Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 22 Foreign investment decisions 655
Investing in Indonesia: at a crossroads
Indonesia’s judiciary unnerves foreign investors – again
Once more Indonesia’s notoriously corrupt courts have struck a blow to the government’s efforts
to woo foreign investors. In a reprise of its 2002 verdict against Manulife, a Canadian insurer,
Jakarta’s commercial court has declared bankrupt Prudential Life Assurance (PLA), the local unit
of Prudential, Manulife’s British rival, even though no one denies that the firm is solvent.
The judges ignored PLA’s rude health and invoked a bizarre article in the bankruptcy law
that allows a company to be declared bankrupt regardless of its financial condition if it refuses
to settle its debts. The company is alleged to owe 365.8 billion rupiah ($42.4 m) to a
Malaysian agent, Lee Boon Siong, mainly for claimed loss of future earnings. Mr Lee says that
his contract was ended nine years prematurely without good reason.
PLA has suspended its operations and is hurriedly filing an appeal with the supreme court.
The company describes the suit as baseless, but refuses to discuss it in detail. Whatever the
merits of Mr Lee’s claim and of allegations of judicial graft, the wider considerations bode ill
both for Prudential and for Indonesia’s stuttering economic recovery.
If the court-appointed administrator is able to secure access to the company’s assets, many
millions of dollars of policyholders’ money could be at risk. PLA claims that last year alone its
premiums from new policies topped 1 trillion rupiah ($11.6 m).
On the national level, the continuing legal uncertainty and accompanying endemic corrup-
tion are driving investors away in droves: Indonesia is the only country in the region recording
negative foreign direct investment. The speed with which Indonesian government ministers
and legislators rallied to support Prudential demonstrates their desperation to resolve what is
unquestionably a deep embarrassment for them. But they have only themselves to blame.
In the wake of the Manulife saga an amendment was proposed to the existing laws to
transfer the power to declare companies bankrupt from the courts to the financial regulators.
This legislation is, however, still buried in the ministry responsible for drafting legislation and
Continued
NPV of remittable after-
tax cash flows
PV of tax savings from
capital allowances
PV of tax savings from
interest deductibility
PV of subsidies
and grants
PV of spillover effects
on other activities
APV = NPV of basic project Plus/Minus PV of financing benefits, etc.
ACCEPT IF APV IS POSITIVE
APV =
+
+
+
+
Figure 22.5
A simple APV model
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656 Part VI International finance
This chapter has examined the strategic motivations that drive firms to enter foreign
markets, and methods of effecting entry, in particular, direct investment. Evaluating
FDI is a complex process that differs in several important respects from evaluation of
home country investment, not least the exposure to FX rate variations. As a result, FDI
evaluation is more art than science, especially as it involves so many unquantifiable
aspects such as the prevailing political mood of the host country, assessing political
and other country risks and devising appropriate safeguards. Clearly, this topic tran-
scends purely financial strategy.
Key points
■ Foreign direct investment (FDI) may be undertaken for a variety of strategic rea-
sons: for example, globalisation of component sources or meeting the threat of a
competitor already based overseas.
■ FDI is generally undertaken when exporting (with relatively high variable costs,
but low fixed costs) becomes more expensive than overseas production (with rela-
tively high fixed costs but low variable costs).
■ In principle, the evaluation of FDI is similar to the evaluation of ‘domestic’ investment.
■ In practice, FDI may be complicated by factors such as concessionary access to local
finance, difficulties in repatriating profits and differential inflation rates.
SUMMARY
Further reading
Interesting and comprehensive texts on international business strategy and operations are
Daniels and Radebaugh (2004) and Rugman et al. (1985). The texts by Eiteman et al. (2003),
Shapiro (2004) and Madura (2005) all focus more closely on multinational business finance, each
devoting several chapters to foreign investment. Special issues of Managerial Finance (Wilson,
1990; Shao, 1996) were devoted to the evaluation of overseas investment, while Holland’s con-
tribution to Firth and Keane (1986) is clear and concise. Prasad (1987) reports on a survey of
there are few signs of its being unearthed soon. Even if it were, parliament’s sloth has resulted
in such a backlog of work that legislators are unlikely to find time for the amendment in the
next six months.
Ironically, the Prudential affair has erupted just as Jakarta’s stock exchange is hitting new
highs almost daily and when government bonds are several times oversubscribed. Interest in
making money in Indonesia thus clearly exists, but mainly in ways that avoid the courts and
come with a simple exit strategy.
Source: The Economist, 8 May 2004.
Self-assessment activity 22.8
List eight ways in which MNCs can lower political risk.
(Answer in Appendix A at the back of the book)
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Chapter 22 Foreign investment decisions 657
MNC motivations to invest in Ireland, while Madura and Whyte (1990) discuss the diversifica-
tion benefits of foreign direct investment.
Buckley (1996) is probably the most comprehensive text on overseas capital budgeting.
The World Investment Report, published each September by UNCTAD (www.unctad.org) is a
mine of information of patterns and trends in FDI.
Excellent analyses of operating exposure can be found in Lessard and Lightstone (1998) and in
Grant and Suenen (2004).
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658 Part VI International finance
QUESTIONS
Questions with a coloured number have solution in Appendix B on page 720.
1 The USD vs. GBP exchange rate is $1.50 vs. A UK MNC operating in the US plans to sell goods worth $100
million at today’s prices to US customers. Show that its GBP revenue in real terms will not be affected if PPP
applies under each of the following conditions:
(i) UK and US inflation at 5% p.a.
(ii) UK inflation 5%, US inflation 2%.
(iii) UK inflation 2%, US inflation 5%.
2 OJ Limited is a supplier of leather goods to retailers in the UK and other Western European countries. The
company is considering entering into a joint venture with a manufacturer in South America. The two compa-
nies will each own 50 per cent of the limited liability company JV (SA) and will share profits equally. £450,000
of the initial capital is being provided by OJ Limited, and the equivalent in South American dollars (SA$) is
being provided by the foreign partner. The managers of the joint venture expect the following net operating
cash flows which are in nominal terms:
Predicted future rates
SA$ 000 of exchange to £ sterling
Year 1 4,250 10
Year 2 6,500 15
Year 3 8,350 21
For tax reasons, JV (SA), the company to be formed specifically for the joint venture, will be registered in
South America.
Ignore taxation in your calculations.
Assume you are a financial adviser retained by OJ Limited to advise on the proposed joint venture.
Required
(a) Calculate the NPV of the project under the two assumptions explained below. Use a discount rate of 16
per cent for both assumptions, and express your answer in sterling.
Assumption 1: The South American country has exchange controls which prohibit the payment of divi-
dends above 50 per cent of the annual cash flows for the first three years of the project. The
accumulated balance can be repatriated at the end of the third year.
Assumption 2: The government of the South American country is considering removing exchange controls
and restrictions on repatriation of profits. If this happens, all cash flows will be distributed
as dividends to the partner companies at the end of each year.
(b) Comment briefly on whether or not the joint venture should proceed based solely on these calculations.
(CIMA)
3 PG plc is considering investing in a new project in Canada that will have a life of four years. Initial investment
is C$150,000, including working capital. The net cash flows that the project will generate are C$60,000 per
annum for years 1, 2 and 3 and C$45,000 in year 4. The terminal value of the project is estimated at C$50,000,
net of tax.
The current spot rate for C$ against the pound sterling is 1.70. Economic forecasters expect the pound to
strengthen against the Canadian dollar by 5 per cent per annum over the next four years. The company eval-
uates UK projects of similar risk at 14 per cent per annum.
Required
Calculate the NPV of the Canadian project using the following two methods:
(i) Convert the foreign currency cash flows into sterling and discount at a sterling discount rate.
(ii) Discount the cash flows in C$ using an adjusted discount rate that incorporates the 12-month forecast spot rate.
(CIMA)
£1.
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Chapter 22 Foreign investment decisions 659
4
Kay plc, a UK-based chemical firm but with plants in Germany and the Netherlands, manufactures man-made
fibres. It would like to expand its exports to Latin America and the country of Copacabana, in particular.
However, Copacabana is unable to pay in Western currency and its own currency, the poncho, is subject to
rapid depreciation, due to high local inflation. One solution to this problem is an arrangement whereby Kay
manages and pays for the construction of a fibres plant and accepts payment in the form of the finished prod-
uct of fibres (a so-called buyback).
Construction will take two years and expenditures can be treated as four equal half-yearly payments of
10 million ponchos at today’s prices, beginning in six months’ time. The plant will have a 15-year life, but will
attract no local investment incentives. The inflation rate in Copacabana is expected to average 20 per cent p.a.
over the construction period. The current exchange rate of the poncho vs. sterling is 1:4 and inflation in the
UK has recently averaged 5 per cent.
The fibres produced and taken as payment can be traded on world markets, probably in Europe, where the
present price is ;500 per tonne. Kay is not prepared to accept payment in this way for more than five years. The
expected production rate of the plant is 20,000 tonnes per annum, and Kay would take 40 per cent of this in
payment.
The current euro vs. sterling rate is per £1, and sterling is expected to depreciate by 5 per cent per
annum prior to joining the euro bloc.
Further information
■ The project will be financed by equity only.
■ Kay is at present debt-free. Its shareholders seek a return of 20 per cent p.a. for projects of this degree of risk.
■ Profits from the operation will be taxed at 30 per cent when repatriated to the UK. Assume no delay in tax
payment. All development costs will qualify for UK tax relief.
■ Any losses will be carried forward to qualify for tax relief.
■ There will be no tax liability in Copacabana.
Required
Determine whether Kay should undertake this project.
5 Brighteyes plc manufactures medical and optical equipment for both domestic and export sale. It is investigat-
ing the construction of a manufacturing plant in Lastonia, a country in the former Soviet bloc. Initial discussions
with the Ministry of Economic Development in Lastonia have met with favourable response, providing the proj-
ect can generate a 10 per cent pre-tax return. Shareholders look for a return of 15 per cent in real terms.
The investment will be partly import-substituting and partly export-based, selling to neighbouring coun-
tries. The project has been offered a local tax holiday, exempting it from all taxes for the first ten years, except
for cash remittances, for which a 20 per cent withholding tax will apply. Modern factory premises on an indus-
trial estate with convenient road and rail links have been offered at a reasonable rent.
The initial investment will be £10 million in plant, machinery and set-up costs, all payable in sterling by
the parent company. Additional funds will come from a bank loan of 20 million latts, the local currency
negotiated with a local bank, at a concessionary rate of interest of 10 per cent p.a. This will be
used to finance working capital. Operating cash flows, the basis for calculating tax, are estimated at L10 mil-
lion in Year 1 and L22 million thereafter until year 5.
The whole of the parent’s earnings after payment of local interest and taxation will be repatriated to the
UK. The Lastonia withholding tax is to be allowed as a deduction before calculating the UK Corporation Tax,
currently at the rate of 30 per cent. All transfers can be treated as occurring on the final day of each account-
ing period, when all taxes become due.
The new venture is expected to ‘cannibalise’ exports that Brighteyes would otherwise have made to neigh-
bouring countries, resulting in post-tax cash flow losses of million in each of years 2 to 5. For planning
purposes, year 5 is the cut-off year, when the realisable value of the plant and equipment is estimated at
L24 million. The working capital will be realised, subject to losses of L2 million on stocks and L2 million on
debtors. Funds realised will be used to repay the local borrowing, and the balance transferred to the UK with-
out further tax penalty or restriction.
The exchange rate is forecast to remain at L4 vs. until year 2, when the Latt is expected to fall to L5 vs.
Required
(i) Is the project acceptable from the Lastonian Ministry’s point of view?
(ii) Is it worthwhile from the viewpoint of the foreign subsidiary?
(iii) Does it create wealth for Brighteyes’ shareholders?
£1.£1
£0.5
14 latts £12,
;1.60
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660 Part VI International finance
6 Palmerston Plc operates in both the UK and Germany. In attempting to assess its economic exposure, it
compiles the following data:
■ UK sales are influenced by the euro’s value as it faces competition from German suppliers. It forecasts
annual UK sales based on three possible scenarios:
Euro:sterling exchange rate Revenue from UK business
1.65:1
1.60:1
1.55:1
■ Revenues from sales made in Germany are expected to be
■ Expected cost of goods sold is from UK materials purchases, and ;200 m from purchases in
Germany.
■ Estimated cash fixed operating expenses are
■ Variable operating expenses are estimated at 20 per cent of total sales value including German sales trans-
lated into sterling).
■ Palmerston is financed entirely by equity and shareholders require a return of 15 per cent p.a.
Required
(i) Construct a forecast cash flow statement for Palmerston under each scenario.
(ii) Value Palmerston’s equity under each scenario, assuming a ten-year operating time horizon. Ignore
terminal values.
(iii) Suggest how Palmerston might restructure its operations to lower its sensitivity to exchange rate
movements.
Ignore taxation.
7 A professional accountancy institute in the UK is evaluating an investment project overseas in Eastasia, a
politically stable country. The project involves the establishment of a training school to offer courses on inter-
national accounting and management topics. It will cost an initial 2.5 million Eastasian dollars (EA$) and it
is expected to earn post-tax cash flows as follows:
Year 1 2 3 4
Cashflow (EA$000) 750 950 1,250 1,350
The following information is available:
■ The expected inflation rate in Eastasia is 3 per cent a year.
■ Real interest rates in the two countries are the same. They are expected to remain the same for the period
of the project.
■ The current spot rate is EA$2 per sterling.
■ The risk-free rate of interest in Eastasia is 7 per cent and in the UK 9 per cent.
■ The company requires a sterling return from this project of 16 per cent. (CIMA)
Required
Calculate the sterling net present value of the project using both the following methods:
(a) by discounting annual cash flows in sterling,
(b) by discounting annual cash flows in Eastasian $.
£1
£50 m p.a.
£120 m p.a.
£120 m p.a.
£220 m
£215 m
£200 m
Inspect the Report and Accounts for a company of your choice, to examine how its international profile of activities
has changed over the years. You may find difficulty in obtaining a full set of accounts reaching very far back in time,
but examination of a sample should give you a flavour of the company’s policy regarding internationalisation.
Look also at the chairman’s statements to glean an indication of the importance attached to overseas operations
in the company’s strategy.
Practical assignment
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Review and behavioural finance
23
Market inefficiencies prove we’re only human
Investors have an insatiable appetite for information.
Company announcements, macro economic variables
and the latest political news are just some of what
they digest on a daily basis. It is almost impossible for
investors to assimilate and process the information
tidal wave of data that faces them every day. But this
does not have to be a problem for market efficiency.
Classical economics tells us that market efficiency is
not driven by the activities of one participant but
rather the overall effect of many self-serving individuals
– Adam Smith’s invisible hand.
More information should increase transparency and
promote efficiency. However, evidence suggests this is
not happening in the stock market. Factors such as
cheap valuations or earnings upgrades turn out to have
predictive power for future share price movements.
This runs counter to the concept of efficient markets
where all information should already be reflected in
the price.
An increasingly persuasive explanation for market
inefficiency comes from the field of behavioural
finance. Not only do individuals make mistakes
when analysing masses of data but, more funda-
mentally, they all seem to make the same mistakes.
Errors are therefore magnified rather than negated
by the combined efforts of many market partici-
pants. Faced with complex financial decisions,
investors often employ heuristics, or rules-of-thumb,
when making decisions. Heuristics can be useful in
everyday life, but these inbuilt tendencies are too
blunt a tool for the complex environment of finan-
cial decision-making.
Source: Based on article by James Hand and Greg Davies, Financial Times,
25 October 2004, p. 6.
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Most readers will be familiar with the popular board game Monopoly. There is more
than a passing resemblance between this game and corporate finance. Both are about
maximising investors’ wealth in risky environments, making investment decisions
with uncertain payoffs, raising finance and managing cash flow. Players and managers
must stick to the rules of governance and seek to devise appropriate investment, financ-
ing and trading strategies to gain competitive advantage. While rational analysis and
sound judgement are essential, there remains room for sentiment, psychology, fun, and,
to make the game interesting, a generous portion of luck!
Some aspects of finance, particularly routine finance decisions, can be opera-
tionalised through clear rules and procedures. But good managers look for something
more than rules and procedures. They seek to understand:
1 Why managers behave as they do.
2 Why firms behave as they do.
3 Why markets, in particular financial markets, behave as they do.
Theories of finance provide explanations for the behaviour of individuals, firms
and markets. The better the theory, the better we understand how finance operates.
Throughout the book we have sought to combine the ‘why’ with the ‘how’ in the the-
ory and practice of finance. By way of revision, we will introduce readers to the main
financial principles covered.
■ Understanding individual behaviour
To understand how organisations function we must first understand individual
behaviour. There are many models of human behaviour (e.g. sociological, psycholog-
ical and political); we shall restrict our examination to two models of most relevance
to finance.
The first is the traditional economic model of human behaviour. Here the manager
is seen as a short-run wealth maximiser. The model is a useful starting point in study-
ing finance because it offers a simple approach to model building, using only the pur-
suit of wealth as a goal. Much of the argument underlying the theories discussed in
this book is based on this model. But we all know that this is a poor explanation of
many aspects of human behaviour. For many people, and in many situations, money
may not come before morality, honesty, love, altruism or having fun. As the song said
‘Money can’t buy me love’.
This leads us to develop a more realistic model of human behaviour which Jensen
and Meckling (1994) term the resourceful, evaluative, maximising model (or REMM).
This model assumes that people are resourceful, self-interested maximisers, but rejects
the notion that they are only interested in making money. They also care about respect,
power, quality of life, love and the welfare of others. Individuals respond creatively to
opportunities presented, seeking out opportunities, evaluating their likely outcomes,
and working to loosen constraints on their actions.
662 Chapter 23 Review and behavioural finance
23.1 INTRODUCTION
This book has presented the theory and practice of modern financial management. This
final chapter summarises the main principles of finance underpinning the book and
develops several key areas, specifically those relating to behavioural finance.
23.2 REVIEW OF MAIN PRINCIPLES IN FINANCE
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Neither of the above models place much emphasis on psychological factors in
human information processing and decision-making. This growing area of finance,
termed behavioural finance, is discussed in a later section.
To sum up the foregoing discussion, money is not the only, or even the most impor-
tant, thing in life. But when all else is equal, we act in a rational economic manner,
choosing the course of action that most benefits us financially. Two fundamental con-
cepts naturally follow.
Managers should only consider present and future costs and benefits
in making decisions
This is the principle of incrementalism – only the additional costs or benefits resulting
from a choice of action should be considered. For example, expenditures already incurred
are not relevant to the decision in hand; they are sunk costs.
Choices often involve trade-offs, denying the possibility of other alternatives. The
opportunity cost of making one decision is the difference between that choice and the
next best alternative.
Most managers are risk averse
Most managers are risk averse; given two investments offering the same return, they
would choose the one with least risk. Unlike the risk-seeker or gambler, most managers
try to avoid unnecessary risks. Risk aversion is a measure of a manager’s willingness
to pay to reduce exposure to risk. This could be in the form of insurance or other ‘hedg-
ing’ devices. Alternatively, it could be by preferring a lower-return investment because
it also has a lower risk.
In business, risk and the expected return are usually related. Rational managers do
not look for more risk unless the likely benefits are commensurately greater. This is the
principle of risk aversion. One way in which investors can reduce risk is by spreading
their capital across a range (portfolio) of investments. This is the principle of
diversification, or not putting all your eggs in one basket. However, the key to risk
management should not simply be to reduce it, but to take decisions in a risky business
environment that create value.
■ Understanding corporate behaviour
A firm may be viewed as a collection of individuals and resources. More precisely, it is
a set of contracts that bind individuals together, each with his or her own interests and
goals. As we have seen, agency theory explores the relationship between the principal
(e.g. owner) and the agents responsible for taking actions on his or her behalf (e.g.
board of directors). It follows that, to understand how firms behave, we must under-
stand the nature of the contracts and monitoring procedures.
Information is not usually available to all parties in business in equal measure. For
example, the board of directors will know more about the future prospects of the busi-
ness than the shareholders, who have to rely on published information. This
information asymmetry means that the investors not only listen to the board’s rheto-
ric and confident projections, but also examine the information content in its corpo-
rate actions. This signalling effect is most commonly seen in the reaction to dividend
declaration and share dealings by the board. An increase in dividends signals that the
company is expected to be able to sustain that level of cash distribution in the future,
because it is regarded as the height of corporate financial incompetence to be forced to
cut a dividend. Similarly, when directors increase their shareholdings, the odds are
that this is favourable information (although the asymmetry factor appears here also,
insofar as share sales are not necessarily dire warnings. For example, directors could
Chapter 23 Review and behavioural finance 663
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664 Chapter 23 Review and behavioural finance
be selling to fund personal expenditures such as refurbishments to a country home, or
to finance a messy divorce. Both rationalisations were used by prominent directors in
2004–5.)
Value is created by investing in wealth-creating opportunities. The firm should
invest in those areas in which it has some competitive advantage, giving rise to superi-
or returns or positive net present value when cash flows are discounted at the rate of
return commensurate with the perceived level of risk. Options have value. An option
is the right, but not the obligation, to do something – usually to buy or sell assets. A firm
will only exercise its right if it adds value to the business. This time, the more risky the
option, the more valuable it is, because only the ‘good news’ is taken up. The convert-
ible loan stock instrument is one example of options in business. ‘Convertibles’ begin
as a loan, but at some point may be converted into ordinary shares of equity. The
investor can decide at that point whether to take up the option to convert, and this
option has a value.
Financing decisions that change the capital structure do not affect the value of the
firm – at least in perfect markets. Value is independent of capital structure just as long
as the total cash flows of the firm’s assets are unaffected. In practice this is unlikely to
be the case because borrowing creates a valuable tax shield for the firm.
■ Understanding how markets behave
To make sound financial decisions consistently, we need to understand how financial
markets operate.
Money has a time-value
Fundamental to the study of financial management is the principle of the time-value of
money. Put simply, we cannot add current and future money together in a meaningful
way without first converting into a common currency. This currency can be either pres-
ent (i.e. today’s) value or future value. The value of money changes with time because
it has an alternative use (opportunity cost): it can be invested somewhere in financial
markets to earn a rate of interest.
Non-diversifiable risk matters
The only risk that really matters is that which cannot be diversified away. The Capital
Asset Pricing Model argues that the required return on an asset is commensurate to the
amount of non-diversifiable risk. While some may question the validity of this model,
it is still probably the best we have and this distinction between diversifiable and non-
diversifiable risk is important.
Capital markets are efficient
In an efficient market, the prices of financial assets, such as those of stocks and shares,
reflect all available information and adjust quickly to new information. There are degrees
of market efficiency and, in Chapter 2, we considered the efficiency of the London
Stock Exchange together with its implications. Many of the theories discussed in the
book assume that capital markets are reasonably efficient in reflecting all available
information.
The exact form of market efficiency in financial markets in developed and develop-
ing countries has been the subject of much debate and research. For major European
stock markets, however, the consensus is that they exhibit efficiency in both weak form
(i.e. share prices contain all past data and superior returns cannot be consistently
achieved from trading rules based on past stock market data) and semi-strong form
(i.e. share prices contain all publicly available information, and superior returns can-
not consistently be achieved from trading rules based on such information).
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