Multinational Capital Budgeting Multinational Business Finance Chapter 19 Multinational Capital Budgeting Multinational Business Finance

Contents Complexities of Budgeting for a Foreign Project Project versus Parent Valuation Illustrative Case : Cemex Enters Indonesia Real Option Analysis Project Financing

Multinational Capital Budgeting The original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions. The specific project, as well as reinvestment decisions – it should be justified by traditional financial analysis. Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.

Multinational Capital Budgeting Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. The basic steps are: Identify the initial capital invested or put at risk Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment Identify the appropriate discount rate to use in valuation Apply traditional capital budgeting decision criteria such as NPV and IRR

19.1 Complexities of Budgeting for a Foreign Project Capital budgeting for a foreign project is considerably more complex than the domestic case: Parent cash flows must be distinguished from project cash flows Parent cash flows often depend on the form of financing Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary The parent must explicitly recognize remittance of funds An array of nonfinancial payments can generate cash flows from subsidiaries to the parent

19.1 Complexities of Budgeting for a Foreign Project Managers must anticipate differing rates of national inflation Managers must keep the possibility of unanticipated foreign exchange rate Use of segmented national capital markets may create an opportunity for financial gains or may lead to additional financial costs Use of host-government-subsidized loans complicates both capital structure and the parent’s ability to determine an appropriate weighted average cost of capital for discounting purposes Managers must evaluate political risk Terminal value is more difficult to estimate

19.2 Project Versus Parent Valuation A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect the firm’s many interest groups.

19.2 Project Versus Parent Valuation Evaluation of a project from the local viewpoint serves some useful purposes, but is should be subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we must pay attention to the project’s local return. Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds (with the same maturity as the project’s economic life).

19.2 Project Versus Parent Valuation Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project. If they are unable to earn superior returns on foreign projects, their stockholders would be better of buying shares in local firms, where possible, and letting those companies carry out the local projects. Most firms appear to evaluate foreign projects from both parent and project viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm).

19.3 Illustrative Case: Cemex Enters Indonesia Overview It is early 1998, Cementos Mexicanos is considering the construction of a cement manufacturing facility on the Indonesian island of Sumatra. This project would be a wholly-owned Greenfield investment. The company has three main reasons for the project: Initiate a productive presence in Southeast Asia To position Cemex to benefit from infrastructural development in the region The positive prospects for Indonesia to act as a produce-for-export site

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.1 A Roadmap to the Construction of Semen Indonesia’s Capital Budget

19.3 Illustrative Case: Cemex Enters Indonesia Overview The first step is to construct a set of pro forma financial statements for Semen Indonesia (in Indonesian Rupiah). The next step is to create two capital budgets, the project viewpoint and parent viewpoint. Financial assumptions are then made about: Capital investment Method of financing Revenue/cost forecasts

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.2 Investment and Financing of the Semen Indonesia Project (all values in 000s unless otherwise noted) Cemex Cost of Equity=6%+7%*1.5=16.5% WACC=16.5%*60%+5.2%*40%=11.98% 1.287 Semen Indonesia Cost of Equity=33%+6%*1.287=40.72% WACC=(40.72%*0.7*0.25+27.184%*0.75)*0.5 +39%*0.5=33.257%

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses Exchange rate Spot rate(Year 1)=10,000*1.3/1.03=12,621 Spot rate(Year 2)=12,621*1.3/1.03=15,930 Fully amortized Repayment Per Year*PVIFA(35%,8)=2,750,000 Repayment /Y=1,058,439 Year 1 Interest Payment=2,750,000*35%=962,500 Principal Payment=1,058,439-962,500=95,939 Year 2 Interest Payment=(2,750,000-95,939)*35% =928,921 Principal Payment=1,058,439-928,921=129,518 10% Annual interest rate

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.4 Semen Indonesia’s Pro Forma Income Statement (millions of rupiah) Gross profit/Total revenues 1 1 Licenses fees Paid to parent company (2% of sales) Interest on parent company debt 2 2 Tax(Year 4)=(1,507,145+1,120,846- 170,256-1,138,965)*0.3 3 3 Net income(US$)/Total revenues(US$)

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.5 Semen Indonesia’s Capital Budget: Project Viewpoint (millions of rupiah) 1 2 1 2

19.3 Illustrative Case: Cemex Enters Indonesia Project Viewpoint The terminal value of the project represents the continuing value of the cement manufacturing facility in the years after year 5. The project viewpoint capital budget indicates a negative NPV and an IRR of only 15.4% compared to the 33.257% cost of capital. These are the returns the project would yield to a local or Indonesian investor in Indonesian rupiah. The project, from this viewpoint, is not acceptable.

19.3 Illustrative Case: Cemex Enters Indonesia Parent Viewpoint A foreign investor’s assessment of a project’s returns depends on the actual cash flows that are returned to it, in its own currency. For Cemex, this means that the investment must be analyzed in terms of US dollar cash inflows and outflows associated with the investment over the life of the project, after-tax, discounted at the appropriate cost of capital.

19.3 Illustrative Case: Cemex Enters Indonesia Parent Viewpoint Parent viewpoint capital budget in two steps. First, we isolate the individual cash flows, adjusted for any withholding taxes imposed by the Indonesian government and converted to US dollars. The second step, that actual parent viewpoint capital budget, combines these US dollar after-tax cash flows with the initial investment to determine the NPV of the proposed Indonesian subsidiary in the eyes (and pocketbook) of Cemex.

19.3 Illustrative Case: Cemex Enters Indonesia Exhibit 19.6 Semen Indonesia’s Remittance and Capital Budget: Parent Viewpoint (millions of rupiah and U.S. dollars) The parent viewpoint capital budget indicates a negative NPV and an IRR of only -1.84% compared to the 11.98% cost of capital and 6% foreign investment premium. The project, from parent’s viewpoint, is not acceptable. Equity 1,100 + Debt 825

19.3 Illustrative Case: Cemex Enters Indonesia Sensitivity Analysis At this point sensitivity analyses are run from both the project and parent viewpoints. Project viewpoint measurement: Political risks Foreign exchange risks Other business specific potentialities Parent viewpoint measurement: Adjusting discount rates Adjusting cash flows

19.4 Real Options Analysis The discounted cash flow (DCF) analysis used in the valuation of Semen Indonesia, and in capital budgeting and valuation in general, has long had its critics. Importantly, when MNEs evaluate competitive projects, traditional cash flow analysis is typically unable to capture the strategic options that an individual invest option may offer. This has led to the development of real options analysis. Real options analysis is the application of the option theory to capital budgeting decisions.

19.4 Real Options Analysis Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects: The option to defer The option to abandon The option to alter capacity The option to start up or shut down

19.5 Project Financing Project finance is the arrangement of financing for long-term capital projects, large in scale, long in life, and generally high in risk. The following four basic properties are critical to the success of project financing: Separability of a project from its investors Long-lived and capital-intensive singular projects Cash flow predictability from third party commitments Finite projects with finite lives