Chapter 14

1. Chapter 14 Capital Budgeting for the Multinational Corporation

2. NPV = -I0 + n  Xt t=1 (1 + k)t 14.A 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. Chapter 14: Capital Budgeting for the Multinational Corporation

3. 14.A 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. Chapter 14: Capital Budgeting for the Multinational Corporation

4. 14.A 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. • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

5. 14.A Capital Budgeting (5) • 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. • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

6. 14.A Capital Budgeting (6) • 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. • 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 postinvestment 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. Chapter 14: Capital Budgeting for the Multinational Corporation

7. 14.A Capital Budgeting (7) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

8. 14.B Discount Rates for Foreign Investments • 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. • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

9. 14.B.i Discount Rates for Foreign Investments:Cost of Equity Capital (1) • 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): 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) Chapter 14: Capital Budgeting for the Multinational Corporation

10. 14.B.i Discount Rates for Foreign Investments:Cost of Equity Capital (8) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

11. 14.B.i Discount Rates for Foreign Investments:Cost of Equity Capital (9) • 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. • Estimating proxy betas – 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. Chapter 14: Capital Budgeting for the Multinational Corporation

12. 14.B.i Discount Rates for Foreign Investments:Cost of Equity Capital (13) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

13. k0’ = (1 – L’)ke’ + Lkd’(1 – t) 14.B.iii Discount Rates for Foreign Investments:Weighted Average Cost of Capital (WACC) (1) • 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. • When project risk and capital structure differ from those of the parent, k0 = k0’. *This equation assumes a pretax kd. If kd is computed after taxes, as in the previous slide, we omit (1-t): k0 = (1 – L)ke + Lkd Chapter 14: Capital Budgeting for the Multinational Corporation

14. 14.B.iii Discount Rates for Foreign Investments:Weighted Average Cost of Capital (WACC) (2) • Example: Compute and compare 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% • The MNC’s foreign investment can support only 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% Chapter 14: Capital Budgeting for the Multinational Corporation

15. 14.C. 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. Chapter 14: Capital Budgeting for the Multinational Corporation

16. 14.C. 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. • Estimating incremental project cash flows • Subtract worldwide parent cash flows (without the investment) from postinvestment 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. Chapter 14: Capital Budgeting for the Multinational Corporation

17. 14.C. Issues in Foreign Investment Analysis (3) • 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 Chapter 14: Capital Budgeting for the Multinational Corporation

18. 14.C. 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 • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

19. 14.C. Issues in Foreign Investment Analysis (6) • 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. • First adjust cash flows for inflation and then convert the projected cash flows into dollars using the forecasted exchange rate. Chapter 14: Capital Budgeting for the Multinational Corporation

20. 14.C. Issues in Foreign Investment Analysis (7) • Exchange rate changes and inflation, continued • Alternative approach • Discount the nominal foreign currency cash flows at the nominal foreign currency required rate of return. • Convert the resulting foreign currency present value to the home currency using e0. • Both approaches should yield the same results. Chapter 14: Capital Budgeting for the Multinational Corporation

21. 14.D. 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%. Chapter 14: Capital Budgeting for the Multinational Corporation

22. 14.D. Establishing a Worldwide Capital Structure (4) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

23. 14.D. Establishing a Worldwide Capital Structure (5) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

24. 14.D. Establishing a Worldwide Capital Structure (6) • 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. Chapter 14: Capital Budgeting for the Multinational Corporation

25. 14.D. Establishing a Worldwide Capital Structure (7) • Joint ventures (JVs) • Debt raised by a joint venture may not be equivalent to parent-raised debt in terms of default risk. • Assessing the effects of leverage in a joint venture requires a qualitative analysis of the partner’s ties to the local financial community. • Conflicts may result if a JV is not isolated from a partner’s operations. • Each owner has an incentive to exploit the other through transfer pricing, royalty and licensing fees, and allocating production and markets among plants. • Lack of complete control leads most MNCs to guarantee JV loans only in proportion to their share of ownership. Chapter 14: Capital Budgeting for the Multinational Corporation