Multinational Capital

Budgeting
International Financial Management
Dr. A. DeMaskey

Learning Objectives
How does domestic capital budgeting differ from

multinational capital budgeting?

How do incremental cash flows differ from total
project cash flows?
What is the difference between foreign project cash
flows and parent cash flows?
How does APV analysis differ from NPV analysis?
How is the capital budgeting analysis adjusted for the
additional economic and political risks?
What is real option analysis?

Complexities of Capital 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

Complexities of Capital 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 parents ability to determine appropriate
WACC
Managers must evaluate political risk
Terminal value is more difficult to estimate because
potential purchasers have widely divergent views

Traditional Capital Budgeting Analysis

NPV Analysis

CFt
TVn
NPV

I0
t
n
(1 k )
t 1 (1 k )
n

If Projects are independent, those with a positive NPV

will be accepted while those with a negative NPV will
be rejected
It two projects are mutually exclusive, the project with
the highest NPV greater than zero will be accepted.
The discount rate, k, is the expected rate of return on
projects of similar risk as the riskiness of the firm as a
whole.

Properties of NPV Rule

Consistent with the goal of maximizing

shareholder wealth.
Focuses on cash flows rather than
accounting profits.
Emphasizes the opportunity cost of money
invested.
Obeys the additivity principle.

Incremental Cash Flows

Only the additional cash flows generated by

the project are relevant.

The difference between total and incremental
cash flows arises from:
Cannibalization
Sales creation
Opportunity cost
Transfer prices
Fees and royalties

Choosing the Correct Case Base

The base case is represented by the

worldwide corporate cash flows without the

investment.
In a competitive world, the base case needs
to be adjusted for competitive behavior.
New product
New production technology
Intangible benefits

Adjusted Present Value (APV)

Project risks and financial structures vary by

country, production state, and position in the

life cycle of the project.
Rather than modifying the WACC, cash flows
can be discounted at an all-equity rate, k*.
Reflects only the riskiness of the projects
expected future cash flows.
Abstracts from the projects financial structure.
Can be viewed as the companys cost of
capital if it were all-equity financed, that is,
with zero debt.

All-Equity Rate
The all-equity rate is based on the CAPM:

k* = rf + * (rm rf)
* is the all-equity or unlevered beta
A levered equity beta, e, is unlevered using
the following equation:
e
*

1 (1 T )( D / E )

Adjusted Present Value Approach

The value of a project is equal to the sum of

the following components:

PV of after-tax project cash flows but before

financing costs discounted at k*.
PV of tax savings on debt financing
discounted at the before-tax dollar cost of
debt, id.
PV of any savings or penalties on interest
costs associated with project-specific financing
discounted at the before-tax dollar cost of
debt, id.

Adjusted Present Value Approach

n

n
n
CFt
Tt
St
APV I 0

t
t
t
(
1

k
*)
(
1

i
)
(
1

i
)
t 1
t 1
t 1
d
d

Tt = tax savings in year t due to the specific

financing package
St = before-tax dollar value of interest
subsidies (penalties)
id = before-tax dollar cost of debt

Issues in Foreign Investment Analysis

Should cash flows be measured from the

viewpoint of the project or that of the parent?

Should the additional economic and political

risks that are uniquely foreign be reflected in

cash flow or discount rate adjustments?

Project versus Parent Valuation

Most firms evaluate foreign projects from both

parent and project viewpoints

The parents viewpoint analyses investments

cash flows as operating cash flows instead of
financing due to remittance of royalty or
licensing fees and interest payments

The parents viewpoint gives results closer to

traditional NPV capital budgeting analysis

Project valuation provides closer
approximation of effect on consolidated EPS

Parent versus Project Cash Flows

Project and parent cash flows can diverge

significantly due to:

Tax regulations
Exchange controls
Fees and royalties
Transfer pricing
Other factors

Three-Stage Approach
Stage1:
Project cash flows are computed from the
subsidiarys perspective.
Stage 2:
Project cash flows to the parent are evaluated
on the basis of specific forecasts concerning
the amount, timing, and form of remittance.
Stage 3:
Account for the additional benefits and costs
of the project.

Incremental Project Cash Flows

Estimating a projects true profitability

requires various adjustments to the project

cash flows:
Adjust for the effects of transfer pricing and
fees and royalties.
Adjust for global costs/benefits that are not
reflected in the projects financial statements.

Cannibalization
Sales creation
Additional taxes
Diversification of production facilities and markets

Tax Factors
Only after-tax cash flows are relevant.
Actual taxes paid are a function of:

Time of remittance
Form of remittance
Foreign income tax rate
Withholding taxes
Tax treaties
Foreign tax credits

Tax Factors
Computing the tax liabilities of foreign

investments assumes that:

The maximum amount of funds are available
for remittance each year.
The tax rate applied is the higher of the home
or host country rate.

Tax Factors: Illustration

Suppose that an affiliate will remit after-tax earnings

of $120,000 to its U.S. parent in the form of a

dividend. Assume the foreign tax rate is 20%, the
withholding tax on dividends is 4%, and excess
foreign tax credits are unavailable.

What is the additional tax owed to the U.S.

government?
What is the marginal rate of additional taxation?

Political and Economic Risk Analysis

There are three main methods for

incorporating the additional political and

economic risks into a foreign investment
analysis:
Shortening the payback period
Raising the required rate of return of the
investment
Adjusting the cash flows to reflect the specific
impact of a given risk.

Uncertainty absorption
Adjusting the expected value of future cash flows

Exchange Rate Changes and Inflation

The analysis should also consider the appreciation or

depreciation of the US dollar.

Approach A:

Convert nominal foreign currency cash flows into

nominal home currency terms.
Discount those nominal cash flows at the nominal
domestic required rate of return.

Approach B:
Discount the nominal foreign currency cash flows at
the nominal foreign currency required rate of return.
Convert the resulting foreign currency present value
into the home currency using the current spot rate.

Political Risk Analysis

The preferred method is to adjust the cash

flows of the project to reflect the impact of a

particular political event on the present value
of the project to the parent.
The biggest risk is:
Expropriation
Blocked funds

Expropriation: Illustration
Suppose a firm projects a $5 million perpetuity from

an investment of $20 million in Spain. If the required

return on this investment is 20%, how large does the
probability of expropriation in year 4 have to be
before the investment has a negative NPV? Assume
that all cash flows occur at the end of the year and
that the expropriation, if it occurs, will occur prior to
the year 4 cash inflows or not at all. There is no
compensation in the event of expropriation.

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)

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.
An expanded NPV rule consists of the
traditional DCF analysis plus the value of an
option.