Academy of Economic Studies

Faculty of International Business and Economics

“International Finance and Payments”

Lecture 3:
“Interest rate & the cost of
International Capital”
PhD Professor Cristian PĂUN
Email: cristian.paun@rei.ase.ro
URL: http://www.finint.ase.ro
International portfolio theory - review
• the difference between certainty, risk and uncertainty in international
financing;
• investment decision is based on risk and return profile;
• investors expectations in terms of return are based on their risk
assessment (direct relationship);
• investors associate an utility function to their expected returns;
• we have different risk attitudes;
• modern portfolio theory:
• Markovitz – efficient frontier
• CAPM (W. Sharpe) – beta and market portfolio
• APT (S. Ross) – arbitrage and market equilibrium
• active and passive portfolio management.

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 Interest rate and market equilibrium
• interest rate = compensation required by the investors because they
lend money for a determined period of time;
• interest rate = market equilibrium between demand and supply of
money;
Security price Interest rate
Demand curve Supply curve
950 $ 5.3%
900 $ 11.1%

E
850 $ 17.6%

i=RET=(FV-P)/P

750 $ 33 %

100 bil. 300 bil. 500 bil. Quantity of bonds

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 Shifts in the demand for bonds
• Wealth;
• Expected returns on bonds relative to alternative assets;
• Expected inflation
• Risk of bonds relative to alternative assets;
• Liquidity of bonds relative to alternative assets.

Shifts in the supply for bonds

• Expected profitability of investment opportunities (increase);
• Expected inflation (real cost of financing is falling down);
• Government activities (public deficits).

Fisher effect: when expected inflation rises, interest rates will rise
Liquidity preference framework: BD+MD=BS+MS (Keynes)
(no real assets)

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Shifts in the demand for money
• Income level (increase);
• Price level (increase);

Shifts in the supply for money

• Central Bank expansionary monetary policy;

2. Interest rate and rate of return

- Zero-cupon bond: i=RET=(FV-IP)/IP

- RET=(Pt+1-Pt+I)/Pt = current yield + capital gain

RET – return for holding a security from time t to time t+1
Pt, Pt+1 – prices at moment t and t+1
Interest payments (Coupon or Dividends)

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Real and Nominal Interest Rate
Inominal=Ireal+Inflation

(1+Inominal)=(1+Ireal)x(1+p) - Fisher Effect

Simple and Compounded Interest Rate

Dsimple
Dcompounded = (1 + )Per − 1
Per
Risk Free Interest Rate

RFR=(FVT-Bills-IPT-Bills)/IPT-Bills

100 USD = IP 110 USD = FV

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Risk Structure of Interest Rate
- Default risk = the chance that the issuer of the bond will be unable to
make interest payments or pay off the face value at the maturity;
Aaa → Baa → Caa (Moody’s)
AAA → BBB → CCC → D (S&P)
Ex:
B Companies: Mariott, Revlon
AA Companies: McDonalds, Mobil Oil
AAA Companies: General Electric, Wisconsin Bell
- Liquidity = the capacity of a security to be cheaply and quickly
converted into cash
- Income Tax Consideration: in case of Municipal Bonds vs. T-Bonds

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Term Structure of Interest Rate
- Securities with identical risk, liquidity and income tax characteristics may have
different interest rates because the maturity is different
- Yield Curve plots the yields on bonds with different terms to maturity but
identical risk, liquidity and tax characteristics

US Treasury Yield Curve / November 2004

Date 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr
11/01/04 1.79 1.99 2.20 2.34 2.61 2.89 3.36 3.76 4.11 4.84
11/02/04 1.86 1.97 2.19 2.33 2.60 2.86 3.34 3.75 4.10 4.84
11/03/04 1.83 1.96 2.18 2.32 2.60 2.85 3.35 3.74 4.09 4.83

Yield
Securities with longer maturities Yield Curve
usually have a higher yield. If
short term securities offer a
higher yield, then the curve is
said to be inverted.
Maturity

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 Cost of International Capital
Step 1: Determine the proportions of each source to be raised as capital.

Step 2: Determine the marginal cost of each source.

Step 3: Calculate the weighted average cost of capital.

International Financing Plan

Credit Years Payoffs Interest An RemainK

Value 200000 euro 1 0 0 0 220000
Interest Rate 10% 2 0 0 0 242000
Maturity 5 years 3 80667 24200 104867 161333
Reimboursement equally 4 80667 16133 96800 80667
5 80667 8067 88733 0
290400

A n − C0

1
Current Yield = C0 period
Current Yield = 9.04%
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Cost of International Capital – Time Value of Money

Financing A1 A2 A3 A4 A5
Decision
Moment

- Translating a value back in time

-- referred to as discounting --
requires determining what a
future amount or cash flow is
worth today.
EX: 1000 USD → 1100 USD after 1 y

Inflation rate of 20%

1100 USD = 1100 / (1+p) = 916.6.

USD in present

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Present Value, Net Present Value, Internal Rate of Return
CFn
PV = (4)
(1 + k) n
M
An
NPVinvestment = −I + 
n =1 (1 + k )
n

M
An
NPVfinancing = +C − 
n =1 (1 + k )
n

IRR = k  NPV = 0

• Inflation rate
Discounted Expectations
in terms of • Interest rate
rate
• Estimated profit for an investment project

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Present Value, Net Present Value, Internal Rate of Return
Bonds
Value 500000 euro
Interest Rate 10% Interest rate 10%
Maturity 5 years Discount Rate 9%
Reimboursement equally Current Yield 8.89%
Face Value 10 euro Present Value 551234
Issuing Price 9 euro Net present value -51234
Maturity Price 11 euro IRR 17.80%
Number of Bonds 50000

Years Nb NV Cupons P An Krem Drate Disc An

1 10000 100000 50000 10000 160000 400000 0.9174 146789
2 10000 100000 40000 10000 150000 300000 0.8417 126252
3 10000 100000 30000 10000 140000 200000 0.7722 108106
4 10000 100000 20000 10000 130000 100000 0.7084 92095
5 10000 100000 10000 10000 120000 0 0.6499 77992
Conclusion 1: 700000 551234

Internal Rate of Return is the best measure for the marginal cost of
international financing (real cost is 17.80 instead 10% or 8.89%)

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Comparing credits in different currencies using NPV
€ USD 9.0% 7.0%
Year An An €/USD k(euro) k(USD)
1 160000 160000 1.2 0.91743 0.934579
2 150000 150000 1.3 0.84168 0.873439
3 140000 140000 1.4 0.77218 0.816298
4 130000 130000 1.5 0.70843 0.762895
5 120000 120000 1.6 0.64993 0.712986
TOTAL 700000 700000 1.4

Method I: € USD
Interest rate 10% 10%
- Estimating k(euro)
Discount Rate 7% 8%
- Estimating k(USD) Present Value 579565 565109
- NPVeuro x spot0 = NPVeuroUSD Net present value -129565 -115109

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Comparing credits in different currencies using NPV
€ USD 9.0% 7.0%
Year An An €/USD k(euro) k(USD)
1 160000 160000 1.2 0.91743 0.934579
2 150000 150000 1.3 0.84168 0.873439
3 140000 140000 1.4 0.77218 0.816298
4 130000 130000 1.5 0.70843 0.762895
5 120000 120000 1.6 0.64993 0.712986
TOTAL 700000 700000 1.4

Method II:
- Estimating k(euro) Interest rate 10% 10%
- Estimating exchange rate Discount Rate 7% 8%
Present Value 579565 510088
- Transforming An from USD in €
Net present value -129565 -60088
- Comparing NPV

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 Comparing credits in different currencies using NPV
€ USD 9.0% 7.0%
Year An An €/USD k(euro) k(USD)
1 160000 160000 1.2 0.91743 0.934579
2 150000 150000 1.3 0.84168 0.873439
3 140000 140000 1.4 0.77218 0.816298
4 130000 130000 1.5 0.70843 0.762895
5 120000 120000 1.6 0.64993 0.712986
TOTAL 700000 700000 1.4

Method III (best accuracy):

- Estimating k(euro) € USD
Interest rate 10% 10%
- Estimating k(USD) Discount Rate 7% 8%
- Estimating an average FX rate Present Value 579565 565109
Net present value -129565 -100375
- Transforming NPV from USD in €
- Comparing NPV
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Comparing credits in different currencies using IRR
Method I: Comparing IRR obtained on initial An expressed in different
currencies
€ USD
Year An An €/USD
1 160000 160000 0.9
2 150000 150000 0.95
3 140000 140000 0.87 We have the same
4 130000 130000 0.83 IRR (= 17.8%)
5 120000 120000 0.81
TOTAL 700000 700000 0.872

Method II: Transforming An from USD to Euro and calculating IRR

€ USD
An An €/USD We have different IRR:
160000 144000 0.9 € USD
150000 142500 0.95
140000 121800 0.87
IRR 17.80% 12.25%
130000 107900 0.83 NPV -129565 -100375
120000 97200 0.81
700000 613400 0.872

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NPV Criteria in International Financing
- Easier to be calculated than IRR
- It is difficult to estimate different discount rates for different financial
markets;
- We should take into consideration the exchange rate when we compare
different NPVs;
- NPV encourage big investment projects and discourage big financing
projects.

IRR Criteria in International Financing

• Independent from FX rate;
• It is quite complicated to be estimated;
• In some cases we can’t calculate it (symmetric annuities, positive
annuities).
CONCLUSION 2: When compare different financing alternatives we should
use both two criteria: NPV and IRR
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Cost of Equity
Scenario A:
- Buy – back of stocks after 5 years:
N  Div n PM  N
M
NPV = + IP  N −  −
n =1 (1 + k ) n
(1 + k ) M

NPV = 0  Kstocks
Scenario B: no buy - back

N  Div n 
NPV = + IP  N − 
n =1 (1 + k ) n

Kstocks = (D0/IP)+g (Gordon – Shapiro Model)

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International Financing Plan - summary

Capital Structure Value Weight Cost

Credit 200000 20% 10%
Bonds 500000 50% 17.80%
Stocks 300000 30% 11.53%

WACC = WDebt  (1 − T )  k DEBT + WEquity  k Equity

WACC = 13.27%

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Global CAPM and WACC
Cov(R M , ri )
i =
 2M

Ei Securities with a higher

risk than market risk

Securities with a lower

risk than market risk
WACC
Rm Rm
Risk premium

Rf

βi=1 Beta

Note: the company has the same risk as the global market has

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Capital Structure Optimization

• trying to find new financing resources with a lower cost

according to the risk level of the borrower
• modifying the credit condition in terms of
reimbursement,
• renouncing to the no – payment periods;
• modifying the capital structure;
• different maturities;
• diversifying international your financing;
• search to issue more fixed income instruments.

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