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Discount Rates for International Projects

Discount Rates for International Projects

Which is riskier for an investor in the United States—the Standard and Poor’s Composite Index or the stock market in Egypt? If you answer Egypt, youre right, but only if risk is defined as total volatility or variance. But does investment in Egypt have a high beta? How much does it add to the risk of a diversified portfolio held in the United States?

Table 9.2 shows estimated betas for the Egyptian market and for markets in Poland, Thailand, and Venezuela. The standard deviations of returns in these markets were two or three times more than the U.S. market, but only Thailand had a beta greater than 1. The reason is low correlation. For example, the standard deviation of the Egyptian market was 3.1 times that of the Standard and Poors index, but the correlation coefficient was only .18. The beta was 3.1 × .18 = .55.

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Table 9.2 does not prove that investment abroad is always safer than at home. But it should remind you always to distinguish between diversifiable and market risk. The opportunity cost of capital should depend on market risk.

Now lets turn the problem around. Suppose that the Swiss pharmaceutical company, Roche, is considering an investment in a new plant near Basel in Switzerland. The financial manager forecasts the Swiss franc cash flows from the project and discounts these cash flows at a discount rate measured in francs. Since the project is risky, the company requires a higher return than the Swiss franc interest rate. However, the project is average-risk compared to Roches other Swiss assets. To estimate the cost of capital, the Swiss manager proceeds in the same way as her counterpart in a U.S. pharmaceutical company. In other words, she first measures the risk of the investment by estimating Roches beta and the beta of other Swiss pharmaceutical companies. However, she calculates these betas relative to the Swiss market index. Suppose that both measures point to a beta of 1.1 and that the expected risk premium on the Swiss market index is 6 percent. Then Roche needs to discount the Swiss franc cash flows from its project at 1.1 × 6 = 6.6 percent above the Swiss franc interest rate.

Thats straightforward. But now suppose that Roche considers construction of a plant in the United States. Once again the financial manager measures the risk of this investment by its beta relative to the Swiss market index. But notice that the value of Roches business in the United States is likely to be much less closely tied to fluctuations in the Swiss market. So the beta of the U.S. project relative to the Swiss market is likely to be less than 1.1. How much less? One useful guide is the U.S. pharmaceutical industry beta calculated relative to the Swiss market index. It turns out that this beta has been .36. If the expected risk premium on the Swiss market index is 6 percent, Roche should be discounting the Swiss franc cash flows from its U.S. project at .36 × 6 = 2.2 percent above the Swiss franc interest rate. Why does Roches manager measure the beta of its investments relative to the Swiss index, whereas her U.S. counterpart measures the beta relative to the U.S. index? Risk cannot be considered in isolation; it depends on the other securities in the investors portfolio. Beta measures risk relative to the investors portfolio. If U.S. investors already hold the U.S. market, an additional dollar invested at home is just more of the same. But, if Swiss investors hold the Swiss market, an investment in the United States can reduce their risk. That explains why an investment in the United States is likely to have lower risk for Roches shareholders than it has for shareholders in Merck or Pfizer. It also explains why Roches shareholders are willing to accept a lower return from such an investment than would the shareholders in the U.S. companies.

When Merck measures risk relative to the U.S. market and Roche measures risk relative to the Swiss market, their managers are implicitly assuming that the shareholders simply hold domestic stocks. Thats not a bad approximation, particularly in the case of the United States.16 Although investors in the United States can reduce their risk by holding an internationally diversified portfolio of shares, they generally invest only a small proportion of their money overseas. Why they are so shy is a puzzle.17 It looks as if they are worried about the costs of investing overseas, but we dont understand what those costs include. Maybe it is more difficult to figure out which foreign shares to buy. Or perhaps investors are worried that a foreign government will expropriate their shares, restrict dividend payments, or catch them by a change in the tax law.

However, the world is getting smaller, and investors everywhere are increasing their holdings of foreign securities. Large American financial institutions have substantially increased their overseas investments, and literally dozens of funds have been set up for individuals who want to invest abroad. For example, you can now buy funds that specialize in investment in emerging capital markets such as Vietnam, Peru, or Hungary. As investors increase their holdings of overseas stocks, it becomes less appropriate to measure risk relative to the domestic market and more important to measure the risk of any investment relative to the portfolios that they actually hold.

Who knows? Perhaps in a few years investors will hold internationally diversified portfolios, and in later editions of this book we will recommend that firms calculate betas relative to the world market. If investors throughout the world held the world portfolio, then Roche and Merck would both demand the same return from an investment in the United States, in Switzerland, or in Egypt.

Some countries enjoy much lower rates of interest than others. For example, as we write this the interest rate in Japan is effectively zero; in the United States it is above 3 percent. People often conclude from this that Japanese companies enjoy a lower cost of capital.

This view is one part confusion and one part probable truth. The confusion arises because the interest rate in Japan is measured in yen and the rate in the United States is measured in dollars. You wouldnt say that a 10-inch-high rabbit was taller than a 9-foot elephant. You would be comparing their height in different units. In the same way it makes no sense to compare an interest rate in yen with a rate in dollars. The units are different.

But suppose that in each case you measure the interest rate in real terms. Then you are comparing like with like, and it does make sense to ask whether the costs of overseas investment can cause the real cost of capital to be lower in Japan. Japanese citizens have for a long time been big savers, but as they moved into a new century they were very worried about the future and were saving more than ever. That money could not be absorbed by Japanese industry and therefore had to be invested overseas. Japanese investors were not compelled to invest overseas: They needed to be enticed to do so. So the expected real returns on Japanese investments fell to the point that Japanese investors were willing to incur the costs of buying foreign securities, and when a Japanese company wanted to finance a new project, it could tap into a pool of relatively low-cost funds.

Taken from Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers (7th edition)

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