Introduction to Corporate Finance

PART 5: SPECIAL TOPICS

with returns on a worldwide share index. This generates the project’s ‘global beta’. Next, to estimate

the project’s required return, the company should apply the CAPM, multiplying the global market risk

premium times the project’s beta, and adding the risk-free rate. In all likelihood, because a globally

diversified portfolio is less volatile than a portfolio containing only domestic securities, the risk premium

on the global market will be less than the domestic risk premium.

A Japanese car manufacturer decides to build a

plant to make cars for the Australian market. The

company estimates two project betas. The first

calculation takes returns on Australian car shares

and calculates their betas relative to those on the

Nikkei share index. Based on these calculations, the

Japanese company decides to apply a beta of 1.1

to the investment. The risk-free rate of interest in

Japan is 2%, and the market risk premium on the

Nikkei index is 8%, so the project’s required return is

calculated as follows:

Rproject = 2% + 1.1(8%) = 10.8%

The second calculation takes the returns on

Australian car manufacturers and determines

their betas relative to those on a world equity

index. It turns out that Australian car shares are

more sensitive to movements in the world market

than they are to the Nikkei. This leads to a higher

estimate of the project beta, say 1.3. However,

offsetting this effect is the fact that the risk premium

on the world market portfolio is just 5%. Therefore,

the second estimate of the project’s required return

is calculated as follows:

Rproject = 2% + 1.3(5%) = 8.5%

example

5 Why does discounting the cash flows of a foreign investment using the foreign cost of capital,

then converting that to the home currency at the spot rate, yield the same NPV as converting the

project’s cash flows to domestic currency at the forward rate and then discounting them at the

domestic cost of capital?

6 Why is it not surprising to find that the risk premium on the world market portfolio is lower than the

domestic risk premium?

CONCEPT REVIEW QUESTIONS 17-2

SUMMARY

■ Though the major currencies of the world

float freely against each other, many

countries have adopted exchange rate

policies that fix the value of their currency

relative to the currencies of other nations.

■ A currency appreciates when it buys more

of another currency over time. A currency

depreciates when it buys less of another

currency over time.

■ The spot exchange rate applies to

immediate currency transactions, whereas

the forward exchange rate applies to trades

that take place at some future time.

■ The foreign exchange market is the world’s

largest financial market, attracting many

types of participants, including exporters and

importers, investors, hedgers, speculators,

governments and dealers.

LO17.1