Week 5 Lecture: International Capital Allocation

1. Week 5 Lecture: International Capital Allocation

2. Outline Capital Budgeting Discount Rates for Foreign Investments Issues in Foreign Investment Analysis Establishing a Worldwide Capital Structure

3. NPV = -I0 + n  Xt t=1 (1 + k)t Capital Budgeting (1) • Capital budgeting – the process ofselecting the prospective capital investments that maximize an MNC’s shareholder value. • A project’s net present value determines the project’s effect on shareholder value. • Net present value (NPV) – the present value of future cash flows discounted at the project’s cost of capital less the initial investment. • Where • I0 = initial investment • Xt = net cash flow in period t • k = cost of capital (also known as weighted average cost of capital, or WACC) • n = investment horizon • Only projects with positive NPV should be accepted. • If two projects are mutually exclusive, the project with the higher NPV should be accepted.

4. 2 3 0 t 1 Xt k Present Value Cumulative Present Value -$4,000,000 1.00 -$4,000,000 -$4,000,000 $1,200,000 1.10 $1,091,000 -$2,909,000 $2,700,000 (1.10)2 $2,231,000 -$678,000 $2,700,000 (1.10)3 $2,029,000 $1,351,000 $1,351,000 NPV Capital Budgeting (2) • Example – compute NPV of a plant expansion project. Assume n = 3 and k = 10% • The project has a positive NPV and is thus acceptable.

5. Capital Budgeting (3) • Incremental cash flows – incremental cash flows may differ from total cash flows for a number of reasons. • Cannibalization • Sales creation • Opportunity cost • Transfer pricing • Fees and royalties • Getting the base case right • Accounting for intangible benefits • The impact of each of these factors on cash flows must be considered in determining the project’s viability.

6. Capital Budgeting (4) • Cannibalization • A company’s new product steals sales from its earlier models. • A firm builds a plant overseas and substitutes foreign production for parent company exports. • To the extent that sales of a new product or plant replace existing corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales. • The relevant measure of cannibalism for capital budgeting purposes is the lost profit on lost sales that would not otherwise have been lost had the new project not been undertaken.

7. Capital Budgeting (5) • Sales creation • The opposite of cannibalization – a new project creates additional sales for existing products. • The new project’s estimated profits must be increased by the additional sales created by the project.

8. Capital Budgeting (6) • Opportunity cost • Project costs must include the true economic cost of any resource required for the project, regardless of whether the firm already owns the resource or acquires it just for the project. • The opportunity cost – that is, the maximum amount of cash the asset could generate for the firm should it be sold or put to some other productive use – must be included in computing the value of undertaking the project.

9. Capital Budgeting (7) • Transfer pricing • If an MNC’s new domestic plant will supply parts to its foreign subsidiary, it can increase the apparent profitability of the new plant by increasing the transfer price to the subsidiary, and vice versa. • Thus, the transfer prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment. • Where possible, prices used to evaluate project inputs or outputs should reflect market prices.

10. Capital Budgeting (8) • Fees and royalties • An MNC often charges fees and royalties to a project to cover various items such as legal counsel, power, lighting, heating, rent, R&D, headquarters staff, management costs, etc. • While fees and royalties are costs to the project, they are a benefit from the parent’s perspective. • The project should be charged only for additional expenses attributable to the project and not for overhead expenses unaffected by the project.

11. Capital Budgeting (9) • Getting the base case right • Generally, a project’s incremental cash flows can be found only by subtracting worldwide corporate cash flows without the investment (the base case) from investment corporate cash flows. • Getting the base case right requires correctly determining what will happen if the firm does not make the investment. • Toward this end, understanding the competitive landscape is critical. • E.g., a firm may forgo investing in a new product for fear of cannibalization, only to create a profitable niche for another company to exploit.

12. Capital Budgeting (10) • Accounting for intangible benefits • Intangible assets include better quality, faster time to market, quicker and more efficient order processing, learning curve, knowledge, and higher customer satisfaction, among other things. • Intangible assets have a very tangible impact on cash flows. • Thus, while intangible benefits from a project cannot be measured precisely, they must be included in the capital-budgeting process.

13. NPV = -I0 + n  Xt t=1 (1 + k0)t Discount Rates for Foreign Investments (1) • For capital budgeting purposes, the cost of capital k0 (also known as weighted average cost of capital, or WACC) is the required return for the project. k0 = (1 – L)ke + Lkd(1 – t) • Where • L = parent’s debt ratio (debt to total assets) • ke= project’s cost of equity capital • kd= project’s cost of debt • t = tax rate • A project’s estimated cash flows are discounted by k0 to determine its NPV (see slide p.2) • Because a project’s risk may be different than the MNC’s risk, the project’s own cost of capital must be used to compute NPV. • And only projects with positiveNPV should be accepted

14. Discount Rates for Foreign Investments (2) • Cost of equity capital ke • The minimum rate of return necessary to induce investors to buy or hold the firm’s stock, consisting of a basic yield to cover time value and a risk premium to account for the specific risk of the project. • The rate used to capitalize total corporate cash flows – the conceptually preferred definition, as ke is a function of the riskiness of the activities in which a firm is engaged, rather than of the riskiness of the firm itself. • keis defined as ri, the expected return on asset i, by the capital asset pricing model (CAPM): k0 = (1 – L)ke + Lkd(1 – t) ri = rf + βi(rm – rf) • Where • rf= rate of return on a risk-free asset (usually a U.S. Treasury bill or bond) • βi= the systematic or nondiversifiable risk of the asset • rm= expected return on the market portfolio consisting of all risky assets • rm – rf = the market risk premium (MRP)

15. βi = ri,mσi σm Discount Rates for Foreign Investments (3) • The CAPM is based on the notion that intelligent, risk-averse shareholders will seek to diversify their risks; thus, the only risk that will be rewarded with a risk premium is systematic risk. • A project’s systematic risk is measured by βi: • Where • ri,m= correlation between returns on project i and the market portfolio • σi= standard deviation of returns on project i • σm= standard deviation of returns on the market portfolio

16. Discount Rates for Foreign Investments (4) • The project risk premium is represented by βi multiplied by the MRP. Risk premiumi = βi(rm – rf) • When the returns and financial structure of a proposed investment are expected to be similar to those of a firm’s typical investment, the corporate ri may serve as a proxy for the project’s ri.

17. Investment in Low correlation increases diversification benefits Developed Country LDC High correlation decreases diversification benefits Investment in Developed Country Discount Rates for Foreign Investments (5) • Less developed countries (LDCs) may provide the largest diversification benefits (lower systematic risk) despite high political risk because their economies are less correlated with the U.S. or other Western economy. • Conversely, diversification benefits from investing in developed countries diminish because of their high correlations.

18. Discount Rates for Foreign Investments (6) • To the extent an MNC can provide low-cost international diversification, investors may be willing to accept a lower rate of return on shares of MNCs than on shares of single-country firms – i.e., the required return on foreign projects may be less than the required return on comparable domestic projects. Single-Country Firm Internationally Diversified MNC Investment choice is single-country firm or MNC: Investors may accept a lower return on MNC shares

19. Discount Rates for Foreign Investments (7) • If individual investors can accomplish international portfolio diversification as easily and cheaply, the discount rate would not be reduced further to reflect investors’ willingness to pay a premium for the indirect diversification provided by an MNC’s shares. Internationally Diversified MNC Internationally Diversified Portfolio of Stocks Investment choice is international portfolio or MNC:Investors maynot accept a lower return on MNC shares

20. Discount Rates for Foreign Investments (8) • Key issues in estimating ri • The information needed to estimate βidirectly – i.e., a history of past subsidiary returns or future subsidiary returns relative to predicted market returns – does not exist. • Thus, an MNC must find publicly traded firms that share similar risk characteristics and use the average beta for the portfolio of corporate surrogates to proxy for βi. • This process requires answering four key questions: • Should the proxies be U.S. or local? • Local companies provide a better indication of risk but may not exist. • U.S. proxies and accessible information exist, but their betas may be very different than those of foreign subsidiaries. ri = rf + βi(rm – rf)

21. Discount Rates for Foreign Investments (9) • Key issues in estimating foreign project discount rates, continued • Four key questions, continued: • Is the relevant base portfolio against which the proxy betas are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio? • A risk that is systematic in the context of the local market may be diversifiable in the context of the U.S. or world portfolio. • In this case, using the local market portfolio will result in a higher required return. • Should the MRP be based on the U.S. market or the local market? • The local MRP is the MRP demanded by investors on investments in that market. • Estimates of the local MRP may be subject to statistical error or irrelevant to the extent that an MNC’s investors are not the same as investors in the local market, and the two sets of investors measure risk differently.

22. Discount Rates for Foreign Investments (10) • Key issues in estimating foreign project discount rates, continued • Four key questions, continued: • How, if at all, should country risk be incorporated into the cost of capital estimates? • A recently adopted approach is to add a country risk premium to the discount rate. • Adding a country risk premium may result in double counting risks.

23. Discount Rates for Foreign Investments (11) • Key issues in estimating foreign project discount rates, continued • Estimating proxy betas or βi – 3 alternatives in order of preference • Use local companies • Because the returns on an MNC’s local operations depend on the local economy, the degree of systematic risk for a foreign project may be lower than that of comparable U.S. companies. • Using U.S companies and their returns to proxy for the returns of a foreign project will likely lead to an upward-biased estimate of the MRP.

24. Discount Rates for Foreign Investments (12) • Key issues in estimating foreign project discount rates, continued • Estimating proxy betas or βi – 3 alternatives in order of preference, continued • Use an industry in the local market whose U.S. industry beta is similar to that of the project’s U.S. industry beta. • Use an adjusted U.S. industry beta – compute the U.S. industry beta for the project and multiply it by the foreign market beta relative to the U.S. index.

25. Discount Rates for Foreign Investments (13) • Key issues in estimating foreign project discount rates, continued • Relevant base portfolio • The relevant base portfolio against which to estimate proxy betas can be the home portfolio or the global market portfolio. • If capital markets are seen as globally integrated, use the global market portfolio. • CAPM becomes the global CAPM: ri = rf + βig(rg – rf) • Where • βig = project beta measured relative to the global market • rg= expected return on the global market

26. βig = ri,gσif σg Discount Rates for Foreign Investments (14) • Key issues in estimating foreign project discount rates, continued • Relevant base portfolio, continued • Using the global CAPM, βig is computed as • Where • ri,g= correlation between returns on project i and the global portfolio • σf= standard deviation of returns on foreign project i • σg= standard deviation of returns on the global portfolio

27. Discount Rates for Foreign Investments (15) • Key issues in estimating foreign project discount rates, continued • Relevant base portfolio, continued • If capital markets are notseen as globally integrated, use the home market portfolio. • For a U.S. MNC, CAPM becomes ri = rf + βius(rus – rf) • Where • βius = project beta measured relative to the U.S. market • rus= expected return on the U.S. market portfolio • Capital markets are now integrated to a great extent and are expected to become more integrated over time. Government regulations and other market imperfections have been barriers to total global integration.

28. Discount Rates for Foreign Investments (16) • Key issues in estimating foreign project discount rates, continued • Relevant base portfolio, continued • Implications of global CAPM for MNCs • Other things equal, the use of a global CAPM means a lower cost of capital because the MRP will be lower. • As long as the domestic economy is less than perfectly correlated with the world economy, βig will be less when measured against the global portfolio than when measured against the domestic portfolio. • Risk that is systematic in the context of the U.S. economy may be unsystematic in the context of the global economy; thus, investors able to diversify internationally will demand a lower risk premium. • Reducing total risk can increase a firm’s cash flows – by operating in a number of countries, an MNC can trade off negative swings in some countries against positive swings in other countries.

29. MRPf = MRPus σf σus Discount Rates for Foreign Investments (17) • Relevant market risk premium • The U.S. MRP is recommended because • The U.S. MRP is likely to be demanded by a U.S. MNC’s mostly American investors; • The betas for foreign subsidiaries are estimated relative to the U.S. market; • The quality, quantity, and time span of U.S. capital market data are the best in the world and thus increase the statistical validity of the estimated MRP. • Even if the market price per unit of risk is uniform worldwide, the MRP may differ across countries because market risk itself differs across countries. • When computing foreign MRPs, adjust the U.S. MRP for differences in risk on a market-by-market basis, as follows: • Where • MRPus= U.S. market risk premium • σf= standard deviation of returns on foreign market portfolio • σus= standard deviation of returns on the U.S. market portfolio

30. Discount Rates for Foreign Investments (18) • Cost of debt kd – the dollar costs of foreign currency debt, which include the interest rate, currency gains/losses, and tax effects, computed as k0 = (1 – L)ke + Lkd(1 – t) kd = rL(1 + c)(1 – ta) + c • Where • rL= interest rate on foreign debt • c = exchange gain/loss, computed as (e1 – e0) / e0 • ta= project’s marginal tax rate • Example: the French subsidiary of a U.S. MNC borrows €10 million for one year • rL = 7% • e0 = $1.34; e1 = $1.30; c = (1.30 – 1.34) / 1.34 = -2.99% • ta= 40% kd = 0.07(1 -0.0299)(1 – 0.40) – 0.0299 = 1.09%

31. NPV = -I0 + n  Xt t=1 (1 + k0)t Discount Rates for Foreign Investments (19) • Using ke and kd, we compute WACC k0 as k0 = (1 – L)ke + Lkd(1 – t) * • Where L = the parent’s debt ratio • The debt ratio must be based on the proportion of the MNC’s capital structure accounted for by each source of capital using market – and not book – values. • The debt ratio to be used must reflect the firm’s target capital structure, and not its historic capital structure. • Note that k0 or discount rate is used to calculate the NPV of foreign investment

32. Discount Rates for Foreign Investments (20) • Example: Compute k0 and k0’ • An MNC planning for a foreign investment has a 40% debt ratio, ke of 14%, and after-tax kd of 6%. k0 = (1 – 0.40)0.14 + 0.40*0.06 = 10.8% • What if the MNC’s foreign investment is supported with a 30% debt ratio and, given the project’s high degree of risk, ke of 16% and after-tax kd of 6%. k0’ = (1 – 0.30)0.16 + 0.30*0.08 = 13.6%

33. Issues in Foreign Investment Analysis (1) • Evaluating project cash flows • Tax regulations and exchange controls can create substantial differences in a project’s cash flow and the amount remitted to the parent. • Project expenses such as management fees and royalties are returns to the parent. • Incremental revenue contributed to the parent can differ from total project revenue. • Economic theory states that the value of a project is determined by the NPV of future cash flows to the investor. • Thus, the parent should value only those cash flows repatriated net of transfer costs.

34. Issues in Foreign Investment Analysis (2) • Evaluating project cash flows, continued • Three-step approach to project evaluation • Estimate project cash flows from the project’s standpoint. • Forecast the amounts, timing, and form of transfers, as well as taxes and other expenses incurred in the transfer process, to the parent. • Consider the indirect benefits and costs of the project.

35. Issues in Foreign Investment Analysis (3) • Evaluating project cash flows, continued • Estimating incremental project cash flows • Subtract worldwide parent cash flows (without the investment) from investment parent cash flows. • Adjust for transfer pricing and fees and royalties • Use market costs/prices for goods, services, and transfer prices. • Add back fees and royalties because they are benefits to the parent. • Remove the fixed portions of costs such as corporate overhead.

36. Issues in Foreign Investment Analysis (4) • Evaluating project cash flows, continued • Estimating incremental project cash flows, continued • Adjust for global costs/benefits not reflected in the project’s financial statements: • Cannibalization • Sales creation • Additional taxes owed when repatriating profits • Foreign tax credits • Diversification of production facilities • Market diversification • Provision of a key link in a global service network • Intangible assets

37. Issues in Foreign Investment Analysis (5) • Political and economic risk analysis • Three primary methods to incorporate political and economic risk into foreign investment analysis • Shorten the minimum payback period • Raise the cost of capital • Adjust cash flows to reflect the specific impact of a given risk

38. Issues in Foreign Investment Analysis (6) • Political and economic risk analysis, continued • Shortening the payback period and raising the cost of capital do not address the actual impact of a particular risk and may adulterate the analysis. • E.g., if expropriation is likely in five years, increasing the cost of capital distorts the meaning of the present value of cash flows. • Adjusting expected cash flows to reflect the specific impact of a given risk on a project’s cash flows is the recommended approach.

39. Issues in Foreign Investment Analysis (7) • Exchange rate changes and inflation • Assessing the effect of exchange rate changes on expected cash flows from a foreign project involves removing the effect of offsetting inflation and exchange rate changes. • Each effect should be analyzed separately.

40. Issues in Foreign Investment Analysis (8) • Exchange rate changes and inflation, continued • First adjust cash flows for inflation and then convert the projected cash flows into dollars using the forecasted exchange rate. • Example: Compute the effects of inflation and currency depreciation on a new project in France. • Year 1 expected cash flow = €1,000,000, with 4% projected growth • Year 2 expected inflation = 6% • e0 = $1.34; Year 2 expected currency depreciation = 5%; e2 = 1.34 (1 – 0.05)2 = $1.209 • Year 2 forecasted cash flow = €1,000,000 (1.04)2 = €1,081,600 • Year 2 forecasted cash flow in dollars = €1,081,600 (1.209) = $1,307,654

41. Establishing a Worldwide Capital Structure (1) • Foreign subsidiary capital structure • MNCs must determine the mix of debt and equity for the parent and all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth (i.e., a worldwide debt ratio). • MNC options for financing affiliates • The parent raises funds in its own country and makes equity investments in the affiliates – debt ratio = 0% • The parent holds one dollar of share capital in each affiliate and requires all affiliates to borrow on their own – debt ratio ≈ 100% • The parent borrows and relends the funds as intracorporate advances – debt ratio ≈ 100%.

42. Equity Investment Dividend Payments Subsidiary Parent Interest and Principal Reloan Interest and Principal Interest and Principal Loan Loan Bank Establishing a Worldwide Capital Structure (2) • Foreign subsidiary capital structure, continued • An MNC’s three primary options for financing affiliate operations

43. Establishing a Worldwide Capital Structure (3) • Effect of foreign investment on debt ratios of affiliate andparent Parent Consolidated Debt Ratio Before Foreign Investment Total Investment = $1,000 D = $300 E = $700 D/E = 3:7 Affiliate Debt Ratio After $100 Investment Whether parent or affiliate raises $100, affiliate’s debt ratio can vary from 0 to infinity 100% Parent Financed 100% Bank Financed D = $0 E = $100 D = $50 E = $50 D = $100 E = $0 D = $100 E = $0 D/E = Infinity D/E = 0 D/E = Infinity D/E = 1:1 Whether parent or affiliate raises $100, parent’s debt ratio is 4:7 Parent Consolidated Debt Ratio After Foreign Investment Total Investment = $1,100 D = $400 E = $700 D/E = 4:7

44. Establishing a Worldwide Capital Structure (4) • Foreign subsidiary capital structure • Again, MNCs must determine the mix of debt and equity for the parent and all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth (i.e., a worldwide debt ratio).

45. Establishing a Worldwide Capital Structure (5) • Foreign subsidiary capital structure, continued • Political risk management • The use of financing to reduce political risks typically involves mechanisms to avoid or reduce the impact of certain risks, such as those related to exchange controls or expropriation. • By raising funds locally, if a subsidiary is expropriated, it would default on loans from local financial institutions. • Because local currency can be used to service local debt, borrowing locally decreases the MNC’s vulnerability to exchange controls. • Foreign investments may be funded through the host or other governments, international development agencies, overseas banks, and customers, with payment to be provided out of production. • Repayment is thus tied to the project’ success.

46. Establishing a Worldwide Capital Structure (6) • Foreign subsidiary capital structure, continued • Currency risk management • Basic rule – finance assets that generate foreign currency cash flows with liabilities denominated in those same foreign currencies. • For contractual cash flows, match net positive positions in each currency with liabilities of similar maturities in the same currency. • For noncontractual cash flows, match net positive positions in each currency with liabilities in the same currency. • Leverage and foreign tax credits • Foreign tax credits (FTCs) are credits that home countries grant against domestic income tax for foreign income taxes already paid. • If the foreign tax on a dollar earned abroad and remitted to the U.S. is less than 35%, additional U.S. taxes will be owed to bring the total tax paid to $0.35. • If the foreign tax on a dollar earned abroad and remitted to the U.S. is greater than 35%, excess taxes paid will offset U.S. taxes owed.

47. Establishing a Worldwide Capital Structure (7) • Foreign subsidiary capital structure, continued • Leasing and taxes • Leasing an asset is economically equivalent to using borrowed funds to purchase the asset. • However, tax consequences of leasing versus borrowing vary. • E.g., an MNC is considering buying or leasing a new asset for use in the U.S. • Under current U.S. tax law, deductible interest expense is a function of the preexisting proportion of assets used abroad versus domestically. E.g., if 50% of all assets are in the U.S., 50% of the interest expense on the new equipment is deductible. • Regardless of the location of existing assets, 100% of lease payments is deductible. • Cost-minimizing approach to global capital structure • MNCs allow subsidiaries with access to low-cost capital markets to exceed the parent capitalization norm, while subsidiaries in higher-cost capital markets would have lower target debt ratios.

48. PostScript • Capital budgeting – the process ofselecting the prospective capital investments that maximize an MNC’s shareholder value. 2008 Financial Highlights: • Our portfolio includes 13 billion dollar brands. • Net operating revenues grew 11% to $31.9 billion. • More than 70% of our net operating revenues and more than 75% of our unit case volume were generated outside of North America.