(2011-S2) - FINS3616 - Tutorial Slides - Week 09

5/20/2018 (2011-S2) - FINS3616 - Tutorial Slides - Week 09

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FINS3616

Week 9


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Russia suffered a currency and stock crisis in 1998 that drove the dollar

value of Russian stocks down to 10% of their pre-crash value. The crash

caught investors by surprise, including hedge fund managers

specializing in emerging markets. One hedge fund manager was

quoted as saying:

If Russia had taken over a plant belonging to General Motors, the

government would have done something about it Essentially, the

Russian government has confiscated Western capital, and nobody is

doing anything about it

Is the risk of a market crash in an emerging economy a political risk or

a financial risk? Explain.

2FINS3616 Peter Kjeld Andersen


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There is not always a clear distinction between political and

financial risks. Indeed, financial risks often result from political

decisions. In Russias case, the financial risks of investment in Russian have

been acerbated by the inability of the Russian government to

es a s an en orce aws an regu a ons or e or er y con uc

of business.

,

economic, financial country risk ratings in Russia.

,

manager clearly holds the Russian government responsible for his

losses.



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Suppose the systematic risk of a domestic investment is:

i = iW (i /W), where iW = 0.4 is the correlation between

domestic asset returns and world market returns, = 0.2 is the

standard deviation of domestic asset returns, and W = 0.1 is the

standard deviation of the world market return.

A comparable foreign asset has fiW = 0.3 and fi = 0.3.

the domestic asset?



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a) Is the total risk of the foreign asset more or less than that of

the domestic asset?

More. Total risk is measured b standard deviation, and the

foreign asset has the higher standard deviation.

b) What about the systematic risk?

i = iW i W = . . . = .

i

domestic = iW

(i/

W) = (0.4)(0.2/0.1) = 0.8.

Therefore, the foreign asset also has the higher systematic

risk.



6/26

You work for an Israeli company that is considering an

investment in China. The investment yields after-tax Chinese

Yuan cash flows (in millions) as follows:

OUTLAY YEAR 1 YEAR 2 YEAR 3

-CNY 600 CNY 200 CNY 500 CNY 300

The required return for this risk class is iILS = 15% in Israel new

. .

Expected inflation is 6% in shekels and 3% in Yuan. Risk-free

. .

Bank bonds are risky and yield 6.09% in Yuan.

e spo exc ange ra e s 0 = . .



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Assume the international parity conditions hold. Calculate the

present value of the investment by using the Chinese discount

rate and then converting into Shekels at the current spot rate.

( ) ( ) ( )

CNY

0 1 2 3

200 500 300600

1 0.11745 1 0.11745 1 0.11745V = + + +

+ + +

CNY194.39m=

ILS CNY CNY ILS/CNY

0 0 0|V i V S =

. . .



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Q. Assume the international parity conditions hold. Convert

the cash flows at expected future spot rates, and then find

the present value using the Israeli discount rate.

A. First, calculate the expected future spot rates

/1 0

1[ ]1

LS

ILS CNY

CNYE S S

+= = +

( )10.5526 1.06 1.03 ILS 0.5687/CNY=

( )2

2[ ] 0.5526 1.06 1.03 ILS 0.5853/CNYE S = =

30.5526 1.06 1.03 ILS 0.6023/CNYE S = =



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Once we have the expected spot rates, we find the expected ILS

value of the cash flows.

= = = =

CFs in CNY CNY 600 +CNY 200 +CNY 500 +CNY 300

St / E[St] ILS 0.5526/CNY ILS 0.5687/CNY ILS 0.5853/CNY ILS 0.6023/CNY

CFs in ILS ILS 331.56 +ILS 113.74 +ILS 292.63 +ILS 180.69

ILS

0 1 2 3

113.74 292.63 180.69

331.56V = + + +

. . .

ILS 107.42 million=



10/26

You currently live in the Land-of-Leisure (currency is the L), and you are

considering investment in a shop in a foreign country called Land-of-Work

(currency is W). Financial markets are perfect and the international parity

. .

the following information.

LEISURE WORK

Nominal Risk Free 0% 50%

Real Required Return on Risk Free 0% 0%

Expected inflation 0% 50%

The spot exchange rate is W100/L.



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Real Re uired Return on Risk Free 0% 0%


Real Required Return on Shops 10% 10%

a) What is the nominal required return on print-shop projects in L. And in

W?nom real = + +

This is the Fisher equation.

( ) ( )L L Lnom reali 1 i 1 1= + + ( ) ( )1 0.10 1 0.00 1= + + 0.10 or 10%=

11FINS3616 Peter Kjeld Andersennom real

i 1 i 1 1= + + 1 0.10 1 0.50 1= + + 0.65 or 65%=


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Real Re uired Return on Risk Free 0% 0%


Real Required Return on Shops 10% 10%

b) Identify the expected future spot rates for the next two years.t

WW/L W/L

t 0 LE S S

1 =

+

W150/L=

1W/L

11.50E S W100/L W150/L

1.00 = =


W/L

2

1.50E S W100/L W225/L1.00

= =

W225/L=


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c) We have the following information about the project:

It will last two years

The land for the shop costs W200,000 and will maintain its realvalue, before being

.

Building the shop will cost another W200,000, which will be straight-line

depreciated over two years to a salvage value of zero. The shop will have zero

market value at the end of two years.

No investment in working capital is necessary.

. ,

per year.

Variable costs are 20% of sales. Fixed costs are W45,000 in the first year and growwith inflation.

Income and capital gains taxes in both countries are 50%.

.



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Identify the expected future cash flows in W on the investment

project. Discount them using the W discount rate and convert

them back at the spot rate.

Investment cash flows (initial outlays)

Terminal cash flows



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OCF Calculation: YEAR 1

600,000

YEAR 2

900,000Revenue

120,000

45,000

180,000

67,500

Less: Variable Costs

Less: Fixed Costs

100,000

335,000

100,000

552,000

Less: Depreciation

= EBIT

,

167,500

100,000

,

276,250

100,000

= NOPAT

Add Back: Depreciation

W267,500 W376,250= Operating Cash Flows



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Investment Cash Flows (Land) 200,000

Investment Cash Flows (Plant) 200,000

Operating Cash Flows 267,500 376,250

Terminal Cash Flows (Land) 450,000

Terminal Cash Flows (Tax on Land) 125,000

Net Cash Flow in W -W400,000 W267,500 W701,250

( ) ( )

W W

0 1 2

, ,V | i W400,000

1 0.65 1 0.65= + +

+ +

,=

L W W19,697= =


W/L

0S


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Investment Cash Flows (Land) 200,000

Investment Cash Flows (Plant) 200,000

Operating Cash Flows 267,500 376,250

Terminal Cash Flows (Land) 450,000

Terminal Cash Flows (Tax on Land) 125,000

Net Cash Flow in W -W400,000 W267,500 W701,250

( ) ( )

L L

0 1 2

, . , .V | i L4,000

1 0.10 1 0.10= + +

+ +

=L197



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CHAPTER 14 PROBLEM 6

Q. Consider the investment in China from problem 14.1.

Suppose each cash flow generated by the project must be

loaned to the China Construction Bank for one year at a zeropercent interest rate?

At what uan rate should ou discount these blocked funds?

What is the present value of the blocked funds in yuan?



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A. The funds are invested with the China Construction Bank, so the

appropr a e oppor un y cos o cap a s e r s y an ra e o .

percent.

flows (in particular, the initial investment) from the analysis. Following the

threeste rocedure from the text:

a) The present value of blocked funds assuming they are not blocked is:

CNY200m CNY500m CNY300m

( ) ( ) ( )0 1 2 3

1 0.0609 1 0.0609 1 0.0609= =

+ + +

.

value of blocked funds is really only:

CNY200m CNY500m CNY300m

19FINS3616 Peter Kjeld Andersen( ) ( ) ( )

0 2 3 4

1 0.0609 1 0.0609 1 0.0609+ + +

.


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c) The opportunity cost of the blocked funds is the difference between

pro ec va ue w an w ou e oc e un s:

SIDE EFFECT PROJECT WITH SIDE EFFECT PROJECT WITHOUT SIDE EFFECTV V V=

CNY 833.26m CNY 844.01m=

CNY 50.75m=



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Q. Consider the investment in China from problem 14.1. China

Construction Bank is willing to provide you with a non-

amortizing loan of CNY 600m at their borrowing rate of6.09% per annum payable over 3 years.

If ou were to finance the ro ect locall in China our

borrowing rate would be 8.15% per annum.

effective tax rate is 40% in both China and Israel.



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A. There are several steps:

I. Work out how much cash interest expense you save per annum by

financing through the subsidy rather than through your actual

(CNY600m)(0.08150.0609)(10.4) = CNY7.416 million.

. .

The after-tax market cost of debt is (8.15%)(10.4) = 4.89% in yuan.

. e presen va ue o a ree-year annu y o . m on

discounted at the after-tax yuan discount rate of 4.89% is:

( ) n

0

1 1 rPV CF

+= =

( ) 3

1 1 0.04897.416

+= CNY 20, 237,306


.


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Q. Consider AGAIN (omg!!!) the investment in China from

problem 14.1. The Chinese government insists that you build

an airport near this project at a cost of CNY 100million.Should you still accept the project?

A. V0CNY = CNY 194.39 million without the side effect.

The air ort ro ect reduces this value b CNY100 million but the NPV with

the side effect is still positive (CNY 94.39 million).

You should accept the project even if the Chinese authorities are notwilling to renegotiate.



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Q. Consider the investment in China from problem 14.1.

Suppose that in any given year there is a 10 % chance that

the Chinese government will expropriate your assets.

If your assets are expropriated in a particular year, then you

will not receive that ears or an later ears cash flow from

your investment. This risk is diversifiable and hence does not

What is the NPV of this asset in shekels, assuming the

n erna ona par y con ons o an e requ re re urns

are iILS = 15% and ICNY = 11.745% are the after-tax discount

rates.



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A. The expropriation risk in Problem 14.9 differs from that in the

chapters Neverland project because there is a probability of

expropriation in each year, rather than just at the end of theproject.

Once ex ro riated ou will not receive an later cash flows

from your investment. This can be represented with a decision



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A.

( ) ( ) ( )

CNY

0 1 2 3

200 0.9 500 0.9 300 0.9V 600

1 0.11745 1 0.11745 1 0.11745

= + + +

+ + +

CNY

0V 42.15m=

( ) ( )ILS CNY0V | i CNY 42.15m ILS 0.5526 / CNY= = ILS 23.29m

SIDE EFFECT PROJECT WITH SIDE EFFECT PROJECT WITHOUT SIDE EFFECTV V V=

= . .

CNY 152.24m=


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(2011-S2) - FINS3616 - Tutorial Slides - Week 09