Transcript IFM_Ch14_multinational capital budgeting

FINC3240
International Finance
Chapter 14
Multinational Capital Budgeting
Capital Budgeting Decision

Capital budgeting: the process of
analyzing projects and decide which ones
to invest in.
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Capital budgeting rules

We will learn to apply 2 capital budgeting
rules:

Net present value (NPV)

Internal rate of return (IRR)
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Net present value (NPV) rule
Accept project if
Net present value > 0
What is Net present value?
Net present value
= Benefits minus Costs
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How do we measure
benefits & costs?
Benefits= Present value of all cash inflows
from the project
Costs= Present value of all cash outflows
from the project
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N
N
CIFt
COFt
NPV = B – C = 

t
t
t 0 1  r 
t 0 1  r 
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Internal rate of return (IRR) 1
IRR: the discount rate that will make the PV
of cash inflows equal to the PV of cash
outflows.
• In other words, IRR is the discount rate such
that the NPV is 0.
N
N
CIFt
COFt

0

t
t
t 0 1  IRR
t 0 1  IRR
PV of cash inflows,
discounted at IRR
PV of cash outflows,
discounted at IRR
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Internal rate of return (IRR) 2
Accept project if
IRR > cost of capital


Intuitively, think of the IRR as the return from
the project.
Then the project should be accepted if the return
is greater than the required rate of return / cost
of capital.
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Apply the NPV and IRR

A firm is considering investment in a
project that costs $1,200 and yields
cash flows of $500 in the first year,
$600 in the second year and $700 in
the third year. Compute the NPV
and IRR of this project. The
appropriate discount rate (cost of
capital) for this project is 10 percent.
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Computing NPV using BA II Plus
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Press CF, press -1200 and then press ENTER for
CF0.
Next press “” and enter 500 for C01.
Press “” and enter 1 for F01.
Similarly enter C02 = 600, F02 = 1, C03 = 700,
and F03 = 1. Make sure that all the cash flows
later than C03 are zero.
Press NPV. Enter the discount rate of 10 percent
by pressing 10 and then ENTER.
The display will show that I = 10.
Next press the “” and press CPT. The calculator
will display the NPV of 276.33. Decision: Accept 10
project
Computing IRR using BA II Plus
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In order to compute the IRR, follow
the same steps as above for entering
the cash flows.
Then instead of pressing NPV, press
the IRR button and then press CPT.
The calculator will display the IRR as
21.92 percent.
Decision: Accept project
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Normal cash flows
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In the previous problem, there is ONE
cash outflow at the beginning. After that,
we have all cash inflows.
A project with such a cash flow pattern is
a project with normal cash flows.
So what? For independent projects with
NORMAL CASH FLOWS, the NPV, IRR rules
will give the SAME decision. This is exactly
what happened in the problem we solved.
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Apply NPV, IRR

Assume a discount rate of 11%. Compute
the NPV, IRR and decide whether the
project should be accepted or rejected.
Project
C0
C1
C2
C3
C4
C5
A
T=0
-1000
T=1
400
T=2
400
T=3
400
T=4
500
T=5
500
Verify that NPV = 603.58, IRR = 31.79%,
Since NPV>0, IRR>11%, accept the project
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Another question
A five-year project, if taken, will require an initial investment
of $120,000. The expected end-of-year cash inflows are as
follows:
C1
C2
C3
C4
C5
30,000
42,000
42,000
28,000
12,000
If the appropriate cost of capital for this project is 11%, which
of the following is a correct decision?
a. Reject the project because NPV = -$30,507, which is less
than 0.
b. Reject the project because IRR is 10.04%, which is less
than the cost of capital, 11%.
c. Both a and b are correct.
d. Accept the project because IRR is positive.
e. None of the above is correct.
14
Multinational Capital Budgeting
Assumption:
The subsidiary is wholly owned by the
parent company. Therefore, the feasibility of
the project depends on the cash flows that
the parent ultimately receives.
Process of Remitting Subsidiary Earnings to Parent
14.1
Input for Multinational Capital
Budgeting
1. Economic and Financial Characteristics
Involved
a. Initial Investment
b. Price and Consumer Demand (and
inflation)
c. Costs (variable and fixed)
d. Tax
e. Remitted Funds
f. Exchange Rates
g. Salvage Value
h. Required Rate of Return
Example 1
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Spartan, Inc. on page 425.
read the textbook
the cash flows received by the parent should be
US$.
How to estimate the cash flows? See
Exhibit 14.2
Financing Arrangement
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Domestic capital budgeting problems would not include
debt payments in the measurement of cash flows because
all financing costs are captured by the discount rate.
When the parent finances the whole foreign project, debt
payments does not count.
When the foreign subsidiary partially finances the foreign
project, we should separate the investment made by the
subsidiary from the investment made by the parent. The
capital budgeting should focus on the present value of cash
flows received by the parent and the initial investment by
the parent.
Adjusting for Risk
1. Risk-Adjusted Discount Rate
the greater the uncertainty about the forecasted cash flows,
the larger should be the discount rate, other things being
equal.
2. Sensitivity Analysis
forecast the cash flows under different possible scenarios,
such as different level of sales, expenses, exchange rate,
etc.
3. Simulation
using software and computer to generate millions of
possible outcomes and calculate the average.
Exhibit 14.3 Analysis Using Different Exchange
Rate Scenarios: Spartan, Inc.
Example 2
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Your employees have estimated the net present
value of project XP to be $1.2 million. Their
report says that they have not accounted for any
risk, but that with such a large NPV, the project
should be accepted since even a risk-adjusted
NPV would likely be positive. You have the final
decision as to whether to accept or reject the
project. What is your decision?
ANSWER: The decision should not be made until risk has
been considered. If the project has a risk of a government
takeover, for example, a large estimated NPV may not be a
sufficient reason to accept the project.
Example 3
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Brower, Inc, is considering constructing a manufacturing
plant in Ghana. The construction cost 9 billion Ghanian
Cedi. Brower intends to leave the plant open for 3 years.
During the 3 years of operation, cash flows are expected to
be 3, 3, and 2 billion cedi, respectively. Operating cash
flows will begin one year from today and are remitted back
to the parent at the end of each year. At the end of the
third year, Brower expects to sell the plant for 5 billion
cedi. Brower has a required rate of return of 17%. It
currently takes 8,700 cedi to buy one US dollar, and the
cedi is expected to depreciate by 5% per year. Should
Brower build the plant?
Solution
Year
Investment
Operating CF
Salvage Value
Net CF
Exchange rate
Cash flows to parent
PV of parent cash flows

0
–9
–9
8,700
–$1,034,483
–$1,034,483
1
2
3
3
3
3
9,135
$328,407.23
$280,689.94
3
9,592
$312,760.63
$228,475.88
2
5
7
10,071
$695,065.04
$433,978.15
NPV=-91,339.03<0, so reject.
Homework 9
Chapter 14 Questions and
applications:
5,10,11,20