International Finance Multinational Capital Budgeting

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

Input Data Initial investment Capital expenditure Working capital Setup costs

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

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

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

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

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

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?

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

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

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

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

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

Corporate Income Tax Rates

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

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

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.

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

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.

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.

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.

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)

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

Country Risk Ratings

Corruption Index Rating Source: Transparency International, 2009

Capital Budgeting Example

Capital Budgeting Example

Sensitivity Analysis: XR

Sensitivity Analysis: XR