WST Ltd, a leader in software development, plans to diversify its activities by establishing operations overseas.

WST has identified three possible locations -- the US, the Euro-area and Hong Kong. Of these, only two locations will be selected, and foreign operations of equal size will be established.

The project life will be five years. The CFO of WST has prepared forecast cash inflows and has also derived their present values applying a discount rate of 18 per cent, without considering the initial outlay of Rs 100 million, in each of the selected locations (Table 1).

The forex-wing of the treasury has also compiled a forecast of average exchange rates attributable to the next five years, and has estimated the correlation coefficients of expected net present values (NPV) as between the three locations (Tables 2 and 3).

The CFO had begun the decision-making exercise, and had jotted down the computations for the Hong Kong operations as shown in Tables 4 and 5.

At this juncture, the CFO of the company suddenly resigned. As an investment analyst who has joined the company recently, the managing director (MD) directs you that:

a) With whatever information available, and continuing the same process adopted by the CFO, make a recommendation as to which of the two locations should be selected for diversification.

b) Independent of the findings under (a), if, in the above evaluation process, you notice any deficiencies, spell them out. (14 + 6 = 20 marks)

Solution: An analysis of the problem: The company wants to invest in two projects. The initial investment is Rs 100 million in each.

Therefore, the total funds available are Rs 200 million. This sum will be invested in equal proportions in two projects. A combination of two locations should be selected, that is, a portfolio with an investment weightage of 0.5 for each location. The portfolio that provides the least risk should be selected.

In other words, the task is to determine the: a) risk of each of the three possible portfolios, and b) identify that portfolio which bears the least risk.

Risk in the Hong Kong location has been identified as Rs 5 million. The risk in the other two locations needs to be computed.

Based on the results, the risk of each of the three portfolios consisting of two locations each is to be derived, by applying the correlation coefficient factors given.

Step 1, computing the investment risk in the US, is presented in Tables 6 and 7.

Step 2, computing the investment risk in the Euro-area, is shown in Tables 8 and 9.

Steps 3, computation of risks -- on Portfolio I (US-Europe), where US is taken as X and Euro-area Y; on Portfolio 2 (HKD-Euro), where HKD is taken as X and Euro-area Y; and on Portfolio 3 (HKD-US), where HKD is taken as X and the US Y -- is presented in Table 10.

Selection of two locations: Ranking of portfolios by risk and recommendation is given in Table 11. Locating of the two foreign operations, one each in Hong Kong and in the US is recommended.

Deficiencies in selection process:

The CFO has computed present value of cash flows, applying a uniform discount rate of 18 per cent for all the three locations. Risk premium will differ for each of the locations and, hence, applying one single discount rate will not throw up meaningful results.

In evaluating overseas investments, two approaches are possible, namely, host-currency approach, and home-currency approach.

The indication in the example incorporated in the problem is an avoidable mix of both host and home currency methods.

The CFO had adopted the host currency (or foreign currency) approach only in part. The NPV, including the initial outflow on investment, should have been taken into account rather than the PV of host currency cash inflows.

Under the host currency approach, foreign currency cash flows are discounted at the discount rate applicable to that country to generate a host currency NPV.

This NPV is thereafter converted at the spot-rate applicable between the host and home currency to derive home currency NPV.

Applying an average exchange rate for converting the foreign-currency cash flows to rupee cash flows is also not in order.

If the host currency method (or home currency method) is adopted in entirety, the findings may throw up a different set of results.

Participatory notes

PRESENT a write-up covering (i) meaning of participatory notes (P-Notes), ii) why market attention is attracted by these instruments, and iii) major reasons why investors invest in P-Notes. (6 marks)

Solution: Meaning: P-Notes are instruments used by foreign funds, not registered in the country, to gain access to invest and trade in the domestic market. P-Notes are comparable to contract notes and are issued by foreign institutional investors who are registered in the country, to their overseas clients who may not be eligible to invest or trade in the Indian stock market.

Example: Merrill Lynch is an FII. Its client in Mauritius is XYZ Ltd, which does not have access to the Indian stock market. Merrill Lynch issues P-Notes to XYZ.

In effect, P-Notes are offshore derivative instruments, against underlying Indian shares or debt-instruments, listed in recognised stock exchanges in India.

Why P-Notes have attracted attention: Market attention has been drawn to P-Notes because of significant inflow of foreign funds into the Indian stock market through this route. Since the ultimate beneficiary of transactions carried out by using P-Notes is not known to the market regular or the tax-authorities, there is scope for misuse and tax avoidance.

Also, since P-notes do not possibly attract the attention of the market regulators of the country in which they are issued, the entities holding P-Notes virtually go unregulated.

Why investments take place through P-Notes: The three primary reasons are:

i) Regulatory delays: FIIs have to register themselves with the RBI and SEBI, which may involve a delay of 4-6 weeks. Some of the prospective investors do not find this time-gap acceptable, and to gain `quick-returns' on investments they adopt the P-Note route.

ii) Cost effectiveness: FIIs registered in India have to pay a pre-determined amount as registration fees and have to set up their offices in India.

For such of those investors whose intention is not to hold on to stocks, or to invest only in a few select stocks for a short-period, could conclude that benefits accruing from such short term investments may be less than cost.

iii) Tax regime: The tax regime also plays an important role in the decision of investing through P-Notes. Countries such as Sri Lanka, Taiwan, Singapore and Hong Kong do tax short-term capital gains (STCG).

If an overseas investor desires to invest directly, the gains are subjected to 10 per cent STCG tax. This can be avoided if the P-Note route is adopted.

Though earlier SEBI had issued directions to FIIs not to issue P-Notes, it has diluted its stand, as in the case of ONGC's offer for sale relating to divestment of government holding.

(Source: Prime Academy, Chennai.)