Multinational Capital Budgeting

1. Multinational Capital Budgeting • I. Capital Budgeting: An overview • II. Capital Budgeting for Foreign Projects • - Two methods • - Foreign Complexities • - Parent vs project valuations

2. I. Capital Budgeting: An overview • Capital Budget: planned expenditures on fixed assets • The capital budgeting process: • - identify the expected future cashflows generated by the investment • incremental cash flows • opportunity costs • - identify the discount rate appropriate for the risk of the cash flow • - Discount the expected future cash flows at the risk-adjusted discount rate • (other decision rules include: IRR, Payback, PI etc) • Decision Rules: • Payback ==> the lower the payback period the better • NPV ==> accept if NPV > 0 • IRR ==> accept if IRR > risk adjusted K • Note: Discount cash flows in a particular currency at discount rate in that currency • Discount nominal cash flows at a nominal discount rate • Discount real cash flows at a real discount rate • Discount before-tax cash flows at a before-tax discount rate • Discount cash flows to equity at an equity discount rate • Discount cash flows to debt at the cost of debt etc

3. II. Capital Budgeting for Foreign Projects • Uses same framework as domestic capital budgeting • Unique features include • cash flows to the parent may differ from project cash flows • legal and regulatory constraints on remittances • additional (unique) risk • foreign exchange risk • political risk • Two methods • discount foreign currency cash flows at foreign discount rate, and convert at spot rate • discount domestic cash flows (after converting at future spot) at domestic discount rate • If (1) capital markets are perfect (e.g. no barriers to capital flows from subsidiary to parent, (2) symmetric (taxes and investor preferences identical), and (3) parity conditions hold, project value in the two methods would be identical. • Otherwise, parent valuation of a project may differ from subsidiary’s valuation of the project.

4. II. Capital Budgeting for Foreign Projects cont’d • Parent Valuation vs Project Valuation • difference in valuation may arise from: • - Disequibrium in financial markets (violation of parity): • e.g. lack of forward and Eurocurrency markets, persistent deviations from PPP • - financial market imperfections • e.g. restriction on repatriation of cashflows , asymmetric taxes etc • Valuation Differences due to disequilibriums in financial markets Parent’s perspective in domestic currency d NPV0d < 0 NPV0d > 0 Look for better projects in the foreign currency Reject Project’s perspective in the foreign currency NPV0f < 0 Lock in the local value in the foreign currency Accept NPV0f > 0

5. II. Capital Budgeting for Foreign Projects cont’d • Positive NPV for Parent but Negative NPV for Project: • + NPV may be due to expected real appreciation in currency ( also restriction in repatriation) • Accepting the project same as speculating in foreign exchange • Look for +NPV project in the foreign currency • If not invest in local gov’t bond - Zero NPV plus allows to capture speculative gain • Positive NPV for Project but Negative NPV for the parent: • Accept project and lock in the + NPV somehow • finance through local borrowing • sell to local investor and convert the proceeds today • joint venture at terms advantageous to parent • Positive NPV to project and parent: • Parent NPV > Project NPV • additional value due to expected real appreciation in foreign currency • parent may speculate by leaving position unhedged • Parent NPV < Project NPV • parent accepts the project, and should hedge against currency risk • or try to capture the additional value in foreign currency, realize it today in domestic currency

6. II. Capital Budgeting for Foreign Projectscont’d Valuation differences from ‘market imperfections’ • restrictions on cash flow repatriations • subsidized financing • negative-NPV tie-in projects • tax holidays • treated as side effects and valued separately VPROJECT WITH SIDE EFFECT = VPROJECT WITHOUT SIDE EFFECT + VSIDE EFFECT • help in negotiating environment with host gov’t prior to investment • e.g. tax holidays may reduce value for long-term projects with early losses - effect of tax-loss carryforwards

7. II. Capital Budgeting for Foreign Projectscont’d • - “country risk” and Foreign Investment • Risk Adjustments • Risk types: • - Business and Financial Risk • - Foreign Risk • - foreign exchange risk • - political risk • Two Methods: • - Adjusting Discount Rate • - Adjusting Cash Flows

8. II. Capital Budgeting for Foreign Projectscont’d • Adjusting Discount Rate: • increase discount rate applicable to foreign projects • Problems • Does not penalize NPV in proportion to risk • e.g. Political Risk • affects entire investment (not just annual cash flows) • adverse effect may occur in more distant future • e.g. Foreign Exchange Risk • change in foreign exchange could be advantageous • Foreign Risks are diversifiable • Most political risks are country-specific - from shareholder’s perspective, diversifiable in large portfolio; • (caution: managers may not be as diversified - total risk matters) • Adjusting cash flows • foreign exchange risk and political risk incorporated as adjustments in forecasted cash flows • discount rate adjusted only for business and financial risk