Transcript Parent Viewpoint

International Finance
FIN456 ♦ Spring 2013
Michael Dimond
Sustaining & transferring Competitive Advantage
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In deciding whether to invest abroad, management must first determine
whether the firm has a sustainable competitive advantage that enables
it to compete effectively in the home market
In order to sustain a competitive advantage it must be:
• Firm-specific
• Transferable
• Powerful enough to compensate the firm for the extra difficulties of operating
abroad
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Some of the competitive advantages enjoyed by MNCs are:
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Economies of scale and scope
Managerial and marketing expertise
Advanced technology
Financial strength
Differentiated products
Competitiveness of the their home market
Michael Dimond
School of Business Administration
Sustaining & Transferring Competitive Advantage
Michael Dimond
School of Business Administration
Multinational Investment Decisions
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Two related behavioral theories behind FDI that are most
popular are
• Behavioral approach to FDI
• International network theory
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Behavioral Approach – Observation that firms tended to invest first in
countries that were not too far from their country in psychic terms
• This included cultural, legal, and institutional environments similar to their
own
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International network theory – As MNCs grow they eventually
become a network, or nodes that operate either in a centralized
hierarchy or a decentralized one
• Each subsidiary competes for funds from the parent
• It is also a member of an international network based on its industry
• The firm becomes a transnational firm, one that is owned by a coalition of
investors located in different countries
Michael Dimond
School of Business Administration
Alternative investments for expansion
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Exporting vs. production abroad
Licensing/management contracts versus control of assets
abroad
Joint ventures versus wholly owned subsidiary
Greenfield investment versus acquisition
• A greenfield investment is establishing a facility “starting from the ground up”
• Usually require extended periods of physical construction and organizational
development
• Here, a cross-border acquisition may be better because the physical assets
already exist, shorter time frame and financing exposure
• However, problems with integration, paying too much for acquisition, post-merger
management, and realization of synergies all exist
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
When making FDI decisions, cost of capital is key
• There are two alternatives in valuing foreign projects:
• Adjusting the discount rate to accommodate risk
• Adjusting the cash flows to accommodate risk
• Adjusting the discount rate is simpler, but the approach can
be over-simplified and lead to poor decisions (& agency cost)
• Adjust with a risk premium
• Adjust with a risk model
Michael Dimond
School of Business Administration
Refresher on WACC
• Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free
rate of interest is 3%. The expected return on the market
portfolio is 8%. After effective taxes, Corcovado’s effective
tax rate is 25%. Its optimal capital structure is 60% debt and
40% equity. If Corcovado’s beta is estimated at 0.8, what is
its weighted average cost of capital?
Michael Dimond
School of Business Administration
Refresher on Beta
• You should be familiar with some of this…
•β = ρ σ / σ
i
im
i
•β = ρ σ / σ
f
fd
f
•β = β β
project
f
m
d
i
Michael Dimond
School of Business Administration
• Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free
rate of interest is 3%. The expected return on the market
portfolio is 8%. After effective taxes, Corcovado’s effective
tax rate is 25%. Its optimal capital structure is 60% debt and
40% equity. If Corcovado’s beta is estimated at 0.8, what is
its weighted average cost of capital?
• Assume the beta of the foreign market vs the domestic
market is 1.375. What is the WACC for Corcovado to engage
in a project in this foreign economy?
Michael Dimond
School of Business Administration
Budgeting for Foreign Projects
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Like domestic capital budgeting, this focuses on the cash
inflows and outflows associated with prospective long-term
investment projects
Capital budgeting follows same framework as domestic
budgeting
– Identify initial capital invested or put at risk
– Estimate cash inflows, including a terminal value or salvage value of
investment
– Identify appropriate discount rate for PV calculation
– Apply traditional analysis
Michael Dimond
School of Business Administration
FDI Example: Cemex enters Indonesia
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Cementos Mexicanos (Cemex) is considering construction of plant in
Indonesia (Semen Indonesia) as a Greenfield project
Cemex is listed on both US and Mexican markets but most of its capital
is US dollar denominated so evaluation of project is in US dollars
Michael Dimond
School of Business Administration
Cemex enters Indonesia
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Financial assumptions
– Capital Investment – cost to build plant estimated at $150/tonne but
Cemex believes it can build the plant at a cost of $110/tonne
• Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is
estimated at Rp22 trillion
• With straight line depreciation on equipment values at Rp17.6 trillion
costing 1.76 trillion per year
– Financing – plant would be financed with 50% equity (all from
Cemex) and 50% debt
• Debt is broken down, with Cemex providing 75% and a bank consortium
providing the remaining 25%
• Cemex’s WACC (in US dollars) is 11.98%
• For the local project (in rupiah) the WACC is 33.257%
Michael Dimond
School of Business Administration
Investment & Financing of Semen Indonesia
All figures in 000s
unless stated
otherwise
Michael Dimond
School of Business Administration
Cemex enters Indonesia
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More financial assumptions
– Revenues – sales are based on export and the plant will operate at
40% capacity producing 8 million tonnes per year
• Cement will be sold in export market at $58/tonne
– Costs – cost per ton is estimated at Rp115,000 in 1999 and rising at
the rate of inflation (30%) per year
• For export costs, loading costs of $2.00/tonne and shipping costs of
$10/tonne must also be added
Michael Dimond
School of Business Administration
Expected Debt Service & Exchange Gain/Loss
Michael Dimond
School of Business Administration
Pro Forma Income Statement
Michael Dimond
School of Business Administration
Project Viewpoint Capital Budget
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Semen Indonsia’s free cash flows are found by looking at EBITDA
and not EBT
Taxes are calculated based on this amount
Terminal value is calculated for the continuing value of the plant
after year 5
– TV is calculated as a perpetual net operating cash flow after year 5
Michael Dimond
School of Business Administration
Remittance of income to parent (MM rupiah & $)
$1,925 is Cemex’s capital
investment, NOT the total
capital invested:
$1,100MM equity
+ $825MM Debt
Michael Dimond
School of Business Administration
Parent Viewpoint Capital Budget
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Now cash flows estimates are constructed from parent’s
viewpoint
• Cemex must now use it’s cost of capital and not the
project’s
• Recall that Cemex’s WACC was 11.98%
• However, Cemex requires an additional yield of 6% for
international projects, thus the discount rate will be 17.98%
• This yields an NPV of -$925.6 million (IRR –1.84%) which is
unacceptable from the parent’s viewpoint
Michael Dimond
School of Business Administration
Sensitivity Analysis: Project Viewpoint
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Political risk – biggest risk is blocked funds or expropriation
– Analysis should build in these scenarios and answer questions such
as how, when, how much, etc.
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Foreign exchange risk
– Analysis should also consider appreciation or depreciation of the US
dollar
Michael Dimond
School of Business Administration
Sensitivity Analysis: Parent Viewpoint
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When a foreign project is analyzed from the parent’s point
of view, the additional risk that stems from its “foreign”
location can be measured in at least two ways;
– Adjusting the discount rates
– Adjusting the cash flows
Michael Dimond
School of Business Administration
Sensitivity Analysis: Parent Viewpoint
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Adjusting discount rates
– The first method is to treat all foreign risk as a single problem, by adjusting
the discount rate applicable to foreign projects relative to the rate used for
domestic projects to reflect the greater foreign exchange risk, political risk,
agency costs, asymmetric information and other uncertainties
– However, adjusting the discount rate applied to a foreign project’s cash flow
to reflect these uncertainties does not penalize NPV in proportion either to
the actual amount at risk or to possible variations in the nature of that risk
over time
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Adjusting cash flows
– In the second method, we incorporate foreign risks in adjustments to
forecasted cash flows of the project
– The discount rate for the foreign project is risk-adjusted only for overall
business and financial risk, in the same manner as for domestic projects
– It is important to remember that the process of forecasting cash flows is
extremely subjective. Document all assumptions.
Michael Dimond
School of Business Administration
Shortcomings of Adjustments
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In many cases, neither adjusting the discount rate nor
adjusting cash flows is optimal
For example, political uncertainties are a threat to the entire
investment, not just the annual cash flows
Apart from anticipated political and foreign exchange risks,
MNCs sometimes worry that taking on foreign projects may
increase the firm’s overall cost of capital because of
investor’s perceptions of foreign risk; in these cases
diversification is a risk mitigant
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Scenario:
• Alpha Tile Co. (U.S.) is considering a capital expenditure of Rs50,000,000
in India to create a wholly owned tile manufacturing plant to export to the
European market. After five years the subsidiary would be sold to Indian
investors for Rs100,000,000 above the value of the NWC tied up in the
project. There wll be no capital gains tax on the final sale. The
assumptions is sales revenue will be Rs30,000,000 next year, with sales
growing 5% per year and 57% of sales required for cash operating
expenses. There will be Rs1,000,000 annual depreciation expenses.
Initial Net Working Capital needs will be Rs3 million, and are expected to
be 12% of sales for each subsequent year. Alpha uses a 14% cost of
capital on domestic investments, and will add 6 percentage points for the
Indian investment because of perceived greater risk. The initial
investment will be made on December 31, 2013, and cash flows will occur
on December 31st of each succeeding year. Indian tax rate = 50%.
• What is the net present value, internal rate of return and payback
period of this investment?
Michael Dimond
School of Business Administration
Complexities of Budgeting for Foreign Projects
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Parent cash flows must be distinguished from project
Parent cash flows sometimes change based on the form of financing, and one
cannot clearly separate cash flows from financing
Additional cash flows from new investment may in part or in whole take away
from another subsidiary; possibly negate the value to entire organization
Parent must recognize remittances from foreign investment because of differing
tax systems, legal and political constraints
An array of non-financial payments can generate cash flows to parent in form of
licensing fees, royalty payments, etc.
Managers must anticipate differing rates of national inflation which can affect
differing cash flows
Use of segmented national capital markets may create opportunity for financial
gain or additional costs
Use of host government subsidies complicates capital structure and parent’s
ability to determine appropriate WACC
Managers must evaluate political risk
Terminal value is more difficult to estimate because potential purchasers have
widely divergent views
Michael Dimond
School of Business Administration
Project Valuation vs Parent Valuation
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Most firms evaluate foreign projects from both parent and project
viewpoints
– The parent’s viewpoint analyses investment’s cash flows as operating cash
flows instead of financing due to remittance of royalty or licensing fees and
interest payments
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Project valuation provides closer approximation of effect on
consolidated EPS
The parent’s viewpoint gives results closer to “proper” NPV capital
budgeting analysis
Michael Dimond
School of Business Administration
Further Details
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Annual cash dividends to the parent company from India will
equal 75% of after tax profit (Indian corporate tax rate is
assumed at 50%). The U.S. corporate tax rate is 40%.
Because the Indian tax rate is greater than the U.S. tax rate,
annual dividends paid to Alpha will not be subject to
additional taxes in the United States. There are no capital
gains taxes on the final sale.
• Alpha forecasts the rupee exchange rate as follows:
2013
2014
2015
2016
2017
2018
Rs/$
50
54
58
62
66
70
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Summary
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The proposed greenfield investment in Indonesia by Cemex was
analyzed within the traditional capital budgeting framework (base case)
The foreign complications were introduced to the analysis, including
foreign exchange and political risks
Parent cash flows must be distinguished from project cash flows. Each
of these two types of flows contributes to a different view of value
Parent cash flows often depend on the form of financing. Thus, cash
flows cannot be clearly separated from financing decisions, as is done
in domestic capital budgeting
Remittance of funds to the parent must be explicitly recognized because
of differing tax systems, legal and political constraints on the movement
of funds, local business norms, and differences in how financial markets
and institutions function
Cash flows from subsidiaries to parent can be generated by an array of
nonfinancial payments, including payment of license fees and payments
for imports from the parent
Michael Dimond
School of Business Administration
Summary
• Differing rates of national inflation must be anticipated
because of their importance in causing changes in
competitive position, and thus in cash flows over a period of
time
• When a foreign project is analyzed from the project’s point of
view, risk analysis focuses on the use of sensitivities, as well
as consideration of foreign exchange and political risks
associated with the project’s execution over time
• When a foreign project is analyzed from the parent’s point of
view, the additional risk that stems from its “foreign” location
can be measured in at least two ways, adjusting the discount
rates or adjusting the cash flows
Michael Dimond
School of Business Administration