Multinational Capital Budgeting (or parts of chapter 16)

Agenda Multinational capital budgeting. Project vs. parent capital budgeting? Adjust capital budgeting analysis of foreign project for risk. Case study: evaluate a greenfield foreign project Real option analysis vs. DCF analysis.

Multinational Capital Budgeting Analysis of cash in- & out- flows associated w/ prospective long-term investment projects. Follows same steps as domestic budgeting: Identify initial capital invested at risk. Estimate cash flows over time (including terminal value/ salvage value). Identify appropriate discount rate for PV. Apply traditional NPV or IRR analysis.

Capital Budgeting for foreign projects Parent cash flows must be distinguished from project’s. Parent cash flows often depend on form of financing => cannot separate operating & financing cash flows. Stand alone subsidiary cash-flow can be worth, but add no value overall. Non-financial payments can generate cash flows to parent, e.g. licensing fees. Need to evaluate political risk, forex risk & differing inflation rates. Segmented national capital markets create financial gain /costs. Host government subsidies complicates WACC computation.

Project vs. Parent Valuation? Most firms evaluate foreign projects from both parent & project viewpoints. Rule of thumb: parent valuation shall have priority. MNE shall invest only if it can earn a risk-adjusted return greater than local competitors. Project valuation provides closer approximation of effect on consolidated EPS US firms consolidate subsidiaries w/ 50%+ ownership/ If ownership b/n 20% & 49% (I.e. affiliate) => consolidate on pro-rate basis. Subsidiaries w/ <20% ownership considered unconsolidated investment.

Case Study: Cemex in Indonesia Cementos Mexicanos (Cemex) considers greenfield investment in Indonesia plant (Cemex Indonesia) Presence in Southeast Asia. Strong prospects for infrastructure growth. Benefit from depreciation of Indonesian Rupiah (RP) Cemex functional currency: US$. Time to build: 1 year Inflation rates: 30% (Indonesia), 3% (US) Notice that we use the US inflation, not Mexico’s one!

Cementos Mexicanos Semex Indonesia Project Viewpoint Capital Budget (Mexico) START Semex Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm Project Viewpoint Capital Budget (Indonesian rupiah) Estimated cash flows of project END Is project investment justified (NPV > 0)? Parent viewpoint Capital Budget (U.S. $) Cash flows remitted to Cemex (RP -> US$)

Step I: Cost of Capital Computation

Debt Service &Forex Gain/Loss

Income Statement Assumptions Revenues Sales based on export. Cement will be sold in export market at $58/ton. Costs Direct cost RP 115,000/ton & rising @ rate of inflation (30% p.a.). Additional production cost of RP20,000/ton & rising @ rate of inflation (30% p.a.). Loading costs $2.00/ton rising @ inflation (3% p.a.). Shipping costs $10/ton rising @ inflation (3% p.a.). License fee: 2% sales Sales, General, & Admin Expenses: 8% (growing @ 1% p.a.)

Pro-forma Income Statement

Project Viewpoint Capital Budget Cemex Indonesia free cash flows found by looking @ EBITDA, not EBT! Taxes calculated based on EBITDA. Terminal value (TV) calculated for continuing value of plant after year # 5. TV calculated as perpetual net operating cash flow after year 5:

Capital Budget: Project Viewpoint

Parent Viewpoint Capital Budget Cash flows estimates are constructed from parent’s viewpoint Cemex must use its cost of capital, not project’s one! Cemex WACC 11.98% Cemex requires additional 6% for international projects => discount rate will be 17.98% This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint

Capital Budget: Parent Viewpoint

Sensitivity Analysis Political risk Foreign exchange risk Risk of blocked funds. Risk of expropriation. Foreign exchange risk appreciation of US $. depreciation of US $.

Real Option Analysis DCF analysis cannot capture value of strategic options, yet real option analysis allows this valuation Real option analysis includes valuation of project w/ future choices: option to defer or abandon (timing option). option to alter capacity (expansion options). option to start up/ shut down (switching). option to learn. Real option analysis treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis) The valuation of real options and the variables’ volatilities is similar to equity option math

Things to remember… Multinational capital budgeting. Project vs. parent capital budgeting? Adjust capital budgeting analysis of foreign project for risk. Case study: evaluate a greenfield foreign project Real option analysis vs. DCF analysis.