Chapter 18

1. Chapter 18 Multinational Capital Budgeting

2. Multinational Capital Budgeting • Extension of the domestic capital budgeting analysis to evaluate a Greenfield foreign project • Distinctions between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment • Adjusting the capital budgeting analysis of a foreign project for risk • Introduction of the use of real option analysis as a complement to DCF analysis in the evaluation of potential international investments

3. Multinational Capital Budgeting • Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects • Capital budgeting follows same framework as domestic budgeting • Identify initial capital invested or put at risk • Estimate cash inflows, including the terminal value or salvage value of the investment • Identify appropriate discount rate for NPV calculation • Determine the NPV and IRR

4. Complexities of 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 – this changes the meaning of NPV • Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as a stand alone a project may provide cash flows but overall may add no value to the entire organization • Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

5. Complexities of Budgeting for a Foreign Project • Non-financial payments can generate cash flows to parent in the form of licensing fees, royalty payments, etc. – relevant for parent’s perspective • Managers must anticipate differing rates of national inflation which can affect cash flows • Use of segmented national capital markets may create opportunity for financial gains 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

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

7. START Parent Firm (US) Foreign Investment US$ invested in overseas Particular investment END Is the project investment Justified (NPV > 0)? Estimated cash flows of project Parent Viewpoint Capital Budget (U.S. dollars) Project Viewpoint Capital Budget (Local Currency) Cash flows remitted to Parent (FC to US$) Project versus Parent Valuation

8. Project Assumptions • Financial assumptions • Capital Investment – cost to build a plant • Financing – depending on financing methods WACC should be calculated for both the project and parent • Revenues • Costs • Exchange rate assumption – parent’s cash flows are converted into home currency

9. Estimating Cash Flows from Project Viewpoint • Project Viewpoint Capital Budget • Estimate the free cash flows of the project by determining EBITDA and not EBT • Taxes are calculated based on this amount • Net Operating Cash Flow = Net Operating Profit After Tax • NOCF = NOPAT

10. Estimating Cash Flows from Project Viewpoint (Continued) • Project Viewpoint Capital Budget • Estimate and incorporate net working capital and capital spending • Free Cash Flow (FCF) = Net Operating Cash Flow – Changes in Net Working Capital – Changes in Fixed Assets

11. Estimating Cash Flows from Project Viewpoint (Continued) • Project Viewpoint Capital Budget • Terminal value is calculated for the continuing value of the project after the investment horizon • TV is calculated as a perpetual net operating cash flow after the investment horizon • All FCFs and Terminal Value is discounted using subsidiary WACC.

12. Parent Viewpoint • Parent Viewpoint Capital Budget • Cash flows estimates are constructed from parent’s viewpoint • Estimate individual cash flows to parent after adjusting for withholding taxes. These cash flows must be in parent firm’s currency • Use parent firm’s investment in subsidiary to determine NPV at parent’s WACC • Parent must now use it’s cost of capital and not the project’s • Parent may require an additional yield for international projects

13. Sensitivity Analysis • Project Valuation Sensitivity Analysis • Political risk – biggest risk is blocked funds or expropriation • Analysis should build in these scenarios and answer questions such as how, when, how much, etc. • Foreign exchange risk • Analysis should also consider appreciation or depreciation of the US dollar

14. Real Options • 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)

15. Real Options (Continued) • 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