Transcript International Valuations

International
Capital Budgeting
Chapter 18
Lecture Objectives
Review of Domestic Capital Budgeting
The Adjusted Present Value Model
Capital Budgeting from the Parent Firm’s
Perspective
Risk Adjustment in the Capital Budgeting
Process
Sensitivity Analysis
Review of Domestic Capital Budgeting
Objective:
To increase shareholder wealth, a company must accept projects
with NPV>0; NPV is the present value of future cash flows minus
the initial investment.
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.
Review of Domestic Capital Budgeting
The basic net present value equation is
T
CFt
TVT
NPV  

 C0
t
T
(1  K )
t 1 (1  K )
where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow in year T, including return of net
working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
Review of Domestic Capital Budgeting
The NPV rule is to accept a project if NPV  0
T
CFt
TVT
NPV  

 C0  0
t
T
(1  K )
t 1 (1  K )
and to reject a project if NPV  0
T
CFt
TVT
NPV  

 C0  0.
t
T
(1  K )
t 1 (1  K )
Review of Domestic Capital Budgeting
For our purposes it is necessary to expand the NPV
equation.
CFt  ( Rt  OCt  Dt  I t )(1  τ )  Dt  I t (1  τ )
Rt is incremental revenue
It is incremental interest expense
OCt is incremental operating
cost
 is the marginal tax rate
Dt is incremental depreciation
Review of Domestic Capital Budgeting
CFt  OCFt (1  τ )  τDt
We can use
to restate the NPV equation
T
as:
CFt
TVT
NPV  

 C0
t
T
(1  K )
t 1 (1  K )
OCFt (1  τ )  τ Dt
TVT
NPV  

 C0
t
T
(1  K )
(1  K )
t 1
T
The Adjusted Present Value Model
OCFt (1  τ )
τ Dt
TVT
NPV  


 C0
t
t
T
(1  K )
(1  K ) (1  K )
t 1
T
Can be converted to adjusted present value (APV)
OCFt (1  τ )
τ Dt
τ It
TVT
APV  



 C0
t
t
t
T
(1  Ku )
(1  i) (1  i) (1  Ku )
t 1
T
The Adjusted Present Value Model
OCFt (1  τ )
τ Dt
τ It
TVT
APV  



 C0
t
t
t
T
(1  Ku )
(1  i) (1  i) (1  Ku )
t 1
T
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.
International Valuations
There is no fundamental difference between
valuations of domestic and international
projects
Although, international valuation involves
complex problems that are not common in a
domestic context
International tax issues
Cash flows in foreign currency
What is the appropriate cost of capital
Political risk
Form of investment, remittance policy, and transfer pricing
Valuation of subsidies and tax breaks
How to evaluate an international investment in light of
all the added complexity?
Capital Budgeting from the Parent Firm’s
Perspective
The APV model as presented before is not useful for capital
budgeting of international projects
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.
T
StOCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(1

K
)
(1

i
)
(1

i
)
t 1
t 1
t 1
ud
d
d
T
T
ST TVT
St LPt

 S0C0  S0 RF0  S0CL0  
T
t
(1  K ud )
(1

i
)
t 1
d
Capital Budgeting from the Parent Firm’s
Perspective
T
StOCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(1

K
)
(1

i
)
(1

i
)
t 1
t 1
t 1
ud
d
d
T
T
ST TVT
St LPt


S
C

S
RF

S
CL


0 0
0
0
0
0
t
(1  K ud )T
(1

i
)
t 1
d
The operating cash flows must
be translated back into the
parent firm’s 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 Firm’s Perspective
T
StOCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(1

K
)
(1

i
)
(1

i
)
t 1
t 1
t 1
ud
d
d
T
T
ST TVT
St LPt

 S0C0  S0 RF0  S0CL0  
T
t
(1  K ud )
(1

i
)
t 1
d
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
parent’s or foreign
subsidiary’s.
Capital Budgeting from the Parent Firm’s Perspective
T
StOCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(1

K
)
(1

i
)
(1

i
)
t 1
t 1
t 1
ud
d
d
T
T
ST TVT
St LPt

 S0C0  S0 RF0  S0CL0  
T
t
(1  K ud )
(1

i
)
t 1
d
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 parent’s currency) of
any concessionary loans,
CL0, and loan payments,
LPt , discounted at id .
Estimating the Future Expected Exchange
Rates
We can appeal to PPP:
(1  π d )t
St  S 0
(1  π f )t
Perspective of valuation
 Parent’s or project’s point of view?
- Differences can exist between the expected cash flows from
parent’s vs project’s point of view
Reasons for this include
Certain CFs are blocked by the host country from being
legally remitted to the parent
Cannibalization of existing cash flows within the firm
- Theory suggests the value of a project to SH is the value of the
cash flows back to the investor
Investment decision should be based only on the value of
incremental cash flows that can be returned to investor
Therefore it is more appropriate to take the parent’s point of
view
Mini-case: Centralia Corporation
Centralia Corporation
• A US manufacturer of small kitchen electrical appliances, and
currently, sells microwaves in Spain through an affiliate
• current sales are 9,600 units/year and increasing at a rate of 5%
• price $180 per unit, of which $35 represents profit margin
• Sales to EU forecast at 25,000 units in the first year and expect
to increase by 12% per year; all sales will be invoiced in €
• Wants to build a manufacturing facility in Zaragoza, Spain
• cost of plant €5,500,000
• borrowing capacity $2,904,000
• Madrid sales affiliate accumulated a net amount of €750,000
from its operations, which can be used to partially finance
construction cost
• new plant will be depreciated over 8 years
Centralia Corporation (continued)
•
•
•
•
•
Sales price €200/unit and production cost €160/unit in the first
year and expect to increase with inflation
Expected inflation: 2.1% in Spain; 3% in the U.S.; and the
current exchange rate: $1.32/€.
Marginal tax rate in Spain and the U.S. at 35%; accumulated
funds at 20%
Centralia will get a special financing deal:
• €4,000,000 at 5% per year
• Normal borrowing rate is 8% in dollars and 7% in €s
• Principal to be repaid in eight equal installments
Dollar all-equity cost of capital is 12%
Calculate the APV of the project.
Centralia Corporation (continued)
1. Initial cost of the project in $
2. Use PPP to estimate the future expected spot exchange rate
3. Calculate the PV of the after-tax operating cash flows (Exhibit 18.2)
- calculate the operating profits (Revenue –costs) of the new
manufacturing facility
- calculate the annual lost sales and contribution margin from
current sales from US to Spain
- discount the operating cash flows at all-equity cost of capital
4. Calculate the present value of the depreciation tax shields (Exhibit
18.3)
Centralia Corporation (continued)
5. Calculate the present value of the concessionary loan payments
(Exhibit 18.4)
6. Calculate the present value of the benefit from the concessionary loan
(Exhibit 18.5)
7. Calculate the present value of interest tax shields (Exhibit 18.6)
8. Calculate the amount of the freed-up restricted remittances
9. Ready to calculate APV
For answers see the text or/and the Excel spreadsheet.
Sensitivity Analysis
•
•
•
In the APV model, each cash flow is uncertain, hence
the realized value may be different from what was
expected.
In sensitivity analysis, different estimates are used for
expected inflation rates(XRs), cost and pricing
estimates, and other inputs for the APV to give the
manager a more complete picture of the planned capital
investment.
Allow the financial managers to understand the
sensitivity of the APV of the project to several factors.
Not all the inputs affect the APV in the same way.
The following section in chapter 18 is not required
for the exam:
- Real options
Learning Outcomes
•
•
•
What makes the APV capital budgeting framework
useful for analyzing foreign capital expenditures?
What is the nature of a concessionary loan and how it is
handled in the APV model?
Numerical problem: Know how to calculate a foreign
project’s APV (or components of it) using a
methodology similar to the one used in mini-case
Centralia (these notes) or/and mini-case Dorchester.