19.1. THE LINK BETWEEN CAPITAL-MARKET SEGMENTATION AND THE
SEQUENCING OF DISCOUNTING AND TRANSLATION 709
flows. In short, although the natural input data are cash flow forecasts expressed in
foreign currency, in principle we have to make the translation from foreign currency
to home currency before we can discount. To what extent would it be acceptable,
instead, to discountfccash flows at afcrate, and then to translate thefcPVinto
hcusing just the current spot rate? After all, this is the way a local investor goes
about the valuation.
This type of valuation in foreign currency, as if the owner were a host-country
investor, is correct if the host- and home-country financial markets are integrated,
that is, if there are no restrictions on cross-border portfolio investment between
the two countries and if investors effectively hold many foreign assets. Indeed. the
implication of market integration is that all investors, regardless of their place of
residence, use the same cost of capital when they compute the price of any given
asset (in some given common currency) from the expected cash flows of this asset
(expressed in the same common currency). One way to explain this claim is by
contradiction. If investors from countries A and B used a different cost of capital
when computing the price of some given asset (in some given base currency) from
the asset’s expected cash flows (measured in the same base currency), then the price
of the asset in country A would differ from the price of the same asset in country
B. The resulting arbitrage opportunities would lead to international trading in the
shares until the price difference disappeared. By equating prices across countries,
international arbitrage also equates the costs of capital that various investors use
when linking the asset’s price to the expected cash flows paid out by the asset.^1
Thus, in integrated markets, a home-country investor and a host-country investor
fully agree about the project’s value.
In the perfect-markets approach of Chapter 4, perfected integration was taken for
granted. But in the case ofFDIinto emerging countries it is not always obvious that
integration is a reasonable approximation, even though restrictions are gradually
being abolished in many countries. The problem is that in segmented markets one
cannot simply value a foreign cash flow as if it were owned by host-country investors.
In the absence of free capital movements, there is no mechanism that equates prices
and discount rates across the two markets. Thus, to the managers of the parent firm,
the relevant question becomes: What price would home-country investors normally
be prepared to pay for the project? As we saw, the way to proceed is to identify cash
flow patterns that have similar risks and that are already priced in the home-country
capital market. Once we have identified a similar asset that is already priced in the
home capital market, we can then use the same discount rate for the project that
(^1) Investors that are not willing to pay a high price then sell to others that are. Portfolio re-
balancing also modifies the risk: the risk of holding Samsung shares is very different depending
whether this company represents 90 % of one’s portfolio versus just 0.1% of a well-diversified pack-
age of securities. So reducing the weight of one asset, and replacing it by others that offer more
diversification, lowers required returns for that asset and increases the price one is willing to pay
for it. In the end, when both domestic and foreign investors hold very similar portfolios, required
returns would converge.