1. FIN 440: International Finance
Topic 19-International Capital Budgeting I
Larry Schrenk, Instructor

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

3. Overview Domestic Capital Budgeting International Capital Budgeting
Net Present Value
(Continued in Topic 20)

4. 1. Domestic Capital Budgeting

5. 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.

6. 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.

7. 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.

8. ‘Domestic’ NPV Calculations
Estimate Future Cash Flows E[CFt]
Include only incremental cash flows
Include all opportunity costs

9. ‘Domestic’ NPV Calculations
Identify Risk-Adjusted Discount Rate
Discount nominal CFs at nominal discount rates and real CFs at real discount rates
WACC
Same Risk
Same Financing
NOTE: Discount rate captures all financing.
Interest payments and ‘double’ counting

10. ‘Domestic’ NPV Calculations
Calculate net present value (NPV)
Based on expected future cash flows and the appropriate risk-adjusted discount rate

11. 2. International Capital Budgeting

12. 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

13. Two Valuation Methods Net Present Value (NPV)
Traditional NPV analysis extended to int’l projects
Adjusted Present Value (APV)
valuation by parts
APV = PV[OCF] + PV[Project costs & benefits]
Project costs and benefits:
PV of tax shields
PV of financial subsidies

14. 3. Net Present Value

15. International Capital Budgeting
Foreign projects generate cash flows in a foreign currency.
Two Approaches
Approach 1: Foreign Project
Approach 2: Parent Firm

16. 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.

17. 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

18. Approach 1: Discount in the Foreign Currency
Estimate future cash flows E[CFtx]
Identify discount rate
3. Calculate net present value
Calculate NPV
Convert to the domestic currency
E[CF1x]
E[CF2f ]
NPV0x ix
NPV0$= S0$/x NPV0x

19. Approach 2: Discount in the Domestic Currency
Estimate E[CFt$] = E[St$/x] E[CFtx ]
Identify discount rate
3. Calculate net present value NPV
E[CF1x]
E[CF2f ]
E[CFt$ ] = E[St$/x ] E[CFtx ]
NPV0

20. 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.

21. PPP PPP must hold. Over the life of the project Differential Inflation
FX rates must change to compensate

22. WACC
If PPP holds:

23. Approach 2: Simple Example
U.S. parent considers building a Swiss factory (millions)
Initial cost: $50
S($/SF):
Dollar discount rate: 10%
Projected CHF cash flows
Year 1: CHF 10 net revenues
Years 2-5: revenue 2%
Year 5 CHF 100 (Salvage/Terminal Value of Factory)

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

25. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
S($/CHF)
PV(Cash Flows $)
NPV

26. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
SFr
SFr
SFr
SFr
SFr
S($/CHF)
PV(Cash Flows $)
NPV

27. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
SFr
SFr
SFr
SFr
SFr
S($/CHF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
PV(Cash Flows $)
NPV

28. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
SFr
SFr
SFr
SFr
SFr
S($/CHF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
$5.05
$5.20
$5.36
$5.52
$58.24
PV(Cash Flows $)
NPV

29. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
SFr
SFr
SFr
SFr
SFr
S($/CHF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
$5.05
$5.20
$5.36
$5.52
$58.24
PV(Cash Flows $)
$4.59
$4.30
$4.03
$3.77
$36.16
NPV

30. NPV Calculation Year 1 2 3 4 5 Cash Flows ($) ($50.00) 1 2 3 4 5
Cash Flows ($)
($50.00)
Cash Flows (CHF)
SFr
SFr
SFr
SFr
SFr
S($/CHF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
$5.05
$5.20
$5.36
$5.52
$58.24
PV(Cash Flows $)
$4.59
$4.30
$4.03
$3.77
$36.16
NPV
$2.85

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

32. Sensitivity Analysis
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 NPV to give the manager a more complete picture of the planned capital investment.

33. 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.