Multinational Capital Budgeting

1. Multinational Capital Budgeting International Financial Management Dr. A. DeMaskey

2. Learning Objectives • How does domestic capital budgeting differ from multinational capital budgeting? • How do incremental cash flows differ from total project cash flows? • What is the difference between foreign project cash flows and parent cash flows? • How does APV analysis differ from NPV analysis? • How is the capital budgeting analysis adjusted for the additional economic and political risks? • What is real option analysis?

3. Complexities of Capital Budgeting for a Foreign Project • Several factors make budgeting for a foreign project more complex • Parent cash flows must be distinguished from project • Parent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing • Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as stand alone may provide cash flows but overall adds no value to entire organization • Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

4. Complexities of Capital Budgeting for a Foreign Project • An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. • Managers must anticipate differing rates of national inflation which can affect differing cash flows • Use of segmented national capital markets may create opportunity for financial gain or additional costs • Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC • Managers must evaluate political risk • Terminal value is more difficult to estimate because potential purchasers have widely divergent views

5. Traditional Capital Budgeting Analysis • NPV Analysis • If Projects are independent, those with a positive NPV will be accepted while those with a negative NPV will be rejected • It two projects are mutually exclusive, the project with the highest NPV greater than zero will be accepted. • The discount rate, k, is the expected rate of return on projects of similar risk as the riskiness of the firm as a whole.

6. Properties of NPV Rule • Consistent with the goal of maximizing shareholder wealth. • Focuses on cash flows rather than accounting profits. • Emphasizes the opportunity cost of money invested. • Obeys the additivity principle.

7. Incremental Cash Flows • Only the additional cash flows generated by the project are relevant. • The difference between total and incremental cash flows arises from: • Cannibalization • Sales creation • Opportunity cost • Transfer prices • Fees and royalties

8. Choosing the Correct Case Base • The base case is represented by the worldwide corporate cash flows without the investment. • In a competitive world, the base case needs to be adjusted for competitive behavior. • New product • New production technology • Intangible benefits

9. Adjusted Present Value (APV) • Project risks and financial structures vary by country, production state, and position in the life cycle of the project. • Rather than modifying the WACC, cash flows can be discounted at an all-equity rate, k*. • Reflects only the riskiness of the project’s expected future cash flows. • Abstracts from the project’s financial structure. • Can be viewed as the company’s cost of capital if it were all-equity financed, that is, with zero debt.

10. All-Equity Rate • The all-equity rate is based on the CAPM: k* = rf + β* (rm – rf) • β* is the all-equity or unlevered beta • A levered equity beta, βe, is unlevered using the following equation:

11. Adjusted Present Value Approach • The value of a project is equal to the sum of the following components: • PV of after-tax project cash flows but before financing costs discounted at k*. • PV of tax savings on debt financing discounted at the before-tax dollar cost of debt, id. • PV of any savings or penalties on interest costs associated with project-specific financing discounted at the before-tax dollar cost of debt, id.

12. Adjusted Present Value Approach • Tt = tax savings in year t due to the specific financing package • St = before-tax dollar value of interest subsidies (penalties) • id = before-tax dollar cost of debt

13. Issues in Foreign Investment Analysis • Should cash flows be measured from the viewpoint of the project or that of the parent? • Should the additional economic and political risks that are uniquely foreign be reflected in cash flow or discount rate adjustments?

14. Project versus Parent Valuation • Most firms evaluate foreign projects from both parent and project viewpoints • The parent’s viewpoint analyses investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments • The parent’s viewpoint gives results closer to traditional NPV capital budgeting analysis • Project valuation provides closer approximation of effect on consolidated EPS

15. Parent versus Project Cash Flows • Project and parent cash flows can diverge significantly due to: • Tax regulations • Exchange controls • Fees and royalties • Transfer pricing • Other factors

16. Three-Stage Approach • Stage1: • Project cash flows are computed from the subsidiary’s perspective. • Stage 2: • Project cash flows to the parent are evaluated on the basis of specific forecasts concerning the amount, timing, and form of remittance. • Stage 3: • Account for the additional benefits and costs of the project.

17. Incremental Project Cash Flows • Estimating a project’s true profitability requires various adjustments to the project cash flows: • Adjust for the effects of transfer pricing and fees and royalties. • Adjust for global costs/benefits that are not reflected in the project’s financial statements. • Cannibalization • Sales creation • Additional taxes • Diversification of production facilities and markets

18. Tax Factors • Only after-tax cash flows are relevant. • Actual taxes paid are a function of: • Time of remittance • Form of remittance • Foreign income tax rate • Withholding taxes • Tax treaties • Foreign tax credits

19. Tax Factors • Computing the tax liabilities of foreign investments assumes that: • The maximum amount of funds are available for remittance each year. • The tax rate applied is the higher of the home or host country rate.

20. Tax Factors: Illustration • Suppose that an affiliate will remit after-tax earnings of $120,000 to its U.S. parent in the form of a dividend. Assume the foreign tax rate is 20%, the withholding tax on dividends is 4%, and excess foreign tax credits are unavailable. • What is the additional tax owed to the U.S. government? • What is the marginal rate of additional taxation?

21. Political and Economic Risk Analysis • There are three main methods for incorporating the additional political and economic risks into a foreign investment analysis: • Shortening the payback period • Raising the required rate of return of the investment • Adjusting the cash flows to reflect the specific impact of a given risk. • Uncertainty absorption • Adjusting the expected value of future cash flows

22. Exchange Rate Changes and Inflation • The analysis should also consider the appreciation or depreciation of the US dollar. • Approach A: • Convert nominal foreign currency cash flows into nominal home currency terms. • Discount those nominal cash flows at the nominal domestic required rate of return. • Approach B: • Discount the nominal foreign currency cash flows at the nominal foreign currency required rate of return. • Convert the resulting foreign currency present value into the home currency using the current spot rate.

23. Political Risk Analysis • The preferred method is to adjust the cash flows of the project to reflect the impact of a particular political event on the present value of the project to the parent. • The biggest risk is: • Expropriation • Blocked funds

24. Expropriation: Illustration • Suppose a firm projects a $5 million perpetuity from an investment of $20 million in Spain. If the required return on this investment is 20%, how large does the probability of expropriation in year 4 have to be before the investment has a negative NPV? Assume that all cash flows occur at the end of the year and that the expropriation, if it occurs, will occur prior to the year 4 cash inflows or not at all. There is no compensation in the event of expropriation.

25. Real Option Analysis • DCF analysis cannot capture the value of the strategic options, yet real option analysis allows this valuation. • Real option analysis includes the valuation of the project with future choices such as: • The option to defer • The option to abandon • The option to alter capacity • The option to start up or shut down (switching)

26. Real Option Analysis • Real option analysis treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis). • The valuation of real options and the variables’ volatilities is similar to equity option math. • An expanded NPV rule consists of the traditional DCF analysis plus the value of an option.