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:
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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 project’s
economic life).
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Multinational firms should invest only if they can earn a risk-adjusted return greater
than locally based competitors can earn on the same project.
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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.
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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:
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Parent cash flows must be distinguished from project cash flows
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Parent cash flows often depend on the form of financing
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Additional cash flows generated by a new investment in one foreign
subsidiary may be in part or in whole taken away from another subsidiary
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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
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Use of segmented national capital markets may create an opportunity for
financial gains or may lead to additional financial costs
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Use of host-government-subsidized loans complicates both capital structure
and the parent’s ability to determine an appropriate weighted average cost of
capital for discounting purposes
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Managers must evaluate political risk, because political events can drastically
reduce the value or availability of expected cash flows
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2. What are the steps of multinational Capital Budgeting?
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Capital budgeting for a foreign project uses the same theoretical framework as
domestic capital budgeting.
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The basic steps are:
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Identify the initial capital invested or put at risk
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Estimate cash flows to be derived from the project over time, including an
estimate of the terminal or salvage value of the investment
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Identify the appropriate discount rate to use in valuation
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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
 The positive prospects for Indonesia to act as a produce-for-export site
A Roadmap to the Construction of Semen Indonesia’s Capital Budget
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Investment and Financing of the Semen Indonesia Project (all values in
000s unless otherwise noted)
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Semen Indonesia’s Debt Service Schedules and Foreign Exchange
Gains/Losses
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Semen Indonesia’s Pro Forma Income Statement (millions of rupiah)
Semen Indonesia’s Capital Budget: Project Viewpoint (millions of rupiah)
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Semen Indonesia’s Remittance and Capital Budget: Parent Viewpoint
(millions of rupiah and U.S. dollars)
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 investor’s assessment of a project’s 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.
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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.
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Real options is a different way of thinking about investment values.
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At its core, it is a cross between decision-tree analysis and pure option-based
valuation.
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Real option valuation also allows us to analyze a number of managerial decisions that
in practice characterize many major capital investment projects:
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The option to defer
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The option to abandon
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The option to alter capacity
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The option to start up or shut down
Q1: Is traditional financial analysis suitable to be applied to Multinational framework?
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