Transcript Multinational Capital Budgeting

Multinational Capital
Budgeting
International Financial Management
Dr. A. DeMaskey
Learning Objectives
 How does domestic capital budgeting differ from
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multinational capital budgeting?
How do incremental cash flows differ from total
project cash flows?
What is the difference between foreign project cash
flows and parent cash flows?
How does APV analysis differ from NPV analysis?
How is the capital budgeting analysis adjusted for the
additional economic and political risks?
What is real option analysis?
Complexities of Capital Budgeting
for a Foreign Project
 Several factors make budgeting for a foreign project
more complex
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Parent cash flows must be distinguished from project
Parent cash flows often depend on the form of
financing, thus cannot clearly separate cash flows from
financing
Additional cash flows from new investment may in part
or in whole take away from another subsidiary; thus as
stand alone may provide cash flows but overall adds
no value to entire organization
Parent must recognize remittances from foreign
investment because of differing tax systems, legal and
political constraints
Complexities of Capital Budgeting
for a Foreign Project
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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
Traditional Capital Budgeting Analysis
 NPV Analysis
n
CFt
TVn
NPV  
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 I0
t
n
(1  k )
t 1 (1  k )
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If Projects are independent, those with a positive NPV
will be accepted while those with a negative NPV will
be rejected
It two projects are mutually exclusive, the project with
the highest NPV greater than zero will be accepted.
The discount rate, k, is the expected rate of return on
projects of similar risk as the riskiness of the firm as a
whole.
Properties of NPV Rule
 Consistent with the goal of maximizing
shareholder wealth.
 Focuses on cash flows rather than
accounting profits.
 Emphasizes the opportunity cost of money
invested.
 Obeys the additivity principle.
Incremental Cash Flows
 Only the additional cash flows generated by
the project are relevant.
 The difference between total and incremental
cash flows arises from:
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Cannibalization
Sales creation
Opportunity cost
Transfer prices
Fees and royalties
Choosing the Correct Case Base
 The base case is represented by the
worldwide corporate cash flows without the
investment.
 In a competitive world, the base case needs
to be adjusted for competitive behavior.
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New product
New production technology
Intangible benefits
Adjusted Present Value (APV)
 Project risks and financial structures vary by
country, production state, and position in the
life cycle of the project.
 Rather than modifying the WACC, cash flows
can be discounted at an all-equity rate, k*.
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Reflects only the riskiness of the project’s
expected future cash flows.
Abstracts from the project’s financial structure.
Can be viewed as the company’s cost of
capital if it were all-equity financed, that is,
with zero debt.
All-Equity Rate
 The all-equity rate is based on the CAPM:
k* = rf + β* (rm – rf)
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β* is the all-equity or unlevered beta
A levered equity beta, βe, is unlevered using
the following equation:
* 
e
1  (1  T )(D / E )
Adjusted Present Value Approach
 The value of a project is equal to the sum of
the following components:
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PV of after-tax project cash flows but before
financing costs discounted at k*.
PV of tax savings on debt financing
discounted at the before-tax dollar cost of
debt, id.
PV of any savings or penalties on interest
costs associated with project-specific financing
discounted at the before-tax dollar cost of
debt, id.
Adjusted Present Value Approach
n
n
n
CFt
Tt
St
APV   I 0  


t
t
t
(
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k
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(
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(
1
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i
)
t 1
t 1
t 1
d
d
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Tt = tax savings in year t due to the specific
financing package
St = before-tax dollar value of interest
subsidies (penalties)
id = before-tax dollar cost of debt
Issues in Foreign Investment Analysis
 Should cash flows be measured from the
viewpoint of the project or that of the parent?
 Should the additional economic and political
risks that are uniquely foreign be reflected in
cash flow or discount rate adjustments?
Project versus Parent Valuation
 Most firms evaluate foreign projects from both
parent and project viewpoints
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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
 The parent’s viewpoint gives results closer to
traditional NPV capital budgeting analysis
 Project valuation provides closer
approximation of effect on consolidated EPS
Parent versus Project Cash Flows
 Project and parent cash flows can diverge
significantly due to:
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Tax regulations
Exchange controls
Fees and royalties
Transfer pricing
Other factors
Three-Stage Approach
 Stage1:
 Project cash flows are computed from the
subsidiary’s perspective.
 Stage 2:
 Project cash flows to the parent are evaluated
on the basis of specific forecasts concerning
the amount, timing, and form of remittance.
 Stage 3:
 Account for the additional benefits and costs
of the project.
Incremental Project Cash Flows
 Estimating a project’s true profitability
requires various adjustments to the project
cash flows:
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Adjust for the effects of transfer pricing and
fees and royalties.
Adjust for global costs/benefits that are not
reflected in the project’s financial statements.
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Cannibalization
Sales creation
Additional taxes
Diversification of production facilities and markets
Tax Factors
 Only after-tax cash flows are relevant.
 Actual taxes paid are a function of:
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Time of remittance
Form of remittance
Foreign income tax rate
Withholding taxes
Tax treaties
Foreign tax credits
Tax Factors
 Computing the tax liabilities of foreign
investments assumes that:
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The maximum amount of funds are available
for remittance each year.
The tax rate applied is the higher of the home
or host country rate.
Tax Factors: Illustration
 Suppose that an affiliate will remit after-tax earnings
of $120,000 to its U.S. parent in the form of a
dividend. Assume the foreign tax rate is 20%, the
withholding tax on dividends is 4%, and excess
foreign tax credits are unavailable.
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What is the additional tax owed to the U.S.
government?
What is the marginal rate of additional taxation?
Political and Economic Risk Analysis
 There are three main methods for
incorporating the additional political and
economic risks into a foreign investment
analysis:
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Shortening the payback period
Raising the required rate of return of the
investment
Adjusting the cash flows to reflect the specific
impact of a given risk.
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Uncertainty absorption
Adjusting the expected value of future cash flows
Exchange Rate Changes and Inflation
 The analysis should also consider the appreciation or
depreciation of the US dollar.
 Approach A:
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Convert nominal foreign currency cash flows into
nominal home currency terms.
Discount those nominal cash flows at the nominal
domestic required rate of return.
 Approach B:
 Discount the nominal foreign currency cash flows at
the nominal foreign currency required rate of return.
 Convert the resulting foreign currency present value
into the home currency using the current spot rate.
Political Risk Analysis
 The preferred method is to adjust the cash
flows of the project to reflect the impact of a
particular political event on the present value
of the project to the parent.
 The biggest risk is:
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Expropriation
Blocked funds
Expropriation: Illustration
 Suppose a firm projects a $5 million perpetuity from
an investment of $20 million in Spain. If the required
return on this investment is 20%, how large does the
probability of expropriation in year 4 have to be
before the investment has a negative NPV? Assume
that all cash flows occur at the end of the year and
that the expropriation, if it occurs, will occur prior to
the year 4 cash inflows or not at all. There is no
compensation in the event of expropriation.
Real Option Analysis
 DCF analysis cannot capture the value of the
strategic options, yet real option analysis
allows this valuation.
 Real option analysis includes the valuation of
the project with future choices such as:
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The option to defer
The option to abandon
The option to alter capacity
The option to start up or shut down (switching)
Real Option Analysis
 Real option analysis treats cash flows in
terms of future value in a positive sense
whereas DCF treats future cash flows
negatively (on a discounted basis).
 The valuation of real options and the
variables’ volatilities is similar to equity option
math.
 An expanded NPV rule consists of the
traditional DCF analysis plus the value of an
option.