Recent Changes

Monday, August 23

  1. page Chapter 22 - International Corporate Finance edited ... Internationally Segmented Capital Markets Up until now, we assumed the international capital …
    ...
    Internationally Segmented Capital Markets
    Up until now, we assumed the international capital markets are integrated. In this section, we consider segmented capital markets, or markets that are not internationally integrated. Firms may face differential access to markets if there is any kind of asymmetry to information about them. For example, a firm may be better known in one country than in another. Because this, investors in the country where the firm is not known may require a higher rate of return to convince them to hold its stock. Because of the commonality of differential access to national capital markets, it explains why currency swaps exist. Currency swaps are contracts in which parties agree to exchange coupon payments and a final face value payment that are in different currencies. With this, a firm can borrow in the market where it has the best access to capital and then swap the coupon and principal payments to whichever currency it would prefer to make payments in.Important macroeconomic arguments for segmented capital markets involve capital controls and foreign exchange controls that create barriers to international capital flows. Many countries monitor and limit capital in and outflows. In addition, there are vast differences that exist in political, legal, socio-cultural characteristics.However, this implies that one country or currency has a higher rate of return than another country or currency, when the two rates are compared in the same currency. If the return difference is a result of a market friction like capital controls, corporations can exploit this by setting up projects in the high-return country and raise capital in the low return country. This extent is limited of course. The existence of segmented capital markets makes many decisions in international corporate finance more complicated but potentially more lucrative for a firm that is well positioned to exploit the market segmentation.
    Capital Budgeting With Exchange Rate Risk
    Finally, another issue that arises is the fact that the cash flows of the project are affected by exchange rate risk. The cash flow is affected by the future level of the exchange rate. Up until now, we assumed that the project's free cash flows are uncorrelated with spot rates. This makes sense if firms operate as a local firm in the foreign market . However, many firms use imported inputs in their production processes or export some of their output to foreign countries. When a project has cash flows that depend on the value of multiple currencies, the most convenient approach is to separate the cash flows according to the currency they depend on. If the revenues and costs are not affected by changes in the spot exchange rates, it makes sense to assume that changes in the free cash flows are uncorrelated with changes in the spot exchange rates. Thus, we can convert pound-denominated free cash flows to equivalent dollar amounts using forward exchange rate. Then, we add dollar-based cash flows to determine projects aggregate free cash flow in dollar terms.

    (view changes)
    8:41 pm
  2. page Chapter 22 - International Corporate Finance edited ... Calculate the NPV in the foreign country and convert it to the local currency at the spot rate…
    ...
    Calculate the NPV in the foreign country and convert it to the local currency at the spot rate.
    Convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows.
    ...
    (1 + Rdollars)
    Rdollars)From this equation and combined, we can put together the Foreign-Denominated Cost of Capital: r(pounds) = [(1 + r pounds) / (1 + r dollars)] x (1 + r dollars) - 1
    Valuation and International Taxation
    Determining the corporate tax rate on foreign income is complicated because corporate income taxes must be paid in two national governments, the host and the home government. If a foreign project is a separately incorporated subsidiary of the parent company, the amount of taxes a firm pays generally depends on the amount of profits repatriated or brought back to the home country. If a firm has a single foreign project and all foreign profits are repatriated immediately, the general international arrangement prevailing with respect to taxation of corporate profits is that the host country gets the first opportunity to tax income produced within its country borders. US tax policy requires US corporations to pay taxes on foreign income at the same rate as profits earned in the US. Also, a full tax credit is given for foreign taxes paid up to the amount of the US tax liability. It pays the foreign tax rate first and the additional amount due up to the US tax rate to the United States. If a firm has multiple projects and is pooling them, the US tax law states that a multinational corporation may use any excess tax credits generated in high-tax foreign countries to offset its net US tax liabilities on earnings in low-tax foreign countries. In this way it pools all foreign taxes together and compares the total to its US total. An opportunity to defer repatriation exists as well. This is very crucial since the foreign operation is set up as a separately incorporated subsidiary and the US tax liability is not incurred until the profits are brought back home. When foreign tax rate is less than US tax rate, deferral can provide significant benefits.
    Internationally Segmented Capital Markets
    Up until now, we assumed the international capital markets are integrated. In this section, we consider segmented capital markets, or markets that are not internationally integrated. Firms may face differential access to markets if there is any kind of asymmetry to information about them. For example, a firm may be better known in one country than in another. Because this, investors in the country where the firm is not known may require a higher rate of return to convince them to hold its stock. Because of the commonality of differential access to national capital markets, it explains why currency swaps exist. Currency swaps are contracts in which parties agree to exchange coupon payments and a final face value payment that are in different currencies. With this, a firm can borrow in the market where it has the best access to capital and then swap the coupon and principal payments to whichever currency it would prefer to make payments in.Important macroeconomic arguments for segmented capital markets involve capital controls and foreign exchange controls that create barriers to international capital flows. Many countries monitor and limit capital in and outflows. In addition, there are vast differences that exist in political, legal, socio-cultural characteristics.However, this implies that one country or currency has a higher rate of return than another country or currency, when the two rates are compared in the same currency. If the return difference is a result of a market friction like capital controls, corporations can exploit this by setting up projects in the high-return country and raise capital in the low return country. This extent is limited of course. The existence of segmented capital markets makes many decisions in international corporate finance more complicated but potentially more lucrative for a firm that is well positioned to exploit the market segmentation.
    

    (view changes)
    8:23 pm
  3. page Chapter 22 - International Corporate Finance edited ... The Actions of central banks in each country - The British Central bank may exchange pounds fo…
    ...
    The Actions of central banks in each country - The British Central bank may exchange pounds for euros in attempt to keep down the value of the pound.
    Exchange rates are thus volatile, especially since supply and demand for currencies varies with global economic conditions. Fluctuating exchange rates cause the importer-exporter dillema, which is a known problem. We can illustrate it with the following example. Suppose I'm importing German car parts. If the German company sets its prices in euros, I face the risk of the dollar falling in value, making the parts for my car I'm building more expensive. If the German company sets its price in dollars, then they face the risk.
    To combat this risk and reduce it, firms will hedge the transaction using currency forward contracts. These are contracts that set the exchange rate and an amount to exchange in advance. Usually, these are written between a bank and a firm, fixing the exchange rate for a transaction to occur down the road. The contract specifies the exchange rate, an amount of currency to be exchanged, and a delivery date on which the exchange will take place. Forward exchange rate is the exchange rate set in the currency forward contract. It applies to an exchange that will occur in the future. The forward contract takes the risk and places is on the bank. The bank is the one that is willing to exchange a certain amount at a certain date. Why are they willing to bear the risk? They are much larger organization and haver more captial to assume the risk without major reprecautions. However, in many cases, the bank will not hold the risk but will pass it to another third party willing to trade.
    There exists an alternative method called the cash-and-carry strategy that enablesa firm to elimiate exchange rate risk. Currency Timeline indicates time horizontally by dates and currencies vertically. Dollars in one year would show in the upper right point and the euros in one year would be found in the lower right point. To convert the cash flows between points, we must convert them at an appropriate rate. Spot Exchange Rate is the current foreign exchange rate. Cash-and-carry strategy is a strategy used to lock in the future cost of an asset by buying the asset for cash today and storing it until a future date. It consists of the following three simultaneous trades:
    Borrow dollars today using a 1 yr. loan at the dollar interest rate.
    Exchange the dollars for euros today at the spot exchange rate.
    Deposit the euros today for 1 yr. at the euro interest rate.
    Below is an illustration of the currency timeline showing forward contract and cash-and-carry strategy:
    {chap_22_pic.jpg} Because the forward contract and the cash-and-carry strategy accomplish the same conversion, by the Law of One Price, they must do so at the same rate. Covered Interest Parity Equation states that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies. It can be calculated by:Forward Rate (pounds in 1 yr / dollars in one yr) = Spot Rate (pounds today / dollars today) x ((1+Rpounds in 1 yr per pounds today) / (1 + Rdollars in one yr per dollars today))When the interest rate differs across countries, investors have an incentive to borrow in the low-interest rate currency and invest in the high-interest rate currency. If you wanted to decrease this risk, you could enter in a forward contract. To solve for this: Forward Rate(t yrs) = Spot rate x [ (1 + Rpounds)^t] / [ (1 + Rdollars)^t]. Another option to hedge risk is to engage in currency options. These are another method that firms commonly use to manage exchange rate risk. They give the holder the right, but not the obligation, to exchange currency at a given exchange rate. They allow firms to lock in a future exchange rate; currency options allow firms to insure themselves against the exchange rate moving beyond a certain level. So why may a firm want to hedge with options instead of forward contracts? Many managers want the firm to benefit if the exchange rate moves in its favor instead of being stuck paying an above-market rate. Also, options always have the "option" to withdraw from the deal if rates are unfavorable.
    Internationally Integrated Capital Markets
    Assuming that any investor can exchange either currency in any amount at the spot rate or forward rates, and is free to purchase or sell any security in any amount in either country at their market prices. These conditions are called internationally integrated capital markets. The value of the investment does NOT depend on the currency we use in the analysis with those conditions.
    Valuing Foreign Currency Cash Flows
    If a foreign project is owned by a domestic corporation, managers and shareholders need to determine the home currency value of the foreign currency cash flows. Two methods are available in an internationally integrated captial market for calculating NPV:
    Calculate the NPV in the foreign country and convert it to the local currency at the spot rate.
    Convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows.
    The expected value of the future cash flows in dollars is the expected value in pounds multiplied by the forward exchange rate. Once you calculate the forward exchange rate, you can calculate the expected free cash flows in dollars by multiplying the expected cash flows in pounds by the forward exchange rate. This will express your foreign project in terms of dollars, allowing you to value the foreign project as if it were a domestic project. We can use the Law of One Price as a check, where the estimate for the foreign cost of capital must satisfy the Law of One Price. If it does not, then managers should be concerned that the simplifying assumptions in their analysis are not valid. Market frictions exist so that the market integration assumption is not a good approximation of reality, or perhaps tere is a significant correlation between spot exchange rates and cash flow. Rewriting the equation yields us:Spot Rate / Forward Rate = (1 + Rpounds) / (1 + Rdollars)

    (view changes)
    7:44 pm
  4. file chap_22_pic.jpg uploaded
    7:03 pm
  5. page Chapter 22 - International Corporate Finance edited Chapter 22 - International Corporate Finance Chapter 17 - Financial Modeling and Pro Forma Anal…

    Chapter 22 - International Corporate Finance
    Chapter 17 - Financial Modeling and Pro Forma Analysis-Introduction - Financial Goals of Long-Term PlanningChapter 3 – The Valuation Principle: The Foundation of Financial Decision Making-IntroductionIntroducing Foreign Exchange
    When engaging in business overseas, you must engage yourself in the buying and selling of money. In foreign exchange markets, every currency has a price in terms of other currencies. Foreign Exchange Rate is a price for a currency denominated in another currency. For example, it might cost you $2 to buy 1 British pound. The foreign exchange market is a large market where currencies are traded and has no central physical location. The main players in this market are the very large, global investment banks such as Deutsche Bank, UBS, and Citibank. These banks trade their own account as well as for client multinational firms. Along with them are some large multinaitonal firms that trade for themselves. Other players include government central banks, hedge funds, and other investment managers and retail brokers. The US dollar and the euro account for more than half of all trading volume in the foreign exchange market, despite the fact that there are 150 currencies in the world.
    Exchange rates are quoted in print everywhere. For example, on Monday, August 23, 2010, the exchange rate for US dollars to Euros was 1 Euro = 1.264 US dollars. This means that, if you have 100 Euros, that amount would be worth (100 * 1.264) $126.40. Exchange rates are market prices and vary daily. This increases the risk of doing business abroad considerably.
    Exchange Rate Risk
    Many exchange rates are floating rates, which means they change constantly depending on the quantity supplied and demanded for each currency in the market. The supply and demand is driven by three factors:
    Firm's trading goods - US dealer exchanges dollars for euros to buy cars from Germany's BMW.
    Investor's trading securities - A German investor exchanges marks for dollars to pruchase US bonds.
    The Actions of central banks in each country - The British Central bank may exchange pounds for euros in attempt to keep down the value of the pound.
    Exchange rates are thus volatile, especially since supply and demand for currencies varies with global economic conditions. Fluctuating exchange rates cause the importer-exporter dillema, which is a known problem. We can illustrate it with the following example. Suppose I'm importing German car parts. If the German company sets its prices in euros, I face the risk of the dollar falling in value, making the parts for my car I'm building more expensive. If the German company sets its price in dollars, then they face the risk.

    (view changes)
    6:28 pm
  6. page home edited ... Chapter 18 - Working Capital Management Chapter 19 - Short-Term Financial Planning Chapter …
    ...
    Chapter 18 - Working Capital Management
    Chapter 19 - Short-Term Financial Planning
    Chapter 22 - International Corporate Finance
    (view changes)
    6:12 pm
  7. page Chapter 17 - Financial Modeling and Pro Forma Analysis edited ... With all this data, we can finally put together a forecasted balance sheet for a planned expan…
    ...
    With all this data, we can finally put together a forecasted balance sheet for a planned expansion. Once again, it is here that you can tell if you will need more financing in the future if assets are not balanced and greater than liabilities and equity. When the opposite is the case, where assets are less, this means we have generated more cash than we needed and can use the excess for things such as building up extra cash reserves, paying down debt, distributing to shareholders as dividends, or even repurchasing shares.
    The Planned Expansion's Value
    ...
    Multiple at HorizonHorizonThis shows that the EBITDA multiple at horizon will have a large impact on our value calculation.Moving on, we can finally have all the pieces in valuing the expansion. First, we compute the present value of the forecasted free cash flows of the firm over the years used. These represent the cash flows available to bondholders and equity holders, making them free of leveragae. Next you calculate the present value of the continuation value. At last, we must calculate the interest tax shield by taking the NET INTEREST EXPENSE x TAX RATE. We calculate the present value of the interest tax shield using the interest rate on debt as the discount rate. THE TOTAL VALUE OF THE EXPANSION IS THE SUM OF THE PRESENT VALUES OF THE FORECASTED UNLEVERED FREE CASH FLOW, THE CONTINUATION VALUE OF THE FIRM, AND THE INTEREST TAX SHIELD. The same process is used to calculate the value of a firm withouth expansion. Once you get the firm value numbers, you can decide if you want to delay the expansion or not. Here, you value your short term loss in production in comparison to the ultimate larger financial outlay that is greater. This timing analysis is yet another important factor.
    Growth and Firm Value
    We must keep in mind that not all growth is favorable. Expansion may strain managers' capacity to monitor and handle the firm's operations. Also, in the net, it may be worth less. Careful NPV analysis can eliminate bad growth decisions from good ones. Internal growth rate, or the maximum growth rate a firm can achieve without restoring to external financing is often what confuses the distinciton. It's esentially the growth a firm can supply by reinvesting its earnings. A more commonly used measure is the sustainable growth rate, or the maximum growth rate a firm can achieve without issuing new equity or increasing its debt-to-equity ratio. The Internal Growth Rate can be calculated by:
    Internal Growth Rate = (Net Income / Begining Assets) x (1 - payout ratio) = ROA x retention rate
    This retention rate is often called the plowback ratio, calculated as one minus the payout ratio of the firm. The Sustainable Growth Rate is calculated by:
    Sustainable Growth Rate = (Net Income / Beginning Equity) x (1 - payout ratio) = ROE x retention rateSince your ROE will be larger than your ROA anytime you have debt, the sustainable growth rate will be greater than your internal growth rate. Even though the internal assumes no financing, the sustainable assumes you will make some use of outside financing equal to the amount of new debt that will keep your debt-to-equity ratio constant as your equity grows through reinvested net income. When forecasting growth greater than your internal growth rate, you are going to have to minimize your payout ratio, plan to raise additional external financing, or a combination of both. If your growth forecasted is bigger than your sustainable growth rate, you will have to increase plowback ratio, raise additional equity, or increase leverage. The downside of these rates is that they cannot tell you if your planned growth increases or decreases a firm's value.

    (view changes)
    6:08 pm
  8. page Chapter 17 - Financial Modeling and Pro Forma Analysis edited Chapter 17 - Financial Modeling and Pro Forma Analysis Chapter 3 – The Valuation Principle: The…

    Chapter 17 - Financial Modeling and Pro Forma Analysis
    Chapter 3 – The Valuation Principle: The Foundation of Financial Decision Making-IntroductionIntroduction - Financial Goals of Long-Term Planning
    As discussed in previous sections, the role of a financial manager is to maximize stockholder value. To facilitate this, managers use financial planning and modeling. One objective of using long-term planning is to identify important linkages that exist (for example) between sales, costs, capital investments and financing. With this, you analyze future impact of certain courses of action such as buying new machinery or investing in updated technology. We also use long term planning to analyze the impact of potential business plans. By building a long term model of your business in terms of finance, you can analyze exactly how such a business plan will impact the firm's free cash flows and value. Another incentive of building a long term model for your business is the fact that it allows you to plan for future funding needs. According to your forecasts, you can analyze when in the future your firm might need financing and this allows you time and more planning to acquire such resources.
    Percent of Sales Method
    A common place to start with forecasting is with the percent of sales method, which assumes that as sales grow, many income statement and balance sheet items will grow proportional to sales. In this case, assuming costs last year were 20% of sales, and last year's sales were $200,000 - meaning costs are $40,000 last year. If sales go up by 10% this year, we will have sales of (200,000 x .10 = 20,000 + 200,000 = 220,000 in sales this year). This means that costs will be 20% of 220,000, or $44,000.
    With this information and assuming other given factors (for example) we can construct pro forma income statements that will outline the total effect of such an increase in sales. Not only will cost of goods be affected now, but so will the depreciation, interest expense, pretax income, income tax, and net income. It's a cascading effect. The slight change of one item will change the rest proportional to sales as well.
    The pro forma balance sheet can also be constructed, but not until we can make assumptions about how our equity and debt will grow in proportion to sales. Once we make these assumptions, it's essentially the same process. With the pro forma balance sheet, you can point out where you will need new financing to fund growth. For example, if your assets are not balancing with liabilities and equity (and assets are higher), you will know that you need new financing. Net New Financing is the amount of additional external financing we need to secure to pay for the planned increase in assets. This can be computed as:
    Net New Financing = Projected Assets - Projected Liabilities and EquityThis new financing needed is sometimes referred to as the plug. It is the amount of net new financing that needs to be added to the liabilities and equity side of the pro forma balance sheet to make it balance. However, as you are projecting this, you should keep in mind that if you take out more debt in the upcoming years, it may throw off your interest assumptions staying constant.
    Forecasting a Planned Expansion
    Although the percent of sales method is useful, it's shortcoming is handling the realities of fast growth requiring "lumpy" investments in new capacity. Real world firms usually don't have the pleasure of being able to smoothly add capacity in line with expected sales. In order to more accurately forecast the free cash flows, we must go through some initial steps. First, we must analyze and estimate a firm's financing needs based on the capital expenditures required for the expansion. In this step of analysis, we look at how a purchase such as a machine will help us acquire our production goals and how such a purchase will affect our income statement and balance sheet pro forma. Along with this, we must think about how we can finance the expansion. Will we loan the money or get it from other sources? Once we settle with this, we can look at the PRO FORMA INCOME STATEMENT. The value of any investment opportunity arises from the future cash flows it will generate. To estimate these, we first start with projection of future earnings. We look at how such a purchase will increase our production, and how such an output will increase our sales and cost of goods sold. From here, we go down the line in forecasting depreciation, interest expense, tax numbers, etc. In the closing steps, we must forecast a company's working capital needs, because an increase in working capital reduces free cash flows. With this, we look at things such as minimum cash required in order to keep the business running smoothly and allow for daily variations in the timing of income and expenses. With this, we know how much cash we will need to plan for in our financing activities. Will the excess cash be distributed as dividend or will it be re-invested? Those are all outcomes that must be analyzed.
    With all this data, we can finally put together a forecasted balance sheet for a planned expansion. Once again, it is here that you can tell if you will need more financing in the future if assets are not balanced and greater than liabilities and equity. When the opposite is the case, where assets are less, this means we have generated more cash than we needed and can use the excess for things such as building up extra cash reserves, paying down debt, distributing to shareholders as dividends, or even repurchasing shares.
    The Planned Expansion's Value
    Once we have an idea of debt, net income, and working capital needs, we can better determine if the expansion is a good idea. We do this by forecasting free cash flows. To compute free cash flows (excluding leverage), we start by adding back the after-tax interest payments associated with the net debt in its capital structure. After-tax Interest Exp = (1 - Tax Rate) x (Interest Earned on Debt - Interest Paid on Excess Cash). The same method can be used to calculate unlevered net income, starting with the EBIT and deducting taxes. To compute the free cash flow from unlevered net income, we add back the depreciation and deduct increases in net working capital/capital expenditures. This computes the total cash available to all investors. To determine the amount paid out to shareholders, we can adjust the free cash flow to account for all payments to or from debt holders. If we chose to pay out all excess cash as dividend, your answer here should match that of the dividend forecasted in the previous sections. So what kind of effect will this have on the firm's value? People generally estimate a firm's continuation value at the end of the forecast horizon using the valuation multiple. Explicitly forecasting cash flows is useful in capturing specific aspects of a company that distinguish the firm from it's competition in the short term outlook. However, the long term expected forecasts should move toward one another. This means that long term expectations of multiples are likely to be relatively homogeneous across firms, bringing us to assume that a firm's multiple will move towards the industry average. In other cases, the EBITDA is used most often. It's more reliable than sales or earnings multiples because it accounts for the firm's operating efficincy and it's not affected by leverage differences between firms. To get this continuation value:Continuation Enterprize Value at Forecast Horizion = EBITDA at Horizon x EBITDA Multiple at Horizon

    (view changes)
    5:23 pm
  9. page home edited ... Chapter 13 - Raising Equity Capital Chapter 14 - Debt Financing Chapter 17 - Financial Mode…
    ...
    Chapter 13 - Raising Equity Capital
    Chapter 14 - Debt Financing
    Chapter 17 - Financial Modeling and Pro Forma Analysis
    Chapter 18 - Working Capital Management
    Chapter 19 - Short-Term Financial Planning
    (view changes)
    4:33 pm

More