International Financial Management

P G Apte
 The Eclectic Paradigm:
The why, where and how of the
MNC
Why  Ownership-specific (O)
advantages

Where  Location-specific (L) advantages

How  Market internalization (I)

advantages
 Ownership-specific (O)
advantages
The why of the multinational
corporation
• Ownership-specific (O) advantages are
brand names, patents, copyrights,
proprietary technology or technological
processes, and marketing and
management expertise

• Ownership-specific advantages can lead

to sustainable competitive advantages
Location-specific (L) advantages
The where of the multinational
corporation

• Location-specific (L) advantages include

location-specific natural resources, man-
made resources, low taxes, low wage
costs, high labor productivity, or state-
supported monopolies

• Location-specific advantages can lead to

sustainable competitive advantages
 Market internalization (I)
advantages
The how of the multinational
corporation
• Ownership-specific and location-specific
advantages by themselves are not sufficient
to ensure the success of the multinational
corporation over local firms

• Market internalization (I) advantages accrue

to the multinational corporation as it exploits
its ownership- specific advantages in local
and international markets
 The life cycle of the multinational
corporation
• Infancy: developing ownership-specific
advantages

• Growth: seeking new markets

• Maturity: milking the cash cow

– defensive strategies to preserve revenues
– defensive strategies to reduce operating costs
– financial considerations

• Decline? or Renewal?
 Introduction
• Why can’t the local reproduce or nullify the ownership-
specific or location-specific advantages of MNCs?
• Many activities are internalized within a firm and carried out
within the framework of internal contractual arrangements rather
than by means of contracts with independent external agents.
• Through vertical integration, exclusive supply contracts,
patents and copyrights MNCs attempt to protect their proprietary
technologies or access to cheap, high-quality inputs.
• The sheer scale of their operations and ability to centralize
many tasks allow them to achieve scale economies which their
smaller local competitors cannot avail of
• MNCs can minimize tax burden by means of transfer pricing
and location in tax havens
 Foreign market entry
• Export entry
– agents/distributors (foreign or domestic)
– foreign sales branches and subsidiaries

• Contract-based entry
– licensing and franchising

• Investment-based entry
– foreign direct investments
– cross-border mergers and acquisitions
– joint ventures
 Investment-based entry
• Foreign direct investment
– relatively slow entry
– maintains control over production, distribution, and
intellectual property

• Cross-border mergers and acquisitions

– relatively rapid entry
– price of entry (acquisition premium) can be high

• Cross-border joint ventures

– may avoid investment restrictions
– less exposure to political/cultural risks
– risk losing control of intellectual properties
– risk creating a competitor
• Since foreign direct investment is the
most important avenue for achieving
multinational presence, it is important to
understand how MNCs might be
evaluating such investment proposals –
sole ownership as well as joint ventures
• The NPV based approach to project
appraisal has to be extended to projects
based outside the firm’s own country.
 Review of the NPV Approach
• The well known Net Present Value (NPV) formula
widely used in evaluating domestic investment
projects
t =T
NPV = - C0 + 
CFt
t
t =1 (1 + k w )

C0: Initial capital cost; CFt : Periodic cash flows

kw : Weighted average cost of capital defined by
kw =  ke + (1-)(1 - )kd
Where ke is cost of equity capital, kd cost of debt capital,  the
proportion of equity in project funding and c the tax rate
 Review of the NPV Approach
There are two implicit assumptions.
(1) The project being appraised has the same business risk as
the portfolio of the firm's current activities
(2) The debt:equity proportion in financing the project is same
as the firm's existing debt:equity ratio.
An alternative formula for cost of capital allows for
differences in the debt:equity ratio :

kw = ke(1-) where ke is the "all equity" required rate of

return reflecting the project's business risk.
If the project's business risk differs from the existing
portfolio of projects, one must estimate the project's beta
and the required "all equity" return from some version of
CAPM
 Cost of Capital for MNCs
• The cost of capital for MNCs may differ
from that for domestic firms because of
the following differences.
 Size of Firm. Because of their size, MNCs
are often given preferential treatment by
creditors. They can usually achieve
smaller per unit flotation costs too.
 Cost of Capital for MNCs
 Acess to International Capital Markets.
MNCs are normally able to obtain funds
through international capital markets,
where the cost of funds may be lower.
 International Diversification. MNCs may
have more stable cash inflows due to
international diversification, such that
their probability of bankruptcy may be
lower.
 Cost of Capital for MNCs
 Exposure to Exchange Rate Risk. MNCs
may be more exposed to exchange rate
fluctuations, such that their cash flows
may be more uncertain and their
probability of bankruptcy higher.
 Exposure to Country Risk. MNCs that
have a higher percentage of assets
invested in foreign countries are more
exposed to country risk.
 Cost of Capital for MNCs
Larger size Preferential
treatment from
Greater access creditors
to international
capital markets Possible
access to low- Cost of
International cost foreign capital
diversification financing

Exposure to
exchange rate Probability of
risk bankruptcy

Exposure to
country risk
 THE ADJUSTED PRESENT VALUE (APV)
FRAMEWORK
(1) In the first step, evaluate the project as if it is financed
entirely by equity. The rate of discount is the required rate of
return on equity corresponding to the risk class of the project.
(2) In the second step, add the present values of any cashflows
arising out of special financing features of the project such as
external financing, special subsidies if any and so forth. The rate
of discount used to find these present values should reflect the
risk associated with each of the cash flows.
(3) Tax benefits of debt:
Additional borrowing capacity : B = TDEGPV
Tax savings : (RD  )B = (RD  )(TDE  GPV)
RD : Pre-tax Cost of Debt  : Tax Rate
Discount using RD
The APV Approach
Add PV of any other cash flows on account of subsidies,
concessional finance etc.
Two assumptions:
(1) Firm will be able to utilize the interest tax shield fully in
every year. If not, carrying it forward involves loss of
time value
(2) The benefit of tax shield is fully appropriated by the firm
i.e. by the shareholders
In general, the calculation of the interest tax shield as
presented here probably represents an overestimate of
the true benefit from added borrowing capacity.
 Cross-Border Projects
The main added complications which distinguish a foreign
project from a domestic project can be summarized as follows :

 Exchange Risk and Capital Market Segmentation

 Political or "Country" Risk

 International Taxation
 Blocked Funds
 In addition, like in domestic projects, we must be careful to
take account of any interactions between the new project and
some existing activities of the firm - e.g. local production will
usually mean loss of export sales.
 The APV Approach for Cross-Border Projects
1. First treat the project as a branch operation of the parent
company. All the cash flows generated by the project belong by
definition to the parent since the project has no distinct identity.
This allows us to focus on the pure economics of the project.
2. Next, consider the project as a fully equity financed, wholly
owned subsidiary of the parent, incorporated under the host
country laws, having a distinct legal identity. Now we focus on
the various financial arrangements between the parent and the
subsidiary and consider what means are available to the parent
to increase the cashflow transfers between the subsidiary and
the parent and minimise the overall tax burden.
3. Finally, as in the case of a domestic project, incorporate the
effects of external financing such as the interest tax shield.
 Valuing Foreign Currency Cash-Flows
First consider the problem of valuing risk-free cash flows in
foreign currency. There are three possible methods :
(1) Find the present value of the cashflows in terms of foreign
currency and translate at today's spot rate. Thus if FCFt is the
cashflow at time t and rF is the risk-free foreign currency
discount rate, the home currency PV is
[FCFt/(1+rF)t]S0
(2) Translate each cashflow FCFt at the forward rate F0,t and
discount at the home currency risk-free discount rate. The PV
is given by
(F0,t)(FCFt)/(1+rH)t
 Valuing Foreign Currency Cashflows
(3) Translate at the expected spot rate E0(St) and discount at a
home currency discount rate that reflects exchange risk
E0 (St)](FCFt)/(1+rH)t
All the three methods would yield identical results if the home
and host country capital and money markets are free and
integrated When the markets are segmented (1) and (2) cannot
be used. It may happen that a project which is financially
viable when evaluated from the local point of view is not
acceptable from the parent point of view or vice versa – a
project may not be viable from the local point of view but
appears acceptable from the parent point of view.
Example
(a) Consider first the case where global capital markets are
fully integrated, investors are risk neutral and all the parity
conditions – Purchasing Power Parity (PPP), Covered
Interest Parity (CIP) and Uncovered Interest Parity (UIP) –
hold continuously. Suppose an Indian firm is considering a
project in Shangrila with the following cash flows measured
in Shangrila dollars (SGD) million

Year 0 1 2
Cash Flow -50 40 60
Suppose the risk free real rates in India and Shangrila are
5% p.a., the inflation rate in India is 5% p.a. while inflation
in Shangrila is 10% p.a. The nominal risk free rates are
10.25% in India and 15.50% in Shangrila.
Example …
The current SGD/INR exchange rate is 0.2000 (i.e. 5.00 SGD
per INR) while the one and two year forward rates are 0.1909
and 0.1822. These in turn equal the spot rates expected at the
end of year 1 and 2 respectively. The project evaluated from a
local point of view yields an NPV of
SGD {-50 + (40.0/1.1550) + [60.0/(1.1550)2] } million
= SGD 29.61 million
Translated into parent currency using the current spot rate
this gives an NPV of INR 5.92 million.
Now translate SGD cash flows into their INR equivalent using
the appropriate forward rates which also equal the expected
spot rate at the relevant time and discount these using the risk
free nominal rate in India.
Example …
This yields an NPV of
{ (-50.0/5.0) + [(40.0  0.1909)/(1.1025)]
+ [(60.0  0.1822)/(1.1025)2]}
= INR 5.92 million
This shows that when global capital markets are perfectly
integrated and all the parity conditions are satisfied,
evaluation of projects can be done from either local or parent
perspective.
Example …
(b) Now consider the case when there are capital controls in
place which segment the international capital markets. In
particular, suppose the government of Shangrila has imposed
capital controls which raise the real rate of interest in
Shangrila. The inflation rates in India and Shangrila are, as
before, 5% and 10% p.a., the real risk free rate in India is 5%
but that in Shangrila is 10%. The risk free nominal rates are
therefore 10.25% in India and 26.50% in Shangrila. The
forward rates are 0.1743 and 0.1519. However, due to capital
controls and intervention on the part of Shangrila’s central
bank the SGD is expected to remain at 0.20 INR. Consider a
project in Shangrila with the following net cash flows (SGD
Million):
Year 0 1 2
-50 30 40
Example …
Using a discount rate of 26.50%, the NPV of these cash flows is
{-50 + (30/1.2650) + [40/(1.2650)2]}m SGD = -1.29m SGD
Now translate these SGD cash flows into their INR equivalents
using the expected spot rate of 0.20 INR per SGD through the
life of the project and discount the resulting INR cash flows
using a discount rate of 10.25%. The cash flows are ( -10, 6, 8)
million INR and the NPV is INR 2.02 million. Thus it appears
that the project is acceptable from parent perspective.
Is this a correct conclusion? If not what is the correct
approach?
Are there any reasons why MNCs might wish to undertake
such projects?
Example …
(c) The opposite case is easy to construct. Consider a
Shangrila firm contemplating a direct investment project in
India under the same cicumstances as in case (b) above.
Suppose the cash flows from the project are (-10, 6, 8) million
INR. With a discount rate of 10.25%, this yields an NPV of
INR 2.02 million from the local perspective – which now is
the Indian perspective. Translated into SGD at the expected
spot rate of 0.2000 INR per SGD, these cash flows would be
(-50, 30,40) million SGD. With a discount rate of 26.50%, the
NPV works out to be –1.29 million SGD. It appears that the
project is viable from the local point of view but not from
parent point of view. What should the Shangrila firm do?
Example …
It should try to acquire local financing for the project.
Suppose it can borrow INR 12.02 million at 10.25% in India.
It can finance the project construction with INR 10 million
out of this and immediately remit the rest to the parent
company. It invests the first year’s net cash flow at 10.25%. At
the end of two years it has INR 14.61 million, which is enough
to pay off its two year loan.
When global capital markets are segmented and parity
conditions are violated, the correct procedure is to value the
project from parent perspective allowing explicitly for
exchange rate risk. Also this example had assumed away the
project’s business risks by assuming the projects cash flows in
local currency to be risk free. The problem becomes more
complicated when the firm must take into account project-
specific risks in addition to the exchange rate risk.
 Valuing Risky Cashflows
____________________________________________________
After-Tax Cashflow(Z$ Million)
Boom Recession
(prob.=0.6) (prob.=0.40)
13.8 10.5
____________________________________________________
Cashflow Translated to Rupees(Million)
Z$/Rs. 7.5 103.5 78.75
(prob.=0.5) (prob.=0.1) (prob.=0.3)
Z$/Rs. 5.5 75.9 57.75
(prob.=0.5) (prob.=0.5) (prob.=0.1)
____________________________________________________
Valuing Risky Cashflows …
Once again, with integrated capital markets and validity of parity
conditions, we can discount the expected foreign currency
cashflow, Zimbabwe dollars [0.613.8+0.410.5] million, using a
discount rate which equals the rate of return required by
Zimbabwean investors from similar projects and translate into
rupees at the current spot rate. In obtaining this discount rate we
must employ the international CAPM which takes account of the
covariance of the project with the world market portfolio and the
Rs/Z$ exchange rate.
If host and home country capital markets are segmented this
procedure cannot be employed. The expected value in home
currency, of a risky foreign currency cashflow at a future date is
given by
Et(CFHT) = Et(CFFT)Et(ST) + cov[CFFT,ST]
Valuing Risky Cashflows …
In the example given above the expected value is
(103.50.1)+(75.90.5)+(78.750.3)+(57.750.1)
= Rs.77.7 million
To estimate this, we need forcasts of future spot rate and an
estimate of the covariance between the spot rate and the foreign
currency cashflow. This has to be discounted at a rate equal to
the rate of return required by home currency investors on
similar projects. This must be estimated with a single-country
CAPM augmented by exchange risk.
Degree of capital market integration is the crucial issue.
Integration is far from complete. This raises difficult issues.
Difficulties in Incorporating Exchange Rate
Risk and Choice of Discount Rates
• Reliable exchange rate forecasts are notoriously difficult to
obtain.
• Linking the performance of the project with the exchange
rate is no less difficult. If the project is intended to serve not
only the host country market but also third-country markets,
the issues are still more complex since the performance of the
project now depends upon several exchange rates and not just
the home country-host country exchange rate.
• The appropriate risk premium to be added for exchange risk
is far from easy to estimate in practice.
• The international CAPM is hard to operationalize.
International taxation introduces further
complications.
• Treatment of dividend income by home country government
• Withholding taxes,
• Treatment (by host and home country tax authorities) of
other forms of transfers such as interest, royalties etc. between
the subsidiary and the parent.
• Existence or otherwise of double taxation avoidance
agreements and their scope.
• The possibility of using transfer prices which are different
from arms-length prices.
• These are all highly complex issues best left to the specialists
in this area.
In practice, firms use their all-equity required rate of return
and add a risk premium which is supposed to reflect not only
exchange risk but also other risks such as political or country
risk and in some cases also the fact that the firm may be
totally unfamiliar with the host country and may have to
incur additional costs. This is a rather arbitrary procedure.

• Some risks should be accounted for by adjusting cash flows

• Some risks are insurable – deduct premium payments from
cash flows
• Exchange risks are to some extent diversifiable.
An arbitrary risk premium may err on the conservative side
and result in the parent firm foregoing potentially high NPV
projects.
THE PRACTICE OF CROSS-BORDER
DIRECT INVESTMENT APPRAISAL
(1) A large majority of practitioners employ DCF as at least
one of the methods for valuation.
(2) Most practitioners are de facto multi-factor model
adherents. More segmented the market under consideration
greater is the number of additional factors used in valuation.
Even those who claimed to use the single factor CAPM include
more than one risk factor proxies.
(3)The use of local market portfolio as the sole risk factor is
less frequent when the evaluator is dealing with countries
which are not well integrated into the global capital markets.
However, they then add other risk factors rather than using
the global market portfolio. For integrated markets such as the
US or the UK, global market portfolio is used more frequently.
THE PRACTICE OF CROSS-BORDER
DIRECT INVESTMENT APPRAISAL …
(4) In the case of less integrated markets like Sri Lanka or
Mexico, exchange risk, political risk (e.g. expropriation),
sovereign risk (e.g. Government defaulting on its obligations)
and unexpected inflation are considered to be important risk
factors in addition to market risk.
(5) Most practitioners adjust for these added risks by adding
ad-hoc risk premia to discount rates derived from some asset
pricing model rather than incorporating them in estimates of
cash flows. This goes against the spirit of asset pricing models
which are founded on the premise that only non-diversifiable
risks should be incorporated in the discount rate.
Practice of Cross-Border Project Appraisal
The Goldman-Sachs Model:
(1) Identify an existing firm in an identical/similar business in
the host country.
(2) Regress its returns on S&P500 to obtain its beta.
(3) Required return on equity for the project:
R = Rf(US) +  RS&P500 + Country Spread
Country Spread is defined as :
Country spread = Yield on the host country government’s
bonds denominated in USD – yield on US
treasuries
Practice of Cross-Border Project Appraisal …
The CSFB Model
R = RBB + d {E [RUSM – Rf(US)]  Ad }  Kd
RBB : Yield on Brady bonds
RUSM : US market portfolio (e.g.S&P500) return
Rf(US) : US risk free return
Ad : Ratio of coefficient of variation of the country market
index to coefficient of variation of US market index
Kd : An adjustment factor to allow for correlation between risk
free rate and risk premium (set at 0.60).
Practice of Cross-Border Project Appraisal …
The Godfrey-Espinosa Model (Journal of Applied
Corporate Finance Vol.9, No.3, Fall 1996, 80-89)
R = Rf (US) + Country Spread
+ (d/ US)(US or World Market Excess Return)
Here d and US are volatilities of the host country and US
indices respectively.
All these models attempt to capture covariance risk with
world/US markets and exchange rate and political risk in a
CAPM like framework. The country spread is taken to
capture the exchange rate and political risk and the beta term
the covariance risk.
 INTERNATIONAL JOINT VENTURES
• Over and above the pure economics of the joint venture
project, the most crucial issue is the sharing of the synergy
gains between the partners.
• Two or more partners join in a venture only because they
have strengths that complement each other, in terms of
technology, distribution, market access, brand equity and so
forth.
• The joint venture is expected to yield gains over and above
the sum of the gains each partner can obtain on its own.
• How should these extra gains be shared between the
partners?
INTERNATIONAL JOINT VENTURES …
Game-theoretic models of bargaining suggest that the
synergy gains should be split equally.
• One way of achieving this is proportional sharing of project
cash-flows. Thus of the two partners, A brings in 30% of the
investment and B the remaining 70%, cash-flows should be
shared in the same proportion.
• This conclusion however needs modification when the two
partners are subject to different tax regimes and tax rates.
INTERNATIONAL JOINT VENTURES …
Fair sharing of synergy gains can also be achieved by other
means.
• Thus a properly designed license contract wherein the joint
venture pays one of the partners a royalty or license fee for
"know-how" can achieve the same result as proportional
sharing of cash-flows.
• Alternatively, one of the partners brings in some intangible
asset (e.g. a brand name) the value of which is negotiated
between the partners.
Joint Ventures
Modes of allocation of cash flows among partners
(A) Pure-Equity Contract: Partners share cash flows in
proportion to their shareholding
(B) License Contract: JV pays royalty to one partner;
subtracted from operating cash-flows; residual cash-
flows shared pro-rata
(C) One partner brings an intangible asset at a negotiated
value. This plus his shareholding determines his share
in cash-flows.
JVs subject to many restrictions.
Joint Ventures …
1. Restrictions on foreign equity holding
2. Ceilings on royalty payments
3. Different tax rates
4. Differential tax treatment of dividend payments vs.
royalty payments
Bargaining theory suggests equal sharing of synergy gains.
Pure equity contracts achieve this; other arrangements can
be designed to achieve this.

Three step approach: Joint branch mode valuation; adjust

for non-proportional sharing; adjust for external financing
Joint Ventures …
• NPVA and NPVB are A and B’s best alternative on their
own. Both know these and other relevant data. Each could go
ahead on its own, find another partner.
• These are their “threat points” – neither will accept less
than its best alternative.
• Nash, Rubinstein, Sutton : Equal sharing
A’s gain = B’s gain > 0
A’s gain : NPV of A’s cash flow from JV – NPVA
B’s gain : NPV of B’s cash flow from JV – NPVB
Joint Ventures ..
Case I : Neutral taxes, integrated capital markets,
simple pro-rata sharing
NPVJV : NPV of joint venture  : A’s share (1- ) : B’s share
Equal gain rule: NPVJV – NPVA = (1 - ) NPVjv – NPVB
 = 0.5 + [(NPVA – NPVB) / 2 NPVJV
If NPVA > NPVB (A’s threat stronger than B’s), A obtains a
larger share.
Each NPV viz. NPVA, NPVB, NPVJV computed as in a wholly
owned subsidiary.
NPVJV must be larger than (NPVA + NPVB)
Joint Ventures …
Case II : Different tax rates and/or discount rates. Suppose B is
host country. A is subject to higher taxes. B’s capital market is
segmented. B investors demand a higher rate of return.
NPV of A’s cash flows = PV of A’s share of operating cash flows
– PV of A’s tax liability on A’s share of taxable income – A’s
share in initial investment
= PV[ a (REV-OPEX)] – PV[a (SALES-COST) TA] – aI0

= a(NPVJV, A)

(NPVJV, A) = PV[REV-OPEX] – PV[(SALES-COST)TA] – I0

Where a is A’s share in initial investment and JV cash flows, I0
initial investment, TA is A’s tax rate (including host and home
country taxes).
Joint Ventures…
Similarly,
NPV of B’s cash flows
= (1-a) NPVJV,B

(NPVJV, B) = PV[REV-OPEX] – PV[(SALES-COST)TB] – I0

Equal gain rule

a (NPVJV,A) – NPVA = (1-a) (NPVJV,B) – NPVB

a = [NPVJV,B/(NPVJV,A+ NPVJV,B)]

+ [(NPVA-NPVB) /(NPVJV,A+ NPVJV,B)]

A > 0.5 even if NPVA = NPVB. A has to be compensated for

higher taxes.
Joint Ventures …
Case III : Unbundled JV with a license contract or a
management contract
Some popular arrangements:
* Royalty paid to one partner, tied to sales.
* An up-front license fee
* Periodic license fee
* One partner brings “know-how” as equity-in-kind
* One partner brings a tangible asset as equity-in-kind and is
allowed to value it above market
Joint Ventures …
Many decision variables: Profit share, royalty %, lump-sum
fee, valuation of intangible asset. Some of these may be
restricted by host country laws.
What motivates license contracts?
• Licensor wants a low-risk income stream
• Information asymmetry: Better informed partner (local
partner) accepts a bigger share of business risk; allows the
other a low-risk cash flow
• Restrictions on equity share
• Tax factors : License fees are tax deductible; branch profits
or foreign dividends may be subject to heavy host country
taxes. However, relative tax rates and presence/absence of
DTAA’s must be considered
Joint Ventures …
Equal Gains Rule with License Contracts
y : Royalty % (of sales) received by A
Lt : Lumpsum fee received by A in year t
LPt = y(Sales) + Lt
TAD : A’s effective tax rate on dividends
TAL : A’s effective tax rate on license fee
TBD : B’s effective tax rate on dividends
Cash flow from JV accruing to A at time t
= LPt(1-TAL) + a(REVt-OPEXt-LPt) – a(SALESt-COSTt-LPt)TAD
Joint Ventures …
= a [REVt – OPEXt – (SALESt – COSTt) TAD]
+ LPt[(1-TAL) – a (1-TAD)]
NPV of A’s cash flows
= PVA(LP) [(1-TAL) – a (1-TAD)]
+ a{PVA [REVt – OPEXt – (SALESt – COSTt) TAD] – I0}
= PVA(LP) [(1-TAL) – a (1-TAD)] + a NPVJV,A
PVA(LP) = y PVA(SALES) + PVA(L)
PVA(SALES) : PV of sales using a discount rate that reflects
riskiness of sales from A’s stockholders’ point of view.
PVA(L) : PV of lump-sum payments
Joint Ventures…
NPV of B’s cash flows
= (1-a) NPVJV,B – (1-a) PVB(LP) (1 – TBD)
Equal gain rule
(1-a) NPVJV,B – (1-a) PVB(LP) (1 – TBD) – NPVB
= PVA(LP) [(1-TAL) – a (1-TAD)] + a NPVJV,A – NPVA
(1) Fix y, Lt and determine a to satisfy equal gains rule
(2) Fix a, Lt, find y
etc.