Foreign exchange exposure in private investment projects

Foreign exchange exposure in private investment projects M Bailing Indexes of profitability of investment projects can be very sensitive to the assumptions made with respect to future ~n~a~on and exchange rates. No theory can provide a firm basis of exchange-rate forecasts. The problems involved in incorporating inflation and exchange-rate risk in project appraisal are discussed. Keywords: exchange rates, investment, project management, pro~tabi~i~, in~ation

Corporate managers and directors with responsibilities for investment decisions need information. Brevity of that information is essential, because their time is scarce. This puts the project analysts in a difficult position because projects can be very complex. Owing to the increased volatility of exchange rates and high and unstable inflation rates, this conflict is more serious today than it has been in the past. The work of the project analyst can be described as a process of collecting, analysing and concentrating information to enable the decision-makers to make the best possible evaluation of the desirability of the investment projects in view of the goals of the corporation. Concentration of information must necessarily decrease complexity and leave out information that the analyst considers to be of secondary importance. All investment projects carry risks. The financial results of the projects are usually exposed to unanticipated negative deviations in many underlying variables. The decision-makers should always be informed by their analytical staff about the risks involved. Two types of risk will be dealt withexchange rate risk and inflation risk. Because they are interrelated to some extent, they are discussed simultaneously. Graduate School of Business Administration, Aarhus, Denmark This paper was presented at Internet 82’ in Copenhagen, September 1982

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In a small open economy with inflation problems such as Denmark’s almost all business firms are affected by exchange rate changes. Not only does this apply to the firms with branches or subsidiaries abroad and to the many thousands of exporting and importing firms, but also to the firms operating only in the domestic market. Owing to the relative size of foreign trade and national differences in inflation rates, domestic markets and prices for goods, services and factors of production depend strongly on the development in the foreign exchange market. In an environment such as the Danish economy, the analysis of the expected outcome of most long-term business projects must accordingly rest on assumptions made with respect to the future course of inflation and exchange rates. Inflation and exchange rates have fluctuated greatly in the past ten years, and can be expected to continue to fluctuate in the future. Quantitative measures of project desirability are calculated on the basis of estimates of the project’s cash flow effects. An attempt should be made to explain some of the possibilities and difficuhies that arise when efforts are made to incorporate in~ation and exchange rate risk into quantitative measures of project desirability2-6.

PROJECT

ASSUMPTIONS

Assume that the Danish firm A/S DF is planning an expansion of its production facilities in Denmark. The firm has no branches or subsidiaries abroad. Goods produced using the new equipment are expected to be sold in Denmark and in the USA. Raw materials will be bought from suppliers in Denmark. The Danish krone (Dkr) and the US dollar will be used as contract currencies, as the management of A/S DF intends to accept the use of the respective domestic currencies of customers and suppliers. Wages are paid in krone. In order to simplify the project appraisal, all other currencies are disregarded-a serious simplification,

$03.00 0 1983 Butterworth

& Co (Publishers) Ltd

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because it eliminates from the discussion currency diversification in accordance with portfolio theory. In order to support the appraisal of projects, the management of A/S DF is supposed to demand net present value (NPV) and internal rate of return (IRR) figures from the company’s analytical staff. Both types of quantitative measure assume that the value of a project depends on all the additional cash flows that follow from a project’s acceptance. In practice, it can be quite complicated for the analytical staff to trace the cash flow effects of the project on the remainder of the business. It is assumed here that it is possible to estimate all the incremental nominal cash flow effects with reasonable accuracy. The calculations are based on forecasts of cash flows. The forecasts rest on a set of uncertain assumptions. In the case considered here, there will be uncertainty in the marketing department’s revenue forecast for the American and the Danish markets. The cash inflows will depend on the growth of these markets, on the firm’s market share, and on the price development. None of these underlying variables can be predicted accurately. There will also be uncertainty in the cost figures forecast from the production department. In other words, the project is to some extent subject to an American as well as a Danish inflation risk. The NPV and IRR can only be calculated if the cash flows are expressed in one single currency. As the shareholders and the company are supposed to be located in Denmark, it is assumed that the project appraisal in A/S DF is based on NPV and IRR figures calculated from anticipated cash flows expressed in krone. It follows from the above assumptions that the project is expected to cause cash inflows denominated in US dollars as well as in krone. The size of these flows expressed in krone may be strongly affected by inflation and exchange rate changes. According to the NPV criterion, a project should be accepted only if its NPV is positive. In most projects, initial net cash outflows are followed by net cash inflows. The higher the predetermined discounting rate, the lower the NPV will be in such projects. In ranking projects according to their NPVs, it is assumed that funds released from the project may be reinvested at the discounting rate. The choice of discounting rate is therefore essential. In NPV calculations, it is often assumed that the discounting rate reflects the inflation rate. The expected investors’ expected inflation rate may to some extent be influenced by the expected exchange rate changes. This relationship between the expectations is natural in small countries with a record of balance of payments deficits and devaluations. NPV calculations are normally made under the assumptions that the discounting rate can be predetermined and that it can be considered constant during the economic life of the project. In a sense, the discounting rate is an average expected reinvestment rate. These assumptions are clearly controversial in a world with poorly understood fluctuations in interest rates, inflation rates and exchange rates. It must therefore be concluded that the predicted cash flow effects of the project as well as the discounting rate, which is necessary to calculate the

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NPV, may be very sensitive to different assumptions with respect to the inflation rates, interest rates, and the future exchange rate development.

SENSITIVITY

ANALYSIS

One technique that the analytical staff can use to help the decision-makers in A/S DF to understand the exposure of the project to exchange rate variations is sensitivity analysis. When export sales related to the project provide for a cash inflow denominated in US dollars, alternative anticipated dollarlkrone exchange rates will produce alternative NPVs for the project. The decision-maker can be expected to be interested in knowing the interval within which the NPV will vary, if the anticipated dollarikrone exchange rate moves from its assumed maximum value to its assumed minimum value. It is, however, no easy task to establish upper and lower bounds for the exchange The recorded exchange rate rate movements. movements provide no safe basis for establishing such a range. The movements of the dollar/krone exchange rate in the five year period 1977 to 1981 is shown in Figure 1. In that period, the dollar rate in Copenhagen varied from Dkr480.55/US$lOO to Dkr808.SO/US$lOO. The recorded variation interval, Dkr328.25, constitutes 51% of the average of the maximum and the minimum exchange rates. Such violent fluctuations in the price of the American dollar have of course had a very strong effect on the profitability of Danish investment projects in firms with a dollar exposure. The wide exchange rate range based on observations during the five year period did, nevertheless, not cover all the exchange rate observations in the spring of 1982. At the end of March 1982, for instance, the dollar rate in Copenhagen was Dkr823SO/US$IOO. The development illustrated in Figure 1 also shows that it may be unrealistic in a sensitivity analysis to establish constant maximum and minimum exchange rates for the whole economic life of a project. This, however, is what is done in the following example.

800

500

c

1978

I

I

I

I

1977

1979

1980

I

1981

Figure 1. movement of do[Ia~~k$one exchange rate over five years Source: A~~zu~l report Danmarks

~~tionalbank

Project Management

Table 1. Anticipated end of period cash inflows End of year

1 2 3 4 5

Anticipated Dkr inflow

700 000 800 000 1 100000 1300 000 2 500 000

Anticipated $ inflow

100 120 130 150 170

000 000 000 000 000

Suppose A/S DF has a project with a cash outflow at the end of period 0 of Dkr5M and subsequent anticipated end of period cash inflows as shown in Table 1. The figures shown for forecast one in the fourth column were inspired by the development shown in Figure 1. The reader could thus try to set period 1 equal to 1977. The net present value of the project in period 0 depends on the discounting rate chosen. This is illustrated by curve 1 in Figure 2. The internal rate of return in the project is 25.15% p.a. when forecast one is applied. The IRR is illustrated geometrically by the intersection point between the curve and the horizontal axis. Suppose the project analyst feels confident that the maximum dollar/krone rate during the economic life

I

IO Discounting rote, per cent po

Forecast one of $/Dkr exchange rate

600.00 550.00 550.00 590.00 720.00

Vol 1 No 2 May 1983

600 660 715 885 1224

Sum of all inflows, Dkr

000 000 000 000 000

1300 1460 1815 2 185 3 724

000 000 000 000 000

of the project is Dkr750.00 while the minimum rate is Dkr500.00. It is then possible to determine curves 2 and 3 in Figure 2 for the maximum and minimum dollar rate respectively. If the discounting rate can be considered to be independent of the dollar/krone exchange rate, the interpretation of Figure 2 is straightforward: the higher the dollar rate, the higher the NPV of the project. This result is of course due to A/S DF’s position as an exporter with net cash inflows in dollars. The risk exposure in the project is, however, connected with the possibility of negative deviations from the expected dollar rate. As already mentioned, it can be difficult to choose a reliable lower bound for the dollarikrone exchange rate. In order to reduce the firm’s total exposure to fluctuations in the exchange rate, it might be suggested that the project should be partly financed by a dollar loan. The question of how the appropriate discounting rate should be determined in the appraisal of risky projects is discussed intensely in the literature7. One approach is to calculate the rate as a function of the cost of debt and equity and their relative proportions. The rationale of this approach is that the lenders’ and the shareholders’ evaluation of the risk is incorporated into the two types of financing costs. If that approach is chosen, the cost of a possible dollar loan should be partly reflected in the discounting rate, and the decision-makers should take into consideration that some degree of risk reduction could be achieved by combining a dollar inflow project with a debt with a net dollar outflow. This reasoning does not provide precise guidelines for the calculation of a discounting rate. Owing to the lack of precision, the information shown in Figure 2 can be interpreted more broadly as showing that for discounting rates in the interval between 15 and 22%, the project should be accepted if the dollarikrone exchange rate is expected to remain within the assumed range.

FURTHER FOREIGN Figure 2. Net present value as a function of the discounting rate under alternative exchange rates; (1) chosen discounting rate, (2) maximum assumed dollar1 krone exchange rate, (3) minimum assumed dollari krone exchange rate

Forecast one value in Dkr of anticipated $ inflow

COMPLICATIONS IN EXCHANGE EXPOSURE

Project risk is in general related to the probability of negative deviations from the expected development. It is therefore appropriate to ask what exchange rate development the analytical staff should expect. There are several theories on the determination of foreign

73

exchange rates, but none of them can provide a firm basis of exchange rate forecasts. One theory-the theory of purchasing power parity (PPP)-deserves mention, however, because some of its proponents claim it is relevant to long-term business decisions, and because its validity seems to be assumed in many contributions to the literature on inflation accounting. Another theory-the interest rate parity theoryrelates differences in national interest levels and forward and spot exchange rates in the shorter terms. According to PPP, exchange rate changes can be explained by differences in national inflation rates. In this hypothetical two-country world, the dollar should have been falling against the krone when the American inflation rate exceeded the Danish inflation rate, and increasing when the inflation rate in Denmark was higher. In a more realistic world with many currencies, PPP calculations must be based on weights reflecting the relative importance of the individual currencies. Morgan Guaranty Trust Company’s calculations of effective exchange rates are, for instance, based on modified PPP considerations. Tables containing this information are published in World Financial Markets. The observed combinations of inflation differentials and exchange rate changes shown in Figure 3 should, according to the PPP theory be dotted around the purchasing power parity line. No statistical test is needed in order to conclude that the bilateral PPP relationship between the dollar and the krone in the period 1977 to 1981 is insignificant on annual figures. This, of course, does not preclude an improvement in the results of PPP tests on long-term data or on a multilateral basis. Some of the prices that are relevant to the project’s cash flows may be adjusted concurrently with the American and the Danish consumer price indexes used in Figure 3. Such a synchronization must, however, be viewed as a special case. In general, the development of the project-related dollar and krone prices will deviate from the development of the general American and Danish price indices. Authors taking PPP as their point of departure may therefore prefer to divide the forecasting of the project-related prices into two stages. In the first stage, the general national inflation rates as reflected in published price indexes are forecast. In the second stage, the deviations of the changes in the project-related prices from the expected inflation rates are forecast. Under this approach, the variability of deviations from exchange rate forecasts based on PPP may be defined as exchange risk, while the variability of deviations from the expected inflation rates may be defined as inflation risk’. It is difficult not to approve of these definitions, and it is tempting to accept them and to conclude from the big deviations from PPP in Figure 3 that the exchange risk is very important. On the other hand, the author remains sceptical with respect to definitions, when their relevance depends on the predictability of inflation rates and exchange rates. As PPP-at least in its simple forms-appears to be a it seems advisable for the very weak relationship, analysts not to commit themselves to believe in a PPP-determined set of exchange rate expectations, but to work with a range of future exchange rates instead.

74

1981 x

c-t 22 20 I8

I

Difference in rote of mflation (US rote -Danish rate)

-10 _,2-

xl978

Figure 3. PPP comparison of differences in inflation rates and changes in dollarlkrone exchange rate (annual figures) Source: Main economic indicators, OECD Annual report Danmarks Nationalbank

CONCLUSIONS The determination of exchange rates in the market is poorly understood. Differences in inflation rates and interest rates play a role, but many other factors, including central bank intervention under different schemes and unpredictable political events, also have an important impact. It is therefore difficult for the analytical staff in a firm to formulate well-founded assumptions with respect to the future exchange rate development. At the same time, however, these assumptions can be very important to the result of the project appraisal. What should the project analysts do? Some may be inclined to give up the calculation of NPV and other indices of profitability completely. The author recommends instead the use of alternative exchange rate assumptions in the calculations. This recommendation is based on the belief that poor indices of profitability are in general better than none at all. Investment decisions should never be based on profitability indices alone. Projects involving the purchase of physical assets are almost certain to have consequences of importance that cannot be captured by a profitability index.

Project

Management

REFERENCES Riis, J 0, Lauridsen, and Runge, F (Eds) Project Management 17 September 1982)

J, Fangel, M, Hildebrandt, S Proc. 7th World Congress on Copenhagen, Denmark (12-

Rappaport, A and Taggart, R A ‘Evaluation of capital expenditure proposals under inflation’ Financial Management Vol 11 No 1 (Spring 1982)

Freidenfelds, J and Kennedy, M ‘Price inflation long-term present-worth studies’ Eng. Econ. 24 No 3 (1979)

and Vol

Oakford, R V and Salazar, A ‘The arithmetic of inflation corrections in evaluating ‘real’ present worths’ Eng. Econ. Vol 27 No 2 (1982)

Boucher, planning financing kets’ Eng.

T 0 ‘A mixed-integer programming model for optimal investment and in segmented international capital marEcon. Vol 27 No 1 (1982)

Burmeister, H ‘The cost of financing to the firm in foreign exchange’ Ch 12 in Derkinderen, F G J and Crum, R L (Eds) Risk, capital costs, and project financing decisions Martinus Nijhoff, Netherlands (1981) Bernhard, R H ‘State preference synthesis of utility and interest with critical implications for discounting under risk’ Eng. Econ. Vol 22 No 3 (1977) Cosandier, P A and Lang, B R ‘Interest tests’ J. Bunking Finance Vol 5 (1981) Eun, C S ‘Global purchasing J. Financial exchange risk’ Analysis Vol 16 No 5 (December

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