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Valuation Measuring and managing the value ofpanies - Koller T.

Koller T., Murrin J. Valuation Measuring and managing the value ofpanies - Wiley & sons , 2000. - 508 p.
ISBN 0-471-36190-9
Download (direct link): valuationmeasuringandmanaging2000.pdf
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To do the forward-rate method, you must use interest-rate parity to forecast future spot foreign exchange rates, and then use the future spot foreign exchange rates to convert predicted foreign currency cash flow into the subsidiary's domestic currency. We will focus on a stream of revenue
Page 343
Exhibit 17.6 English Subsidiary's Forecasted French Revenues
( ZZZZjZZZZZZ^^ ---------
French Euro Forecasted future ? equivalent
revenue spot FX rate, cash revenue
Year (Euro, million) (?/Euroj - (? million)
1 106 .5821 next year ?61.70
2 114 . 5882 2 years ahead 67.05
3 123 . 5948 3 years ahead 73.16
4 119 .60164 years ahead 71.59
5 125 .6055 5 years ahead 75.69
v_________________________________________________________________________________________________________________________________________)
received from France by the English subsidiary. The forecasted Euro revenues are shown in Exhibit 17.6.
The interest-rate parity theory is based on the idea that changes in foreign exchange rates are related to the ratio of expected inflation rates between two countries. Exhibit 17.7 plots the relationship between domestic inflation and domestic interest rates for 47 countries from 1977 to 1981. Inflation often explains most of the difference in nominal interest rates.
Across countries, the interest-rate parity theory is expressed as follows: the expected spot foreign exchange rate in year t, Xft, is equal to the current Exhibit 17.7 Relationship between Inflation and Interest Rates
Average of banks’ lending rate at start of year (percent)
Source: Morgan Guaranty Bank World I manual Markets.
V_____________________________________________________________________________________________________________________________________________/
Page 344
spot rate, X0, multiplied by the ratio of nominal rates of return in the two countries over the forecast interval, t (for a derivation, see Copeland and Weston, pp. 790-8033):
Where, f = The foreign currency d = The domestic currency
To illustrate the theory for a single year, suppose that our English subsidiary can borrow one-year money in Switzerland at a 4 percent nominal interest rate, N, while the borrowing rate in England is 7.1 percent. The spot exchange rate, X0, is 2.673 Swiss francs per pound sterling and the one-year forward rate, X, is 2.5944 Swiss francs per dollar. We can use interest-rate parity to estimate what English borrowing rate a 4 percent borrowing rate in Switzerland is equivalent to:
— (1.04)(2,673 fr./poundts + 2.594 fr./pound?i)
No practical difference exists between borrowing in England at 7.15 percent or in Switzerland at 4 percent, because the Swiss rate is equivalent to 7.15 percent in England. The foreign borrowing rate, when converted to a domestic equivalent rate, is usually close to the domestic rate (unless there are tax implications).
Next, we show how to use interest-rate parity to forecast future spot rates and use that information to convert the French Euro revenues in Exhibit 17.6 to English pounds. Exhibit 17.8 uses U.K. and French data to illustrate. The first two rows are the term structures of interest rates on government debt for England and France. The third row is the ratio of nominal rates. We know from the interest-rate parity theory that the ratio of nominal rates multiplied by the current spot rate (pounds/Euros) provides an estimate of the forward exchange rate.
As indicated in the fifth row, the market is forecasting that the pound will strengthen versus the Euro. The French Euro revenues in line 6 of Exhibit 17.8 are converted to pound revenues (line 7) by using the interest-rate
3 T.E. Copeland and J.F. Weston, Financial Theory and Corporate Policy, 3rd ed. (Reading, MA: Addison-Wesley, 1988).
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Exhibit 17.8 Example of Forecasting Forward Exchange Rates
/----------------------------------------------------------------------------------------------------------------\
1-year 2-year 3-year 4-year 5-year
1. British gilts, Nd 6.5% 6.6 6.7 6.8 6.8
2. French Euros, N| 5.2% 5.4 5.5 5.6 5.7
3. [(1+N<|)/(1+Nf)]* 1.0124 1.02291 1 0345 1.0462 1.0531
4. Spot rate ?/Euro, Xo 0.5750 0.5750 0.5750 0.5750 0.5750
5. Forecasted forward exchange rate, ?/Euro, Xf 0.5821 0.5882 0.5948 0.6016 0.6055
6. Revenues in Euros 106.00 114.00 123.00 119.00 125.00
7. Revenues in ?, 61.70 67.05 73.16 71.59 75.69
V------------------------------------------------------------------------------------------------------------------------------^
parity relationship. Once all revenues and costs of the English subsidiary have been converted to pounds sterling, the result is a complete forecast of the subsidiary income statement and balance sheet in pounds sterling.
Step 3—
Estimate Foreign Currency Discount Rate
To estimate the foreign currency discount rate, the general principle is to discount foreign cash flow at foreign risk-adjusted rates. The fact that a subsidiary is located in a foreign country does not change the definition of the weighted average cost of capital. The two most common errors in setting the WACC are making ad hoc adjustments for risk and using the parent country WACC to discount foreign currency cash flow. Regarding the first point, ad hoc adjustments to the discount rate to reflect political risk, foreign investment risk, or foreign currency risk are entirely inappropriate. As we will explain in Chapter 19, political risk is best handled by adjusting expected cash flow, weighting it by the probability of various scenarios. Foreign currency or foreign investment risk is handled by the spot exchange rate, and is perfectly symmetrical. An equal chance of a gain or a loss of purchasing power exists. It should be clear that if cash flow is predicted in units of the foreign currency, it should be discounted at the foreign country discount rate because this rate reflects the opportunity cost of capital in the foreign country, including expected inflation and the market risk premium.
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