Since the past few months, the telecom service provider Uninor has been under scanner on eligibility criteria for allocation of 2G spectrum, by the former telecom minister of India. India’s Department of Telecom (DoT) has imposed a penalty of Rs 6.35 crore for not complying with the roll-out obligations, of which Uninor has been directed to pay Rs 3.8 crore by the telecom tribunal TDSAT, following the company’s petition challenging the penalty imposed by the DoT. The cancellation of licences or even the imposition of penalties could severely hurt cash flows of Uninor and of some other telcos which were issued similar notices.
Uninor is a joint venture between reality firm Unitech and telecom firm Telenor of Norway, of which the Norwegian government is a major shareholder. Telenor’s acquisition of 67.25% stake in Unitech Wireless of India was funded with a Rights issue in October 2008. Telenor’s share price had dropped by 25% on the announcement day and by 45% over the month. The negative market reaction could have stemmed from the fact that India was an unknown market for Norwegian investors and they had doubts regarding the future returns from investments in India.Now, with India’s Supreme court monitoring the 2G scam investigations, their future is increasingly looking uncertain. Till date Uninor is reported to have invested around Rs 9,000-10,000 crore and set up 30,000 towers.
This brings us to the question why do companies invest overseas and what are the risks and the expected returns for investing in the foreign markets.
Some of the key reasons for which companies choose to invest overseas are to gain access to new markets, to obtain superior or less costly access to the inputs of production (land, labor, capital, and natural resources) than at home or to build strategic assets, such as distribution networks or new technology. Diversification into uncorrelated markets may result in reduction of risks.
A point to be noted is that the cost of capital for investors of a company that invests in a foreign land is different from the cost of capital for investors of a company investing in its own stock market. This is due to the fact that the investors investing in a foreign country are exposed to risks such as exchange rate risk, political, sovereign and expropriations risks. The dividends can be paid to these investors only after the generated cash is repatriated to the home country. During war or unrest there could be possibility of expropriation in a foreign land. As such, the parent company may not be able to repatriate interests, dividends, or royalties it earned abroad, send home the funds held in a foreign bank account opened by a branch office. Sovereign risk or transfer risk refers to the possibility of the cash generated in the foreign country being blocked when the reserves of hard currency in the host country are low. Such risks can typically be insured by private or government insurance companies.
In case of Telenor, the cost of capital for evaluating an investment in India is likely to be different from the cost of capital for an Indian firm, let’s say Idea cellular evaluating a similar investment in India. The returns from the investment of an Indian firm in India are likely to be strongly correlated with the Indian market index since there are common factors that affect all Indian firms in similar ways. On one hand exchange rate risk, political, sovereign and expropriations risks increase the riskiness of the Norwegian investment. On the other hand, the same project may yield benefits of diversification of risk for Telenor, if the returns from the Indian project are essentially uncorrelated with the returns on the Norwegian market portfolio.
The return on equity for an Indian firm making an investment in India can be calculated by using a beta (the non-diversifiable risk of a company) obtained by regressing returns from a portfolio of stocks in the same industry on the Indian stock market index. Beta is the product of the relative volatility of a security’s returns and the correlation of the security’s returns to the market’s returns.
For the Norwegian firm, the company would first forecast the cash flows from operations in India. It would then take into account the effect of intra-firm transactions, which will be affected by international taxation, transfer risks and remittance Policy. At the same time, the discount rate by which the cash flows will be discounted will be different for domestic company & a foreign company. For the foreign company the discount rate will take care of the exchange rate risk, country risk, political, sovereign and expropriations risks. At the same time the beta used for calculation of the discount rates will also be different, to account for correlation with the market.
Due to the inherent riskiness of overseas investment, investors may have a home bias and would expect higher returns on the cost of capital if the target acquisition is funded with investors’ money.