Evaluating International Investment Projects

Basic Capital Budgeting (review) I. Steps in Capital Budgeting Project Cash Flow Calculate NPV II. Key Issues Predicting cash flows Choosing approriate discount factor

Special problems evaluating international projects 1. Cash Flow Issues Special problems evaluating international projects

Three-stage cash flow projections Project cash flows from the subsidiary’s point of view. (local currency) Project cash transfers to parent and their costs including tax consequences Adjust for spillovers affecting the rest of the global enterprise Ref. Shapiro Multinational Financial Management (6th ed.) p. 725 ff.

Special problems: Local cash flows Sovereign Risk: risk of sudden regulatory change even expropriation Opportunity for concessionary financing tax holiday Guaranteed markets or supplies

Special problems: Local cash flows Opportunities for special financial structure for example project finance Differences in tax treatment

Special problems: Getting Funds Home Exchange rates (use forward rates where possible Risk of currency blockage (political risk) Taxes Local: Dividend withholding or other taxes owed when repatriating profits U.S.: The project generates foreign tax credits usable against other foreign income or additional U.S. taxes will be due on the repatriated income.

Impact on the rest of the MNE Adjust for spillovers and intangible cost/benefits that are not reflected in the project’s financial statements Remove misleading effects of transfer pricing, fees and royalties Adjust for value of real options generated

Global cost/benefits Spillovers Intangible benefits Cannibalization of sales of other units Creation of incremental sales by other units Intangible benefits Diversification of production facilities Diversification of markets Provision of a key link in a global service network Knowledge of competitors, technology, markets, or products

Transfer prices Transfer prices are internal prices used for transfers of goods within the MNE. If they do not reflect market value, using them to calculate cash flows can distort the value of a project

Remove misleading effects of Transfer Pricing Use market costs/prices for goods, services and capital transferred internally. Add back fees and royalties to project cash flows, because they are benefits to the parent. Remove the fixed portion of such costs as corporate overhead.

Real Option: Definitions (Financial) option: Right – but not obligation - to buy (to sell if a put) at a set price. An option is acquired at a cost, the “option premium”. A real option results when an investment project creates the possibility (but not the requirement) to execute a further project.

Real options occur with some frequency in international business. For example, initial market entry (retail distribution in Rio) lowers cost of the next step (distribution in Sao Paulo). Key point: Rio entry creates value beyond that evident in numbers for Rio alone.

2. Discount factor issues

Example: Wilcox Enterprises Initial investment: $10 M Net after-tax CF: $1.75M / year perpetuity Expected return to equity: 21% Expected return to debt: 14% Effective marginal tax rate: 35% Debt/Value ratio: 50%

Wilcox Enterprises: Solution

Weighted average cost of capital WACC = .14 (1-.35)(.5) + .21(.5) WACC = .1505 (15.05%)

Wilcox: Net Present Value PV of cash flows = ($1.75M/.1505) = 11.628 Initial investment cost -10.0 NPV 1.628 Accept project.

Discussion: Discount factor issues Why use WACC of the firm to evaluate a specific project? WACC is valid under the assumption: The project replicates the firm.

Weighted average cost of capital

Discussion: Discount factor issues WACC is appropriate discount factor when: The new project has the same risk profile as the firm as a whole The new project uses the same financial structure as the firm as a whole No special financing connected to the project Financing for the project is taxed the same way as all other financing for the firm

Discussion: Cash flow issues Most cash flow issues do not affect validity of WACC as a discount factor. (Unless they raise one of the above issues.) However, if WACC must be abandoned, it does have implications for cash flows considered. Specifically cash flows related to financing (which are normally ignored) must be considered.

Cash flows ignored using WACC Financing for the project Example: Financing for the previous WE example involved receiving $5M in proceeds of a bond issue; annual interest payments (at 14%) of $700,000 and an ultimate repayment of the $5M. Why are these cash flows ignored?

Cash flows ignored using WACC Tax shields from financing Example: In addition, deducting these interest payments from income results (at a 35% tax rate) in a savings of $245,000 per year. Why are these cash flows ignored in evaluating the project?

Conclusion on WACC If the assumptions required for WACC to be valid do not hold, It may be necessary to use a different discount factor Cash flows associated with the financing of the project must also be considered explicitly

In international projects WACC assumptions are less plausible Inherent risk of the project more likely to differ. Local tax structure likely to differ. Financial structure may differ Concessionary financial terms offered Opportunity for “project finance”

Application to international investment decisions Where WACC is inappropriate, APV should be used.

Adjusted Present Value

Calculating APV Determine after-tax cash flows for the project itself. Find cash flows (positive and negative) of financing including value of tax shields Calculate NPV of these net cash flows using the opportunity cost of capital for the project. Ref. Brealey and Myers Principles of Corporate Finance (6th edition) Chapter 19 The firm’s WACC estimates the opportunity cost of capital for the project only if the risk of the project and of the firm as a whole are the same.

Calculating APV (continued) Determine the amount of additional debt that must now be issued (or liquidated) to restore the parent to its target debt ratio. Calculate the value of the tax shield created (lost) as a result of the additional debt. Calculate the present value of the tax shield using the after-tax cost of debt. Brealey & Myers suggest the (before tax) cost of debt for the PV in 5, but with some reservations. The risk on repayment, and therefore the appropriate discount rate may be higher. (B&M p.558)

Calculating APV (continued) 7. Add the PV of the tax shields from the adjustment to the PV of the project and its financing to obtain APV Brealey & Myers suggest the (before tax) cost of debt for the PV in 5, but with some reservations. The risk on repayment, and therefore the appropriate discount rate may be higher. (B&M p.558)

Example: Wilcox Enterprises Suppose the expansion project of the previous example is to be built in Taiwan instead of at home. All facts about the cost and cash flows of the project as well as about the cost of capital to WE continue to apply.

Example: Wilcox Enterprises Additional Information If the project is built in Taiwan, the opportunity cost of capital (the cost when all-equity financing is used) is 18% The effective marginal tax rate for operations in Taiwan is 20%.

Example: Wilcox Enterprises Additional Information The Taiwanese government has offered a loan of $7M at 5% interest if the project is built. Interest is to be paid in annual installments with the principal repaid at the end of five years