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International Capital Budgeting (Chapter 17)
Multinational Finance, Jörgen Hellström
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)
Today’s lecture: International capital budgeting
Methods for assessing the profitability of FDI (comparing different options)
Multinational Finance, Jörgen Hellström
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, Jörgen Hellström
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, Jörgen Hellström
Basics of Capital Budgeting Firms must select combinations of investment projects that maximize the firms value to it’s 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. Jörgen Hellström 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. Jörgen Hellström Xt − I0 t t =1 (1 + k ) n 3 .
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 don’t make investment Multinational Finance. Jörgen Hellström Incremental Cash Flows Total project vs.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.Net Present Value Need to calculate: Net cash flows (in. Jörgen Hellström 4 .
g.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 plant’s 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. Jörgen Hellström Incremental Cash Flows Sales creation Opposite of cannibalization “investment leads to increasing cash flows at other production sites (than otherwise). a stronger local position of the firm” Incremental cash flow = investments total cash flows + “sales creation cash flows” Multinational Finance. Jörgen Hellström 5 . due to e.
Jörgen Hellström 6 . 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.rent. headquarter staff.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. 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. Jörgen Hellström Other Cash Flow Issues Fees and Royalties Firms charges of legal counsel. 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. heat . power. R&D.
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. Jörgen Hellström 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. Jörgen Hellström 7 .
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. Jörgen Hellström 8 . Jörgen Hellström 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 + β * ( rm − r f ) where r f = riskless rm = interest rate of interest rate of the market portfolio d with an β = all .equity beta (associate unleverage d cash flow) * Note: k* = riskless rate of interest + risk premium based on the risk of the project (systematic risk) Multinational Finance.
Jörgen Hellström 9 . Jörgen Hellström 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. subsidize interest rates) Multinational Finance. 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.Estimating the All-equity Beta Estimate the firm’s stock price beta βe To transform βe into β* the effect of debt financing need to be separated out β* = βe 1 + (1 − t ) D / E where D = debt E = equity t = marginal tax rate Multinational Finance.g.
Jörgen Hellström n n Xt Tt St +∑ +∑ − I0 * t t t t =1 (1 + k ) t =1 (1 + id ) 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.Adjusted Present Value APV = ∑ where I 0 = the initial cash investment X t = the net cash (after .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. Jörgen Hellström 10 .tax) flow in period t k * = the all .
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.1) Parent vs. exchange rate controls Unanticipated foreign exchange rate changes Royalties and fees are returns to the parent company Multinational Finance. Jörgen Hellström 11 . Jörgen Hellström 1) Parent vs.g. Multinational Finance. 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 firm’s many interest groups.
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. fees and royalties Use market cost/prices for goods.A Three-Stage Approach A three-stage approach is recommended for simplifying project (investment) analysis 1) Project cash flows are calculated from the foreign subsidiary’s standpoint (as if it were a separate firm) 2) Obtain specific forecasts concerning the amounts. Jörgen Hellström Estimation of Incremental Project Cash Flow to the Parent Firm Estimation entails: 1) Adjust for effects of transfer pricing. 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. Jörgen Hellström 12 .
Jörgen Hellström 13 . Jörgen Hellström 2) Accounting for Foreign Economical and Political Risks When evaluating investments firms must assess the consequence of different political and economic risks (e. 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. expropriation. 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.g.g. markets and products Multinational Finance.Estimation of Incremental Project Cash Flow to the Parent Firm 2) Adjust for global costs/benefits that are not reflected in the investment’s 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. Jörgen Hellström 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. Jörgen Hellström 14 .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. 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.
Jörgen Hellström 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. Jörgen Hellström Accounting for Exchange Rate Changes 15 . take account of different inflation levels between countries) and adjust for offsetting inflation and exchange rate changes Multinational Finance.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.g.
Jörgen Hellström 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.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. Jörgen Hellström 16 .
390) × 40.174 NPV = Multinational Finance.15 = −$652. 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 .000.000 1.000 − 1.5 (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. Jörgen Hellström 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.Example: Growth Option Decision to reopen a gold mine: Cost: $1 million 40. Jörgen Hellström 17 .
043 Multinational Finance.15 = $913. Jörgen Hellström 18 .000 1.Example: Growth Option Multinational Finance.000 NPV = − 1.000. Jörgen Hellström Example: Growth Option Incorporating the mine owner’s option not to mine when the gold price falls below the extraction cost gives the NPV: $2.200.
043 vs. Jörgen Hellström 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.174) Multinational Finance. Jörgen Hellström 19 . -$652.Example: Growth Option The ability to alter decisions in response to new information may contribute significantly to the value of an investment ($913.
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. Jörgen Hellström 20 . Jörgen Hellström 1) Avoidance Screening out investments in politically uncertain countries Ignores potentially high returns Multinational Finance.
Jörgen Hellström 21 .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. Jörgen Hellström 3) Negotiation Reach an understanding with the host government before the investment. defining rights and responsibilities of both parties – concession agreement Multinational Finance.
Jörgen Hellström 22 . international financial institutions) Multinational Finance.4) Structuring the investment Increasing the host government’s 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.