AJAFIN 6605-09

International Capital Budgeting and Cost of Capital

Capital budgeting /investment appraisal is the process of
planning to determine whether a firm's long term investments
(new machinery, replacement machinery, new plants, new products,
and R&D projects) are worth pursuing.

An Outline:
(a) Inputs into a Capital Budgeting Decision
(b) Additional Factors in Multinational Capital Budgeting
(c) Adjusted Present Value Method
(d) Cost of Capital
(e) Exercises
1
A. Basics of Capital Budgeting
Inputs into the Capital Budgeting Decision
→ Initial investment
→ Consumer demand
→ Price
→ Variable cost
→ Fixed cost
→ Project lifetime
→ Salvage value
→ Tax-laws
→ Required rate of return - (WACC, CAPM, Dividend
Valuation Model)
2
Other Factors in "Multinational" Capital Budgeting
* Exchange rate fluctuations
* Relative inflation
* Financing arrangements - subsidies/penalties
* Blocked funds
* Remittance provisions
* Uncertain salvage values
* Impact of project on prevailing cash flows
* Government incentives
* Political risk / country risk
* Transfer prices
* Fees, royalties, etc.
* "Disaggregating" the cash flows and assigning applicable
discount rate for component flows. 3
Basics of Capital Budgeting
Popular Techniques
1 Payback Period: Is the length of time needed to recoup
the initial investment. This equals the length of time it
takes for cumulative nominal cash inflows to equal the
initial outlay. (Discus Discounted Payback Period)
2 Net Present Value: Is the expected value, in today's
dollars, after considering all costs, of cash flows from a
project.
n
C Ft
N P V = - I0 + ∑ t
t=1 (1 + k )

k = project’s cost of capital

n = the investment horizon
4
Weighted average cost of capital (WACC) is frequently
employed. This is given by:

 E   D 
WACC =   Ke +   K d (1- t)
 E + D  E + D
where:
E = Equity
D = Debt
t = Tax rate

Decision Rule: When NPV>0, accept the project.

When NPV<0, reject the project.
When two mutually exclusive projects each have positive NPV,
the project with the higher NPV should be selected.
5
3 Profitability Index (PI): Considers the ratio of present
value of a project's cash flows to its initial outlay.

n
CF t
∑
t=1 (1 + k )
t
PI =
I0
CFt = cash flow at time t
I0 = initial outlay
k = required rate of return (cost of capital)

Decision Rule: When PI>1, accept the project.

When PI<1, reject the project.
6
4 Internal Rate of Return (IRR): Is the rate of return that the
firm expects to earn on the project. Mathematically, it is
the "discount rate" that equates the present value of cash
flows to the initial outlay.
n
C Ft
∑t=1 (1 + IRR)t - I 0 = 0
Decision Rule: When IRR>required rate of return, accept project
When IRR<required rate of return, reject project

7
 5. Modified Internal Rate of Return (MIRR): This is given by:
PV Cost = PV of Terminal Value

k n n-t
COF t CIF t (1 + k )
∑
t=0 (1 + k )
t = ∑
t=1 (1 + MIRR )
n

TV
PV Cost = n
(1 + MIRR )
n n-t
TV C IFt (1 + k )
P V C ost=
(1 + M IR R)n
= ∑t=1 (1 + M IR R)n
C O F0 C O F1 C O F2 C O Fk C I F1 C I F2 C I F3 C I Fn
|--------
| --------
| ----------------
| ----------------
| -------
| --------
| -----------------
| ----------------------
I
0 1 2 k t t+ 1 t+ 2 n
where: C O F = cash outflows; C I F = cash inflows

8
 Incremental Cash Flows
✦ Shareholders wealth maximization is the primary
objective.
✦ Shareholders are interested in how many additional
dollars they will receive in the future for the dollars
invested today.
✦ Therefore, what matters is not the project’s cash flow
per period BUT the incremental cash flows generated
by the project.

9
Incremental and Total Cash Flows can Differ for Many Reasons:

Effects of sales from the (new) investment on other divisions:

✦ Cannibalization: New product taking away sales from the

firm's existing products, e.g., substituting foreign production
for parent company exports. (Honda’s Acura line of cars
attracted customers away from Accords)
✦ Sales Creation: New investment creates additional sales for
existing products. The benefits of additional sales (or lost
sales) and associated incremental (decreased) cash flows
should be attributed to the project.
Example: GM’s auto plants in Britain use parts made by its
US plants; Black & Decker’ investment in Europe resulted
in expanded exports to Europe.
10
 Other Considerations:
✦ Opportunity Costs: Project costs must include the true
economic cost of any resource required for the project -
already owned or just acquired.
✦ Sunk Costs: Cash outlay already incurred, and which
cannot be recovered regardless of whether project is
accepted or rejected, e.g., site analysis, feasibility
studies, etc. Exclude sunk costs from cost
considerations.
✦ Transfer Pricing: Prices at which goods and services
are traded internally can significantly distort the
profitability of a proposed investment.
As far as possible prices of project's inputs and outputs
should be market prices. 11
 Fees and Royalties:
✦ These are costs to the project but are benefits to the
parent, e.g., legal counsel, power, lighting, heat, rent,
R&D, H.O. cost, and management costs, etc.

✦ A project should be charged only for additional

expenditures that are attributable to the project.

✦ In general, incremental cash flows associated with an

investment can be found by subtracting worldwide
corporate cash flows without the new investment from
"with" the new investment cash flows.

12
 Intangible Benefits:
✦ Intangibles such as higher customer satisfaction,
better quality, faster time to market, superior order-
processing, valuable learning experience, broader
knowledge base, enhanced competitive skills, can
have a very tangible impact on corporate cash flows
despite the difficulty of measuring them precisely.

✦ Adapting to/adopting practices, products and

technologies encountered overseas can improve a
company’s competitive position worldwide.

13
 Foreign Complexities and Opportunities
Capital budgeting analysis for a foreign project is
considerably more complex than domestic case for a
number of reasons including:
✦ Parent Cash Flows Vs. Project Cash Flows: Parent cash flows
often depend on the form of financing - so that cash flows cannot
be clearly separated from financing decisions as is done in a
purely domestic capital budgeting.
✦ Remittance of funds to parent is compounded by different tax
systems, legal and political constraints on funds movement,
financial markets and institutions.
✦ Cash flows from affiliate to parent can be generated by an array
of operational or financial or non-financial payments, e.g., fees,
royalties, transfer pricing, etc. 14
✦ Different rates of national inflation introduce changes
in competitive position.
✦ Unanticipated changes in foreign exchange rates have
direct and indirect effects on costs, prices, and sales
volume.
✦ Transaction across segmented national markets may
create opportunities for financial gains or lead to
additional costs.
✦ Enhanced global service network.
✦ Diversification of production facilities.
✦ Market diversification. 15
✦ Availability of host government subsidized loans
complicate capital structure decisions and appropriate
WACC.
✦ Political risks must be evaluated, and costs may be
involved in the management of political risks.
✦ Salvage value is more difficult to estimate, i.e., more
uncertain salvage value.
✦ Foreign complexities must be "quantified" as
modifications to either expected cash flows or the
rate of discount.

16
 Adjusted PV Approach:
 The WACC as a discount rate is appropriate only if the
financial structures and commercial risks are similar for all
investments.
 Special concessionary loans are frequently associated with
foreign investments, so that their cost of capital may be
different from that of domestic projects.
 The WACC can be modified to reflect these deviations.
 Use the all equity rate, the rate which will apply if project were
financed entirely by equity.
This rate is based solely on the riskiness of the project’s
anticipated cash flows and abstracts from the effects of
financing.
 An all-equity cost of capital (K*), is the required rate of return
on a specific project, and equals to KRF + Risk Premium.
So, K* varies according to the risk of a specific project in a
portfolio context. 17
According to the CAPM,

K x = K RF+ β x( K m - K RF )
The market prices only systematic risks relative to the
market rather than total corporate risk.
Thus each project has its own required return and can be
evaluated regardless of the firms other present/prospective
investment.
This is the primary advantage of the CAPM, especially the
concept of value additivity which allows projects to be
considered independently.

18
 The Adjusted Present Value Technique
 This technique rests on the principle of value additivity,
i.e., the whole is equal to the sum of the parts.
 It is a "divide and conquer" strategy applied to complex
capital budgeting problems.
 It does not attempt to capture all effects in one
calculation. It divides up the PV terms and focuses on
each term to maximize the development and use of
information.
 Each PV term is assigned an appropriate discount rate
consistent with the level of systematic risk. Each cash
flow is adjusted according to its specific risk.
19
 The APV for a foreign project can be written as follows:

( e*t CF *t - L e*t )(1 - τ )

T T
DA tτ
APV = - e0 K 0 + e0 AF 0 + ∑ t
+ ∑ t
t=1 (1 + DR e ) t=1 (1 + DR a )
T
r g BC 0τ  T
LR  T TD
*
+∑ t
+ e0 CL 0 - ∑ t
t
+ ∑ t
t
t=1 (1 + DR b )  t =1 (1 + DR c )  t =1 (1 + DR d )
T *
+∑ RF t
t
+ PV (SV )
t=1 (1 + DR f )
where,
e0 = Spot exchange rate, period t = 0, d/f

et * = Expected spot rate, period t

K0 = Capital cost of project in foreign currency units

AF0 = Restricted funds activated by project

CFt* = Expected remittable cash flow in foreign currency units

20
 Let* = Profit attributed to lost sales, in dollars
t = Higher of U.S. and foreign corporate tax rates
T = Life of project
DAt = Depreciation allowances in dollar units.
Adjust if allowance is in local currency
BC0 = Contribution of project to borrowing capacity
in dollars, e.g. by altering the parent capital
structure
CL0 = Face value of concessionary loan in foreign
currency
RFt* = Expected indirect repatriation of income

21
LRt = Loan repayments on concessionary loan in
foreign currency

TDt* = Expected tax savings from deferrals, inter-

subsidiary transfer pricing

DRe = Discount rate for cash flows, assuming all-

equity financial
DRa = Discount rate for depreciation allowances

DRb = Discount rate for tax saving on interest deduction

from contribution to borrowing capacity
DRc = Discount rate for saving on concessionary
interest rate
22
 DRd = Discount rate for saving via inter-subsidiary
transfers
DRf = Discount rate for indirect repatriated project
flows
rg = Market borrowing rate at home
Examine each of the terms in APV
e0K0 = "Capital cost" of a project, denominated in
foreign currency and incurred in year zero only.
Hence converted at exchange rate e0.

e0AF0 = Capital cost is reduced by any blocked funds

activated by project. AF0 is face value of blocked funds
minus their value in the next best use.
23
 T
( e CF - L e )(1 - τ )
* * *

∑
t=1
i t

(1 + DRe ) t
i

where CFt* represents the expected legally remittable project

cash flows. We subtract the lost income from other facilities
that are replaced by the new investment. The cash flows are
adjusted for the effective tax rate - which is the higher of the
domestic and foreign corporate taxes. The discount rate is the
all-equity cost of capital that reflects all systematic risks.

DA t τ
T

∑
t=1 (1 + DR a )
t

24
Depreciation is allowed against corporate taxes for
projects located at home or abroad. This is the tax benefit
thereof. Adjust for exchange rate changes if DAt is in
local currency.
T
r g BC 0 τ
∑
t=1 (1 + DR b )
t

When debt is used to finance a project at home or

abroad, the interest payments are tax-deductible. Tax
savings on the amount that could be borrowed should be
calculated as a benefitT
 LRt 
e0 CL0 - ∑ t
t=1 (1 + DRc ) 
 25
The current value of a concessionary loan is the difference
between the face value of the loan and the PV of repayments on
the loan discounted at interest that would have been faced in
the absence of the concessionary loans. DRc is the discount rate
on concessionary loans. The term,
T *
TDi
∑
t=1 (1 + DR d )
t

represents expected savings from deferrals and transfer pricing.

T *
RF i
∑
t=1 (1 + DR f )
t

The cash flow CFi* is a conservative estimate, assuming that

royalties, fees, transfer pricing reflect their market values. A
MNC may manipulate transfer pricing or royalty payments to
repatriate more income. Extra remittances, or indirect cash
flows, can be included in the APV after direct cash flows have
been computed, hence the RFi* term is included. 26
 Selecting the Appropriate Discount Rates
 The systematic component of total risk is all what matters.
This risk requires a premium in the "discount rate" to reflect
a firm's level of risk.
 However, "additional" risks of doing business abroad are
mitigated by the "independence" of cash flows from foreign
project which results in lower variance of corporate cash
flows.
 Hence the applicable discount rate may be lower.
 Pooling of flows from different countries reduces business
risk. Therefore, MNC offer diversification benefits.
 Political and foreign exchange risks, like business risk, can be
diversified if a firm invests in a "portfolio" of securities of
different countries and denominated in different currencies 27
.
Treatment of inflation:
Recall that FE suggests that:

i≈ r + π
Consistency is needed in deciding which discount rate to use,
nominal or real.
The same conclusion is reached if we discount nominal cash
flows by nominal rates and real cash flows by real interest rate.

In the case of predetermined or contractual cash flows, we do

not have a choice between real and nominal discounts.
Contractual amounts are fixed in nominal terms and must be
discounted at the nominal rate.

28
Other Issues in Foreign Investment Analysis
Parent Vs. Project Cash Flows
 A substantial difference may exist between the cash
flows of a project and the amount that is remitted to
the parent (tax regulation and exchange controls)
 Given these differences, an important question is
which relevant cash flow is to be used in project
evaluation?
 According to economic theory, the value of a project is
determined by the net present value of future cash flows
back to the investor.
Therefore, parent company should value only those cash
flows that can be repatriated net of any transfer costs.
29
 Adjusting for additional economic and political risks
via cash flow or discount rate adjustment.
The value of a project is determined by the PV of future
cash flows to the investor.
MNC should value only those cash flows that are
or can be repatriated net of any transfer costs.

Shapiro recommends a three-stage analysis:

→ Compute project cash flows from the subsidiary's stand
point.
→ Shift to parent's perspective. Undertake a specific
forecast concerning the amounts, timing, and forms of
transfers to headquarters.
→ Finally account for indirect benefits and costs on the
rest of the system. 30
 Multinational Capital Budgeting Exercises.
See Problem Set II and Suggested Solutions.

31
 Political and Economic Risk Analysis:
 Confiscation: Government takeover without compensation.
 Expropriation: Government takeover with compensation.
 Nationalization: Conversion from private to public
(governmental) ownership - with (some) compensation.
 Others: Currency inconvertibility, wars, riots, revolutions,
coups, blocked funds, etc.
 Political and economic risks can be incorporated in a
number of ways, including:
a. Shortening the (minimum) payback period.
b. Raising the required rate of return.
c. Adjusting cash flows for the costs of risk reduction.
For example the premium for the purchase of loss
of investment insurance or overseas political risk
insurance…………. 32
 Sources of Insurance Include:
→ In the U.S.: Overseas Private Investment Corporation (OPIC)
insures U.S. private investments in underdeveloped countries.
Since 1980 OPIC has joined private insurance companies to
move the insurance into the private sector.
→ In Canada: Foreign investment insurance is provided by
Exports Development Corporation (EDC). Its role is similar to
OPIC of the U.S. It also offers insurance against non-payment
for Canadian exports - a function performed by the Export-
Import Bank in the U.S.
Similar programs exist in UK, Australia, Denmark, France,
Germany, Holland, Japan, Norway, Sweden, Switzerland.
→ MIGA - Multilateral Investment Guarantee Agency:
A subsidiary of the World Bank provides political insurance for
MNC with FDI in the developing countries. 33
 d. Adjusting cash flows to reflect specific impact of a
given non-systematic risk.

e. Using certainty equivalent in place of "expected"

cash flows.
 In general a theoretical point of view suggests that cash
flows should be adjusted to reflect the change in expected
values caused by a particular risk.
Discount rates should be adjusted only if the risk
is systematic.
 Certainty Equivalent Method:
Involves computing risk-adjusted cash flows and
discounting them at the risk-free rate. 34
B. The Cost of Capital For Foreign Investments
 Knowledge of appropriate cost of capital is crucial for
making foreign investment decisions.
 The question to be confronted is whether the required
rate of return is higher, lower, or the same for foreign
investments as for domestic investments.

35
 Definition: Cost of capital for a given investment is the
minimum risk-adjusted return required by shareholders of the
firm for undertaking that investment.
It is the basic measure of
financial performance.

→ The emphasis here is on cost of capital or required rate of

return for a specific project (foreign) rather than for the
firm as a whole.
→ The use of a single overall cost of capital for all projects
is incorrect unless financial structures and commercial
risks are similar for all projects.
→ The overall cost of capital is useful in valuing the firm as
it currently exists. 36
 Cost of Equity Capital:
→ Isthe minimum rate of return necessary to induce
investors to buy or hold the firm's stock.
→ Is also the rate used to capitalize total corporate cash
flows, hence it is equal to the weighted average cost
of capital (WACC).
Thus the cost of equity capital can be used to set a
price on equity shares in the firm.
It cannot, however, be used to measure the
required rate of return on equity investments in future
projects unless these are of similar nature to the
average of those already being undertaken.
37
The CAPM provides an approach for determining project-
specific required rate of return on equity.
According to CAPM, equilibrium relation exists between an
asset's return and its associated risk, as follows:

Ki = K R F + β i [ K m - K R F ]
where
Ki = equilibrium expected return on asset i.
KRF = risk-free rate (30 day U.S. government T-bill).
Km = expected return on market portfolio.
bi = cov(Ki, Km)/σ2Km = systematic risk.

38
In practice, a market proxy, such as the NYSE index
is used for Km.
Note that only systematic risk is
rewarded with a risk premium.
The risk premium on
the market equals (Km- Krf), while the risk premium on
asset i, is equal to:

β i [ K m - K RF ]

39
✦ Problems with the CAPM:
- Identifying the relevant market portfolio.
- Estimating project betas (bi).
- Do investors differentiate between systematic and
non-systematic risk?
✦ Dividend Valuation Model provides a check on CAPM-derived
required rate of return for the firm as a whole.
From the Gordon model

D1
Ke = + g
P0
Where: Ke = cost of equity capital.
P0 = current stock price.
D1 = expected dividend in year 1.
g = dividend growth rate. 40
 This dividend capitalization model (traditional approach)
assumes that the required return on equity is
determined by the market's preference for tradeoff
between risk and return.
Risk is typically measured by
standard deviation, σ , of stock returns or coefficient
of variation CV = σ /m (std dev/mean) of returns.
 The dividend growth rate can be estimated using
historical data or expectations of future earnings.
 This estimate of required rate of return is not
applicable to project-specific required rate of returns
where the project characteristic diverges from the
corporate norm.
41
The WACC for Foreign Projects:
In practice, the required return on equity for a
particular investment assumes that the financial
structure and risk of the project is similar to that of the
firm as a whole, Hence:
E D
WACC = K w = Ke + K d (1 - t)
D+ E D+ E
This yields a WACC for the parent and the project.
However, both project risk and project financial
structure can vary from the corporate norm.
It is therefore necessary to adjust the various costs
and weights to reflect their actual values.
42
 The All-Equity Cost of Capital for Foreign Projects:
An alternative to WACC, is to use an all-equity discount rate
K*. This is based strictly on anticipated project cash flows,
abstracting from project's financial structure.
K
*
= K RF + β ( K m - K RF )
*

β* = all equity beta, i.e., the beta associated with the

unleveraged cash flows.
Example: If a foreign firm has a β* of 1.15, and
K RF=13%; K m=21%, then:
K * = .13 + 1.15(.21 - .13) = 22.2%
It is difficult to estimate β*
in reality.
A possible estimate is by reference to βe from CAPM:

K e = K RF + βe ( K m - K RF )
43
To transfor
β* =
βe

of debt fina
[1 + (1 - t)D / E ]

44
 Discount Rate for Foreign Investments:
→ Should MNCs demand increased or decreased returns on foreign
projects?
→ Corporate diversification should be beneficial to shareholders -
especially where there are barriers to international portfolio
diversification.
→ Investors may be willing to pay a premium price for the shares of
MNCs or accept lower rate of return on them to the extent to
which MNCs can provide low-cost international diversification. It
is therefore possible that the risk premium applied to foreign
projects may be lower than for domestic ones and the required rate
of return lower than for domestic cases.
→ Developing economies are more segmented, or less correlated
with USA economy than other industrial countries.
Projects in developing economies may therefore carry a lower
required rate of return than the ones in USA or Japan. 45
 Growth Options and Project Evaluation
 The discounted cash flow analysis treats a project’s
cash flows as given at the outset. It is a static
approach to investment decision making.
 In reality, the opportunity to make decisions
contingent upon available future information is an
essential feature of many investment decisions.
 The opportunity a firm may have to invest capital to
increase the profitability of existing product lines and
benefit from expanding into new products or markets
may be viewed as “growth options”
46
 A firm’s ability to capitalize on its managerial talents,
experience in a particular product line, brand name,
technology, or its other resources may provide
valuable but uncertain future prospects, a growth
option.
 Many strategically important investments such as
R&D, factory automation, brand name, distribution
network, etc, provide growth opportunities because
they are often only the first link in a chain of future
investment decisions.
 Valuation of investments that incorporate
discretionary follow-up projects requires an expanded
net present value rule that considers the attendant
options. 47
 Valuing Growth Options Depends on:
 The length of time a project can be deferred.
A project that can be deferred gives the firm more
time to examine the course of future events and avoid
costly errors, and raises the odds that a positive turn
of events will boost the project’s profitability.
 The risk of the project. The riskier the investment
the more valuable is an option on it.
 The level of interest rates.
A high discount rate lowers the present value of the
cash outlay needed to exercise the option
48
 Proprietary nature of the option.
An exclusively owned option is more valuable than
one that is shared with others.
 An options pricing model may be used to evaluate
options associated with a new project.

49
 The Relevant Market Portfolio:
 A systematic risk in the "domestic" market context may be
diversifiable in the context of a "global" market.
 The appropriate market portfolio to be used depends on the
manager's view of world capital markets.
Are capital markets globally integrated or not?
Commonly used proxies for "global" market portfolio include:
· World market index - capitalization weighted
- price weighted
- equally weighted
· U.S. market index - DJIA
- S&P500
· Japanese market index - Nikkei 225
- TOPIX Index
· UK market index - FTSE 100 50