IBUS 302: International Finance

1. IBUS 302: International Finance Topic 20-International Capital Budgeting II Lawrence Schrenk, Instructor

2. Learning Objectives • Explain the conditions for using adjusted present value (APV).▪ • Calculate a basic APV problem. • Calculate an international APV problem.▪

3. Why APV?

4. Firm/Project Value • Firms create two sources of value: • Operating Value: What they ‘produce’ • Left-Hand Side of Balance Sheet • Financing Value: How they finance what they ‘produce’. • Right-Hand Side of Balance Sheet

5. NPV versus APV Strategy • NPV Strategy • Include the financing values, e.g., the tax advantages of debt, financial distress costs, by adjusting the discount rate. • That is, use the WACC as the discount rate. • APV Strategy • Separate the financing values, e.g., the tax advantages of debt, financial distress costs, into different calculations. • Value Additivity Model

6. NPV Flaws • Aggregates Operating and Financing Values • WACC • Estimation Problems • Book Values • Changes in WACC over Time • Sensitivity Analysis • Cannot always use the firm’s WACC for a project • Single Discount Rate • No Real Options

7. APV Solutions • Financing, etc. Valued Separately • No WACC • Multiple Discount Rates • Real Options

8. Why APV? • APV is better at: • Accurate Valuation of Financing Values • Providing Information on the Sources of Value • APV can include features NPV cannot: • Real Options • Changes in Capital Structure, e.g., LBO’s • Debt Repayment Schedule

9. APV Basics

10. Key Idea • Separate Valuation of… • A) Operating Cash Flows for Unlevered Firm • B) Other Value Components • Tax Advantages of Debt • Financial Distress • Subsidies • Hedges • Costs of Issuing Securities • Etc.

11. A) Operating Cash Flows for Unlevered Firm • Construct Annual OCF • Same procedure as in NPV • Discount with Cost of Equity • Estimation of the Cost of Equity • CAPM • Empirical Comparisons • Why is this easier and more accurate than WACC? • Find NPVOCF for OCF of Unlevered Firm

12. B) Other Value Components • These are ‘adjustments’ to the NPVOCF to account for other value changes. • Financing • Tax Advantages of Debt and Depreciation (+) • Financial Distress (-) • Hedges (+ hopefully ) • Other • Subsidies (+) • Real Options (+)

13. The APV Calculation APV = NPVOCF + PV(Tax Advantage) – PV(Financial Distress) + PV(Real Options) + … A B

14. Multiple Discount Rates • NPV/WACC has a single discount rate. • Everything is discounted at the ‘average’ rate • APV allows multiple rates: • Discount rates should reflect risk of individual cash flows • Do all cash flows have the same risk? • Are sales predictions as reliable as cost predictions?

15. A Simple Example • A firm is considering a new project which will cost $500,000 and generate $175,000 for four years. • The cost of equity for the firm is 12%. • The project will be funded by issuing $300,000 in debt at 8% and the rest from internal funds. • The issuance costs are 1.5% of the principal, and the corporate tax rate is 20%.

16. A Simple Example • Investment $500,000 • Annual Cash Flow $175,000 • Debt Issued $300,000 • Cost of Equity 12% • Cost of Debt 8% • Corporate Tax Rate 20% • Issuance Costs 1.5%

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26. A Simple Example • Such a simple example illustrates APV, but doesn’t really show its true value. • APV analysis does allow us to distinguish • The value of the project: $31,536 • The value of the financing: $11,398 • NPV calculation would obscure this. ▪ • Could APV be positive if the value of the project were negative? ▪

27. Second Example • What is the value if the debt must be repaid in equal installments over the first three years of the project? • NOTE: You could not value this with NPV. • The project leverage changes, • But WACC must be constant.

28. Second Example

29. International APV

30. Lessard Model • APV model for a multinational corporation analyzing a foreign capital expenditure. • This model incorporates many features that are distinctive to foreign direct investment. • Parent firm perspective

31. Lessard Model • The Full Equation

32. Lessard Model: OCF • Discounting Operating Cash Flows • Find after-tax OCF • Convert OCF to dollars • Discount at unlevered rate

33. Lessard Model: Depreciation • Discounting Depreciation Tax Shields • Find annual tax advantage • Convert CF to dollars • Discount at cost of debt

34. Lessard Model: Interest/Debt • Interest Tax Shields • Find annual tax advantage • Convert CF to dollars • Discount at cost of debt

35. Lessard Model: Terminal Value • Discounting Terminal Value • Convert OCF to Dollars • Discount at unlevered rate

36. Lessard Model: Investment and Restricted Funds • Investment: Convert to Dollars • Restricted Funds: Convert to Dollars

37. Lessard Model: Concessionary Loans • Concessionary Loan Principal: Convert to Dollars • Concessionary Loan Principal: Convert to Dollars and Discount

38. Estimating the Future Expected Exchange Rates We can apply PPP: Note: This is what we did in the NPV example.

39. Example • A project in Germany will generate €150,000 for three year and requires an investment of €400,000. • €300,000 of the investment is depreciable using straight line depreciation. • The project funding will include issuing €200,000 in debt.

40. Example • Cost of Equity 15% • Cost of Debt 11% • Corporate Tax Rate 35% • Dollar Inflation 6% • Euro Inflation 3% • Issuance Costs 2% • S($/€) 1.5544

41. Example: Spot Rates • Calculate expected spot rates using PPP

42. Example: NPVOCF

43. Example: Depreciation

44. Example: Debt

45. Example: APV