International Capital Budgeting

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
• Extra taxes
• Marginal tax rates
• Interest rates
• Exchange 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.
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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.
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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
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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
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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.
• Opt to delay to gain further information.