24-1

International
Capital Budgeting
24-2
Some Background
Fill product gaps in foreign markets where
excess returns can be earned.
To produce products in foreign markets
more efficiently than domestically.
To secure the necessary raw materials
required for product production.
What is a companys motivation to
invest capital abroad?
24-3
International
Capital Budgeting
1. Estimate expected cash flows in the foreign
currency.
2. Compute their U.S.-dollar equivalents at the
expected exchange rate.
3. Determine the NPV of the project using the U.S.
required rate of return, with the rate adjusted
upward or downward for any risk premium effect
associated with the foreign investment.
How does a firm make an international
capital budgeting decision?
24-4
International
Capital Budgeting
Only consider those cash flows that can
be repatriated (returned) to the home-
country parent.

24-5
International Capital
Budgeting Example
A firm is considering an investment in
Freedonia, and the initial cash outlay is 1.5
million marks.
The project has 4-year project life with cash
flows given on the next slide.
The appropriate required return for
repatriated U.S. dollars is 18%.
The appropriate expected exchange rates are
given on the next slide.
International project details:
24-6
International Capital
Budgeting Example
0 -1,500,000 2.50 -600,000 -600,000
1 500,000 2.54 196,850 166,822
2 800,000 2.59 308,880 221,833
3 700,000 2.65 264,151 160,770
4 600,000 2.72 220,588 113,777
Net Present Value = 63,202
End
of
Year
Expected
Cash Flow
(marks)
Expected
Cash Flow
(U.S. dollars)
Present Value
of Cash Flows
at 18%
Exchange
Rate (marks
to U.S. dollar)
24-7
International
Capital Budgeting
International diversification and risk
reduction
U.S. Government taxation
Taxable income derived from non-domestic
operations through a branch or division is taxed
under U.S. code.
Foreign subsidiaries are taxed under foreign tax
codes until dividends are received by the U.S.
parent from the foreign subsidiary.
Related issues of concern:
24-8
International
Capital Budgeting
Tax codes and policies differ from country to
country, but all countries impose income taxes
on foreign companies.
The U.S. government provides a tax credit to
companies to avoid the double taxation
problem.
A credit is provided up to the amount of the
foreign tax, but not to exceed the same
proportion of taxable earnings from the foreign
country.
Excess tax credits can be carried forward.
Foreign Taxation
24-9
International
Capital Budgeting
Expropriation is the ultimate political risk.
Developing countries may provide financial
incentives to enhance foreign investment.
Bottom line: Forecasting political instability.
Protect the firm by hiring local nationals, acting
responsibly in the eyes of the host government,
entering joint ventures, making the subsidiary
reliant on the parent company, and/or
purchasing political risk insurance.
Political Risk
24-10
Important
Exchange-Rate Terms
Currency risk can be thought of as the volatility
of the exchange rate of one currency for
another (say British pounds per U.S. dollar).
Spot Exchange Rate -- The rate today for
exchanging one currency for another for
immediate delivery.
Forward Exchange Rate -- The rate today
for exchanging one currency for another at
a specific future date.
24-11
Types of Exchange-
Rate Risk Exposure
Translation Exposure -- Relates to the change in
accounting income and balance sheet statements
caused by changes in exchange rates.
Transactions Exposure -- Relates to settling a
particular transaction at one exchange rate when
the obligation was originally recorded at another.
Economic Exposure -- Involves changes in
expected future cash flows, and hence economic
value, caused by a change in exchange rates.
24-12
Management of Exchange-
Rate Risk Exposure
Natural hedges
Cash management
Adjusting of intracompany
accounts
International financing hedges
Currency market hedges
24-13
Natural Hedges
Both scenarios are natural hedges as any gain
(loss) from exchange rate fluctuations in pricing
is reduced by an offsetting loss (gain) in costs in
similar global markets.
Globally Domestically
Determined Determined
Scenario 1
Pricing X
Cost X
Scenario 2
Pricing X
Cost X
24-14
Natural Hedges -- Not!
Both of these scenarios are not natural hedges and
thus create a possible firm exposure to events that
impact one market and not the other market.
Globally Domestically
Determined Determined
Scenario 3
Pricing X
Cost X
Scenario 4
Pricing X
Cost X
24-15
Cash Management
Exchange cash for real assets (inventories) whose
value is in their use rather than tied to a currency.
Reduce or avoid the amount of trade credit that will
be extended as the dollar value that the firm will
receive is reduced and reduce any cash that does
arrive as quickly as possible.
Obtain trade credit or borrow in the local currency
so that the money is repaid with fewer dollars.
What should a firm do if it knew that a local foreign
currency was going to fall in value (e.g., drop from
$.70 per peso to $.60 per peso)?
24-16
Cash Management
Generally, one cannot predict the future
exchange rates, and the best policy would be
to balance monetary assets against monetary
liabilities to neutralize the effect of exchange-
rate fluctuations.
A reinvoicing center is a company-owned
financial subsidiary that purchases exported
goods from company affiliates and resells
(reinvoices) them to other affiliates or
independent customers.
24-17
Cash Management
Generally, the reinvoicing center is billed in the
selling units home currency and bills the purchasing
unit in that units home currency.
Allows better management of intracompany
transactions.
Netting -- A system in which cross-border
purchases among participating subsidiaries of
the same company are netted so that each
participant pays or receives only the net amount
of its intracompany purchases and sales.
24-18
International
Financing Hedges
Foreign commercial banks perform essentially the
same financing functions as domestic banks except:
They allow longer term loans.
Loans are generally made on an overdraft basis.
Nearly all major commercial cities have U.S. bank
branches or offices available for customers.
The use of discounting trade bills is widely utilized
in Europe versus minimal usage in the United States.
1. Commercial Bank Loans and Trade Bills
24-19
International
Financing Hedges
Eurodollars are bank deposits denominated in U.S.
dollars but not subject to U.S. banking regulations.
This market is unregulated. Therefore, the
differential between the rate paid on deposits and
that charged on loans varies according to the risk of
the borrower and current supply and demand forces.
Rates are typically quoted in terms of the LIBOR.
It is a major source of short-term financing for the
working capital requirements of the multinational
company.
2. Eurodollar Financing
24-20
International
Financing Hedges
A Eurobond is a bond issued internationally outside
of the country in whose currency the bond is
denominated.
The Eurobond is issued in a single currency, but is
placed in multiple countries.
A foreign bond is issued by a foreign government or
corporation in a local market. For example, Yankee
bonds, and Samurai bonds.
Many international debt issues are floating rate notes
that carry a variable interest rate.
3. International Bond Financing
24-21
International
Financing Hedges
Currency-option bonds provide the holder with the
option to choose the currency in which payment is
received. For example, a bond might allow you to
choose between yen and U.S. dollars.
Currency cocktail bonds provide a degree of exchange-
rate stability by having principal and interest payments
being a weighted average of a basket of currencies.
Dual-currency bonds have their purchase price and
coupon payments denominated in one currency, while
a different currency is used to make principal
payments.
4. Currency-Option and Multiple-Currency bonds
24-22
Currencies and the Euro
Each country has a representative currency like
the $ (dollar) in the United States or the (pound)
in Britain.
On January 1, 1999, the euro started trading.
The euro is the common currency of the European
Monetary Union (EMU), which currently includes
the following 12 European Union (EU) countries:
Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, and Spain.
Euro The name given to the single European
currency. Symbol is (much like the dollar, $).
24-23
Currency Market Hedges
A forward contract is a contract for the delivery of a
commodity, foreign currency, or financial instrument at a
price specified now, with delivery and settlement at a
specified future date.
Spot rate $.168 per EFr
90-day forward rate .166 per EFr
As shown, the Elbonian franc (EFr) is said to sell at a
forward discount as the forward price is less than the
spot rate.
If the forward rate is $.171, the EFr is said to sell at a
forward premium.
1. Forward Exchange Market
24-24
Currency Market Hedges
The firm has the option of selling 1 million Elbonian
francs forward 90 days. The firm will receive
$166,000 in 90 days (1 million Elbonian francs x
$.166).
Therefore, if the actual spot price in 90 days is less
than .166, the firm benefited from entering into this
transaction.
If the rate is greater than .166, the firm would have
benefited from not entering into the transaction.
Fillups Electronics has just sold equipment worth
1 million Elbonian francs with credit terms of net
90. How can the firm hedge the currency risk?
24-25
Currency Market Hedges
Typical discount or premium ranges for
stable currencies are from 0 to 8%, but may
be as high as 20% for unstable currencies.
How much does this insurance cost?

Annualized cost of protection
= ( $.002 )/( $.168 ) X ( 365 days / 90 days)
= .011905 X 4.0556
= .0483 or 4.83%
24-26
Currency Market Hedges
A futures contract is a contract for the delivery of a
commodity, foreign currency, or financial instrument at
a specified price on a stipulated future date.
A currency futures market exists for the major
currencies of the world.
Futures contracts are traded on organized exchanges.
The clearinghouse of the exchange interposes itself
between the buyer and the seller. Therefore,
transactions are not made directly between two parties.
Very few contracts involve actual delivery at expiration.
2. Currency Futures
24-27
Currency Market Hedges
Sellers (buyers) cancel a contract by purchasing
(selling) another contract. This is an offsetting position
that closes out the original contract with the
clearinghouse.
Futures contracts are marked-to-market daily. This is
different than forward contracts that are settled only at
maturity.
Contracts come in only standard-size contracts (e.g.,
12.5 million yen per contract).
2. Currency Futures (continued)
24-28
Currency Market Hedges
A currency option is a contract that gives the holder
the right to buy (call) or sell (put) a specific amount of a
foreign currency at some specified price until a certain
(expiration) date.
Currency options hedge only adverse currency
movements (one-sided risk). For example, a put
option can hedge only downside movements in the
currency exchange rate.
Options exist in both the spot and futures markets.
The value depends on exchange rate volatility.
3. Currency Options
24-29
Currency Market Hedges
In a currency swap two parties exchange debt
obligations denominated in different currencies. Each
party agrees to pay the others interest obligation. At
maturity, principal amounts are exchanged, usually at a
rate of exchange agreed to in advance.
The exchange is notional -- only the cash flow
difference is paid.
Swaps are typically arranged through a financial
intermediary, such as a commercial bank.
A variety of (complex) arrangements are available.
4. Currency Swaps
24-30
Macro Factors Governing
Exchange-Rate Behavior
The idea that a basket of goods should sell for
the same price in two countries, after exchange
rates are taken into account.
For example, the price of wheat in Canadian
and U.S. markets should trade at the same
price (after adjusting for the exchange rate). If
the price of wheat is lower in Canada, then
purchasers will buy wheat in Canada as long as
the price is cheaper (after accounting for
transportation costs).
Purchasing-Power Parity (PPP)
24-31
Macro Factors Governing
Exchange-Rate Behavior
Thus, demand will fall in the U.S. and increase in
Canada to bring prices back into equilibrium.
The price elasticity of exports and imports influences
the relationship between a countrys exchange rate and
its purchasing-power parity.
Commodity items and products in mature industries
are more likely to conform to PPP.
Frictions such as government intervention and
trade barriers cause PPP not to hold.
Purchasing-Power Parity (PPP continued)
24-32
Macro Factors Governing
Exchange-Rate Behavior
It suggests that if interest rates are higher in one
country than they are in another, the formers
currency will sell at a discount in the forward market.
Remember that the Fisher effect implies that the
nominal rate of interest equals the real rate of
interest plus the expected rate of inflation.
The international Fisher effect suggests that
differences in interest rates between two countries
serve as a proxy for differences in expected inflation.
Interest-Rate Parity
24-33
Macro Factors Governing
Exchange-Rate Behavior
F = current forward exchange-rate in foreign
currency per dollar.
S = current spot exchange-rate in foreign currency
per dollar.
r
foreign
= foreign interbank Euromarket interest rate
r
dollar
= U.S. interbank Euromarket interest rate

Interest-Rate Parity (continued)
The international Fisher effect suggests:
F
S
=
1 + r
foreign

1 + r
dollar
24-34
Interest-Rate
Parity Example
The current German 90-day interest rate is
4%.
The current U.S. 90-day interest rate is 2%.
The current spot rate is .706 Freedonian
marks per U.S. dollar ($1.416 per mark).
What is the implied 90-day forward rate?
24-35
Interest-Rate
Parity Example
F = (1.04) x (.706) / (1.02)
= .720
Thus, the implied 90-day forward
rate is .720 marks per dollar.
The implied 90-day forward rate is:
F
.706
=
1 + .04
1 + .02
24-36
Structuring International
Trade Transactions
In international trade, sellers often have
difficulty obtaining thorough and accurate
credit information on potential buyers.
Channels for legal settlement in cases of
default are more complicated and costly to
pursue.
Key documents are (1) an order to pay
(international trade draft), (2) a bill of lading,
and (3) a letter of credit.
24-37
International Trade Draft
The international trade draft (bill of exchange) is a
written statement by the exporter ordering the importer
to pay a specific amount of money at a specified time.
Sight draft is payable on presentation to the party
(drawee) to whom the draft is addressed.
Time draft is payable at a specified future date after
sight to the party (drawee) to whom the draft is
addressed.
24-38
Time Draft Features
An unconditional order in writing signed
by the drawer, the exporter.
It specifies an exact amount of money
that the drawee, the importer, must pay.
It specifies the future date when this
amount must be paid.
Upon presentation to the drawee, it is
accepted.
24-39
Time Draft Features
The acceptance can be by either the
drawee or a bank.
If the drawee accepts the draft, it is
acknowledged in writing on the back of
the draft the obligation to pay the amount
so many specified days hence.
It is then known as a trade draft (bankers
acceptance if a bank accepts the draft).
24-40
Bill of Lading
It serves as a receipt from the transportation
company to the exporter, showing that specified
goods have been received.
It serves as a contract between the transportation
company and the exporter to ship goods and deliver
them to a specific party at a specific destination.
It serves as a document of title.
Bill of Lading -- A shipping document
indicating the details of the shipment and
delivery of goods and their ownership.
24-41
Letter of Credit
A letter of credit is issued by a bank on behalf of the
importer.
The bank agrees to honor a draft drawn on the
importer, provided the bill of lading and other details
are in order.
The bank is essentially substituting its credit for that
of the importer.
Letter of Credit - A promise from a third party
(usually a bank) for payment in the event that
certain conditions are met. It is frequently used
to guarantee payment of an obligation.
24-42
Countertrade
Used effectively when exchange restrictions exist or
other difficulties prevent payment in hard currencies.
Quality, standardization of goods, and resale of
goods that are delivered are risks that arise with
countertrade.
Countertrade -- Generic term for barter and
other forms of trade that involve the
international sale of goods or services that are
paid for -- in whole or in part -- by the transfer
of goods or services from a foreign country.
24-43
Forfaiting
The forfaiter assumes the credit risk and collects
the amount owed from the importer.
Most useful when the importer is in a less-
developed country or in an Eastern European
nation.
Forfaiting -- The selling without recourse of
medium- to long-term export receivables to a
financial institution, the forfaiter. A third party,
usually a bank or governmental unit,
guarantees the financing.