International Capital Budgeting Applications
The previous chapter’s coverage of cross-border valuation featured two basic types of international capital budgeting applications: the acquisition and sale of a foreign operation. This chapter looks at some additional international capital budgeting scenarios: (a) a plant modernization proposal by an overseas subsidiary; and (b) a proposal to relocate some or all of production from the home country to a foreign country, or vice versa, considering possible changes in political risk or FX operating exposure. The relocation scenarios may be adapted to a company decision on whether to locate production in the home country or a foreign country.
Foreign Direct Investment
A multinational will make a foreign direct investment (FDI ) into an overseas operation to avoid tariffs or other foreign country import barriers, to engage in operational hedging, and so forth. The construction of a new facility is referred to as a greenfield investment. However, a cross-border acquisition or merger is often the preferred FDI mode of entry or expansion into foreign markets, where an existing local firm may be acquired by a multinational that wishes to avoid the construction time and other frictions of a greenfield investment.
Other reasons for foreign acquisitions include: consolidating worldwide excess capacity, combining firms in fragmented industries (“roll-ups”), exploiting developed marketing channels, eliminating a competitor, achieving critical mass required for innovative approaches to R&D and production, obtaining an innovation (patent, knowledge, technology), or entering a market to exploit an innovation. In 2007, total worldwide FDI was almost $2 trillion, with roughly half being greenfield investments and the other half being cross-border mergers and acquisitions (M&A). Some additional information on cross-border M&A activity is in the box.
Cross-Border Mergers & Acquisitions
The total volume of cross-border M&A has been growing worldwide, from 23% of the total merger volume in 1998 to 45% in 2007. Recent cross-border M&A activity has mostly been nonconglomerate, instead involving firms in the same industry (horizontal M&A) or along the supply/distribution chain (vertical M&A). In 1999, about 70% of all global M&As were horizontal. The major industries in which these horizontal combinations occurred were the automobile, pharmaceutical, chemical, food, beverage, tobacco, and more recently telecommunications and utilities. Some of the more well-known ones include Daimler-Benz (Germany)-Chrysler (U.S.); Vodaphone (U.K.)-AirTouch Communications (U.S.); British Petroleum (U.K.)-Amoco and ARCO (U.S.); Alcatel (France)-DSC Communications (U.S.); Deutsche Telecom (Germany)-Voice Stream Wireless (U.S.); and Sony (Japan)-Columbia Pictures (U.S.).
About 90% of cross-border M&A activity in 1999 occurred in developed countries. The great majority of global combinations were between firms in the major western industrial countries. At that time, the foreign targets of U.S. firms (outward U.S. FDI) were primarily located in the United Kingdom, Canada, and Europe. Japan was a relatively minor target of outward U.S. FDI. British firms were the source of the most acquisitions of U.S. firms and in a wide variety of industries. Other acquirers of U.S. firms came from Japan, Nether-lands, Canada, Germany, France and other European countries.
The prior trends have been changing. Per The World Investment Report 2011, 25% of global M&A activity in 2010 was undertaken in emerging and developing countries. At the same time, investors from these economies are becoming increasingly important players in cross-border M&A markets, which previously were dominated by developed country players.
In a sample of almost 57,000 international M&A deals for the years 1990 to 2007, 80% targeted a non-U.S. firm, while 75% of the acquirers were from outside the United States. The clear majority of cross-border mergers involved private firms as either bidder or target: 96% of the deals involved a private target, 26% involved a private acquirer, and 97% had either private acquirers or targets.
Incremental Cash Flow Application
Often, a capital budgeting analysis involves incremental cash flows. Examples include projects to: (a) expand foreign production capacity because of growth in product demand; and (b) replace an operation’s old equipment with modern, more efficient equipment.
For an example scenario, we assume that the U.S. multinational Olympic Machine Tools acquired the Austrian company Luna Instruments five years ago. Now, the expected future operating cash flow stream is a level perpetuity of €1m per year. Olympic’s managers believe that if the plant equipment is modernized, the production process will be signifi-cantly improved. The plant modernization would require a time-0 outlay of €1.2m, and expected operating costs would be lower by €100,000 per year. Thus, the expected operating cash flows in euros would be €1.1m per year instead of €1m. Olympic’s managers must decide whether to approve the plant modernization proposal.
Assumptions: (1) From the US dollar perspective, Luna’s FX operating exposure to the euro is 1.50 (so the FX exposure to the US dollar is −0.50), and the cost of capital in US dollars is 9%. (2) The euro risk-free rate is 2.39%, E*(x$/€) = −0.81%, E*(x€/$) = 1.87%, and the volatility of percentage changes in the $/€ FX rate is 0.103. (3) The $/€ FX rate is correctly valued at time 0 and expected to be correctly valued in the future. The time-0 spot FX rate is 1.16 $/€, and the forecasted time-1 FX rate is 1.15 $/€. Per equation (4.1), the operation’s cost of capital in euros is (1 + 0.09)[1 + 0.0187] − 1.50(0.103)2 − 1 = 0.0945, or 9.45%.
This capital budgeting project involves an incremental expected cash inflow perpetuity in euros of €100,000 per year. The intrinsic value of the expected future incremental cash flows in euros is €100,000/0.0945 = €1.06m. Since the project does not involve any expected FX windfalls, the NPV in euros may be used for the decision: €1.06m − 1.2m = −€0.14m. The proposal should be rejected.
Olympic Machine Tools is considering an alternative plant modernization proposal for Luna Instruments, requiring a time-0 outlay of €800,000 that would reduce expected operating costs by €80,000 per year into perpetuity. Make the same the other assumptions as in the text example. Should Olympic approve the modernization proposal?
Answer: The intrinsic value of the incremental expected cash flows is €80,000/0.0945 = €846,561. Since the project does not involve any expected FX windfalls, the NPV in euros may be used for the decision: €846,851 − 800,000 = €46,851. The project should be accepted.
Change in Political Risk
When you use expected incremental cash flows in an NPV analysis, you are making the implicit assumption that the project’s adoption would not change the risk of the operation and thus would not affect the hurdle rate. In many domestic capital budgeting situations, this implicit assumption is acceptable. However, in international capital budgeting applications, it is easy to think of situations where the project will affect the operation’s risk and hurdle rate. For example, assume that Olympic Machine Tools Co. is now considering an alternative to the Luna Instruments’ plant modernization proposal discussed in the previous text example. Instead, Olympic is now looking at a proposal to produce some components for Luna Instruments in a “cheap labor” country, namely Poland.
A proposal to shift a portion (or all) of production to a different country involves two potential changes to the operation’s risk. One potential risk change is related to FX operating exposure. However, in the present scenario, we ignore this possibility for the following reason: Poland has (for now) its own currency, the zloty, not the euro. But in anticipation of eventually joining the Eurozone, the Polish zloty is controlled to “track” the euro closely. So, in this situation, changing the currency denomination of some of the operating costs is not likely to significantly affect Luna’s FX operating exposure. We cover the impact of FX operating exposure changes shortly.
The other type of potential risk change is in political risk. In Exhibit 3.2, Poland’s political risk premium estimate is 0.65%, whereas Austria’s is assumed to be 0 because Austria is a developed country. The operation’s new political risk involves two countries. One simple way to handle this situation is to assume that the overall political risk for the operation is driven by the higher political risk country, which is Poland in this case. We apply this approach even though there is plenty of room for judgment here, and some capital budgeting analyses might justify a weighted average approach to the political risk. Also, for simplicity, we assume that the operation’s political risk exposure is 1. Since Poland’s political risk premium is 65 basis points, the operation’s new hurdle rate would be higher by 1[0.0065] = 0.0065, or 65 basis points. Recall the operation’s cost of capital in euros of 9.45%; the operation’s new hurdle rate (in euros) would be 9.45% + 0.65% = 10.1%.
When the capital budgeting proposal involves a change in the hurdle rate, you cannot do an NPV analysis with incremental cash flows. Instead, you need to compare two business alternatives. In the Olympic/ Luna case, you need to compare the intrinsic business value after the move with the intrinsic business value before the move and the investment outlay needed to make the move. To find the NPV of the proposal, you need to find the incremental intrinsic business value, and then subtract the investment outlay. Luna’s intrinsic business value (in euros) before the move is €1m/0.0945 = €10.6m. Assume that the initial outlay at time 0 to shift the component production to Poland is €3m, and that the operating costs would drop by €300,000 per year. So, the new expected operating cash flow stream in euros would be €1.30m a year, perpetually. Luna’s new intrinsic business value (in euros) would be €1.30m/0.101 = €12.9m.
The new intrinsic business value of €12.9m is higher than the intrinsic business value before the shift, €10.6m. But the time-0 outlay for the shift is €3m. So, the NPV is negative, because €12.9m − 10.6m – 3m = −€0.7m.
Use the following scenario and redo Olympic’s proposal to move component production for the Luna operation to Poland. Assume that the proposal would require an outlay of €1.5m and the future expected operating costs would be reduced by €250,000 per year. Thus, the expected operating cash flows would be €1.25m per year instead of €1m. Assume that the operation’s political risk exposure is 1, and that the political risk premium for Poland is 0.65%. Should Olympic approve the proposal?
Answer: Luna’s new intrinsic business value (in euros) would be €1.25m/0.101 = €12.4m. The new intrinsic business value of €12.4m is higher than the intrinsic business value before the shift, €10.6m. The time-0 outlay for the shift is €1.5m. So, the NPV is positive, because €12.4m − 10.6m − 1.5m = €0.3m. Accept.
Operational Hedging and Beta
A firm that changes its operational hedging strategy changes the FX operating (business) exposure. Changes in operational hedging occur when: (1) a company changes the currency habitat for source materials or other production inputs; or (2) a company changes the currency location of all or part of the production process. Perhaps a U.S. exporter will close a plant in the United States and build or buy a facility in the export market. This production offshoring should increase operational hedging and thus reduce the FX operating exposure. Or, a firm could do the reverse, shut down a plant in the overseas market and shift production to the home country. This production reshoring would reduce operational hedging, implying a higher (positive) FX operating exposure.
One benefit of lower FX operating exposure is lower operating cash flow volatility and thus lower expected costs of financial distress. Similarly, reducing operational hedging would raise the expected costs of financial distress. So, the capital budgeting analysis of a production relocation decision should, in principle, incorporate the change in the expected financial distress costs, in addition to the change in expected operating cash flows and the net investment outlay required to close production in one country and become operational in the other country. However, estimating the expected financial distress costs is beyond our scope here.
Instead, we focus on the possibility that a change in FX operating exposure affects an operation’s hurdle rate: If the foreign currency has systematic risk, the operational hedging decision may affect the firm’s systematic risk and thus the cost of capital. We need to know the impact of a change in the FX exposure to currency C on the operation’s beta: In words, the beta change, 
, is equal to the FX exposure change, 
, times the beta of currency C versus the home currency, 
, as shown in equation (6.1):1
Beta and FX Exposure to Currency C
To illustrate, assume that if the U.S. exporter Taylor Metals Co. offshores a manufacturing process to the export market in the United Kingdom, the FX operating (business) exposure to the British pound would drop from 
, because of the operational hedging. We want to know the impact of the offshoring on Taylor’s business beta. Assume that the currency beta for the British pound versus the US dollar, 
, is 0.20. Let Taylor’s initial business beta, 
, be 0.80. Using equation (6.1), Taylor’s new business beta, 
, is 0.80 + 0.20[0.50 − 1.50] = 0.60.
By moving production to the United Kingdom, Taylor would lower its business beta to 0.60 (from 0.80), due to the pound’s systematic risk, = 0.20, and to the lower FX business exposure to the pound. Assume that the GCAPM is the risk–return relationship in US dollars, the US dollar risk-free rate is 3%, and the global risk premium in US dollars is 6%. Taylor’s cost of capital is currently 0.03 + 0.80[0.06] = 0.078, or 7.80%. Taylor’s pro forma cost of capital, given the decision to offshore the manufacturing process to the United Kingdom, would be lower: 0.03 + 0.60[0.06] = 0.066, or 6.60%.
Exhibit 6.1 shows some currency beta estimates for various currencies versus the US dollar. The currency beta estimates versus the US dollar may be higher for countries other than those in Exhibit 6.1, because currency betas tend to be higher for emerging countries than developed ones. Of course, it’s possible for changes in political risk and FX operating exposure to work in the opposite directions, as the next boxed example illustrates.
Exhibit 6.1 Currency Beta Estimates: Currency C versus US Dollar
Statistical Parameter Estimation Period: 1999–2016 |
|
|
|
Eurozone (euro) |
0.27 |
Japan (yen) |
−0.03 |
China (yuan) |
0.01 |
Britain (pound) |
0.20 |
Canada (dollar) |
0.37 |
Australia (dollar) |
0.53 |
Taiwan (dollar) |
0.16 |
Switzerland (franc) |
0.17 |
India (rupee) |
0.23 |
Korea (won) |
0.41 |
Brazil (real) |
0.62 |
Mexico (peso) |
0.36 |
Sweden (krona) |
0.41 |
Hong Kong (dollar) |
0.00 |
Norway (krone) |
0.35 |
Denmark (krone) |
0.27 |
New Zealand (dollar) |
0.49 |
Singapore (dollar) |
0.18 |
South Africa (rand) |
0.49 |
Thailand (baht) |
0.18 |
The U.S. firm Omberg Components Co. makes and exports machine components to Switzerland. Omberg’s FX operating exposure to the Swiss franc is 2. Assume that Omberg’s operating beta is 1.20, given that the production is in the United States. If Omberg decides to offshore production to Switzerland, the FX operating exposure to the Swiss franc will fall to 1, due to operational hedging. Assume that political risk does not change. (a) If the Swiss franc’s currency beta is 0.17 (per Exhibit 6.1), find Omberg’s new operating beta if it off-shores production to Switzerland. (b) Assume that the GCAPM is the risk–return trade-off, the risk-free rate in US dollars is 3%, and the global risk premium in US dollars is 6%. Compare the pro forma cost of capital to the current cost of capital.
Answers: (a) Using equation (6.1), Omberg’s new operating beta would be 1.20 + 0.17[1 − 2] = 1.03. (b) The new cost of capital would be 0.03 + 1.03[0.06] = 0.0618, or 6.18%, higher than the current cost of capital, 0.03 + 1.20[0.06] = 0.102, or 10.2%.
The U.S. firm Norton Controls Co. makes and exports electronic controls to Brazil. Norton’s FX operating exposure to the Brazilian real is 2.3. Assume that Norton’s operating beta in US dollars is 1.82, given that the production is in the United States. If Norton decides to offshore production to Brazil, the FX operating exposure to the real will fall to 1.3, due to operational hedging. Assume that Brazil’s political risk premium is 1.15%, per Exhibit 3.2, and that the business has a political risk exposure of 1. (a) If the real’s estimated currency beta versus the US dollar is 0.62 (per Exhibit 6.1), find Norton’s new operating beta if it offshores production to Brazil. (b) Assume that the GCAPM is the risk–return trade-off, the risk-free rate in US dollars is 3%, and the global risk premium in US dollars is 6%. Compare the current and pro forma hurdle rate in US dollars.
Answers: (a) Using equation (6.1), Norton’s new operating beta would be 1.82 + 0.62[1.3 − 2.3] = 1.20. (b) The current cost of capital and hurdle rate in US dollars is 0.03 + 1.82[0.06] = 0.139, or 13.9%. The new hurdle rate in US dollars would be 0.03 + 1.20[0.06] + 1[0.0115] = 0.1135, or 11.35%.
Most currency betas versus the US dollar are positive, like the British pound’s beta of 0.20 versus the US dollar. As in the Taylor Metals illustration earlier, a positive currency beta implies that more operational hedging by an exporter results in a lower operating beta and thus a lower cost of capital, and vice versa. However, there is one case of a negative currency beta estimate versus the US dollar in Exhibit 6.1, the Japanese yen. In this case, higher operational hedging, and lower FX operating exposure, imply a higher operating beta and cost of capital, and vice versa.
An importer may also change FX operating exposure by changing the currency denomination of some operating costs. Say a U.S. firm initially imports raw materials/components from the United Kingdom, with prices fixed in pounds. Assume that the firm’s FX operating (business) exposure to the pound is −2, and the business beta is 1.25. If the firm decides to change suppliers, and sources more from the United States, the FX business exposure to the pound will be smaller, say −1. What will happen to the importer’s business beta if the currency beta of the pound versus the US dollar is 0.20? Using equation (6.1), the importer’s new business beta will be 1.25 + 0.20[−1 − (−2)] = 1.45. So, the importer’s business beta is higher if the FX operating exposure is smaller.
However, the impact of a change in FX operating (business) exposure is the opposite if the currency beta is negative. Say a U.S. importer sources from Japan. Given the Japanese yen’s negative currency beta estimate versus the US dollar, the importer’s business beta is lower if the FX operating (business) exposure is smaller, and vice versa. The next boxed example illustrates this impact.
The U.S. firm Denton Machine Co. imports machine components from Japan. Denton’s initial FX business exposure to the yen is −1.75 and the business beta is 0.80. If Denton changes the source of some components to the United States, the FX business exposure would be −1.25. (a) If the yen’s currency beta estimate is −0.03, find Denton’s new business beta if it makes the sourcing change. (b) Assume that the GCAPM is the risk–return trade-off, the risk-free rate in US dollars is 3%, and the global risk premium in US dollars is 6%. Compare the new cost of capital to the current cost of capital.
Answers: (a) Using equation (6.1), Denton’s new operating beta is 0.80 − 0.03[−1.25 − (−1.75)] = 0.785. (b) The new cost of capital is 0.03 + 0.785[0.06] = 0.077, or 7.7%. The current cost of capital is 0.03 + 0.80[0.06] = 0.078, or 7.8%. The estimated currency beta is negative, and an importer who reduces a negative FX business exposure has a lower cost of capital.
Increase in Operational Hedging and Business Beta
Currency Beta |
Exporter |
Importer |
Positive |
|
|
Negative |
|
|
Different FX Operating Exposures and Project NPV
As we saw earlier, incorporating a hurdle rate change in a capital budgeting analysis requires that we use a slightly different procedure than the traditional one with expected incremental cash flows. The reason is that you only use expected incremental cash flows in the analysis when adopting the project would not cause the hurdle rate to change. If the hurdle rate will change as a direct result of the investment decision, we should use the more general approach of finding the intrinsic business value before and after the investment.
For example, we extend the previous Taylor Metals example. For convenience, we do the NPV analysis in the home currency (US dollars), given the assumption that FX rates are correctly valued to avoid dealing with expected FX windfalls. Assume that from the US dollar perspective, Taylor initially expects operating cash flows of $1,560 per year into perpetuity. So, with Taylor’s initial US dollar cost of capital of 7.8%, Taylor’s intrinsic business value is initially $1,560/0.078 = $20,000. Assume further that if the production relocation is undertaken, the new expected annual operating cash flow would be $1,500. So, with Taylor’s new US dollar cost of capital of 6.60%, the new intrinsic business value would be $1,500/0.0660 = $22,727, an increase in intrinsic business value of $22,727 − 20,000 = $2,727. Assume further that the necessary outlay for the relocation is $1,000. The NPV would be $2,727 − 1,000 = $1,727, and so the relocation decision should be made.
Note that if you ignore the change in the cost of capital, and use the traditional procedure of discounting the incremental expected cash flows using the initial cost of capital, you would mistakenly calculate the NPV to be −$60/0.078 − 1,000 = −$1,669. So, you might mistakenly reject the project because you did not consider the impact of the project on the cost of capital.
Extend the previous boxed example on the U.S. firm Omberg Co. Assume that Omberg initially expects annual operating cash flows of $2.8m into perpetuity and has a cost of capital of 10.2%. If Omberg offshores production to Switzerland, the expected annual operating cash flows would be $3.6m per year and the cost of capital will be 6.18%. Assume that the net investment outlay to complete the offshoring would be $10m. (a) Find the NPV of the offshoring proposal. (b) Should Omberg offshore production to Switzerland? (c) What would be the incorrect NPV of the offshoring proposal if Omberg ignores the cost of capital change?
Answers: (a) NPV = $3.6m/0.0618 − 2.8m/0.102 – 10m = $58.25m − 27.45m − 10m = $20.8m. (b) Accept the relocation proposal because the NPV is positive. (c) The incremental expected perpetual annual operating cash flow is $3.6m − 2.8m = $0.8m. The proposal’s incorrect NPV would be $0.8m/0.102 − 10m = $7.84m – 10m = −$2.16m. The negative incorrect NPV would lead to an incorrect decision to reject.
One can adapt the previous scenario to a company’s choice between building/buying a plant to produce in the home country versus building/buying a plant to produce in a foreign country. For example, assume that the U.S. firm Thompson Appliance Co. has experienced significant growth in Italian sales, to the point of needing a separate production facility to specifically serve the Italian market. Revenues in euros on Italian sales are expected to be €10m per year forever. If Thompson decides to produce in Italy, the expected annual operating costs in euros will be 75% of expected revenues, and the investment outlay for the plant will be €20m. From the US dollar perspective, the FX operating exposure to the euro would be 1.20 (so the FX exposure to the US dollar is −0.20), and the operating beta would be 1. Using the GCAPM with a US dollar risk-free rate of 3% and US dollar global risk premium of 6%, the operation’s cost of capital in US dollars would be 9%.
If Thompson instead decides to produce in the United States, the expected annual operating costs (including shipping and other export costs) will be 80% of expected revenues (after conversion to US dollars), and the investment outlay for the plant will be $15m. A “what if” analysis suggests that the FX operating exposure to the euro would be 4.70. Other assumptions: (1) E*(x$/€) = −0.81%, E*(x€/$) = 1.87%, and the volatility of percentage changes in the $/€ FX rate is 0.103. (2) The $/€ FX rate is correctly valued at time 0 and expected to be correctly valued in the future. The time-0 spot FX rate is 1.16 $/€, and the forecasted time-1 FX rate is 1.15 $/€.
If Thompson decides to produce in Italy, the operation’s cost of capital in euros, per equation (4.1), is (1 + 0.09)[1 + 0.0187] − 1.20(0.103)2 − 1 = 0.0977, or 9.77%. The NPV in euros for the Italian plant option is €2.5m/0.0977 − 20m = €5.59m, which is equivalent to an NPV in US dollars of (€5.59m)(1.16 $/€) = $6.48m.
If Thompson decides to produce in the United States, the expected time-1 revenue in US dollars, per equation (4.3), is €10m(1.15 $/€)[1 − (−0.20)(0.103)2] = $11.52m, and the expected operating cash flow in US dollars is 0.20($11.52m) = $2.3m. The euro’s currency beta versus the US dollar is 0.27 per Exhibit 6.1; applying equation (6.1) to estimate the operation’s beta with U.S. production yields: 1 + 0.27[4.70 − 1.20] = 1.945. Therefore, the operation’s new cost of capital in US dollars would be 0.03 + 1.945[0.06] = 0.1467, or 14.67%. Assuming a perpetual expected cash flow in US dollars of $2.3m, the NPV in US dollars for the U.S. plant option is $2.3m/0.1467 − 15m = $0.68m. The Italian plant option has a higher NPV in US dollars, $6.48m versus $0.68m.
The U.S. firm Thompson Appliance Co. has experienced signifi-cant growth in Norwegian sales, to the point of needing a separate production facility to serve the Norwegian market. Revenues in Norwegian kroner are expected to be Nk100m per year forever. If Thompson decides to produce in Norway, the expected annual operating costs in kroner will be 75% of expected revenues, and the investment outlay for the plant will be Nk200m. From the US dollar perspective, the FX operating exposure to the krone would be 1.20 (so the FX exposure to the US dollar = −0.20), and the operating beta would be 1. Using the GCAPM with a US dollar risk-free rate of 3% and US dollar global risk premium of 6%, the operation’s cost of capital in US dollars would be 9%. If Thompson decides to produce in the United States, the expected annual operating costs (including shipping and other export costs) will be 80% of expected revenues (in US dollars), the investment outlay for the plant will be $15 m, and a “what if” analysis suggests that the FX operating exposure to the krone would be 4.7. Other assumptions: (1) E*(x$/Nk) = 0, E*(xNk/$) 1.28%, the volatility of percentage changes in the $/Nk FX rate is 0.116, and the krone’s currency beta versus the US dollar is 0.35, per Exhibit 6.1. (2) The $/Nk FX rate is correctly valued at time 0 and expected to be correctly valued in the future. In direct terms from the US dollar point of view, the time-0 spot FX rate is 0.12 $/Nk, and the forecasted time-1 FX rate is the same, 0.12 $/Nk. (a) Find the NPV of the Norwegian production option in kroner. (b) Find the NPV of the U.S. production operation in US dollars.
Answers: (a) Producing in Norway, the operation’s cost of capital in kroner, per equation (4.1) is (1 + 0.09)[1 + 0.0128] − 1.20(0.116)2 − 1 = 0.0878, or 8.78%. The NPV in kroner for the Norwegian plant option is Nk25m/0.0878 – 200m = Nk84.7m, which is equivalent to an NPV in US dollars of (Nk84.7m)(0.12 $/Nk) = $10.2m. (b) With U.S. production, the expected time-1 revenue in US dollars, per equation (4.3), is Nk100m(0.12 $/Nk)[1 − (−0.20)(0.116)2] = $12m, and the expected operating cash flow in US dollars is 0.20($12m) = $2.4m. Apply equation (6.1) to estimate the operation’s beta with U.S. production: 1 + 0.35[4.70 − 1.20] = 2.25. Therefore, the cost of capital would be 0.03 + 2.25[0.06] = 0.165, or 16.5%. Assuming a perpetual expected cash flow in US dollars of $2.4m, the NPV in US dollars for the U.S. plant option is $2.4m/0.165 – 15m = −$0.45m. The Norwegian plant option has a higher NPV in US dollars, $10.2m versus −$0.45m. One reason why the Norwegian plant option is better is that the U.S. plant option’s cost of capital is higher because of the higher FX operating exposure.
Operational Hedging and the ICAPM
A change in a firm’s FX operating exposure to a specific currency may sometimes also result in a material change in the firm’s FX business exposure to the ICAPM foreign currency index, 
. We ignore this possibility for the US dollar perspective, because does not have much impact on the cost of capital estimate in US dollars. For home currencies where we want to apply the ICAPM to estimate the cost of capital, we need to consider the impact of an FX operating (business) exposure change on .
The impact on depends on the exposure-currency’s weight in the home currency’s foreign currency index. Equation (6.2) shows the general formula for the change in FX exposure to the (wealth-weighted) ICAPM foreign currency index for a given change in a firm’s FX exposure to currency C in the index.
FX Exposure to ICAPM FX Index
For example, from the euro perspective, assume that the US dollar’s weight in the ICAPM foreign currency index, w$/(1 − w€), is 47.6% (per Chapter 2). Consider a Eurozone exporter to the United States that has an initial FX business exposure to the US dollar, 
, of 2, and an initial FX business exposure to the ICAPM foreign currency index, 
, of 0.80. The company relocates some production to the United States, which lowers the FX operating (business) exposure to the US dollar to 1.40. Per equation (6.2), the new will be 0.80 + 0.476[1.40 − 2] = 0.51.
Next, we use equation (6.1) and the US dollar’s currency beta versus the euro, 0.155 (per Exhibit 4.1), to find the company’s new business beta if the initial business beta is 0.90: 
= 0.90 + 0.155[1.40 − 2] = 0.807.
Finally, we compare the new cost of capital to the initial cost of capital using the ICAPM in equation (2.2) from the euro perspective, with inputs from Exhibit 2.2: 
= 5.54% and 
= −0.92%. Also, assume that the euro risk-free rate is 2.5%. The initial cost of capital is 0.025 + 0.90[0.0554] + 0.80[−0.0092] = 0.0675, or 6.75%. The new cost of capital is 0.025 + 0.807[0.0554] + 0.51[−0.0092] = 0.065, or 6.50%.
The British firm London Tools Ltd. exports machine components to United States buyers. London Tools’ initial FX operating (business) exposure to the US dollar is 1.75, the business beta is 1.20, and the FX business exposure to the ICAPM foreign currency index is 0.90. London Tools is considering moving some of the latter stages of manufacturing to the United States for operational hedging, and so would lower the FX business exposure to the US dollar to 1.25. (a) Find the proportion of the US dollar in the ICAPM foreign currency index portfolio from the British pound perspective. Hint: See Exhibit 5.4. (b) Find London Tools’ new FX business exposure to the foreign currency index. (c) The US dollar’s currency beta versus the pound is 0.087, per Exhibit 6.3. Find London’s new business beta. (d) Use the ICAPM risk-return expression in equation (2.2) from the British pound perspective; assume that the pound risk-free rate is 3.50%; and use inputs from the British pound perspective from Exhibit 5.4. Compare the new cost of capital to the current cost of capital.
Answers: (a) w$/(1 − w€) = 0.379/(1 − 0.066) = 0.406. (b) Per equation (6.2), the new FX business exposure to the ICAPM foreign currency index is 0.90 + 0.406[1.25 − 1.75] = 0.70. (c) Per equation (6.1), the new business beta is 1.20 + 0.087[1.25 − 1.75] = 1.16. (d) The initial cost of capital is 0.035 + 1.20[0.0559] + 0.90[−0.0071] = 0.0957, or 9.57%. The new cost of capital is equal to 0.035 + 1.16[0.0559] + 0.70[−0.0071] = 0.0949, or 9.49%.
Summary Action Points
• A capital budgeting proposal to relocate production to a different country should take into consideration the impact of the move on political risk, FX risk, and the hurdle rate.
• If the currency beta of the foreign currency is not zero, a firm’s business beta will change if the FX business exposure changes. The resulting change in the firm’s cost of capital needs to be considered as part of the financial evaluation of the capital budgeting proposals that change FX operating exposure.
• When using the ICAPM to estimate cost of capital, one should also investigate how an FX business exposure change will affect the FX business exposure to the foreign currency index.
Glossary
Greenfield Investment: The construction of a new plant or facility.
Horizontal M&A: Merger or acquisition involving firms in the same industry.
Offshoring: A change of production location by an exporter from the home country to the export market.
Reshoring: A change of production location by an exporter from the export market to the home country.
Vertical M&A: Merger or acquisition involving firms of a supply or distribution chain.
Problems
1. The U.S. firm Renwick Co. has a U.K. subsidiary in that is expected to generate £100,000 in operating cash flow each year into perpetuity. A “what if” analysis shows that the subsidiary’s FX operating exposure to the British pound is 0.70. The cost of capital in US dollars for the subsidiary is 8%. Renwick is evaluating a plant modernization proposal by the U.K. subsidiary that would require an outlay of £100,000. At the same time, the expected operating costs would be reduced by £10,000 per year. Thus, the new expected operating cash flows in British pounds would be £110,000 per year instead of £100,000. Assume: (1) the time-0 spot FX rate is 1.30 $/£; (2) the expected rate of change in the FX price of the British pound versus the US dollar is 0.42% per year; and (3) the volatility of percentage changes in the British pound versus the US dollar is 0.085. Renwick’s management believes that the FX rates are always correctly valued. Find the NPV of the modernization proposal in US dollars. Should Renwick approve the modernization proposal?
2. The U.S. firm Robichek & Myers Co. has a subsidiary in Brazil that makes machine tools for sale locally in Brazil. All parts, raw materials, and labor are sourced locally in Brazil. R&M has become worried about the impact of political risk on the availability of some parts and raw materials, and proposes to replace some of the Brazilian suppliers with U.S. suppliers. The managers estimate that the operation’s political risk exposure would drop from 1.50 to 1, but that the FX operating exposure to the Brazilian real would rise from 1.3 to 2.0, due to less operational hedging. Assume that the operating beta in US dollars is presently 1.20, given that all suppliers are in Brazil. Assume that Brazil’s political risk premium is 1.15%, per Exhibit 3.2. (a) If the real’s estimated currency beta versus the US dollar is 0.62 (per Exhibit 6.1), find R&M’s new operating beta with the new supply plan. (b) Assume that the GCAPM is the risk– return trade-off, the risk-free rate in US dollars is 3%, and the global risk premium in US dollars is 6%. Compare the current and pro forma hurdle rate in US dollars. (c) If the new supply plan requires no time-0 investment outlay, and would not change the operation’s expected operating cash flows in US dollars, should the plan be accepted or rejected?
3. Blackstone Co. is a U.S. firm that sources raw materials and parts from the United States. Blackstone’s business beta is 0.80. Black-stone is considering a proposal to change a supplier to a British firm whose prices are fixed in British pounds. Blackstone’s FX operating (business) exposure to the pound would change from 0 to −1.50. What will happen to Blackstone’s business beta if the currency beta of the pound versus the US dollar is 0.20?
Answers to Problems
1. Since there are no expected FX windfalls, the foreign currency approach is easy. The tricky part is to use equation (5.2) to approximate the equilibrium expected rate of change in the US dollar versus the British pound, which is −0.0042 + (0.085)2 = 0.003, or 0.30%. Using equation (4.1), the cost of capital in British pounds is (1.08) [1 + 0.003] − 0.70(0.085)2 − 1 = 0.078, or 7.8%. The NPV in British pounds is £10,000/0.078 − £100,000 = £28,205, which is equivalent to £28,205(1.30 $/£) = $36,667, the NPV in US dollars. Since the NPV > 0, accept the proposal.
2. (a) Using equation (6.1), the new operating beta would be 1.20 + 0.62[2.0 − 1.3] = 1.63. (b) In US dollars, the current cost of capital is 0.03 + 1.20[0.06] = 0.102, or 10.2%, and current hurdle rate is 10.2% + 1.50[1.15%] = 11.9%. The new hurdle rate in US dollars would be 0.03 + 1.63[0.06] + 1[0.0115] = 0.139, or 13.9%. (c) Reject, because the hurdle rate is higher with the new plan, so the intrinsic business value will be lower if the expected operating cash flow stream does not change.
3. Using equation (6.1), Blackstone’s new business beta will be equal to 0.80 + 0.20[−1.50 − 0] = 0.50. So, the business beta is lower even though there is more FX operating exposure.
Discussion Questions
1. If the currency beta is positive, what is the impact on the cost of capital of offshoring production to the export market country? Explain.
2. What is the impact on the cost of capital of an importer that reduces sourcing from an exporting country, if that country’s currency beta is positive? Explain.
3. What is the impact on the cost of capital of an importer that reduces sourcing from an exporting country, if that country’s currency beta is negative? Explain.