international capital budgeting and cost of capital

8/14/2019 International Capital Budgeting and Cost of Capital

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AJAFIN 6605-09

International Capital Budgeting and Cost of Capital

Capital budgeting /investment appraisal is the process ofplanning to determine whether a firm's long term investments(new machinery, replacement machinery, new plants, new products,

and R&D projects) are worth pursuing.

AnOutline:

(a) Inputs into a Capital Budgeting Decision

(b) Additional Factors in Multinational Capital Budgeting

(c) Adjusted Present Value Method

(d) Cost of Capital

(e) Exercises

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A. Basics of Capital Budgeting

Inputs into the Capital Budgeting Decision

Initial investment

Consumer demand

Price

Variable cost

Fixed cost

Project lifetime

Salvage value Tax-laws

Required rate of return - (WACC, CAPM, Dividend

Valuation Model) 2


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Other Factors in "Multinational" Capital Budgeting

* Exchange rate fluctuations

* Relative inflation

* Financing arrangements - subsidies/penalties

* Blocked funds

* Remittance provisions

* Uncertain salvage values* Impact of project on prevailing cash flows

* Government incentives

* Political risk / country risk* Transfer prices

* Fees, royalties, etc.

* "Disaggregating" the cash flows and assigning applicable

discount rate for component flows. 3


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Basics of Capital BudgetingPopular Techniques

1 Payback Period: Is the length of time needed to recoup

the initial investment. This equals the length of time ittakes for cumulative nominal cash inflows to equal theinitial outlay. (Discus Discounted Payback Period)

2 Net Present Value: Is the expected value, in today's

dollars, after considering all costs, of cash flows from aproject.

k = projects cost of capital

n = the investment horizon

N P V = - I +C F

(1 + k )

0

t=1

nt

t

4


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Weighted average cost of capital (WACC) is frequentlyemployed. This is given by:

where:

E = EquityD = Debt

t = Tax rate

Decision Rule: When NPV>0, accept the project.When NPV


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3 Profitability Index (PI): Considers the ratio of presentvalue of a project's cash flows to its initial outlay.

CFt = cash flow at time t

I0 = initial outlay

k = required rate of return (cost of capital)

Decision Rule: When PI>1, accept the project.

When PI


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4 Internal Rate of Return (IRR): Is the rate of return that the

firm expects to earn on the project. Mathematically, it is

the "discount rate" that equates the present value of cash

flows to the initial outlay.

Decision Rule:When IRR>required rate of return, accept project

When IRR


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5. Modified Internal Rate of Return (MIRR): This is given by:

PV Cost = PV of Terminal Value

t=0

k

tt

t=1

n

t

n-t

nCOF

(1 + k)= CIF (1 + k)

(1 + MIRR) PV Cost =

TV

(1 + MIRR )n

PV C ost =TV

(1 + M IRR)=

C IF(1 + k )

(1 + M IRR)n

t=1

nt

n-t

n

C OF0 C OF1 C OF2 C OFk C IF1 C IF2 C IF3 C IFn

|--------|--------|----------------|----------------|-------|--------|-----------------|----------------------I0 1 2 k t t+ 1 t+ 2 n

where: C OF = cash outflows; C IF = cash inflows

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Incremental Cash Flows

3 Shareholders wealth maximization is the primary

objective.

3 Shareholders are interested in how many additional

dollars they will receive in the future for the dollars

invested today.

3 Therefore, what matters is not the projects cash flow

per period BUT the incremental cash flows generatedby the project.

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Incremental and Total Cash Flows can Differ for Many Reasons:

Effects of sales from the (new) investment on other divisions:

3 Cannibalization:New product taking away sales from thefirm's existing products, e.g., substituting foreign productionfor parent company exports. (Hondas Acura line of carsattracted customers away from Accords)

3 Sales Creation:New investment creates additional sales forexisting products. The benefits of additional sales (or lostsales) and associated incremental (decreased) cash flows

should be attributed to the project.

Example: GMs auto plants in Britain use parts made by itsUS plants; Black & Decker investment in Europe resultedin expanded exports to Europe.

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Other Considerations:3 Opportunity Costs: Project costs must include the true

economic cost of any resource required for the project -

already owned or just acquired.

3 Sunk Costs: Cash outlay already incurred, and whichcannot be recovered regardless of whether project is

accepted or rejected, e.g., site analysis, feasibilitystudies, etc. Exclude sunk costs from costconsiderations.

3

Transfer Pricing: Prices at which goods and servicesare traded internally can significantly distort the

profitability of a proposed investment.

As far as possible prices of project's inputs and outputs

should be market prices. 11


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Fees and Royalties:

3 These are costs to the project but are benefits to the

parent, e.g., legal counsel, power, lighting, heat, rent,R&D, H.O. cost, and management costs, etc.

3 A project should be charged only for additional

expenditures that are attributable to the project.

3 In general, incremental cash flows associated with an

investment can be found by subtracting worldwide

corporate cash flows without the new investment from"with" the new investment cash flows.

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Intangible Benefits:

3 Intangibles such as higher customer satisfaction,

better quality, faster time to market, superior order-processing, valuable learning experience, broader

knowledge base, enhanced competitive skills, can

have a very tangible impact on corporate cash flows

despite the difficulty of measuring them precisely.

3 Adapting to/adopting practices, products and

technologies encountered overseas can improve acompanys competitive position worldwide.

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Foreign Complexities and Opportunities

Capital budgeting analysis for a foreign project is

considerably more complex than domestic case for anumber of reasons including:

3 Parent Cash Flows Vs. Project Cash Flows: Parent cash flows

often depend on the form of financing - so that cash flows cannotbe clearly separated from financing decisions as is done in a

purely domestic capital budgeting.

3 Remittance of funds to parent is compounded by different tax

systems, legal and political constraints on funds movement,financial markets and institutions.

3 Cash flows from affiliate to parent can be generated by an array

of operational or financial or non-financial payments, e.g., fees,

royalties, transfer pricing, etc. 14


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3 Different rates of national inflation introduce changes

in competitive position.

3 Unanticipated changes in foreign exchange rates havedirect and indirect effects on costs, prices, and sales

volume.

3 Transaction across segmented national markets maycreate opportunities for financial gains or lead to

additional costs.

3 Enhanced global service network.

3 Diversification of production facilities.

3 Market diversification. 15


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3 Availability of host government subsidized loans

complicate capital structure decisions and appropriate

WACC.

3 Political risks must be evaluated, and costs may be

involved in the management of political risks.

3 Salvage value is more difficult to estimate, i.e., more

uncertain salvage value.

3 Foreign complexities must be "quantified" as

modifications to either expected cash flows or the

rate of discount.

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Adjusted PV Approach:

The WACC as a discount rate is appropriate only if thefinancial structures and commercial risks are similar for all

investments. Special concessionary loans are frequently associated with

foreign investments, so that their cost of capital may bedifferent from that of domestic projects.

The WACC can be modified to reflect these deviations. Use the all equity rate, the rate which will apply if project were

financed entirely by equity.

This rate is based solely on the riskiness of the projectsanticipated cash flows and abstracts from the effects offinancing.

An all-equity cost of capital (K*), is the required rate of returnon a specific project, and equals to KRF + Risk Premium.

So, K* varies according to the risk of a specific project in aportfolio context. 17


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According to the CAPM,

The market prices only systematic risks relative to the

market rather than total corporate risk.

Thus each project has its own required return and can be

evaluated regardless of the firms other present/prospective

investment.

This is the primary advantage of the CAPM, especially theconcept of value additivity which allows projects to be

considered independently.

)K-K(+K=K R FmxR Fx

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The Adjusted Present Value Technique

This technique rests on the principle of value additivity,

i.e., the whole is equal to the sum of the parts. It is a "divide and conquer" strategy applied to complex

capital budgeting problems.

It does not attempt to capture all effects in onecalculation. It divides up the PV terms and focuses on

each term to maximize the development and use of

information.

Each PV term is assigned an appropriate discount rate

consistent with the level of systematic risk. Each cash

flow is adjusted according to its specific risk.

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The APV for a foreign project can be written as follows:

where,e0 = Spot exchange rate, period t = 0, d/f

et* = Expected spot rate, period t

K0

= Capital cost of project in foreign currency units

AF0 = Restricted funds activated by project

CFt* = Expected remittable cash flow in foreign currency units

)(

(

SVPV)DR+(1

RF+

)DR+(1

TD+

)DR+(1

LR-CLe+

)DR+(1

BCr+

)DR+1

DA+

)DR+(1

)-)(1eL-CFe(+AFe+Ke-=APV

t

f

*t

T

=1t

t

d

*t

T

=1t

t

c

tT

=1t

00t

b

0gT

=1t

t

a

tT

=1t

t

e

*t

*t

*t

T

=1t

0000

+

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Let* = Profit attributed to lost sales, in dollars

t = Higher of U.S. and foreign corporate tax rates

T = Life of projectDAt = Depreciation allowances in dollar units.

Adjust if allowance is in local currency

BC0 = Contribution of project to borrowing capacityin dollars, e.g. by altering the parent capital

structure

CL0 = Face value of concessionary loan in foreign

currency

RFt* = Expected indirect repatriation of income

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LRt = Loan repayments on concessionary loan in

foreign currency

TDt* = Expected tax savings from deferrals, inter-subsidiary transfer pricing

DRe = Discount rate for cash flows, assuming all-

equity financial

DRa = Discount rate for depreciation allowances

DRb = Discount rate for tax saving on interest deduction

from contribution to borrowing capacity

DRc = Discount rate for saving on concessionary

interest rate

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DRd = Discount rate for saving via inter-subsidiary

transfers

DRf = Discount rate for indirect repatriated projectflows

rg = Market borrowing rate at home

Examine each of the terms in APV

e0K0 = "Capital cost" of a project, denominated in

foreign currency and incurred in year zero only.Hence converted at exchange rate e0.

e0AF0 = Capital cost is reduced by any blocked funds

activated by project. AF0 is face value of blocked funds

minus their value in the next best use.

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where CFt* represents the expected legally remittable project

cash flows. We subtract the lost income from other facilities

that are replaced by the new investment. The cash flows are

adjusted for the effective tax rate - which is the higher of thedomestic and foreign corporate taxes. The discount rate is the

all-equity cost of capital that reflects all systematic risks.

t=1

Ti*

t*

i*

e

t

(e CF - Le )(1 - )

(1 + DR )

t=1

Tt

at

DA

(1 + DR )

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Depreciation is allowed against corporate taxes for

projects located at home or abroad. This is the tax benefit

thereof. Adjust for exchange rate changes if DAtis in

local currency.

When debt is used to finance a project at home or

abroad, the interest payments are tax-deductible. Tax

savings on the amount that could be borrowed should becalculated as a benefit

)DR+(1

BCrt

b

0gT

=1t

0 0

t=1

Tt

cte CL -

LR

(1 + DR )

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The current value of a concessionary loan is the difference

between the face value of the loan and the PV of repayments on

the loan discounted at interest that would have been faced in

the absence of the concessionary loans. DRc is the discount rateon concessionary loans. The term,

represents expected savings from deferrals and transfer pricing.

The cash flow CFi* is a conservative estimate, assuming that

royalties, fees, transfer pricing reflect their market values. AMNC may manipulate transfer pricing or royalty payments to

repatriate more income. Extra remittances, or indirect cash

flows, can be included in the APV after direct cash flows have

been computed, hence the RFi* term is included.

t=1

Ti*

dt

TD

(1 + DR )

t=1

Ti*

ft

RF

(1 + DR )

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Selecting the Appropriate Discount Rates

The systematic component of total risk is all what matters.This risk requires a premium in the "discount rate" to reflecta firm's level of risk.

However, "additional" risks of doing business abroad aremitigated by the "independence" of cash flows from foreign

project which results in lower variance of corporate cashflows.

Hence the applicable discount rate may be lower.

Pooling of flows from different countries reduces businessrisk. Therefore, MNC offer diversification benefits.

Political and foreign exchange risks, like business risk, can bediversified if a firm invests in a "portfolio" of securities of

different countries and denominated in different currencies.27


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Treatment of inflation:

Recall that FE suggests that:

Consistency is needed in deciding which discount rate to use,

nominal or real.

The same conclusion is reached if we discount nominal cash

flows by nominal rates and real cash flows by real interest rate.

In the case of predetermined or contractual cash flows, we do

not have a choice between real and nominal discounts.

Contractual amounts are fixed in nominal terms and must be

discounted at the nominal rate.

i r +

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Other Issues in Foreign Investment Analysis

Parent Vs. Project Cash Flows

A substantial difference may exist between the cashflows of a project and the amount that is remitted tothe parent (tax regulation and exchange controls)

Given these differences, an important question iswhich relevant cash flow is to be used in projectevaluation?

According to economic theory, the value of a project isdetermined by the net present value of future cash flows

back to the investor.Therefore, parent company should value only those cashflows that can be repatriated net of any transfer costs.

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Adjusting for additional economic and political risksvia cash flow or discount rate adjustment.

The value of a project is determined by the PV of future

cash flows to the investor.MNC should value only those cash flows that are

or can be repatriated net of any transfer costs.

Shapiro recommends a three-stage analysis:Compute project cash flows from the subsidiary's stand

point.

Shift to parent's perspective. Undertake a specificforecast concerning the amounts, timing, and forms oftransfers to headquarters.

Finally account for indirect benefits and costs on the

rest of the system. 30


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Multinational Capital Budgeting Exercises.

See Problem Set II and Suggested Solutions.

31

P liti l d E i Ri k A l i


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Political and Economic Risk Analysis:

Confiscation:Government takeover without compensation. Expropriation: Government takeover with compensation. Nationalization:Conversion from private to public

(governmental) ownership - with (some) compensation. Others:Currency inconvertibility, wars, riots, revolutions,

coups, blocked funds, etc.

Political and economic risks can be incorporated in anumber of ways, including:

a. Shortening the (minimum) payback period.

b. Raising the required rate of return.c. Adjusting cash flows for the costs of risk reduction.For example the premium for the purchase of loss

of investment insurance or overseas political risk

insurance.32


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Sources of Insurance Include:

In the U.S.: Overseas Private Investment Corporation (OPIC)

insures U.S. private investments in underdeveloped countries.

Since 1980 OPIC has joined private insurance companies tomove the insurance into the private sector.

In Canada: Foreign investment insurance is provided by

Exports Development Corporation (EDC). Its role is similar toOPIC of the U.S. It also offers insurance against non-payment

for Canadian exports - a function performed by the Export-

Import Bank in the U.S.

Similar programs exist in UK, Australia, Denmark, France,Germany, Holland, Japan, Norway, Sweden, Switzerland.

MIGA - Multilateral Investment Guarantee Agency:

A subsidiary of the World Bank provides political insurance for

MNC with FDI in the developing countries. 33


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d. Adjusting cash flows to reflect specific impact of a

given non-systematic risk.

e. Using certainty equivalent in place of "expected"cash flows.

In general a theoretical point of view suggests that cash

flows should be adjusted to reflect the change in expectedvalues caused by a particular risk.

Discount rates should be adjusted only if the risk

is systematic.

Certainty Equivalent Method:Involves computing risk-adjusted cash flows and

discounting them at the risk-free rate.34


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B. The Cost of Capital For Foreign Investments

Knowledge of appropriate cost of capital is crucial for

making foreign investment decisions.

The question to be confronted is whether the required

rate of return is higher, lower, or the same for foreign

investments as for domestic investments.

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Definition: Cost of capital for a given investment is the

minimum risk-adjusted return required by shareholders of the

firm for undertaking that investment.

It is the basic measure offinancial performance.

The emphasis here is on cost of capital or required rate of

return for a specific project (foreign) rather than for thefirm as a whole.

The use of a single overall cost of capital for all projects

is incorrect unless financial structures and commercialrisks are similar for all projects.

The overall cost of capital is useful in valuing the firm as

it currently exists. 36

C t f E it C it l


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Cost of Equity Capital:

Is the minimum rate of return necessary to induce

investors to buy or hold the firm's stock. Is also the rate used to capitalize total corporate cash

flows, hence it is equal to the weighted average cost

of capital (WACC).

Thus the cost of equity capital can be used to set aprice on equity shares in the firm.

It cannot, however, be used to measure therequired rate of return on equity investments in futureprojects unless these are of similar nature to theaverage of those already being undertaken.

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Th CAPM id h f d i i j


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The CAPM provides an approach for determining project-

specific required rate of return on equity.

According to CAPM, equilibrium relation exists between an

asset's return and its associated risk, as follows:

where

Ki = equilibrium expected return on asset i.

KRF = risk-free rate (30 day U.S. government T-bill).

Km = expected return on market portfolio.

bi = cov(Ki, Km)/2

Km = systematic risk.

i R F i m R FK = K + [K - K ]

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i S i


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In practice, a market proxy, such as the NYSE index

is used for Km.

Note that only systematic risk is

rewarded with a riskpremium.The risk premium on

the market equals (Km- K

rf), while the risk premium on

asset i, is equal to:

i m RF[K - K ]

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3 Problems ith the CAPM:


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3 Problems with the CAPM:

- Identifying the relevant market portfolio.

- Estimating project betas (bi).

- Do investors differentiate between systematic andnon-systematic risk?

3 Dividend Valuation Model provides a check on CAPM-derivedrequired rate of return for the firm as a whole.

From the Gordon model

Where: Ke= cost of equity capital.

P0

= current stock price.

D1

= expected dividend in year 1.

g = dividend growth rate.

e1

0

K =D

P+ g

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Thi di id d it li ti d l ( di i l h)


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This dividend capitalization model (traditional approach)assumes that the required return on equity isdetermined by the market's preference for tradeoff

between risk and return.Risk is typically measured by

standard deviation, , of stock returns or coefficientof variation CV = /m (std dev/mean) of returns.

The dividend growth rate can be estimated usinghistorical data or expectations of future earnings.

This estimate of required rate of return is notapplicable to project-specific required rate of returnswhere the project characteristic diverges from thecorporate norm.

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Th WACC f F i P j t


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The WACC for Foreign Projects:

In practice, the required return on equity for a

particular investment assumes that the financial

structure and risk of the project is similar to that of the

firm as a whole, Hence:

This yields a WACC for the parent and the project.

However, both project risk and project financial

structure can vary from the corporate norm.

It is therefore necessary to adjust the various costs

and weights to reflect their actual values.

WACC =K

=E

D + EK+

D

D + EK(1 - t)

w e d

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Th All E it C t f C it l f F i P j t


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The All-Equity Cost of Capital for Foreign Projects:

An alternative to WACC, is to use an all-equity discount rate

K*. This is based strictly on anticipated project cash flows,

abstracting from project's financial structure.*

RF*

m RFK = K + (K - K )

*= all equity beta, i.e., the beta associated with theunleveraged cash flows.

Example: If a foreign firm has a * of 1.15, andKRF=13%; Km=21%, then:

K* = .13 + 1.15(.21 - .13) = 22.2%

It is difficult to estimate * in reality.A possible estimate is by reference to e from CAPM:

e RF e m RFK = K + (K - K ) 43


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To transfo

of debt fin[ ]

* e=

1 + (1 - t)D / E

44

Di t R t f F i I t t


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Discount Rate for Foreign Investments: Should MNCs demand increased or decreased returns on foreign

projects?

Corporate diversification should be beneficial to shareholders -especially where there are barriers to international portfolio

diversification.

Investors may be willing to pay a premium price for the shares of

MNCs or accept lower rate of return on them to the extent towhich MNCs can provide low-cost international diversification. It

is therefore possible that the risk premium applied to foreign

projects may be lower than for domestic ones and the required rate

of return lower than for domestic cases. Developing economies are more segmented, or less correlated

with USA economy than other industrial countries.

Projects in developing economies may therefore carry a lower

required rate of return than the ones in USA or Japan. 45

G th O ti d P j t E l ti


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Growth Options and Project Evaluation

The discounted cash flow analysis treats a projects

cash flows as given at the outset. It is a staticapproach to investment decision making.

In reality, the opportunity to make decisions

contingent upon available future information is anessential feature of many investment decisions.

The opportunity a firm may have to invest capital to

increase the profitability of existing product lines andbenefit from expanding into new products or markets

may be viewed as growth options

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A firms ability to capitalize on its managerial talents


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A firm s ability to capitalize on its managerial talents,experience in a particular product line, brand name,technology, or its other resources may provide

valuable but uncertain future prospects, a growthoption.

Many strategically important investments such as

R&D, factory automation, brand name, distributionnetwork, etc, provide growth opportunities becausethey are often only the first link in a chain of futureinvestment decisions.

Valuation of investments that incorporatediscretionary follow-up projects requires an expandednet present value rule that considers the attendant

options. 47

V l i G th O ti D d


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Valuing Growth Options Depends on:

The length of time a project can be deferred.

A project that can be deferred gives the firm moretime to examine the course of future events and avoid

costly errors, and raises the odds that a positive turn

of events will boost the projects profitability.

The risk of the project. The riskier the investment

the more valuable is an option on it.

The level of interest rates.

A high discount rate lowers the present value of the

cash outlay needed to exercise the option

48

P i t t f th ti


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Proprietary nature of the option.An exclusively owned option is more valuable than

one that is shared with others.

An options pricing model may be used to evaluate

options associated with a new project.

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The Relevant Market Portfolio:


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The Relevant Market Portfolio: A systematic risk in the "domestic" market context may be

diversifiable in the context of a "global" market.

The appropriate market portfolio to be used depends on themanager's view of world capital markets.

Are capital markets globally integrated or not?

Commonly used proxies for "global" market portfolio include:

World market index - capitalization weighted

- price weighted

- equally weighted

U.S. market index - DJIA

- S&P500

Japanese market index - Nikkei 225

- TOPIX Index

UK market index - FTSE 100

international capital budgeting and cost of capital

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