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LAURENCED. BOOTH*
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.
*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.
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
MODELS
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 lowcost development loan used to at
tract an MNC into a developed or underdeveloped country. Because the stock
holder does not have access to this lowcost 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 lowcost 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:
Kd21
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:
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 lowcost loans available to the
MNC. For the general case, Lessard [7, p. 581) writes the APV equation for MNC
capital budgeting as,
T
Ct(1  tc) tcDEPt tclNTt AINTt TRt
APV =
APV E
[ + + + +
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 aftertax 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 aftertax 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).
TABLE 1
Kd2
borrow on margin  aD(1  tc) K  Kd2D(1  tc)
Kdl
a Vu  D(1  tc)
KdI [F Kd2D](1 tc)
L K2KdlJ
Definitions:
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.
z, (4)
Kd1D
KdlD
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 lowcost 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
project.7
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 (1tc)
>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 projectthat 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 aftertax 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 lowcost 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 aftertax 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 lowcost 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 lowcost 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'
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 debtequity 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
TABLE2
Capital Budgeting Techniques
TraditionalNPVanalysis
f(1  t) I S* D*
KA = Ke + Kd(1  tc)
KA V V
AdjustedPresentValueanalysis
7r(1  tc) idD* (1  tc)
+ Dt
>D
+ + 0
Ko Kdl
Flowsto Equityanalysis
(  KdD*)(1  tc) _ ( D*) >
Ke
TABLE 3
X = 216,000
(216,000)(0.5)
NPV  1,000,000 = 0
0.108
(216,000)(0.5) /2\ 
APV .1 + 6000 
1,000 ,000 = 0
0.18
(216,000  60,000)(0.5)

FTE 00 [1,000,000  600,000] = 0
0.195
= 250,000
(250,000)(0.5)
NPV  1,000,000 = 157,407
0.108
(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
0.195
= 200,000
(200,000)(0.5)
NPV  1,000,000 =  74,074
0.108
'X': 1 = 250,000, id = 5%
(250,000)(0.5))
NPV  1,000,000 = 157,407
0.108
(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
0.195
'Y': = 307,500, id = 0
(307,500)(0.5)
5
NPV 305  1,000,000 = 138,888
0.135
(307,500)(0.5)
APV 00 + 0.5[500,000]  1,000,000 = 104,166
0.18
(307,500 75,000)(0.5)
FTE 050 [1,000,000  500,000] = 96,154
0.195
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
techniques:
(250,000) (0.5) (0.5)_
NPV (9)
0.108 0.135
(250,000)(0.5)
. 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)
0.195
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 solutionhowever, 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.
TABLE 5
> 312,500 Y Y Y
312,500 > r> 304,000 X Y Y
T < 304,000 X X X
VL = Vu + Dtc + D.
Kdl
This indicates that the tax advantage to debt is constant, increased borrowing offsetting
lower interest costs and that the provision of lowcost 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 lowcost funds avail
able. In this case, the firm would borrow the maximum amount of lowcost 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
creases.
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).