A NOTE ON CROSS BORDER VALUATION

    FINC 580 – Ken Shah

    There are two different approaches which, in theory, would give the same value:

    Approach A: Convert foreign currency cash flows to local currency ($) using expected future (forward) exchange rate. Discount at local ($) WACC. This approach assumes Interest Rate Parity holds. There should be an adjustment for political risk.

    Approach B: Foreign currency CF discounted at foreign WACC. This is as if you are doing a normal valuation in a foreign country. Arrive at value in foreign currency, and then use spot exchange rate to get US $ value. Does not assume IRP, and no explicit adjustment for political risk.

Most multinationals use Approach A for valuing investments in emerging

    countries. This requires the estimation of US $ required rates of return for a foreign project/company.

Estimating US $ required rates of return (R) of a foreign project/firm: e

There are two approaches:

    ; Global single factor CAPM

    ; Segmented Markets CAPM

    Global single factor CAPM: Assumes high degree of capital market integration between a local equity market and global equity market. If capital markets are assumed to be integrated globally, then estimation of a (foreign) firm’s beta is done using the global market index. The political risk of a particular country in a globally diversified market portfolio is an unsystematic risk, and is diversified away. Hence, there is no explicit adjustment for political risk of the foreign country in this approach.

R = R +(Beta x EMRP) eflocalFirm GlobalGlobal

    ; Rf is based on local (US) government bonds

    ; Beta and EMRP is estimated using a global market index

    Note: You still need to unlever/relever beta to reflect the intended capital structure (D/E) ratio. Use local tax rate. Also, in WACC, use local tax rate. Cost of debt is in local currency.

This approach is simpler to implement.

    Segmented Markets Approach: Assumes that equity markets are not integrated, especially between developed and emerging countries. Modifies the CAPM as used for local (US) market for two additional effects: political risk (π), and country

    equity market volatility (Beta). Country

R = R + π + (Beta x Betax (EMRP) efCountryFirm)

    ; R and EMRP are in local currency ($) f

    ; Beta is beta for similar companies in local (US) market – again Firm

    unlever/relever to reflect the proper capital structure (D/E).

    ; Political risk premium (π): This adjustment is necessary because using

    local inputs assumes political risk in the local country, not foreign country.

    One measure is the yield spreads between foreign and local government

    bonds.

    ; Country equity market volatility (Beta): This is based on the idea that: Country

    Beta = Beta x Beta ForeignLocalForeign Equities vs. US Equities

    Beta is also called the ‘country beta’ – and is the Foreign Equities vs. US Equities

    measure of correlation between local and foreign equity markets:

    Beta = Covariance (Foreign, Local) / Variance (local) Foreign Equities vs. US Equities

    Beta is beta of similar firms in the local country Local

    In this approach, the cost of debt in WACC should be what the foreign company could borrow in local currency (US $).

    The tax rate applied in this approach is the foreign tax rate, not local tax rate.

    Summary of Approaches:

    Valuing Foreign Investment

    Approach B

    Foreign CF discounted at

    Approach A foreign WACC. Convert Convert foreign CF to value to local currency local currency CF using using spot exchange rate

    forward rates. Discount at

    local WACC. Gives value

    in local currency.

    Re using Global Re using Segmented Single Factor CAPM Market CAPM

    $ WACC $ WACC

    Valuing Foreign Investment