Multinational Capital Budgeting

1. Multinational Capital Budgeting Chapter Fourteen Eitman, Stonehill, & Moffett Chapter 18 - Capital Budgeting

2. Relevant cash flowsIncremental cash flows • Book definition: The incremental cash flows for a project evaluation consist of any and all changes to the firm’s future cash flows that are a direct consequence of taking on the project. Chapter 18 - Capital Budgeting

3. Incremental Cash Flows • incremental Cash inflow • revenues generated specific to a project • incremental Cash outflow • direct costs accrued specific to a project • opportunity costs of foregone opportunities • sunk costs • cost already incurred, not incremental costs • Externalities (cannibalization Chapter 18 - Capital Budgeting

4. Capital expense - not included • Accountants count capital expenses • For capital budgeting one must deduct the actual cash flow when it occurs Chapter 18 - Capital Budgeting

5. Tax effects of capital expenses • CCA - capital cost allowances or Depreciation • these are capital expenses, not cash expenses • Since these affect Taxable income • deducted before taxes • added back in after taxes Chapter 18 - Capital Budgeting

6. Net Working Capital - included • Incremental change in CA • cash • accounts receivable to support additional sales • inventories • Input inventories • output inventories • Financed by an incremental change in CL • increase in payables (more input inventories) • increase in accruals (more labor) Chapter 18 - Capital Budgeting

7. Net Working Capital con’t • NWC = CA - CL must be financed through Debt or Equity • Change in NWC • at t = 0, negative CF, CA are obtained prior to production • at t = 1 . . ., negative or positive • negative added CA needed because or increased production • positive CA released because of reduced production • at t = T, NWC returned to the firm for use elsewhere Chapter 18 - Capital Budgeting

8. Opportunity Costs - included as foregone possibilities • cash flows from land or buildings which could be leased if not used • cost of a manager that must be hired to replace someone reallocated to the project Chapter 18 - Capital Budgeting

9. Sunk Costs - not included • costs already incurred • the cost of a feasibility study • cost of building already owned Chapter 18 - Capital Budgeting

10. Side Effects - externalities • try to include these, if possible • potential positive cash flows • marketing advantages of an existing network • salvage value of the of machines or plants • potential negative cash flows • pollution • adjust for potential effects of inflation Chapter 18 - Capital Budgeting

11. Example - assumptions • Project operating cash flows • 46,000 units will be sold first year • $5.20/unit • 15% growth in demand per year • 3-year project • COGS = 58% of sales • Administrative costs = $20,000 • CCA category 30% • Marginal tax rate = 40% • rw = 12.4% Chapter 18 - Capital Budgeting

12. Depreciation • 1st year’s CCA 50% of 30% of previous UCC • 2nd year’s CCA 30% of previous UCC Chapter 18 - Capital Budgeting

13. Earnings Before Interest & Taxes t1 t2 t3 Revenue 230,000 264,500 304,175 (COGS) (133,400) (153,410) (176,422) (Op costs) (20,000) (20,000) (20,000) (CCA) (17,250) (29,325) (20,528) EBIT 59,350 61,765 87,225 Chapter 18 - Capital Budgeting

14. Operating Cash Flows t1 t2 t3 EBIT 59,350 61,765 87,225 (Taxes) (23,740) (24,706) (34,890) CCA 17,250 29,325 20,528 Oper CF 52,860 66,380 72,863 Chapter 18 - Capital Budgeting

15. Working Capital requirements1st year Current Assets Current Liabilities Cash 2,600 Payables 3,150 Securities 0 Notes 1,500 Receivables 3,950 Labor Acc 2,250 Input Inv 2,880 Tax Acc 1,240 Output Inv 4,130 CA 13,560 CL 8,140 Chapter 18 - Capital Budgeting

16. Capital Expenditures • Investment cost = $115,000 • Purchase price • Installation cost • Salvage = $53,000 • UCC = $47,897 • Capital Gain = 5,103 • Tax = 5,103*0.7*0.4=$1,429 • Gain net of tax = $3,674 Chapter 18 - Capital Budgeting

17. Net Working Capital &Capital Spending Chapter 18 - Capital Budgeting

18. Total Cash Flows Chapter 18 - Capital Budgeting

19. Net Present Value Chapter 18 - Capital Budgeting

20. NPV – benefits • Adjusts for time value of money • Adjust for risk • wacc • Uses all incremental cash flows • Uses economically justified benchmark • All the investors in the firm receive their required rate of return • wacc Chapter 18 - Capital Budgeting

21. Cost cutting proposals • incremental CFs only • Cost of the upgrade • Cost savings from upgrade • Cost and installation = $35,000 • CCA rate 30% • Tax rate = 40% • r = 12.4% • Cost savings annually = $15,000 for 4 years • Salvage = $10,000 (70%) Chapter 18 - Capital Budgeting

22. Cost cutting proposals con’t t0 t1 t2 t3 t4 Savings 15,000 15,000 15,000 15,000 (CCA) (5,250) (8,925) (6,248) (4,373) Op Inc 9,750 6,075 8,752 10,627 (Tax) (3,900) (2,430) (3,501) (4,251) CCA 5,250 8,925 6,248 4,373 Salvage (35,000) 147 NCF (35,000) 11,100 12,570 11,499 10,896 Chapter 18 - Capital Budgeting

23. NPV cost cutting proposal Chapter 18 - Capital Budgeting

24. Incremental CFs • Cost cutting • Change to oper inc • Cost of new machine • Salvage • Replacing an asset • Salvage of old machine • Change to oper inc • Cost of new machine • Salvage of new machine • Start with operating income • Net of COGS, Operating Costs, taxes • CCAs have already been deducted before taxes • CCAs have already been added back after taxes Chapter 18 - Capital Budgeting

25. Complexities • Different tax laws • Regulatory environment • Market protection • Environmental regulation • Real exchange rate changes (operating & transaction exposure) • Net Present Value • Calculated in foreign currency terms • Calculated in home currency terms • Political risk • Nationalization • Capital controls (rules against repatriation of profits) • Sale and repatriation • Segmented capital markets • Affect weighted average cost of capital • Separability of capital budgeting and financing decisions Chapter 18 - Capital Budgeting