Foreign Investment & Financing Decisions

• Foreign investment decisions involve considering country risk, which includes risks associated with investing in a foreign country such as political or social problems, the risk of government expropriation or nationalization, barriers to free capital flow in and out of the country, lack of infrastructure, etc.
• Currency risk is the risk of financial loss due to adverse movements in foreign exchange rates.
• The steps to follow in evaluating a foreign investment include calculating the risk adjusted discount rate, estimating the future cash flows in the foreign currency, converting the cash flows to a benchmark currency (USD or EURO), calculating the Net Present Value (NPV) in the benchmark currency (USD or EURO), and translating the NPV into Rands using the current spot rate.
• The loan is redeemed for €200,000.
• A loan of €200,000 is received with an interest rate of 6%.
• The after tax cost of debt (IRR) is calculated as 5.1%.
• The first step in the suggested solution is to estimate the after tax financing-related cash flows in the foreign currency.
• A tax benefit of €12,000 is received due to the interest paid.
• An example of a foreign investment decision is Strange Limited contemplating an investment in India.
• The exchange rate used is R15, R15.20, R15.32, R15.38, R15.45, and R15.56.
• The cash flows in the foreign currency are converted to Rands.
• The estimated cash flows associated with Strange Limited's investment in India are: 0, 1, 2, 3, 4 - 800,000,000 INR.
• Current spot exchange rates are: 1 USD = 13.45 ZAR, 1 INR = 0.01392 USD.
• Forecast spot exchange rates are: In 1 years’ time 1 INR = 0.01386 USD, In 2 years’ time 1 INR = 0.01378 USD, In 3 years’ time 1 INR = 0.01374 USD.
• The yield on a note with a maturity close to that of the project life expectation is US treasury note 1.4%.
• The international equity market risk premium is 6%.
• The Indian bond spread relative to US treasury is 2%.
• To calculate the cost of the Euro bond, you can ignore the impact of section 24J of the Income Tax Act in your answer.
• This risk can be hedged using forward exchange contracts, options or futures, but it would drastically increase the cost of the finance.
• Future exchange rates must be predicted and there is a risk that the estimates used in the calculation are incorrect.
• Sensitivity analyses, Monte Carlo analysis, and assigning probabilities to different outcomes can be used to determine the effect of risk on forecast cash flows.
• The steps to follow when estimating the after tax financing-related cash flows in a foreign currency are: 1) Estimate the after tax financing-related cash flows in the foreign currency, 2) Convert the cash flows to Rands, 3) Calculate the after tax cost of debt (IRR).
• You can assume a tax rate of 28% in South Africa.
• The Rand weakens and interest and capital repayments become more expensive.
• One alternative is a Euro bond with a fixed coupon of 6% per annum payable annually in arrears and redeemed at the end of 5 years at par value.
• This risk may be automatically hedged where a company earns foreign income as it allows for the matching of cash flows.
• If foreign currency risk is not hedged, it's important that the company performs additional procedures to explore the effects of risk and uncertainty.
• When performing the financing decision, the effect of expected foreign currency movements should be incorporated in the calculation.
• Vision Limited is currently considering various financing options for a new investment in Germany with a cost of € 200 000.
• The current R:€ exchange rate is R15:€1 and the forecast spot exchange rates are: In 1 years’ time R15.20, In 2 years’ time R15.32, In 3 years’ time R15.38, In 4 years’ time R15.45, In 5 years’ time R15.56.
• Foreign cash inflows can be used to settle the financing cash outflows.
• The required return on the investment is 18.9%.
• Undiversified investment-specific risk is estimated at 3%.
• The country risk premium (Rc) is the investment country bond spread relative to the benchmark bond.
• The net present value (NPV) of the investment is calculated in the benchmark currency (USD or EURO).
• The NPV of the investment is translated into Rands using the current spot rate.
• The risk-adjusted discount rate for Strange Limited is calculated as WACC = (ke x%) + (kd x%).
• A company may consider using foreign finance where local sources of finance are limited or where foreign finance is cheaper than local finance.
• The cost of equity for an international investment is Ke = (Rfg + Rc) + B (Rm – Rf) + Ri.
• The required return on the investment (Ke) is calculated as the sum of the cost of equity for a local investment, the cost of equity for an international investment, the beta coefficient, the market risk premium, and the premium for undiversified investment-specific risks.