Multinational Finance

1. 1 Multinational Finance Adrian Buckley Fifth Edition Chapter 22, 23 The International Capital Budgeting Model

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3. 3 A Decision Criterion for the Long Run PV is the "present value" of an expected future income stream, V is a predicted future net income (or return) in each of n future periods. The decision criterion: The rate of return, r, is at least as great as the best market interest rate, i, or r = i. Payback: If r is the internal rate of return and K is the capital outlay required to implement the investment opportunity.

4. 4 Example: investment decision criterion: r =i where i =8% Table1. Hypothetical investment opportunities and rates of return Figure1. The marginal efficiency of capital.

5. 5 MNCs have more complexities comparing to domestic capital projects 2 steps to evaluate an oversees subsidiary project return: The project cash flow evaluated at local currency using NPV Cash flow accruing to parent company using NPV: the present value of remittable cash flow

6. 6 International Project appraisal Given exchange control, remittable parent cash flows may be achieved by: Dividend repatriation; royalties and management fees; loan repayment; countertrades; other means of unblocking, e.g., swaps, currency invoicing, parallel loans, etc.

7. 7 The income statement format for calculating operating cash inflows is: Revenue - Expenses (Excluding Depreciation) = Profits Before Depreciation and Taxes - Depreciation = Net Profits Before Taxes - Taxes = Net Profits After Taxes + Depreciation = Operating Cash Inflows Finding the Operating Cash Inflows

8. 8 Interpreting the Cash Flows: NPV n NPV = ?? i=1 = Present Value of Cash Inflows - Initial Investment

9. 9 Internal Rate of Return Internal Rate of Return (IRR) is the rate of return earned by a project's discounted cash inflows, i.e., the discount rate makes the NPV equal $0 Notes: IRR has the same idea as computing the yield-to-maturity of a bond The higher the IRR, the more attractive the project

10. 10 IRR is calculated by solving: n ? t = 1 PV of Cash Inflows = Initial Investment The Internal rate of return is the rate of return that equalize the present value of the project to the investment outlay (II).

11. 11 Adjusted Present Value in International Capital Budgeting APV = - Initial costs + Present value of op. cash flows + Present value of tax shield What rate should be used to discount cash flows in APV?

12. 12 Rules on Taxation Foreign tax is deducted, no double tax Withholding tax is paid when repatriating profit Home country tax is deducted plus foreign tax credit ( to avoid double taxation). See the example in chapter 22. Net of tax profit flow is finally achieved

13. 13 Risk Adjustment Techniques Certainty Equivalents (CE's) adjust cash inflows to determine the percentage of estimated inflows that investors would be satisfied to receive for certain in exchange for those that are possible each year NPV when CE's are used is calculated as: n NPV = ? = - I I t =1 (1 + RF)t ?t = Certainty Equivalent factor in year t (0 < ?t < 1) CFt = Relevant cash inflow in year t RF = Risk-free rate of return

14. 14 Risk-Adjustment Techniques Risk-Adjusted Discount Rates (RADR's) adjust for risk by changing the discount rate -- raising it for higher risk and lowering it for lower risk RADR's are calculated as n NPV = ?? t =1 The use of RADRs is closely linked to the capital asset pricing model (CAPM)

15. 15 RADR and CAPM Recall that total risk = non-diversifiable risk + diversifiable risk Beta is a measure of non-diversifiable risk and Rj = RF + ?j (Rm-R F) (CAPM) If we assume that real corporate assets are traded in efficient markets, CAPM can be modified as follows: RProject j = RF + ?j Project (Rm-RF) where: ?j Project is the relationship between the project's expected return and the market's expected return

16. 16 RADR and CAPM

17. 17 Applying RADRs Since real corporate assets are not traded in an efficient market, total risk must be considered The firm must develop a market risk-return function depicting discount rates associated with various levels of project risk RADR is a function of the risk-free rate plus a risk premium, which is the amount by which a project's required discount rate exceeds the risk-free rate.

18. 18 Analysis of Polar’s Projects A and B using Risk-Adjusted Discount Rates

19. 19 Risk Classes and RADR’s

20. 20 Application: Pertamina Pertamina is considering expanding its oil drilling operations. Under consideration is a new platform rig requiring an initial investment of $12,000,000. The new rig will produce incremental net cash inflows of $2,750,000 per year over the 15-year useful life of the rig. Pertamina requires a 25% return (after tax) on all investments of the type due to the riskiness of the operations. Should Pertamina purchase the new rig? Determine NPV of Project NPV = $2,750,000 x (PVIFA25%,15) - $12,000,000 = [$2,750,000 x (3.859)] - $12,000,000 = $10,612,250 - $12,000,000 = ($1,387,750) Thus reject the project

21. 21 Risk-Adjusted Investment Cutoff Rates COUNTRY CUTOFF RATE ARGENTINA 17% AUSTRALIA 10 BELGIUM 10 BRAZIL 14 CANADA 10 FRANCE 12 GERMANY 10 GREECE 17 INDIA 20 INDONESIA 17 ITALY 14 JAPAN 14 MALAYSIA 12 MEXICO 17

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