18-1

International

Capital Budgeting(Eun and Resnick chapter 18)

18-2

Identify the size and timing of all relevant cash flows on a time line.

Identify the riskiness of the cash flows to determine the appropriate discount rate.

Find NPV by discounting the cash flows at the appropriate discount rate.

Compare the value of competing cash flow streams at the same point in time.

Review of Domestic Capital Budgeting

18-3

Review of Domestic Capital Budgeting

The basic net present value equation is

01 )1()1(

CK

TV

K

CFNPV

TT

T

tt

t

Where:

CFt = expected incremental after-tax cash flow in year t

TVT = expected after-tax terminal value 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

The NPV rule is to accept a project if NPV 0

18-4

Review of Domestic Capital Budgeting

For our purposes it is necessary to expand the NPV equation.

Rt is incremental revenue

OCt is incremental operating cash flow

Dt is incremental depreciation

It is incremental interest expense

is the marginal tax rate

CFt = (Rt – OCt – Dt – It)(1 – t) + Dt + It (1 – t)

18-5

Review of Domestic Capital Budgeting

We can use CFt = (OCFt)(1 – t) + t Dt

to restate the NPV equation,

as:

NPV = St = 1

TCFt

(1 + K)t– C0

TVT

(1 + K)T+

NPV = St = 1

T (OCFt)(1 – t) + t Dt

(1 + K)t– C0

TVT

(1 + K)T+

18-6

The Adjusted Present Value Model

can be converted to adjusted present value (APV)

by appealing to Modigliani and Miller’s results.

NPV = St = 1

T (OCFt)(1 – t)

(1 + K)tC0

TVT

(1 + K)T+

t Dt

(1 + K)t+ –S

t = 1

T

APV =St = 1

T (OCFt)(1 – t)

(1 + Ku)tC0

TVT

(1 + Ku)T+

t Dt

(1 + i)t+ –

t It

(1 + i)t+

18-7

The Adjusted Present Value Model

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.

APV =St = 1

T (OCFt)(1 – t)

(1 + Ku)tC0

TVT

(1 + Ku)T+

t Dt

(1 + i)t+ –

t It

(1 + i)t+

18-8

International Capital Budgeting from the Parent Firm’s

Perspective

The APV model is useful for a domestic firm analyzing a domestic capital expenditure or for a foreign subsidiary of an MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint.

The APV model is NOT useful for an MNC in analyzing foreign capital expenditure from the parent firm’s perspective.

APV =St = 1

T (OCFt)(1 – t)

(1 + Ku)tC0

TVT

(1 + Ku)T+

t Dt

(1 + i)t+ –

t It

(1 + i)t+

18-9

International Capital Budgeting from the Parent Firm’s

Perspective Donald Lessard developed an APV model

for MNCs analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.

T

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(

18-10

Denotes the present value (in the parent’s currency) of any

concessionary loans, CL0, and loan payments, LPt ,

discounted at id .

S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.

The marginal corporate tax rate, , is the larger of the parent’s or foreign subsidiary’s.

OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.

The operating cash flows must be discounted at the unlevered domestic rate

The operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period.

APV Model of Capital Budgeting from the Parent Firm’s Perspective

APV = St = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

t Dt

(1 + id)t+

–

StOCFt(1 – t)

S0C0 + S0RF0 + S0CL0 -

St = 1

TSt t It

(1 + id)tSSt+t = 1

T

St LPt

(1 + id)tSSt

t = 1

T

18-11

One recipe for international decision makers:– Estimate future cash flows in foreign

currency.– Convert to the home currency at the

predicted exchange rate.• Use PPP, IRP, et cetera for the predictions.

– Calculate NPV using the home currency cost of capital.

Capital Budgeting from the Parent Firm’s Perspective

18-12

Dorchester case Read the case carefully from the text Develop and present all the

calculations in Excel The goal is to calculate the APV

(formula 18.7 in the text) Follow the methodology described

for Centralia in the text First exhibit summarizes the

assumptions and the simple calculations

Prepare the same exhibits