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Encyclopedic Dictionaryof International Financeand Banking Jae K. Shim Michael Constas St. Lucie Press Boca Raton London New York Washington, D.C.
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Encyclopedic Dictionaryof International Financeand Banking Jae K. Shim Michael Constas St. Lucie Press Boca Raton London New York Washington, D.C.
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Library of Congress Cataloging-in-Publication Data Shim, Jae K. Encyclopedic dictionary of international finance and banking / Jae K. Shim and Michael Constas. p. cm. ISBN 1-57444-291-0 (alk. paper) 1. International finance—Encyclopedias. 2. Banks and banking, International—Encylopedias. 3. International economic relations—Encyclopedias. I. Constas, Michael, 1952- . II. Title. HG3880 .S55 2001 332′ .042′068—dc21 2001001297 This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. A wide variety of references are listed. Reasonable efforts have been made to publish reliable data and information, but the author and the publisher cannot assume responsibility for the validity of all materials or for the consequences of their use. Neither this book nor any part may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, microfilming, and recording, or by any information storage or retrieval system, without prior permission in writing from the publisher. The consent of CRC Press LLC does not extend to copying for general distribution, for promotion, for creating new works, or for resale. Specific permission must be obtained in writing from CRC Press LLC for such copying. Direct all inquiries to CRC Press LLC, 2000 N.W. Corporate Blvd., Boca Raton, Florida 33431. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation, without intent to infringe. Visit the CRC Press Web site at www.crcpress.com © 2001 by CRC Press LLC St. Lucie Press is an imprint of CRC Press LLC No claim to original U.S. Government works International Standard Book Number 1-57444-291-0 Library of Congress Card Number 2001001297 Printed in the United States of America 1 2 3 4 5 6 7 8 9 0 Printed on acid-free paper
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PREFACE WHAT THIS BOOK WILL DO FOR YOU The Encyclopedic Dictionary of International Finance and Banking is written and compiled for working professionals engaged in the fields of international finance, global trade, foreign investments, and banking. It may be used for day-to-day practice and for technical research. The Encyclopedic Dictionary is a practical reference of proven techniques, strategies, and approaches that are successfully used by professionals to diagnose multinational finance and banking problems. The book covers virtually all important topics dealing with multinational business finance, investments, financial planning, financial economics, and banking. It also covers such topics as computers, quantitative techniques and models, and economics as applied to international finance and banking. The Encyclopedic Dictionary will benefit prac- ticing financial analysts, CFOs, controllers, financial managers, treasurers, money managers, fund managers, investment analysts, and professional bankers, among others. The subjects are explained with • Clear definitions and explanations, including step-by-step instructions • Exhibits and statistical data, as needed • Charts, exhibits, and diagrams, where appropriate • Checklists • Practical applications The Encyclopedic Dictionary will enlighten the practitioner by presenting the most current information, offering important directives, and explaining the technical procedures involved in the aforementioned dynamic business disciplines. This reference book will help you diagnose and evaluate financial situations faced daily. This library of international finance and banking will answer nearly every question you may have. Real-life examples are provided, along with suggestions for handling everyday problems. The Encyclopedic Dictionary applies to large, medium, or small multinational companies. It will help you to make smart decisions in all areas of international finance and banking. It should be used as an advanced guide for working professionals, rather than as a reference guide for laymen or a glossary of international finance and banking terms. The Encyclopedic Dictionary is a handy reference for today’s busy financial executive. It is a working guide to help you quickly pinpoint • What to look for • How to do it • What to watch out for • How to apply it in the complex world of business • What to do You will find ratios, formulas, examples, applications, exhibits, charts, and rules of thumb to help you analyze and evaluate any business-related situation. New, up-to-date methods and techniques are included. Throughout, you will find this Encyclopedic Dictionary practical, comprehensive, quick, and useful. In short, this is a veritable cookbook of guidelines, illus- trations, and how-to’s for you, the modern decision maker. The uses of this handbook are as varied as the topics presented. Keep it handy for easy reference throughout your busy day.
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There are approximately 570 major topics in international finance, banking, and investments covered in the Encyclopedic Dictionary, as well as numerous related entries. Where appropriate, there is a cross-reference to another entry to explain the topic in greater detail. The entries are listed in alphabetical order for easy reference. There are approximately 120 examples and 110 exhibits to help explain the material. The Encyclopedic Dictionary is so comprehensive that almost any subject area of interest to financial executives, as well as other interested parties, can be found.
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ABOUT THE AUTHORS Jae K. Shim, Ph.D., is Professor of Business at California State University, Long Beach. He received his M.B.A. and Ph.D. degrees from the University of California at Berkeley (Haas School of Business). He is also Chief Financial Officer (CFO) of a Los Angeles–based multinational firm. Dr. Shim is a coauthor of Encyclopedic Dictionary of Accounting and Finance; Handbook of Financial Analysis, Forecasting, and Modeling; Managerial Accounting; Financial Man- agement; Strategic Business Forecasting; Barron’s Accounting Handbook; Financial Accounting; The Vest-Pocket CPA; The Vest-Pocket CFO, and the best selling Vest-Pocket MBA. Dr. Shim has 45 other professional and college books to his credit. Dr. Shim has also published numerous refereed articles in such journals as Financial Management, Advances in Accounting, Corporate Controller, The CPA Journal, CMA Mag- azine, Management Accounting, Econometrica, Decision Sciences, Management Science, Long Range Planning, OMEGA, Journal of Operational Research Society, Journal of Business Forecasting, and Journal of Systems Management. He was a recipient of the 1982 Credit Research Foundation Outstanding Paper Award for his article on financial management. Michael Constas, Ph.D., J.D., is a Professor of Business at California State University, Long Beach. Before teaching, he was a partner in a major California law firm. Dr. Constas received his Ph.D., J.D., and M.B.A. from U.C.L.A. He has published numerous articles in the area of investments in academic and professional journals. He is a coauthor of The International Investment Source Book (with Dr. Shim). Dr. Constas is an author of Private Real Estate Syndications, which is part of the collections at the libraries of our nation’s leading universities.
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NOTES AND ABBREVIATIONS KEY NOTES 1. This book has the following features: • Plenty of examples and illustrations • Useful strategies and checklists • Ample number of exhibits (tables, figures, and graphs) 2. Foreign exchange rate quotations—direct or indirect—may confuse some readers. Indirect quotes are used more widely in examples throughout the book. 3. Selling forward means “buy a forward contract to sell a given currency,” and buying forward means “buy a forward contract to buy a given currency.” As a matter of terminology, selling forward or buying forward could mean the same transaction. For example, a contract to deliver dollars for British pounds in 180 days might be referred to as selling dollars forward for pounds or buying pounds forward for dollars. ABBREVIATIONS USED IN THIS TEXT A$ Australian Dollar £ British Pound C$ Canadian Dollar DM Deutsche Mark € Euro FFr French Franc IRS Internal Revenue Service ¥ Japanese Yen LC Local Currency MNC Multinational Corporation SFr Swiss Franc ¢ U.S. cent $ U.S. Dollar U.S.$ U.S. Dollar
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A ABSOLUTE PURCHASING POWER PARITY See PURCHASING POWER PARITY. ABSOLUTE RATE An interest rate that is determined without reference to an index or funding base such as LIBOR or U.S. treasury rates. For example, rather than LIBOR + 0.75%, the bid is expressed as 10.375%. ACCOUNTING EXPOSURE See TRANSLATION EXPOSURE. ACCOUNTING FOR MULTINATIONAL OPERATIONS At the beginning of the 21st century, the world economy has become truly internationalized and globalized. Advances in information technology, communications, and transportation have enabled businesses to service a world market. Many U.S. companies, both large and small, are now heavily engaged in international trade. The foreign operations of many large U.S. multinational corporations now account for a major percentage (10 to 50%) of their sales and/or net income. The basic business functions (i.e., finance/accounting, production, management, market- ing) take on a new perspective when conducted in a foreign environment. There are different laws, economic policies, political framework, and social/cultural factors that all have an effect on how business is to be conducted in that foreign country. From an accounting standpoint, global business activities are faced with three realities: 1. Accounting standards and practices differ from country to country. Accounting is a product of its own economic, legal, political, and sociocultural environment. Because this environment changes from country to country, the accounting system of each country is unique and different from all others. 2. Each country has a strong “accounting nationalism.” It requires business companies operating within its borders to follow its own accounting standards and practices. Consequently, a foreign company operating within its borders must maintain its books and records and prepare its financial statements in the local language, use the local currency as a unit of measure, and be in accordance with local accounting standards and procedures. In addition, the foreign company must comply with the local tax laws and government regulations. 3. Cross-border business transactions often involve receivables and payables denom- inated in foreign currencies. During the year, these foreign currencies must be translated (converted) into the local currencies for recording in the books and records. At year-end, the foreign currency financial statements must be translated (restated) into the parent’s reporting currency for purposes of consolidation. Both the recording of foreign currency transactions and the translation of financial state- ments require the knowledge of the exchange rates to be used and the accounting treatment of the resulting translation gains and losses. 1
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2 ACCOUNTING FOR MULTINATIONAL OPERATIONS The biggest mistake a company can make in international accounting is to not be aware of, or even worse, to ignore these realities. It should know that differences in accounting standards, tax laws, and government regulations do exist and that these differences need to be an integral part of formulating its international business plan. A. Accounting for Foreign Currency Transactions International business transactions are cross-border transactions; therefore, two national cur- rencies are usually involved. For example, when a United States corporation sells to a corporation in Germany, the transaction can be settled in U.S. dollars (the seller’s currency) or in German marks (the buyer’s currency). A.1. Transactions Denominated in U.S. Currency When the foreign transaction is settled in U.S. dollars, no measurement problems occur for the U.S. corporation. As long as the U.S. corporation receives U.S. dollars, the transaction can be recorded in the same way as a domestic transaction. EXAMPLE 1 A U.S. firm sells on account equipment worth $100,000 to a German company. If the German company will pay the U.S. firm in U.S. dollars, no foreign currency is involved and the transaction is recorded as usual: Accounts Receivable 100,000 Sales 100,000 (To record sales to German company) A.2. Transactions Denominated in Foreign Currency If the transaction above is settled in German marks, however, the U.S. corporation will receive foreign currency (German marks) that must be translated into U.S. dollars for purposes of recording on the U.S. company’s books. Thus, a foreign currency transaction exists when the transaction is settled in a currency other than the company’s home currency. A foreign currency transaction must be recorded in the books of accounts when it is begun (date of transaction), then perhaps at interim reporting dates (reporting date), and finally when it is settled (settlement date). On each of these three dates, the foreign currency transaction must be recorded in U.S. dollars, using the spot rate on that date for translation. A.3. Accounting at Transaction Date Before any foreign currency transaction can be recorded, it must first be translated into the domestic currency, using the spot rate on that day. For the U.S. company, this means that any receivable and payable denominated in a foreign currency must be recorded in U.S. dollars. EXAMPLE 2 Assume a U.S. firm purchases merchandise on account from a French company on December 1, 20X1. The cost is 50,000 French francs, to be paid in 60 days. The exchange rate for French francs on December 1 is $.20. Using the exchange rate on December 1, the U.S. firm translates the FFr 50,000 into $10,000 and records the following entry: Dec. 1 Purchases 10,000 Accounts Payable 10,000 [To record purchase of merchandise on account (FFr 50,000 × $.20 = $10,000).]
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ACCOUNTING FOR MULTINATIONAL OPERATIONS 3 A.4. Accounting at Interim Reporting Date Foreign currency receivables and payables that are not settled at the balance sheet date are adjusted to reflect the exchange rate at that date. Such adjustments will give rise to foreign exchange gains and losses that are to be recognized in the period when exchange rates change. EXAMPLE 3 Assume the same facts as in Example 2 and that the U.S. corporation prepares financial statements as of December 31, 20X1 when the exchange rate for the French franc is $0.22. The U.S. firm will make the following adjusting entry: Dec. 31 Foreign Exchange Loss 1,000 Accounts Payable 1,000 [To adjust accounts payable to current exchange rate (FrF 50,000 × $0.22 = $11,000; $11,000 − $10,000 = $1,000).] A.5. Accounting at Settlement Date When the transaction is settled, if the exchange rate changes again, the domestic value of the foreign currency paid on the settlement date will be different from that recorded on the books. This difference gives rise to translation gains and losses that must be recognized in the financial statements. EXAMPLE 4 To continue our example, assume that the payable is paid on February 1, 20X2 when the exchange rate for the French franc is $0.21. The settlement will be recorded as follows: Feb. 1 Accounts Payable 11,000 Cash 10,500 Foreign Exchange Gain 500 [To record payment of accounts payable (FrF 50,000 × $0.21 = $10,500) and foreign exchange gain.] To summarize: In recording foreign currency transactions, SFAS 52 adopted the two- transaction approach. Under this approach, the foreign currency transaction has two compo- nents: the purchase/sale of the asset and the financing of this purchase/sale. Each component will be treated separately and not netted with the other. The purchase/sale is recorded at the exchange rate on the day of the transaction and is not adjusted for subsequent changes in that rate. Subsequent fluctuations in exchange rates will give rise to foreign exchange gains and losses. They are considered as financing income or expense and are recognized separately in the income statement in the period the foreign exchange fluctuations happen. Thus, exchange gains and losses arising from foreign currency transactions have a direct effect on net income. B. Translation of Foreign Currency Financial Statements When the U.S. firm owns a controlling interest (more than 50%) in another firm in a foreign country, special consolidation problems arise. The subsidiary’s financial statements are usu- ally prepared in the language and currency of the country in which it is located and in accordance with the local accounting principles. Before these foreign currency financial statements can be consolidated with the U.S. parent’s financial statements, they must first be
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4 ACCOUNTING FOR MULTINATIONAL OPERATIONS adjusted to conform with U.S. GAAP (Generally Accepted Accounting Principles) and then translated into U.S. dollars. Two different procedures may be used to translate foreign financial statements into U.S. dollars: (1) translation procedures and (2) remeasurement procedures. Which one of these two procedures is to be used depends on the determination of the functional currency for the subsidiary. B.1. The Functional Currency SFAS 52 defines the functional currency of the subsidiary as the currency of the primary economic environment in which the subsidiary operates. It is the currency in which the subsidiary realizes its cash flows and conducts its operations. To help management determine the functional currency of its subsidiary, SFAS 52 provides a list of six salient economic indicators regarding cash flows, sales price, sales market, expenses, financing, and intercom- pany transactions. Depending on the circumstances: • The functional currency can be the local currency. For example, a Japanese sub- sidiary manufactures and sells its own products in the local market. Its cash flows, revenues, and expenses are primarily in Japanese yen. Thus, its functional currency is the local currency (Japanese yen). • The functional currency can be the U.S. dollar. For foreign subsidiaries that are operated as an extension of the parent and integrated with it, the functional currency is that of the parent. For example, if the Japanese subsidiary is set up as a sales outlet for its U.S. parent, i.e. it takes orders, bills and collects the invoice price, and remits its cash flows primarily to the parent, then its functional currency would be the U.S. dollar. The functional currency is also the U.S. dollar for foreign subsidiaries operating in highly inflationary economies (defined as having a cumulative inflation rate of more than 100% over a three-year period). The U.S. dollar is deemed the functional currency for translation purposes because it is more stable than the local currency. Once the functional currency is determined, the specific conversion procedures are selected as follows: • If foreign currency is the functional currency, use translation procedures. • If U.S. dollar is the functional currency, use remeasurement procedures. B.2. Translation Procedures If the local currency is the functional currency, the subsidiary’s financial statements are trans- lated using the current rate method. Under this method: • All assets and liabilities accounts are translated at the current rate (the rate in effect at the financial statement date); • Capital stock accounts are translated using the historical rate (the rate in effect at the time the stock was issued); • The income statement is translated using the average rate for the year; and • All translation gains and losses are reported on the balance sheet, in an account called “Cumulative Translation Adjustments” in the stockholders’ equity section. The purpose of these translation procedures is to retain, in the translated financial state- ments, the financial results and relationships among assets and liabilities that were created by the subsidiary’s operations in its foreign environment.
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ACCOUNTING FOR MULTINATIONAL OPERATIONS 5 EXAMPLE 5 Assume that the following trial balance, expressed in the local currency (LC) is received from a foreign subsidiary, XYZ Company. The year-end exchange rate is 1 LC = $.1.50, and the average exchange rate for the year is 1 LC = $1.25. Under the current rate method, XYZ Company’s trial balance would be translated as in Exhibit 1 which shows the translation proce- dures applied to XYZ Company’s trial balance. Note that the translation adjustment is reflected as an adjustment of stockholders’ equity in U.S. dollars. EXHIBIT 1 Translation Procedures XYZ COMPANY Trial Balance 12/31/01 Local Currency U.S. Dollars Debit Credit Exchange Rate Debit Credit Cash LC 5,000 (1 LC = $ 1.50) $7,500 Inventory 15,000 " 22,500 Fixed Assets 30,000 " 45,000 Payables LC 40,000 " $60,000 Capital Stock 4,000 Historical rate 5,000 Retained Earnings 6,000 to balance 10,000 Sales 300,000 (1 LC = $1.25) 375,000 Cost of Goods Sold 210,000 " 262,500 Depreciation Expense 5,000 " 6,250 Other Expenses 85,000 " 106,250 LC 350,000 LC 350,000 $450,000 $450,000 B.3. Remeasurement Procedures If the U.S. dollar is considered to be the functional currency, the subsidiary’s financial statements are then remeasured into the U.S. dollar by using the temporal method. Under this method: • Monetary accounts, such as cash, receivables, and liabilities, are remeasured at the current rate on the date of the balance sheet; • Nonmonetary accounts, such as inventory, fixed assets, and capital stock, are remeasured using the historical rates; • Revenues and expenses are remeasured using the average rate, except for cost of sales and depreciation expenses that are remeasured using the historical exchange rates for the related assets; and • All remeasurement gains and losses are recognized immediately in the income statement. The objective of these remeasurement procedures is to produce the same U.S. dollar financial statements as if the foreign entity’s accounting records had been initially maintained in the U.S. dollar. Exhibit 2 shows these remeasurement procedures applied to XYZ Company’s trial balance. Note that the translation gain/loss is included in the income statement.
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6 ACCOUNTING FOR MULTINATIONAL OPERATIONS EXHIBIT 2 Remeasurement Procedures XYZ COMPANY Trial Balance 12/31/01 Local Currency U.S. Dollars Debit Credit Exchange Rate Debit Credit Cash LC 5,000 (1 LC = $1.50) $7,500 Inventory 15,000 (1 LC = $1.30) 19,500 Fixed Assets 30,000 (1 LC = $0.95) 28,500 Payables LC 40,000 (1 LC = $1.50) $60,000 Capital Stock 4,000 — 5,000 Retained Earnings 6,000 7,000 Sales 300,000 (1 LC = $1.25) 375,000 Cost of Goods Sold 210,000 (1 LC = $1.30) 273,000 Depreciation Expense 5,000 (1 LC = $0.95) 4,750 Other Expenses 85,000 (1 LC = $1.25) 106,250 439,500 447,000 Translation Gain/Loss 7,500 LC 350,000 LC 350,000 $447,000 $447,000 C. Interpretation of Foreign Financial Statements To evaluate a foreign corporation, we usually analyze its financial statements. However, the analysis of foreign financial statements needs special considerations: 1. We often have the tendency of looking at the foreign financial data from a home country perspective. For example, a U.S. businessman has the tendency of using U.S. GAAP to evaluate the foreign financial statements. However, U.S. GAAP are not universally recognized and many differences exist between U.S. GAAP and the accounting principles of other countries (industrialized or nonindustrialized). 2. Because of the diversity of accounting principles worldwide, we have to overcome the tendency of using our home country GAAP to evaluate foreign financial statements. Instead, we should try to become familiar with the foreign GAAP used in the preparation of these financial statements and apply them in our financial analysis. 3. Business practices are culturally based. Often they are different from country to country and have a significant impact on accounting measurement and disclosure practices. Therefore, local economic conditions and business practices should be taken into consideration to correctly analyze foreign financial statements. D. Harmonization of Accounting Standards The diversity of accounting systems is an obstacle in the development of international trade and business and in the efficiency of the global capital markets. Many concerted efforts have been made to reduce this diversity through the harmonization of accounting standards. Also, as international business expands, there is a great need for international accounting standards that can help investors make decisions on an international scale. The agencies working toward the harmonization of accounting standards are:
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ACCOUNTS RECEIVABLE MANAGEMENT 7 D.1. The International Accounting Standards Committee (IASC) The IASC was founded in 1973. At that time, its members consisted of the accountancy bodies of Australia, Canada, France, Ireland, Japan, Mexico, the Netherlands, the United Kingdom, the United States, and West Germany. Since its founding, membership has grown to around 116 accountancy bodies from approximately 85 countries. IASC’s fundamental goal is the development of international accounting standards. It is also working toward the improvement and harmonization of accounting standards and pro- cedures relating to the presentation and comparability of financial statements (or at least through enhanced disclosure, if differences are present). To date, it has developed a conceptual framework and issued a total of 32 International Accounting Standards (IAS) covering a wide range of accounting issues. It is currently working on a project concerned with the core standards in consultation with other international groups, especially the International Orga- nization of Securities Commissions (IOSCO), to develop worldwide standards for all corpo- rations to facilitate multilisting of foreign corporations on various stock exchanges. D.2. The International Federation of Accountants (IFAC) IFAC was founded in 1977 by 63 accountancy bodies representing 49 countries. By 1990, IFAC membership had grown to 105 accountancy bodies from 78 different countries. Its purpose is to develop “a coordinated worldwide accountancy profession with harmonized standards.” It concentrated on establishing auditing guidelines to help promote uniform auditing practices throughout the world. It also promoted general standards for ethics, edu- cation, and accounting management. In addition to the IASC and IFAC, there are a growing number of regional organizations involved in accounting harmonization at the regional level. These organizations include, among others, the Inter-American Accounting Association established in 1949, the ASEAN Federation of Accountants (AFA) established in 1977, and the Federation des Experts Compt- ables Europeens (FEE), created by the merger in 1986 of the former Union Europeenne des Experts Comptables Economiques et Financiers (UEC) and the Groupe d’Etude (GE). D.3. The European Economic Community (EEC) The EEC, although not an accounting body, has made great strides in harmonizing the accounting standards of its member countries. During the 1970s, it began the slow process of issuing EEC directives to harmonize the national accounting legislation of its member countries. The directives must go through a three-step process before they are finalized. First, they are proposed by the EEC Commission and presented to the national representatives of the EEC members. Second, if the proposal is satisfactory to the nations, it is adopted by the commission. Finally, it must be issued by the Council of Ministers of the EEC, before it can be enforced on the members. The most important directives in the harmonization of accounting standards among EEC members are: • The Fourth Directive (1978), regarding the layout and content of annual accounts, valuation methods, annual report, publicity, and audit of public and private company accounts; • The Seventh Directive (1983), regarding the consolidation of accounts for certain groups of enterprises; and • The Eighth Directive (1984), regarding the training, qualification, and indepen- dence of statutory auditors. ACCOUNTS RECEIVABLE MANAGEMENT Accounts receivable management is the strategy used by some MNCs to adjust their accounts receivable (A/R) to reduce currency risk and to optimally time fund transfers. Various hedging alternatives are available, including forward and money-market hedges. Operating and finan- cial strategies can also be used to minimize currency risk exposure. For example, in countries
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8 ACU where currency values are likely to drop, financial managers of the subsidiaries should avoid giving excessive trade credit. If accounts receivable balances are outstanding for an extended time period, interest should be charged to absorb the loss in purchasing power. Note: a net asset position (i.e., assets minus liabilities) is not desirable in a weak or potentially depreci- ating currency. In this case, you should expedite the disposal of the asset. Likewise, you should lag or delay the collection against a net asset position in a strong currency. See also TRANSACTION EXPOSURE. ACU See ASIAN CURRENCY UNIT. ADB See ASIAN DEVELOPMENT BANK. ADJUSTED PRESENT VALUE Adjusted present value (APV) is a type of net present value (NPV) analysis by multinational companies in capital budgeting. A foreign investment project that is financed differently from that of the parent firm could be evaluated using this approach. In APV, operating cash flows are discounted separately from (1) the various tax shields provided by the deductibility of interest and other financial charges and (2) the benefits of project-specific concessional financing. Each component cash flow is discounted at a rate appropriate for the risk involved. Typically, the operating cash flows from the project are discounted at the all-equity rate plus any financing side effects discounted at all-debt rate. Or T CF T FIN APV = −I + ∑-----------------t - + ∑--------------------t - (1 + k)t (1 + kf )t t=1 t=1 where −I = the initial investment or cash outlay, CFt = estimated cash flows in t (t = 1,…T ), k = the discount rate on those cash flows, FINt = any additional financial effect on cash flows, and kf = the discount rate applied to the financial effects. Possible financial effects include the tax shield arising from depreciation charges, subsidies, credit terms, interest savings, or penalties associated with project-specific financing. A project that is financed differently from that of the parent company should be evaluated with APV. For example, consider a parent firm whose capital structure is 60% equity and 40% debt that is evaluating the financial feasibility of a potential foreign subsidiary whose capital structure would be only 40% equity and 60% debt. Discounting the potential subsidiary’s estimated net operating cash flows by the parent’s weighted average cost of capital (WACC) could be inappropriate. APV divides the present value analysis into two components: (1) the operating cash flows which are customarily considered the only relevant cash flows and (2) the financial effects such as interest expense tax shields resulting from the use of debt in the financing of the project. Each component cash flow is discounted by its appropriate cost of all-equity and all-debt discount rates, respectively. EXAMPLE 6 Suppose MYK Gold Miners has an opportunity to enter a small, developing country and apply its new gold recovery technique to some old mines that no longer yield profitable amounts of
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ADJUSTED PRESENT VALUE 9 ore under conventional mining. MYK estimates that the cost of establishing the foreign operation will be $12 million. The project is expected to last for two years, during which period the operating cash flows from the new gold extracted will be $7.5 million per year. In addition, the new operating unit will allow the company to repatriate an additional $1 million per year in funds that have been tied up in the developing country by capital controls. If MYK applies a discount rate of 6% to operating cash flows and 10% to the funds that will be freed from controls, then the APV is: APV = – $12 + $7.5/(1 + 0.06) + $7.5/(1 + 0.06)2 + $1/ 1( + 0.10) + $1/(1 + 0.10)2 = – 12 + 7.5 T4 6%, 2 years( ) + 1T4 10%, 2 years( ) = – 12 + 7.5 1.8334( ) + 1 1.7355( ) = – 12 + 15.49 = 3.49 where T4 = present value of an annuity of $1. (See Table 4 in the Appendix.) Thus, the APV of the gold recovery project equals $3.49 million. The firm can compare this value to the APV of other projects it is considering in order to budget its capital expenditures in the optimum manner. EXAMPLE 7 Am-tel Corporation is an MNC which owns a foreign subsidiary named Ko-tel. It has the following operating cash flows: Year 0 1 2 3 4 5 Operating cash flows −11,000.0 1,274.4 1,881.4 2,578.3 3,378.8 11,343.4 (in thousands) Assume Ko-tel was capitalized with 40% equity capital from Am-tel and the remaining 60% debt, the Am-tel’s capital structure was 40% debt and 60% equity, the cost of debt was 12.12%, the cost of equity was 18%, and U.S. taxes were 34%. The weighted average cost of capital would be: WACC = (0.40) (12.12%) (1 − 0.34) + (0.60) (18%) = 14%. The regular NPV approach yields: NPV = – $11,000.0 + $1,274.4/(1 + 0.14) + $1,881.4/(1 + 0.14)2 + $2,578.3/(1 + 0.14)3 + $2,378/(1 + 0.14)4 + $11,343.4/(1 + 0.14)5 = – $11,000.0 + $1,274.4 T3 14%, 1( ) + $1,881.4 T3 14%, 2( ) + $2,578.3 T3 14%, 3( ) + $2,378 T3 14%, 4( ) + $11,343.4 T3 14%, 5( ) = − $11,000.0 + $1,274.4 0.8772( ) + $1,881.4 0.7695( ) + $2,578.3 0.6750( ) + $2,378 0.5921( ) + $11,343.4 0.5194( ) = – $11,000.0 + $12,197.83 = $1,197.83 where T3 = present value of $1. (See Table 3 in the Appendix.) In contrast, APV would decompose the valuation into the above operating cash flows and the tax shields arising from the use of debt in the foreign subsidiary. The operating cash flows from above would then be discounted by the cost of equity for a similar project undertaken with 100% equity. For illustration purposes here, we use the firm’s current cost of equity: (Continued)
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