Cross-border DCF valuation: discounting cash flows in foreign currency
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Cross‑border DCF valuation: discounting cash flows in foreign currency Andreas Schüler1
© The Author(s) 2020
Abstract The paper seeks to develop a comprehensive framework to cross-border discounted cash flow valuation. Although the literature on company valuation and on international financial management is vast, such a framework has not yet been proposed. We build upon well-known fundamentals and relevant contributions, e.g. on the derivation of the risk-adjusted rate of return. Relevant risks are exchange rate risk, business risk, financial risk, the risk of the tax effects induced by debt financing, and the risk of default. Additional tax effects beyond the well-known tax shield on interest expenses must be considered. Risk discounts from cash flows and risk premia to be added to risk-free interest rates are derived according to the global capital asset pricing model. A conceptual choice occurs not only between the foreign currency and the home currency approach, but also regarding the estimation of future exchange rates. The paper shows how a valuation can be implemented with or without consideration of covariances between cash flows and rate of returns with exchange rates. It also derives the discount rates if forward exchange rates are applied. We discuss the consequences of assuming the uncovered interest parity to hold. We assume deterministic debt and apply the adjusted present value approach. In addition, we derive the RADR to be used in the flow to equity and weighted average cost of capital approach. The paper addresses not only the valuation of a foreign company, but also the valuation of a domestic company that generates cash flows in foreign currency and/or uses debt in foreign currency. Keywords Exchange risk · Foreign currency · Cross-border valuation · Valuation · International finance
* Andreas Schüler [email protected] 1
Universität der Bundeswehr München, Fakultät für Wirtschafts- und Organisationswissenschaften, Professur für Finanzwirtschaft & Finanzdienstleistungen, 85577 Neubiberg, Germany
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A. Schüler
JEL classification G15 · G32 · M16
1 Introduction The literature on company valuation is vast. Key contributions to discounted cash flow (DCF) valuation were made by Modigliani and Miller (1958, 1963), Miles and Ezzell (1980), Harris and Pringle (1985) and Inselbag and Kaufold (1997). Of course, this is also true for the literature on international financial theory. For example, forecasting and hedging flexible exchange rates, international parity theories, the properties of international capital markets, or the pricing of assets in these markets has been of interest to researchers over decades. The textbooks of Sercu (2009) and Bekaert and Hodrick (2018) provide a good overview and a thorough analysis of this field. The interface between these two streams of the literature, the cross-border valuation of companies, has been analyzed extensively when it comes to the expected rate of returns for shareholders (cost of equity). Numerous papers have analy
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