Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 22 Foreign investment decisions 645
Self-assessment Activity 22.6
A UK-owned MNC produces in the USA and also exports to South American countries
directly from the UK where it is paid in US$. Its US revenue is $50 million and its operat-
ing costs are $30 million. Export sales to South America are $100 million. What is its
exposure to the US$/sterling exchange rate?
(Answer in Appendix A at the back of the book)
22.9 HOW MNCs MANAGE OPERATING EXPOSURE
Managing operating exposure involves taking steps to insulate the firm’s operating
cash flows as far as possible from the effect of unexpected FX changes, so as to minimise
the effect on the value of the whole firm.
In Chapter 21, we explained a number of theories of the operation of FX markets.
The upshot of these is that, if they are valid, firms need not worry about FX variations.
However, because foreign exchange markets cannot always be relied upon to move
quickly to new equilibria, it is often considered prudent to safeguard against the
impact of future contingencies. Moreover, given the strongly competitive nature of
many international markets, it is sensible to anticipate how competitors are likely to
behave when operating conditions change.
There are two broad ways in which operating exposure can be minimised. The first
involves structuring the firm’s operations to insulate it from damage, and the second,
structuring its financial policy to this end.
The general aim is to construct a natural hedge. This occurs when there is little or
no exposure because the adverse impact on cash inflows is exactly offset by the bene-
ficial impact on cash outflows. A British firm producing and selling in the USA has a
high degree of protection against sterling/dollar variations. If sterling appreciates,
thus reducing the sterling value of dollar inflows, the adverse effect is largely counter-
balanced by the corresponding fall in the sterling value of its US$-denominated
inputs. Only the profit element is unhedged.
Firms that service only one overseas location can achieve this ‘self-hedging’ effect
in various ways:
■ Source components and other inputs in the country where sales are made.
■ Open an operating subsidiary there to manufacture or assemble the product.
■ Borrow in the same currency as that of cash inflows. The stream of outflows (inter-
est and capital repayments) will help to match the series of inflows.
■ The firm may pay suppliers in other countries with the currency received from
sales. If it sells in US$, and sources from Poland, it can pay the Polish suppliers in
US$ rather than zlotys. This is called currency switching.
Consequently, a full answer would depend on more rigorous strategic evaluation of
the various consequences of the sterling depreciation. Similar comments apply to the
increased sterling costs of supplies. Will Pitt try to absorb these costs? Will it try to pass
them on wholly or partly? Will it seek alternative UK suppliers? In addition, there may
be wider effects – will Pitt win sales from US competitors in the UK and elsewhere? How
will fellow UK rivals respond to the sterling depreciation? How will non-exporting UK
firms that import from the USA respond?
Having to grapple with these issues provides a powerful stimulus for seeking ways
of trying to negate the effects of FX exposure.
currency switching
Where an exporter pays for
imported supplies in the cur-
rency of the export deal
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646 Part VI International finance
Self-assessment activity 22.7
Revisit SAA 22.6.
Suggest three ways for the firm to lower its exposure.
(Answer in Appendix A at the back of the book)
The hedge constructed may not be a match in the same currency. As some currencies
tend to move together due to the interdependence of the associated economies, e.g.
Canada and the USA, the MNC could offset, say, a US$ revenue stream with a C$ cost
stream. This is termed parallel matching.
Where several locations are serviced, the key is diversification of operations. A
diversified firm is better placed both to recognise dis-equlibrium situations in foreign
exchange markets and also to adapt accordingly. For example:
■ If relative costs in sterling terms alter as between different locations, a diversified
MNC can arrange to reschedule production between locations.
■ If product prices change in different markets, the MNC may strengthen its market-
ing efforts to exploit greater profit opportunities where prices are higher.
■ If raw material prices alter as between different locations, the MNC can alter its
sourcing policy.
Admittedly, such adjustments are likely to trigger certain conversion or switch-over
costs, but the MNC may still benefit from favourable ‘portfolio effects’. The variability
of cash flows in domestic currency terms is likely to fall if the firm receives income in a
variety of currencies – foreign exchange rate variations may increase competitiveness
in some markets to offset lower competitiveness in others. This, of course, underpins
the diversification motive for foreign investment, mentioned earlier in the chapter.
Portfolio diversification is considered more fully in Chapter 9.
22.10 HEDGING THE RISK OF FOREIGN PROJECTS
This issue has already been addressed. Operating a foreign investment involves both
translation exposure and economic exposure. The translation risk stems from exposure
to unexpected exchange rate movements: for example, a fall in the value of the Australian
dollar (AUD) against GBP will reduce the GBP value of assets appearing in the Australian
subsidiary’s Balance Sheet. When consolidated into the parent’s accounts, this will
require a write-down of the value of assets in GBP terms. This problem can be avoided
if the exposed assets are matched by a corresponding liability. For example, if the initial
investment is financed by a loan denominated in AUD, the diminution in the sterling
value of assets will be matched by the diminution in the GBP value of the loan.
Perfect matching of assets and liabilities is not always possible. Many overseas capi-
tal markets are not equipped to supply the required capital. Besides, it is probably politic
to provide an input of parent company equity to signal commitment to the project, the
government and the country. However, perfect matching is probably unnecessary, since
some assets such as machinery can be traded internationally. The cause of the exchange
rate depreciation (i.e. higher internal prices) will lead to a rise in prices, and if the Law
of One Price holds, this appreciation in the value of locally-held assets will compensate
for the reduced GBP value of the currency. As a result, the need to match probably
applies only to property assets and items of working capital such as debtors, which can-
not readily be traded on international markets. (Note the obvious attraction of operating
with a sizeable volume of short-term creditors, especially at the financial year end.)
Economic exposure is the long-term counterpart of transaction exposure – it applies
to a stream of cash inflows and outflows. In theory, the problem of variations in the
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Chapter 22 Foreign investment decisions 647
prices of inputs and outputs should also be solved by the operation of the Law of One
Price. For example, local price inflation at a rate above that prevailing in the parent
company’s country will be exactly offset by depreciation in the local currency, thus
maintaining intact the GBP value of locally produced goods.
However, in practice, problems arise when PPP does not apply in the short term and
when project prices alter at different rates from prices in general. The movement in the
local price index is only an average price change, hiding a wide spread of higher and
lower price variations. In principle, the firm could use the forward market to remove
this element of unpredictability in the value of cash flows, but in practice, the forward
market has a very limited time horizon, or is non-existent for many currencies.
Nevertheless, the parent company with widely spread overseas operations can
adopt a number of devices. It can mix the project’s expected cash flows and outflows
with those of other transactions to take advantage of netting and matching opportu-
nities. It can lead and lag payments when it expects adverse currency movements,
although host governments usually object to this. It can also use third-party curren-
cies. For example, if it invests in oil extraction, its output will be priced in USD and the
otherwise exposed cost of inputs may be sourced or invoiced in USD or in a currency
expected to move in line with USD. A more aggressive policy might involve invoicing
sales in currencies expected to be strong and sourcing in currencies expected to be
weak, perhaps including the local one.
Another tactic is to use the foreign project’s net cash flows to purchase goods pro-
duced in the host country that are exportable, or can be used as inputs for the parent’s
own production requirements. This converts the foreign currency exposure of the pro-
ject’s cash flow into a world price exposure of the goods traded. This may be desirable
if the degree of uncertainty surrounding the relevant exchange rate is greater than that
attaching to the relevant product price.
Much world trade is conducted on the stipulation that the exporter accepts payment
in goods supplied by the trading partner, or otherwise undertakes to purchase goods
and services in the country concerned. This linking of export contracts with reciprocal
agreements to import is known as counter-trade. It is usually found where the importer
suffers from a severe shortage of foreign currency or limited access to bank credits.
One form of countertrade is buy-back, which is a way of financing and operating for-
eign investment projects. In a buy-back, suppliers of plant, equipment or technical know-
how agree to accept payment in the form of the future output of the investment concerned.
This long-term supply contract with the overseas partner raises some interesting princi-
pal/agent issues, concerning in particular the quality of the output and the management
of the operation. Ideally, the output should be a product for which a ready market is avail-
able or that the exporter can use as an input to its own production process. In recent years,
Iran has signed buy-back deals with European energy majors Royal Dutch/Shell,
TotalFinaElf and ENI to finance the development of oil and gas projects.
The advantage of buy-backs for a Western company is that they secure long-term
supplies and obviate any need to worry about exchange rate movements. The effective
cost is the cost incurred in financing the original construction, and perhaps an oppor-
tunity cost if world prices of the goods received fall. Buy-backs thus offer a way of
locking into the present world price for the goods transferred, which has some appeal
in markets where prices fluctuate widely, for example, oil.
22.11 POLITICAL AND COUNTRY RISK
According to Euromoney, which conducts a regular analysis of political risk: ‘Political
Risk is the risk of non-payment or non-servicing of payment for goods and services, or
trade-related finance and dividends, and the non-repatriation of capital.’
The definition and the above discussion imply a distinction between economic and
political risk, the former resulting from governmental interference and the latter from
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648 Part VI International finance
general economic turbulence. But because these are usually inter-twined, the two risks
are often grouped under the heading of country risk.
It is not surprising that FDI by MNCs involves strong elements of political risk. Their
very size and strength in relation to host countries creates the possibility of politically-
inspired action, whether favourable, e.g. granting generous incentives, or adverse, e.g.
expropriation of assets. Where the goals of the host government and the MNC conflict,
the political risk escalates. Political risk is heightened where political and social insta-
bility prevails, and host government objectives are unclear.
The task of the MNC’s planners is to define, identify and predict these sources of
instability. Instability results from internal pressures or civil strife that may be caused
by factors such as inequities, actual or perceived, between internal factions (whether
racial, religious, tribal, etc.), extremist political programmes, forthcoming independ-
ence or impending elections.
An MNC that is considering FDI may observe the signals of political instability, but
to measure its extent is a complex task. A major cause of political and social instabili-
ty is due to economic influences. Factors such as oscillating oil prices, banking crises,
foreign exchange crises and rampant inflation all promote instability.
As in Argentina, Turkey and Egypt in the early 2000s, economic instability often
necessitates heavy overseas borrowing to finance reconstruction. Because reforms take
time to implement, risk of default is ever-present. Default risk can be gauged by fac-
tors such as a country’s debt service ratio (debt service payments relative to exports) and
the debt age profile. The political risks of such pressures can provoke actions such as:
■ exchange controls
■ restrictions on registration of foreign companies
■ restrictions on local borrowing
■ expropriation or nationalisation
■ tax discrimination
■ import controls
■ limitation on access to strategic sectors of the economy.
Expropriation – confiscation of corporate assets with or without compensation –
asset freezing – loss of control over asset management – and outright nationalisation
represent the greatest political threat to foreign investors. The main risk is less that of
expropriation per se, but the risk that compensation will be inadequate or delayed.
‘Creeping’ expropriation may also occur where mounting restrictions on prices,
issue of work permits, transfer of shares, imports and dividends become likely when
a nation feels threatened by the size and influence of MNCs. Hence, prior to deciding
whether to operate in a new country, a pertinent question to consider is whether the
MNC, either individually, or collectively with other MNCs, will dominate the indus-
try, as occurs when oligopolistic rivals follow the strategic entry of a leader. If this is a
strong probability, the political risk is greater than when penetration is low.
■ Assessing political and country risk (PCR)
There are several ways of assessing PCR:
1 Scoring systems
The magazines Institutional Investor and Euromoney produce country risk ratings on a
regular basis. Euromoney’s ratings are based on a weighted average method, using the
following scoring system, based on percentages:
■ Political risk – 25 per cent
■ Economic performance – 25 per cent
■ Debt indicators – 10 per cent
■ Debt in default or rescheduled – 10 per cent
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Chapter 22 Foreign investment decisions 649
■ Credit ratings – 10 per cent
■ Access to bank finance – 5 per cent
■ Access to short-term finance – 5 per cent
■ Access to capital markets – 5 per cent
■ Discount on forfaiting (see Chapter 15) – 5 per cent
Scores and rankings for selected countries as at September 2004 are shown in Table
22.4 (Pedzinski, 2004).
Although there is a high element of arbitrariness and subjectivity in such systems,
there appears to be a strong degree of correlation between competing league tables.
Given the subjectivity, consideration of movements of countries up and down the
tables over time is worth study, e.g. Saudi Arabia and Zimbabwe have been down-
wardly mobile in recent years.
2 Delphi technique
Also known as ‘consulting the oracle’, this involves canvassing a panel of experts for
their opinions, via questionnaires or direct personal or telephone contact, and then
aggregating the replies. The Euromoney analysis is essentially a combination of check-
listing and the Delphi technique.
3 Inspection visits
Key staff from the MNC’s Head Office make a ‘Grand Tour’ to the prospective host
country, often accompanied by local embassy officials.
4 Using local intelligence
Consulting local experts, e.g. official insiders and credit analysts from banks, to advise
on prevailing local trends.
Table 22.4
Country risk scores for
selected locations
Rank Country Score out of 100
1 Luxembourg 99.78
2 Norway 99.70
3 Switzerland 97.69
4 USA 97.49
5 Denmark 95.97
7 UK 94.48
10 Netherlands 93.88
16 Germany 91.31
44 Saudi Arabia 66.59
45 Poland 66.40
50 China 62.77
60 India 56.47
62 Kazakhstan 53.63
134 Mololova 34.18
138 Nigeria 33.27
177 Zimbabwe 21.87
181 Cuba 16.00
182 Democratic Rep. of Congo 11.19
183 Iraq 7.13
184 North Korea 6.55
185 Afghanistan 6.39
Source: Euromoney, September 2004 (www.euromoney.com).
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650 Part VI International finance
■ Corruption
A major issue in dealing with foreign officials is often corruption. Several agencies
attempt to assess the extent to which local officials misuse their positions for personal
gain when dealing with MNCs. For example, Transparency International publishes a
regular league table, based on a scale of 0–10 In its table
published in October 2004, Finland was reckoned to be the least corrupt country in the
world, with New Zealand second. Other European countries ranked as follows: Britain
(11), Germany (15), France (22), Italy (42), while Nigeria (144) and Bangladesh (145)
were reckoned to be the most corrupt.
In similar vein, consultancies such as the Kurtzman Group and the Milken Institute
generate indices that attempt to measure the risks associated with unclear legal sys-
tems, regulations, economic policies and corporate governance standards, as well as
corruption. In Kurtzman’s October 2004 ‘Opacity Index’, covering 48 countries, Finland
again gets the cleanest bill of health, with Indonesia, Venezuela, China and Nigeria in
the rearguard.
110 minimum corruption2.
22.12 MANAGING POLITICAL AND COUNTRY RISK (PCR)
Protection against the adverse consequences of changes in the political or economic
complexion of a host country can be achieved in four ways:
■ Pre-investment negotiation
■ Laying down operating strategies
■ Preparation of a contingency crisis plan
■ Insurance
These aspects are now considered in turn.
■ Pre-investment negotiation
The best approach to PCR management is to anticipate problems and negotiate an
understanding beforehand. Different countries apply different codes of ethics regard-
ing the honouring of prior contracts, especially if concluded under a previous regime.
Nevertheless, pre-negotiation does provide a better basis for subsequent wrangling.
An investment agreement sets out respective rights and obligations on both the
MNC and the host government. It could cover aspects such as:
■ The basis whereby financial flows, such as dividends, management fees, royalties,
patent fees and loan repayments may be remitted back to the home country.
■ The basis for setting transfer prices used for costing inputs delivered from the home
country.
■ Rights relating to third-country markets, i.e. who can serve them.
■ Obligations to build or fund social infrastructure like schools and hospitals.
■ Methods of taxation – rates and calculation procedures.
■ Requirements for offset, i.e. local sourcing.
■ Access to host country financial markets.
■ Employment practices, especially regarding openings for nationals. This is very
common in the Middle East, e.g. Oman has an ‘Omanisation’ policy.
■ Operating strategies
Flexible, risk-averting strategies that enhance the MNC’s bargaining position can be
devised in several areas.
offset
The requirement for a MNC to
undertake a proportion of local
sourcing as condition of the
award of an export deal (very
common in the armaments
industry)
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Chapter 22 Foreign investment decisions 651
Production and logistics
■ Local sourcing increases local employment and may head off trouble if local inter-
ests would be damaged thereby.
■ Siting production facilities to minimise risk, e.g. siting oil refineries in low-risk loca-
tions.
■ Retaining control of transportation facilities like oil tankers and pipelines.
■ Control of technology embodied in patents and the appointment of home country
staff to manage complex technological processes. Coca Cola has never divulged its
magic formula, reputedly locked in a bank vault in Atlanta, Georgia.
Marketing
■ Controlling markets by eliminating competition – locals are often happy to sell out.
■ Controlling brand names and trademarks. McDonald’s only franchises operations
to local entrepreneurs.
Financial
■ Issuing equity on the local stock market to extend ownership to locals. A Joint
Venture is also an effective way to promote local participation.
■ Restricting parental equity input – local debt financing is preferable to equity fund-
ing as it creates a hedge to offset local inflation and exchange rate depreciation, and
also exerts leverage on local politicians if local banks stand to suffer from political
intervention.
■ Multi-source borrowing – raising loans from banks in several countries, and per-
haps international development agencies, will build a wide nexus of vested inter-
ests in keeping the MNC healthy.
■ Preparation of a contingency crisis plan
Contingency planning helps in two ways, first, by providing an action plan to imple-
ment if things do go wrong, and second, it forces managers to think about the contin-
gencies to which their foreign operation is most vulnerable.
■ Investment insurance
MNCs may be able to shift risk to a home country agency that specialises in accepting
international risks. In the UK, the Export Credit Guarantee Department (ECGD) offers
confiscation cover for new overseas investments and Lloyds offers insurance facilities
for existing and new investments in a comprehensive and non-selective form. In the
USA, the government-owned Overseas Private Investment Corporation (OPIC) will
cover risks relating to inability to convert overseas earnings into dollars, expropriation,
war and revolution, and loss of business income arising from events of political vio-
lence that damage MNC assets.
22.13 FINANCING FDI
A multinational company (MNC) may have more opportunities to lower the overall
cost of capital than a ‘domestic’. This is often due to its larger size, and partly due to
greater access to international financial markets, allowing it to exploit any temporary
disequilibria, as well as receiving host government concessions.
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652 Part VI International finance
The international financing decision has two elements:
1 In terms of the optimal capital structure, whether to borrow and how much to borrow?
2 Where to borrow?
■ Key issues
The issues that determine these decisions are:
■ Gearing ratio. The debt–equity mix selected for overseas activities is influenced by
the gearing of the parent, or by the debt–equity ratios of comparable, competing
firms in the location of the FDI. If the parent guarantees the subsidiary’s borrowing,
so long as the existing gearing of the parent is ‘reasonable’, the subsidiary’s bor-
rowing may be a separate issue, especially if a joint venture is formed and the bor-
rowing of the overseas affiliate can be kept off-Balance Sheet. This enables fuller
exploitation of subsidised loans and lower tax rates.
■ Taxation. MNCs need to examine differences between the treatment of withholding
taxes, losses, interest and dividend payments. Tax deductibility of interest provides
an incentive to borrow locally.
■ Currency risk. Local borrowing can also reduce foreign exchange exposure by
enabling a match of interest and capital repayments against locally-generated cash
inflows denominated in local currency.
■ Political risk. Expropriation of assets or other interference is less likely if the MNC
borrows from local banks or from the international markets. The host government
is unlikely to want to offend the international financial community as it would
damage its own credit standing. If the MNC borrows via the World Bank, it can
include a cross-default clause, so that a default to any creditor automatically trig-
gers default on a World Bank loan.
■ The case for borrowing
■ Less risky than using equity which puts owners’ capital at risk.
■ Debt service is based on a strict schedule, helping cash flow planning and currency
hedging. Dividends are more erratic.
■ Debt service payments are less likely to antagonise host governments. Erratic divi-
dend flows may interfere with a host government’s attempts to manage the exter-
nal value of its currency, especially if the MNC is a major contributor to local GDP.
■ Tax relief on interest.
■ Opportunity to hedge foreign exchange risk by matching.
■ Protection against political risk.
■ Access to concessionary local finance.
■ Overseas equity markets (if they exist) can be highly inefficient.
■ The case against borrowing
■ The parent’s debt–equity ratio may already be high.
■ There may be only limited local borrowing facilities.
■ Local borrowing may entail more intensive credit risk investigation fees, and high-
er interest rates if the MNC has no local credit rating.
■ The host government may place an upper limit on local borrowing to restrict tax
avoidance.
■ Assessment
The balance of argument usually points to borrowing to finance foreign subsidiaries;
indeed braver corporate treasurers may try to exploit perceived disequilibria in global
financial markets to access ‘cheap’ finance. However, the International Fisher Effect
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Chapter 22 Foreign investment decisions 653
(explained in Chapter 21) should caution against this. The benefit of borrowing at ‘low’
interest rates should always (eventually at least) be offset by the appreciation in cur-
rency in which debts are to be repaid.
Yet global markets often ‘overshoot’ – the euro seemed undervalued vs. the US$
during 1999–2002, and sterling looked overvalued vs. the euro during 1999–2002.
Astute treasurers may raise funds denominated in overvalued funds for long maturi-
ties and avoid borrowing in undervalued currencies.
Larger MNCs may set up their own financial subsidiaries as Special Purpose
Vehicles, established largely for the purpose of obtaining the funds required to finance
the entire firm’s ongoing growth needs. This avoids problems over costs and access to
capital in the host country. The SPV simply borrows on world markets using the cred-
it rating of the parent. Firms that use SPVs include General Electric Corporation (via
GE Capital), BMW and Ford.
■ The currency cocktail
There is a strong argument for borrowing in a range or ‘cocktail’ of currencies to spread
the risk over a diversified portfolio of borrowed currencies. By diversifying sources of
finance, the MNC may take advantage of what it perceives as unusually low rates in
certain financial centres. This requires the MNC to be well-known in international
financial markets and to have established, sound banking relationships. Thus a firm
needing to refinance a medium term loan maturing in London where interest rates are
7 per cent may decide to borrow in Japan where interest rates for corporate borrowing
are 2–3 per cent.
To illustrate a currency cocktail, consider British Airways plc (BA). It borrows main-
ly in sterling, accounting for about 60 per cent of its total borrowings at its 2004 year-
end, in US$ (about 20 per cent) and Japanese yen (about 20 per cent). Table 22.5 shows
the composition of group borrowing. Notice that this includes both short-term and
long-term borrowing. It also includes finance leases and hire purchase arrangements,
but excludes accruals and provisions.
Special Purpose Vehicles
An entity set up specifically for
managing a firm’s financial
requirements and obligations
22.14 THE WACC FOR FDI
In Section 22.6, we explained how a project-specific discount rate could be obtained for
a foreign investment. At that point, we were assuming all-equity funding. But what if
the project is partly debt financed? This issue is often highly relevant where foreign
Table 22.5
British Airways plc
borrowings as at 31
March 2004
Currency Amount (m)
Sterling
US$ $1,931
Yen
Total
Source: British Airways Report and Accounts, 2003/20004 (www.ba.com).
£5,716
¥181,738
£3,409
BA explains that ‘Sterling represents our natural “home” currency, whilst a sub-
stantial proportion of the Group’s fixed assets are priced and transacted in US dollars.
The Japanese yen liabilities arise as a result of the Group’s cross-border hire purchase
arrangements entered into during the period 1990–1999.’ Of the total borrowing, about
66 per cent net of swaps and cash carried fixed interest rates and 34 per cent was at
floating rates. The proportion of fixed rate borrowing has risen in recent years, as the
Group elected to focus its early debt repayments on floating rate debt, leaving fixed
rate intact, to take advantage of generally falling interest rates.
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654 Part VI International finance
22.15 APPLYING THE APV TO FDI
Discounting at the WACC implies that all the complex interactions involved in the
investment can be factored into a single discount rate. In no case is this more difficult
than for foreign investment projects that differ from domestic activities in areas such as
taxation, foreign exchange rate variability, concessionary financing and numerous
additional dimensions of risk. This makes FDI a prime candidate for evaluation by the
APV method.
For FDI, the evaluation procedure is:
1 Evaluate the core project assuming it is financed entirely by owners’ equity to find
the base case, as if the project were undertaken in the home country.
2 Separately evaluate the ‘extras’ such as the tax breaks and subsidies offered by the
host government, and any spill-over effects on other activities, e.g. lost export trade.
3
4 Accept the project if the APV is positive.
A simple APV model is shown in Figure 22.5. The APV is defined as the inherent
value of the foreign-located project to the firm’s owners, adjusted for all positive and
negative side effects. For foreign projects, the APV is particularly useful when project
financing differs from the parent firm’s capital structure, but suffers the limitation that
calculation of these side-effects and their associated degrees of risk is difficult in prac-
tice. Inevitably, a high degree of judgement is required.
Calculate APV 3base case NPV PV of extras4
governments offer concessionary interest rates, often prompting a level of local debt
financing well above the parent’s own gearing. The most appropriate solution is to use
a tailor-made WACC calculated to reflect the particular financing mix of the project.
To illustrate this, let us revisit the case of Malaku Mining from page 638. Recall that
it was decided that a local Beta value of 8.75 was appropriate to use, resulting in a proj-
ect-specific equity cost of 8.75 per cent.
Now assume that Malaku can borrow in Indonesia at the concessionary rate of
3 per cent and that local regulations allow it to offset interest charges against local
taxation, paid at 40 per cent. The WACC for the Indonesian mining project is found
in the usual way by weighting the cost of each form of finance by its contribution
to financial structure, in this case, project financing. Now assume that the project is
financed 25 per cent by parental equity and 75 per cent by local borrowing. The
WACC is thus:
This is an interesting result indeed. The combination of low interest rate and high
debt proportion results in a remarkably low required return. These sorts of calcula-
tion, although based on sound CAPM logic, can often generate much lower project
cut-off rates than for comparable UK investment. To many executives, it is inconceiv-
able that high risk, foreign projects should be evaluated at lower discount rates than
UK projects.
Financial managers often have some difficulty in explaining and justifying lower
WACCs to sceptical executives whose natural inclination is to use higher rates for for-
eign projects. The response is that although foreign projects often have higher total
risks, additional risks are usually project- and country-specific, and are thus very dif-
ferent from those affecting UK projects. These risks are best handled in more effective
ways, e.g. by hedging foreign exchange risk, than by simply hiking the discount rate.
Raising the hurdle rate, and possibly excluding an attractive, albeit risky, project is
inferior to a considered policy of risk management.
19.5% 25%2 11.8% 75%2 12.4% 1.4%2 3.8%
19.5% equity weight2 13% 31 40% 4 debt weight2
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