Multinational Capital Budgeting.st

8/6/2019 Multinational Capital Budgeting.st

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Multinational CapitalBudgeting

International Financial ManagementDr. A. DeMaskey


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Learning Objectives

H ow does domestic capital budgeting differ frommultinational capital budgeting?H ow do incremental cash flows differ from total

project cash flows?What is the difference between foreign project cashflows and parent cash flows?H ow does APV analysis differ from NPV analysis?

H ow is the capital budgeting analysis adjusted for theadditional economic and political risks?What is real option analysis?


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Complexities of Capital Budgeting

for a Foreign ProjectS everal factors make budgeting for a foreign projectmore complex

Parent cash flows must be distinguished from projectParent cash flows often depend on the form of financing, thus cannot clearly separate cash flows fromfinancing

Additional cash flows from new investment may in partor in whole take away from another subsidiary; thus asstand alone may provide cash flows but overall addsno value to entire organizationParent must recognize remittances from foreigninvestment because of differing tax systems, legal andpolitical constraints


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Complexities of Capital Budgeting

for a Foreign Project An array of non-financial payments can generate cashflows to parent in form of licensing fees, royaltypayments, etc.Managers must anticipate differing rates of nationalinflation which can affect differing cash flowsUse of segmented national capital markets may createopportunity for financial gain or additional costsUse of host government subsidies complicates capital

structure and parents ability to determine appropriateWACCManagers must evaluate political riskTerminal value is more difficult to estimate becausepotential purchasers have widely divergent views


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Traditional Capital Budgeting

AnalysisNPV Analysis

If Projects are independent, those with a positive NPVwill be accepted while those with a negative NPV willbe rejected

It two projects are mutually exclusive, the project withthe highest NPV greater than zero will be accepted.The discount rate, k, is the expected rate of return onprojects of similar risk as the riskiness of the firm as awhole.

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Properties of NPV Rule

Consistent with the goal of maximizingshareholder wealth.Focuses on cash flows rather thanaccounting profits.Emphasizes the opportunity cost of moneyinvested.

Obeys the additivity principle.


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I ncremental Cash Flows

Only the additional additional cash flows generated bythe project are relevant relevant .The difference between total and incrementalcash flows arises from:

CannibalizationS ales creation

Opportunity costTransfer pricesFees and royalties


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Choosing the Correct Case Base

The base casebase case is represented by theworldwide corporate cash flows without theinvestment.In a competitive world, the base case needsto be adjusted for competitive behavior.

New product

New production technologyIntangible benefits


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Adjusted Present Value (APV )

Project risks and financial structures vary vary bycountry, production state, and position in thelife cycle of the project.

R ather than modifying the WACC, cash flowscan be discounted at an all all--equity rateequity rate , k*.R eflects only the riskiness of the projectsexpected future cash flows.

Abstracts from the projects financial structure.Can be viewed as the companys cost of capital if it were all-equity financed, that is,with zero debt.


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All-Equity Rate

The all-equity rate is based on the CAPM:

k* = r f + * (r m r f )

* is the all-equity or unlevered beta A levered equity beta, e, is unlevered usingthe following equation:

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Adjusted Present Value Approach

The value of a project is equal to the sum of the following components:

PV of after-tax project cash flows but before

financing costs discounted at k*.PV of tax savings on debt financingdiscounted at the before-tax dollar cost of debt, i d.PV of any savings or penalties on interestcosts associated with project-specific financingdiscounted at the before-tax dollar cost of debt, i d.


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Adjusted Present Value Approach

Tt = tax savings in year t due to the specificfinancing packageS

t = before-tax dollar value of interestsubsidies (penalties)id = before-tax dollar cost of debt

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I ssues in Foreign I nvestment Analysis

S hould cash flows be measured from theviewpoint of the project or that of the parent?

S hould the additional economic and politicalrisks that are uniquely foreign be reflected incash flow or discount rate adjustments?


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Project versus Parent Valuation

Most firms evaluate foreign projects from bothparent and project viewpoints

The parents viewpoint analyses investmentscash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments

The parents viewpoint gives results closer totraditional NPV capital budgeting analysisProject valuation provides closer approximation of effect on consolidated EP S


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Parent versus Project Cash Flows

Project and parent cash flows can divergedivergesignificantly due to:

Tax regulationsExchange controlsFees and royaltiesTransfer pricing

Other factors


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Three-Stage Approach

S tage1:Project cash flows are computed from thesubsidiarys perspective.

S tage 2:Project cash flows to the parent are evaluatedon the basis of specific forecasts concerningthe amount, timing, and form of remittance.

S tage 3: Account for the additional benefits and costsof the project.


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I ncremental Project Cash Flows

Estimating a projects true profitabilityrequires various adjustments to the projectcash flows:

Adjust for the effects of transfer pricing andfees and royalties. Adjust for global costs/benefits that are notreflected in the projects financial statements.

CannibalizationS ales creation

Additional taxesDiversification of production facilities and markets


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Tax Factors

Only after after--tax tax cash flows are relevant. Actual taxes paid are a function of:

Time of remittanceForm of remittanceForeign income tax rateWithholding taxes

Tax treatiesForeign tax credits


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Tax Factors

Computing the tax liabilities of foreigninvestments assumes that:

The maximum amount of funds are availablefor remittance each year.The tax rate applied is the higher of the homeor host country rate.


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Tax Factors: I llustration

S uppose that an affiliate will remit after-tax earningsof $120,000 to its U. S . parent in the form of adividend. Assume the foreign tax rate is 20%, thewithholding tax on dividends is 4%, and excessforeign tax credits are unavailable.

What is the additional tax owed to the U. S .government?What is the marginal rate of additional taxation?


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Political and Economic Risk Analysis

There are threethree main methods for incorporating the additional political andeconomic risks into a foreign investment

analysis:S hortening the payback periodR aising the required rate of return of theinvestment

Adjusting the cash flows to reflect the specificimpact of a given risk.Uncertainty absorption

Adjusting the expected value of future cash flows


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Exchange Rate Changes and I nflation

The analysis should also consider the appreciation or depreciation of the U S dollar.

Approach A:Convert nominal foreign currency cash flows intonominal home currency terms.Discount those nominal cash flows at the nominaldomestic required rate of return.

Approach B:Discount the nominal foreign currency cash flows atthe nominal foreign currency required rate of return.Convert the resulting foreign currency present valueinto the home currency using the current spot rate.


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Political Risk Analysis

The preferred method is to adjust the cashflows of the project to reflect the impact of aparticular political event on the present valueof the project to the parent.

The biggest risk is:ExpropriationBlocked funds


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Expropriation: I llustration

S uppose a firm projects a $5 million perpetuity froman investment of $20 million in S pain. If the requiredreturn on this investment is 20%, how large does theprobability of expropriation in year 4 have to bebefore the investment has a negative NPV? Assumethat all cash flows occur at the end of the year andthat the expropriation, if it occurs, will occur prior tothe year 4 cash inflows or not at all. There is nocompensation in the event of expropriation.


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Real Option Analysis

DCF analysis cannot capture the value of thestrategic options, yet real option analysisallows this valuation.R eal option analysis includes the valuation of the project with future choices such as:

The option to defer The option to abandonThe option to alter capacityThe option to start up or shut down (switching)


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Real Option Analysis

R eal option analysis treats cash flows interms of future value in a positive sensewhereas DCF treats future cash flows

negatively (on a discounted basis).The valuation of real options and thevariables volatilities is similar to equity optionmath.

An expanded NPV rule consists of thetraditional DCF analysis plus plus the value of anoption.

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