International Capital Budgeting Defined as the process for the selection of long-term capital investments. Our objective is to provide an in-depth discussion of the methodologies that multinational firms can use to analyze long-term capital investments in foreign projects. International Capital Budgeting Fifth Edition EUN / RESNICK 18-0

OBJECTIVE: Objective: To maximize the current wealth of shareholders of the parent firm. In which currency? Value created is in terms of the domestic currency of the parent company. For a US MNC, the value added we seek should be in USD. 18-1

Approaches to International Capital Budgeting Adjusted Present Value (APV): The APV of a project is defined as: APV = NPV if all equity financed + NPV of financing side effects + PV of real options The first term estimates the value of the project as a stand-alone entity financed with 100% equity. The free cash flows are discounted at the unlevered cost of capital. The second term includes the net present value of any side effects associated with the financing of the project. For example, the PV of interest tax-shields. The last term adds the PV of any real options associated with the project. 18-2

Approaches to Capital Budgeting continued 2. WACC Approach: determines the total value of a project by discounting the FCFs (100% equity financed) at a weighted average of the after-tax cost of debt and the levered cost of equity. The weights used are the market value proportions of debt to total value (D/V) and equity to total value (E/V). The total market value of the firm is given by: V = D + E After-tax cost of debt = before-tax cost(1 - tax rate) The cost of equity is found by using the CAPM. 18-3

Approaches continued 3. Flow-to-Equity Approach: the after-tax cash flows to stockholders are discounted at the levered cost of equity. This approach requires the estimation of residual cash flows to equity as well as other adjustments; when used to value foreign projects or subsidiaries using the parent company’s perspective.

Free Cash Flow Definition Free Cash Flow (FCF): the unencumbered cash flow available(if>0) to all suppliers of capital to the firm. If FCF is negative, then it is the cash provided by the suppliers of capital. FCF = EBIT(1 – tax rate) + Depreciation - Change in NWC - Capex. Where: EBIT = Revenues - Costs - Depreciation NWC = net working capital Capex = Long-term capital expenditures 18-5

FCF to Equity Definition FCF to equity = Net Income + Depreciation – Change in NWC - Capex – Principal Repayment + New debt proceeds. This approach can be useful when the parent company’s perspective is adopted. The FCFs to equity must be adjusted for withholding taxes, foreign exchange controls, royalty payments, licensing agreements, US taxes, and overhead management fees before they are discounted to establish value.

Parent Versus Subsidiary Cash Flows There can be significant differences between the cash flows that accrue directly to the foreign subsidiary from a project, and the cash flows received by the parent firm. Since the parent company’s perspective is the most important, our analysis must determine the portions of the foreign project’s cash flows that will be received by the parent company. 18-7

Comparison of the three approaches The APV and the WACC approaches are useful for determining the value added by a foreign project from the perspective of the subsidiary of the MNC. If the manager knows the level of debt used by the foreign project in all future periods, then the APV approach is indicated for determining the stand-alone value of a foreign project. Also the value of real options can be accounted for by using this approach. 18-8

Comparison continued If the manager is planning on keeping a constant debt-to-equity ratio in the future, as it is assumed in the WACC, then the WACC approach is the better method to value the project on stand-alone basis, or from the perspective of the foreign subsidiary. With changing levels of leverage in the future, both APV and WACC are difficult to apply. The Flow-to-Equity is ideal for the parent company perspective for the reasons stated in the discussion of FCF.

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. 18-10

Capital Budgeting from the Parent Firm’s Perspective The cash flow received by the parent company can differ from the cash flow available to the subsidiary due to: Withholding taxes imposed on remitted cash flow. U.S. corporate taxes imposed on the earnings of the subsidiary in addition to foreign taxes paid to host government. Changes in exchange rates. Blocked funds. Repayment of local currency loans. 18-11

Capital Budgeting from the Parent Firm’s Perspective One recipe for international decision makers: 1. Estimate future free cash flows in foreign currency. 2. Convert to the home currency at the projected exchange rates. Use PPP, IRP et cetera for the predictions. 3. Calculate NPV using the home currency cost of capital. 18-12 2

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 1 €500 2 €300 3 The inflation rate in the euro zone is € = 3%, the inflation rate in dollars is p$ = 6%, and the business risk of the investment would lead an unlevered U.S.-based firm to demand a return of 15%. 18-13 2

Capital Budgeting from the Parent Firm’s Perspective: Example –€600 €200 1 €500 2 €300 3 € $1.25 S0($/€) = The current exchange rate is 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 15%. 18-14 2

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 –€600 €200 1 €500 2 €300 3 CF0 = (€600)× S0($/€) =(€600)× = $750 € $1.25 Finding the dollar value of the initial cash flow is easy; convert at the spot rate: € $1.25 S0($/€) = 18-15 2

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 –€600 €200 1 €500 2 €300 3 The exchange rate expected to prevail in the first year, S1($/€), can be found with PPP: 1 + € 1 + $ S1($/€) =  S0($/€) 1.03 1.06 =  € $1.25 = $1.2864/€ CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28 18-16 2

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 $661.94 –€600 €200 1 €500 2 €300 3 CF2 1.03 1.06 = € $1.25   €500 = $661.94 18-17 2

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257.28 $661.94 $408.73 –€600 €200 1 €500 2 €300 3 CF3 1.03 1.06 = € $1.25   €300 = $408.73 18-18 2

Capital Budgeting from the Parent Firm’s Perspective: Example $408.73 $661.94 –$750 $257.28 1 2 3 Find the NPV using the cash flow menu of your financial calculator and and interest rate of 15%: CF0 = –$750 CF1 = $257.28 CF2 = $661.94 I = 15 CF3 = $408.73 NPV = $242.99 18-19 2

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 18-20 2

Foreign Currency Cost of Capital Method Before we find euro required rate 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. 18-21 2

Finding the Foreign Currency Cost of Capital: i€ Recall that the Fisher Effect holds that (1 + rr) × (1 + $) = (1 + i$) real rate inflation rate nominal rate So for example the real rate in the U.S. must be 8.49% (1 + rr) = (1 + i$) (1 + $) = 1.15 1.06 – 1 = 0.0849 18-22 2

Finding the Foreign Currency Cost of Capital: If Fisher Effect holds here and abroad then (1 + rr$) = (1 + i$) (1 + $) (1 + rr€) = (1 + i€) (1 + €) and If the real rates are the same in dollars and euros(rr€ = rr$) we have a very useful parity condition: (1 + i$) (1 + $) = (1 + i€) (1 + €) 18-23 2

Finding the Foreign Currency Cost of Capital: i€ If we have any three of these variables, we can find the fourth: (1 + i$) (1 + $) = (1 + i€) (1 + €) In our example, we want to find i€ (1 + i€) = (1 + i$) × (1 + €) (1 + $) i€ = (1.15) × (1.03) (1.06) – 1 i€ = 0.1175 18-24 2

International Capital Budgeting: Example – €600 €200 1 €500 2 €300 3 Find the NPV using the cash flow menu and i€ = 11.75%: CF0 = –€600 I = 11.75 CF1 = €200 NPV = €194.39 CF2 = €500 $1.25 = $242.99 €194.39 × € CF3 = €300 18-25 2

– €600 €200 1 €500 2 €300 3 NPV = –€600 + (1.1175)3 €300 + 1.1175 €200 = €194.39 (1.1175)2 €500 $1.25 = $242.99 €194.39 × € $408.73 $661.94 –$750 $257.28 1 2 3 $257.28 $661.94 $408.73 NPV = –$750 + + + = $242.99 1.15 (1.15)2 (1.15)3 18-26 2

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. 18-27

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. 18-28

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. 18-29

Real Options 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. A growth option is an option to increase the scale of the investment. A suspension option is an option to temporarily cease production. An abandonment option is an option to quit the investment early. 18-30