lecture 6 international capital budgeting two

8/7/2019 Lecture 6 International Capital Budgeting Two

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Multinational Finance, JörgenHellström

Multinational Finance

International Capital Budgeting

(Chapter 17)


Where we are?

Previous lecture:Foreign direct investments (FDI)Reasons for FDIProcess of becoming MNC (FDI)Strategies to remain MNCWhere to FDI ? – Country risk analysis

– Political risk (assessing the risk of investing in differentcountries)

Today’s lecture:International capital budgetingMethods for assessing the profitability of FDI

(comparing different options)



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Outline of LectureBasics of capital budgeting (investment

analysis)

Issues in foreign investment analysis

Incorporating political risk analysis

Growth options (dynamic investment

analysis)Managing political risks


Multinational Capital Budgeting

Multinational capital budgeting , like traditional domesticcapital budgeting, focuses on the cash inflows andoutflows associated with prospective long-term (foreign)investment projects

Same theoretical framework as domestic capitalbudgeting

The basic steps are: Identify the initial capital invested Estimate cash flows to be derived from the project over time,

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

Present Value (NPV) and Internal Rate of Returns (IRR) Alternative, Adjusted Present Value (APV).



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Basics of Capital BudgetingFirms must select combinations of investment

projects that maximize the firms value to it’s shareholders

Decision rule/criteria is needed:

Net Present Value (NPV)Consistent with shareholder wealth maximization

(focus on cash flows and opportunity cost of moneyinvested – not accounting profits)

Value additive : “The NPV of a set of independentproject is simply the sum of NPVs of the individualprojects – Implication: each project can be considered on its own


Net Present Value

“present value of future cash flowsdiscounted at the projects cost of capitalminus the initial net cash outlay for the

project”

horizoninvestment n

rate)(discount capital of cost s project' the k

t period in flow tax)-(after cash net the X

investment cashinitial the I

where

I k

X NPV

t

0

n

t t

t

=

=

=

=

−+

= ∑=

0

1 )1(



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Net Present ValueNeed to calculate:

Net cash flows (in- and out flows) from theproject

Cost of funding the project

The terminal value of project

Need to decide on:

The lifetime of the project (horizon)

The discount rate (projects cost of capital)


Incremental Cash Flows

Total project vs. incremental cash flows

“Shareholders are interested in how manyadditional dollars they will receive in the future

for the dollars they lay out today”Distinction between the projects total cash flows

and the incremental cash flow from the project

Incremental cash flow: compare worldwidecorporate cash flows without investment (basecase) with post-investment corporate cash flowsNeed to assess what will happen if we don’t make

investment



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Incremental Cash FlowsProject total cash flow and incremental cash

flows may deviate due to:

Cannibalization:

A new investment (product) takes sales away fromthe existing products

A foreign production plant’s production substitutesparent company export

Incremental cash flow: If investment replace other

existing cash flows (that otherwise would haveexisted) these cash flows (the replaced) need to besubtracted from the investments total cash flow to obtain the incremental cash flow of the investment


Incremental Cash Flows

Sales creation

Opposite of cannibalization

“investment leads to increasing cash flows atother production sites (than otherwise), due toe.g. a stronger local position of the firm”

Incremental cash flow = investments totalcash flows + “sales creation cash flows”



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Other Cash Flow IssuesOpportunity cost

Project/investment cost must include the trueeconomic cost of any resource required for the projectregardless if the firm already owns it.

What the resource would be worth in use or on the market otherwise – the opportunity cost

Transfer prices

“the price at which goods and service are traded

internally”Prices used in the capital budgeting process should

be valued at market prices


Other Cash Flow Issues Fees and Royalties

Firms charges of legal counsel, power, heat ,rent, R&D,headquarter staff, management costs usually in form of fees androyalties

Should only be included in capital budgeting process if theinvestment leads to additional expenditures

Intangible benefits Better quality, faster distribution times and higher customer

satisfaction and so on Learning experience Broader knowledge base Higher competitive skills Should be attribute as positive benefits to an investment Usually hard to estimate (the value of the intangible benefits) Can be stated separate in the investment analysis



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Choice of Discount RateStandard discount rate: Weighted Average Cost of Capital (WACC) (Chapter 14)

WACC (assuming the financial structure and riskof the project similar as for the firm as whole):

level tax t

capital debt of cost k capital equity of cost k

assets) total to(debt ratio debt s parent' L

where

t Lk k L k

d

e

d e

=

=

=

=

−+−= )1()1(0


Choice of Discount RateWACC (assuming the financial structure and

risk of the project different than for the firm aswhole):

level tax t

capital debt of cost s project k

capital equity of cost s project k

ratio debt s project' L

where t k L k L k

d

e

'

d e

=

=

=

=

−+−=

'

'

)1()1(

'

'''''

0



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Choice of Discount RateWACC – weights are based on the proportion of

the firms capital structure or the financingstructure of the project

Alternative discount rate:Discount cash-flowsusing the all-equity rate

Abstracts from the projects financial structure

Based on the riskiness of the projects anticipated

cash flowThe firms cost of capital if the firm was all-equity

financed (no debt)


All-Equity Rate To calculate the all-equity rate k* we can use the CAPM

model (gives the relationship between the expected returnand the systematic risk of the asset)

flow) cash d unleverage

anwith d (associate betaequity- all

portfolio market the of rateinterest r

interest of rate riskless r

where

r r r k

CAPM The

m

f

f m f

=

=

=

−+=

*

** )(

β

β

Note: k* = riskless rate of interest + risk premium based on the riskof the project (systematic risk)



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Estimating the All-equity BetaEstimate the firm’s stock price beta βe

To transform βe into β* the effect of debtfinancing need to be separated out

rate tax marginal t

equity E

debt D

where

E D t

e

=

=

=

−+=

/ )1(1

* ββ


Adjusted Present Value

The value of the project is equal to:1) The present value of project cash flow after

taxes but before financing costs, discounted

at k*2) The present value of the tax savings on debt

financing (interest tax shield)

3) The present value of any savings (penalties)on interest cost associated with projectspecific financing (government may e.g.subsidize interest rates)



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Adjusted Present Value

debt currency home of cost tax beforei

)(penalties subsidies rate

interest of value currency home tax beforeS

financing debt to due t yearin savingsTaxT

horizoninvestment n

rateequity- all the k

t period in flow tax)-(after cash net the X

investment cashinitial the I

where

I i

S

i

T

k

X APV

d

t

t

t

0

n

t t

d

t n

t

n

t t

d

t

t

t

−=

−=

=

=

=

=

=

−+

++

++

= ∑∑ ∑== =

*

0

11 1*

)1()1()1(


Issues in Foreign InvestmentAnalysis

Two additional issues raised in theanalysis of a foreign project:

1) Should the cash flow be measured fromthe viewpoint of the project or that of theparent firm?

2) How should additional economic andpolitical risks that are uniquely foreign bereflected in the investment analysis?



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1) Parent vs. Project Cash FlowA substantial difference can exist between the

cash flow of a (foreign) project and the amountthat is remitted to the parent firm

Differing tax systems

Legal and political constraints on the movement of funds e.g. exchange rate controls

Unanticipated foreign exchange rate changes

Royalties and fees are returns to the parent company


1) Parent vs. Project Cash Flow

Any foreign project must be analyzed fromthe viewpoint of the parent since:

Cash flows to the parent are the basis for:dividends to stockholders

reinvestment elsewhere in the world

repayment of corporate-wide debt

other purposes that affect the firm’s manyinterest groups.



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A Three-Stage Approach A three-stage approach is recommended for simplifyingproject (investment) analysis

1) Project cash flows are calculated from the foreignsubsidiary’s standpoint (as if it were a separate firm)

2) Obtain specific forecasts concerning the amounts,timing and form of transfer to parent firm, as well asinformation concerning taxes and other expenses in thetransfer process

3) Take account of indirect benefits (“sales creation”) andcosts (“cannibalization”) the investment confers on therest of the corporation

Calculate incremental cash flow from the investment tothe parent firm


Estimation of Incremental ProjectCash Flow to the Parent Firm

Estimation entails:

1) Adjust for effects of transfer pricing, fees androyalties

Use market cost/prices for goods, services andcapital transferred internally

Add back fees and royalties to project cash flowsince these are benefits to the parent firm

Remove the fixed portions of costs like corporateoverhead



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Estimation of Incremental Project

Cash Flow to the Parent Firm2) Adjust for global costs/benefits that are not reflected in

the investment’s financial statement

Cannibalization of sales of other units

Creation of incremental sales by other units

Additional taxes owed when repatriating profits

Foreign tax credits usable elsewhere (e.g. from debt interestrates)

Effects from diversification of production facilities

Effects from market diversification

Effect from providing a key link in a global network

Effects from increased knowledge about competitors,technology, markets and products


2) Accounting for ForeignEconomical and Political Risks

When evaluating investments firms mustassess the consequence of different politicaland economic risks (e.g. expropriation,currency fluctuations)

Three main methods:1) Shortening the minimum pay-back period

2) Raising the required rate of return on theinvestment

3) Adjusting cash flows to reflect the specificimpact of a given risk



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2) Accounting for Foreign

Economical and Political RisksMethod 1 and 2 are commonly used

Due to vague views of the specific risk directed towards theinvestment

Ease of implementation

Drawback: How much should the required rate of return be raised?

How much shorter should the pay-back period be?

Penalizes all future cash-flows equal without regard todifferences in risk over time

Adjusting pay-back period and rate of returns – less attractivefrom a theoretical standpoint


2) Accounting for ForeignEconomical and Political Risks

Adjusting future cash-flow – preferred froma logical point of view

Possibility of incorporating all availableinformation about the impact of a specificrisk (e.g. at a specific point in time) onfuture cash flow

Adjust the cash-flow each period with theprobability for different outcomes due tothe risk



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2) Accounting for Foreign Economical and

Political RisksExample: Risk of expropriation (with probability p) during the next year of Banana plantation

Compensation if expropriated: $100 million

Expected value (if not expropriated):$300 million

Have an offer to sell plantation: $128 million

Discount rate: 22%


Accounting for Exchange RateChanges

Two ways:

1) Convert nominal foreign currency cash flow into nominalhome currency terms (forecasts of future exchange rate ) → discount the nominal home currency cash flowwith the nominal domestic required rate of return

2) Discount the nominal foreign currency cash flows at thenominal foreign currency required rate of return →convert the foreign currency present value into thehome currency using the spot rate

Should give the same result if international Fisher effect(IFE) holds

Keep parity conditions in mind (e.g. take account of different inflation levels between countries) and adjustfor offsetting inflation and exchange rate changes



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Growth OptionsDiscounted cash flow (DCF) analysis treat

expected cash flows as given at the outset

DCF – static approach – all operatingdecisions are set in advance

However, in reality:

“opportunity to make decisions contingent on

information that becomes available in thefuture”


Growth Options

The ability to alter decisions in response tonew information in the future has a value –similar to an option – that should beincorporated in the investment analysis

An initial investment that holds futurepossibilities (close, increase sales…) is agrowth option



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Example: Growth Option Decision to reopen a gold mine: Cost: $1 million

40, 000 ounces of gold in the mine

Variable cost $390/ounce

Expected gold price in one year: $400/ounce

Discount rate: 15%

174,652$

000,000,115.1

−=

−×

= 40,000 390)-(400

NPV

analysis DCF


Example: Growth Option

DCF analysis ignores the option not to produce if it is unprofitable to do so

Suppose that the gold price next year is either $300/ounce with probability 0.5 or $500/ouncewith probability 0.5 (expected value $400)

Allow decision to mine or not to depend onfuture gold price

If gold price $300/ounce – do not mine

If gold price $500/ounce - mine



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Incorporating the mine owner’s option not tomine when the gold price falls below theextraction cost gives the NPV:

043,913$

000,000,115.1

000,200,2$

=

−= NPV



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Example: Growth OptionThe ability to alter decisions in response to

new information may contributesignificantly to the value of an investment($913,043 vs. -$652,174)


Growth options

The value of the flexibility to act on future informationdepends on (similar as options):

1) The length of time the project can be deferred – longer timelarger value of the project

2) The risk of the project – the higher risk the higher value of theproject (gains and losses are asymmetric)

3) The level of interest rates – high interest rate do in generalincrease the value of the project since the present value of theoption to defer decreases

4) The proprietary nature of the option – the more exclusivelyowned option the higher value of the project



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Managing Political Risk Assume the firm has decided to invest

How can the firm minimize the politicalrisk?

1) Avoidance

2) Insurance

3) Negotiation

4) Structuring the investment


1) Avoidance

Screening out investments in politicallyuncertain countries

Ignores potentially high returns



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2) InsuranceMost developed countries sell political risk

insurances to cover the foreign assets of domestic firms

Insurance against risk of expropriation,currency inconvertibility and politicalviolence


3) Negotiation

Reach an understanding with the hostgovernment before the investment,defining rights and responsibilities of bothparties – concession agreement




4) Structuring the investmentIncreasing the host government’s cost of

interfering with the companies operationsLocal affiliate dependent on sister companies

(supplier)

Establish a single global trade mark

Sourcing production in multiple plants

External financial stakeholders (other governments, international financialinstitutions)

lecture 6 international capital budgeting two

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