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Corporate Finance
MLI28C060
Lecture 14
Thursday 29 October 2015
Exam Structure
• 2 Parts
• 3 Hours duration (start 9am with finish at 12 midday)
• First Part: Two Numerical calculation questions (35
marks each)
– Maximum – 70% of marks
• Second Part: Three Essay based questions – each
question is worth 10 marks
– Maximum – 30% of marks
1. Classification of exchange rate regime
Continuum from flexible to rigid
FLEXIBLE CORNER
1) Free float
2) Managed float
INTERMEDIATE REGIMES
3) Target zone/band
4) Basket peg
5) Crawling peg
6) Adjustable peg
FIXED CORNER
7) Currency board
9) Monetary union
8) Dollarization
3. Advantages of fixed rates
1) Encourage trade <= lower exchange risk.
• In theory, can hedge risk.
But costs of hedging:
missing markets, transactions costs, and risk premia.
• Empirical:
Exchange rate volatility ↑ => trade ↓ ?
Time-series evidence showed little effect. But more in:
- Cross-section evidence,
especially small & less developed countries.
- Borders, e.g., Canada-US:
McCallum-Helliwell (1995-98); Engel-Rogers (1996).
- Currency unions:
Rose (2000).
Advantages of fixed rates, cont.
2) Encourage investment
<= cut currency premium out of interest rates
3) Provide nominal anchor for monetary policy
• By anchoring inflation expectations, achieve lower inflation for same Y.
• But which anchor? Exchange rate target vs. Alternatives
4) Avoid competitive depreciation
5) Avoid speculative bubbles that afflict floating.
(If variability were all from fundamental real exchange rate risk, and no bubbles,
then
fixing the nominal exchange rate would mean it would just pop up in prices
instead.)
4. Advantages of floating rates
1. Monetary independence
2. Automatic adjustment to trade shocks
3. Central bank retains seignorage
4. Central bank retains Lender of Last
Resort capability, for rescuing banks
5. Avoiding crashes that hit pegged rates,
particularly if origin of speculative attacks
is multiple equilibria, not fundamentals.
Prices and Exchange Rates
• The Law of one price states that all else being equal
(no transaction costs) a product’s price should be the
same in all markets
• Even if prices for a particular product are in different
currencies, the law of one price states that
¥
P$
 S=
P¥
P
S $
P
Where the price of the product in US dollars (P$), multiplied
by the spot exchange rate (S, yen per dollar), equals the
price of the product in Japanese yen (P¥)
Figure: Interest Rate Parity (IRP) and
Equilibrium
Figure: Forward Rate as an Unbiased
Predictor for Future Spot Rate
Interest Rates and Exchange Rates
• The Forward Rate
F90FC/$  SFC/$

 FC 90 
 1   i x 360 


x 

 $ 90 
1

i x


360 


• The best estimate future period Spot Rate
FC/$
1
S
 S0
1   
1   
FC
FC/$
x
$
Figure: Covered Interest Arbitrage (CIA)
Figure: Uncovered Interest Arbitrage
(UIA): The Yen Carry Trade
Introduction of 3 principle methods to hedge
exposure (unhedged, forward contracts, simple
currency options)
Trident’s Transaction Exposure
Managing an Account Receivable
• Maria Gonzalez, CFO of Trident, has just concluded a
sale to Regency, a British firm, for £1,000,000
• The sale is made in March for settlement due in
three months time, June
– Assumptions
•
•
•
•
•
Spot rate is $1.7640/£
3 month forward rate is $1.7540/£
Trident’s cost of capital is 12.0%
UK 3 month borrowing rate is 10.0% p.a.
UK 3 month investing rate is 8.0% p.a.
Trident’s Transaction Exposure
Managing an Account Receivable
– Assumptions
• US 3 month borrowing rate is 8.0% p.a.
• US 3 month investing rate is 6.0% p.a.
• June put option in OTC market for £1,000,000; strike
price $1.75; 1.5% premium
• Trident’s foreign exchange advisory service forecasts
future spot rate in 3 months to be $1.7600/£
• Trident operates on thin margins and Maria
wants to secure the most amount of US dollars;
her budget rate (lowest acceptable amount) is
$1.7000/£
Trident’s Transaction Exposure
Managing an Account Receivable
• Maria faces four possibilities:
– Remain unhedged
– Hedge in the forward market
– Hedge in the options market
Trident’s Transaction Exposure
Managing an Account Receivable
• Unhedged position
– Maria may decide to accept the transaction risk
– If she believes that the future spot rate will be
$1.76/£, then Trident will receive £1,000,000 x
$1.76/£ = $1,760,000 in 3 months time
– However, if the future spot rate is $1.65/£, Trident
will receive only $1,650,000 well below the
budget rate
Trident’s Transaction Exposure
Managing an Account Receivable
• Forward Market hedge
– A forward hedge involves a forward or futures contract and
a source of funds to fulfill the contract
– The forward contract is entered at the time the A/R is
created, in this case in March
– When this sale is booked, it is recorded at the spot rate.
– In this case the A/R is recorded at a spot rate of $1.7640/£,
thus $1,764,000 is recorded as a sale for Trident
– If Trident does not have an offsetting A/P in the same
amount, then the firm is considered uncovered
Trident’s Transaction Exposure
Managing an Account Receivable
• Forward Market hedge
– Should Maria want to cover this exposure with a forward
contract, then she will sell £1,000,000 forward today at the 3
month rate of $1.7540/£
– She is now “covered” and Trident no longer has any
transaction exposure
– In 3 months, Trident will received £1,000,000 and exchange
those pounds at $1.7540/£ receiving $1,754,000
– This sum is $6,000 less than the uncertain $1,760,000
expected from the unhedged position
– This would be recorded in Trident’s books as a foreign
exchange loss of $10,000 ($1,764,000 as booked, $1,754,000
as settled)
Trident’s Transaction Exposure
Managing an Account Receivable
• Option market hedge
– Maria could also cover the £1,000,000 exposure by
purchasing a put option. This allows her to speculate on the
upside potential for appreciation of the pound while limiting
her downside risk
• Given the quote earlier, Maria could purchase 3 month put option at
an ATM strike price of $1.75/£ and a premium of 1.5%
• The cost of this option would be
(Size of option) x (premium) x (spot rate)  cost of option
£1,000,000 x 0.015 x $1.7640  $26,460
Trident’s Transaction Exposure
Managing an Account Receivable
• Because we are using future value to compare the various
hedging alternatives, it is necessary to project the cost of
the option in 3 months forward
• Using a cost of capital of 12% p.a. or 3.0% per quarter, the
premium cost of the option as of June would be
$26,460  1.03 = $27,254
• Since the upside potential is unlimited, Trident would not
exercise its option at any rate above $1.75/£ and would
purchase pounds on the spot market
• If for example, the spot rate of $1.76/£ materializes, Trident
would exchange pounds on the spot market to receive
£1,000,000  $1.76/£ = $1,760,000 less the premium of the
option ($27,254) netting $1,732,746
Trident’s Transaction Exposure
Managing an Account Receivable
• Unlike the unhedged alternative, Maria has limited
downside with the option
• Should the pound depreciate below $1.75/£, Maria
would exercise her option and exchange her
£1,000,000 at $1.75/£ receiving $1,750,000
– Less the premium of the option, Maria nets $1,722,746
– Although this downside is less than that of the forward or
money market hedge, the upside potential is not limited
Strategy Choice and Outcome
Hedging Strategy
Outcome/Payout
Remain uncovered @ $1.76/£ (her best estimate of FX rate)
$1,760,000
Forward Contract hedge @ $1.754/£
$1,754,000
Put option hedge @ strike $1.75/£
Minimum if exercised
$1,722,746
Maximum if not exercised
Unlimited
International Diversification and Risk
• Portfolio Risk reduction
International Diversification and Risk
Internationalizing the Domestic Portfolio
• The optimal domestic portfolio
International Diversification and Risk
• International diversification
Cost of Equity and Debt
• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)
k e  k rf   (k m  k rf )
Where
ke
krf
km
β
= expected rate of return on equity
= risk free rate on bonds
= expected rate of return on the market
= coefficient of firm’s systematic risk
• The normal calculation for cost of debt is analyzing the various
proportions of debt and their associated interest rates for the firm
and calculating a before and after tax weighted average cost of debt
Worked Example: Trident’s WACC
• Maria Gonzales, Trident’s CFO, believes that Carlton has access to global
capital markets and because it is headquartered in the US, that the US should
serve as its base for market risk and equity risk calculations
k WACC  17.00%(0.60) 8.00%(1  0.35)(0.40)
k WACC  12.28%
Where
kWACC = weighted average cost of capital
ke
= Carlton’s cost of equity is 17.0%
kd
= Carlton’s before tax cost of debt is 8.0%
t
= tax rate of 35.0%
E/V = equity to value ratio of Carlton is 60.0%
D/V = debt to value ratio of Carlton is 40.0%
Estimating the Cost of Debt
• For developed countries, the target’s local or the acquirer’s home country
cost of debt.
• For emerging countries, the cost of debt (k d ) is as follows:
k d  R f  CRP  FRP
where
Rf = Local risk free rate or U.S. treasury bond rate converted to a local nominal
rate if cash flows are in the local currency; if cash flows in dollars, the U.S.
treasury rate
CRP = Specific country risk premium expressed as difference between the local
country’s (or a similar country’s) government bond rate and the U.S. treasury
bond rate of the same maturity
FRP = Firm’s default risk premium (i.e., additional premium for similar firms
rated by credit rating agencies or estimated by comparing interest coverage
ratios used by rating agencies to the firm’s interest coverage ratios to
determine how they would rate the firm.)
Weighted Average Cost of Capital
k WACC
E
D
 k e  k d (1  t)
V
V
Where
kWACC = weighted average cost of capital
ke
= risk adjusted cost of equity
kd
= before tax cost of debt
t
= tax rate
E
= market value of equity
D
= market value of debt
V
= market value of firm (D+E)
Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is
found by subtracting the present value of the
after-tax outflows from the present value of
the after-tax inflows.
9-32
Net Present Value (NPV)
• Net Present Value (NPV): Net Present Value is
found by subtracting the present value of the
after-tax outflows from the present value of the
after-tax inflows.
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
9-33
NPV Strengths and Weaknesses
Strengths:
– Cash flows
assumed to be
reinvested at the
hurdle rate.
– Accounts for TVM.
– Considers all
cash flows.
Weaknesses:
– May not include
managerial
options embedded
in the project.
Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows
with the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
9-35
Internal Rate of Return (IRR)
• The Internal Rate of Return (IRR) is the discount rate
that will equate the present value of the outflows
with the present value of the inflows.
• The IRR is the project’s intrinsic rate of return.
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
9-36
IRR Strengths and Weaknesses
Strengths:
– Accounts for
Time Value of
Money
– Considers all
cash flows
– Less
subjectivity
Weaknesses:
– Assumes all cash
flows reinvested at
the IRR
– Difficulties with
project rankings and
Multiple IRRs
Payback Period (PBP)
0
-40 K
1
2
3
10 K
12 K
15 K
4
5
10 K
7K
PBP is the period of time required for
the cumulative expected cash flows
from an investment project to equal
the initial cash outflow.
PBP Strengths and Weaknesses
Strengths:
Weaknesses:
– Easy to use and
understand
– Can be used as a
measure of
liquidity
– Easier to forecast ST
than LT flows
– Does not account
for TVM
– Does not consider
cash flows beyond
the PBP
– Cutoff period is
subjective
Comparing Methods
Basis of
measurement
Measure
expressed as
Strengths
Limitations
Payback
period
Cash
flows
Number
of years
Easy to
Understand
Net present
value
Cash flows
Profitability
Dollar
Amount
Considers time
value of money
Internal rate
of return
Cash flows
Profitability
Percent
Considers time
value of money
Allows
Accommodates Allows
comparison
different risk
comparisons
across projects levels over
of dissimilar
a project's life projects
Doesn't
Difficult to
Doesn't reflect
consider time
compare
varying risk
value of money dissimilar
levels over the
projects
project's life
Doesn't
consider cash
flows after
payback period
What are BGs?
• Business Groups are ubiquitous (Korea, Thailand,
Malaysia, Brazil, Argentina, Mexico, India, Italy,
Belgium, Sweden…).
• Diverse (scope of activities, control structure,
interactions with government and society).
• Common feature: legally independent entities,
operating across industries, bound by formal and
informal ties, often family ownership, varying
degrees of outside participation.
• (Unlike conglomerates or franchises).
Pyramiding
Payment of dividends
Family
• 51%
Tunnelling of resources and profits
Firm 1
• 51%
Firm 3
• 51%
Firm 4
• 51%
Firm 5
Cross-shareholding
20%
Firm 2a
Firm 1a
20%
20%
Cross shareholdings
20%
20%
Family
Firm 2b
20%
20%
Cross shareholdings
20%
20%
Firm 1b
Firm 2c
“Soft”
• These include:
– Interlocking (shared/common) directors
– Socialization of directors
• Examples range from training courses in head office
• To communal membership of Presidential Club
(common feature of Japanese Keiretsu’s)
– Exertion of control over boards of group-firms
• Preferential hiring of nonexecutives from group/family
• Chairperson and CEO from group/family
– A range of entrenchment tools such as salary
packages, contingent-pay and ownership tied to
group holding company
“Hard”
• Ownership-based forms of control
– However in configurations of ownership where “voting
rights” are in excess of “cash flow” rights
– All equity entitles holder to “one-share-one-vote”
– However through elaborate pyramids and crossshareholding networks of firms voting rights are in effect
“enhanced” (maximised” in contrast to relatively minimal
actual ownership of firms within network (or business
group)
• Pyramid Structure
• Cross-shareholding
• …..and combinations of above two….
Business group structure
Pros
Cons
-Risk Sharing and Mutual Assurance: Firms within
-Tunneling of resources
group can share risks and enjoy mutual assurance
(1) Controlling shareholder tunnels resources from firm
effect through investment relation and mutual lending
that he has less share to firm that he has more share.
(2) Controlling shareholder sacrifices some firms
-Incumbent firms able to draw on reputation of wider
shareholder value in order to maximize his profit.
group to preferentially access external capital, labour
and product markets
-BG’s frequently encounter controversy (tax, regulatory,
legal issues) in conjunction with notions of “cross
-Ability to counter “institutional voids” or deficiencies
border expropriation” when in fact all that is happening
in domestic capital, product and labour markets
is the far-sighted redirection/redistribution of capital
through the optimal use of “internal” markets and
flows from well-performing group firms to poorer-
superior “internal coordination” based on group-
performing firms
structure
-BG’s structure and coordination system effectively
-Some evidence from India that BG’s are more effective
in providing services and building regional economies
than State Owned Enterprises
-Benefits of far-sighted investment horizon in groups
“prop up” (support) firms that would otherwise fail
Corporate governance II: Agency versus Stakeholder
views of firm structure
Figure: The Structure of Corporate Governance
Market Stakeholder Map
Nonmarket Stakeholder Map