Multinational Capital Budgeting

Multinational Capital Budgeting
Chapter 13 Multinational Capital Budgeting Learning objectives  The algebra of capital budgeting – Domestic and cross-border NPV algebra – An example  Disequilibria in the int’l parity conditions – Parent v project perspectives on valuation – Financing/hedging of foreign projects  Special circumstances – Blocked funds, subsidized financing, negative-NPV tie-in projects, expropriation risk, tax holidays

13.1 The Algebra of Multinational Capital Budgeting The NPV of a domestic project V0d = St E[CFtd ] / (1+id )t 1. Estimate future cash flows E[CFtd] Include only incremental cash flows. Include all opportunity costs.

13.1 The Algebra of Multinational Capital Budgeting The NPV of a domestic project V0d = St E[CFtd ] / (1+id )t 1. Estimate future cash flows E[CFtd] 2. Identify the risk-adjusted discount rate Discount after-tax (before-tax) CFs at an after-tax (before-tax) discount rate Discount nominal (real) CFs at a nominal (real) discount rate Discount equity (debt) CFs at the appropriate required return for equity (debt) Discount CFs to debt and equity at the WACC Discount cash flows in a particular (e.g. domestic) currency at a discount rate in that currency

13.1 The Algebra of Multinational Capital Budgeting The NPV of a domestic project V0d = St E[CFtd ] / (1+id )t 1. Estimate future cash flows E[CFtd]. 2. Identify the risk-adjusted discount rate. 3. Calculate net present value V0d Based on expected future cash flows and the appropriate risk-adjusted discount rate.

13.1 The Algebra of Multinational Capital Budgeting The NPV of a foreign project V0d = ??? There are two ways to find the NPV of a foreign project in the parent’s domestic currency. Recipe 1: Discount in the foreign currency Discount in the foreign currency at if and convert the foreign currency NPV to a domestic currency value V0d|if at the spot exchange rate S0d/f. Recipe 2: Discount in the domestic currency Convert foreign cash flows into the domestic currency at expected future spot rates and then discount at the domestic rate id to find V0d|id.

13.1 The Algebra of Multinational Capital Budgeting Recipe 1 Discount in the foreign currency 1. Estimate future cash flows E[CFtf]. 2. Identify if. 3. Calculate net present value V0d|if. Calculate V0f = St E[CFtf ] / (1+if )t Convert to domestic currency E[CF1f] E[CF2f] V0f if V0d|if = S0d/f V0f

13.1 The Algebra of Multinational Capital Budgeting Recipe 2 Discount in the domestic currency 1. Estimate future cash flows in the domestic currency E[CFtd] = E[Std/f ] E[CFtf ] + Cov(CFtf,Std/f). The first term is similar to Vtd = Vtf Std/f. The covariance term reflects the foreign project’s operating exposure to fx risk, and often is assumed to be zero. In this case, E[CFtd] ≈ E[Std/f ] E[CFtf ].

13.1 The Algebra of Multinational Capital Budgeting Recipe 2 Discount in the domestic currency 1. Estimate future cash flows in the domestic currency E[CFtd] ≈ E[Std/f ] E[CFtf ]. 2. Identify id. 3. Calculate net present value V0d|id. E[CF1f ] E[CF2f ] E[CFtd ] ≈ E[Std/f ] E[CFtf ] V0d|id id

13.1 The Algebra of Multinational Capital Budgeting Equivalence of the two recipes Recipe 2: Discount in the domestic currency V0d|id = St E[CFtd ] / (1+id )t with E[CFtd ] = Ftd/f E[CFtf ] …from forward parity  V0d|id = St Ftd/f E[CFtf ] / (1+id )t Recipe 1: Discount in the foreign currency with (1+id )t = (1+if )t (Ftd/f / S0d/f ) …from IRP  V0d|if = St Ftd/f E[CFtf ] / ((1+if )t (Ftd/f / S0d/f )) = S0d/f St E[CFtf ] / (1+if )t = S0d/f V0f

13.2 Wendy’s Restaurant in Neverland
Wendy and Peter plan to open a restaurant on an abandoned pirate ship in Neverland. The joint venture will be incorporated in Neverland. The restaurant’s target market is Neverland’s pirates. Wendy will provide the capital from her London home. Peter will man the ship with his crew of Lost Boys. Neverland is ruled by the dictator Captain Hook. Wendy doesn’t trust Hook, despite his assurances that he will not interfere in the project. Neverland’s currency is the croc. The international parity conditions hold between Neverland crocs and UK pounds sterling (Wendy’s domestic currency).

These international parity conditions hold for interest rates and FX rates in crocs and pounds: F1Cr/£/S0Cr/£ = (1+iFCr)/(1+iF£) = (1.375)/(1.100) = (1+pCr)/(1+p£) = (1.3614)/(1.0891) = (1+iCr)/(1+i£) = (1.50)/(1.20) = E[S1Cr/£]/S0Cr/£ = Þ the pound sells at a 25% forward premium Interest rate parity Inflation differential Risky restaurant projects Expected spot rate changes

Parity conditions for crocs and sterling: U.K. Neverland Nominal T-bill rate iF£ = 10% iFCr = 37.5% Nominal required project return i£ = 20% iCr = 50% Expected inflation p£ » 8.91% pCr » 36.14% Real required T-bill return ʀF£ = 1% ʀFCr = 1% Real required project return ʀ£ » 10.18% ʀCr » 10.18% Spot exchange rate S0Cr/£ = Cr4/£

Forward rates & expected future spot rates The 25 percent forward premium reflects the cross-currency difference in nominal interest rates and expected inflation. Expected future spot rates also reflect this 25 percent cross-currency differential. Time FtCr/£ = E[StCr/£]   0 Cr4.0000/£ 1 Cr5.0000/£ 2 Cr6.2500/£ 3 Cr7.8125/£ 4 Cr9.7656/£

Initial and end-of-project cash flows: An investment in a pirate ship will cost Cr40,000 (or £10,000 at the Cr4/£ spot rate). The ship is expected to retain its Cr40,000 real value. The ship is owned by a Neverland subsidiary and depreciated straight-line to a zero salvage value according to Neverland’s depreciation schedule. A £6,000 (Cr24,000) investment in inventory is carried at historical cost using LIFO accounting and should sell for Cr24,000 in real terms at t = 4. Income and capital gains taxes are 50 percent.

Useful formulas for terminal values: E[Nominal value at time t] = E[Real value at time t] (1+E[inflation])t Tax on sale of an asset = (MV – BV) (Tax rate) After-tax sale of the ship Sale of ship = Cr40,000 (1.3614)4 = Cr137,400 Tax on sale of ship = (0.5) (Cr137,400 – 0) = Cr68,700 After-tax sale of the inventory Sale of inventory = Cr24,000 (1.3614)4 = Cr82,440 Tax on sale of inventory = (0.5) (Cr82,440 – Cr24,000) = Cr29,220

Investment and disinvestment cash flows (in Neverland crocs) t= t=4 Ship –40,000 Inventory –24,000 Sale of ship 137,400 – Tax on sale –68,700 Sale of inventory 82,440 – Tax on sale –29,220 Balance sheet cash flows –64, ,920

Operating cash flows All operating cash flows occur at year-end. Income & capital gains taxes are 50%. The Cr40,000 investment in a pirate ship at time t=0 is depreciated straight-line to a zero salvage value. Expected nominal revenues in years 1-4 are Cr30,000, Cr60,000, Cr90,000, and Cr60,000. Variable operating costs are 20% of sales. A Cr1,881 fixed operating expense to be paid at the end of the first year (t = 1) is expected to increase at the croc rate of inflation thereafter.

Operating cash flows (in Neverland crocs) t=1 t=2 t=3 t=4 Revenues 30, ,000 90,000 60,000 – Variable costs –6,000 –12,000 –18,000 –12,000 – Fixed cost –1,881 –2,561 –3,486 –4,746 – Depreciation –10,000 –10,000 –10,000 –10,000 Taxable income 12,119 35,439 58,514 33,254 – Taxes –6,060 –17,720 –29,257 –16,627 Net income 6, , ,257 16,627 + Depreciation 10, , ,000 10,000 Operating CFs 16,060 27,720 39,257 26,627

Cash flows of the Neverland project t=0 t=1 t=2 t=3 t=4 Bal sheet CF –64, ,920 Operating CF 16,060 27,720 39,257 26,627 E[CFtCr] –64, ,060 27,720 39, ,547

Recipe 1: Discounting in crocs t=0 t=1 t=2 t=3 t=4 Bal sheet CF –64, ,920 Operating CF 16,060 27,720 39,257 26,627 E[CFtCr] –64, ,060 27,720 39, ,547 V0Cr = Cr0 at iCr = 50% or V0£|iCr = £0 at S0Cr/£ = Cr4/£

Recipe 2: Discounting in pounds sterling t=0 t=1 t=2 t=3 t=4 Bal sheet CF –64, ,920 Operating CF 16,060 27,720 39,257 26,627 E[CFtCr] –64, ,060 27,720 39, ,547 FtCr/£ E[CFt£] –16,000 3,212 4,435 5,025 15,211 V0£|i£ = £0 at i£ = 20%

13.3 International Parity Disequilibria
Parent corporations want returns in their functional currency Valuing a Chinese investment in the United States Chinese investment in ¥ in the U.S. Project valuation within the U.S. Chinese parent firm Return to the Chinese parent firm in ¥

Disequilibria: When ceteris isn’t paribus: A parent corporation wants a return in its own functional currency. NPVs calculated from the project and parent perspectives can differ when the international parity conditions do not hold. A comparison of NPVs from the parent’s and project’s perspectives provides guidance on how to structure a foreign project to best capture a return for the parent.

When parity doesn’t hold… V0d|if > 0 The project has value from the perspective of a foreign investor that is, relative to alternatives in the foreign (or local) market. V0d|id > 0  The project has value from the perspective of the parent.

When parity might not hold… Interest rate parity always holds for exchange rates and risk-free Eurocurrency interest rates Ftd/f = S0d/f(1+iFd)/(1+iFf) Equilibrium doesn’t always hold for expected future exchange rates or for risky assets E[Std/f] ≠ S0d/f(1+id)(1+if)

When parity might not hold… 1. Cross-currency differences in real interest rates (ʀd ≠ ʀf) or risk premia (rpd ≠ rpf) (1+i) = (1+E[p])(1+ʀ) = (1+iF)(1+rp) Ftd/f/S0d/f = [(1+iFd)/(1+iFf)]t [(1+id)/(1+if)]t 2. Managers have exchange rate expectations that can differ from market rates Ftd/f E[Std/f]/S0d/f [(1+id)/(1+if)]t

Clear losers… Exhibit 3.9 Parent’s perspective V0d|id < 0 V0d|id > 0 Reject V0d|if < 0 Project’s perspective V0d|if > 0

Local losers: There must be something better… Exhibit 3.9 Parent’s perspective V0d|id < 0 V0d|id > 0 Reject Look for better projects in the foreign currency V0d|if < 0 Project’s perspective V0d|if > 0

Local winners: Somebody’s gotta want this… Exhibit 3.9 Parent’s perspective V0d|id < 0 V0d|id > 0 Reject Look for better projects in the foreign currency V0d|if < 0 Project’s perspective Try to lock in the time 0 value of the project V0d|if > 0

Alternatives for capturing the time t=0 value of a foreign project In the asset markets: Sell the project to a local investor. Bring in a joint venture partner. In the financial markets: Hedge the cash flows from the project against currency risk. Finance the project with local currency debt or equity.

If foreign cash flows are certain, then you can create a perfect hedge. Suppose Wendy’s croc CFs were riskless… Underlying cash flows +Cr16,060 +Cr27,720 +£3,212 +£4,435 Forward hedge -Cr16,060 -Cr27,720 Net position +£3,212 +£4,435

If foreign cash flows are uncertain, then forward hedges are imperfect hedges. In fact, Wendy’s croc cash flows are risky… Underlying cash flows +Cr16,060 +Cr27,720 +£3,212 +£4,435 Forward hedge -Cr16,060 -Cr27,720 Net position +£3,212 +£4,435 Cr 0 Cr 0

Winners: Structuring the deal… Figure 3.9 Parent’s perspective V0d|id < 0 V0d|id > 0 Reject Look for better projects in the foreign currency V0d|if < 0 Project’s perspective Try to lock in the time 0 value of the project Accept, then structure the deal V0d|if > 0

V0d|if > V0d|id > 0 The project has more value locally than it does from the parent’s perspective.  You should hedge Hedging provides the parent with higher expected value and lower exposure to currency risk.

As in the bottom left cell, the comparison Ftd/f ≷ S0d/f(1+iBd)/(1+iBf) determines whether to hedge with forward exchange rates Ftd/f or with foreign currency debt iBf. Note that iBf should be the all-in cost of debt; that is, the internal rate of return of the cash flows associated with the debt including any placement fees.

V0d|id > V0d|if > 0 The project has more value from the parent’s perspective than it does to local investors.  Whether you hedge or not will depend on the firm’s risk management policy Hedging lowers exposure to currency risk, but also lowers the expected NPV of the project.

Domestic currency Domestic currency NPV is negative. NPV is positive. Reject Do you feel lucky? Foreign currency This is a loser A favorable FX rate forecast results in a NPV is any way you positive expected NPV from the domestic negative. look at it. currency perspective but leaves you exposed to FX risk if unhedged. Accept, Accept, & then structure the deal & then hedge When foreign currency NPV is higher, Foreign Lock in then hedging yields lower risk & higher currency the positive expected value → You should hedge. NPV is foreign currency positive. NPV with an When domestic currency NPV is higher, FX hedge. then hedging yields lower risk & lower expected value → Use your judgment. From Butler-O’Brien-Utete, “A fresh look at cross-border valuation & FX hedging decisions,” J. of Applied Finance, 2013.

13.4 Special Circumstances
Special circumstances in project valuation VPROJECT WITH SIDE EFFECT = VPROJECT WITHOUT SIDE EFFECT + VSIDE EFFECT Side effects that are commonly attached to international projects include: Blocked funds Subsidized financing Expropriation risk Tax holidays Negative-NPV tie-in projects

13.4 Special Cases: Blocked Funds
An example of blocked funds t=0 t=1 t=2 t=3 t=4 E[CFtCr] –64, , , , ,547 Suppose Hook requires 50 percent of operating cash flows in years 1 to 3 be retained in Hook’s treasure chest at a 0 percent interest rate. The opportunity cost of capital on this ‘riskless’ croc investment is iCr (1 - TCr) = 37.5% ( ) = 18.75%.

50% of operating CF is blocked in years 1–3 Market rate Hook’s rate (18.75%) (0%) 13,446 8,030 19,544 13,860 23,309 19,628 8,030 13,860 19,628 Cr28, ,300 41,518 Cr20,879 Discounted at percent for four years

50% of operating CF is blocked in years 1–3 After-tax opportunity cost of blocked funds = Cr28,312 – Cr20,879 = Cr7,433 VPROJECT w/ SIDE EFFECT = VPROJECT w/o SIDE EFFECT + VSIDE EFFECT ≈ Cr0 + (-Cr7,433) = -Cr7,433 < Cr0 or about –£1,858 at S0Cr/£ = Cr4/£

13.4 Special Cases: Subsidized Financing
An example of subsidized financing Market rate: Wendy can borrow Cr40,000 for four years at the corporate bond rate of 40 percent.  (0.40)(Cr40,000) = Cr16,000 in annual interest expense Subsidized rate: Hook will loan Wendy Cr40,000 for four years at Hook’s borrowing rate of 37½ percent.  (0.375)(Cr40,000) = Cr15,000 This yields Cr1,000 in annual interest savings, or an after-tax interest savings of (Cr1,000)(0.5) = Cr500.

13.4 Special Cases: Subsidized Financing
The value of the financing subsidy Annual after-tax interest savings of Cr500 Discounting the after-tax interest savings at the 20% after-tax cost of debt, this is worth Cr1,294. VPROJ w SIDE EFFECT = VPROJ w/o SIDE EFFECT + VSIDE EFFECT ≈ Cr0 + Cr1,294 = Cr1,294 > Cr0 or about £323.5 at S0Cr/£ = Cr4/£ Cr500 Cr500 Cr500 Cr500 iDCr(1 - T) = (40%)( ) = 20%

13.4 Special Cases: Expropriation Risk
Suppose there is an 80% chance Hook will expropriate the ship at time t=4 Actual Expected Ship Cr0 +Cr137,400 Tax on ship Cr0 –Cr68,700 Total Cr0 +Cr68,700 The expected after-tax loss is then = (Probability of loss)(Actual – Expected) = (0.8)(0 – Cr68,700) = –Cr54,960

Expected loss at time t=4 Assuming the ship has the same risk as the operating cash flows, then the appropriate discount rate is the opportunity cost of capital on the project; that is, either iCr = 50% or i£ = 20%. -Cr54,960

If parity holds, the expected loss in value can be found by discounting in crocs or in pounds. Discounting in crocs PV(E[after-tax loss]) = [ E[CF4Cr] / (1+iCr)4 ] / S0Cr/£ = [ (–Cr54,960) / (1.50)4 ] / (Cr4/£) = (–Cr10,856) / (Cr4/£) = –£2,714 VPROJ w SIDE EFFECT = VPROJ w/o SIDE EFFECT + VSIDE EFFECT ≈ £0 + (–£2,714) = –£2,714 < £0

If parity holds, the expected loss in value can be found by discounting in crocs or in pounds. Discounting in pounds PV(E[after-tax loss]) = [E[CF4Cr] / E[S4Cr/£]] / (1+i£)4 = [ (–Cr54,960) / (Cr9.7656/£) ] / (1.20)4 = (–£5,628) / (1.20)4 = –£2,714 VPROJ w SIDE EFFECT = VPROJ w/o SIDE EFFECT + VSIDE EFFECT ≈ £0 + (–£2,714) = –£2,714 < £0

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