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Multinational Capital Budgeting 14 Chapter South-Western/Thomson Learning © 2006 Slides by Yee-Tien (Ted) Fu

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14 - 2 Chapter Objectives To compare the capital budgeting analysis of an MNC’s subsidiary with that of its parent; To demonstrate how multinational capital budgeting can be applied to determine whether an international project should be implemented; and To explain how the risk of international projects can be assessed.

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14 - 3 Subsidiary versus Parent Perspective Should the capital budgeting for a multi- national project be conducted from the viewpoint of the subsidiary that will administer the project, or the parent that will provide most of the financing? The results may vary with the perspective taken because the net after-tax cash inflows to the parent can differ substantially from those to the subsidiary.

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14 - 4 Subsidiary versus Parent Perspective Such differences can be due to: ¤ Tax differentials What is the tax rate on remitted funds? ¤ Regulations that restrict remittances ¤ Excessive remittances The parent may charge its subsidiary very high administrative fees. ¤ Exchange rate movements

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14 - 5 Remitting Subsidiary Earnings to the Parent Conversion of Funds to Parent’s Currency Parent Cash Flows to Parent Corporate Taxes Paid to Host Government Retained Earnings by Subsidiary After-Tax Cash Flows Remitted by Subsidiary Withholding Tax Paid to Host Government Cash Flows Remitted by SubsidiaryAfter-Tax Cash Flows to Subsidiary Cash Flows Generated by Subsidiary

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14 - 6 A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive net present value for the parent should enhance the firm’s value. However, one exception to this rule occurs when the foreign subsidiary is not wholly owned by the parent. Subsidiary versus Parent Perspective

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14 - 7 Input for Multinational Capital Budgeting The following forecasts are usually required: 1. Initial investment 2. Consumer demand over time 3. Product price over time 4. Variable cost over time 5. Fixed cost over time 6. Project lifetime 7. Salvage (liquidation) value

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14 - 8 The following forecasts are usually required: Input for Multinational Capital Budgeting 9. Tax payments and credits 10. Exchange rates 11. Required rate of return 8. Restrictions on fund transfers

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14 - 9 Multinational Capital Budgeting Capital budgeting is necessary for all long-term projects that deserve consideration. One common method of performing the analysis involves estimating the cash flows and salvage value to be received by the parent, and then computing the net present value (NPV) of the project.

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14 - 10 Multinational Capital Budgeting NPV=– initial outlay n + cash flow in period t t =1 (1 + k ) t + salvage value (1 + k ) n k = the required rate of return on the project n = project lifetime in terms of periods If NPV > 0, the project can be accepted.

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14 - 11 Multinational Capital Budgeting Example: Spartan, Inc. is considering the development of a subsidiary in Singapore that will manufacture and sell tennis rackets locally.

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14 - 12 Capital Budgeting Analysis: Spartan, Inc.

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14 - 13 Capital Budgeting Analysis: Spartan, Inc.

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14 - 14 Capital Budgeting Analysis Period t 1.Demand(1) 2.Price per unit(2) 3.Total revenue(1) (2)=(3) 4.Variable cost per unit(4) 5.Total variable cost (1) (4)=(5) 6.Annual lease expense(6) 7.Other fixed annual expenses(7) 8.Noncash expense (depreciation)(8) 9.Total expenses(5)+(6)+(7)+(8)=(9) 10.Before-tax earnings of subsidiary(3)–(9)=(10) 11.Host government taxtax rate (10)=(11) 12.After-tax earnings of subsidiary(10)–(11)=(12)

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14 - 15 Capital Budgeting Analysis Period t 13.Net cash flow to subsidiary (12)+(8)=(13) 14.Remittance to parent(14) 15.Tax on remitted fundstax rate (14)=(15) 16.Remittance after withheld tax(14)–(15)=(16) 17.Salvage value(17) 18.Exchange rate(18) 19.Cash flow to parent(16) (18)+(17) (18)=(19) 20.PV of net cash flow to parent(1+k) - t (19)=(20) 21.Initial investment by parent(21) 22.Cumulative NPV PVs–(21)=(22)

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14 - 16 Factors to Consider in Multinational Capital Budgeting Exchange rate fluctuations Since it is difficult to accurately forecast exchange rates, different scenarios can be considered together with their probability of occurrence.

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14 - 17 Analysis Using Different Exchange Rate Scenarios: Spartan, Inc.

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14 - 18 Sensitivity of the Project’s NPV to Different Exchange Rate Scenarios: Spartan, Inc.

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14 - 19 Factors to Consider in Multinational Capital Budgeting Inflation Although price/cost forecasting implicitly considers inflation, inflation can be quite volatile from year to year for some countries.

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14 - 20 Factors to Consider in Multinational Capital Budgeting Financing arrangement Financing costs are usually captured by the discount rate. However, when foreign projects are partially financed by foreign subsidiaries, a more accurate approach is to separate the subsidiary investment and explicitly consider foreign loan payments as cash outflows.

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14 - 21 Factors to Consider in Multinational Capital Budgeting Blocked funds Some countries require that the earnings generated by the subsidiary be reinvested locally for at least a certain period of time before they can be remitted to the parent.

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14 - 22 Capital Budgeting with Blocked Funds: Spartan, Inc. Assume that all funds are blocked until the subsidiary is sold.

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14 - 23 Factors to Consider in Multinational Capital Budgeting Uncertain salvage value Since the salvage value typically has a significant impact on the project’s NPV, the MNC may want to compute the break- even salvage value. Impact of project on prevailing cash flows The new investment may compete with the existing business for the same customers.

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14 - 24 Adjusting Project Assessment for Risk When an MNC is unsure of the estimated cash flows of a proposed project, it needs to incorporate an adjustment for this risk. One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that should be applied to the cash flows.

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14 - 25 Adjusting Project Assessment for Risk An MNC may also perform sensitivity analysis or simulation using computer software packages to adjust its evaluation. Sensitivity analysis involves considering alternative estimates for the input variables, while simulation involves repeating the analysis many times using input values randomly drawn from their respective probability distributions.

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Chapter 9 Project Cash Flows and Risk © 2005 Thomson/South-Western.

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