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ifm euro disneyland case solution

ifm euro disneyland case solution

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231
CHAPTER 17CAPITAL BUDGETING FOR THE MULTINATIONALCORPORATION
This chapter focuses on three aspects of foreign investment analysis that are infrequently considered in evaluatingdomestic projects: the difference between project and parent cash flows; incorporating political risks such asexpropriation and currency controls; and factoring in inflation and exchange rate changes in cash flow estimates. It alsoevaluates the various methods used to incorporate in the investment analysis the additional risks encountered overseas.These points are brought out in the process of working through the International Diesel Corporation Case. The abilityto perform a capital budgeting analysis is one of the most valuable skills we can provide our students; this case isdesigned to make them aware of many of the intricacies involved in doing such an analysis. At the back of the chapterI have included a set of questions (2-13) that students should bear in mind while reading the case. Addressing thesequestions will help them to get more out of the case. I have found that a quick review of capital budgeting basics, givenin the first section, is useful for most students.The key point made in Appendix 17A is that a firm's exposure to political risk is a function of government actions andthe impact of those actions on the firm's cash flows. The corollary is that a firm can take actions, preferably beforemaking an investment, to reduce its susceptibility to political risk. Thus, much of political risk is firm-specific ratherthan county-specific. I discuss general principles as well as specific tactics that MNCs can use to reduce their politicalrisk exposure. A key point here is that a firm's political risk is not independent of the ways in which the firm isstructured and financed. The chapter illustrate the application of these principles and tactics by showing how AmericanMotors dealt with the risk it faced at its Jeep factory in Communist China and how Anaconda and Kennecott preparedfor the risk of having their Chilean copper mines expropriated by the government.Although several cases are available to give students experience in applying to actual numbers the analytical techniquespresented in this chapter, my favorite case remains "Ghana Fertilizers," in Raymond Vernon and Louis Wells,
 Manager in the International Economy
(Third edition), Prentice-Hall. It forces students to calculate cash flows, to analyzevarious political and economic risks, and to think in terms of the firm's overall strategy. Although quite old, this caseis a classic.
SUGGESTED ANSWERS TO CHAPTER 17 QUESTIONS
1.A foreign project that is profitable when valued on its own will always be profitable from the parent firm'sstandpoint. True or false. Explain.
A
NSWER
.
There are many reasons why project cash flows can diverge from the incremental cash flows accruing tothe parent. Therefore, the correct answer is false.2.What are the principal cash outflows associated with the IDC-U.K. project?
A
NSWER
.
The principal cash outflows associated with the IDC-U.K. project area)The initial investment outlay, consisting of the plant purchase, equipment expenditures, and working capitalrequirementsb)Operating expensesc)Later additions to working capital as sales expandd)Taxes paid on its net income.
 
232 INSTRUCTORS MANUAL:
FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT 
, 4THED.3.What are the principal cash inflows associated with the IDC-U.K. project?
A
NSWER
.
The principal cash inflows associated with the IDC-U.K. project includea)Cash inflows from sales in England and other EC countriesb)The tax shield provided by depreciation and interest chargesc)Interest subsidiesd)The terminal value of its investment, net of any capital gains taxes owed upon liquidation. This figure includesrecapture of working capital.4.In what ways do parent and project cash flows differ on the IDC- U.K. project? Why?
A
NSWER
.
Parent and project cash flows differ on the IDC-U.K. project in several ways:a)Funds remitted to IDC-U.S. may lead to additional taxes paid to England or the United States. These are cashoutflows from the view of IDC-U.S. but not IDC-U.K.b)IDC-U.S. owes tax to the U.S. Internal Revenue Service on gains associated with the sale for $5 million of equipment having a book value of zero.c)IDC-U.S. receives licensing and overhead allocation fees each year, for which it incurs no additional expenses.These fees are costs to IDC-U.K.d)IDC-U.S. also profits from exports to IDC-U.K.e)If sales of IDC-U.K. just substitute for exports from IDC-U.S., then IDC-U.K.'s profits are overstated by anamount equal to the incremental cash flow that IDC-U.S. would have earned on these lost exports.5.Suppose the real value of the pound declines. How would this decline likely affect the economics of the IDC-U.K.project?
A
NSWER
.
If the real value of the pound declines, the dollar value of revenues on sales in England will undoubtedlydecline. At the same time, however, dollar costs of production will also decline. The net effect on IDC-U.K. dependson what would have been done absent this project. If IDC-U.S. would have continued to service the U.K. market, thenany reduction in revenues from the pound devaluation is irrelevant since it would not be incremental from the project'sstandpoint. In this case, we are left with the cost reduction and the net impact of pound devaluation on the project isunambiguously positive. In contrast, if export sales would have ceased in the absence of the IDC-U.K. project, thenthe net impact of a pound devaluation must take into account both the revenue decline and the cost reduction. The netimpact depends critically on the price elasticity of demand. The odds are that the impact will be negative but onlyslightly. The reason for the word "slightly" is that dollar costs of production decline on 100% of IDC-U.K.'s output butsales of only half the output are affected by pound devaluation (the other half is sold to other EEC nations).6.Describe the alternative ways to treat the interest subsidy provided by the British government.
A
NSWER
.
The interest subsidy provided by the British government can be incorporated in the investment analysisin one of two ways:a)Employ a weighted cost of capital, where the interest rate used in this cost figure is the subsidized rate.b)Explicitly include the subsidy (equal to the difference between the market interest rate and the subsidized ratemultiplied by the subsidized principal amount) as one of the cash flows.
 
CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION2337.Suppose England raised its corporate tax rate by one percentage point. How would this affect the economics of the IDC-U.K. project?
A
NSWER
.
If the U.K. raised its corporate tax rate by one percentage point, the project's NPV would be minimallyaffected because IDC-U.S. can use all available foreign tax credits from IDC-U.K.8.Why are IDC-U.S. earnings on exports to IDC-U.K. credited to the project?
A
NSWER
.
IDC-U.S. earnings on exports to IDC-U.K. are credited to the project because these earnings would be lostwithout the project. This assumes that by next year, IDC-U.S. will be producing at capacity to supply the U.S. market.9.Why are loan repayments by IDC-U.K. to Lloyds and NEB treated as a cash inflow to the parent company?
A
NSWER
.
Loan repayments by IDC-U.K. to Lloyds and NEB are treated as cash inflows to the parent because theyreduce its outstanding consolidated debt burden and increase the value of its equity by an equivalent amount. Assumingthat the parent would repay these loans regardless, then having IDC-U.K. borrow and repay funds is equivalent toIDC-U.S. borrowing the money, investing it in IDC- U.K., and then using IDC-U.K.'s higher cash flows (since it nolonger has British loans to service) to repay IDC-U.S.'s debts.10.Under what circumstances should IDC-U.S. earnings on lost export sales to the United Kingdom and the rest of the Common Market countries be treated as a cost of the project?
A
NSWER
.
IDC-U.S. earnings on lost export sales to the U.K. and other EEC countries should be treated as a cost of the project if IDC-U.S. had sufficient excess capacity to have continued selling in the EEC in the absence of theIDC-U.K. project.11.Under what circumstances should these lost export earnings be ignored when evaluating the project?
A
NSWER
.
The lost export earnings should be ignored when evaluating the project if the sales would have been lostanyway because (1) IDC- U.S. no longer had sufficient capacity to service both the U.S. market and the Europeanmarket or (2) import restrictions would have kept out exports otherwise.12.How sensitive is the value of the project to the threat of currency controls and expropriation? How can thefinancing be structured to make the project less sensitive to these political risks?
A
NSWER
.
Figures in Exhibit 17.6 reveal that the value of IDC's English project is quite sensitive to the potentialpolitical risks of currency controls and expropriation. The project NPV does not turn positive until well after its fifthyear of operation (assuming there are no lost sales). Should expropriation occur or exchange controls be imposed atsome point during the first five years, the project is unlikely to ever be economically viable. In the face of these risks,the project is viable only if compensation is sufficiently great in the event of expropriation, or if unremitted funds canearn a return reflecting their opportunity cost to IDC-U.S., with eventual repatriation, in the event of exchange controls.The project can be made less sensitive to political risks by using pound financing. Pound cash flows from the projectcan be used to service these debts. By borrowing from British banks, IDC will also have fewer assets at risk in the eventof expropriation. In addition, the impact of potential currency controls can be minimized by setting high initial transferprices on the sale of components to IDC-U.K. by other units, by setting fees and royalties at a high initial level, and,to the extent possible, by investing parent funds as debt rather than equity.13.What options does investment in the new British diesel plant provide to IDC-U.S.? How can these options beaccounted for in the traditional capital budgeting analysis?

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