International Business Finance - Research Paper Example

I. Multinational Capital Budgeting A. Introduction This paper aims to evaluate two international investment project to Smith International Hotel Group. By analysing two investment prospects using capital budgeting techniques, the company is given a recommendation as to which one to choose and how to proceed. Also, the advantages and disadvantages of certain capital budgeting techniques have been used in order to provide grounds for the recommendation. B. Capital budgeting analysis i. Cash flow determination Plan A. 600-bedroom Hotel in London. The initial investment for the hotel includes the construction of the building which amounts to 15,000,000 pounds at the end of 2010. Since this hotel is valued at 12,000,000 pounds at the end of the projects life – December 31, 2015, this will be considered as the projects salvage value, since there no specific provisions for the effects of taxes and depreciation on this value. These amounts are all in UK pounds. In order to compute for the annual operating cash flows, revenues have to be determined first. This can be done by multiplying the revenue per unit by the occupancy in volume – average occupancy in percentage multiplied by 600 bedrooms multiplied by 365 days (see Hotel in London Part A in Appendices). The revenue per unit, however is a function of the variable cost – it amounts to full recovery of the variable cost plus 100% of it. Since the variable costs are stated in the current prices, the variable costs, the fixed costs as well as the revenue per unit should be adjusted according to the inflation in the UK, by 1.5% per year (see Hotel in London Schedule 1 in Appendices). After both the total variable costs and the total fixed costs are deducted from the total revenues, the total operating income is derived. Since there is no provision in the case about the effect of the taxes and depreciation on the companys cash flows, the operating income is equal to the annual operating cash flows. These are the annual operating cash flows in their respective years (see Hotel in London Part A in Appendices): 511,560 in 2011, 5,482,857.45 in 2012, 3,275,064.67 in 2013, 2,394,436.17 I 2014, and 1,486,651.93 in 2015. The timing of the cash flows occurrence within the life of the project is very important especially in discounting them later. By adding the cash flows according to their respective years, the total cash flows from UK operations are as follows (see Hotel in London Part B in Appendices): negative 15,000,000 in 2010 as the amount invested in the construction of the building, 511,560 in 2011, 5,482,857.45 in 2012, 3,275,064.67 in 2013, 2,394,436.17 I 2014, and 13,486,651.90 in 2015. Plan B. Health club and spa in Paris. The initial investment for the health club and spa includes the construction of the building which amounts to 20,000,000 Euros at the end of 2010. Since this hotel is valued at 15,000,000 Euros at the end of the projects life – December 31, 2015, this will be considered as the projects salvage value, since there no specific provisions for the effects of taxes and depreciation on this value. These amounts are all in Euros. In order to compute for the annual operating cash flows, revenues have to be determined first. This can be done by multiplying the revenue per unit by the occupancy in volume – average occupancy in percentage multiplied by 500 persons multiplied by 365 days (see Health Club and Spa in Paris Part A in Appendices). The revenue per unit, however is a function of the variable cost – it amounts to full recovery of the variable cost plus 100% of it. Since the variable costs are stated in the current prices, the variable costs, the fixed costs as well as the revenue per unit should be adjusted according to the inflation in France, by 2.8% per year (see Health Club and Spa in Paris Schedule 1 in Appendices). After both the total variable costs and the total fixed costs are deducted from the total revenues, the total operating income is derived. Since there is no provision in the case about the effect of the taxes and depreciation on the companys cash flows, the operating income is equal to the annual operating cash flows. These are the annual operating cash flows in their respective years (see Health Club and Spa in Paris Part A in Appendices): 2,540,445 in 2011, 3,961,619.02 in 2012, 3,378,622.99 in 2013, 3,473,224.43 in 2014, and 2,103,824.73 in 2015. The timing of the cash flows occurrence within the life of the project is very important especially in discounting them later. By adding the cash flows according to their respective years, the total cash flows from French operations are as follows (see Health Club and Spa in Paris Part B in Appendices): negative 20,000,000 in 2010 as the amount invested in the construction of the building, 2,540,445 in 2011, 3,961,619.02 in 2012, 3,378,622.99 in 2013, 3,473,224.43 in 2014, and 17,103,824.73 in 2015. ii. Net present value Net present value is the most preferred method of companies when doing capital budgeting analysis, as well as considered as the most reliable (Brealey, Myers 2003). Because net present value incorporates the timing of the cash flows and the concept of time value of money by discounting them according to a hurdle rate or cost of capital, companies have a better idea of how much value is being contributed to the company by a undertaking a certain project (Brealey, Myers 2003). The rule of thumb for the NPV is to accept projects with positive amounts. Plan A. 600-bedroom Hotel in London. Since the total cash flows are in UK pounds, these amounts have to be converted into US dollars before the net present value to Smith International Hotel Group is computed. The expected spot rate is computed as using the following formula: expected spot rate (USD) = current spot rate (USD) x [(1 + ί USD) / (1 + ί GBP)] where ί USD is the inflation rate in the US at 3.85%, and ί GBP is the inflation rate in the UK at 1.5%. Hence, by using the current spot rate of 1.6723 US dollars per 1 UK pound, the expected spot rates are computed (see Hotel in London Schedule 2 in Appendices). By multiplying this expected spot rate to the total cash flows from the UK operations, the total cash flows available to Smith International Hotel Group is computed. This are then discounted using the 10% cost of capital. The net present value for this project amounts to US$6,750,417.26. Plan B. Health club and spa in Paris. Since the total cash flows are in Euros, these amounts have to be converted into US dollars before the net present value to Smith International Hotel Group is computed. The expected spot rate is computed as using the following formula: expected spot rate (USD) = current spot rate (USD) x [(1 + ί USD) / (1 + ί EURO)] where ί USD is the inflation rate in the US at 3.85%, and ί EURO is the inflation rate in France at 2.8%. Hence, by using the current spot rate of 1.4744 US dollars per 1 Euro, the expected spot rates are computed (see Health Club and Spa in Paris Schedule 2 in Appendices). By multiplying this expected spot rate to the total cash flows from the French operations, the total cash flows available to Smith International Hotel Group is computed. This are then discounted using the 10% cost of capital. The net present value for this project amounts to US$2,854,042.09. iii. Internal rate of return The internal rate of return is also a good method, however, it is less favoured than the NPV method because with this method, it is assumed that the returns are reinvested at the rate of the IRR instead of the required rate of return of investors, which is mostly not the case in the real world. The IRR is higher because of the compounding effect on the assumption of reinvestment using it, instead of using the required rate of return (Brealey, Myers 2003). Therefore, it is considered inferior to the net present value method. The rule of thumb for accepting the project using the IRR method is to accept projects that have IRR higher than the cost of capital, and reject those that do not. Both projects have IRRs higher than 10%: Plan A with 17.27% and Plan B with 12.75%. iv. Payback method The weakest among the four methods is the payback period, which measures the length of time before the initial investment is recoup with the annual cash flows, without reference to the concept of time value of money. Because the payback method does not include the concept of the time value of money in its computation, the price of money or the opportunity cost in the form of interest rate is not included (Brealey, Myers 2003). Therefore, from the financial management perspective, it is the weakest form of investment appraisal method. The payback period for Plan A is 4 years and 10 months, while 4 years and 7.9 months for Plan B. C. Conclusion and recommendation Smith International Hotel Group is deciding between two projects outside the United States. This involves a capital budgeting decision. In order to analyse the companys prospects, cash flows from the projects must be determined first in the respective currency that the country Smith intends to operate in is using. After the cash flows have been determined, the expected spot rates have to be determined using the US inflation rate and the inflation rate in the countries it aims to operate in. This is to offset the differences that inflation brings to each currencies using the purchasing power parity concept. Then, capital budgeting techniques are applied such as the NPV, IRR and payback period in order to make the decision between the two projects. Plan A has a higher NPV with US$6,750,417.26 than Plan Bs US$2,854,042.09. Plan As IRR is also higher at 17.27% than Plan Bs 12.75%. However, Plan Bs payback is shorter than that of Plan As, at 4 years and 7.9 months than Plan Bs 4 years and 10 months. Smith International Hotel Group must pursue Plan A, and build a 600-bedroom hotel in London. NPV and IRR as decision criteria are stronger than the payback method; by choosing this option the hotel project will bring a higher value to the company. II. Hedging Techniques A. Introduction In this age of globalisation, many companies conduct businesses in countries other than their own. With opportunities in new markets come various types of risks—business risks, macro environmental risks, as well as foreign exchange risks (Pattichis et al. 2004). This paper discussed different kinds of hedging techniques to minimise the risk that fluctuations in currency can bring the business. B. Body i. Why manage transaction exposure Transaction exposure occurs when the firm engages in different transactions that require the use of another currency, and where the time frame before the transaction is completed may result in drastic changes in foreign exchange rates which could affect the respective budgets of the company (Collier & Davis 1985). When firms engage in these transactions, such as a purchase of material from another country with a different currency, these transactions normally complete after a certain period. By the time the period completes, the fluctuation in foreign exchange rates can have an impact on the contract price of the transaction (Collier & Davis 1985). In order to avoid these instances, managing foreign exchange risk is crucial. Firms manage transaction exposure by using foreign currency derivatives (Williams 2004). In the United Kingdom, there are five types of derivative instruments that are used—the over the counter forwards, futures, over the counter options, exchange options, and swaps (Mallin et al. 2001). In a study by Mallin et al., OTC forwards is the most commonly used for hedging currency risks, followed by OTC options, and then swaps (2001). ii. Hedging with options As discussed earlier, one of the techniques multinational companies protect themselves from foreign exchange risks is by hedging with options, especially a put option is more commonly used, especially when a domestic company bets on the fall of the value of the foreign currency in the country where it operates in (Makar & Huffman 2008). In the case of Smith International Hotel Group which plans to either enter the United Kingdom or France, the company has to protect itself against fluctuations on the UK pound and the Euro relative to the US dollar. A put option gives the holder the “right to sell an asset at a specified exercise price on or before the exercise date (Brealey, Myers, Marcus 2004, 642).” When the foreign currency falls, it takes more of the foreign currency units to be converted to the domestic currency. This is where the transaction exposure comes in, and what managers tend to avoid. In order to hedge against the fall in values of the sterling and the Euro, Smith International Hotel Group can buy put options on the currencies. This gives the company the option to sell or convert the currencies into dollars at a pre-set price; if ever either the sterling or the Euro falls in value, the supposed amount will be converted into the dollar amount according to the pre-set price, which will not distort the companys revenues and profits amount due to the fluctuation (Demirag & De Fuentes 1999). iii. Hedging with forwards/futures contract Forwards are “custom-tailored future contracts (Brealey, Myers, Marcus 2004, 673).” If an option gives its holder an option to buy or sell a specific asset at an exercise date according to the exercise price, futures is a “firm promise to deliver the [asset] at a fixed selling price (Brealey, Myers, Marcus 2004, 669).” Thus, in hedging foreign currency risks, futures/forwards are more commonly used. This is how forwards work in the case of Smith International Hotel Group: in order to protect the company from fluctuations of either the value of pounds or Euros, the company can enter an agreement with a bank in those countries and enter a forward contract with it. What is included in the agreement is a fixed amount of dollars per Euro or pound, depending on the date the company wishes to exercise the contract. Thus, the companys position is hedged against the fluctuations in the currencies. iv. Hedging with currency swaps Hedging with currency swaps is another technique to hedge against transaction risks. Currency swaps work by exchanging debt obligations among firms where the base currencies are different. This is how it works – Smith International Hotel Group can borrow dollar notes in the United States. The company then finds itself a counter-party, another company either in France or the UK which it can enter a swap agreement with. Under this agreement, Smith agrees to pay the counter-party in pounds or in Euros where the counter party agrees to pay Smith dollars at a certain time. If the pound or Euro falls in value, each profit dollar in the UK or France will bring fewer dollars to Smith International Hotel Group. With the help of this swap, it costs Smith fewer dollars than what it loses if the Euro or pounds fall in value. Like other derivatives, using swap has its share of advantages and disadvantages. One of these advantages include the benefit of hedging for a longer time, which is usually not available to options and futures/forwards because they are short-lived, or at a specified period of time (Williams 2004). However, the major disadvantage of using swap is that the foreign exchange risks are translated into counter-party risks, where the other company might default on paying a companys debt obligations (Williams 2004). C. Conclusion When companies have investments outside their home countries, these investments are usually exposed to foreign exchange risk. Transactional risks, or foreign exchange risk arising from transaction exposure have more direct effect on the profitability of the company. Because of the lag before transactions are completed, the fluctuation in the foreign exchange rate can have a significant effect on the contract price of the transaction. In order to minimise these risks, they have to be managed. Common techniques in hedging against these risks include foreign currency options, forwards, and currency swaps. Smith International Hotel Group may choose the derivative according to the preferences of its managers when it comes to risk management. Using one or more of these techniques ensure managers to focus more on the viability of international projects rather than be influenced by risks associated with fluctuations in the currencies. III. Appendices A. Hotel in London B. 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