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parity relationship. Once all revenues and costs of the English subsidiary have been converted to pounds sterling, the result is a complete forecast of the subsidiary income statement and balance sheet in pounds sterling.

Estimate Foreign Currency Discount Rate

To estimate the foreign currency discount rate, the general principle is to discount foreign cash flow at foreign risk-adjusted rates. The fact that a subsidiary is located in a foreign country does not change the definition of the weighted average cost of capital. The two most common errors in setting the WACC are making ad hoc adjustments for risk and using the parent country WACC to discount foreign currency cash flow. Regarding the first point, ad hoc adjustments to the discount rate to reflect political risk, foreign investment risk, or foreign currency risk are entirely inappropriate. As we will explain in Chapter 19, political risk is best handled by adjusting expected cash flow, weighting it by the probability of various scenarios. Foreign currency or foreign investment risk is handled by the spot exchange rate, and is perfectly symmetrical. An equal chance of a gain or a loss of purchasing power exists. It should be clear that if cash flow is predicted in units of the foreign currency, it should be discounted at the foreign country discount rate because this rate reflects the opportunity cost of capital in the foreign country, including expected inflation and the market risk premium.

The target capital structure for a subsidiary is the mix of financing, stated in market values, that it would maintain in the long run on a stand-alone basis. The actual capital structure imposed on the subsidiary by its parent may depart widely from the subsidiary's target. For tax reasons, the subsidiary may be loaded up with debt. The tax effect of this type of transfer-pricing arrangement is captured when expected cash flow is estimated and should not be double counted when estimating the discount rate.

Discount Free Cash Flow

Having determined the subsidiary's weighted average cost of capital, you are ready to discount the free cash flow forecasted in step 2 and convert it to your domestic currency. Exhibit 17.9 shows the expected free cash flow to our example subsidiary in England. It is discounted to the present at the subsidiary's WACC, assumed to be 11.8 percent, and then converted to dollars by multiplying the present value in pounds sterling by the spot exchange rate, 0.63 pounds/dollar.

One caveat is in order: Because we have discounted cash flow to the subsidiary, its present value in the domestic currency (dollars in our example) to the parent may be different if a country has restrictions that limit the expatriation of cash flow to the parent. Although ways around these constraints can sometimes be found—for example, barter or transfer pricing—keep in mind that the value to the parent depends on the quantity and timing of free cash flow (or cash equivalents) that can actually be paid out.

The Effects of Foreign Exchange Hedging

Hedging is a conceptually difficult topic mainly because it is hard to justify on theoretical grounds as beneficial to shareholders. It is not unusual for multinational companies to take large positions in foreign exchange forward contracts to hedge against unexpected changes in exchange rates. Though designed to reduce currency risk, this practice is often risky in itself. It has

Exhibit 17.9 English Subsidiary Valuation

Tree cash flow

Present value [.tutor at 11.6% foreign rate

Present value

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