Multinational Finance

International Capital Budgeting (Chapter 17)

Multinational Finance, J Jrgen Hellstr Hellstrm

Where we are?
Previous lecture: Foreign direct investments (FDI)
Reasons for FDI Process of becoming MNC (FDI) Strategies to remain MNC Where to FDI ? Country risk analysis
Political risk (assessing the risk of investing in different countries)

Todays lecture: International capital budgeting

Methods for assessing the profitability of FDI (comparing different options)
Multinational Finance, J Jrgen Hellstr Hellstrm

Outline of Lecture
Basics of capital budgeting (investment analysis) Issues in foreign investment analysis Incorporating political risk analysis Growth options (dynamic investment analysis) Managing political risks
Multinational Finance, J Jrgen Hellstr Hellstrm

Multinational Capital Budgeting

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term (foreign) investment projects Same theoretical framework as domestic capital budgeting The basic steps are:
Identify the initial capital invested Estimate cash flows to be derived from the project over time, including an estimate of the terminal value of the investment Identify the appropriate discount rate to use in valuation Apply traditional capital budgeting decision criteria such as Net Present Value (NPV) and Internal Rate of Returns (IRR) Alternative, Adjusted Present Value (APV).
Multinational Finance, J Jrgen Hellstr Hellstrm

Basics of Capital Budgeting

Firms must select combinations of investment projects that maximize the firms value to its shareholders Decision rule/criteria is needed: Net Present Value (NPV)
Consistent with shareholder wealth maximization (focus on cash flows and opportunity cost of money invested not accounting profits) Value additive: The NPV of a set of independent project is simply the sum of NPVs of the individual projects
Implication: each project can be considered on its own
Multinational Finance, J Jrgen Hellstr Hellstrm

Net Present Value

present value of future cash flows discounted at the projects cost of capital minus the initial net cash outlay for the project
NPV = where I 0 = the initial cash investment X t = the net cash (after - tax) flow in period t k = the project' s cost of capital (discount rate) n = investment horizon
Multinational Finance, J Jrgen Hellstr Hellstrm

Xt I0 t t =1 (1 + k )

Net Present Value

Need to calculate:
Net cash flows (in- and out flows) from the project Cost of funding the project The terminal value of project

Need to decide on:

The lifetime of the project (horizon) The discount rate (projects cost of capital)
Multinational Finance, J Jrgen Hellstr Hellstrm

Incremental Cash Flows

Total project vs. incremental cash flows Shareholders are interested in how many additional dollars they will receive in the future for the dollars they lay out today Distinction between the projects total cash flows and the incremental cash flow from the project Incremental cash flow: compare worldwide corporate cash flows without investment (base case) with post-investment corporate cash flows
Need to assess what will happen if we dont make investment
Multinational Finance, J Jrgen Hellstr Hellstrm

Incremental Cash Flows

Project total cash flow and incremental cash flows may deviate due to: Cannibalization:
A new investment (product) takes sales away from the existing products A foreign production plants production substitutes parent company export Incremental cash flow: If investment replace other existing cash flows (that otherwise would have existed) these cash flows (the replaced) need to be subtracted from the investments total cash flow to obtain the incremental cash flow of the investment
Multinational Finance, J Jrgen Hellstr Hellstrm

Incremental Cash Flows

Sales creation
Opposite of cannibalization investment leads to increasing cash flows at other production sites (than otherwise), due to e.g. a stronger local position of the firm Incremental cash flow = investments total cash flows + sales creation cash flows

Multinational Finance, J Jrgen Hellstr Hellstrm

Other Cash Flow Issues

Opportunity cost
Project/investment cost must include the true economic cost of any resource required for the project regardless if the firm already owns it. What the resource would be worth in use or on the market otherwise the opportunity cost

Transfer prices
the price at which goods and service are traded internally Prices used in the capital budgeting process should be valued at market prices
Multinational Finance, J Jrgen Hellstr Hellstrm

Other Cash Flow Issues

Fees and Royalties
Firms charges of legal counsel, power, heat ,rent, R&D, headquarter staff, management costs usually in form of fees and royalties Should only be included in capital budgeting process if the investment leads to additional expenditures

Intangible benefits
Better quality, faster distribution times and higher customer satisfaction and so on Learning experience Broader knowledge base Higher competitive skills Should be attribute as positive benefits to an investment Usually hard to estimate (the value of the intangible benefits) Can be stated separate in the investment analysis

Multinational Finance, J Jrgen Hellstr Hellstrm

Choice of Discount Rate

Standard discount rate: Weighted Average Cost of Capital (WACC) (Chapter 14) WACC (assuming the financial structure and risk of the project similar as for the firm as whole):
k0 = (1 L) ke + Lkd (1 t ) where L = parent' s debt ratio (debt to total assets) ke = cost of equity capital kd = cost of debt capital t = tax level
Multinational Finance, J Jrgen Hellstr Hellstrm

Choice of Discount Rate

WACC (assuming the financial structure and risk of the project different than for the firm as whole):
' ' k0 = (1 L' ) ke' + L' kd (1 t )

where L' = project' s debt ratio ke' = project ' s cost of equity capital kd = project ' s cost of debt capital t = tax level
Multinational Finance, J Jrgen Hellstr Hellstrm

Choice of Discount Rate

WACC weights are based on the proportion of the firms capital structure or the financing structure of the project Alternative discount rate:Discount cash-flows using the all-equity rate
Abstracts from the projects financial structure Based on the riskiness of the projects anticipated cash flow The firms cost of capital if the firm was all-equity financed (no debt)

Multinational Finance, J Jrgen Hellstr Hellstrm

All-Equity Rate
To calculate the all-equity rate k* we can use the CAPM model (gives the relationship between the expected return and the systematic risk of the asset)
The CAPM k * = r f + * ( rm r f ) where r f = riskless rm = interest rate of interest rate of the market d cash flow) portfolio d with an

= all - equity beta (associate

unleverage

Note: k* = riskless rate of interest + risk premium based on the risk of the project (systematic risk)

Multinational Finance, J Jrgen Hellstr Hellstrm

Estimating the All-equity Beta

Estimate the firms stock price beta e To transform e into * the effect of debt financing need to be separated out

* =

1 + (1 t ) D / E where D = debt E = equity

t = marginal tax rate

Multinational Finance, J Jrgen Hellstr Hellstrm

Adjusted Present Value

The value of the project is equal to:
1) The present value of project cash flow after taxes but before financing costs, discounted at k* 2) The present value of the tax savings on debt financing (interest tax shield) 3) The present value of any savings (penalties) on interest cost associated with project specific financing (government may e.g. subsidize interest rates)
Multinational Finance, J Jrgen Hellstr Hellstrm

Adjusted Present Value

APV = where I 0 = the initial cash investment X t = the net cash (after - tax) flow in period t k * = the all - equity rate n = investment horizon Tt = Tax savings in year t due to debt financing St = before tax home currency value of interest rate subsidies (penalties) id = before tax cost of home currency debt
Multinational Finance, J Jrgen Hellstr Hellstrm

n n Xt Tt St + + I0 * t t t t =1 (1 + id ) t =1 (1 + k ) t =1 (1 + id ) n

Issues in Foreign Investment Analysis

Two additional issues raised in the analysis of a foreign project: 1) Should the cash flow be measured from the viewpoint of the project or that of the parent firm? 2) How should additional economic and political risks that are uniquely foreign be reflected in the investment analysis?
Multinational Finance, J Jrgen Hellstr Hellstrm

10

1) Parent vs. Project Cash Flow

A substantial difference can exist between the cash flow of a (foreign) project and the amount that is remitted to the parent firm
Differing tax systems Legal and political constraints on the movement of funds e.g. exchange rate controls Unanticipated foreign exchange rate changes Royalties and fees are returns to the parent company

Multinational Finance, J Jrgen Hellstr Hellstrm

1) Parent vs. Project Cash Flow

Any foreign project must be analyzed from the viewpoint of the parent since: Cash flows to the parent are the basis for:
dividends to stockholders reinvestment elsewhere in the world repayment of corporate-wide debt other purposes that affect the firms many interest groups.
Multinational Finance, J Jrgen Hellstr Hellstrm

11

A Three-Stage Approach
A three-stage approach is recommended for simplifying project (investment) analysis 1) Project cash flows are calculated from the foreign subsidiarys standpoint (as if it were a separate firm) 2) Obtain specific forecasts concerning the amounts, timing and form of transfer to parent firm, as well as information concerning taxes and other expenses in the transfer process 3) Take account of indirect benefits (sales creation) and costs (cannibalization) the investment confers on the rest of the corporation Calculate incremental cash flow from the investment to the parent firm
Multinational Finance, J Jrgen Hellstr Hellstrm

Estimation of Incremental Project Cash Flow to the Parent Firm

Estimation entails: 1) Adjust for effects of transfer pricing, fees and royalties
Use market cost/prices for goods, services and capital transferred internally Add back fees and royalties to project cash flow since these are benefits to the parent firm Remove the fixed portions of costs like corporate overhead

Multinational Finance, J Jrgen Hellstr Hellstrm

12

Estimation of Incremental Project Cash Flow to the Parent Firm

2) Adjust for global costs/benefits that are not reflected in the investments financial statement
Cannibalization of sales of other units Creation of incremental sales by other units Additional taxes owed when repatriating profits Foreign tax credits usable elsewhere (e.g. from debt interest rates) Effects from diversification of production facilities Effects from market diversification Effect from providing a key link in a global network Effects from increased knowledge about competitors, technology, markets and products
Multinational Finance, J Jrgen Hellstr Hellstrm

2) Accounting for Foreign Economical and Political Risks

When evaluating investments firms must assess the consequence of different political and economic risks (e.g. expropriation, currency fluctuations) Three main methods: 1) Shortening the minimum pay-back period 2) Raising the required rate of return on the investment 3) Adjusting cash flows to reflect the specific impact of a given risk
Multinational Finance, J Jrgen Hellstr Hellstrm

13

2) Accounting for Foreign Economical and Political Risks

Method 1 and 2 are commonly used
Due to vague views of the specific risk directed towards the investment Ease of implementation

Drawback:
How much should the required rate of return be raised? How much shorter should the pay-back period be? Penalizes all future cash-flows equal without regard to differences in risk over time Adjusting pay-back period and rate of returns less attractive from a theoretical standpoint

Multinational Finance, J Jrgen Hellstr Hellstrm

2) Accounting for Foreign Economical and Political Risks

Adjusting future cash-flow preferred from a logical point of view Possibility of incorporating all available information about the impact of a specific risk (e.g. at a specific point in time) on future cash flow Adjust the cash-flow each period with the probability for different outcomes due to the risk
Multinational Finance, J Jrgen Hellstr Hellstrm

14

2) Accounting for Foreign Economical and Political Risks

Example: Risk of expropriation (with probability p) during the next year of Banana plantation Compensation if expropriated: $100 million Expected value (if not expropriated):$300 million Have an offer to sell plantation: $128 million Discount rate: 22%

Multinational Finance, J Jrgen Hellstr Hellstrm

Two ways: 1) Convert nominal foreign currency cash flow into nominal home currency terms (forecasts of future exchange rate) discount the nominal home currency cash flow with the nominal domestic required rate of return 2) Discount the nominal foreign currency cash flows at the nominal foreign currency required rate of return convert the foreign currency present value into the home currency using the spot rate Should give the same result if international Fisher effect (IFE) holds Keep parity conditions in mind (e.g. take account of different inflation levels between countries) and adjust for offsetting inflation and exchange rate changes
Multinational Finance, J Jrgen Hellstr Hellstrm

Accounting for Exchange Rate Changes

15

Growth Options
Discounted cash flow (DCF) analysis treat expected cash flows as given at the outset DCF static approach all operating decisions are set in advance However, in reality:
opportunity to make decisions contingent on information that becomes available in the future
Multinational Finance, J Jrgen Hellstr Hellstrm

Growth Options
The ability to alter decisions in response to new information in the future has a value similar to an option that should be incorporated in the investment analysis An initial investment that holds future possibilities (close, increase sales) is a growth option

Multinational Finance, J Jrgen Hellstr Hellstrm

16

Example: Growth Option

Decision to reopen a gold mine:
Cost: $1 million 40, 000 ounces of gold in the mine Variable cost $390/ounce Expected gold price in one year: $400/ounce Discount rate: 15%

DCF analysis (400 - 390) 40,000 NPV = 1,000,000 1.15 = $652,174

Multinational Finance, J Jrgen Hellstr Hellstrm

Example: Growth Option

DCF analysis ignores the option not to produce if it is unprofitable to do so Suppose that the gold price next year is either $300/ounce with probability 0.5 or $500/ounce with probability 0.5 (expected value $400) Allow decision to mine or not to depend on future gold price
If gold price $300/ounce do not mine If gold price $500/ounce - mine
Multinational Finance, J Jrgen Hellstr Hellstrm

17

Example: Growth Option

Multinational Finance, J Jrgen Hellstr Hellstrm

Example: Growth Option

Incorporating the mine owners option not to mine when the gold price falls below the extraction cost gives the NPV:

$2,200,000 NPV = 1,000,000 1.15 = $913,043

Multinational Finance, J Jrgen Hellstr Hellstrm

18

Example: Growth Option

The ability to alter decisions in response to new information may contribute significantly to the value of an investment ($913,043 vs. -$652,174)

Multinational Finance, J Jrgen Hellstr Hellstrm

Growth options
The value of the flexibility to act on future information depends on (similar as options):
1) The length of time the project can be deferred longer time larger value of the project 2) The risk of the project the higher risk the higher value of the project (gains and losses are asymmetric) 3) The level of interest rates high interest rate do in general increase the value of the project since the present value of the option to defer decreases 4) The proprietary nature of the option the more exclusively owned option the higher value of the project

Multinational Finance, J Jrgen Hellstr Hellstrm

19

Managing Political Risk

Assume the firm has decided to invest How can the firm minimize the political risk?
1) 2) 3) 4) Avoidance Insurance Negotiation Structuring the investment

Multinational Finance, J Jrgen Hellstr Hellstrm

1) Avoidance
Screening out investments in politically uncertain countries Ignores potentially high returns

Multinational Finance, J Jrgen Hellstr Hellstrm

20

2) Insurance
Most developed countries sell political risk insurances to cover the foreign assets of domestic firms Insurance against risk of expropriation, currency inconvertibility and political violence

Multinational Finance, J Jrgen Hellstr Hellstrm

3) Negotiation
Reach an understanding with the host government before the investment, defining rights and responsibilities of both parties concession agreement

Multinational Finance, J Jrgen Hellstr Hellstrm

21

4) Structuring the investment

Increasing the host governments cost of interfering with the companies operations
Local affiliate dependent on sister companies (supplier) Establish a single global trade mark Sourcing production in multiple plants External financial stakeholders (other governments, international financial institutions)
Multinational Finance, J Jrgen Hellstr Hellstrm

22