International Capital Budgeting Chapter 18

Lecture Objectives Review of Domestic Capital Budgeting The Adjusted Present Value Model Capital Budgeting from the Parent Firm’s Perspective Risk Adjustment in the Capital Budgeting Process Sensitivity Analysis

Review of Domestic Capital Budgeting Objective: To increase shareholder wealth, a company must accept projects with NPV>0; NPV is the present value of future cash flows minus the initial investment. 1. Identify the SIZE and TIMING of all relevant cash flows on a time line. 2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate. 3. Find NPV by discounting the cash flows at the appropriate discount rate.

Review of Domestic Capital Budgeting The basic net present value equation is where: CFt = expected incremental after-tax cash flow in year t, TVT = expected after tax cash flow in year T, including return of net working capital, C0 = initial investment at inception, K = weighted average cost of capital. T = economic life of the project in years.

Review of Domestic Capital Budgeting The NPV rule is to accept a project if NPV  0 and to reject a project if NPV  0

Review of Domestic Capital Budgeting For our purposes it is necessary to expand the NPV equation. Rt is incremental revenue OCt is incremental operating cost Dt is incremental depreciation It is incremental interest expense  is the marginal tax rate

Review of Domestic Capital Budgeting We can use to restate the NPV equation as:

The Adjusted Present Value Model Can be converted to adjusted present value (APV)

The Adjusted Present Value Model The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually. Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.

International Valuations There is no fundamental difference between valuations of domestic and international projects Although, international valuation involves complex problems that are not common in a domestic context International tax issues Cash flows in foreign currency What is the appropriate cost of capital Political risk Form of investment, remittance policy, and transfer pricing Valuation of subsidies and tax breaks How to evaluate an international investment in light of all the added complexity?

Capital Budgeting from the Parent Firm’s Perspective The APV model as presented before is not useful for capital budgeting of international projects Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.

Capital Budgeting from the Parent Firm’s Perspective The operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period. The operating cash flows must be discounted at the unlevered domestic rate

Capital Budgeting from the Parent Firm’s Perspective OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm. The marginal corporate tax rate, , is the larger of the parent’s or foreign subsidiary’s.

Capital Budgeting from the Parent Firm’s Perspective S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project. Denotes the present value (in the parent’s currency) of any concessionary loans, CL0, and loan payments, LPt , discounted at id .

Estimating the Future Expected Exchange Rates We can appeal to PPP:

Perspective of valuation Parent’s or project’s point of view? Differences can exist between the expected cash flows from parent’s vs project’s point of view Reasons for this include Certain CFs are blocked by the host country from being legally remitted to the parent Cannibalization of existing cash flows within the firm Theory suggests the value of a project to SH is the value of the cash flows back to the investor Investment decision should be based only on the value of incremental cash flows that can be returned to investor Therefore it is more appropriate to take the parent’s point of view

Mini-case: Centralia Corporation A US manufacturer of small kitchen electrical appliances, and currently, sells microwaves in Spain through an affiliate current sales are 9,600 units/year and increasing at a rate of 5% price $180 per unit, of which $35 represents profit margin Sales to EU forecast at 25,000 units in the first year and expect to increase by 12% per year; all sales will be invoiced in € Wants to build a manufacturing facility in Zaragoza, Spain cost of plant €5,500,000 borrowing capacity $2,904,000 Madrid sales affiliate accumulated a net amount of €750,000 from its operations, which can be used to partially finance construction cost new plant will be depreciated over 8 years

Centralia Corporation (continued) Sales price €200/unit and production cost €160/unit in the first year and expect to increase with inflation Expected inflation: 2.1% in Spain; 3% in the U.S.; and the current exchange rate: $1.32/€. Marginal tax rate in Spain and the U.S. at 35%; accumulated funds at 20% Centralia will get a special financing deal: €4,000,000 at 5% per year Normal borrowing rate is 8% in dollars and 7% in €s Principal to be repaid in eight equal installments Dollar all-equity cost of capital is 12% Calculate the APV of the project.

Centralia Corporation (continued) Initial cost of the project in $ Use PPP to estimate the future expected spot exchange rate Calculate the PV of the after-tax operating cash flows (Exhibit 18.2) - calculate the operating profits (Revenue –costs) of the new manufacturing facility - calculate the annual lost sales and contribution margin from current sales from US to Spain - discount the operating cash flows at all-equity cost of capital Calculate the present value of the depreciation tax shields (Exhibit 18.3)

Centralia Corporation (continued) 5. Calculate the present value of the concessionary loan payments (Exhibit 18.4) 6. Calculate the present value of the benefit from the concessionary loan (Exhibit 18.5) 7. Calculate the present value of interest tax shields (Exhibit 18.6) 8. Calculate the amount of the freed-up restricted remittances 9. Ready to calculate APV For answers see the text or/and the Excel spreadsheet.

Sensitivity Analysis In the APV model, each cash flow is uncertain, hence the realized value may be different from what was expected. In sensitivity analysis, different estimates are used for expected inflation rates(XRs), cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment. Allow the financial managers to understand the sensitivity of the APV of the project to several factors. Not all the inputs affect the APV in the same way.

The following section in chapter 18 is not required for the exam: - Real options

Learning Outcomes What makes the APV capital budgeting framework useful for analyzing foreign capital expenditures? What is the nature of a concessionary loan and how it is handled in the APV model? Numerical problem: Know how to calculate a foreign project’s APV (or components of it) using a methodology similar to the one used in mini-case Centralia (these notes) or/and mini-case Dorchester.