Definitions in Multinational Capital Budgeting

Definitions in Multinational capital budgeting:
Multinational capital budgeting, like traditional domestic capital budgeting,

focuses on the cash inflows and outflows associated with prospective long-
term investment projects.
Important points in MNEs capital budgeting:
Almost any project should at least be able to earn a cash return

equal to the yield available on host government bonds (with the
same maturity as the projects economic life).
Multinational firms should invest only if they can earn a risk-adjusted

return greater than locally based competitors can earn on the same
project.
If they are unable to earn superior returns on foreign projects, their

stockholders would be better off buying shares in local firms, where
possible, and letting those companies carry out the local projects.
Most firms appear to evaluate foreign projects from both parent and
project viewpoints (to obtain perspectives on NPV and the overall
effect on consolidated earnings of the firm).
Possible problems:
Capital budgeting for a foreign project is considerably more complex

than the domestic case:
Parent cash flows must be distinguished from project cash

flows
Parent cash flows often depend on the form of financing
Additional cash flows generated by a new investment in one

foreign subsidiary may be in part or in whole taken away from
another subsidiary
Managers must keep the possibility of unanticipated foreign

exchange rate changes in mind because of possible direct
effects on the value of local cash flows, as well as indirect
effects on the competitive position of the foreign subsidiary
Use of segmented national capital markets may create an

opportunity for financial gains or may lead to additional
financial costs
Use of host-government-subsidized loans complicates both

capital structure and the parents ability to determine an
1
appropriate weighted average cost of capital for discounting
purposes
Managers must evaluate political risk, because political events

can drastically reduce the value or availability of expected
cash flows
2. What are the steps of multinational Capital Budgeting?
Capital budgeting for a foreign project uses the same theoretical

framework as domestic capital budgeting.
The basic steps are:
Identify the initial capital invested or put at risk
Estimate cash flows to be derived from the project over time,

including an estimate of the terminal or salvage value of the
investment
Identify the appropriate discount rate to use in valuation
Apply traditional capital budgeting decision criteria such as

NPV and IRR
3. What are the NPV and IRR?
NPV is the net present value of a firm or a project. It is to evaluating the

future expected cash flow using discounted cash flow method.
IRR is internal rate of return method. When we set the NPV=0 we will have
a cutoff rate of return (the internal rate of return) which is different from
the discount rate. The investment criteria is then, if the IRR is larger than
(or equal to) the discount rate (i.e. the required return of the risky project),
we can decide to go through with the project. If it is less than the required
return on the project, we will reject the project.
Case in point: the book case of Cemex Enters Indonesia
It is early 1998, Cementos Mexicanos is considering the construction of

a cement manufacturing facility on the Indonesian island of Sumatra.
This project would be a wholly-owned greenfield investment.
The company has three main reasons for the project:
Initiate a productive presence in Southeast Asia

To position Cemex to benefit from infrastructural development in the
region
2
The positive prospects for Indonesia to act as a produce-for-export
site
A Roadmap to the Construction of Semen Indonesias

Capital Budget
Investment and Financing of the Semen Indonesia

Project (all values in 000s unless otherwise noted)
3
4
Semen Indonesias Debt Service Schedules and
Foreign Exchange Gains/Losses
5
Semen Indonesias Pro Forma Income Statement
(millions of rupiah)
Semen Indonesias Capital Budget: Project Viewpoint

(millions of rupiah)
6
Semen Indonesias Remittance and Capital Budget:
Parent Viewpoint (millions of rupiah and U.S. dollars)
7
The project capital budget indicates a negative NPV: an IRR of only
15.4% compared to the 33.3% cost of capital. These are the returns the
project would yield to a local or Indonesian investor in Indonesian
rupiah. Therefore the project, from the single firm viewpoint, is not
acceptable. What about from the parent company view point? (A
foreign investors assessment of a projects returns depends on the
actual cash flows that are returned to it, in its own currency.)
We build this parent viewpoint capital budget in two steps.
First, we isolate the individual cash flows, adjusted for any withholding
taxes imposed by the Indonesian government and converted to US
dollars.
The second step, that actual parent viewpoint capital budget, combines
these US dollar after-tax cash flows with the initial investment to
determine the NPV of the proposed Indonesian subsidiary in the eyes
(and pocketbook) of Cemex.
Most corporations require that the new investments more than cover
the cost of the capital employed in their undertaking.
It is therefore not unusual for the firm to require a hurdle rate of 3%

over the cost of capital for domestic investments, and 6% more for
international projects.
At this point sensitivity analyses are run from both the project and
parent viewpoints.
This would include analyzing (for the project): Political risks, Foreign
exchange risks and Other business specific potentialities
And analyzing (for the parent): A range of discount rates and Varying
cash flow patterns.
Further analysis:
The discounted cash flow (DCF) analysis used in the valuation of Semen
Indonesia, and in capital budgeting and valuation in general, has long
had its critics.
Importantly, when MNEs evaluate competitive projects, traditional cash

flow analysis is typically unable to capture the strategic options that an
individual invest option may offer.
This has led to the development of real options analysis.
Real options analysis is the application of the option theory to capital

budgeting decisions.
Real options is a different way of thinking about investment values.
8
At its core, it is a cross between decision-tree analysis and pure
option-based valuation.
Real option valuation also allows us to analyze a number of

managerial decisions that in practice characterize many major
capital investment projects:
The option to defer
The option to abandon
The option to alter capacity
The option to start up or shut down
Q1: Is traditional financial analysis suitable to be applied to Multinational

framework?

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Definitions in Multinational capital budgeting:

Multinational capital budgeting, like traditional domestic capital budgeting,

Important points in MNEs capital budgeting:

Almost any project should at least be able to earn a cash return

Multinational firms should invest only if they can earn a risk-adjusted

If they are unable to earn superior returns on foreign projects, their

Capital budgeting for a foreign project is considerably more complex

Parent cash flows must be distinguished from project cash

Parent cash flows often depend on the form of financing

Additional cash flows generated by a new investment in one

Managers must keep the possibility of unanticipated foreign

Use of segmented national capital markets may create an

Use of host-government-subsidized loans complicates both

Managers must evaluate political risk, because political events

2. What are the steps of multinational Capital Budgeting?

Capital budgeting for a foreign project uses the same theoretical

The basic steps are:

Identify the initial capital invested or put at risk

Estimate cash flows to be derived from the project over time,

Identify the appropriate discount rate to use in valuation

Apply traditional capital budgeting decision criteria such as

3. What are the NPV and IRR?

NPV is the net present value of a firm or a project. It is to evaluating the

Case in point: the book case of Cemex Enters Indonesia

It is early 1998, Cementos Mexicanos is considering the construction of

This project would be a wholly-owned greenfield investment.

The company has three main reasons for the project:

Initiate a productive presence in Southeast Asia

A Roadmap to the Construction of Semen Indonesias

Investment and Financing of the Semen Indonesia

Semen Indonesias Capital Budget: Project Viewpoint

We build this parent viewpoint capital budget in two steps.

It is therefore not unusual for the firm to require a hurdle rate of 3%

Importantly, when MNEs evaluate competitive projects, traditional cash

This has led to the development of real options analysis.

Real options analysis is the application of the option theory to capital

Real options is a different way of thinking about investment values.

Real option valuation also allows us to analyze a number of

The option to defer

The option to abandon

The option to alter capacity

The option to start up or shut down

Q1: Is traditional financial analysis suitable to be applied to Multinational

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