Chapter Objective: This chapter discusses the methodology that a multinational firm can use to analyze the Fifth Edition investment of capital in a foreign country. EUN / RESNICK
18-2 Chapter Outline Review of Domestic Capital Budgeting The Adjusted Present Value Model Capital Budgeting from the Parent Firm’s Perspective Risk Adjustment in the Capital Budgeting Process Sensitivity Analysis Real Options
18-3 Review of Domestic Capital Budgeting 1. Identify the SIZE and TIMING of all relevant cash flows on a time line.
2. Identify the RISKINESS of the cash flows to determine the
appropriate discount rate.
3. Find NPV by discounting the cash flows at the appropriate
discount rate.
4. Compare the value of competing cash flow streams at the
same point in time.
18-4 Review of Domestic Capital Budgeting 1. Identify the SIZE and TIMING of all relevant cash flows on a time line.
2. Identify the RISKINESS of the cash flows to determine the
appropriate discount rate.
3. Find NPV by discounting the cash flows at the appropriate
discount rate.
4. Compare the value of competing cash flow streams at the
same point in time.
18-5 Review of Domestic Capital Budgeting The basic net present value equation is T CFt TVT NPV C0 t 1 (1 K ) (1 K ) t 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 18-6 = economic life of the project in years. Review of Domestic Capital Budgeting The NPV rule is to accept a project if NPV 0 T CFt TVT NPV C0 0 t 1 (1 K ) (1 K ) t T
and to reject a project if NPV 0
T CFt TVT NPV C0 0. t 1 (1 K ) (1 K ) t T
18-7 Review of Domestic Capital Budgeting For our purposes it is necessary to expand the NPV equation.
CFt = (Rt – OCt – Dt – It)(1 – ) + Dt + It (1 – )
Rt is incremental revenue It is incremental interest expense OCt is incremental operating cash flow is the marginal tax rate Dt is incremental depreciation
18-8 Alternative Formulations CFt
CFt = (Rt – OCt – Dt – It)(1 – ) + Dt + It (1 – )
CFt = NIt + Dt + It (1 – ) CFt = (Rt – OCt – Dt ) (1 – ) + Dt CFt = (NOIt)(1 – ) + Dt CFt = (Rt – OCt)(1 – ) + Dt CFt = (OCFt)(1 – ) + Dt 18-9 Review of Domestic Capital Budgeting We can use CFt = (OCFt)(1 – ) + Dt
18-10 The Adjusted Present Value Model T (OCFt)(1 – ) T Dt NPV = t=1 (1 + K) t + t = 1 (1 + K) t + TVT (1 + K)T – C0
Can be converted to adjusted present value (APV)
T (OCFt)(1 – ) Dt It APV = t=1 (1 + Ku)t + (1 + i)t + (1 + i) t + TVT (1 + Ku) T – C0
By appealing to Modigliani and Miller’s results.
18-11 The Adjusted Present Value Model T (OCFt)(1 – ) Dt It APV = t=1 (1 + Ku)t + (1 + i)t + (1 + i) t + TVT (1 + Ku) T – C0
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.
18-12 Domestic APV Example Consider this project, the timing and size of the incremental after-tax cash flows for an all-equity firm are: -$1,000 $125 $250 $375 $500
0 1 2 3 4 The unlevered cost of equity is r0 = 10%: CF0 = –$1000 The project would be rejected by CF1 = $125 an all-equity firm:
CF2 = $250 I = 10 CF3 = $500 NPV = –$56.50 18-13 Domestic APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at r = 8%. The tax rate is 40%, so they have an interest tax shield worth ×I = .40×$600×.08 = $19.20 each year.
18-14 -$1,000 $125 $250 $375 $500
0 1 2 3 4
The APV of the project under leverage is:
T (OCFt)(1 – ) Dt It APV = t=1 (1 + Ku)t + (1 + i)t + (1 + i) t + TVT (1 + Ku) T – C0
APV = $7.09 The firm should accept the project if it finances with debt. 18-15 Capital Budgeting from the Parent Firm’s Perspective T (OCFt)(1 – ) Dt It APV = t=1 (1 + Ku)t + (1 + i)t + (1 + i) t + TVT (1 + Ku) T – C0
The APV model is useful for a domestic firm
analyzing a domestic capital expenditure or for a foreign subsidiary of a MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint. The APV model is NOT useful for a MNC in analyzing a foreign capital expenditure from the parent firm’s perspective.
18-16 Capital Budgeting from the Parent Firm’s Perspective Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.
T S t OCFt (1 τ ) T St τDt T St τI t APV t 1 (1 K ud ) t t 1 (1 id ) t t 1 (1 id ) t
T ST TVT St LPt S 0C0 S 0 RF0 S 0CL0 (1 K ud ) T t 1 (1 id ) t
18-17 APV Model of Capital Budgeting from the Parent Firm’s Perspective T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t
St TVT T + (1 + Kud) T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t
18-18 Capital Budgeting from the Parent Firm’s Perspective T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t
St TVT T + (1 + Kud) T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t The operating cash flows must be translated back into the The operating cash flows parent firm’s currency at the must be discounted at the spot rate expected to prevail in unlevered domestic rate each period.
18-19 Capital Budgeting from the Parent Firm’s Perspective T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t
St TVT T + (1 + Kud) T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t
OCFt represents only the The marginal corporate tax
portion of operating cash flows rate, , is the larger of the available for remittance that parent’s or foreign can be legally remitted to the subsidiary’s. parent firm. 18-20 Capital Budgeting from the Parent Firm’s Perspective T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t
St TVT T + (1 + Kud) T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t
S0RF0 represents the value of Denotes the present value
accumulated restricted funds (in the parent’s currency) (in the amount of RF0) that are of any concessionary loans, freed up by the project. CL0, and loan payments, LPt , discounted at id . 18-21 Capital Budgeting from the Parent Firm’s Perspective One recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to the home currency at the predicted exchange rate. Use PPP, IRP et cetera for the predictions. 3. Calculate NPV using the home currency cost of capital.
18-22 Capital Budgeting from the Parent Firm’s Perspective: Example A U.S.-based MNC is considering a European opportunity. It’s a simple example There is no incremental debt There is no incremental depreciation There are no concessionary loans There are no restricted funds
18-23 Capital Budgeting from the Parent Firm’s Perspective: Example We can use a simplified APV: T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t
St TVT T + (1 + Kud)T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t
T StOCFt(1 – ) APV = t=1 (1 + Kud)t – S0C0
18-24 Capital Budgeting from the Parent Firm’s Perspective: Example One recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to the home currency at the predicted exchange rate. Use PPP, IRP et cetera for the predictions. 3. Calculate NPV using the home currency cost of capital.
18-25 Capital Budgeting from the Parent Firm’s Perspective: Example A U.S.-based MNC is considering a European opportunity. It’s a simple example There is no incremental debt There is no incremental depreciation There are no concessionary loans There are no restricted funds
18-26 Capital Budgeting from the Parent Firm’s Perspective: Example A U.S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows are:
–€600 €200 €500 €300
0 1 2 3
The inflation rate in the euro zone is € = 3%, the inflation
rate in dollars is $ = 6%, and the business risk of the investment would lead an unlevered U.S.-based firm to demand a return of Kud = i$ = 15%. 18-27 Capital Budgeting from the Parent Firm’s Perspective: Example –€600 €200 €500 €300
0 1 2 3 $1.25 The current exchange rate is S0($/€) = €
Is this a good investment from the perspective of the
U.S. shareholders? To address that question, let’s convert all of the cash flows to dollars and then find the NPV at i$ = 15%. 18-28 Capital Budgeting from the Parent Firm’s Perspective: Example –$750 –€600 €200 €500 €300
0 1 2 3
CF0 = (€600)× S0($/€) =(€600)× $1.25 = $750
€
Finding the dollar value of the initial cash
$1.25 flow is easy; convert at the spot rate: S0($/€) = € 18-29 Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 –€600 €200 €500 €300
0 1 2 3 The exchange rate expected to prevail in the first year, S1($/€), can be found with PPP: 1 + $ 1.06 $1.25 S1($/€) = 1 + S0($/€) = = $1.2864/€ € 1.03 €
CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28
18-30 Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 $661.94 –€600 €200 €500 €300
0 1 2 3
1.06 1.06 $1.25
CF2 = €500 = $661.94 1.03 1.03 €
18-31 Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 $661.94 $408.73 –€600 €200 €500 €300
0 1 2 3
1.06 1.06 1.06 $1.25
CF3 = €300 = $408.73 1.03 1.03 1.03 €
18-32 Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 $661.94 $408.73
0 1 2 3 Find the NPV using the cash flow menu of your financial calculator and and interest rate i$ = 15%: CF0 = –$750 CF1 = $257.28 CF2 = $661.94 I = 15 CF3 = $408.73 NPV = $242.99 18-33 Capital Budgeting from the Parent Firm’s Perspective: Alternative Another recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Estimate the foreign currency discount rate. 3. Calculate the foreign currency NPV using the foreign cost of capital. 4. Translate the foreign currency NPV into dollars using the spot exchange rate There is no “$” key on your calculator 18-34 Foreign Currency Cost of Capital Method – €600 €200 €500 €300
0 1 2 3
€ = 3% Let’s find i€ and use that on the euro
cash flows to find the NPV in euros. i$ = 15% Then translate the NPV into dollars $ = 6% at the spot rate. $1.25 The current exchange rate is S0($/€) = € 18-35 Foreign Currency Cost of Capital Method
Before we find i€ let’s use our intuition.
Since the euro-zone inflation rate is 3% lower than the dollar inflation rate, our euro denominated discount rate should be lower than our dollar denominated discount rate.
18-36 Finding the Foreign Currency Cost of Capital: i€ Recall that the Fisher Effect holds that (1 + e) × (1 + $) = (1 + i$)
real inflation nominal
rate rate rate So for example the real rate in the U.S. must be 8.49%
(1 + i$) 1.15 (1 + e) = e= – 1 = 0.0849 (1 + $) 1.06 18-37 Finding the Foreign Currency Cost of Capital: i€ If Fisher Effect holds here and abroad then (1 + i$) (1 + i€) (1 + e$) = and (1 + e€) = (1 + $) (1 + €)
If the real rates are the same in dollars and euros (e€ = e$) we have a very useful parity condition: (1 + i$) (1 + i€) = (1 + $) (1 + €) 18-38 Finding the Foreign Currency Cost of Capital: i€ If we have any three of these variables, we can find the fourth:
18-41 International Capital Budgeting You have two equally valid approaches: Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the $NPV using the dollar cost of capital. Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate. If you watch your rounding, you will get exactly the same answer either way. Which method you prefer is your choice.
18-42 Computing IRR Recall that a project’s Internal Rate of Return (IRR) is the discount rate that gives a project a zero NPV. €200 €500 €300 NPV = –€600 + + + = €0 1+IRR€ (1+IRR€) 2 (1+IRR€) 3
IRR$ = 24.85% CF0 = –$750 CF1 = $257.28 CF2 = $661.94 CF3 = $408.73 IRR = 32.23% 18-45 Converting from IRR$ to IRR€ Use the same IRP and PPP conditions that we used to convert from one discount rate to another. 1+IRR$ 1+IRR€ In our example, it was easy to find IRR€ = (1 + $) (1 + €) Finding IRR$ without converting all cash flows into dollars is straightforward:
(1+IRR€)(1 + $) (1.2848)(1.06)
(1+IRR$) = i€ = –1 (1 + €) (1.03) IRR$ = 32.23% € = 3%, $ = 6% 18-46 Back to the full APV Using the intuition just developed, we can modify Lessard’s APV model as shown above, if we find it convenient. S0 S0 S0 T T T StOCFt(1 – ) St Dt St It APV = t = 1 (1 + Kud) t + t = 1 (1 + id) t + t = 1 (1 + id) t S0 f f f St TVT T + (1 + Kud) T – S0C0 + S0RF0 + S0CL0 + St LPt t = 1 (1 + id) t
f S0 f 18-47 Risk Adjustment in the Capital Budgeting Process Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.
18-48 Sensitivity Analysis In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs to give the manager a more complete picture of the planned capital investment. Lends itself to computer simulation.
