1 (of 30) IBUS 302: International Finance Topic 20-International Capital Budgeting II Lawrence Schrenk, Instructor

2 (of 30) Learning Objectives 1. Explain the conditions for using adjusted present value (APV).▪ 2. Calculate a basic APV problem. 3. Calculate an international APV problem.▪

3 (of 30) Why APV?

Firm/Project Value Firms create two sources of value: Operating Value: What they ‘produce’ Left-Hand Side of Balance Sheet Financing Value: How they finance what they ‘produce’. Right-Hand Side of Balance Sheet 4 (of 28)

NPV versus APV Strategy NPV Strategy Include the financing values, e.g., the tax advantages of debt, financial distress costs, by adjusting the discount rate. That is, use the WACC as the discount rate. APV Strategy Separate the financing values, e.g., the tax advantages of debt, financial distress costs, into different calculations. Value Additivity Model 5 (of 28)

NPV Flaws Aggregates Operating and Financing Values WACC Estimation Problems Book Values Changes in WACC over Time Sensitivity Analysis Cannot always use the firm’s WACC for a project Single Discount Rate No Real Options 6 (of 28)

APV Solutions Financing, etc. Valued Separately No WACC Multiple Discount Rates Real Options 7 (of 28)

Why APV? APV is better at: Accurate Valuation of Financing Values Providing Information on the Sources of Value APV can include features NPV cannot: Real Options Changes in Capital Structure, e.g., LBO’s Debt Repayment Schedule 8 (of 28)

9 (of 30) APV Basics

Key Idea Separate Valuation of… A) Operating Cash Flows for Unlevered Firm B) Other Value Components Tax Advantages of Debt Financial Distress Subsidies Hedges Costs of Issuing Securities Etc. 10 (of 28)

A) Operating Cash Flows for Unlevered Firm Construct Annual OCF Same procedure as in NPV Discount with Cost of Equity Estimation of the Cost of Equity CAPM Empirical Comparisons Why is this easier and more accurate than WACC? Find NPV OCF for OCF of Unlevered Firm 11 (of 28)

B) Other Value Components These are ‘adjustments’ to the NPV OCF to account for other value changes. Financing Tax Advantages of Debt and Depreciation (+) Financial Distress (-) Hedges (+ hopefully ) Other Subsidies (+) Real Options (+) 12 (of 28)

The APV Calculation APV = NPV OCF + PV(Tax Advantage) – PV(Financial Distress) + PV(Real Options) + … 13 (of 28) A B

Multiple Discount Rates NPV/WACC has a single discount rate. Everything is discounted at the ‘average’ rate APV allows multiple rates: Discount rates should reflect risk of individual cash flows Do all cash flows have the same risk? Are sales predictions as reliable as cost predictions? 14 (of 28)

A Simple Example A firm is considering a new project which will cost $500,000 and generate $175,000 for four years. The cost of equity for the firm is 12%. The project will be funded by issuing $300,000 in debt at 8% and the rest from internal funds. The issuance costs are 1.5% of the principal, and the corporate tax rate is 20%. 15 (of 28)

A Simple Example Investment$500,000 Annual Cash Flow$175,000 Debt Issued $300,000 Cost of Equity 12% Cost of Debt 8% Corporate Tax Rate 20% Issuance Costs 1.5% 16 (of 28)

A Simple Example 17 (of 28)

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A Simple Example 22 (of 28)

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A Simple Example 25 (of 28)

A Simple Example Such a simple example illustrates APV, but doesn’t really show its true value. APV analysis does allow us to distinguish The value of the project:$31,536 The value of the financing:$11,398 NPV calculation would obscure this. ▪ Could APV be positive if the value of the project were negative? ▪ 26 (of 28)

Second Example What is the value if the debt must be repaid in equal installments over the first three years of the project? NOTE: You could not value this with NPV. The project leverage changes, But WACC must be constant. 27 (of 28)

Second Example 28 (of 28)

29 (of 30) International APV

Lessard Model APV model for a multinational corporation analyzing a foreign capital expenditure. This model incorporates many features that are distinctive to foreign direct investment. Parent firm perspective 30 (of 28)

Lessard Model The Full Equation

Lessard Model: OCF Discounting Operating Cash Flows 1. Find after-tax OCF 2. Convert OCF to dollars 3. Discount at unlevered rate 32 (of 28)

Lessard Model: Depreciation Discounting Depreciation Tax Shields 1. Find annual tax advantage 2. Convert CF to dollars 3. Discount at cost of debt 33 (of 28)

Lessard Model: Interest/Debt Interest Tax Shields 1. Find annual tax advantage 2. Convert CF to dollars 3. Discount at cost of debt 34 (of 28)

Lessard Model: Terminal Value Discounting Terminal Value 1. Convert OCF to Dollars 2. Discount at unlevered rate 35 (of 28)

Lessard Model: Investment and Restricted Funds Investment: Convert to Dollars Restricted Funds: Convert to Dollars 36 (of 28)

Lessard Model: Concessionary Loans Concessionary Loan Principal: Convert to Dollars Concessionary Loan Principal: Convert to Dollars and Discount 37 (of 28)

Estimating the Future Expected Exchange Rates We can apply PPP: Note: This is what we did in the NPV example.

Example A project in Germany will generate €150,000 for three year and requires an investment of €400,000. €300,000 of the investment is depreciable using straight line depreciation. The project funding will include issuing €200,000 in debt. 39 (of 28)

Example Cost of Equity15% Cost of Debt11% Corporate Tax Rate35% Dollar Inflation 6% Euro Inflation 3% Issuance Costs 2% S($/€) (of 28)

Example: Spot Rates Calculate expected spot rates using PPP 41 (of 28)

Example: NPV OCF 42 (of 28)

Example: Depreciation 43 (of 28)

Example: Debt 44 (of 28)

Example: APV 45 (of 28)