18 International Capital Budgeting

INTERNATIONALFINANCIAL

MANAGEMENT

EUN / RESNICK

Fifth Edition

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

EUN / RESNICK

Fifth Edition

Chapter Objective:This chapter discusses the methodology that a multinational firm can use to analyze the investment of capital in a foreign country.

18 Chapter Eighteen

International Capital Budgeting

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


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


The basic net present value equation is

01 )1()1(

CK

TV

K

CFNPV

TT

T

tt

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 = economic life of the project in years.18-6


The NPV rule is to accept a project if NPV 0

0)1()1( 0

1

CK

TV

K

CFNPV

TT

T

tt

t

and to reject a project if NPV 0

.0)1()1( 0

1

CK

TV

K

CFNPV

TT

T

tt

t

18-7


For our purposes it is necessary to expand the NPV equation.

Rt is incremental revenue

OCt is incremental operating cash flow

Dt is incremental depreciation

It is incremental interest expense

is the marginal tax rate

CFt = (Rt – OCt – Dt – It)(1 – ) + Dt + It (1 – )

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


We can use CFt = (OCFt)(1 – ) + Dt

to restate the NPV equation

as:

NPV = t = 1

TCFt

(1 + K)t– C0

TVT

(1 + K)T+

NPV = t = 1

T (OCFt)(1 – ) + Dt

(1 + K)t– C0

TVT

(1 + K)T+

18-10

The Adjusted Present Value Model

Can be converted to adjusted present value (APV)

By appealing to Modigliani and Miller’s results.

NPV = t = 1

T (OCFt)(1 – )

(1 + K)tC0

TVT

(1 + K)T+

Dt

(1 + K)t+ –

t = 1

T

APV =t = 1

T (OCFt)(1 – )

(1 + Ku)tC0

TVT

(1 + Ku)T+

Dt

(1 + i)t+ –

It

(1 + i)t+

18-11

The Adjusted Present Value Model

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.

APV =t = 1

T (OCFt)(1 – )

(1 + Ku)tC0

TVT

(1 + Ku)T+

Dt

(1 + i)t+ –

It

(1 + i)t+

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:

0 1 2 3 4

-$1,000 $125 $250 $375 $500

The unlevered cost of equity is r0 = 10%:The project would be rejected by

an all-equity firm:

CF0 = –$1000

CF1 = $125

CF2 = $250

CF3 = $500

I = 10

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

APV =$125

1.10

0 1 2 3 4

-$1,000 $125 $250 $375 $500

+$250

(1.10)2+

$375

(1.10)3+

$500

(1.10)4

+$19.20

(1.08)2+

$19.20

(1.08)3+

$19.20

(1.08)4

$19.20

1.08+ – $1,000

APV = $7.09

The APV of the project under leverage is:

The firm should accept the project if it finances with debt.

APV =t = 1

T (OCFt)(1 – )

(1 + Ku)tC0

TVT

(1 + Ku)T+

Dt

(1 + i)t+ –

It

(1 + i)t+

18-15

Capital Budgeting from the Parent Firm’s Perspective

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.

APV =t = 1

T (OCFt)(1 – )

(1 + Ku)tC0

TVT

(1 + Ku)T+

Dt

(1 + i)t+ –

It

(1 + i)t+

18-16


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

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(

18-17

APV Model of Capital Budgeting from the Parent Firm’s Perspective

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

18-18


The operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period.

The operating cash flows must be discounted at the unlevered domestic rate

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

18-19


OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.

The marginal corporate tax rate, , is the larger of the parent’s or foreign subsidiary’s.

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

18-20


S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.

Denotes the present value (in the parent’s currency)

of any concessionary loans, CL0, and loan payments,

LPt , discounted at id .

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

18-21

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


We can use a simplified APV:

APV = t = 1

TStOCFt(1 – )

(1 + Kud)t– S0C0

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

18-24

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


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


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%.

–€600

0

€200

1

€500

2

€300

3

A U.S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows are:

18-27


Is this a good investment from the perspective of the U.S. shareholders?

–€600

0

€200

1

€500

2

€300

3

€$1.25

S0($/€) =The current exchange rate is

To address that question, let’s convert all of the cash flows to dollars and then find the NPV at i$ = 15%.

18-28


–$750

CF0 = (€600)× S0($/€) =(€600)× = $750€

$1.25

€$1.25

S0($/€) =Finding the dollar value of the initial cash flow is easy; convert at the spot rate:

–€600

0

€200

1

€500

2

€300

3

18-29


–$750 $257.28–€600

0

€200

1

€500

2

€300

3

CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28

The exchange rate expected to prevail in the first year, S1($/€), can be found with PPP:

= $1.2864/€1.03

1.06=

€

$1.251 + € 1 + $

S1($/€) = S0($/€)

18-30


$661.94–$750 $257.28

CF2 1.03

1.06=

€

$1.25

1.03

1.06 €500 = $661.94

–€600

0

€200

1

€500

2

€300

3

18-31


$408.73$661.94–$750 $257.28–€600

0

€200

1

€500

2

€300

3

CF3 1.03

1.06=

€

$1.25

1.03

1.06 €300 = $408.73

1.03

1.06

18-32


$408.73$661.94–$750 $257.28

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

CF3 = $408.73

I = 15

NPV = $242.9918-33

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

Capital Budgeting from the Parent Firm’s Perspective: Alternative

There is no “$” key on your calculator18-34

Foreign Currency Cost of Capital Method

Let’s find i€ and use that on the euro cash flows to find the NPV in euros.

Then translate the NPV into dollars at the spot rate.

– €600

0

€200

1

€500

2

€300

3

€ = 3%

i$ = 15%

$ = 6%

€$1.25

S0($/€) =The current exchange rate is 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 rate

inflation rate

nominal rate

So for example the real rate in the U.S. must be 8.49%

(1 + e) =(1 + i$)

(1 + $)e =

1.15

1.06– 1 = 0.0849

18-37


If Fisher Effect holds here and abroad then

If the real rates are the same in dollars and euros (e€ = e$)

(1 + e$) =(1 + i$)

(1 + $)(1 + e€) =

(1 + i€)

(1 + €)and

(1 + i$)

(1 + $)=

(1 + i€)

(1 + €)

we have a very useful parity condition:

18-38


If we have any three of these variables, we can find the fourth:

(1 + i€) = (1 + i$) × (1 + €)

(1 + $)

In our example, we want to find i€ (1 + i$)

(1 + $)=

(1 + i€)

(1 + €)

i€ = (1.15) × (1.03)

(1.06)– 1

i€ = 0.1175

18-39

International Capital Budgeting: Example

Find the NPV using the cash flow menu and i€ = 11.75%:

CF0 = –€600

CF1 = €200

CF2 = €500

CF3 = €300

I = 11.75

NPV = €194.39

– €600

0

€200

1

€500

2

€300

3

$1.25 = $242.99€194.39 ×€

18-40

NPV = –$750 +(1.15)3

$408.73+

1.15

$257.28= $242.99+

(1.15)2

$661.94

$408.73$661.94–$750 $257.28

0 1 2 3

NPV = –€600 +(1.1175)3

€300+

1.1175

€200= €194.39 +

(1.1175)2

€500

$1.25 = $242.99€194.39 ×€

– €600

0

€200

1

€500

2

€300

3

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.

NPV = –$750 +(1+IRR$)3

$408.73+

1+IRR$

$257.28= $0+

(1+IRR$)2

$661.94

NPV = –€600 +(1+IRR€)3

€300+

1+IRR€

€200= €0 +

(1+IRR€)2

€500

IRR€ = 28.48%

IRR$ = 32.23%18-43

Computing IRR

Easily done with the IRR key

NPV = –€600 +(1+IRR€)3

€300+

1+IRR€

€200= €0 +

(1+IRR€)2

€500

IRR€ = 28.48%CF0 = –€600

CF1 = €200

CF2 = €500

CF3 = €300 IRR€ = 28.48%18-44

Computing IRR

Easily done with the IRR key

CF0 = –$750

CF1 = $257.28

CF2 = $661.94

CF3 = $408.73 IRR = 32.23%

NPV = –$750 +(1+IRR$)3

$408.73+

1+IRR$

$257.28= $0+

(1+IRR$)2

$661.94

IRR$ = 24.85%

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€)(1 + $)

(1 + €)

In our example, it was easy to find IRR€

Finding IRR$ without converting all cash flows into dollars is straightforward:

1+IRR$

(1 + $)=

1+IRR€

(1 + €)

i€ = (1.2848)(1.06)

(1.03)– 1

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

S0

S0

f f f

f f

APV = t = 1

T

(1 + Kud)t

TVT

(1 + Kud)T+

Dt

(1 + id)t+

–

StOCFt(1 – )

S0C0 + S0RF0 + S0CL0 +

t = 1

TSt It

(1 + id)t St+t = 1

T

St LPt

(1 + id)t St

t = 1

T

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.

18-49

18 International Capital Budgeting

Documents

t t t t

c0 t t t

idt t t

t ocft1 x

year t

t s t dt st i t apv

rf0 s 0cl0 t t

t cft tvt npv