Professional Documents
Culture Documents
Week 12
International Capital Budgeting
Shapiro: Chapters 16 + 17
B&H: Chapters 15 + 16
\
from SHAPIRO – Multinational Financial Management (10E)
from BEKAERT & HODRICK – International Financial Management (2E)
YOUR TUTOR & TUTOR IN CHARGE
Peter Kjeld Andersen
peter.andersen@unsw.edu.au
PARENT’S PERSPECTIVE
(i.e. when cash flows are first converted to the parent’s domestic currency
at the expected future spot rates and then discounted)
REJECT ALSO!
This is a BAD project when evaluated as
NPV IS REJECT! from the project’s perspective. But it
looks good from the parent perspective
NEGATIVE (duh!) purely because of expected favourable
currency movements. This is basically
PROJECT’S just using a project as an excuse for
PRESPECTIVE currency speculation.
Expected inflation is 6.0% in the Brazilian real and 2.0% in the United States dollar. Assume that the
international parity conditions hold.
Required returns for projects in this risk class are:
BRL
rWACC = 19.0% in Brazilian real
USD
rWACC = 14.509% in United States dollars
The spot exchange rate is:
SBRL/USD
0 = BRL 3.8735/USD
Q. What is the NPV of the investment from the project’s perspective? That is, calculate NPV0BRL | rWACC
USD
Q. What is the NPV of the investment from the parent’s perspective? That is, calculate NPV0BRL | rWACC
BRL
Step II: Convert the NPV from the project currency (USD) at today’s spot rate to the parent currency (BRL)
NPV0BRL = NPV0USD SBRL/USD
0
2 2
BRL/USD 1 + 1 + 0.06
BRL
E S 2
BRL/USD
= S0 = BRL 3.8735/USD 1 + 0.02 = BRL 4.1833/USD
1 + USD
3 3
1 + BRL 1 + 0.06
E S BRL/USD
= S BRL/USD
USD
= BRL 3.8735/USD 1 + 0.02 = BRL 4.3473/USD
1+
3 0
Expected inflation is 16.0% in the Swedish krona and 3.0% in the Danish krone.
Required returns for projects in this risk class are:
SEK
rWACC = 13.5% in Swedish krona
DKK
rWACC = 13.1% in Danish krone
The spot exchange rate is:
S0SEK/DKK = SEK 1.3696/DKK
Q. What is the NPV of the investment from the project’s perspective?
Step II: Convert the NPV from the project currency (DKK) at today’s spot rate to the parent currency (SEK)
NPV0SEK = NPV0DKK S0SEK/DKK
= ( −DKK 324.99 ) SEK1.3696/DKK
= − SEK 445.11
2 2
SEK/DKK 1 + 1 + 0.16
SEK
E S 2
SEK/DKK
= S0 = SEK 1.3696/DKK 1 + 0.03 = SEK 1.7371/DKK
1 + DKK
3 3
1 + SEK 1 + 0.16
E S SEK/DKK
= S SEK/DKK
DKK
= SEK 1.3696/DKK 1 + 0.03 = SEK 1.9564/DKK
1+
3 0
Expected inflation is 9.0% in the Indian rupee and 6.0% in the United States dollar. Assume that the
international parity conditions hold.
Required returns for projects in this risk class are:
INR
rWACC = 14.0% in Indian rupee USD
rWACC = 10.862% in United States dollar
And take the difference between the unblocked and blocked values to calculate the opportunity cost:
0 = Value Unblocked0 − Value Blocked0
Opportunity Cost USD USD USD
Step IV: Convert this final value into Indian rupee at today’s current spot rate
NPV0,INRwith side effects = NPV0,USDwith side effects SINR/USD
0
YEAR 1 2 3 4 5 6 7 8 9 10
Forecast inflation 7.00% 5.50% 5.00% 4.75% 4.60% 4.50% 4.43% 4.38% 4.33% 4.30%
AUD running cost of
48.55 51.22 53.78 56.34 58.93 61.58 64.31 67.12 70.03 73.04
old machine
% cost saving 10% 15% 20% 20% 20% 20% 20% 20% 20% 20%
Pre-Tax AUD Cost
4.86 7.68 10.76 11.27 11.79 12.32 12.86 13.42 14.01 14.61
Savings
• The basic FCFF calculation is to the right. In this question Add: Depreciation
= Effect on EBIT =2.26 =5.08 =8.16 =8.67 =9.19 =7.62 =8.16 =8.72 =9.31 =9.91
Less: Tax @ 40% –0.90 –2.03 –3.26 –3.47 –3.68 –3.05 –3.26 –3.49 –3.72 –3.96
= Effect on NOPAT =1.36 =3.05 =4.90 =5.20 =5.51 =4.57 =4.90 =5.23 =5.59 =5.95
Add Back: New Dep +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70
= Effect on CFs =3.96 =5.65 =7.50 =7.80 =8.11 =9.27 =9.60 =9.93 =10.29 =10.65
Then at this stage you have two options for working out the NPV in your domestic currency (the USD):
1. Work out the NPV at t=0 in AUD by discounting the AUD cash flows above using an AUD discount rate. And then convert that
NPV at t=0 at today’s spot exchange rate (S0) from AUD to USD.
2. Convert all of the AUD cash flows from t=0 to t=10 at the appropriate spot rates (S0 to S10) into USD equivalents. And then
present value those USD cash flows to work out the USD NPV directly.
If all of the international parity conditions hold, the two methods should give you the same USD answer.
But if the parity conditions DON’T hold they might give you either:
1. A different sized positive USD NPVs to each other (so which is the real USD NPV?)
2. A positive USD NPV via one method and negative via the other (so accept or reject?)
Tax shields could be the same every year for a FINITE number of years (for example, if you’ve got a 10
year bond with annual coupons. Then you only have 10 years of interest payments that you can deduct
from your profits.
Or, as we’ll see in the coming example, you might have a different interest charge every year over the
life of your debt (because it’s a loan whose principal amortizes each year), which means your tax shield
will get smaller and smaller each year over the loan’s life also!
So 8 equal annual payments of $52.7022m each year will fully and exactly pay off the $327.27m principal
we borrow for the loan at t=0 and the interest accumulated each year over it’s life.
Principal repaid in year $33.07 $35.05 $37.15 $39.38 $41.75 44.25 $46.90 $49.72
(total repayment – interest repaid)
Mandatory loan
–$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70
repayment
Interest Tax Shield +$6.68 +$6.00 +$5.29 +$4.53 +$3.73 +$2.87 +$1.97 +$1.01
(Interest Charged x 34% tax rate)
= Total Dollar Cash Flows +$327.27 –$46.03 –$46.70 –$47.42 –$48.17 –$48.98 –$49.83 –$50.73 –$51.69
Q. What does the amortization schedule of this €300m loan look like?
YEAR 0 1 2 3 4 5 6 7 8
Opening Principal Balance 300.00 266.86 232.55 197.05 160.30 122.27 82.91 42.17
Add: Interest Charged on
+€10.50 +€9.34 +€8.14 +€6.90 +€5.61 +€4.28 +€2.90 +€1.48
Opening Balance at 3.5%
Less: Mandatory loan
–€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64
repayment
= Closing Principal Bal €300.00 €266.86 €232.55 €197.05 €160.30 €122.27 €82.91 €42.17 €0.00
Principal repaid in year €33.14 €34.30 €35.50 €36.75 €38.03 €39.36 €40.74 €42.17
(total repayment – interest repaid)
1 + iRF
T 0
in each currency when forecasting exchange rates in
the general market. That would be dumb dumb.
1
1 + 0.04
E S $/ €
= $1.0909/€ = $1.0805/€
+
1
1 0.05
2
1 + 0.04
E S $/ €
= $1.0909/€ = $1.0702/€
+
2
1 0.05
7
1 + 0.04
E S $/€
= $1.0909 /€ = $1.0202/€
1 + 0.05
7
8
1 + 0.04
E S $/€
= $1.0909/€ = $1.0105/€
1 + 0.05
8
Principal Repayment in € €33.14 €34.30 €35.50 €36.75 €38.03 €39.36 €40.74 €42.17
Spot and Forecast Spots $1.0909/€ $1.0805/€ $1.0702/€ $1.0600/€ $1.0499/€ $1.0399/€ $1.0300/€ $1.0202/€ $1.0105/€
Less: Interest Payment in $ –$11.35 –$10.00 –$8.63 –$7.24 –$5.83 –$4.41 –$2.96 –$1.49
(Interest paid in € x Spot Rate )
Add: Interest Tax Shield +$3.86 +$3.40 +$2.93 +$2.46 +$1.98 +$1.50 +$1.01 +$0.51
(Interest paid in $ x 34% tax rate)
Less: Capital Gains Tax –$0.12 –$0.24 –$0.37 –$0.51 –$0.66 –$0.81 –$0.98 –$1.15
(€ Principal PaidT x (S0–ST) x 34%)
= Total Dollar Cash Flows +$327.27 –$43.42 –$43.55 –$43.70 –$43.87 –$44.06 –$44.27 –$44.50 –$44.75
Q. What does the amortization schedule of this ¥36b loan look like?
YEAR 0 1 2 3 4 5 6 7 8
Opening Principal Balance ¥36.00 ¥31.73 ¥27.40 ¥23.00 ¥18.54 ¥14.00 ¥9.41 ¥4.74
Add: Interest Charged on
+¥0.54 +¥0.48 +¥0.41 +¥0.34 +¥0.28 +¥0.21 +¥0.14 +¥0.07
Opening Balance at 1.5%
Less: Mandatory loan
–¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81
repayment
= Closing Principal Bal ¥36.00 ¥31.73 ¥27.40 ¥23.00 ¥18.54 ¥14.00 ¥9.41 ¥4.74 ¥0.00
Principal repaid in year ¥4.27 ¥4.33 ¥4.40 ¥4.46 ¥4.53 ¥4.60 ¥4.67 ¥4.74
(total repayment – interest repaid)
1 + iRF
1
1 + 0.025
E S ¥/$
= ¥110/$ = ¥108.41/$
1 + 0.04
1
2
1 + 0.025
E S ¥/$
= ¥110/$ = ¥106.85/$
1 + 0.04
2
7
1 + 0.025
E S ¥/$
= ¥110/$ = ¥99.36/$
+
7
1 0.04
8
1 + 0.025
E S ¥/$
= ¥110/$ = ¥97.93/$
+
8
1 0.04
Principal Repayment in ¥b ¥4.27 ¥4.33 ¥4.40 ¥4.46 ¥4.53 ¥4.60 ¥4.67 ¥4.74
Spot and Forecast Spots ¥110.00/$ ¥108.41/$ ¥106.85/$ ¥105.31/$ ¥103.79/$ ¥102.29/$ ¥100.82/$ ¥99.36/$ ¥97.93/$
Less: Interest Payment in $ –$4.98 –$4.45 –$3.90 –$3.32 –$2.72 –$2.08 –$1.42 –$0.73
(Interest paid in ¥ ÷ Spot Rate )
Add: Interest Tax Shield +$1.69 +$1.51 +$1.33 +$1.13 +$0.92 +$0.71 +$0.48 +$0.25
(Interest paid in $ x 34% tax rate)
Add: Capital Gains Subsidy +$0.19 +$0.39 +$0.61 +$0.83 +$1.06 +$1.29 +$1.54 +$1.80
(See over slide)
= Total Dollar Cash Flows +$327.27 –$42.47 –$43.10 –$43.73 –$44.38 –$45.03 –$45.70 –$46.37 –$47.05
1 1
= ¥4.27b − 34% = −$0.19m (negative implying tax subsidy)
¥110/$ ¥1 0 8 .41 /$
1 1
= ¥4.74b − 34% = −$1.80m (negative implying tax subsidy)
¥110/$ ¥ 9 7 .93/$
NOTE: In the solutions on each slide to this ¥ loan I have automatically converted from billions of ¥ to millions of $ without showing
the addition division factor of 1,000. Just be careful :)
FINS3616 — Peter Kjeld Andersen (2018-S2)
SUMMARY: Comparing the three loans:
• Borrowing $327.27m directly in your domestic USD has a NPV of $26.42m
• Borrowing €300m from your German supplier has a NPV of $54.31m
• Borrowing ¥36b from your Japanese supplier has a NPV of $50.75m
Banana should take the subsidized German loan of €300m as it adds the most value to the firm.
Both the German and Japanese loans have much higher NPVs than just borrowing domestically, as the
Hard Disk suppliers are offering us those loans at a subsidized interest rate BELOW their domestic risk-free
rate to entice us to borrow from them. But our domestic U.S. bank isn’t generous like that.
The expected depreciation of the € over the 8 year loan term makes it easier and cheaper to repay the
principal & interest repayments on the € loan.
Whereas the expected appreciation of the ¥ makes it harder and more costly to repay the principal and
interest on the ¥ loan each year.
Less: Depreciation
= EBIT EBIT: Earnings Before Interest & Taxes aka “Pre-Tax Operating Income”
Add: Depreciation
= Operating Cash Flows In addition to your OCF (aka “Gross Cash Flow”), in any year of the
project you could also have changes in working capital AND capital
Less: Δ Non-cash Working Capital
expenditure occurring. These things can happen anytime, not just
Less: Capital Expenditure at the start/end of the project. Similarly you could dispose of
assets and have an after-tax salvage value at any point in time;
Add: After-Tax Savage Value NOT just at the end. It always depends on the particulars of the
project in question.
= Project Net Free Cash Flows
FINS3616 — Peter Kjeld Andersen (2018-S2)
Q. What is meant by the cannibalization of an export market?
A. When you choose to change how you service a market to which you are exporting, either because you are
building a new plant in the foreign country or you are expanding production in an existing plant, you would
like to know the incremental profitability of this new project.
Cannibalization of exports refers to the lost exports in this market that you are now serving differently if no
market can be found for the goods that were formerly being exported to that country.
These lost exports could be from the parent or from another one of its foreign subsidiaries in a different
country. The lost profits on these exports must be considered to be a cost of accepting the new project.
If the exports that were formerly being sent to the country can be sold elsewhere in the world, there is no
cannibalization.
Q. Projects with different risks are likely to have different debt capacities, which require the same capital
structure.
A. False. The capital structures should be allowed to be separate for each project, and so allow differences.
Q. The additional economic and political risks faced by the MNC should be incorporated into the capital
budgeting analysis by adjusting the discount rate instead of the cash flows.
A. False. The cash flows should be adjusted in preference to changing the discount rate.
Q. The discount rate should always be in the parent firm’s functional currency.
A. False. The discount rate should be in the currency in which the cash flows are received.
Q. In capital budgeting, repatriation occurs when expatriate employees return to the parent firm.
A. False. Repatriation is the act of remitting cash flows to the parent firm.
Q. Emerging countries sometimes require that foreign companies investing capital locally take on additional
development or infrastructure projects.
A. True.
Q. When forecasting the price at which products can be sold in the foreign country, domestic prices should
be used as the most likely estimate.
A. False. The likely selling price for products in the foreign country may have no relation to domestic prices
(different inflation, market share, industrial structure) and so information from the foreign country should
be used.
Q. Because funds rest with the subsidiary and are therefore a part of the MNC, fund-transfer restrictions are
irrelevant in multinational capital budgeting.
A. False. A key measure of the value of a project in the foreign country is the value of cash flows from the
project that can be repatriated to the parent (domestic) country. Restrictions on the transfer of funds from
the subsidiary to the parent may change project value for the parent.
Q. Because inflation is only one of many factors that influence exchange rates, there is no guarantee that a
currency will depreciate when the local inflation rate is relatively high.
A. True.
Q. The greater the uncertainty about a project’s forecast cash flows, the larger should be the discount rate
applied to cash flows, other things being equal.
A. True.
MARKET VALUE
OF EQUITY
E or MVE
Since a D/E ratio of 0.5 means you have $0.5 of debt for every $1.0 of equity... or $50 of debt for every $100
of equity… or $0.5b of debt per $1.0b of equity (etc.), you can apply our re-arranged M&M w/ taxes
equation to find RA:
MVEquity MVDebt
RA = RE + R D ( 1 − TC )
VU VU
MVEquity MVDebt
= RE + R D ( 1 − TC )
MVEquity + MVDebt ( 1 − TC ) MVEquity + MVDebt ( 1 − TC )
$1.00 $0.50
= 12.7% + 6% ( 1 − 0.34 )
$1.00 + $0.50 ( 1 − 0.34 ) $1.00 + $0.50 ( 1 − 0.34 )
= 11.0376%
FINS3616 — Peter Kjeld Andersen (2018-S2)
FINANCIAL
PV OF INTEREST DISTRESS COSTS
TAX SHIELDS PVBC
VL:LEVERED FIRM VALUE
Find VL directly by
discounting FCFFs
at WACC
Find MVD by
discounting
coupons at YTM. MARKET VALUE
OF DEBT
YTM should be
ABOVE the risk- D or MVD
free now, as the
UNLEVERED company has risk
FIRM VALUE of bankruptcy
that must be
VU compensated for
MARKET VALUE
OF EQUITY
E or MVE
Q. So what “annual income” (i.e. Free Cash Flow to Firm) gives NPV=£0?
FCFF1
A. NPV0 = − CF0
R WACC
FCFF1
£0 = − £30m → FCFF1 = £30m 0.1619 = £4.857m of cash flow annually
0.01619
VU = E + D − TC D = E + D(1 − TC )
UNLEVERED
FIRM VALUE
MARKET VALUE
VU OF EQUITY
= £25.8m E or MVE
65% of £30m
= £19.5m
For curiosity (and to align with the lecture slides), another way to calculate FCFE (or “FTE”) from FCFF
(without going back to EBIT first like I did) is as follows:
FCFE = FCFF − Interest Expense ( 1 − TC ) + Net Debt Issued
= ¥1.132b − ¥0.36 ( 1 − 0.30 ) + $0 = ¥1.132b − ¥0.252
= ¥0.88b of cash flow available for EQUITY holders every year