1 Multinational Financial Management Alan Shapiro 7 th Edition J.Wiley & Sons Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

2 CHAPTER 17 CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION

3 CHAPTER OVERVIEW: I.BASIS OF CAPITAL BUDGETING II.ISSUES IN FOREIGN INVESTMENT ANALYSIS III. POLITICAL RISK ANALYSIS IV.GROWTH OPTIONS AND PROJECT EVALUATION

4 I.BASICS OF CAPITAL BUDGETING A. Basic Criterion: Net Present Value B.Net Present Value Technique: 1. Definition The present value of future cash flows, discounted at the project’s cost of capital less the initial net cash outlay.

5 BASICS OF CAPITAL BUDGETING 2.NPV Formula: where I 0 = initial cash outlay x t = net cash flow at t k = cost of capital n = investment horizon

6 BASICS OF CAPITAL BUDGETING 3.Most important property of NPV technique: -focus on cash flows with respect to shareholder wealth 4.NPV obeys value additive principle: - the NPV of a set of projects is the sum of the individual project NPV

7 BASICS OF CAPITAL BUDGETING C.International Cash Flows 1.Important principle when estimating: Incremental basis 2.Distinguish total from incremental flows to account for a.cannibalization b.sales creation c.opportunity cost d.transfer pricing e.fees and royalties

8 BASICS OF CAPITAL BUDGETING 3.Getting the base case correct Rule of thumb: Incremental GlobalGlobal cash flows = corporate - flow cash flow without with projectproject

9 BASICS OF CAPITAL BUDGETING 4. Intangible Benefits a. Valuable learning experience b. Broader knowledge base

10 II. ISSUES IN FOREIGN INVESTMENT ANALYSIS II. TWO ISSUES IN FOREIGN INVESTMENT ANALYSIS A.Issue #1 Parent v. Project Cash Flow -the cash flows from the project may differ from those remitted to the parent 1. Relevant cash flows become quite important

11 ISSUES IN FOREIGN INVESTMENT ANALYSIS 2.Three Stage Approach -to simplify project evaluation a. compute subsidiary’s project cash flows b. evaluate the project to the parent c. incorporate the indirect effects

12 ISSUES IN FOREIGN INVESTMENT ANALYSIS 3.Estimating Incremental Project Flows What is the true profitability of the project? a.Adjust for tax effects of 1.)transfer pricing 2.)fees and royalties

13 ISSUES IN FOREIGN INVESTMENT ANALYSIS 4.Tax Factors: determine the amount and timing of taxes paid on foreign-source income.

14 ISSUES IN FOREIGN INVESTMENT ANALYSIS B.Issue #2 How to adjust for increased economic and political risk of project? 1. Three Methods of Economic and Political Risk Adjustments: a.Shortening minimum payback period b.Raising required rate of return c.Adjusting cash flows

15 ISSUES IN FOREIGN INVESTMENT ANALYSIS 2.Accounting for Exchange Rate and Price Changes (inflationary) Two stage procedure: a.Convert nominal foreign cash flows into home currency terms b.Discount home currency flows at domestic required rate of return.

16 III. POLITICAL RISK ANALYSIS I. POLITICAL RISK ANALYSIS A.Political risks can be incorporated into an NPV analysis by - adjusting expected project cash flows to reflect the risks.

17 POLITICAL RISK ANALYSIS B. EXPROPRIATION - the extreme form of political risk C.BLOCKED FUNDS

18 IV. GROWTH OPTIONS AND PROJECT EVALUATION A. Options: 1.an important component of many investment decisions 2.ignoring options will understate the NPV of that investment

19 GROWTH OPTIONS AND PROJECT EVALUATION B.Project Evaluation 1.Growth options require an expanded NPV rule 2.Investments in emerging markets can be viewed as growth options