Foundations Of Emerging Market Finance Chapter 10: International Capital Budgeting and Project Finance

1
Foundations Of Emerging Market FinanceChapter
10 International Capital Budgeting and Project
Finance
Most material for this lecture is drawn from
Campbell R. Harvey and Stephen Grays
International Project Evaluation. It also draws
from Richard Ruback's note, "Applications of the
Net Present Value Rule, and Guofu Zhou's
"Capital Budgeting".
Prof. J.P. Mei
2
Overview

• Some Simple Guidelines in Capital Budgeting
• 1. Pay attention to the timing of cash flow.
• 2. Use after-tax discount rate and cash flows.
• 3. Generally do not include opportunity cost
• 4. Use a common currency
• Investments in international project
• What are the cost of capital?
• How do you assess risk and returns in foreign
  currencies?
• Capital budgeting with real options

3
International Capital Budgeting

• Arctis, a canadian manufacturer of heating
  equipment, considers building a plant in Japan.
  The plant would cost Yen1.3m to build and would
  produce cash flows of Yen200,000 for the next 7
  years. Other data are
• Yen interest rate2.9
• C interest rate 8.75
• Spot rate Yen/C 83.86
• Assumption the investment is risk free
• How should you calculate the NPV?

4
Two Ways of Calculating NPV

• Method I
• Step 1 Forecast cash flows in Yen
• Step 2 Discount at interest rate for Yen gives
  NPV in Yen
• Step 3 Convert NPV in Yen into Canadian dollars
  at spot exchange rate, gives NPV in C

• Method II
• Step 1 Forecast cash flows in Yen
• Step 2 Convert cash flows into C using implied
  forward rate
• Step 3 Discount C cash flows using the interest
  rate for C, gives NPV in C.

5
Results for Two Methods

• Method I Present value -Yen 49,230
• Method II Present value -C 590 -Yen
  (59083.86)-Yen49,230
• Both methods yield the same result!
• Why is this necessary?

6
Alternative Exchange Rate Forecast

• Suppose the corporate treasurer argues that the
  true value of the investment is understated,
  because the market is too pessimistic about the
  Yen
• Assume the Yen appreciates 2.5 p. a. faster than
  anticipated by the market
• Now the PV with Method II becomes C 976 or Yen
  81,840
• Now the project looks profitable, should you take
  it?

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Capital Budgeting and Currency Speculation

• Break down your project into two investments
• 1. Borrow C 15.502 and convert them into Yen for
  Yen1.3m
• Zero-NPV project
• 2. Invest the proceeds into plant for heating
  equipment
• Negative NPV (Yen -49,230).
• Compare this with an alternative combination of
  two investments
• 1. Borrow C 14.915 and convert them into Yen for
  Yen1.251m
• 2. Invest the proceeds into a 7-year bond with
  repayment of 200.
• Positive NPV of C 1,563 if optimistic treasurer
  is correct
• Hence, investing in plant has two consequences
• Profit of C 1,563 on speculation on Yen
• Loss of C 587 on plant
• Net gain is 1,563-587C976

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SummaryOff-shore Borrowing

• There is no easy gain from offshore borrowing
• Implication of covered interest rate parity
• Use discount rate for relevant currency
• It does not matter which one you take
• Use consensus forecast of market
• Dont delude yourself by taking a view on
  exchange rates

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The Limitations of Simple NPV

• Aim
• Analyse risky projects under circumstances where
  uncertainty can be managed.
• Simple NPV-Analysis
• Treat investment as one-off decision
• Project stays constant cannot be adapted.
• Treat uncertainty as an exogenous factor
• Decision Trees and real options
• Managers respond to risk-factors
• Integrate strategy and capital budgeting
• What is the value of flexibility and
  responsiveness?

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Investment under UncertaintyThe Simple NPV Rule
0
1
2
...
T
...
Period
Revenue
120
120
120
...
...
if Demand
is high
50
Initial
Investment
I
50
Revenue
80
80
80
...
...
if Demand
is low
Cost of Capital 10
NPV - I 100/0.1 1000 - I
Invest if I lt 1000
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Investment under Uncertainty Delay
Strategy Wait one Period
Case 1 I gt 800, do not invest if demand is low
0
1
2
...
T
...
Period
Revenue
- I
120
120
...
...
0
if Demand
is high
50
Demand
50
Revenue
if Demand
0
0
...
...
0
0
is low
0.5
1200 - I
120
120
(- I

... )
NPV
1.1
1.12
1.1
2.2
12
Investment under Uncertainty Delay (2)
Strategy Wait one Period
Case 2 I lt 800, always invest
0
1
2
...
T
...
Period
Revenue
120
120
...
...
if Demand
- I
0
is high
50
Demand
50
Revenue
if Demand
- I
80
80
...
...
0
is low
1
1000 - I
100
100
(- I

... )
NPV
1.1
1.12
1.1
1.1
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Summary of Strategies

• Decision rule NPV
• (1) Simple NPV 1000 - I
• (2) Delay if I gt 800
• (3) Delay if I lt 800
• Delay is never optimal if I lt 800
• Delay is better than investing now if I gt 833
• Investment is never optimal if I gt 1200

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Comparison of both Strategies
NPV
I gt 1200
Never invest
833 lt I lt 1200
Wait invest if demand is high
1000
I lt 833
Invest now
909
1000 - I
(1000 - I)/1.1
Vertical distance

value of flexibility
181
(1200-I)/2.2
0
I
0
833
1000
1200
800
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Results of Comparison (1)

• 1 If 833 lt I lt 1000
• Investment now has positive NPV 1000 - I
• However Waiting is optimal in order to see how
  uncertainty over demand resolves.
• Benefits from waiting receive information to
  avoid loss.
• Costs of waititng delay of receiving cash flows.
• Investment in positive NPV projects is not always
  optimal
• the flexibility gained from waiting has a
  positive value.
• Note Critical point is 833, not 800, why?

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Results of Comparison (2)

• 2. If 1000 lt I lt 1200
• Investment now has negative NPV.
• However The project should not be abandoned if
  demand turns out high later, it has a positive
  NPV.
• Negative NPV-projects should be delayed,
• but not always be dismissed.

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Total NPV and Simple NPVIncorporating the Value
of Flexibility

• The project can be broken down into two
  components
• The investment possibility itself
• Has a Simple NPV of 1000-I
• The flexibility of the project from the option to
  delay investment
• Value of Flexibility is
• Max (Value of investment later - Value of
  investing now, 0)
• Total NPV is the value of the whole project
• Total NPV Simple NPV Value of Flexibility
• Investing immediately ignores that option of
  delay is valuable
• Decisions must be based on total NPV
• The value of flexibility is never negative
• Total NPV leads always to the correct decision

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Compute the Value of Flexibility

• If Ilt833, invest now, hence option to delay has
  no value.
• If 1000gtIgt833, then
• Value of investing now 1000 - I
• Expected value of investing later is (1200-I)/2.2
• Value of flexility is then
• So, with I833, the value of flexibility is zero
  (why?), with I1000 it increases to 91.
• If 1200gt Igt1000, the value of flexibility is
  simply (1200-I)/2.2.
• How does this change if the investment becomes
  more risky?

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How to Use Total NPV

• Assume I900gt833, hence value of flexibility
  positive.
• Value of following optimal strategy Total NPV
• Value of investing now Simple NPV
• Value of flexibility 80/2.236.4
• Should you invest now?
• Investing now gives 1000-900100,
• Simple NPV 100gt0
• Investing later gives
• Total NPV Simple NPV Value of Flexibility
• 100 36.4 136.4
• Total NPV gt Simple NPV, therefore delay!
• Deciding on the basis of Simple NPV ignores that
  investing now kills the option
• Base decision always on Total NPV!

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The Impact of Volatility

• How does the value of flexibility depend on
  uncertainty?
• Compare previous case with situation of more
  volatile prices
• Revenue (High Demand) 150
• Revenue (Low Demand) 50
• Expected revenue is unchanged ( 100).
• Volatility is higher.

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Flexibility in a Volatile Environment
Value of
Flexibility
Prices 150/50
250
Prices 120/80
I
0
0
583
833
1000
1200
1500
Flexibility has a higher value in a more volatile
environment
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The Option to Abandon

• Assume same scenario as before, but no option to
  delay
• Revenue (High Demand) 120
• Revenue (Low Demand) 80
• Investment outlay I 1010
• If there is no option to delay, NPV1000-I-10
• Do not invest!
• Assume assets have a scrap value
• At the end of the period scrap value 910
• After the first period scrap value 0

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The Option to Abandon

• High revenue state (120)
• PV (Cash Flow) 1200 gt 910
• Continue after period 1!
• Receive 1200 120 in period 1
• Low revenue state (80)
• PV (Cash Flows) 800 lt 910
• Divest and abandon project in period 1!
• Receive 910 80 in period 1
• With option to abandon, NPV40
• Invest Option to abandon makes the project
  viable.

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Flexibility and Project Design

• Many projects have built-in flexibility
• Options to contract or expand.
• Possibility to abandon if the assets have values
  outside the project (secondary market).
• Development opportunities
• Sequence of models of the same product.
• Oil fields.
• In many cases the project can be designed to be
  more flexible
• Leasing contracts.
• Make or buy decisions.
• Scale versus adaptability.