International Capital Budgeting Chapter 17 International Capital Budgeting

Chapter Outline 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 Real Options

Review of Domestic Capital Budgeting 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. 4. Compare the value of competing cash flow streams at the same point in time.

International Capital Budgeting One recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to U.S. dollars at the predicted exchange rate. 3. Calculate NPV using the U.S. cost of capital. 2

International Capital Budgeting Example – 600€ 200€ 1 500€ 2 300€ 3 € = 3% i$ = 15% p$ = 6% Is this a good investment from the perspective of the U.S. shareholders? € $.55265 S0($/€) = 2

International Capital Budgeting: Example $331.60 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF0 = (€600)× S0($/€) =(€600)× = $331.60 € $.55265 2

International Capital Budgeting: Example $331.60 $113.70 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF1 = (€200)×E[ S1($/€)] = E[ S1($/€)] can be found by appealing to the interest rate differential: 1.03 1.06 E[S€(1)] =  S0($/€) 1.03 1.06 =  € $.55265 = $.5687/€ so CF1 = (€200)×($.5687/€) = $113.7 2

International Capital Budgeting: Example $331.60 $113.70 $292.60 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years Similarly, CF2 = × S0($/€) (€500) = $292.6 1.03 1.06 × 2

International Capital Budgeting: Example $331.60 $113.70 $292.60 $180.70 – 600€ 200€ 500€ 300€ 0 1 year 2 years 3 years CF3 = × S0($/€) (€300) = $180.7 (1.03)3 (1.06)3 2

International Capital Budgeting Another recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Estimate the foreign currency discount rate. 3. Calculate the foreign currency NPV using the foreign cost of capital. 4. Translate the foreign currency NPV into dollars using the spot exchange rate 2

Foreign Currency Cost of Capital Method – €600 €200 1 €500 2 €300 3 Let’s find i€ and use that on the euro cash flows to find the NPV in euros. Then translate the NPV into dollars at the spot rate. € = 3% i$ = 15% p$ = 6% € $.55265 S0($/€) = 2

Finding the Foreign Currency Cost of Capital: i€ Recall that if Fisher Effect holds here and abroad… (1 + e)×(1 + $) = (1 + i$) (1 + e) = (1 + i$) (1 + $) (1 + i€) = (1 + e) × (1 + €) and if the real rates are the same, then (1 + i€) = (1 + i$)×(1 + €) (1 + $) 2

International Capital Budgeting Example – €600 €200 1 €500 2 €300 3 (1 + i€) = (1 + i$)×(1 + €) (1 + $) (1.15)×(1.03) (1.06) = = 11.75% NPV 11.75% = € 194.39 € = 3% i$ = 15% p$ = 6% € 194.39× € $.55265 € $.55265 S0($/€) = = $107.43 2

International Capital Budgeting You 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. If you watch your rounding, you will get exactly the same answer either way. Which method you prefer is your choice.

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 Ct is incremental operating cash flow Dt is incremental depreciation It is incremental interest expense  is the marginal tax rate

Review of Domestic Capital Budgeting For our purposes it is necessary to expand the NPV equation.

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) By appealing to Modigliani and Miller’s results.

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.

Domestic APV Example -$1,000 $125 $250 $375 $500 0 1 2 3 4 Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: 0 1 2 3 4 -$1,000 $125 $250 $375 $500 The unlevered cost of equity is r0 = 10%: The project would be rejected by an all-equity firm: NPV < 0.

Domestic APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at r = 8%. Pearson’s tax rate is 40%, so they have an interest tax shield worth t×I = .40×$600×.08 = $19.20 each year. The net present value of the project under leverage is: Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow. So, Pearson should accept the project with debt.

Domestic APV Example (continued) Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan: Which is the same answer as before.

Capital Budgeting from the Parent Firm’s Perspective 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 .

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

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.