Multinational Capital Budgeting

International Financial Management

Dr. A. DeMaskey

Learning Objectives
How does domestic capital budgeting differ from

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

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

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 parents 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

CFt TV n NPV I0 t n (1 k ) t 1 (1 k )

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:

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.

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*.

Reflects only the riskiness of the projects expected future cash flows. Abstracts from the projects financial structure. Can be viewed as the companys 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 + * (rm rf)

* is the all-equity or unlevered beta A levered equity beta, e, 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:

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 CFt Tt St APV I 0 t t t ( 1 k *) ( 1 i ) ( 1 i ) t 1 t 1 t 1 d d n

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

The parents viewpoint analyses investments cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments

The parents 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:

Tax regulations Exchange controls Fees and royalties Transfer pricing Other factors

Three-Stage Approach
Stage1: Project cash flows are computed from the subsidiarys 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 projects true profitability

requires various adjustments to the project cash flows:

Adjust for the effects of transfer pricing and fees and royalties. Adjust for global costs/benefits that are not reflected in the projects financial statements.

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:

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:

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.

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:

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.

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:

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:

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:

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.