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Capital Budgeting frameworks for the Multinational Corporation

Article  in  Journal of International Business Studies · June 1982

DOI: 10.1057/palgrave.jibs.8490554 · Source: RePEc


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Laurence Booth
University of Toronto


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Universityof Toronto

Abstract. This article discusses the relative merits of different capital budgeting tech-
niques used by MNCs. The purpose is to show that the APV method, which has recently
gained popularity, can cause incorrect choices to be made between competing projects
unless the NPV is already determined. The author suggests that complicated cost of capi-
tal adjustments may be the only route to calculating a project's NPV correctly.

* Capital budgeting for an MNC is complicated because of the complexity of INTRODUCTION

cash flows and financing options available to the MNC. This complexity is illus-
trated in the approach to capital budgeting adopted in some MBA level texts on
international financial management, where a case analysis is often given promi-
nence1; however, recently, Lessard [7] has tackled the theoretical framework ap-
propriate for analyzing capital budgeting decisions in an MNC. His argument is
that the complexities of international financial arrangements make the cost of
capital technique, whereby all financing costs are embedded in a single weighted
average cost, too complicated to use. He proposes reverting instead to the Modi-
gliani and Miller [8] valuation equation, which explicitly decomposes value into
that part contributed by the operating and financial characteristics of the project
respectively. This approach, which was dubbed the 'adjusted present value' (APV)
approach by Myers [10], is gaining widespread acceptance.
In fact, Taggert [14] has shown that the APV and cost of capital methods produce
identical results when correctly applied, as does the flows to equity method (FTE)
which capitalizes the stockholder's net income. Thus, Lessard's argument is that
if the three methods produce identical results, why make complicated adjust-
ments to the cost of capital, in the way suggested by Shapiro [13], when we can
use the simpler APV method? Lessard states: "it provides a superior basis for
developing simple rules that can be applied for recurring investment decisions.
For large, complex projects with numerous project-specific financing arrange-
ments, it appears to be the simplest appropriate approach." [7, p. 578]
It is the objective of this paper to caution the acceptance of Lessard's use of the
APV approach in MNC capital budgeting, and the criticism is appropriate to all
uses of the APV approach. However, the apparent comparative advantage of the
APV approach in the complex environment of the MNC makes it only too easy to
ignore its very real weaknesses. This paper shows that the APV approach cannot
be applied correctly without the information that is produced by calculating the
correct net present value of the project-in other words, it will produce incorrect
results unless the answer is already known! Moreover, without this information
not only is the estimated net present value incorrect, but also in comparing mutu-
ally exclusive projects the APV method can lead to an incorrect decision. Finally,
to be correct, as will be shown, the APV method needs all the complicated adjust-
ments required for the conventional cost of capital method. It will be aruged that
Lessard's arguments in favor of the APV approach to MNC capital budgeting are
overstated and the approach should be adopted only with the full understanding
of its limitations.

*LaurenceD. Booth's main interests lie in the financing and financial management decisions
of MNCs. He has published articles on the cost of capital and capital structure decisions in
the Journal of Finance, the QuarterlyReview of Economics and Business, the Financial Ana-
lysts Journal, and the Journal of Banking and Finance as well as journal articles on other
financial topics. This paper was presented at the 1981 Eastern Finance Association Meetings
in Newport,Rhode Island.

Journal of International Business Studies, Fall 1982 113

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The following section determines first how to value correctly a capital budgeting
project faced by an MNC. In order to internationalize the model, a widespread
phenomenon in international finance is assumed: that the host government
makes available to the MNC low-cost financing if the MNC undertakes a particu-
lar project. This 'imperfection' to the efficient functioning of international finan-
cial markets is common both to the developed and underdeveloped countries and
represents an important part of the financial environment of MNCs.2 Then, a
practical application of the three capital budgeting techniques to a simple inter-
national project is presented, followed by an analysis of the problems that arise
in using the APV and FTEapproaches and of how incorrect decisions can result.
Some conclusions are suggested at the end of the paper as to how to structure
capital budgeting decisions for an MNC.

THE The basic requirement for any capital budgeting model is a valuation equation.
SPECIFICATION Modigliani and Miller[8]were the first authors to analyze rigorously the corporate
OF CAPITAL financial leverage decision and to derive a valuation equation that reflected the
BUDGETING value to investors of corporate leverage. In their seminal work they advanced the
penetrating argument that in an efficient market investors will not value corpo-
rate leverage unless they cannot duplicate the effects of that leverage them-
selves. This simple argument is sufficient to produce a valuation equation where
what is valued are the special services that the corporation provides for its stock-
holders; hence, the complex financial arrangements that MNCs enter into are val-
uable only if investors cannot duplicate those arrangements for themselves. An
example of such an arrangement is the low-cost development loan used to at-
tract an MNC into a developed or underdeveloped country. Because the stock-
holder does not have access to this low-cost loan, he will be prepared to pay more
for the stock of an MNCthat avails itself of this source of financing.3 For simplic-
ity, we shall assume that this is the only financial advantage available to the MNC.
The author assumes the standard valuation assumptions: that the expected net
operating income is a perpetuity, that the firm pays out 100 percent of its earn-
ings in dividends, that financial markets are perfect, that income from common
stock is treated as ordinaryincome, and, last, that the stockholder can invest in a
perfect operating substitute to the MNC investment. This last assumption is the
equivalent of the Modigliani and Miller risk class assumption. Hamada [5] has
shown that with perfect financial markets a security that is a perfect substitute
can always be found; hence, this last assumption is not restrictive. This assump-
tion is made only because it simplifies the analysis and enables a direct compari-
son with the classic 'arbitrage' arguments of Modigliani and Miller.
The objective of the arbitrage proof is quite simple. The returnon an equity share
in an MNC operation financed through a low-cost loan is compared with the re-
turn an investor could obtain by investing on margin in an equivalent operation fi-
nanced with debt at market rates. The intent is to equalize the expected returns
and thus provide a valuation equality that must hold to prevent arbitrage. The ad-
justed Modigliani and Millerarbitrage table is shown as Table 1 along with a list
of definitions. The key variable of interest is the subsidized loan available to the
MNC at a rate of Kd2, which is less than the market rate Kdl.4 In equilibrium, be-
cause the equivalent risk assumption is invoked, and the expected return equal-
ized, we must have:
VL= Vu + D 1 - (1 - tc) Kd (1)
Kdl -

Note that with no interest rate subsidy the conventional Modigliani and Miller re-
sult, that the value of the firm is equal to the value of an unlevered firm plus the
value of the tax shield is achieved. Rearranging (1) we obtain:

114 Journal of International Business Studies, Fall 1982

VL = Vu + Dtc + d(1 - tc)D, (2)

where id is the interest rate subsidy provided by the host country and by definition
Kd2 + id = Kdl.
If we subtract the cost of the investment, I, from equation (2), we have the basic
APV valuation equation for the imperfection of low-cost loans available to the
MNC. For the general case, Lessard [7, p. 581) writes the APV equation for MNC
capital budgeting as,
Ct(1 - tc) tcDEPt tclNTt AINTt TRt
APV- =
[ + + + +
t= L (1 + K1)t (1 + K2)t (1 + K3)t (1 + K4) (1 + K5)t

REMt 1
+(1 + K)t -I, (3)
(1 + K6)tj
where the first two terms are remittable after-tax operating cash flows and depre-
ciation, respectively, which, under the perpetuity assumption, are part of the
value of the unlevered firm. The third term is the tax shield from debt on 'normal
borrowing,' with the fourth term a financial subsidy or penalty. These two terms
correspond to Dtc and id/kdl (1 - tc)D, respectively. Lessard's final two terms rep-
resent the value of any tax reduction or deferrals and interaffiliate transfers and
remittances. In the author's arbitrage model these last two terms are indepen-
dent of the financial leverage decision and would also be available to the un-
levered foreign operations; hence, these two terms would be included in the total
value of the unlevered firm. Generally in the framework for capital budgeting
these last two MNC options affect the project's after-tax internal rate of return
and are not part of the financing decision.5 Hence, from the arbitrage argument,
assuming automatic reinvestment of depreciation, Lessard's equation collapses
to the author's equation (2).


Transaction Investment Return

a in MNClevered stock c[SL = VL - D] a[f - Kd2D](1- tc)

a in unlevered stock a[Su = Vu] oC[71(1- tc)

borrow on margin - aD(1 - tc) K - Kd2D(1 - tc)

a Vu - D(1 - tc)--
KdI [F- Kd2D](1- tc)
L K2KdlJ

L, U = levered and unlevered respectively;
T = expected perpetual net operating income (NOI);
Kd = interest cost;
tc = foreign corporate tax rate;
D = market value of debt;
S = market value of equity;
V =value of firm (VL= S + D);
Ko = investor's required returnon equity when the firm has no financial leverage;
Ke = investor's required returnon an equity investment;
a = proportionalinvestment.

Journal of International Business Studies, Fall 1982 115

It should be noted that as in the normal Modigliani and Millermodel a finite debt
capacity fixed by institutional constraints and fear of bankruptcy is assumed.6
This bankruptcyconstraint is determined by the firm's ability to cover fixed finan-
cial obligations as determined by a cash flow analysis in the way suggested by
Donaldson. [2] This constraint is assumed to take the form of a simple coverage
ratio. Hence, without access to low cost funds the constraint would be:

z, (4)

where z represents the minimum acceptable coverage ratio. This is a realistic as-
sumption, because a coverage ratio such as (4) is frequently included as a con-
straint in the bond contract. The implication of (4) is that the firm's debt capacity
is altered by its access to the low-cost funds provided by the host government.
Note that in (4) it is the interest cost of the debt that determines the firm's debt
capacity; therefore, at the subsidized interest rate, Kd2, the MNCcan increase the
amount of borrowing from the host government (D*) without increasing the risks
of financial distress. The amount of debt in equation (2) is thus determined by the
coverage ratio constraint of equation (4) appropriate to the risk of the investment
To determine the optimal level of investment (2) is differentiated with respect to
the level of investment, and the condition is observed that the marginal investment
must at least increase market value by its cost; that is, dVL/dl= 1. After rearrang-
ing we find,
d (1-tc)
>Ko 1 - D*t + (1 - tc)-i idtl
dl - V( Kdl) (5)
Here, D*/V is the optimal debt ratio, which for the marginal project is the incre-
mental debt raised to finance the project-that is dD/dl. The righthand side of
equation (5) is the adjusted Modigliani and Millercost of capital criterion, where,
if id=O, we have the normal Modigliani and Miller cost of capital. The left hand
side of (5) in the perpetuity model is the after-tax internal rate of return.As can be
seen from (5), the effect of the cheap debt is to lower the overall cost of capital
and increase the level of investment. This of course is the government's objective
in providing the low-cost loan.8
To derive the traditional weighted average cost of capital and the flows to equity
criteria, we first derive the shareholder's required return, which in the perpetuity
model is the after-tax earnings yield. If we follow Modigliani and Miller and use
equation (2) in the definition of the earnings yield, we obtain:9
Kd2 D*
Ke = Ko + (1 - tc)(Ko - Kd2) ; (6)
Kdl S
where if Kd2= Kdl, there is no interest subsidy, and we have the Modigliani and
Miller equation. However, we know also that the low-cost debt provided by the
host government (D*)would not sell at par if it were traded on a financial market;
its market value would be Kd2D*/Kdl. If we substitute this market value of the low-
interest debt, we again obtain the Modiglianiand Millerequation; Ke = Ko + (1 -
tc) (Ko- Kdl)D/S.Because the interest charges remain constant by our constant
real financial leverage assumption of (4), the shareholder's required return is un-
changed by the provision of low-cost loans.
If we rearrange (6) to solve for Koand substitute into (5), we obtain,
d7r(1 - tc) S* D*
Ke + Kd2(1 - tc) (7)
diIVdl V'

116 Journal of International Business Studies, Fall 1982

which states that the after-tax internal rate of return must exceed the traditional
weighted average cost of capital (KA).Note that KAincludes the effects of the low-
cost loans in the reduced interest charge of Kd2and the increased leverage of D*/V.
Finally, if we rearrange the definition of the earnings yield we have the flows to
equity formulation,
(x - Kd2D*)(1- tc) - (I- D*)? 0,
-Ke ^-(I- D*) O, (8)

where S* = I- D* is the amount of equity financing. In equation (8), because from

(6) ke is constant, the low-cost loans option affects the profitabilityof a project by
altering the amount of equity investment (I- D*).
The result is three, capital-budgeting decision criteria that incorporate the ef-
fects of having access to low-cost debt financing. The traditional cost of capital
in equation (7) adjusts to the low-cost loan by altering the debt ratio and interest
cost. The APV method goes directly to the valuation equation (2) to value each
component of value independently. The flows to equity method of equation (8) de-
termines directly the net present value of the residual flow to equity holders. All
three equations are derived from the fundamental valuation equation of (2) and are
consistent; therefore, we have replicated Taggert's analysis for an 'imperfection'
that describes the financial environment of an MNC.The next section determines
the robustness and suitability of these three investment criteria to evaluate
Lessard's objections to the cost of capital and advocacy of the APV formulation.
(Table 2 summarizes the three basic valuation equations.)10

Assume a situation where without any debt financing the investor's required re- APPLICATIONS
turn on an equity investment in the MNC is 18 percent (Ko).The market cost of
debt is 15 percent and the MNC maintains an optimal debt ratio of 50 percent
debt. From equation (6) we would observe that the required return on equity with
the tax rate of 50 percent and DIS= 1 would be 191/2percent. Hence, the Modigli-
ani and Miller cost of capital (equation [5])and the traditional weighted average
(equation [7])would both give a value of 131/2percent. If the host government now
provided a 5 percent interest rate subsidy, lowering the cost of 'investment funds'
to the MNCto 10 percent, the optimal debt-equity ratio would increase to 11/2and
the debt ratio of 60 percent, because the coverage ratio allows increased debt ca-
pacity by (4). Hence, substituting these values into equation (5) gives the Modigli-

Capital Budgeting Techniques
f(1 - t) I S* D*
KA = Ke-- + Kd(1 - tc)

7r(1 - tc) idD* (1 - tc)
+ Dt
+ + 0
Ko Kdl

Flowsto Equityanalysis
(- - KdD*)(1 - tc) _ ( D*) >

Journal of International Business Studies, Fall 1982 117

ani and Miller cost of capital of 10.8 percent. Similarly, if we use the new debt
ratio in equation (7) with the lower interest rate we get a traditional weighted aver-
age of 10.8 percent. This confirms the result that the method of calculating the
cost of capital, either the adjusted Modigliani and Miller formula or the tradi-
tional weighted average, is not important.11
Suppose the MNC is now faced with a capital project costing 1,000,000 which will
generate perpetual NOI of 216,000. At a 50 percent corporate tax rate the net pres-
ent value of the project is zero under all three of the capital budgeting techniques.
In the traditional NPV analysis, by using the 10.8 percent cost of capital, the pres-
ent value of the project is equal to its cost. In the APV method the value of the op-
erating profit of 600,000, plus the value of the tax shield of 300,000, plus the value
of the wealth transfer of 100,000 equals the project cost.12 In the FTE method the
capitalized earnings to the common stockholders are valued at the same equity
investment required of 400,000.
This happy state of affairs of identical net present values is not the general
result. Assume instead two cases with expected NOI of 250,000 and 200,000, re-
spectively. With the same 1,000,000 cost and 60 percent debt ratio, consider the
results in Table 3. Note that the FTE and APV methods undervalue a profitable
project and overvalue an unprofitable project relative to the NPV as derived under
the traditional cost of capital formulation.


X = 216,000

NPV - 1,000,000 = 0
(216,000)(0.5) /2\ -
APV .1 + 6000 -
1,000 ,000 = 0
(216,000 - 60,000)(0.5)
FTE 00 [1,000,000 - 600,000] = 0
= 250,000

NPV - 1,000,000 = 157,407
(250,000)(0.5) /2\
APV 0. + 600,000 - - 1,000,000 = 94,444
0.18 3/
(250,000 - 60,000)(0.5)
FTE - 400,000 = 87,179
= 200,000

NPV - 1,000,000 = - 74,074

APV -(200,000)(0.5) + 600,000 - 1,000,000 =- 44,445

(200,000 - 60,000)(0.5)
FTE .- 400,000 - 41,026

118 Journal of International Business Studies, Fall 1982

The reason for the incorrect results derived under APV and FTE is the problem of
deriving the optimal financing of the project. For APV and FTEto provide consis-
tent results the amount of debt financing must equal the optimal debt ratio times
the value of the project and not the cost of the project. As Haley and Schall [4,
p. 34] point out, when "financing investment the firm must issue new bonds equal
to D/Vtimes the incremental value of the firm resulting from investment in order
for the ratio of debt to firm value to remain constant." Obviously, for a project
with NPV=0, the bond financing that results from cost equals that which results
from using value and there is no inconsistency. However, for a project with posi-
tive or negative net present value, the value of the tax shield and wealth transfer in
the APVequation and the interest charges and equity financing in the FTEformu-
lation are incorrect-hence, the error in calculating the project's NPV.
If we now accept the NPV results, that value changes by 157, 407 and - 74,074 if
NOIs are expected to be 250,000 and 200,000, respectively, we can determine that
debt financing must be 694,444 and 555,555, respectively, and not the constant
600,000-otherwise the firm's overall debt ratio will not stay at 60 percent after
the project is adopted. If we substitute these levels of debt financing into the APV
formulation, the net present value becomes identical to that of the cost of capital
formulation. Similarly, this level of financing causes interest charges and resid-
ual equity financing to change to (69,444; 305,555) and (55,555; 444,445), respec-
tively. Therefore, using these figures in the FTEformulation also gives the correct
net present values.
The conclusion to be drawn from these examples is that the FTE, APV, and the
cost of capital derived NPV are consistent and will give correct results when used
correctly. However, how do we determine the optimal level of debt financing to be
used in the APV and FTE formulations, if we do not derive the NPV by using the
traditional cost of capital formulation first? Moreover, if we already know the
optimal level of debt financing, why do we need the APV and FTE analyses?
Hence, the APV and FTE methods should be judged on the basis of their results
when the debt financing is taken to be the first approximation of multiplying the
investment cost times the optimal debt-ratio. By this criterion the methods would
give correctly the go/no-go solutions for independent projects, while incorrectly
estimating the contribution of the project to stock market value. Moreover,unlike
the cost of capital formulation they give incorrect signals to the controller's of-
fice on the amount of debt and equity financing required.
The above comments do not, however, apply to the case of mutually exclusive
projects, where the use of APV and FTE methods could give incorrect decisions
when compared with the cost of capital formulation. Suppose, for example, the
preceding project with expected NOI of 250,000 were for a production facility in
country X where the low-cost loan was being provided as an inducement to offset
low labor productivity.The alternative is to set up production in country Y, where
there is no government subsidy, but the higher labor productivity offers the ex-
pectation of NOIof 307,500. Otherwise the projects are identical. In this case we
get the results in Table 4. Note that for the choice Y, we use the 50 percent debt
ratio that is optimal in the absence of interest rate subsidies to derive interest
payments of 75,000 and tax shield of 250,000 respectively. When using the cost of
capital formulation, project X is found to be superior to Y. The inducement of the
low-cost loan is sufficient to outweigh the lower labor productivity. On the other
hand, by using either the APV or the FTE methods of capital budgeting, we get a
reversal of choice and would select project Y, the higher productivity-nosubsidy
choice. Obviously, if we knew the answer beforehand, that the NPVs of the two
projects were 157, 407, and 138,888 respectively, we could change the amount of
debt financing to arrive at the optimal solution under both the APV and FTE
methods; however, this then makes the exercise redundant.

Journal of International Business Studies, Fall 1982 119


'X': 1 = 250,000, id = 5%

NPV - 1,000,000 = 157,407

(250,000)(0.5) /2\
APV 00 + 600,000 (- - 1,000,000 = 94,444
0.18 \3/

(250,000 - 60,000)(0.5)
FTE 500- [1,000,000 - 600,000] = 87,179

'Y': = 307,500, id = 0

NPV 305 - 1,000,000 = 138,888
APV 00 + 0.5[500,000] - 1,000,000 = 104,166
(307,500- 75,000)(0.5)
FTE 050- [1,000,000 - 500,000] = 96,154

To find out why the switch occurs, we can determine the indifference level of NOI
required of the free market option, choice Y, under the three capital budgeting
(250,000) (0.5) (0.5)_
NPV (9)
0.108 0.135
. 2 7r(0.5)
+ -[600,000] - - 0.5 [500,000] = 0; APV (10)
0.18 3 0.18
(250,000 - 60,000)(0.5) (F - 75,000)(0.5)
0.195- 0.195
0195100,000 = 0. FTE (11)

Solving for 7rwe get 312,500, 304,000, and 304,000 respectively; hence, the range
of preferences shown in Table 5. If NOI is expected to be greater than 312,500, all
three methods give the correct solution. Similarly, if NOI is expected to be less than
304,000, all three methods give the correct solution-however, between 312,500
and 304,000, the application of the FTE or APV methods of capital budgeting would
imply that between the competing projects an incorrect decision would be made.
Hence, the FTE and APV formulations are suspect.



> 312,500 Y Y Y
312,500 > r> 304,000 X Y Y
T < 304,000 X X X

120 Journal of International Business Studies, Fall 1982

It is possible that Lessard's suggestion that APV (or FTE)is easier to use might
mitigate its tendency to give incorrect results. In considering this we note that in
our simple case adjustments have to be made to all three of the capital budgeting
techniques to adapt to the complexity of international finance. Before consider-
ing these adjustments, however, we should note the three fundamental steps in
capital budgeting: 1. estimate the required return on equity for the project with-
out debt financing (that is, ko);2. estimate the project's debt capacity and hence
its own 'optimal capital structure'13;and 3. estimate the annual cash inflows.
These steps have to be taken regardless of the capital budgeting technique. In
the traditional NPV analysis the adjustment to our complexity of international fi-
nance is to adjust the project's debt ratio and then substitute this plus the new
subsidized interest rate into the weighted average cost of capital. This adjust-
ment follows directly from step two. In the APV analysis, the subsidized interest
rate and optimal debt ratio are also needed in equation (2), but unlike the cost of
capital approach the APV also needs the value of the debt financing. Similarly, in
the FTEapproach the interest charges in Table 2 require that the amount of debt
be known, as does the determination of the amount of residual equity financing.
Hence, in this case, far from being simpler, the APV and FTEapproaches require
extra information on the dollar values of the optimal debt and equity financing.
The point of the foregoing analysis is that every complicated financing option
that causes the calculation of the cost of capital to be difficult also causes the
calculation of the additional terms in the APV equation or the equity flows in the
FTEequation to be difficult. Moreover,the APV and FTEequations create an ad-
ditional burden in requiringthat knowledge of the amount of the optimal debt fi-
nancing be known. It is true that Shapiro's [13] cost of capital adjustments and
others like them are cumbersome and awkward, but the same adjustments have
to be made in APV and FTE. Moreover,financial analysts are now being weaned
away from the single cost of capital concept in domestic finance by the inclusion
of risk adjustments via the CAPMin the requiredreturnon equity, and by indepen-
dent project debt capacity analysis. Because the additional complexities of inter-
national finance do not really require appreciably more complicated adjustments
than those currently required in domestic capital budgeting problems, Lessard's
argument for using the APV approach on grounds of simplicity is not proven.

The conclusions of this paper are listed; CONCLUSIONS

1. The FTE,APV,and cost of capital frameworks for capital budgeting will give
identical results if correctly used.
2. The FTEand APV frameworks require that the NPV of the project be known
prior to the analysis, otherwise the frameworks undervalue profitable proj-
ects and overvalue unprofitable ones.
3. The FTE and APV frameworks as normally applied can give incorrect deci-
sions in evaluating mutually exclusive projects.
4. The FTEand APV frameworks give little help to the controller in determining
the company's equity and debt financing requirements.
5. The FTEand APVframeworks requirethe same complicated adjustments as
the cost of capital formulation and are not in general easier to use if correct
solutions are required.
In summary, the APV and FTE approaches need to be used with care. In partic-
ular, the APV method is not a panacea to cope with the intricacies of capital
budgeting for the MNC. One should not be seduced by the precision of the APV
valuation equation into believing that it is in any way simpler to use or more accu-
rate than the traditional NPV cost of capital technique.

Journal of International Business Studies, Fall 1982 121

FOOTNOTES 1. Eiteman and Stonehill [3] devote one chapter specifically to capital budgeting and most
of the chapter is devoted to analyzing the MEC-USAcase. Rodriguez and Carter [11] spend
four chapters on the investment decision, including two specifically on capital budgeting
techniques. Although they spend considerable time on an extended case analysis, the Free-
port Minerals case, they discuss the three capital budgeting techniques compared in this
paper as well as presenting an extended analysis of the portfolio approach.
2. This 'imperfection'exists to a lesser degree for purely domestic corporations, but is not
a significant part of their financial environment.
3. The same argument is made by Rodriguez and Carter [11, p. 486]: "Whetheror not the
corporation can do better than the individualinvestor depends on the corporation's access
to projects which the individualcan not invest in directly."
4. We abstract from the problem of exchange rate changes because both investments are
in the same country. The eurocurrencyborrowingrate can be used to approximate the real
borrowingrate (Kdl) if interest rate subsidies are pervasive.
5. As pointed out by a referee, from an operational standpoint this is not a strong argu-
ment, because countries do not impose equal restrictions on cash repatriated as dividends
and interest; hence, the financing decision will affect these remittances and transfers as
the parent attempts to maximize the cash flow capable of being returned for possible in-
vestment elsewhere. However, the addition of another term will not affect the structure of
these results or the objective of this paper of comparing different capital budgeting tech-
niques. An alteration of the valuation equation would be requiredif any of these techniques
were to be applied to a particularproblem.
6. See any of the recent analyses of bankruptcy,by Kim [6] and Scott [12] for example.
7. The increased borrowing is merely a reflection of the constant real financial leverage
and the fact that if traded the low-cost loans provided by the host government would only
be worth D = Kd2D*/Kdl. This implies that equation (2) overstates the tax advantage to debt
(D*tc)and understates the advantage of being provided with low-cost loans id(1 - tc)D*/
Kdl. Substituting the 'market'value of the low-cost loans into equation (2) and rearranging
we have,

VL = Vu + Dtc + -D.
This indicates that the tax advantage to debt is constant, increased borrowing offsetting
lower interest costs and that the provision of low-cost loans is really a straight wealth
transfer from the host government to the MNCstockholders. However, because the debt is
not marketable, the author will use equation (2) to analyze the capital budgeting criteria.
Also note that in practice the firm may be limited as to the amount of low-cost funds avail-
able. In this case, the firm would borrow the maximum amount of low-cost debt and then
top up with debt at market rates until the constraint of (4) is binding.This would change the
valuation equation of (2), because the wealth transfer is not as great. However,the analysis
that follows would go through exactly the same, once this alteration to the valuation equa-
tion was made.
8. According to the alternative valuation equation of footnote 7, where debt is valued at its
implicit market value, the Modigliani and Millercost of capital is Ko[1 - D/V[tc + ic/Kdl]],
and we can see more clearly that the cost of capital must fall as the interest subsidy (id)in-
9. The earnings yield, Ke,is defined as
(7 - Kd2D*)(1 - tc)
Ke =

if we add and subtract Kd2D*(1- tc)/Kofrom equation (2),subtract D* from both sides, mul-
tiply through by Ko/S*,and rearrangeusing the above definition,we obtain (6).
10. This paper concentrates on the three capital budgeting techniques analyzed by Tag-
gert with specific reference to the APV/FTEv's cost of capital question raised by Lessard
[7]. If further complexities are added, such as, blocked funds or expropriation, other tech-
niques, such as, the terminal rate of return(TROR)suggested by Rodriguezand Carter [11],
may be useful. In this analysis with no such restrictions, the TROR,assuming reinvestment
at the cost of capital, would give the same results as the cost of capital formulation.
11. See Booth [1] for an analysis of the equality of the Modiglianiand Millerand traditional
cost of capital calculations with personal taxes and bankruptcyrisk.
12. If we use the equations in (7) and (8), then the true values are 200,000 for the tax shield
on debt and 200,000 for the wealth transfer. The nominal debt value of 600,000 overstates
the tax shield value and understates the wealth transfer. Its 'market value' would be only
400,000. In table 3 the '2/3' is arrivedat by substituting t = 0.5, id = 0.05, and Kdl = 0.15
into the debt term in (2).

122 Journal of International Business Studies, Fall 1982

13. Note that while the APV method "explicitly recognizes the interaction between invest-
ment and financing effects," Lessard [7, p. 578], by separating out each component's con-
tribution to value, it is of no help in determining that interaction-that is, the individual
project's debt capacity. Hence we need the kind of portfolio approach to debt capacity con-
sidered in Rodriguez and Carter [11]. In our hypothetical examples debt capacity was fixed
by the coverage ratio constraint at a debt ratio of 60 percent. Whateverthe debt ratio of the
project is determined to be, our analysis shows that the APV and FTEapproaches will not
give the correct NPV,as long as that NPV is not zero. Hence, none of the three capital bud-
geting techniques have anything to say on the interaction between the investment and fi-
nancing decision. They are concerned with the calculation of the net present value once
that decision has been made, and here only the cost of capital formulation is free of
methodological bias.

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Journal of International Business Studies, Fall 1982 123

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