1. International Finance
Multinational
Capital Budgeting

2. Direct Investment MNC is parent Subsidiary is child
May be joint venture with national company
Need to calculate NPV and/or IRR

3. Input Data Initial investment Capital expenditure Working capital
Setup costs

4. Input Data Price and consumer demand Compare with competitive products
Inflation expectations for future prices
Expected market share growth

5. Input Data Costs Variable costs Costs of components Expected inflation
Demand forecast
Fixed costs

6. Input Data Taxes Tax laws vary by country
Money to stay in foreign country or repatriated to U.S.?

7. Input Data Exchange rates Hedge or not? How to forecast?
Effects of forecasting errors
Sensitivity analysis

8. Input Data Project length Political stability in country
Attitude in foreign country towards MNC direct investment
Risk of expropriation
Plans to sell subsidiary

9. Input Data Required rate of return
May be higher or lower than if done in U.S.
Risk of project
Political risk of country
Benefit to diversification within company?

10. Capital Budgeting Example
MNC wants to develop subsidiary in Singapore
Manufacture and sell tennis rackets locally
Project will end in four years

11. Capital Budgeting Example
Initial investment
20 million Singapore dollars (S$)
Includes working capital
Spot XR is .50 $/S$
$10 million

12. Capital Budgeting Example
Price and demand
All currency figures are nominal
Year 1
Year 2
Year 3
Year 4
Unit Price
S$350
S$360
S$380
Demand
60,000
100,000

13. Capital Budgeting Example
Costs
Variable costs
Fixed costs
Office lease: S$1 million/year
Overhead: S$1 million/year
Year 1
Year 2
Year 3
Year 4
VC/Unit
S$200
S$250
S$260

14. Capital Budgeting Example
Taxes
Singapore government
20% tax on income
10% tax on funds remitted to parent in U.S.
U.S. government
Tax credit for taxes paid in Singapore

15. Corporate Income Tax Rates

16. Capital Budgeting Example
Project length
Singapore government will pay parent S$12 million to purchase subsidiary after 4 years

17. Capital Budgeting Example
Exchange rates
Spot rate is .50 $/S$
Current spot rate is used as forecast of future spot rates
Required rate of return
Set at 15% based on low country risk for Singapore

18. Adjusting for Country Risk
First – ask the question: Are capital markets globalized or segmented when dealing with this country?
If capital markets are globalized, there is no need to adjust for the risk of this country.

19. Adjusting for Country Risk
Why?
The real risk-free rate will be the same in the U.S. and in this country
Exchange rates are expected to adjust for differences in interest rates
The “market” is a global market, not just a U.S. market and the market risk premium (Rm – Rf) is a global market risk premium
Your firm’s beta is its covariance with the global market divided by the variance of the global market

20. Adjusting for Country Risk
But if capital markets are segmented with regard to this country, there are various ways to adjust for country risk
1. Consider the spread between the yields on this country’s government bonds vs. U.S. Treasury bonds of comparable maturities
This is a very simple way to come up with a risk-premium for the country you are looking at.

21. Adjusting for Country Risk
2. Calculate the relative standard deviation of that country’s market index and multiply it by the U.S. market risk premium
Relative σ = Country σ / U.S. σ
Adjusted Market Risk Premium = (U.S. MRP) (Relative σ)
Use the Adjusted Market Risk Premium when employing the CAPM for projects in this country.

22. Adjusting for Country Risk
3. Calculate the relative standard deviation of the country’s equities vs. sovereign debt and multiply it by the Country Default Spread found in (1) earlier to obtain a Country Risk Premium
(Country Default Spread) (σ of country’s equity / σ of country’s debt)
This Country Risk Premium can then be added to the U.S. market risk premium to get a market risk premium for this country.

23. Adjusting for Country Risk
There are two simple methods to integrate country risk into the cost of capital:
Req. Rate of Return equals
Rf + β(U.S. MRP) + Country RP or,
Rf + β(U.S. MRP + Country RP)

24. Adjusting for Country Risk
There are various companies and organizations that attempt to quantify Country Risk based on different measurements

25. Country Risk Ratings

26. Corruption Index Rating
Source: Transparency International, 2009

27. Capital Budgeting Example

28. Capital Budgeting Example

29. Sensitivity Analysis: XR

30. Sensitivity Analysis: XR