INTERNATIONAL

FINANCIAL
MANAGEMENT
EUN / RESNICK
Fifth Edition
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
EUN / RESNICK
Fifth Edition

Chapter Objective:
This chapter discusses the methodology that a
multinational firm can use to analyze the
investment of capital in a foreign country.

18
Chapter Eighteen
International Capital
Budgeting
18-1
Chapter Outline
Review of Domestic Capital Budgeting
The Adjusted Present Value Model
Capital Budgeting from the Parent Firms
Perspective
Risk Adjustment in the Capital Budgeting Process
Sensitivity Analysis
Real Options
18-2
Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows
on a time line.

2. Identify the RISKINESS of the cash flows to determine the
appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate
discount rate.

4. Compare the value of competing cash flow streams at the
same point in time.
18-3
Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows
on a time line.

2. Identify the RISKINESS of the cash flows to determine the
appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate
discount rate.

4. Compare the value of competing cash flow streams at the
same point in time.
18-4
Review of Domestic Capital Budgeting
The basic net present value equation is
0
1
) 1 ( ) 1 (
C
K
TV
K
CF
NPV
T
T
T
t
t
t

+
+
+
=

=
Where:
CF
t
= expected incremental after-tax cash flow in year t,
TV
T
= expected after tax terminal value including return of
net working capital,
C
0
= initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
18-5
Review of Domestic Capital Budgeting
The NPV rule is to accept a project if NPV > 0
0
) 1 ( ) 1 (
0
1
>
+
+
+
=

=
C
K
TV
K
CF
NPV
T
T
T
t
t
t
and to reject a project if NPV s 0
. 0
) 1 ( ) 1 (
0
1
s
+
+
+
=

=
C
K
TV
K
CF
NPV
T
T
T
t
t
t
18-6
Review of Domestic Capital Budgeting
For our purposes it is necessary to expand the NPV
equation.
R
t
is incremental revenue
OC
t
is incremental operating
cash flow
D
t
is incremental depreciation
I
t
is incremental interest
expense
t is the marginal tax rate
CF
t
= (R
t
OC
t
D
t
I
t
)(1 t) + D
t
+ I
t
(1 t)
18-7
Alternative Formulations CF
t

CF
t
= (R
t
OC
t
D
t
I
t
)(1 t) + D
t
+ I
t
(1 t)
CF
t
= NI
t
+ D
t
+ I
t
(1 t)
CF
t
= (R
t
OC
t
D
t
) (1 t) + D
t

CF
t
= (NOI
t
)(1 t) + D
t

CF
t
= (R
t
OC
t
)(1 t) + t D
t

CF
t
= (OCF
t
)(1 t) + t D
t

18-8
Review of Domestic Capital Budgeting
We can use CF
t
= (OCF
t
)(1 t) + t D
t

to restate the NPV equation
as:
NPV =
E
t = 1
T
CF
t

(1 + K)
t
C
0
TV
T

(1 + K)
T
+

NPV =
E
t = 1
T
(OCF
t
)(1 t) + t D
t
(1 + K)
t
C
0
TV
T

(1 + K)
T
+

18-9
The Adjusted Present Value Model
Can be converted to adjusted present value (APV)
By appealing to Modigliani and Millers results.
NPV =
E
t = 1
T
(OCF
t
)(1 t)

(1 + K)
t
C
0
TV
T

(1 + K)
T
+

t D
t
(1 + K)
t
+

E
t = 1
T
APV =
E
t = 1
T
(OCF
t
)(1 t)

(1 + K
u
)
t
C
0
TV
T

(1 + K
u
)
T
+

t D
t
(1 + i)
t
+

t I
t
(1 + i)
t
+

18-10
The Adjusted Present Value Model
The APV model is a value additivity approach to
capital budgeting. Each cash flow that is a source
of value to the firm is considered individually.
Note that with the APV model, each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.
APV =
E
t = 1
T
(OCF
t
)(1 t)

(1 + K
u
)
t
C
0
TV
T

(1 + K
u
)
T
+

t D
t
(1 + i)
t
+

t I
t
(1 + i)
t
+

18-11
Domestic APV Example
Consider this project, the timing and size of the incremental
after-tax cash flows for an all-equity firm are:
0 1 2 3 4
-$1,000 $125 $250 $375 $500
The unlevered cost of equity is r
0
= 10%:
The project would be rejected by
an all-equity firm:
CF
0
= $1000
CF
1
= $125
CF
2
= $250
CF
3
= $500
I = 10
NPV = $56.50
18-12
Domestic APV Example (continued)
Now, imagine that the firm finances the project with
$600 of debt at r = 8%.
The tax rate is 40%, so they have an interest tax
shield worth tI = .40$600.08 = $19.20 each
year.
18-13
APV =
$125

1.10

0 1 2 3 4
-$1,000 $125 $250 $375 $500
+

$250

(1.10)
2
+

$375

(1.10)
3
+

$500

(1.10)
4
+

$19.20
(1.08)
2
+

$19.20
(1.08)
3
+

$19.20
(1.08)
4
$19.20

1.08

+

$1,000

APV = $7.09

The APV of the project under leverage is:
The firm should accept the project if it finances with debt.
APV =
E
t = 1
T
(OCF
t
)(1 t)

(1 + K
u
)
t
C
0
TV
T

(1 + K
u
)
T
+

t D
t
(1 + i)
t
+

t I
t
(1 + i)
t
+

18-14
Capital Budgeting from the Parent
Firms Perspective
The APV model is useful for a domestic firm
analyzing a domestic capital expenditure or for a
foreign subsidiary of a MNC analyzing a proposed
capital expenditure from the subsidiarys viewpoint.
The APV model is NOT useful for a MNC in
analyzing a foreign capital expenditure from the
parent firms perspective.
APV =
E
t = 1
T
(OCF
t
)(1 t)

(1 + K
u
)
t
C
0
TV
T

(1 + K
u
)
T
+

t D
t
(1 + i)
t
+

t I
t
(1 + i)
t
+

18-15
Capital Budgeting from the Parent
Firms Perspective
Donald Lessard developed an APV model for a
MNC analyzing a foreign capital expenditure. The
model recognizes many of the particulars peculiar to
foreign direct investment.

=
= = =
+
+ +
+
+
+
+
+
+
+

=
T
t
t
d
t t
T
ud
T T
T
t
t
d
t t
T
t
t
d
t t
T
t
t
ud
t t
i
LP S
CL S RF S C S
K
TV S
i
I S
i
D S
K
OCF S
APV
1
0 0 0 0 0 0
1 1 1
) 1 ( ) 1 (
) 1 ( ) 1 ( ) 1 (
) 1 (
18-16
APV Model of Capital Budgeting from the
Parent Firms Perspective
APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-17
Capital Budgeting from the Parent
Firms Perspective
The operating cash flows must
be translated back into the
parent firms currency at the
spot rate expected to prevail
in each period.
The operating cash flows
must be discounted at the
unlevered domestic rate
APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-18
Capital Budgeting from the Parent
Firms Perspective
OCF
t
represents only the
portion of operating cash flows
available for remittance that
can be legally remitted to the
parent firm.
The marginal corporate tax
rate, t, is the larger of the
parents or foreign
subsidiarys.
APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-19
Capital Budgeting from the Parent
Firms Perspective
S
0
RF
0
represents the value of
accumulated restricted funds
(in the amount of RF
0
) that are
freed up by the project.
Denotes the present value
(in the parents currency) of
any concessionary loans,
CL
0
, and loan payments,
LP
t
, discounted at i
d
.
APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-20
One recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Convert to the home currency at the predicted
exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost
of capital.
Capital Budgeting from the Parent
Firms Perspective
18-21
Capital Budgeting from the Parent
Firms Perspective: Example
A U.S.-based MNC is considering a European
opportunity.
Its a simple example
There is no incremental debt
There is no incremental depreciation
There are no concessionary loans
There are no restricted funds
18-22
Capital Budgeting from the Parent
Firms Perspective: Example
We can use a simplified APV:
APV =
E
t = 1
T
S
t
OCF
t
(1 t)
(1 + K
ud
)
t
S
0
C
0
APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-23
One recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Convert to the home currency at the predicted
exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost
of capital.
Capital Budgeting from the Parent
Firms Perspective: Example
18-24
Capital Budgeting from the Parent
Firms Perspective: Example
A U.S.-based MNC is considering a European
opportunity.
Its a simple example
There is no incremental debt
There is no incremental depreciation
There are no concessionary loans
There are no restricted funds
18-25
Capital Budgeting from the Parent
Firms Perspective: Example
The inflation rate in the euro zone is t

= 3%, the inflation

rate in dollars is t
$
= 6%, and the business risk of the
investment would lead an unlevered U.S.-based firm to
demand a return of K
ud
= i
$
= 15%.
600
0
200
1
500
2
300
3
A U.S. MNC is considering a European opportunity.
The size and timing of the after-tax cash flows are:
18-26
Capital Budgeting from the Parent
Firms Perspective: Example

Is this a good investment from the perspective of the
U.S. shareholders?
600
0
200
1
500
2
300
3

$1.25
S
0
($/) = The current exchange rate is
To address that question, lets convert all of the cash
flows to dollars and then find the NPV at i
$
= 15%.
18-27
Capital Budgeting from the Parent
Firms Perspective: Example
$750
CF
0
= (600) S
0
($/) =(600) = $750

$1.25

$1.25
S
0
($/) =
Finding the dollar value of the initial cash
flow is easy; convert at the spot rate:
600
0
200
1
500
2
300
3
18-28
Capital Budgeting from the Parent
Firms Perspective: Example
$750 $257.28
600
0
200
1
500
2
300
3
CF
1
= 200 S
1
($/) = 200 $1.2864/ = $257.28
The exchange rate expected to prevail in the first year, S
1
($/),
can be found with PPP:
= $1.2864/
1.03
1.06
=

$1.25
1 + t

1 + t
$

S
1
($/) = S
0
($/)
18-29
Capital Budgeting from the Parent
Firms Perspective: Example
$661.94 $750 $257.28
CF
2

1.03
1.06
=

$1.25

1.03
1.06
500 = $661.94
600
0
200
1
500
2
300
3
18-30
Capital Budgeting from the Parent
Firms Perspective: Example
$408.73 $661.94 $750 $257.28
600
0
200
1
500
2
300
3
CF
3

1.03
1.06
=

$1.25

1.03
1.06
300 = $408.73
1.03
1.06
18-31
Capital Budgeting from the Parent
Firms Perspective: Example
$408.73 $661.94 $750 $257.28
0 1 2 3
Find the NPV using the cash flow menu of your financial
calculator and and interest rate i
$
= 15%:
CF
0
= $750
CF
1
= $257.28
CF
2
= $661.94
CF
3
= $408.73
I = 15
NPV = $242.99
18-32
Another recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the
foreign cost of capital.
4. Translate the foreign currency NPV into
dollars using the spot exchange rate
Capital Budgeting from the Parent
Firms Perspective: Alternative
There is no $ key on your calculator
18-33
Foreign Currency Cost of Capital
Method

Lets find i

and use that on the euro

cash flows to find the NPV in euros.
Then translate the NPV into dollars at
the spot rate.
600
0
200
1
500
2
300
3
t

= 3%
i
$
= 15%
t
$
= 6%

$1.25
S
0
($/) = The current exchange rate is
18-34
Foreign Currency Cost of Capital
Method
Before we find i

lets use our intuition.

Since the euro-zone inflation rate is 3% lower
than the dollar inflation rate, our euro
denominated discount rate should be lower than
our dollar denominated discount rate.

18-35
Finding the Foreign Currency Cost of
Capital: i

Recall that the Fisher Effect holds that
(1 + e) (1 + t
$
) = (1 + i
$
)
real
rate
inflation
rate
nominal
rate
So for example the real rate in the U.S. must be 8.49%
(1 + e) =
(1 + i
$
)
(1 + t
$
)
e =
1.15
1.06
1 = 0.0849
18-36
Finding the Foreign Currency Cost of
Capital: i

If Fisher Effect holds here and abroad then
If the real rates are the same in dollars and euros (e

= e
$
)
(1 + e
$
) =
(1 + i
$
)
(1 + t
$
)
(1 + e

) =
(1 + i

)
(1 + t

)
and
(1 + i
$
)
(1 + t
$
)
=
(1 + i

)
(1 + t

)
we have a very useful parity condition:
18-37
Finding the Foreign Currency Cost of
Capital: i

If we have any three of these variables, we can find the fourth:
(1 + i

) =
(1 + i
$
) (1 + t

)
(1 + t
$
)
In our example, we want to find i

(1 + i
$
)
(1 + t
$
)
=
(1 + i

)
(1 + t

)
i

=
(1.15) (1.03)
(1.06)
1
i

= 0.1175
18-38
International Capital Budgeting:
Example
Find the NPV using the cash flow menu and i

= 11.75%:
CF
0
= 600
CF
1
= 200
CF
2
= 500
CF
3
= 300
I = 11.75
NPV = 194.39
600
0
200
1
500
2
300
3
$1.25
= $242.99
194.39

18-39
NPV = $750 +
(1.15)
3
$408.73
+
1.15
$257.28
= $242.99 +
(1.15)
2
$661.94
$408.73 $661.94 $750 $257.28
0 1 2 3
NPV = 600 +

(1.1175)
3
300
+
1.1175
200
= 194.39 +
(1.1175)
2
500
$1.25
= $242.99
194.39

600
0
200
1
500
2
300
3
18-40
International Capital Budgeting
You have two equally valid approaches:
Change the foreign cash flows into dollars at the
exchange rates expected to prevail. Find the $NPV
using the dollar cost of capital.
Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars at
the spot exchange rate.
If you watch your rounding, you will get exactly
the same answer either way.
Which method you prefer is your choice.
18-41
Computing IRR
Recall that a projects Internal Rate of Return (IRR)
is the discount rate that gives a project a zero NPV.
NPV = $750 +
(1+IRR
$
)
3
$408.73
+
1+IRR
$
$257.28
= $0 +
(1+IRR
$
)
2
$661.94
NPV = 600 +

(1+IRR

)
3
300
+
1+IRR

200
= 0 +
(1+IRR

)
2
500
IRR

= 28.48%
IRR
$
= 32.23%
18-42
Computing IRR
Easily done with the IRR key
NPV = 600 +

(1+IRR

)
3
300
+
1+IRR

200
= 0 +
(1+IRR

)
2
500
IRR

= 28.48%
CF
0
= 600
CF
1
= 200
CF
2
= 500
CF
3
= 300 IRR

= 28.48%
18-43
Computing IRR
Easily done with the IRR key
CF
0
= $750
CF
1
= $257.28
CF
2
= $661.94
CF
3
= $408.73 IRR = 32.23%
NPV = $750 +
(1+IRR
$
)
3
$408.73
+
1+IRR
$
$257.28
= $0 +
(1+IRR
$
)
2
$661.94
IRR
$
= 24.85%
18-44
Converting from IRR
$
to IRR

Use the same IRP and PPP conditions that we
used to convert from one discount rate to another.
(1+IRR
$
) =
(1+IRR

)(1 + t
$
)
(1 + t

)
In our example, it was easy to find IRR

Finding IRR
$
without converting all cash
flows into dollars is straightforward:
1+IRR
$

(1 + t
$
)
=
1+IRR

(1 + t

)
i

=
(1.2848)(1.06)
(1.03)
1
IRR
$
= 32.23%
t

= 3%, t
$
= 6%
18-45
Back to the full APV
Using the intuition just developed, we can modify
Lessards APV model as shown above, if we find
it convenient.
S
0
S
0
S
0
S
0
S
0
f

f

f

f

f

APV =
E
t = 1
T
(1 + K
ud
)
t
TV
T

(1 + K
ud
)
T
+

t D
t
(1 + i
d
)
t
+

S
t
OCF
t
(1 t)
S
0
C
0
+ S
0
RF
0
+ S
0
CL
0
+


E
t = 1
T
S
t
t I
t
(1 + i
d
)
t
E
S
t
+

t = 1
T
S
t LP
t
(1 + i
d
)
t
E
S
t
t = 1
T
18-46
Risk Adjustment in the Capital
Budgeting Process
Clearly risk and return are correlated.
Political risk may exist along side of business
risk, necessitating an adjustment in the discount
rate.
18-47
Sensitivity Analysis
In sensitivity analysis, different estimates are used
for expected inflation rates, cost and pricing
estimates, and other inputs to give the manager a
more complete picture of the planned capital
investment.
Lends itself to computer simulation.
18-48