1 Multinational Finance, Jörgen Hellström Multinational Finance International Capital Budgeting (Chapter 17) Multinational Finance, Jörgen Hellström Where we are? Previous lecture: Foreign direct investments (FDI) Reasons for FDI Process of becoming MNC (FDI) Strategies to remain MNC Where to FDI ? – Country risk analysis – Political risk (assessin g the risk of inve sting in differe nt countries) Today’s lecture: International capital budgeting Methods for assessing the profitability of FDI (comparing different options)
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8/7/2019 Lecture 6 International Capital Budgeting Two
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)
8/7/2019 Lecture 6 International Capital Budgeting Two
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 Finance, JörgenHellström
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).
8/7/2019 Lecture 6 International Capital Budgeting Two
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
Multinational Finance, JörgenHellström
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(
8/7/2019 Lecture 6 International Capital Budgeting Two
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)
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two
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
Multinational Finance, JörgenHellström
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”
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
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two
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
Multinational Finance, JörgenHellström
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)
8/7/2019 Lecture 6 International Capital Budgeting Two
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
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two
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%
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two
DCF – static approach – all operatingdecisions are set in advance
However, in reality:
“opportunity to make decisions contingent on
information that becomes available in thefuture”
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two
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)
Multinational Finance, JörgenHellström
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
8/7/2019 Lecture 6 International Capital Budgeting Two