Multinational Capital Budgeting (or parts of chapter 16)

1. Multinational Capital Budgeting (or parts of chapter 16)

2. Agenda • Multinational capital budgeting. • Project vs. parent capital budgeting? • Adjust capital budgeting analysis of foreign project for risk. • Case study: evaluate a greenfield foreign project • Real option analysis vs. DCF analysis.

3. Multinational Capital Budgeting • Analysis of cash in- & out- flows associated w/ prospective long-term investment projects. • Follows same steps as domestic budgeting: • Identify initial capital invested at risk. • Estimate cash flows over time (including terminal value/ salvage value). • Identify appropriate discount rate for PV. • Apply traditional NPV or IRR analysis.

4. Capital Budgeting for foreign projects • Parent cash flows must be distinguished from project’s. • Parent cash flows often depend on form of financing => cannot separate operating & financing cash flows. • Stand alone subsidiary cash-flow can be worth, but add no value overall. • Non-financial payments can generate cash flows to parent, e.g. licensing fees. • Need to evaluate political risk, forex risk & differing inflation rates. • Segmented national capital markets create financial gain /costs. • Host government subsidies complicates WACC computation.

5. Project vs. Parent Valuation? • Most firms evaluate foreign projects from both parent & project viewpoints. • Rule of thumb: parent valuation shall have priority. • MNE shall invest only if it can earn a risk-adjusted return greater than local competitors. • Project valuation provides closer approximation of effect on consolidated EPS • US firms consolidate subsidiaries w/ 50%+ ownership/ • If ownership b/n 20% & 49% (I.e. affiliate) => consolidate on pro-rate basis. • Subsidiaries w/ <20% ownership considered unconsolidated investment.

6. Case Study: Cemex in Indonesia • Cementos Mexicanos (Cemex) considers greenfieldinvestment in Indonesia plant (Cemex Indonesia) • Presence in Southeast Asia. • Strong prospects for infrastructure growth. • Benefit from depreciation of Indonesian Rupiah (RP) • Cemex functional currency: US$. • Time to build: 1 year • Inflation rates: 30% (Indonesia), 3% (US) • Notice that we use the US inflation, not Mexico’s one!

7. START Cementos Mexicanos (Mexico) Semex Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm END Is project investment justified (NPV > 0)? Estimated cash flows of project Parent viewpoint Capital Budget (U.S. $) Project Viewpoint Capital Budget (Indonesian rupiah) Cash flows remitted to Cemex (RP -> US$)

8. Step I: Cost of Capital Computation

9. Debt Service &Forex Gain/Loss

10. Income Statement Assumptions • Revenues • Sales based on export. • Cement will be sold in export market at $58/ton. • Costs • Direct cost RP 115,000/ton & rising @ rate of inflation (30% p.a.). • Additional production cost of RP20,000/ton & rising @ rate of inflation (30% p.a.). • Loading costs $2.00/ton rising @ inflation (3% p.a.). • Shipping costs $10/ton rising @ inflation (3% p.a.). • License fee: 2% sales • Sales, General, & Admin Expenses: 8%(growing @ 1% p.a.)

11. Pro-forma Income Statement

12. Project Viewpoint Capital Budget • Cemex Indonesia free cash flows found by looking @ EBITDA, not EBT! • Taxes calculated based on EBITDA. • Terminal value (TV) calculated for continuing value of plant after year # 5. • TV calculated as perpetual net operating cash flow after year 5:

13. Capital Budget: Project Viewpoint

14. Parent Viewpoint Capital Budget • Cash flows estimates are constructed from parent’s viewpoint • Cemex must use its cost of capital, not project’s one! • Cemex WACC 11.98% • Cemex requires additional 6% for international projects => discount rate will be 17.98% • This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint

15. Capital Budget: Parent Viewpoint

16. Sensitivity Analysis • Political risk • Risk of blocked funds. • Risk of expropriation. • Foreign exchange risk • appreciation of US $. • depreciation of US $.

17. Real Option Analysis • DCF analysis cannot capture value of strategic options, yet real option analysis allows this valuation • Real option analysis includes valuation of project w/ future choices: • option to defer or abandon (timing option). • option to alter capacity (expansion options). • option to start up/ shut down (switching). • option to learn. • 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

18. Things to remember… • Multinational capital budgeting. • Project vs. parent capital budgeting? • Adjust capital budgeting analysis of foreign project for risk. • Case study: evaluate a greenfield foreign project • Real option analysis vs. DCF analysis.