FINC3240 International Finance Chapter 14 Multinational Capital Budgeting

Capital Budgeting Decision FI 3300 - Corporate Finance leng Ling Capital Budgeting Decision Capital budgeting: the process of analyzing projects and decide which ones to invest in. Real asset/project is defined in very broad terms. Concrete examples of projects: Introducing a new product to the market Installing and using new plant & machinery Installing a cost saving technology Implementing a new accounting software (e.g., SAP)

Capital budgeting rules We will learn to apply 2 capital budgeting rules: Net present value (NPV) Internal rate of return (IRR)

Net present value (NPV) rule FI 3300 - Corporate Finance leng Ling Net present value (NPV) rule Accept project if Net present value > 0 What is Net present value? Net present value = Benefits minus Costs

How do we measure benefits & costs? Benefits= Present value of all cash inflows from the project Costs= Present value of all cash outflows from the project

NPV = B – C =

Internal rate of return (IRR) 1 IRR: the discount rate that will make the PV of cash inflows equal to the PV of cash outflows. In other words, IRR is the discount rate such that the NPV is 0. PV of cash outflows, discounted at IRR PV of cash inflows, discounted at IRR

Internal rate of return (IRR) 2 Accept project if IRR > cost of capital Intuitively, think of the IRR as the return from the project. Then the project should be accepted if the return is greater than the required rate of return / cost of capital.

FI 3300 - Corporate Finance leng Ling Apply the NPV and IRR A firm is considering investment in a project that costs $1,200 and yields cash flows of $500 in the first year, $600 in the second year and $700 in the third year. Compute the NPV and IRR of this project. The appropriate discount rate (cost of capital) for this project is 10 percent.

Computing NPV using BA II Plus FI 3300 - Corporate Finance leng Ling Computing NPV using BA II Plus Press CF, press -1200 and then press ENTER for CF0. Next press “” and enter 500 for C01. Press “” and enter 1 for F01. Similarly enter C02 = 600, F02 = 1, C03 = 700, and F03 = 1. Make sure that all the cash flows later than C03 are zero. Press NPV. Enter the discount rate of 10 percent by pressing 10 and then ENTER. The display will show that I = 10. Next press the “” and press CPT. The calculator will display the NPV of 276.33. Decision: Accept project

Computing IRR using BA II Plus FI 3300 - Corporate Finance leng Ling Computing IRR using BA II Plus In order to compute the IRR, follow the same steps as above for entering the cash flows. Then instead of pressing NPV, press the IRR button and then press CPT. The calculator will display the IRR as 21.92 percent. Decision: Accept project

FI 3300 - Corporate Finance leng Ling Normal cash flows In the previous problem, there is ONE cash outflow at the beginning. After that, we have all cash inflows. A project with such a cash flow pattern is a project with normal cash flows. So what? For independent projects with NORMAL CASH FLOWS, the NPV, IRR rules will give the SAME decision. This is exactly what happened in the problem we solved.

FI 3300 - Corporate Finance leng Ling Apply NPV, IRR Assume a discount rate of 11%. Compute the NPV, IRR and decide whether the project should be accepted or rejected. Project C0 C1 C2 C3 C4 C5 T=0 T=1 T=2 T=3 T=4 T=5 A -1000 400 500 Verify that NPV = 603.58, IRR = 31.79%, Since NPV>0, IRR>11%, accept the project

FI 3300 - Corporate Finance leng Ling Another question A five-year project, if taken, will require an initial investment of $120,000. The expected end-of-year cash inflows are as follows: If the appropriate cost of capital for this project is 11%, which of the following is a correct decision? a. Reject the project because NPV = -$30,507, which is less than 0. b. Reject the project because IRR is 10.04%, which is less than the cost of capital, 11%. c. Both a and b are correct. d. Accept the project because IRR is positive. e. None of the above is correct. C1 C2 C3 C4 C5 30,000 42,000 28,000 12,000

Multinational Capital Budgeting Assumption: The subsidiary is wholly owned by the parent company. Therefore, the feasibility of the project depends on the cash flows that the parent ultimately receives.

Process of Remitting Subsidiary Earnings to Parent 14.1

Input for Multinational Capital Budgeting 1. Economic and Financial Characteristics Involved a. Initial Investment b. Price and Consumer Demand (and inflation) c. Costs (variable and fixed) d. Tax e. Remitted Funds f. Exchange Rates g. Salvage Value h. Required Rate of Return

Example 1 Spartan, Inc. on page 425. read the textbook the cash flows received by the parent should be US$. How to estimate the cash flows? See Exhibit 14.2

Financing Arrangement Domestic capital budgeting problems would not include debt payments in the measurement of cash flows because all financing costs are captured by the discount rate. When the parent finances the whole foreign project, debt payments does not count. When the foreign subsidiary partially finances the foreign project, we should separate the investment made by the subsidiary from the investment made by the parent. The capital budgeting should focus on the present value of cash flows received by the parent and the initial investment by the parent.

Adjusting for Risk 1. Risk-Adjusted Discount Rate the greater the uncertainty about the forecasted cash flows, the larger should be the discount rate, other things being equal. 2. Sensitivity Analysis forecast the cash flows under different possible scenarios, such as different level of sales, expenses, exchange rate, etc. 3. Simulation using software and computer to generate millions of possible outcomes and calculate the average.

Exhibit 14.3 Analysis Using Different Exchange Rate Scenarios: Spartan, Inc.

Example 2 Your employees have estimated the net present value of project XP to be $1.2 million. Their report says that they have not accounted for any risk, but that with such a large NPV, the project should be accepted since even a risk-adjusted NPV would likely be positive. You have the final decision as to whether to accept or reject the project. What is your decision? ANSWER: The decision should not be made until risk has been considered. If the project has a risk of a government take­over, for example, a large estimated NPV may not be a suffi­cient reason to accept the project.

Example 3 Brower, Inc, is considering constructing a manufacturing plant in Ghana. The construction cost 9 billion Ghanian Cedi. Brower intends to leave the plant open for 3 years. During the 3 years of operation, cash flows are expected to be 3, 3, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17%. It currently takes 8,700 cedi to buy one US dollar, and the cedi is expected to depreciate by 5% per year. Should Brower build the plant?

Solution NPV=-91,339.03<0, so reject.

Homework 9 Chapter 14 Questions and applications: 5,10,11,20