Chapter 18 Outline
Multinational Capital Budgeting
• Review of Capital Budgeting
• The Adjusted Present Value Model
•
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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.
• Capital budgeting for a foreign project uses the same
theoretical framework as domestic capital budgeting. The
basic steps are:
•
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Multinational capital budgeting
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
•
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Complexities of Budgeting for a Foreign Project
The parent must explicitly recognize remittance of funds
because of differing tax systems, legal and political
constraints on the movement of funds, local business
norms, and differences in the way financial markets and
institutions function
• An array of nonfinancial payments can generate cash flows
from subsidiaries to the parent
• Managers must keep the possibility of unanticipated
foreign exchange rate changes in mind because of possible
direct effects on cash flows as well as indirect effects on
competitiveness
•
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Complexities of Budgeting for a Foreign Project
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 parent’s ability to determine an
appropriate weighted average cost of capital for
discounting purposes
•
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Complexities of Budgeting for a Foreign Project
Managers must evaluate political risk, because political
events can drastically reduce the value or availability of
expected cash flows
• Terminal value is more difficult to estimate, because
potential purchases from the host, parent, or third
countries, or from the private or public sector, may have
widely divergent perspectives on the value to them of
acquiring the project
•
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Review of capital Budgeting
We consider evaluation of various investment projects
(investing in new production lines, etc.).
• Capital budgeting is a technique that helps you (a finance
manager of a firm) decide which projects to pursue.
• In order to maximize shareholder wealth, managers need
to:
•
•
•
•
Identify potential investment opportunities.
Select from many potential projects.
Managers should accept projects that increase shareholder
wealth.
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An illustrative example
Invest in a new airplane?
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Initial Investment
Capital expenditure itself + training etc.
• Increase in net working capital
•
(cash + inventories + receivables − payables)
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Incremental Cash Revenues and Expenses (Consider
cannibalization and/or synergies).
Exclude financing costs (interest expenses, etc.) here.
• Add back depreciation (Depreciation is not a cash flow).
• Deduct taxes.
• Consider additional investment needs (replacements,
updates, etc.)
•
Terminal value / Salvage value.
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Capital Budgeting Evaluation Techniques
Payback period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
•
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Payback Period and NPV
Payback Period is the minimum period of time until total
cash flows equal the initial investment amount (C0 ).
• Net Present Value (NPV) is the present value of expected
future cash flows minus the initial investment (C0 ).
•
NP V =
T
X
|t=1
CFt
T VT
−C0
t +
(1 + K)
(1 + K)T
{z
}
P V of expected future cash flows discounted by the WACC
K: required rate of return (WACC)
• T = economic life of the project in years
•
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Undertake positive NPV projects!
Assume an WACC of 10% per year. Will you accept the
following projects?
Initial investment: $10, 000
Year 1 Cash flow: $4, 400
Year 2 Cash flow: $7, 381
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Practice
Consider this project, the timing and size of the
incremental after-tax cash flows for an all-equity firm are
in the next graph.
• What is the NPV of this project?
•
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-$1,000
$125
0
1
$250
2
$375
3
$500
4
The unlevered cost of equity is r0 = 10%:
CF0 = —$1000
CF1 =
$125
CF2 =
$250
CF3 =
$375
CF4 =
$500
K
= 10
NPV = —$56.50
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Why is the NPV rule useful ?
•
•
•
•
•
•
•
Considers the Time Value of Money.
Clear decision criterion (undertake if positive NPV).
Consistent with maximizing shareholder wealth.
Can adjust for risk: WACC.
NPV decreases as the required discount rate (WACC)
increases.
What is the cut-off discount rate for a project to be
accepted (i.e., positive NPV)?
That is, at what discount rate does the project’s NPV
become zero ?
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Internal Rate of Return (IRR)
IRR is the discount rate that makes the project’s
N P V = 0.
• That is, IRR is the discount rate that equates the present
value of future cash flows of a project to its initial
investment.
• Accept a project if its IRR is greater than the firm’s
required rate of return (WACC; Called the “Hurdle
Rate.”).
•
•
•
Accept a project if IRR > W ACC, if it is an
“average” project.
A “big” project can affect the WACC.
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Disadvantages of the IRR
•
Serious computational problem. Because IRR is a solution
to a polynomial equation;
T
X
t=1
CFt
T VT
− C0 = 0
t +
(1 + IRR)
(1 + IRR)T
â Solution may not exist.
â Multiple solutions may exist.
• We should not use IRR to rank projects.
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International capital budgeting
One recipe for international decision makers:
1
2
Estimate future cash flows in foreign currency.
Convert to the home currency at the predicted exchange
rate.
•
3
Use relative PPP (RPPP), IRP etc. for the
predictions.
Calculate NPV using the home currency cost of capital.
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Example
A U.S.-based MNC is considering a European opportunity.
•
•
•
•
•
The size and timing of the after-tax cash flows are:
Year 0
1
2
3
CF
-e600 e200 e500 e300
The inflation rate in the euro zone is πe = 3%,
The inflation rate in dollars is π$ = 6%,
The business risk of the investment would lead an
unlevered U.S. based firm to demand a return of K =
15%.
Spot rate (S0) is $1.25=e1.00
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Is this a good investment from the perspective of
the U.S. shareholders?
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International capital budgeting
Another recipe for international decision makers:
1
2
3
4
Estimate future cash flows in foreign currency.
Estimate the foreign currency discount rate.
Calculate the foreign currency NPV using the foreign cost
of capital.
Translate the foreign currency NPV into dollars using the
spot exchange rate
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•
You have two equally valid approaches:
1
2
Change the foreign cash flows into dollars at the
exchange rates expected to prevail. Find the $NPV
using the dollar cost of capital.
Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars at
the spot exchange rate.
If you watch your rounding, you will get exactly the same
answer either way.
• Which method you prefer is your choice.
•
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The Adjusted Present Value Model
APV formula:
AP V =
"
T
X
OCFt (1 − τ )
t
t=1
(1 + Ku )
#
τ Dt
τ It
T VT
−C0
+
t+
t +
T
(1 + i) (1 + i)
(1 + Ku )
Note we use CFt = (OCFt )(1 − τ ) + τ Dt
OCFt is incremental operating cash flow
Ku is cost of equity for an all-equity financed (unlevered)
firm
Dt is incremental depreciation
It is incremental interest expense
i is the levered firm’s borrowing rate
τ is the marginal tax rate
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The Adjusted Present Value Model
Derivation
CFt = (Rt − OCt − Dt − It ) (1 − τ ) + Dt + It (1 − τ )
= N It + Dt + It (1 − τ )
= (Rt − OCt − Dt ) (1 − τ ) + Dt
= N OIt (1 − τ ) + Dt
= (Rt − OCt ) (1 − τ ) + τ Dt
= OCFt (1 − τ ) + τ Dt
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•
•
•
•
•
•
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.
OCFt and T VT are discounted at Ku – the firm would
receive these cash flows from a capital project regardless
of whether the firm has leverage
The tax savings due to interest τ It are discounted at the
before-tax borrowing rate i
The tax savings due to depreciation τ Dt are also
discounted at i because they are relatively less risky
Let’s reconsider this project:
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-$1,000
$125
0
1
$250
2
$375
3
$500
4
The unlevered cost of equity is r0 = 10%:
CF0 = —$1000
CF1 =
$125
CF2 =
$250
CF3 =
$375
CF4 =
$500
K
= 10
NPV = —$56.50
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•
Now, assume everything remains the same. Imagine,
except that the firm finances the project with $600 of
debt at i = 8% . The tax rate is 40%, so they have an
interest tax shield worth τ I = .40 × $600 × .08 = $19.20
each year.
What is the APV of the project under leverage?
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Should the firm accept or reject the project if it finances with
debt?
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Adjusted Present Value (APV): Details
The key: separate operating cash flows from financing side
effects.
VProject = VOperating CFs + VFinancing Side Effects
Discount less-risky financing side effects by lower rates.
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APV: a simplified example
The 5-year project requires equipment that costs $105,000. If
undertaken, the shareholders will contribute $25,000 cash and
borrow $80,000 at 6% with an interest-only loan with a
maturity of 5 years and annual interest payments.
• There will be a pre-tax salvage value of $5,000.
• The equipment will be depreciated straight-line to $5,000
over the 5-year life of the project.
• There are no other start-up costs at year 0. During years
1 through 5, the firm will sell 25,000 units of product at
$5; variable costs are $3;
• there are no fixed costs.
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i = 6%, Ku = 12%, KW ACC = 8.74%
τ = 34%
CF 0 = −$105, 000
CF 1−5 = $39, 800
0.34
= 25, 000 × ($5 − $3) × (1 − 0.34) + $20, 000 × |{z}
|
{z
OCF1−5
}
|
{z
1−τ
}
| {z }
D1−5
τ
For year five, TV5 =$5,000×(1 – .34)
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What is the NPV of the project using the WACC
methodology?
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What is the PV of after-tax operating CF?
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What is the PV of depreciation tax shield?
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What is the PV of interest tax shield?
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Finally what is the APV of the project?
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