1 (of 30) IBUS 302: International Finance Topic 16-International Capital Budgeting Lawrence Schrenk, Instructor

2 (of 30) Learning Objectives 1. Explain the process of capital budgeting▪ 2. Discuss how the process changes in an international environment. 3. Calculate a cross-border NPV from the parent firm’s perspective. 4. Describe some uses of real options in capital budgeting.▪

3 (of 30) Domestic Capital Budgeting

NPV NPV is the present value of future cash flows minus the initial net cash outlay for the project discounted at the project’s cost of capital. Assuming the goal of maximizing shareholder wealth, any project with a positive NPV should be pursued. Generally, the source of financing is irrelevant to the investment decision. 4 (of 30)

NPV Advantages Evaluates investment in the same manner as a company’s shareholders. Focuses in on cash and not accounting profits Emphasizes the opportunity cost of the money invested. 5 (of 30)

NPV Difficulties Estimating cash flows. The cost of the project The cash inflows during the life of the project (especially hard where there are relevant spillovers–cannibalization or sales creation) The terminal or ending values of the project. 6 (of 30)

“Domestic” NPV Calculations 1.Estimate Future Cash Flows E[CF t ] Include only incremental cash flows Include all opportunity costs The algebra of cross-border investment analysis

“Domestic” NPV Calculations 2.Identify Risk-Adjusted Discount Rate Discount nominal CFs at nominal discount rates and real CFs at real discount rates Discount equity CFs at equity discount rates and debt CFs at debt discount rates Discount CFs to debt and equity at the WACC Discount cash flows in a particular currency at a discount rate in that currency The algebra of cross-border investment analysis

“Domestic” NPV Calculations 3.Calculate net present value NPV Based on expected future cash flows and the appropriate risk-adjusted discount rate The algebra of cross-border investment analysis

10 (of 30) International Capital Budgeting

New Issues Which Currency to Use Exchange Rate Risk Does Purchasing Power Parity Hold Foreign & Domestic Tax Rates Cost of Capital Special elements: Political Risk Subsidies 11 (of 28)

Two Valuation Methods NPV Traditional NPV analysis extended to int’l projects APV (valuation by parts) APV = PV[OCF] + PV[Project costs & benefits] Project costs & benefits: PV of tax shields PV of financial subsidies 12 (of 28)

13 (of 30) Net Present Value

International Capital Budgeting Foreign projects generate cash flows in a foreign currency. Two Approaches Approach 1: Foreign Project Approach 2: Parent Firm 14 (of 30)

Approach 1: Project’s (Local) Perspective Estimate cash flows in foreign currency Discount in the foreign currency Find the foreign currency NPV Convert foreign currency NPV to a domestic currency value at the spot exchange rate. The algebra of cross-border investment analysis

Approach 2: Parent’s Perspective Estimate cash flows in foreign currency Convert foreign cash flows into the domestic currency at expected future spot rates Discount in the domestic currency Find the domestic NPV The algebra of cross-border investment analysis

E[CF 2 f ] Approach 1: Discount in the Foreign Currency 1.Estimate future cash flows E[CF t f ] 2.Identify discount rate 3.Calculate net present value Calculate NPV Convert to the domestic currency ifif NPV 0 f NPV 0 d = S 0 d/f NPV 0 f The algebra of cross-border investment analysis E[CF 1 f ]

E[CF 2 f ] Approach 2: Discount in the Domestic Currency 1.Estimate E[CF t d ] = E[S t d/f ] E[CF t f ] 2.Identify discount rate 3.Calculate net present value NPV E[CF t d ] = E[S t d/f ] E[CF t f ] NPV 0 The algebra of cross-border investment analysis E[CF 1 f ]

Two Approaches You should have two equally valid approaches: Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the $NPV using the dollar cost of capital. Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate. 19 (of 30)

PPP PPP must hold. Over the life of the project Differential Inflation FX rates must change to compensate 20 (of 28)

WACC If PPP holds: 21 (of 28)

Approach 2: Simple Example U.S. parent considers building a Swiss factory (millions) Initial cost:$50 S($/SF):.50 Projected SF cash flows Year 1: 10 SF net revenues Years 2-5: revenue 2% Year 5100 SF Salvage/Terminal Value of Factory

Approach 2: Simple Example Exchange rate forecast: PPP Swiss inflation forecast: 2%/year U.S. inflation forecast:3%/year Predicted SF appreciation:1%/year

NPV Calculation 24 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) S($/SF) Cash Flows ($) PV(Cash Flows $) NPV

NPV Calculation 25 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) SFr SFr SFr SFr SFr S($/SF) Cash Flows ($) PV(Cash Flows $) NPV

NPV Calculation 26 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) SFr SFr SFr SFr SFr S($/SF)$0.5000$0.5050$0.5101$0.5152$0.5203$ Cash Flows ($) PV(Cash Flows $) NPV

NPV Calculation 27 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) SFr SFr SFr SFr SFr S($/SF)$0.5000$0.5050$0.5101$0.5152$0.5203$ Cash Flows ($)($50.00)$5.05$5.20$5.36$5.52$58.24 PV(Cash Flows $) NPV

NPV Calculation 28 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) SFr SFr SFr SFr SFr S($/SF)$0.5000$0.5050$0.5101$0.5152$0.5203$ Cash Flows ($)($50.00)$5.05$5.20$5.36$5.52$58.24 PV(Cash Flows $)($50.00)$4.59$4.30$4.03$3.77$36.16 NPV

NPV Calculation 29 (of 30) Year Cash Flows ($)($50.00) Cash Flows (SF) SFr SFr SFr SFr SFr S($/SF)$0.5000$0.5050$0.5101$0.5152$0.5203$ Cash Flows ($)($50.00)$5.05$5.20$5.36$5.52$58.24 PV(Cash Flows $)($50.00)$4.59$4.30$4.03$3.77$36.16 NPV$2.85

Political Risk Adjustment Political Risk Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate. 30 (of 30)

Sensitivity Analysis In the APV model, each cash flow has a probability distribution associated with it. Hence, the realized value may be different from what was expected. In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.

Real Options The application of options pricing theory to the evaluation of investment options in real projects is known as real options. A timing option is an option on when to make the investment. A growth option is an option to increase the scale of the investment. A suspension option is an option to temporarily cease production. An abandonment option is an option to quit the investment early.