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International Capital Budgeting

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.

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

Review of Domestic Capital Budgeting

- The NPV rule is to accept a project if NPV ? 0

and to reject a project if NPV ? 0

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

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

Review of Domestic Capital Budgeting

- We can use CFt (OCFt)(1 t) t Dt

to restate the NPV equation

as

The Adjusted Present Value Model

- Can be converted to adjusted present value (APV)

By appealing to Modigliani and Millers results.

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.

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

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.

-1,000 125 250 375

500

0 1 2 3 4

The APV of the project under leverage is

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

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.

Capital Budgeting from the Parent Firms

Perspective

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

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.

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 .

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.

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

Capital Budgeting from the Parent Firms

Perspective Example

- We can use a simplified APV

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.

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.

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

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

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.

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

?

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

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

International Capital Budgeting Example

Find the NPV using the cash flow menu and i

11.75

CF0

I

CF1

NPV

CF2

CF3

Capital Budgeting from the Parent Firms

Perspective Example

Without a financial calculator, the NPV can be

found as

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.

Back to the full APV

- Using the intuition just developed, we can modify

Lessards APV model as shown above, if we find it

convenient.

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.

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.

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.

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

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.

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

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.

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