Chapter 18 Multinational Capital Budgeting

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Multinational Capital Budgeting Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions – as well as reinvestment decisions – it should be justified by traditional financial analysis. Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Multinational Capital Budgeting Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. The basic steps are: –Identify the initial capital invested or put at risk –Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment –Identify the appropriate discount rate to use in valuation –Apply traditional capital budgeting decision criteria such as NPV and IRR

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Complexities of Budgeting for a Foreign Project Capital budgeting for a foreign project is considerably more complex than the domestic case: –Parent cash flows must be distinguished from project cash flows –Parent cash flows often depend on the form of financing –Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Complexities of Budgeting for a Foreign Project –The parent must explicitly recognize remittance of funds because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function –An array of nonfinancial payments can generate cash flows from subsidiaries to the parent –Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on cash flows as well as indirect effects on competitiveness

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Project Versus Parent Valuation A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate- wide debt, and other purposes that affect the firm’s many interest groups. However, this viewpoint violates a cardinal concept of capital budgeting – that financial cash flows should not be mixed with operating cash flows.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Project Versus Parent Valuation Evaluation of a project from the local viewpoint serves some useful purposes, but is should be subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we must pay attention to the project’s local return. Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds (with the same maturity as the project’s economic life).

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Project Versus Parent Valuation Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project. If they are unable to earn superior returns on foreign projects, their stockholders would be better of buying shares in local firms, where possible, and letting those companies carry out the local projects. Most firms appear to evaluate foreign projects from both parent and project viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm).

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia It is early 1998, Cementos Mexicanos is considering the construction of a cement manufacturing facility on the Indonesian island of Sumatra. This project would be a wholly-owned greenfield investment. The company has three main reasons for the project: –Initiate a productive presence in Southeast Asia –To position Cemex to benefit from infrastructural development in the region –The positive prospects for Indonesia to act as a produce- for-export site

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia The following exhibit details the complete multinational capital budgeting analysis for Cemex in Indonesia. Essentially, the parent company will invest US dollar-denominated capital, which flows through the creation and operation of the Indonesian subsidiary which subsequently generates cash flows that are returned to the parent in various forms (in US dollars).

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 18.1 A Road-Map to the Construction of Semen Indonesia’s Capital Budget Cementos Mexicanos (Mexico) Semen Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm Project Viewpoint Capital Budget (Indonesian rupiah) Parent viewpoint Capital Budget (U.S. dollars) Estimated cash flows of project Cash flows remitted to Cemex (Rp to US$) END Is the project investment Justified (NPV > 0)? START

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia The first step is to construct a set of pro forma financial statements for Semen Indonesia (in Indonesian Rupiah). The next step is to create two capital budgets, the project viewpoint and parent viewpoint. Financial assumptions are then made about: –Capital investment –Method of financing –Revenue/cost forecasts

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia The project viewpoint capital budget indicates a negative NPV and an IRR of only 15.4% compared to the 33.3% cost of capital. These are the returns the project would yield to a local or Indonesian investor in Indonesian rupiah. The project, from this viewpoint, is not acceptable.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia A foreign investor’s assessment of a project’s returns depends on the actual cash flows that are returned to it, in its own currency. For Cemex, this means that the investment must be analyzed in terms of US dollar cash inflows and outflows associated with the investment over the life of the project, after- tax, discounted at the appropriate cost of capital.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia We build this parent viewpoint capital budget in two steps. First, we isolate the individual cash flows, adjusted for any withholding taxes imposed by the Indonesian government and converted to US dollars. The second step, that actual parent viewpoint capital budget, combines these US dollar after-tax cash flows with the initial investment to determine the NPV of the proposed Indonesian subsidiary in the eyes (and pocketbook) of Cemex.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia Most corporations require that the new investments more than cover the cost of the capital employed in their undertaking. It is therefore not unusual for the firm to require a hurdle rate of 3% over the cost of capital for domestic investments, and 6% more for international projects.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Illustrative Case: Cemex Enters Indonesia At this point sensitivity analyses are run from both the project and parent viewpoints. This would include analyzing (for the project): –Political risks –Foreign exchange risks –Other business specific potentialities And analyzing (for the parent): –A range of discount rates –Varying cash flow patterns

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Real Options Analysis The discounted cash flow (DCF) analysis used in the valuation of Semen Indonesia, and in capital budgeting and valuation in general, has long had its critics. Importantly, when MNEs evaluate competitive projects, traditional cash flow analysis is typically unable to capture the strategic options that an individual invest option may offer. This has led to the development of real options analysis. Real options analysis is the application of the option theory to capital budgeting decisions.

Copyright © 2004 Pearson Addison-Wesley. All rights reserved Real Options Analysis Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects: –The option to defer –The option to abandon –The option to alter capacity –The option to start up or shut down