Multinational Capital Budgeting

Capital Budgeting in Foreign Subsidiaries MNCs evaluate international projects by using multinational capital budgeting, which compares the costs and benefits of these projects. Many international projects are irreversible and cannot be easily sold to other corporations at a reasonable price. Proper use of multinational capital budgeting can identify the international projects worthy of implementation.

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.

Subsidiary versus Parent Perspective Since the subsidiary is a subset of the MNC, what is good for the subsidiary would appear to be good for the MNC. WRONG!

Subsidiary versus Parent Perspective The difference in cash inflows is due to : Tax differentials What is the tax rate on remitted funds? If the parent’s government imposes a high tax rate on the remitted funds, the project may be feasible from the subsidiary’s point of view, but NOT from the parent’s point of view! Parent should NOT consider!

Regulations that restrict remittances Where host government restrictions require a percentage of the subsidiary earnings to remain in the host country and parent may never have access to these funds, the project is NOT attractive to the parent. This may be considered though since the portion of funds not allowed to be sent to the parent can be used to cover the financing costs over time.

Excessive remittances The parent may charge its subsidiary very high administrative fees. Consider a parent that charges the subsidiary very high administrative fees because management is centralized at the headquarters, the fees represent an expense for the subsidiary and for the parent, the fees represent revenue that may substantially exceed the actual cost of managing the subsidiary.

Exchange rate movements When earnings are remitted to the parent, they are normally converted from the subsidiary’s local currency to the parent’s currency. The amount received by the parent is therefore influenced by the existing exchange rate.

Subsidiary versus Parent Perspective 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 may occur when the foreign subsidiary is not wholly owned by the parent.

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

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

Input for Multinational Capital Budgeting The following forecasts are usually required: 8. Fund-transfer restrictions 9. Tax laws 10. Exchange rates 11. Required rate of return

Initial Investment This may constitute the major source of funds to support a particular project. Funds initially invested in a project may include not only whatever is necessary to start the project but also additional funds, such as working capital, to support the project over time. Such funds are needed to finance inventory, wages, and other expenses until the project starts to generate revenue. Because cash inflows will not always be sufficient to cover upcoming cash outflows, working capital is needed throughout a project’s lifetime.

Consumer Demand An accurate forecast of consumer demand for a product is quite valuable, but future demand is often difficult to forecast. Demand forecasts can sometimes be aided by historical data on the market share other MNCs in the industry pulled when they entered this market, but historical data are not always an accurate indicator of the future.

Price The price at which the product could be sold can be forecasted using competitive products in the markets as a comparison. The future prices will most likely be responsive to the future inflation rate of the host country, but the future inflation rate is NOT known. Thus, future inflation rates must be forecasted in order to develop projections of the product price over time.

Variable Cost Like the price estimate, variable-cost forecasts can be developed from assessing prevailing comparative costs of the components (i.e. hourly labor costs). Such costs should normally move in tandem with the future inflation rate of the host country. Even if the VC/u can be accurately predicted, the projected total variable cost may be wrong if the demand is inaccurately forecasted.

Fixed Cost Fixed cost is sensitive to any change in the host country’s inflation rate from the time the forecast is made until the time the FC are incurred.

Project Lifetime Some projects have indefinite lifetimes that can be difficult to assess, while other projects have designated specific lifetimes, at the end of which they will be liquidated. This makes the capital budgeting analysis easier to apply. An MNC does not always have complete control over the lifetime decision. In some cases, certain events (i.e. Political) may force the firm to liquidate the project earlier than planned.

Salvage (liquidation) Value The after-tax salvage value of most projects is difficult to forecast. It will depend on several factors, including the success of the project and the attitude of the host government toward the project. As an extreme possibility, the host government could take over the project without adequately compensating the MNC.

Restriction on Fund Transfers In some cases, a host government will prevent a subsidiary from sending its earnings to the parent. This restriction may reflect an attempt to encourage additional local spending or to avoid excessive sales of the local currency in exchange for some other currency.

Tax Laws The tax laws on earnings generated by a foreign subsidiary or remitted to the MNC’s parent vary among countries. Because after-tax cash flows are necessary for an adequate capital budgeting analysis, international tax effects must be determined on any proposed foreign projects.

Exchange Rates Any international project will be affected by exchange rate fluctuations during the life of the project, but these movements are often very difficult to forecast. Though hedging techniques can be used to cover short and long-term positions (through forward contracts and swaps), the MNC has no way of knowing the amount of funds that it should hedge.

Required Rate of Return Once the relevant cash flows of a proposed project are estimated, they can be discounted at the project’s required rate of return, which may differ from the MNC’s cost of capital because of the at particular project’s risk.

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

Multinational Capital Budgeting NPV = – initial outlay n + S 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.

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 periodic 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 tax tax rate(10)=(11) 12. After-tax earnings of subsidiary (10)–(11)=(12)

Capital Budgeting Analysis Period t 13. Net cash flow to subsidiary (12)+(8)=(13) 14. Remittance to parent (14) 15. Tax on remitted funds tax 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. Investment by parent (20) 21. Net cash flow to parent (19)–(20)=(21) 22. PV of net cash flow to parent (1+k) - t(21)=(22) 23. Cumulative NPV PVs=(23)

Factors to Consider in Multinational Capital Budgeting Exchange rate fluctuations. Different scenarios should be considered together with their probability of occurrence. Inflation. Although price/cost forecasting implicitly considers inflation, inflation can be quite volatile from year to year for some countries.

Factors to Consider in Multinational Capital Budgeting Financing arrangement. Financing costs are usually captured by the discount rate. However, many foreign projects are partially financed by foreign subsidiaries. Blocked funds. Some countries may require that the earnings be reinvested locally for a certain period of time before they can be remitted to the parent.

Factors to Consider in Multinational Capital Budgeting Uncertain salvage value. The salvage value typically has a significant impact on the project’s NPV, and 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. Host government incentives. These should also be considered in the analysis.

Adjusting Project Assessment for Risk If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its assessment for this risk. One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that is applied. Many computer software packages are also available to perform sensitivity analysis and simulation.

Impact of Multinational Capital Budgeting on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Multinational Capital Budgeting Decisions