lecture 5 International Investment Appraisals

A set of flashcards based on lecture notes about international investment appraisal, covering key concepts and theories related to foreign investment, exchange rates, and project evaluation.

What is International Investment Appraisal?

Checking a Foreign Project

It is the process of using the Net Present Value (NPV) method to see if a business project in another country is worth the cost. It helps managers deal with different currencies and changing money values.

Why do companies invest in other countries?

Reasons for Going Global

1. Market Growth: Finding more customers to buy their products.

2. Higher Returns: Making more money than they could at home.

3. Efficient Resources: Gaining access to cheaper labor, raw materials, or better technology.

4. Spare Capacity: Using machines or workers that aren't busy at home.

What is the Risk of Exchange Rate Fluctuations?

The Money-Value Risk

When you do business abroad, the value of foreign money changes every day. This is a risk because the profit you make in another country might be worth much less when you change it back into your home currency.

What is Purchasing Power Parity (PPP)?

Predicting Future Prices

PPP is a theory that says exchange rates between two countries will change based on their inflation rates. If a country has high inflation (prices go up fast), its currency usually gets weaker.

What is the formula for Purchasing Power Parity?

Calculating the Future Rate

S1 = S0 \times \frac{1 + ih}{1 + if}

• S_1: The expected price of money in the future.

• S_0: The price of money right now (the spot rate).

• i_h: The price increase (inflation) in your home country.

• i_f: The price increase (inflation) in the foreign country.

What is Repatriation and Remittance?

Sending Profit Home

• Repatriation: The act of changing foreign profits back into your own currency.

• Remittances: The actual transfer of those funds from the foreign branch back to the main parent company.

How do you use the Home Currency Approach?

Step-by-Step: The Home Way

This method converts all money into your own currency before doing the math:

1. Estimate: Guess the cash flows in the foreign currency.

2. Predict: Use the PPP formula to guess future exchange rates.

3. Convert: Change the foreign money into your home money using those rates.

4. Discount: Use your home country's discount rate (k_h) to find the total value today.

How do you use the Foreign Currency Approach?

Step-by-Step: The Foreign Way

This method does the math in foreign money first:

1. Estimate: Guess the cash flows in the foreign currency.
2. Find the Rate: Calculate a special foreign discount rate (k_f) using the International Fisher Effect.
3. Calculate NPV: Find the value today using the foreign currency and foreign rate.
4. Convert: Change that final value into your home money using today's exchange rate.

What is the International Fisher Effect formula?

Finding the Foreign Discount Rate

(1 + kf) = (1 + kh) \times \frac{1 + if}{1 + ih}
Use this formula to find the foreign discount rate (k_f) by comparing home interest rates and inflation differences between the two countries.

What is Foreign Direct Investment (FDI)?

Building Abroad

FDI is when a company spends money to build its own physical operations—like factories, offices, or stores—inside another country instead of just trading stocks.

How do you calculate the Basic Net Present Value (NPV)?

The Profit Test

NPV = \sum \frac{CFt}{(1 + k)^t} - I0

• CF_t: Cash you get at time t.
• k: The discount rate (interest/cost of money).
• I_0: The money you spent to start the project.
  If the answer is positive, the project is a good deal!

Direct vs. Indirect Currency Quotes

Reading the Price Tag

1. Direct Quote: The cost of 1 unit of foreign money in your own money (e.g., 1 \text{ USD} = 0.80 \text{ GBP} from a UK view).
2. Indirect Quote: How much foreign money you get for 1 unit of your home money (e.g., 1 \text{ GBP} = 1.25 \text{ USD}).

What are Transfer Pricing and Arbitrage?

Money Strategies

• Transfer Pricing: The price branches of the same company charge each other. It is used to manage taxes between countries.
• Arbitrage: Buying something at a low price in one market and selling it at a high price in another at the same time to make a risk-free profit.

What are Market Makers and Country Risks?

Trading and Safety

• Market Makers: Big banks that are always ready to buy or sell currency. They make money on the 'spread' (price difference).
• **Country Risks