective but feasible from the subsid­iary's perspective.

The third reason is excessive remittances. This occurs when the multina­tional firm charges the subsidiary high administrative fees, making the cash flows accruing to the subsidiary lower than those accruing to it. In this case, the project may be feasible from the parent firm's perspective but not from the perspective of the subsidiary. There are obviously differences between the revenue/cost configurations of the parent firm and the subsidiary: what is regarded as revenue by the parent firm is regarded as cost by the subsidiary. The same conclusion would be valid if the parent firm charged the subsidiary high transfer prices.

The fourth reason for differences in cash flows is exchange rate movements. If the base currency appreciates against the foreign currency, then the cash flows received by the parent firm will be reduced in value measured in terms of the base currency. Remember that the subsidiary and the parent firm calcu­late the net present value and other measures of the feasibility of a project on the basis of cash flows denominated in terms of two different currencies. Fluc­tuations in exchange rates lead to fluctuations in the cash flows received by the parent firm in terms of the base currency for a given amount received from the subsidiary denominated in the foreign currency.

The fifth reason is differences in the discount rates used by the parent firm and the subsidiary to calculate the present value of future cash flows arising from the project. From the subsidiary's perspective, the appropriate discount rate should relate to the cost of funding facing the subsidiary's local competi­tors. For the parent firm, the discount rate should be related to the cost of capital pertaining to its worldwide operations. Obviously, the two rates can diverge significantly.

Figure 12.1 shows that a cash flow, Xt, arising from an FDI project is not exactly what is received by the subsidiary or the parent firm. The differences arise from the foreign tax rate, t* ; the domestic tax rate, t; the percentage of blocked funds that the subsidiary cannot remit to the parent firm, 0; and the exchange rate, S. What the parent firm receives also depends on whether or not there is tax credit, and whether the tax credit is full or partial.

FIGURE 12.1 Cash flows received by a parent firm and its subsidiary.

12.4 PROJECT EVALUATION CRITERIA

The accounting rate of return

The accounting rate of return is the percentage return on capital invested in the project, normally (but not necessarily) the average annual percentage profit before taxation relative to the average amount of capital invested in the project. This method is criticised because it is based on profit, which is an accounting concept, rather than on cash flows, which are more appropriate for a resource allocation decision-making problem like capital investment. Another problem with this technique is that it takes no account of the size of the project or the time value of money. Moreover, the accounting rate of return is affected by accounting conventions such as the choice of the depreci­ation method. Simply stated, there is no "correct way" of measuring the accounting rate of return.

The payback period

The payback period measures how quickly the initial outlay in an investment is paid back from after-tax cash flows that are generated from the investment. Only the projects that are paid back within a period of time that is acceptable to the investor will be undertaken. The payback period method is preferable to the accounting rate of return method because it is based on cash flows. However, it also ignores the time value of money as well as the cash flows that occur after the initial investment has been paid back. Moreover, setting a maximum acceptable payback period is essentially an arbitrary decision: there is no easy way to relate the payback period to more general criteria such as profit maximisation or value maximisation.

Because the risk associated with international projects increases as years into the future are considered, the payback period is often used as a "short­hand" way of incorporating risk. Although this method is incomplete from the standpoint of financial theory, it has the advantage of providing a concrete cash-oriented measure of risk because it helps answer the question: how long will the investor's funds be tied up in the project under consideration? It is because of this "risk-bounding interpretation" of the payback period that this criterion is used as a constraint that needs to be satisfied before accepting the project. Of course, it is possible to adjust this method to take into account the time value of money by discounting the cash flows. However, the discounted payback criterion still takes no account of the cash flows arising after the cut­off date.

The net present value

The net present value (NPV) is a project evaluation criterion that is based on cash flows, taking account of the time value of money by discounting future cash flows at an appropriate discount rate. NPV measures the absolute finan­cial benefit of a project, consistently leading to an absolute financial gain by adding to the shareholders' net worth. A project is found acceptable if the NPV is positive. To choose between two mutually exclusive projects the one that is picked must have a higher NPV.

The NPV is the difference between the initial investment outlay (the capital cost) and the sum of the discounted cash flows realised from the project. If the initial investment is X₀ and the cash flows resulting from the project over years 1, 2, ..., n, are X^, X2, ..., X_n, then the NPV is given by the equation

n X V

NPV =-X ₀ +V + ^Vn (12.1)

⁰ £(1 + k)^t (1 + k)^{n V} '

where k is the discount rate, n is its lifetime and V_n is its salvage value (also called the terminal or liquidation value). The discount rate is normally taken to be (or is closely related to) the cost of capital or the required rate of return on the investment. The underlying idea here is that for a project to be financially acceptable it must attract a rate of return that is at least equal to the cost of obtaining the funds required to finance it.

Equation (12.1) is the net present value from the perspective of the subsid­iary when there are no taxes. It may also represent the NPV from the

perspective of the parent firm if the exchange rate is fixed at parity and there are no taxes or blocked funds (that is, S_t = 1, t* = t = q). Otherwise the NPV from the perspective of the parent firm if there is full tax credit can be calcu­lated from the equation

n S X S V

NPV = -So X ₀ + [(1 -1* )(1 - q)(1 -1 +1* )] Y -^SX- + (12.2)

⁰ o LV A A + k )_t (1 + _k )ⁿ V >

Figure 12.2 shows the relationship between the NPV and the discount rate for various values of the other parameters. In 1, it is assumed that St = 1 and t = t = q = 0. In 2, the assumption of a depreciating foreign currency is intro­duced, whereas 3 is based on the assumption of constantly appreciating foreign currency. In 4 and 5, there is no change in the exchange rate, but q takes the values 0.2 and 0.5 respectively. Finally, 6 assumes that q = 0.3, t* = 0.4, t = 0.5, and that there is a full tax credit.

It is cash flows, and not accounting profits, that should be discounted when NPV is calculated. Income statements, in which accounting profits are reported, are used to show how well the firm has performed, but they do not track cash flows. In principle, the profit figure is intended to measure changes in value, albeit imperfectly. (Operating) cash flows are the funds generated by the firm's operations and are available for spending. The funds may be used to expand investment in fixed assets, to pay dividends, to expand working capital, to retire debt or for a variety of other purposes.

Consider a project that costs X0, producing X_t in year t, where t = 1, ..., n. Assuming a zero salvage value, the project's NPV is given by

ⁿ X

t= 1

NPV =-X 0 +/ (12.3)

(1 + k y

If we calculate the NPV on the basis of accounting profits, the capital cost is depreciated over the life of the project. Hence accounting profit for year t is X_t - Xo/n. In this case the NPV will be given by the equation

NPV = Z ^{Xt - X o/n} (12.4)

t=1 ⁽¹ + ^{k )t}

which can be manipulated to produce

n 1 n X

^NPV=-^X 0 Z ~r\~_k\t +£ Ti-h (¹².⁵)

t=i n⁽¹ + ^k)t t=1⁽¹ + ^k)t

which is obviously larger than in the original case (equation 12.3). Hence, a misleading picture would emerge if project evaluation is based on accounting profits. This difference is due to whether investment expenditure is recog­nised when it occurs (the first case) or when it shows up as depreciation (the second case). The first case is more logical: projects are financially viable

500 400

<D

1 300

■u

§ 200

<u

^ 100

<u

^Z 0 -100

because the cash flows they generate are used either for distribution to share­holders or for reinvestment. One reason for the difference between cash flows and accounting profits is that accountants recognise profit when it is earned, not when it is realised.

In order to calculate the present value of the future cash flows, a discount rate, k, must be used. This discount rate is normally the required rate of return on the project, which may or may not be equal to the parent firm's cost of capital. Whether or not the required rate of return is equal to the project's cost of capital depends on the riskiness of the project.

The internal rate of return

The internal rate of return (IRR) is the discount rate that makes the NPV of a project equal to zero. It is calculated by solving for r the equation

-X ₀ + V -i- + —^V-n— = 0 (12.6)

⁰ £1(1 + r)' (1 + r )^{n K} '

Thus, the IRR on a project with a zero NPV is equal to the discount rate or the cost of capital. A project will have a positive NPV if the IRR is greater than the cost of capital and vice versa. The problem with the IRR, however, is that its calculation is based on the assumption that cash flows can be reinvested at the same rate, and this is not necessarily the case. Hence, it may be in conflict with NPV when competing projects have different sizes or time horizons. Moreover, a project may, under certain circumstances, have multiple IRRs, which creates difficulty in interpreting the simple decision rule whereby a project is selected if the IRR is greater than the cost of capital. For example, how can we implement this rule if one of the values of the IRR is lower than the cost of capital?

0 5 10 15 20 25

Discount rate

FIGURE 12.2 Net present value, the discount rate and other factors.

In general, the NPV and IRR criteria may lead to conflicting conclusions when mutually exclusive projects have different scales or when the time patterns of the cash flows are different. If such a conflict arises, the decision should be based on the NPV criterion.

The profitability index

The profitability index (PI) is calculated by dividing the present value of cash flows by the initial investment, Xo. Hence the profitability index (ignoring the salvage value) is calculated as

Sⁿ _iX_t/(1 + k)^t

PI = ^{t=1 t v} (12.7)

^Xo

A project is undertaken if its profitability index is greater than one. To choose between two mutually exclusive projects we pick the project that has a higher profitability index. A conflict may arise between the NPV and the PI in the case of mutually exclusive projects due to differences in the project size. In this case the conflict should be resolved in favour of the NPV if the parent firm is not under a capital rationing constraint (see Ross et al., 1996, Chapter 6).

The adjusted present value

The adjusted present value (APV) equation takes the form

" O_t (1 -1) ⁿ tD_t ⁿ tI_t V_n APV =-X _n +V '- + y +V + ⁿ (12.8)

⁰ ÙÎ (1 + k_uy tx (1 + i)^t éî(1 + i)^t (1 + k u)ⁿ

where O represents operating cash flows, D is depreciation, I is interest payments, k_u is the cost of equity for an all-equity financed firm and i is the borrowing rate. Just like the NPV, a project is accepted if the APV is positive, and a project is chosen from two mutually exclusive projects if it has a higher APV.

It is obvious from equation (12.8) that each cash flow that is a source of value is considered individually and discounted at a discount rate consistent with the risk inherent in that cash flow. Operating cash flows and the salvage value are discounted at k_u because the firm would receive these cash flows irrespec­tive of its capital structure. The tax savings resulting from interest payments, tI_t, are discounted at the borrowing rate, i. The tax savings due to deprecia­tion, tD_t, are also discounted at i because these cash flows are less risky than the operating cash flows.

Lessard (1985) developed an APV formula that explicitly recognises currency conversion and special cash flows that are encountered in the anal­ysis of foreign projects. This formula takes the form

En(S, )Ot (1 -1) , n Eo(^Sf )tDt ,n^En(Sf )tI_t , En(S_t V

Apv = V ^ + y ^t +y + _

n

(12.9)

t 1 (1 + k u)^t t 1 (1 + i)^t t 1 (1 + i)^t (1 + ku )ⁿ

t=1

^{- S}0 ^X 0 + ^Sn ^0 + ^Sn ^Ln ^- Z " ⁰( ^t ) P

(1 + i)^t

where Eo(S_t) is the expected value of the exchange rate at time t when the expec­tation is made at time 0, R represents the restricted funds freed by the project, L represents concessionary loans and P is the payment needed to cover the concessionary loan. Thus, the APV of a foreign project can be estimated as the capital cost (cash outflow) plus the present values of the following items: (i) remittable operating cash flows; (ii) tax saving from depreciation and capital allowances; (iii) subsidies to the project; (iv) other tax savings; (v) the project's effect on corporate debt capacity; (vi) other cash inflows and outflows that result directly from the project. Booth (1982) shows that under certain circum­stances the NPV and APV are equivalent.

12.5 ADJUSTING PROJECT ASSESSMENT FOR RISK

International capital budgeting involves a consideration of more risk than domestic capital budgeting. Both domestic and international projects are subject to market risk, which is specific to industries and may involve the likely evolution of markets and competitor behaviour. The parent firm may perceive the market risk for international projects as exceeding that associated with domestic projects. This may be attributed to the relative lack of knowl­edge about foreign markets.

International capital budgeting also involves a consideration of country risk, which is the risk of an adverse outcome arising from economic and polit­ical factors in the host country. For example, inflationary policies in the host country are an adverse factor for a subsidiary that depends on local supplies while exporting its products if there is no offsetting depreciation of the currency. Country risk would also be present if the government of the host country imposes import controls when a subsidiary depends on imported raw materials. It also involves changing the "rules of the game" such as changes in tax laws and the regulations governing the repatriation of capital.

From the previous discussion, it is obvious that a typical project evaluation process consists of the following steps:

1. Estimating the incremental cash flows arising in the host country, taking into account any tax effects.

2. Estimating remittable cash flows to the parent firm and translating these cash flows into the base currency at the spot exchange rates expected to prevail in each future time period.

3. Incorporating into the remitted cash flows any indirect costs and benefits that arise as a result of undertaking the project. All tax effects applicable to the parent firm must be considered at this stage.

4. Discounting the parent firm's incremental cash flows at a rate that reflects the risk associated with the project or the particular cash flow.

When a parent firm uses either the NPV or the APV method to evaluate foreign investment projects, a problem is typically encountered as to the accu­racy of the cash flows that are expected to materialise in the future as a result of operating the project. Risk means that cash flows generated by the project may fluctuate far away from the expected value that would normally be used to calculate the NPV and the APV. If it is felt that this is the case then some adjustment may be made to account for risk. There are three methods to deal with risk in situations like these.

The risk-adjusted discount rate

The greater the risk associated with future cash flows the greater should be the discount rate used to calculate the present value of the future cash flows. This is why the discount rate may differ from the cost of capital. This is also the reason why different discount rates are used in the APV formula (equation 12.9), as more risky cash flows are discounted at higher rates. For example, cash flows associated with tax saving from depreciation and interest payments to creditors are less risky than operating cash flows, and this is why the latter are discounted at a higher rate.

This approach to the adjustment for risk is easy to implement, but it is criti­cised as being somewhat arbitrary. Furthermore, it does not take into account changes in the riskiness of cash flows from one time period to another, since the discount rate is assumed to be constant across time for a class of cash flows with a particular degree of risk. An example of changes in the riskiness of cash flows over time is changes in blocked funds and tax laws in a country with a high degree of political risk. Despite these shortcomings, the method of adjusting the discount rate is used because of its simplicity. It is also arguable that this technique is more appropriate to deal with country risk than with market risk.

Risk-adjusted cash flows

Some economists argue that adjusting the cash flows is more appropriate than adjusting the discount rate, particularly if the project involves market risk. This approach, it is arguable, allows the parent firm to reflect more specifically the impact of the risk during the investment. Shapiro (1992) also argues that better information is available on the effect of risk on cash flows than on the discount rate.

This approach is normally known as the certainty equivalent approach, as it is based on a reduction of risky future cash flows to a lower level that is accepted by the market. This adjustment is made separately for each period of the project's life. The adjusted risk-free cash flows are then discounted at the risk-free discount rate to estimate the NPV of the project. The difference between this method and the adjusted discount rate method is that this method considers time and risk separately, whereas the previous method treats them jointly. Although this method is theoretically more appealing, it is not widely used because there are practical problems in identifying the equiv­alent risk-free cash flows.

In this case the NPV formula is modified to the following:

NPV =-X ₀ + f + (12.10)

⁰ £(1 + k) (1 + k)^{n V} '

where 0 < 11 < 1is the certainty equivalent factor applicable to cash flow X_t and 0 < f < 1 is the certainty equivalent factor applicable to the salvage value, V_n. Because it is invariably the case that risk rises the further into the future the cash flow is, it follows that 1j > 1 2 >• • • > 1 _n.

Sometimes a problem arises as to accounting for risk by adjusting cash flows or adjusting the discount rate. The likelihood of a bad outcome should be allowed for in the calculation of the cash flows rather than by adjusting the discount rate. Suppose, for example, that there are two possible outcomes, good and bad. If the cash flows under the good and bad outcomes are X^ and Xj_tt, arising with probabilities p and (1 - p) respectively, then the cash flow pXi_/t + (1- p)Xj_tt should be discounted at the unadjusted discount rate. It would be wrong in this case to discount Xi_tt at a higher discount rate to reflect the possi­bility of a bad outcome.

Sensitivity analysis

Sensitivity analysis entails the use of "what if" scenarios, which are imple­mented by changing the input variables, including the exchange rate. If the NPV or APV remains positive for several scenarios, then the parent firm should become more comfortable with the project. Sensitivity analysis can be applied to the discount rate or rates as well.

Simulation

Simulation can be used to generate a probability distribution for the NPV or the APV based on various combinations of the values of input variables. Consider, for example, a situation in which the exchange rate is forecast to be within a certain range such that any value within this range can materialise with equal probability. A large number of iterations are performed: in each iteration the value assumed by the exchange rate is picked randomly. This value is then used to calculate the cash flows and subsequently the NPV or APV. Each iteration produces a value for the NPV or APV, and after a large number of iterations we end up with a probability distribution for the APV or the NPV. From the probability distribution it is possible to estimate the proba­bility with which the NPV or APV will be positive.

Break-even analysis

In break-even analysis, the focus is placed on the point at which the NPV or the APV switches from positive to negative. The initial cash flow, X₀, does not depend on sales revenue, whereas the present value of subsequent cash flows is a positive function of sales revenue. The equality of the initial cash flow and the present value of subsequent cash flows defines the level of sales that generates a zero NPV, the break-even level of sales. Below this level, the NPV is negative, and above this level the NPV is positive.

Incorporating country risk analysis in capital budgeting

Country risk analysis can also be incorporated in capital budgeting analysis, as suggested by Robock (1971), Kobrin (1979), Sethi and Luther (1986) and Clark (1997). One way to do this is by adjusting the discount rate or the cash flows. The higher the country risk is, the higher the discount rate applied to the project's cash flows. If, for example, blocked funds are anticipated then the discount rate may be raised from 10 to 13%. The problem with this procedure is that there is no precise formula for adjusting the discount rate for country risk, which makes adjustment rather arbitrary. The use of a shorter payback period may be resorted to for the same purpose. However, Haendel (1979) argues that neither of these two methods provides a detailed examination of the risk involved or a true reflection of the investor's fear. This is why it may be preferable to incorporate country risk analysis by adjusting the cash flows as suggested by Shapiro (1992).

Suppose that a project is analysed under three scenarios derived from country risk analysis: (i) that nothing will happen, (ii) that the host country will block a certain percentage of the funds to be transferred to the parent firm, and (iii) that the project will be confiscated after few years. Suppose also that these scenarios produce three net present values (NPV\, NPV2 and NPV3) with probabilities of p\, p2 and p3 respectively. The NPV of the project in this case should be calculated as the expected NPV, which is the weighted average of NPV1, NPV2 and NPV3, where the weights are the probabilities. Hence 3

NPV = / p NPVi (12.11)

i=1

Levi (1990) has suggested the following formalisation of the process whereby country risk is allowed for in capital budgeting. Let Xt be the cash flow expected to arise from a project in the absence of country risk. Assume that country risk is present such that the project would cease to exist (for example, because of a takeover by the host government) at year t with a proba­bility p. Hence the probability that a cash flow arises in each individual year is 1 - p. This means that the probability that cash flows arise for t years is (1 - p)^t. The expected value of the cash flow in year t is Xt(1 - p)^t. If Xt is constant such that X_t = X, then the present value of the cash flow is given by

PV = ± ^{(1 -}P^)tXt (12.12)

h (1+k)^t /=1(1+k)^{t y} '

As n ® ¥, we obtain

£ = V-p (12.13)

t=1 (1 + k)' ^k + p ^V '

Hence

PV = (12.14)

k + p

In the absence of country risk, we have

X

PV = ^X (12.15)

It is obvious that the present value of the cash flows in the absence of country risk is greater than what is obtained when country risk is present.

Agmon (1985) has suggested a workable and comprehensive way to inte­grate country risk into capital budgeting. Agmon's method is based on the proposition that the potential dependence of a project on the external envi­ronment is divided into two components: vulnerability and cost. Vulnerability is expressed in terms of the probability that an event that is likely to affect the project (such as tax changes) will occur. Vulnerability is also defined in terms of a probability distribution, and for simplicity it is assumed that the distribu­tion can be fully described by its first and second moments. Cost, on the other hand, is measured as the actual impact on the cash flows of the project if a given event occurs. The distinction between vulnerability and cost is crucial because firms do not need to be concerned with all possible events. Only the non-trivial effects on cash flows have to be weighted by the probabilities that they will take place.

i

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»

i

Index

accounting for inflation 295 accounting period 102 accounting standards 295 active (portfolio) management 303 adjusted present value 335-6 affiliates 320 AGS test 171

American Depository Receipts 302 arbitrage

between eurocurrency and domestic

rates 49-51 between futures and forwards 52 combined with hedging and

speculation 197-203 commodity 44-7 covered interest 19-22, 24-6, 36-9, 63

definition of 1

Eurocurrency-Eurobond 51-2 misconceptions about 60-4 multi-currency 15-18 real interest 53-4 three-currency 12-15, 36-9 two-currency 2-12 uncovered interest 39-41, 54-60 under the gold standard 47-9 ARCH 160 average rate 102

bandwagon effect 183 bankers' acceptances 252, 253 Bank for International Settlements 69 Bankhaus Herstatt 63 beta 309

bilateral netting 255

bond markets 296

bonds with equity warrants 275

book value 101

bootstrapping 230 Box-Pierce Q statistic 219 break-even analysis 338-9 bulldogs 274

capital controls 7, 34, 51 capital structure 283-6 cash management 253-8 centralised cash management 253-7 certainty equivalent approach 337 certificates of deposit 253 chart formations 222 chartists 236 closing rate 102 commercial papers 252 commitment fees 272 comparability criterion 29 conditional VAR 71-2 consolidation 100 constrained optimisation 314 convertible bonds 275 convertible currencies 252 correlation 55, 83, 139, 140, 167, 169,

269, 270, 286, 304, 306 cost of capital 280-3 covered interest parity 20, 22-4, 36, 38,

39, 64, 119, 128, 197, 202, 263 covered margin 20, 24, 25, 26 credit swaps 280 cross default 273 cross listing 278 currency collars 144-6 currency diversification 138, 254 currency of invoicing 142-4, 154 currency portfolios 267 currency swaps 137 current rate 102 current rate method 103

current/non-current method 102

debt-equity ratio 284, 286 decentralised cash management 257-8 default costs 109 demand for money 217 depreciation 336

differential rates of return hypothesis 321

discounting (of bills) 252 discount rate 330, 332, 334, 337 distributed lag 210 diversification in bonds 308 diversification hypothesis 321 domestic bank lending 272 double bottoms 222 double moving average rule 229 double tops 222 downside semi-variance 68 dynamic models of capital structure 286

eclectic theory 323-4 economic value 101 economies of scale 254, 282 effective financing rate 258-62 effective rate of return 258-62 electronic trading 296 emerging equity markets 308 Eurobonds 274 Eurocurrency market 252 Euroloans 271 European currency unit 60 European Monetary System 191 excessive remittances 330 Exchange Rate Mechanism 191 exotic options 196 expectations adaptive 212

bandwagon 211 contrarian 216-17 destabilising 211 explosive 211 extrapolative 209-10, 211 heterogenous 216 long-run 217 mixed 216-17 rational 213-16 regressive 210-12 short-run 217 stabilising 211 static 211

twist 217 unbiasedness 217 expected shortfall 71-2 expected tail loss 71-2 exposure coefficient 82 competition 91-2 contingent 131-6 conversion 89 cost 88-9 debt 287-93 definition of 73-80 demand 90 economic 84, 151 equity 288-93 indirect 89, 92 interest 287 line 80-1 long 80, 113 multimarket 92-3 multiple 81-2 net cash flow 287 netting 141-2, 150 operating 84-7, 93-100, 147-9 price 89-90 revenue 88-9 short 80, 113 transaction 82-4, 118, 151 translation 100-2, 149-50, 151

face value 296 factoring 252 fees 272

filter rules 226-8, 244 firm-specific advantages 322 fixed-income securities 296 flexible price monetary model 231 floating rate notes 275 flow model 231 foreign bonds 274 foreign direct investment classification 319-20 conglomerate 319 and country risk 326 defensive 319 definition 318 and exchange rates 325-6 expansionary 319 export-increasing 319 government-initiated 319 and government regulations 327 greenfield 319

horizontal 319 import-substituting 319, 322 and political risk 326 and strategic factors 327-8 and tax policies 326-7 theories of 321-8 and trade barriers 327 vertical 319 foreign exchange accounting 295 foreign listing 278 foreign loans 271 forex beta 105 forfeiting 252

forward contracts 52, 126, 133, 137,

150, 151, 193, 314 functional currency 100 fund adjustment 150 fundamental analysis 221 fundamentalists 236 fundamental models 231, 232 fundamental rules 237 futures contracts 52, 64, 126, 314

GARCH 160, 162, 171

GDL model 213

German hyperinflation 217

German reunification 191

Global Asset Pricing Model 309-10

global bonds 276

global funds 302

gold export point 48

gold import point 49

gold points 47

government lending 280

head and shoulders 222 hedge ratio bivariate model of 163-4 constant 172 conventional model of 161 definition 156-8 empirical models of 160 error correction model of 161-2 GARCH error correction model of 163-4

implied model of 161 measurement of 158-60 minimum-risk 159 multicurrency 166-7 naive model of 160 nonlinear models of 165-6 optimal 158

random walk model of 161 time-varying 164, 165, 172 hedging basic principles of 110 basket 313-16 combined with arbitrage and

speculation 197-203 cross 139-41, 158, 174-80 decision 106-10 direct 140, 158 dynamic 172-4 effectiveness 128, 167-72 and exchange rate forecasting 113-18

against exchange rate volatility

136-7 external 111

financial 111-13, 137, 148, 154, 156 foreign exchange risk in portfolios

312-17 forward 124-6, 157 futures 126-8 internal 111, 151 matched 313 money market 118-24 motivation for 105-6 operating exposure 147-9 operational 110-11, 138, 154 options 128-37 perfect 113 in practice 150-5 as a speculative activity 203-4 static 172 strategy 110

transaction exposure 118-47, 149-50 hedging effect (of debt financing) 288 heterogeneity 237-43 heteroscedasticity 230 historical rate 102 historical value 101 Hooper-Morton model 231

industrial organisation hypothesis 321 information asymmetry 109 interest parity forward rate 22, 40, 119,

158, 197, 198 internal financing hypothesis 324-5 internal rate of return 334 internalisation hypothesis 323 international bonds 274, 275 international capital asset pricing model 308, 311 international capital budgeting 328-31 international diversification 303-8, 309, 326

international equity financing 277-9 international funds 302 international loans 271, 272 international portfolio management 302

joint ventures 320

Kalman filter 164

lagging 138

lag operator 213

law of one price 44, 45

leading 138

learning mechanism 216

leverage effect (of debt financing) 287

LIBOR 272, 273

lines of credit 252

liquidation value 332

loan documentation 273-4

location hypothesis 323

locational advantages 323

loss aversion 159

macroeconomic fundamentals 231 management fees 272 market beta 105 market microstructure 216 market portfolio 309 market psychology 207 market segmentation 311-12 market size hypothesis 322 mass hysteria 207 mean absolute deviation 68 mean-variance optimisation 313 mergers and acquisitions 319, 320 Microsoft 154

microstructural hypotheses 238 mint parity 47 misalignment 47, 221 modern theory of forward exchange 197

modified active management 303 momentum model 230 momentum oscillators 222 monetary/non-monetary method 103 moving average rules 228-9, 244 multicurrency bonds 276 multilateral netting 255-7 multinational firms 320-1

negative pledge 274

net present value 328, 323-34

netting 254, 255-7

non-nested model selection tests 222

non-transaction gains/losses 103

note issuance facilities 252

OECD 272

oligopolistic reaction hypothesis 324

OLS 82, 160

online trading 296

OPEC 142

option cylinder 145

options 128-31, 151, 195, 314

oscillators 222

overdrafts 252

overlay managers 312

parallel loans 138, 279-80

participation fees 272

passive indexation 302

payback period 331-2

pecking order 286

pooling 254

portfolio investment 318

portfolio theory 106

primary market 276

private placement 279

probability distribution 66, 67, 68, 186,

265, 338, 340 product life cycle hypothesis 324 profitability index 335 project evaluation criteria 331-6 Prospect Theory 159 purchasing power parity 45-7, 53, 108, 109

quantitative technical indicators 222

range forward 144-6

rational bubbles 207

real interest differential model 231

real interest parity 53, 54

real interest rate 53

real option 148

rectangles 222

reference rate 272

relative strength index 224

reporting currency 100

resistance levels 219 restricted remittances 330 retrenchment parameter 219 reversal patterns 222 revolving credit arrangements 252 revolving underwriting facilities 252 risk business 295

country 272, 301, 311, 326, 336,

339-40 credit 272, 285 economic 295

foreign exchange 39, 65-6, 250, 301,

309, 311, 313 Herstatt 1, 62 liquidity 295 market 301, 336 measurement of 66-8 political 29-30, 51, 311, 326 purchasing power 311 systematic 301, 309 unsystematic 302 risk-adjusted cash flows 337 risk-adjusted discount rate 337 risk-adjusted profits 230 risk-adjusted rate of return 309 risk-free rate 283, 308, 310 risk insurance 106 risk neutrality 321 risk premium 215, 284, 309 risk-return trade-off 106 risk sharing 142-4 rollover CDs 253

salvage value 332 Samurai bonds 274 secondary market transactions 296 Securities and Exchange Commission 278

sensitivity analysis 338 serial correlation 230 short selling 193 short-term financing 249-50 short-term investment 249-50 SIBOR 272 simpletons 236 simulation 338 single country funds 302 single moving average rule 228 special drawing rights 60, 142 speculation based on special events 191-3 on the basis of expectation 209-18

on the basis of fundamentals 231 on the basis of technical analysis 218-26

on the basis of trading rules 226-31 combined with arbitrage and hedging

197-203 definition of 183 destabilising 204-5 forward 194, 200 with options 195-7 as a source of deviation from CIP

202-3 spot 184-91 spot-forward 193-4 stabilising 204-6 speculative bubbles 206-8 sticky price monetary model 211, 231

straddle 136, 196 straight bonds 275 straight loans 252 subsidiaries 320 support levels 219 syndicated loans 271 synthetic options 151

tactical asset management strategy 302

tail conditional expectation 71-2

tap CDs 253

tax differentials 30-1

technical analysis 218-26, 239

temporal method 103

terminal value 332

term loans 252

time deposits 253

time value of money 331, 332

Tobin tax 6

trade-off models 286

trader irrationality 207

trading rules 226-31

tranche CDs 253

transaction costs 28-9, 51, 109, 230, 311

transaction profit 104

transaction gains/losses 103

translation methods 101, 102-4

triangles 222

triple bottoms 222

triple tops 222

uncovered interest parity 39, 40, 41-3,

53, 64, 108, 263, 265, 311 uncovered margin 41, 54, 59, 60

US prime lending rate 272

value at risk 69-73 variance ratio 167 variance reduction 167 volatility 237-43 volatility puzzle 232 voodoo finance 219

wedges 222

weighted average cost of capital 281-3 worst conditional expectation 71-2

Yankee bonds 274

zero coupon bonds 275, 296

^x,t - ^y - (3.27)

2. This amount is converted into currency y at the prevailing offer exchange rate, S_a,t, to obtain K/(1 + iy,b) foreign currency units. This amount is the present value of the payables.

4. At time t + 1, the base currency loan becomes due, so the amount of the principal and interest should be repaid. This amount is equal to KS a,t(1 + ix,a)/(1 + iy,b).

A decision to hedge payables will be taken if

t

> 0 (10.31)

d(^Dx,t^/Vx,t ) [1 -(D x,t/Vx,t )]²

30 20 _re 10

□

R ⁰

x

e

£■-10 "d

!T

^m -20 -j -30 -40

1 +^P x ,t+1 ¹ + ^P y ,t+ 1

The suggested modification means that the condition will be written as follows:

2 The selling price is set in terms of currency y, so that Py is unaffected by changes in the exchange rate.

3 + i

y,a

4^aRows represent the hedging currencies, whereas columns represent the exposure currencies. Hedge ratios are calculated from the regression Sj = a + hSj, where i and j represent rows and columns respectively. The coefficient of determination, which measures hedging effective­ness, is placed in parentheses. ^bStatistically significant at the 5% level.

5

p = K

6t