1 International Capital Budgeting 2 Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows on a time line.
2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate.
3. Find NPV by discounting the cash flows at the appropriate discount rate.
4. Compare the value of competing cash flow streams at the same point in time.
3 Review of Domestic Capital Budgeting
The basic net present value equation is
Where T economic life of the project in years. CFt expected incremental after-tax cash flow in year t, TVT expected after tax terminal value including return of net working capital, C0 initial investment at inception, K weighted average cost of capital. K (1 ?)Kl ?(1 t)i 4 Review of Domestic Capital Budgeting
The NPV rule is to accept a project if NPV ? 0
and to reject a project if NPV ? 0 5 Review of Domestic Capital Budgeting
For our purposes it is necessary to expand the NPV equation.
CFt (Rt OCt Dt It)(1 t) Dt It (1 t) Rt incremental revenue OCt incremental operating costs Dt incremental depreciation It incremental interest expense ? the marginal tax rate 6 Alternative Formulations CFt CFt (Rt OCt Dt It)(1 t) Dt It (1 t) CFt (NIt Dt It (1 t) CFt (Rt OCt Dt(1 t) Dt CFt (NOIt)(1 t) Dt CFt (Rt OCt)(1 t) t Dt CFt (OCFt)(1 t) t Dt 7 Review of Domestic Capital Budgeting
We can use CFt (OCFt)(1 t) t Dt
to restate the NPV equation as 8 The Adjusted Present Value Model
Can be converted to adjusted present value (APV)
By appealing to Modigliani and Millers results. 9 The Adjusted Present Value Model
The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually.
Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.
10 Domestic APV Example
Consider this project, the timing and size of the incremental after-tax cash flows for an all-equity firm are
The unlevered cost of equity is r0 10 CF0 I CF1 NPV CF2 CF3 11 Domestic APV Example
Now, imagine that the firm finances the project with 600 of debt at r 8.
The tax rate is 40, so they have an interest tax shield worth tI .40600.08 19.20 each year.
12 -1,000 125 250 375 500 0 1 2 3 4 The APV of the project under leverage is 13 Capital Budgeting from the Parent Firms Perspective
The APV model is useful for a domestic firm analyzing a domestic capital expenditure or for a foreign subsidiary of a MNC analyzing a proposed capital expenditure from the subsidiarys viewpoint.
The APV model is NOT useful for a MNC in analyzing a foreign capital expenditure from the parent firms perspective.
Blocked cash flows
Marginal tax rates
14 Capital Budgeting from the Parent Firms Perspective
Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.
15 Capital Budgeting from the Parent Firms Perspective 16 Capital Budgeting from the Parent Firms Perspective
The operating cash flows must be translated back into the parent firms currency at the spot rate expected to prevail in each period.
The operating cash flows must be discounted at the unlevered domestic rate 17 Capital Budgeting from the Parent Firms Perspective
OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.
The marginal corporate tax rate, ?, is the larger of the parents or foreign subsidiarys. 18 Capital Budgeting from the Parent Firms Perspective
S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.
Denotes the present value (in the parents currency) of any concessionary loans, CL0, and loan payments, LPt , discounted at id . 19 Capital Budgeting from the Parent Firms Perspective Alternative 1
One alternative for international decision makers
1. Estimate future cash flows in foreign currency.
2. Convert to the home currency at the predicted exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost of capital.
20 Capital Budgeting from the Parent Firms Perspective Example
A U.S.-based MNC is considering a European opportunity.
Its a simple example
There is no incremental debt
There is no incremental depreciation
There are no concessionary loans
There are no restricted funds
21 Capital Budgeting from the Parent Firms Perspective Example
We can use a simplified APV
22 Capital Budgeting from the Parent Firms Perspective Example
A U.S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows are
The inflation rate in the euro zone is ? 3, the inflation rate in dollars is p 6, and the business risk of the investment would lead an unlevered U.S. based firm to demand a return of Kud i 15. 23 Capital Budgeting from the Parent Firms Perspective Example
Is this a good investment from the perspective of the U.S. shareholders? To address that question, lets convert all of the cash flows to dollars and then find the NPV at i 15. 24 Capital Budgeting from the Parent Firms Perspective Alternative 2
Another recipe for international decision makers
1. Estimate future cash flows in foreign currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the foreign cost of capital.
4. Translate the foreign currency NPV into dollars using the spot exchange rate
25 Foreign Currency Cost of Capital Method Lets find i and use that on the euro cash flows to find the NPV in euros. Then translate the NPV into dollars at the spot rate. ? 3 i 15 p 6
26 Foreign Currency Cost of Capital Method
Before we find i lets use our intuition.
Since the euro-zone inflation rate is 3 lower than the dollar inflation rate, our euro denominated discount rate should be lower than our dollar denominated discount rate.
27 Finding the Foreign Currency Cost of Capital i Recall that the Fisher Effect holds that (1 e) (1 ?) (1 i) So for example the real rate in the U.S. must be ? 28 Finding the Foreign Currency Cost of Capital i If Fisher Effect holds here and abroad then and If the real rates are the same in dollars and euros (e e) we have a very useful parity condition 29 Finding the Foreign Currency Cost of Capital i If we have any three of these variables, we can find the fourth In our example, we want to find i 30 International Capital Budgeting Example Find the NPV using the cash flow menu and i 11.75 CF0 I CF1 NPV CF2 CF3 31 Capital Budgeting from the Parent Firms Perspective Example Without a financial calculator, the NPV can be found as 32 International Capital Budgeting
You have two equally valid approaches
Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the NPV using the dollar cost of capital.
Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate.
If you watch your rounding, you will get exactly the same answer either way.
Which method you use is your choice.
33 Back to the full APV
Using the intuition just developed, we can modify Lessards APV model as shown above, if we find it convenient.
34 Risk Adjustment in the Capital Budgeting Process
Clearly risk and return are correlated.
Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.
35 Sensitivity Analysis
In the APV model, each cash flow has a probability distribution associated with it.
Hence, the realized value may be different from what was expected.
In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.
36 Real Options
The application of options pricing theory to the evaluation of investment options in real projects is known as real options.
A timing option is an option on when to make the investment.
A growth option is an option to increase the scale of the investment.
A suspension option is an option to temporarily cease production.
An abandonment option is an option to quit the investment early.
37 Value of the Option to Delay Example
A French firm is considering a one-year investment in the United Kingdom with a pound-denominated rate of return of 15.
The firms local cost of capital is i 10
The cash flows are
38 Value of the Option to Delay Example
Suppose that the Bank of England is considering either tightening or loosening its monetary policy.
It is widely believed that in one year there are only two possibilities
S1() 2.20 per
S1() 1.80 per
Following revaluation, the exchange rate is expected to remain steady for at least another year.
39 Option to Delay Example
If S1() 1.80 per the project will have turned out to be a loser for the French firm
If S1() 2.20 per the project will have turned out to be a winner for the French firm
IRR 3.50 IRR 26.50 40 Option to Delay Example
An important thing to notice is that there is an important source of risk (exchange rate risk) that is not incorporated into the French firms local cost of capital of i 10.
Thats why there are no NPV estimates on the last slide.
Even with that, we can see that taking the project on today entails a win biglose big gamble on exchange rates.