Prepared by Shafiq Jadallah

1. Chapter 16 Multinational Capital Budgeting Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

2. Chapter 16Multinational Capital Budgeting • Learning Objectives • Extend the domestic capital budgeting analysis to evaluate a Greenfield foreign project • Distinguish between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment • Adjust the capital budgeting analysis of a foreign project for risk • Introduce the use of real option analysis as a complement to DCF analysis in the evaluation of potential international investments

3. Multinational Capital Budgeting • Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects • Capital budgeting follows same framework as domestic budgeting • Identify initial capital invested or put at risk • Estimate cash inflows, including a terminal value or salvage value of investment • Identify appropriate discount rate for PV calculation • Apply traditional NPV or IRR analysis

4. Complexities of Budgeting for a Foreign Project • Several factors make budgeting for a foreign project more complex • Parent cash flows must be distinguished from project • Parent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing • Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as stand alone may provide cash flows but overall adds no value to entire organization • Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

5. Complexities of Budgeting for a Foreign Project • An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. • Managers must anticipate differing rates of national inflation which can affect differing cash flows • Use of segmented national capital markets may create opportunity for financial gain or additional costs • Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC • Managers must evaluate political risk • Terminal value is more difficult to estimate because potential purchasers have widely divergent views

6. Project versus Parent Valuation • Most firms evaluate foreign projects from both parent and project viewpoints • The parent’s viewpoint analyses investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments • The parent’s viewpoint gives results closer to traditional NPV capital budgeting analysis • Project valuation provides closer approximation of effect on consolidated EPS

7. Illustration: Cemex Goes Abroad • Cementos Mexicanos (Cemex) is considering construction of plant in Indonesia (Semen Indonesia) as a Greenfield project • Cemex is listed on both US and Mexican markets but most of its capital is US dollar denominated so evaluation of project is in US dollars

8. START Cementos Mexicanos (Mexico) Semen Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm END Is the project investment Justified (NPV > 0)? Estimated cash flows of project Parent viewpoint Capital Budget (U.S. dollars) Project Viewpoint Capital Budget (Indonesian rupiah) Cash flows remitted to Cemex (Rp to US$) Illustration: Cemex Goes Abroad

9. Illustration: Cemex Goes Abroad • Financial assumptions • Capital Investment – cost to build plant estimated at $150/tonne but Cemex believes it can build the plant at a cost of $110/tonne • Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is estimated at Rp22 trillion • With straight line depreciation on equipment values at Rp17.6 trillion costing 1.76 trillion per year

10. Illustration: Cemex Goes Abroad • Financial assumptions • Financing – plant would be financed with 50% equity (all from Cemex) and 50% debt • Debt is broken down, with Cemex providing 75% and a bank consortium providing the remaining 25% • Cemex’s WACC (in US dollars) is 11.98% • For the local project (in rupiah) the WACC is 33.257%

11. Illustration: Cemex Goes Abroad

12. Illustration: Cemex Goes Abroad • Financial assumptions • Revenues – sales are based on export and the plant will operate at 40% capacity producing 8 million tonnes per year • Cement will be sold in export market at $58/tonne • Costs – cost per ton is estimated at Rp115,000 in 1999 and rising at the rate of inflation (30%) per year • For export costs, loading costs of $2.00/tonne and shipping costs of $10/tonne must also be added

15. Illustration: Cemex Goes Abroad • Project Viewpoint Capital Budget • Semen Indonesia’s free cash flows are found by looking at EBITDA and not EBT • Taxes are calculated based on this amount • Terminal value is calculated for the continuing value of the plant after year 5 • TV is calculated as a perpetual net operating cash flow after year 5

16. Illustration: Cemex Goes Abroad

18. Illustration: Cemex Goes Abroad • Parent Viewpoint Capital Budget • Now cash flows estimates are constructed from parent’s viewpoint • Cemex must now use it’s cost of capital and not the project’s • Recall that Cemex’s WACC was 11.98% • However, Cemex requires an additional yield of 6% for international projects, thus the 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

20. Illustration: Cemex Goes Abroad • Project Valuation Sensitivity Analysis • Political risk – biggest risk is blocked funds or expropriation • Analysis should build in these scenarios and answer questions such as how, when, how much, etc. • Foreign exchange risk • Analysis should also consider appreciation or depreciation of the US dollar

21. Illustration: Cemex Goes Abroad • Real Option Analysis • DCF analysis cannot capture the value of the strategic options, yet real option analysis allows this valuation • Real option analysis includes the valuation of the project with future choices such as • The option to defer • The option to abandon • The option to alter capacity • The option to start up or shut down (switching)

22. Illustration: Cemex Goes Abroad • Real Option Analysis • 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

23. Summary of Learning Objectives • Parent cash flows must be distinguished from project cash flows. Each contributes to a different view of value • Parent cash flows often depend on the form of financing, thus cash flows cannot be clearly separated from financing decisions • Additional cash flows generated by new investments may be in part or wholly taken away from another foreign subsidiary – thus the net result may be negative or flat

24. Summary of Learning Objectives • Remittance of funds to the parent must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, and local business and capital market norms • Cash flows from subsidiaries to parent can be generated by an array of non-financial payments • Differing rates of national inflation must be anticipated because of their importance in causing changes in cash flows

25. Summary of Learning Objectives • A foreign project’s capital budgeting analysis should be adjusted for potential foreign exchange and political risks • Alternative methods are used for adjusting for risk, including adding an additional risk premium to the discount factor used, decreasing expected cash flows and conducting detailed sensitivity analysis • Real options is a different way of thinking about investment values – it is a cross between decision tree analysis and pure option valuation

26. Summary of Learning Objectives • Real option valuation also allows evaluation of the option to defer, to abandon, to alter capacity or the option of switching