Investment Analysis with Inflation and Exchange Rate Risk

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• Investment Analysis with Inflation and Exchange
  Rate Risk

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Boeing 747 What about exchange rate risk?

• A substantial portion of Boeings cash flows on
  the Super Jumbo will come from sales to foreign
  airlines. Assuming that the price is set in U.S.
  dollars, this exposes Boeing to exchange rate
  risk. Should there be a premium added on to the
  discount rate for exchange rate risk? (Should we
  use a cost of capital higher than 9.32?)
• Yes
• No

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Should there be a risk premium for projects with
substantial foreign exposure?

• The exchange rate risk may be diversifiable risk
  (and hence should not command a premium) if
• the company has projects is a large number of
  countries (or)
• the investors in the company are globally
  diversified.
• For Boeing, it can be argued that this risk is
  diversifiable.
• The same diversification argument can also be
  applied against political risk, which would mean
  that it too should not affect the discount rate.
  It may, however, affect the cash flows, by
  reducing the expected life or cash flows on the
  project.
• For Boeing, this risk too is assumed to not
  affect the cost of capital. Any expenses
  associated with protecting against political risk
  (say, insurance costs) can be built into the cash
  flows.

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Equity Analysis The Parallels

• The investment analysis can be done entirely in
  equity terms, as well. The returns, cashflows and
  hurdle rates will all be defined from the
  perspective of equity investors.
• If using accounting returns,
• Return will be Return on Equity (ROE) Net
  Income/BV of Equity
• ROE has to be greater than cost of equity
• If using discounted cashflow models,
• Cashflows will be cashflows after debt payments
  to equity investors
• Hurdle rate will be cost of equity

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Dealing with Expected Inflation in Project
Analysis

• To incorporate expected inflation into the
  estimates of future cash flows.
• To estimate cash flows in real terms, and to
  discount these real cash flows at real discount
  rate.
• Real cash flownNominal cash flown
• 1/(1Expected inflation rate)n

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A New Store for the Home Depot

• It will require an initial investment of 20
  million in land, building and fixtures.
• The Home Depot plans to borrow 5 million, at an
  interest rate of 5.80, using a 10-year term
  loan.
• The store will have a life of 10 years. During
  that period, the store investment will be
  depreciated using straight line depreciation. At
  the end of the tenth year, the investments are
  expected to have a salvage value of 7.5
  million.
• The store is expected to generate revenues of 40
  million in year 1, and these revenues are
  expected to grow 5 a year for the remaining 9
  years of the stores life.
• The pre-tax operating margin, at the store prior
  to depreciation, is expected to be 10 for the
  entire period.

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Interest and Principal Payments
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Net Income on The Home Depot Store
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The Hurdle Rate

• The analysis is done in equity terms. Thus, the
  hurdle rate has to be a cost of equity
• The cost of equity for the Home Depot is 9.78.
  Since the Home Depots investments are assumed to
  be homogeneous, the cost of equity for this
  project is also assumed to be 9.78.

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ROE on this Project
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From Project ROE to Firm ROE

• As with the earlier analysis, where we used
  return on capital and cost of capital to measure
  the overall quality of projects, we can compute
  return on equity and cost of equity to pass
  judgment on whether a firm is creating value to
  its equity investors.
• Boeing Home Depot InfoSoft
• Return on Equity 7.58 22.37 33.47
• Cost of Equity 10.58 9.78 13.19
• ROE - Cost of Equity -2.99 12.59 20.28

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Additional Assumptions

• Working capital is assumed to be 8 of revenues
  and the investment in working capital is at the
  beginning of each year. At the end of the project
  life, the working capital is fully salvaged.
• At the end of the project life, the book value of
  the store is assumed to be equal to the salvage
  value.

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An Incremental CF Analysis
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NPV of the Store
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Estimate of Expected Inflation

• To derive the expectation from the market by
  using the interest rates on the treasury bond and
  the inflation-indexed treasury bond.
• Inflation-indexed treasury bond is a government
  bond that guarantees a real interest rate rather
  than a nominal rate.
• Expected inflation(1nominal T.Bond
  Rate)/(1Inflation-Indexed T.Bond Rate)
• Real Cost of Equity(1nominal cost of
  equity)/(1expected Inflation)-1
• Deflation factorn1/(1expected inflation rate)n

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The Consistency Rule for Cash Flows

• The cash flows on a project and the discount rate
  used should be defined in the same terms.
• If cash flows are in one currency, the discount
  rate has to be estimated in that currency.
• If the cash flows are nominal (real), the
  discount rate has to be nominal (real).
• If consistency is maintained, the project
  conclusions should be identical, no matter what
  cash flows are used.

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From Nominal to Real The Home Depot

• To do a real analysis, you need a real cost of
  equity or capital
• Nominal cost of equity for The Home Depot 9.78
• Expected Inflation rate (1.05/1.0291)-12.03
• Real Cost of Equity (1.0978/1.0203)-1 7.59
• To estimate cash flows in real terms
• Real Cash flowt Nominal Cash flowt / (1
  Expected Inflation rate)t

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Nominal versus Real
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Dealing with Inflation

• In our analysis, we used nominal dollars and
  pesos. Would the NPV have been different if we
  had used real cash flows instead of nominal cash
  flows?
• It would be much lower, since real cash flows are
  lower than nominal cash flows
• It would be much higher
• It should be unaffected

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Internal Rate of Return The Home Depot Store
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Analyzing Foreign Projects

• To consider whether the discount rate we will use
  for these projects needs to be adjusted to
  include the additional risk associated with
  foreign projects, and if so, how to make that
  adjustment.
• To decide whether to present the cash flows in
  domestic currency terms or foreign currency
  terms, and how to forecast exchange rates to make
  this conversion.

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Parity Conditions for Exchange Rates

• Purchasing power parity
• The relationship between expected inflation and
  exchange rate changes
• International Fisher Effect
• Relationship between nominal interest rates in
  two markets and expected exchange rate changes
• Interest rate Parity
• Relationship between forward rate and spot rate

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Estimating Discount Rates for Foreign Projects

• Sources of Project Risk
• Additional variability in earnings created by
  unanticipated movements in exchange rates
• For firms with globally diversified stockholders
  or investments in multiple countries, we can
  argue with some justification that exchange risk
  is diversifiable, and should not command a
  premium.
• For firms with primarily domestic or
  undiversified stockholders. Exchange rate risk
  may require additional compensation and higher
  hurdle rates.
• The risk associated with any additional
  volatility in the foreign markets, in both
  political and economic terms, relative to the
  firms own domestic market.
• More difficult to diversify away.

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The Home Depot A New Store in Chile

• It will require an initial investment of 4700
  million pesos for land, building and fixtures.
  The Home Depot plans to borrow 1880 million
  pesos, at an interest rate of 12.02, using a
  10-year term loan.
• The store will have a life of 10 years. During
  that period, the store will be depreciated using
  straight line depreciation. At the end of the
  tenth year, the investments are expected to have
  a salvage value of 2,350 million pesos.
• The store is expected to generate revenues of
  7,050 million pesos in year 1, and these revenues
  are expected to grow 12 a year for the remaining
  9 years.
• The pre-tax operating margin at the store, prior
  to depreciation, is expected to be 6 for the
  entire period.
• The working capital requirements are estimated to
  be 10 of total revenues, and investments will be
  made at the beginning of each year.

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The Home Depot Chile Store Cashflows in Pesos
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The Home Depot Chile Store Cost of Equity in
Pesos

• Cost of Equity for a U.S. store 9.78
• Estimating the Country Risk Premium for Chile
• Default spread based on Chilean Bond rating
  1.1
• Relative Volatility of Chilean Equity to Bond
  Market 2.2
• Country risk premium for Chile 1.1 2.2
  2.42
• Cost of Equity for a Chilean Store (in U.S. )
• 5 0.87 (5.5 2.42) 11.88
• Assume that the expected inflation rate in Chile
  is 8 and the expected inflation rate in the U.S.
  is 2.
• Cost of Equity for a Chilean Store (in Pesos)
• (1 Cost of Equity in ) (1
  inflationChile)/ (1 inflationUS) - 1
• 1.1188 (1.08/1.02) -1 18.46

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NPV in Pesos
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Converting Pesos to U.S. dollars

• This entire analysis can be done in dollars, if
  we convert the peso cash flows into U.S. dollars.
• If you want the analysis to yield consistent
  conclusions, expected exchange rates have to be
  estimated based upon expected inflation rates
• Current Exchange Rate 470 pesos
• Expected Ratet Exchange Rate (1
  inflationChile)/ (1 inflationUS)
• Expected Exchange Rate in year 1 470 pesos
  (1.08/1.02) 497.65

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Analyzing the Project U.S. Dollars
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NPV in U.S. Dollars