18

International Capital Budgeting INTERNATIONAL FINANCIAL MANAGEMENT

18-0

Seventh Edition

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

EUN / RESNICK

EUN / RESNICK

Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Domestic Capital Budgeting n 

l 

Expected background reading

The Adjusted Present Value Model n 

INTERNATIONAL FINANCIAL MANAGEMENT

Chapter Objective:

Suggested background reading

Capital Budgeting from Parent Firm’s Perspective Risk Adjustment in the Capital Budgeting Process l  Sensitivity Analysis l  Real Options

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-1

Chapter Outline l 

Chapter Eighteen

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.

l  l 

18-2

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-3

International Capital Budgeting Example

International Capital Budgeting First possible recipe for international managers:

– 600€

200€

500€

300€

0

1

2

3

1. Estimate future cash flows in foreign currency 2. Convert to U.S. dollars at the predicted exchange rate 3. Calculate NPV using the U.S. cost of capital

18-4

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

π€ = 3% i$ = 15%

π$ = 6%

18-5

S0($/€) =

$.55265 €

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

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

1

International Capital Budgeting: Example

International Capital Budgeting: Example

$331.60

– 600€ 0

$331.60

200€ 1 year

500€ 2 years

300€ 3 years

CF0 = (€600)× S0($/€) =(€600)× $.55265 = $331.60 €

$113.70

– 600€

200€

0

500€

1 year

2 years

300€ 3 years

CF1 = (€200)×E[ S1($/€)] = ? E[ S1($/€)] can be found by appealing to PPP: E[S€(1)] = 1.06 × S0($/€) = 1.03

1.06 × $.55265 = $.5687/€ 1.03 €

so CF1 = (€200)×($.5687/€) = $113.7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-6

International Capital Budgeting: Example $331.60

– 600€ 0 Similarly,

$113.70

$292.60

200€

500€

1 year

2 years

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18-7

International Capital Budgeting: Example $331.60

300€ 3 years

CF2 = 1.06 × 1.06 × S0($/€) ×(€500) = $292.6 1.03 1.03

$113.70

$292.60

$180.70

200€

500€

300€

– 600€ 0 CF3 =

1 year

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

International Capital Budgeting

3 years

(1.06)3 × S ($/€) ×(€300) = $180.7 (1.03)3 0

NPV = −$331.60 + 18-8

2 years

$113.70 $292.60 $180.70 + + = $107.30 (1.15) (1.15) 2 (1.15)3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-9

Foreign Currency Cost of Capital Method

Second possible recipe for international managers:

– €600

€200

0

1

€500

€300

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

π€ = 3%

4. Translate the foreign currency NPV into dollars using the spot exchange rate

π$ = 6%

i$ = 15%

S0($/€) = 18-10

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-11

3 2 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.

$0.55265 €

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

2

International Capital Budgeting Example

Finding the Foreign Currency Cost of Capital: i€ Recall that if the Fisher Effect holds here and abroad…

(1 + ρ$) ×(1 + π$) = (1 + i$) (1 + i$) (1 + ρ$) = (1 + π$) and if the real interest rates are the same, then:

18-12

(1 + i$)×(1 + π€)

n 

l  l 

€300

0

1

2

3

(1 + i$)×(1 + π€)

(1 + π$)

Change the foreign cash flows into dollars at the FX 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.

(1 + π$)

=

(1.15)×(1.03) (1.06)

= 11.75%

NPV @11.75% = € 194.39

i$ = 15%

π$ = 6%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

You have two equally valid approaches: n 

€500

π€ = 3% $.55265 S0($/€) = €

à € 194.39 ×

$0.55265 1€

= $107.43

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-13

International Capital Budgeting l 

€200

(1 + i€) =

(1 + i€) = (1 + ρ€) × (1 + π€)

(1 + i€) =

– €600

Adjusted Present Value l 

The rest of this PDF file and the corresponding material in the E&R’s Chapter 18 are Not Exam Material (NEM)

You will get the same answer either way. Which method you prefer is your choice. n  18-14

Caveat: sometimes easier to estimate CoC than FX rates Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Domestic Capital Budgeting The basic net present value equation is T CFt TVT NPV = ∑ + − C0 t ( 1 + K ) ( 1 + K )T t =1

Where: CFt = expected incremental after-tax cash flow in year t, TVT = expected after tax cash flow in year T, 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. 18-16

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-15

Review of Domestic Capital Budgeting The NPV rule is to accept a project if NPV ≥ 0 T

NPV = ∑ t =1

CFt TVT + − C0 ≥ 0 (1 + K )t (1 + K )T

and to reject a project if NPV ≤ 0 T

NPV = ∑ t =1

18-17

CFt TVT + − C0 ≤ 0. t (1 + K ) (1 + K )T Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

3

Review of Domestic Capital Budgeting

Review of Domestic Capital Budgeting

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

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

CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ ) Rt is incremental revenue

It is incremental interest expense

OCt is incremental operating τ is the marginal tax rate costs

CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ ) = NI t + Dt + I t (1 − τ ) = ( Rt − OCt − Dτ )(1 − τ ) + Dt = NOI t (1 − τ ) + Dt = ( Rt − OCt )(1 − τ ) + τDt = OCFt (1 − τ ) + τDt

Dt is incremental depreciation Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-18

Review of Domestic Capital Budgeting We can use CFt = OCFt (1 − τ ) + τDt to restate the NPV equation T

CFt TVT NPV = ∑ + − C0 t (1 + K )T t =1 (1 + K )

as:

T

OCFt (1 − τ ) + τDt TVT + − C0 t ( 1 + K ) ( 1 + K )T t =1

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18-19

The Adjusted Present Value Model T

OCFt (1 − τ ) τDt TVT + + − C0 t t ( 1 + K ) ( 1 + K ) ( 1 + K )T t =1

NPV = ∑

Can be converted to adjusted present value (APV) T

OCFt (1 − τ ) τDt τI t TVT + + + − C0 t t t ( 1 + K ) ( 1 + i ) ( 1 + i ) ( 1 + K u )T t =1 u

APV = ∑

By appealing to Modigliani and Miller’s results.

NPV = ∑

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18-20

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18-21

The Adjusted Present Value Model T

OCFt (1 − τ ) τDt τI t TVT + + + − C0 t t t ( 1 + K ) ( 1 + i ) ( 1 + i ) ( 1 + K u )T t =1 u

APV = ∑

Domestic APV Example Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are:

-$1,000

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 given the riskiness of the cash flow.

0

$125

$250

$375

$500

1

2

3

4

The unlevered cost of equity is r0 = 10%:

NPV10% = −$1,000 +

$125 $250 $375 $500 + + + (1.10) (1.10) 2 (1.10) 3 (1.10) 4

NPV10% = −$56.50 The project would be rejected by an all-equity firm: NPV < 0.

18-22

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18-23

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4

Domestic APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at r = 8%. l  Pearson’s tax rate is 40%, so they have an interest tax shield worth τ×I = 0.40×$600×0.08 = $19.20 each year. •  The net present value of the project under leverage is: APV = NPV + NPVF Note that with the 4 APV model, each cash $19.20 APV = −$56.50 + ∑ flow is discounted at a t rate that is appropriate t =1 (1.08) l 

APV = −$56.50 + 63.59 = $7.09

to the riskiness of the cash flow.

•  So, Pearson should accept the project with debt. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-24

Capital Budgeting from the Parent Firm’s Perspective l 

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

APV = ∑ t =1

+

T St OCFt (1 − τ ) T St τDt S τI +∑ +∑ t t t t t (1 + K ud ) t =1 (1 + id ) t =1 (1 + id )

T S LP ST TVT − S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t T (1 + K ud ) t =1 (1 + id ) Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-26

Capital Budgeting from the Parent Firm’s Perspective T

APV = ∑ t =1

T St OCFt (1 − τ ) T St τDt S τI +∑ +∑ t t t t t (1 + K ud ) t =1 (1 + id ) t =1 (1 + id )

Domestic APV Example (continued) l 

Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan: 4

NPVloan = $600 − ∑ t =1

NPVloan = $63.59 APV = NPV + NPVloan APV = −$56.50 + 63.59 = $7.09 Which is the same answer as before.

S LP ST TVT − S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t (1 + K ud )T t =1 (1 + id )

OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm. 18-28

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

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-25

Capital Budgeting from the Parent Firm’s Perspective T

APV = ∑ t =1

+

T St OCFt (1 − τ ) T St τDt St τI t + + ∑ ∑ t t t (1 + K ud ) t =1 (1 + id ) t =1 (1 + id )

T S LP ST TVT − S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t T (1 + K ud ) t =1 (1 + id )

The operating cash flows must The operating cash flows be translated back into the must be discounted at the parent firm’s currency at the unlevered domestic rate spot rate expected to prevail in each period. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

18-27

Capital Budgeting from the Parent Firm’s Perspective T

APV = ∑ t =1

T

+

$600 × .08 × (1 − .4) $600 − (1.08) t (1.08) 4

+

T St OCFt (1 − τ ) T St τDt S τI +∑ +∑ t t t t t (1 + K ud ) t =1 (1 + id ) t =1 (1 + id )

T S LP ST TVT − S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t T (1 + K ud ) t =1 (1 + id )

S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project. 18-29

Denotes the present value (in the parent’s currency) of any concessionary loans, CL0, and loan payments, LPt , discounted at id .

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5

Risk Adjustment in the Capital Budgeting Process l  l 

Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

18-30

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Sensitivity Analysis In the APV model, each cash flow has a probability distribution associated with it. l  Hence, the realized value may be different from what was expected. l  In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment. l 

18-31

Real Options l 

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End Chapter Seventeen

The application of options pricing theory to the evaluation of investment options in real projects is known as real options. A timing option is an option on when to make the investment. n  A growth option is an option to increase the scale of the investment. n  A suspension option is an option to temporarily cease production. n  An abandonment option is an option to quit the investment early. n 

18-32

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18-33

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6