Bachelor of Accounting(Hons)

International Finance: Markets and

Management

International Investment and Financing

Decisions
(Week 9)

PowerPoint® Slides
By Uma
 Learning Objectives

On successful completion of this topic students should

understand the following:
• Impact upon the value of a project of alternative

exchange rate assumptions;

• How to forecast project or company free cash flows in

any specified currency and determine the project’s net

present value or company value under differing
exchange rate, fiscal and transaction cost assumptions;
• The significance of exchange controls for a give

investment decision and strategies for dealing with

restricted remittance.

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 Learning Outcomes

On successful completion of this topic students should be

able to:
Assess the impact upon the value of a project of alternative
exchange rate assumptions;
Forecast project or company free cash flows in any
specified currency and determine the project’s net
present value or company value under differing
exchange rate, fiscal and transaction cost assumptions;
Evaluate the significance of exchange controls for a give
investment decision and strategies for dealing with
restricted remittance.

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 Part 1
INTRODUCTION

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 Causes of exchange rate fluctuations

• While making international investment decisions, the

effect of changes in currency rates over the period of
the project must be evaluated to arrive at the correct
project value.
• Causes of exchange rate fluctuations:
 Purchasing power parity

 Interest rate parity

 International fisher effect

 Market expectation theory

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 Example

• The rate of inflation in Colombia is 55% and their

government is taking measures to reduce this rate each
year by 15%. The Colombian peso/US dollar rate is
currently 220 Colombian peso/US $1.
• Inflation in the US over the next years is expected to be:
1st year 5.0%
2nd year 4.0%
3rd year 3.5%

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 Example

• Calculate the exchange rate for the Colombian peso

against the dollar for the next three years.
• Also, calculate the impact of changes in exchange rate
on the value of a project which a US company plans to
start in Colombia If the net cash flows of the project in
million Colombian pesos are as follows and the base
rate of inflation is 55%:
Year 0 1 2 3

Cash flows (8,500) 4,400 5,200 6,300

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 Example: Step 1

Calculate the rate of inflation in Colombia for the next

three years.
Year Base rate of 15% reduction Actual rate of
inflation inflation

1 55% 8.25% 46.75%

2 46.75% 7.0125% 39.7375%

3 39.7375% 5.961% 33.7765%

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 Example: Step 2

Estimate the Colombian peso/US dollar rate of exchange

using the PPP theory

F0  S 0 x
1  hcolombia 
1  hUS 
Year Estimated exchange rate

1 220 x (1.4675/1.05) = 307.48 peso/USD

2 220 x (1.397375/1.04) = 295.60 peso/USD

3 220 x (1.337765/1.035) = 284.36 peso/USD

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 Example: Step 3

Calculate the impact of changing exchange rates on the

value of the project
Year 0 1 2 3
Cash flows in (8,500) 4,400 5,200 6,300
pesos (mill)
Exchange 220 307.48 295.60 = 284.36
rate peso/USD peso/USD peso/USD peso/USD

Value in US (38.64) 14.31 17.59 22.16

dollars (mill)

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 Part 2
INVESTMENT APPRAISAL

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 Investment appraisal using NPV method

• Identify the size and timing of all relevant cash flows on a

time line.
• Identify the riskiness of the cash flows to determine the
appropriate discount rate.
• Find NPV by discounting the cash flows at the
appropriate discount rate.
• Compare the value of competing cash flow streams at
the same point in time.

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 Investment appraisal using NPV method

• NPV = PV of inflows – Cost

= Net gain in wealth
• If projects are independent, accept if the project NPV >
0.
• If projects are mutually exclusive, accept projects with
the highest positive NPV, those that add the most value.

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 Investment appraisal using NPV method

Year Cash Present value at 10% Present Value

flow ($) ($) = (1/ 1+ i^n)

0 (15,000) - (15,000)

1 7,000 0.9091 6,363

2 6,000 0.8264 4,959

3 3,000 0.7513 2,254

4 2,000 0.6830 1,366

5 1,000 0.6209 621

TOTAL PV 15,563

NPV 15,563 – 15,000 = 563

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 Investment appraisal using NPV method

1. Convert the foreign currency cash flows into the local

currency.
2. Using estimated exchange rates.
3. And then discount them at the parent company’s cost of
capital.

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 Example

Springdale Inc, a US-based MNC, produces perfumes

and artificial flowers. It has a global presence with a
variety of products traded under a well-established
brand, Lilac.

The company now plans to set up a subsidiary in

Switzerland to increase its global market share by an
estimated 5% within four years.

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 Example (Cont’d)

The initial capital investment is estimated at €800m. The

working capital at €125m, which would be recovered at
the end of the four years. The cash inflows are estimated
at €330m at the end of each of the first two years and
€480m at the end of each of the last two years. The
scrap value at the end of the project is estimated to be
€40m.
The tax rate is Switzerland is 45% as compared to 35%
in the US. A double taxation agreement exists between
the two countries. The tax is payable in the year
following the year in which the taxable profits arise.

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 Example (Cont’d)

The current $/€ exchange rate is 1.3255. However, due

to rising inflation, the Euro is expected to appreciate by
2% each year.

The company’s WACC for a similar project is 12%.

Assess whether Springdale should invest in this project

assuming that it achieves its target increase in the
market share by the end of the four years.

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 Solution

Year Cash After Exchang Cash After US Discount Discount

Flow Euro e Rate Flow Tax Cash ed cash ed Cash
(€) Tax USD/€ After Flow flow PVIF Flow @
(mill) Cash Conversi (USD) (1/1+i^n) 12%
Flow on (USD) (mill) (USD)
(€) (mill) (mill)
(mill)

0 (800) (800) 1.3255 (1,060.40) (1,060.40) - (1,060.40)

1 330 181.50 1.3520 245.39 159.50 0.8929 142.41
2 330 181.50 1.3791 250.31 162.70 0.7971 129.70
3 480 264 1.4066 371.34 241.37 0.7118 171.80
4 480 264 + 1.4348 378.79 + 246.21 + 0.6355 233.98
+85 = 85 = 121.96 121.96 =
565 349 368.17
NPV (382.51)

PS : For Year 4, only the cash flow from the investment project (€480) is taxed, not the
cash flow from, working capital – scrap
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value (i.e. €125 - €40 = €85).
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 Investment Decision

Since the NPV = (USD 382.51) < 0, Springdale should not

invest in this project because it will suffer losses if it does
so.

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 Reference

Madura, J. (2012). International corporate finance (11th

ed.): South-Western Cengage Learning.

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 THE END

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