I.

The Multinational Corporation

Definition:
Globalization: producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest,
without worrying about national boundaries.

Multinational corporation: A parent company in the firm’s originating country and operating subsidiaries, branches, and affiliates
abroad in order to take advantage of globalization opportunities.

→ Goal: Increasing the value of the company, primarily equity value of company.

Strategic Motives to Operate Abroad:

1. Market seekers: produce in foreign markets to satisfy local demand or export to markets other than their home market. E.g.
Coca-Cola in >200 countries to increase sales
2. Raw material seekers: extract raw materials wherever they can be found to export or further processing and sell in the
country in which they are found. E.g. Shell to get access to oil
3. Production efficiency seekers: produce in countries where one or more of the factors of production are underpriced relative
to their productivity. E.g. IBM to get access to cheap highly skilled labor
4. Knowledge seekers: Firms which operate in foreign countries to gain access to technology or managerial expertise. E.g.
Huawei to get specifically skilled workers
5. Political safety seekers: acquire or establish new operations in countries with lower political risk than their home country.

The Globalization Process:

- For quality reasons

- Intellectual property
protection
- Control over value
chain
= FDI Orange = multinational
- Very expensive
- Control of Marketing, product portfolio, corporations
quality
- Lower risk

- Lower investment (50/50)

- Use of knowledge of local
partner

Nothing there yet

(production, sales
network etc.)

Foreign Direct Investment – Motivation:

Why do corporations directly invest in foreign countries?
1. Trade barriers
- Tariffs, quota, and other restrictions on the free flow of goods, services, and people
- Trade Barriers can also arise naturally due to high transportation costs, particularly for low value-to-weight goods
2. Labor Market Imperfections
- Among all factor markets, the labor market is the least perfect
- If there exist restrictions on the flow of workers across borders (e.g. immigration barriers, social preferences), then
labor services can be underpriced relative to productivity
3. Intangible Assets
- Coca-Cola has a very valuable asset in its closely guarded “secret formula”
- To protect that proprietary information, Coca-Cola has chosen FDI over licensing
- Since intangible assets are difficult to package and sell to foreigners, MNCs often enjoy a comparative advantage
with FDI

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 4. Vertical Integration
- MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable
price
- May be backward or forward
o Backward: furniture maker buys a logging company
o Forward: U.S. auto maker buys a Japanese auto dealership
5. Product Life Cycle
- Domestic firms develop new products in the developed world for the domestic market, and then markets exoand
overseas as products mature
- FDI takes place when product maturity hits and cost become an increasingly important consideration for the MNC
- Product innovations take place outside the developed countries as well and new products are being introduced
simultaneously in many countries
6. Shareholder Diversification
- Firms may be able to provide indirect diversification to their shareholders if there exists significant barrier to the
cross-border flow of capital

FDI: Specific Considerations for Multinational Corporations:

1. Market Imperfections:
- Legal restrictions on the movement of goods, people, money
- Transaction costs
- Shipping costs
- Discriminatory taxation
2. Foreign Exchange Risk:
- Risk that foreign currency profits may evaporate in home currency terms due to unanticipated unfavorable
exchange rate movements
- Suppose 1USD = 1YEN, you buy 10 shares of Toyota at 10,000YEN per share. If yen has depreciated to 1USD =
120YEN, investment has lost money in dollar terms.
3. Political Risk:
- Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders
- These laws sometimes change in unexpected ways

II. Fundamentals of Capital Budgeting

Example HomeNet:
HomeNet is an application to run an entire home from any internet connection. A feasibility study supports the attractiveness. How
to decide whether this is a good project?

General approach for project evaluation:

Net present value rule (Kapitalwertmethode):
𝑁
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑
(1 + 𝑖)𝑡
𝑡=0
𝑁
𝐶𝐹𝑡
𝑁𝑃𝑉 = −𝐼0 ∑
(1 + 𝑖)𝑡
𝑡=1

Practical considerations:
- How to forecast future CFs?
- How to deal with infinite projects?
- How to determine the right discount rate?
- How to deal with the impact of project financing in a world with taxes? (Ch. III)

Steps:
1. Forecast incremental earnings
2. Determine FCF from earnings
3. Determine risk-adjusted discount rate
4. Calculate the Net Present Value

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Step 1 – Forecast earnings: Revenue and cost forecasts:
Definition: Incremental earnings is the amount by which the firm’s earnings are expected to change as a result of the investment
decision → Relevant starting point.
E.g. SG&A costs already exist.

Example:
- Revenues:
- Project has an estimated life of 4 years.
- Revenue estimates:
▪ Sales 100,000 units/year (amount usually increases over project time)
▪ Price per unit $260
- Costs:
- Up-Front R&D=$15,000,000 (not CapEx, no asset, but operational expense)
- Up-Front New Equipment = $7,500,000
▪ Expected life is 5 years
▪ Housed in existing lab
- Annual overhead = $2,800,000 (=SG&A)
- Per Unit Cost = $110
- No interest expenses as we assume the company is 100% equity financed

Example HomeNet:

Step 1 – Forecast earnings: Impact of financing:

Why are interest expenses not included in the earnings forecast?
- In capital budgeting decisions, interest expense is typically not included, because the project should be judged on its own, not
on how it will be financed.
- Assuming all projects are 100% equity financed. Financing included at later stage.
- Rules:
- In perfect capital markets: Financing does not influence the value of a project (separation principle)
- In a world with taxes: Interest tax shield creates value and must be included in valuation. Different methods see
Chapter III.

Step 1 – Forecast earnings: Taxes:

How do taxes affect the forecasted earnings?
- Marginal Corporate Tax Rate = tax rate on marginal or every additional dollar of pre-tax income.

𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 = 𝐸𝐵𝐼𝑇 ∗ 𝜏𝑐

𝜏𝑐 = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

- Note: A negative tax is equal to a tax credit.

Example HomeNet:
- The $15 mio in costs from the project reduce Cisco’s taxable income in year 0 by $15 mio.
- If Cisco earns a taxable income elsewhere in year 0 to offset HomeNet’s losses (all costs are consolidated)
Cisco will owe $15 million x 40% = $6 mio less in taxes in year 0
- A similar credit applies in year 5

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Step 1 – Forecast earnings: Indirect effects:
Opportunity Cost:
= The value a resource could have provided in its best alternative use

Example HomeNet:
Space will be required for the investment. Even though the equipment will be housed in an existing lab, the opportunity cost of not
using the space in an alternative way (e.g., renting it out) must be considered.
Example: Alternative use: Warehouse space rented out for $200,000 per year. Extra costs of $200,000 during years 1-4.

Project Externalities:
- = Indirect effects of the project that may affect the profits of other business activities of the firm. Cannibalization is when
sales of a new product displace sales of an existing product.

Example HomeNet:
25% of customers would have purchased other Linksys product at a price of $100.
→ Loss in sales of 25% x 100,000 units x $100/unit = $2.5 mio p.a.
→ Reduction in costs of 25% x 100,000 units x $60/unit = $1.5 mio p.a.

Example HomeNet:

→ Final result of Step 1

Step 1 – Forecast earnings: Sunk costs:

Sunk costs = costs that have been or will be paid regardless of the decision whether or not the investment is undertaken.
- General rule: If our decision does not affect the cash flows, then the cash flow should not affect our decision.
- E.g. restaurant scenario: feeling full but eating because you paid
- Examples:
- Fixed overhead expenses, when no additional resources required
- Past R&D expenditures. E.g. feasibility study not included in example P&L, but R&D was included, but in t=0 so
suggested to be sunk costs.

Step 1 – Forecast earnings: Revenue forecasts in practice:

In general: Revenues = Units sold x Unit price
→ Quantity and unit price should be forecasted separately. Both variables are highly influenced by market forces.
Quantity: Market matured? Innovations to enter market? Growing market? Competition?
Price: Increasing (scarcity, monopoly), stable, decreasing (as competition increases).

Two general approaches:

Bottom-up:
- = Extrapolation (estimation of future values based on historical data) of quantities and prices based on initial revenue on a
company level.
- Key problems:
- Often driven by “wishful thinking” and often leading to revenue figures which would represent an unlikely gain in
market share.
- Lack of data on a company level.

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Top- down:
MORE RELIABLE
- Step 1: Extrapolation of total market size based on market expectations for quantities and prices (trends and driver based)
- Step 2: Derivation of company revenues based on expected market share.

Step 1 – Forecast earnings: Cost forecasts in practice:

In general: Costs are mainly driven by internal company processes.
→ Costs should be forecasted based on current cost situation of the company + expectations on future changes.

Approach:
1. Determine key driver(s) of each cost line item. E.g. estimated future sales x costs per unit
- Examples:
▪ COGS: Number of units sold (from topline forecast) and COGS per unit (bottom-up estimate)
▪ Selling and shipping costs: % of sales
2. Determine historic values for drivers as a basis for forecast (if applicable)
3. Forecast future values of drivers (constant or explicit changes if reasonable)
4. Calculate cost items

Future forecast will include P&L forecast AND balance sheet forecast for upcoming year.
→ Time consuming, but reliable.
→ Probably lack of input data.
Much easier: Assume EBIT Margin on historical data or competitors/market data

How to increase EBIT:

- Economies of scale
- Increase in price (very rare)
- Higher sales, but also higher COGS

How to decrease EBIT:

- Increasing costs for raw material without increasing prices
- Pressure on prices (competition) while costs are stable → shift focus on managing down the costs.

Step 2 – Forecast earnings: Revenue forecasts in practice:

- Earnings are only an accounting figure. You cannot pay anything from earnings. In Finance we look at the impact of a
decision on cash (Cash is king).
- The incremental effect of a project on a firm’s available cash is its free cash flow.
= The FCF represents the cash that is available for distribution among creditors and shareholders of a company after
investments have been made and taxes are paid.

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Why taxes on EBIT?: Bc. financing should not have impact = assuming company is 100% equity financed and bc. of depreciation tax
shield (not interest tax shield!!).
NOPLAT = Unlevered net income
NWC: Minus when increase, plus when decrease

Step 2 – Determining Cash Flows: Example HomeNet:

Example HomeNet:

Line 12 and 13 after NWC.

Step 2 – Determining Cash Flows: Net Working Capital:

Net working capital are current assets which are long-term financed. E.g. Cash for bills.
We need change in NWC to get impact on FCF.

∆𝑁𝑊𝐶𝑡 = 𝑁𝑊𝐶𝑡 − 𝑁𝑊𝐶𝑡−1

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 Example HomeNet:
Assumptions:
- No cash, no inventory
- Receivables: 15% of sales
- Payables: 15% of COGS

→ Spent 2,100

Step 2 – Determining Cash Flows: Direct Calculation of FCF:

Same as in table as a formula:

1. Formula:

𝐹𝐶𝐹 = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) ∗ (1 − 𝜏𝑐 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶

EBIT Unlevered Net Income

2. Formula:

𝐹𝐶𝐹 = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠) ∗ (1 − 𝜏𝑐 ) − 𝐶𝑎𝑝𝐸𝑥 − ∆𝑁𝑊𝐶 + 𝜏𝑐 ∗ 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

After-tax cash flow from operations Investments Depreciation tax shield

Depreciation tax shield: Tax savings from ability to deduct depreciation → positive impact on cash flow.

Step 3 – Discount rate: CAPM to determine equity cost of capital:

- Discount rate should reflect an appropriate risk-adjusted cost of capital
- For now, we have assumed that the project/firm is 100% equity financed
- Discount rate should reflect the expected return that investors could earn on their best alternative equity investment
with similar risk
- Capital Asset Pricing Model (CAPM)
• The cost of capital of any investment opportunity equals the expected return of available investments
with the same beta
• Beta is the expected percent change in the return of the security for a 1% change in the return of the
market portfolio.
→ Beta measures systematic risk. Total risk is not important as firm-specific risk can be eliminated by
diversification.
→ The higher the beta the higher the risk premium. An average investor is risk-averse and the risk
premium is a compensation.
• The cost of capital is provided by the Security Market Line equation:
𝑟𝑖 = 𝑟𝑓 + ß𝑖 ∗ (𝐸[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )

𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑓𝑜𝑟 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖

𝑟𝑓 = 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐸[𝑅𝑀𝑘𝑡 ] = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

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Step 3 – Discount rate: Practical aspects of applying CAPM:
Market portfolio:
- In practice, proxies for market portfolios are used, e.g. S&P 500, MSCI World, CDAX
- Arithmetic or geometric mean of historical returns as estimate of expected future return

Market risk premium:

- Risk-free rate:
- Yield on risk-free long-term government bonds
- 10 to 30 year treasuries (e.g. Bundesanleihen)
- Usually not zero because of time value of money (inflation and postponed consumption)
- What if there is no risk-free government bond e.g. in Thailand?: Use e.g. Germany, convert currencies and
consider the difference in inflation.
- Market risk premium:
- Practitioners consider market risk premium in the range of 3-6% as possible.

Beta factor:
- Most common approach is to use beta factor from firm with comparable business.
Watchout: Beta needs to be adjusted if comparable firm is levered.
- Practitioners often use external data sources, e.g. MSCI, Bloomberg, OnVista/Comdirect
- If it is a publicly traded company information availability is good. If not, look for competitors.

Step 3 – Discount rate: Characteristics of high beta investments:

Beta expresses the sensitivity of the return of an investment relative to the overall market.
High beta means that investment reacts highly sensitive to up- and down-swings of the overall market (=economic conditions).

Typical characteristics of high beta investments include:

- Strong cyclicality of the business
- Industry with growth but strong competition
- Weak competitive position
- High operational leverage (high level of fixed costs)
- High financial leverage (high debt-to-value ratio)
- Low value of tangible assets

Step 4 – Calculating the NPV:

Example HomeNet:
Recall that in order to determine the NPV of an investment, the FCF has to be discounted using the risk-adjusted cost of capital:
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑𝑁 𝑡=0 (1+𝑖)𝑡

Assumption: Cost of equity capital = 12%

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Step 4 – Calculating the NPV: Choosing among alternatives:
Evaluating manufacturing alternatives:

Assume the company could produce each unit inhouse for $95 if it spends $5 mio upfront to change the assembly facility (versus
$110 per unit if outsourced). The inhouse manufacturing method would also require an additional investment in inventory equal to
one month’s worth of production (=1 month of COGS).

When comparing alternatives, only those CFs that differ between them need to be considered:
Upfront investment, COGS, NWC.

Outsource In-house
Cost per Unit = $110 Cost per Unit = $95
Investment in A/P = 15% of COGS Up-front cost = $5,000,000
- COGS = 100,000 units x $110= $11 mio. Investment in A/P = 15% of COGS
- Investment in A/P = 15% x $11 mio = $1.65 mio - COGS = 100,000 units x $95= $9.5 mio.
- NWC= -$1.65 mio in year 1 and will increase by - Investment in A/P = 15% x $9.5 mio = $1.425 mio
$1.65 mio in year 5 - Investment in inventory = $9.5mio /12 = $0.792 mio.
- NWC falls since this A/P is financed by suppliers - NWC= $0.792 mio - $1.425 mio = -$0.633 mio
→ NWC will fall by $0.633 mio in year 1 and increase
*A/P = accounts payables by $0.633 mio in year 5

→ EBIT equals COGS as this is the only line item that differs
→ Outsourcing leads to higher NPV and should therefore be preferred.
Due to simplification: only relative value (difference between both NPVs) is meaningful. Full-blown calculation leads to same
difference in relative numbers.

Step 4 – Calculating the NPV: Terminal or Continuation Value:

- Often times investments do not have a finite life, e.g. firm expansions, acquisitions of entire firms.
- NPV must consider all future cash flows over the entire (potentially indefinite) lifetime.

Practitioners approach:
- Explicit forecast of FCF over a shorter horizon (3-5 years)
- Additional one-time CF at the end of the forecast horizon, which captures the value of all remaining CFs until infinity
- Terminal Value mostly based on assumption that CFs grow with a constant growth rate beyond the forecast horizon. TV has
a large impact on NPV → think of assumptions on TV, no quick decisions.
→ for infinite value the discounted value is decreasing over time, approaching zero at one time.
Growth rate should be between inflation and market growth
Growth rate = 0%: due to inflation company would be shrinking
Growth rate = Inflation rate: no real growth
Growth rate > market growth rate: Cannot grow above market forever, market share is limited
Growth rate < market growth rate: no long-term growth is faster than the overall economy
Growth rate > discount rate: CFs will grow, DCF will also grow → infinite value.

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Example:

Continuation Value:
→ For year 5 and beyond

𝐹𝐶𝐹4 ∗ (1 + 𝑔)
CV in year 4 =
𝑟−𝑔

g = growth rate
r = discount rate

Result is value in year 4, therefore has to be discounted

III. Capital Budgeting and Valuation with Leverage

Excursus: Interest Tax Shield:

Definition: reduction in taxes paid due to the tax deductibility of interest.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠

Interest Tax Deduction: Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the
amount of corporate taxes.

Example:

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 - Because leverage allows the firm to pay out more in total to its investors, it will be able to raise more total capital initially
(=higher value).
- Application of formula in Safeways case:
𝐺𝑎𝑖𝑛 = $648 𝑚𝑖𝑜 − $525 𝑚𝑖𝑜 = $123 𝑚𝑖𝑜 𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑡𝑎𝑥𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 35% ∗ $350 𝑚𝑖𝑜 = $123 𝑚𝑖𝑜
- When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
- CFs to investors each year are higher than they would be without leverage by the amount of the interest tax shield.

Method Initial valuation Adjustments Result

ANPV - Cash flows: All equity firm (FCF) - Interest tax shield
- Discount rate: Unlevered cost of equity - Other sources of
→ Value of unlevered firm/project value: Subsidized
total value

financing, real
options,…
WACC - Cash Flows: All equity firm (FCF) Value of levered
- Discount rate: After-tax weighted average cost of firm/project
capital (Cost of equity and debt included, and tax → All methods lead to
shield included) the same result
FTE - Cash flows; After interest flow to equity - Add value of debt
equity value

- Discount rate: Levered cost of equity

→ Value of equity

Assumptions for example:

- The project has average risk: (Market) risk of the project is comparable to (market) risk of the overall firm which conducts
the project.
- The firm’s debt-equity ratio is constant: Firm adjusts its leverage to maintain a constant debt-to-equity ratio in terms of
market value.
→ Crucial assumption for WACC and FTE method, will be relaxed later
- Corporate taxes are the only imperfection: Main effect of leverage on valuation is due to corporate tax shield.

WACC: General idea:

- Instead of discounting CFs with an (unlevered) cost of capital, the CFs will now be discounted using a weighted average cost
of capital which includes the (levered) cost of equity as well as the after-tax cost of debt.
We can take into account the capital structure of the firm and incorporate the effect of the tax shield.
- Assuming that the firm maintains a constant debt-equity ratio and that the WACC remains constant over time, cost of capital
is calculated as follows (using market values!):
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = ∗𝑟 + ∗ 𝑟 ∗ (1 − 𝜏𝑐 )
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
𝑟𝐷 : 𝐷𝑒𝑏𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑟𝐸 : 𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑇𝑎𝑥 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

- If there are other types of financing, they must be included here.

- Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, by
discounting its future free cash flow using the WACC:
𝐹𝐶𝐹1 𝐹𝐶𝐹2
𝑉0𝐿 = + +⋯
1 + 𝑟𝑊𝐴𝐶𝐶 (1 + 𝑟𝑊𝐴𝐶𝐶 )2

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Example tax shield:
Loan $100,000
Interest Rate 10%
Interest expense annual -$10,000
= $90,000 → taxable income is reduced by $10,000
Tax rate 40%
Tax saving $4,000

Effective cost of debt:

$4,000-$10,000=$6,000 → equals 6% interest rate

𝑟𝐷 ∗ (1 − 𝜏𝑐 ) = 10% + (1 − 0,4) = 6%

Example Avco:

WACC: Summary:
1. Determine the FCF of the investment (before interest)
2. Compute weighted average cost of capital
→ In practice: this step is often centralized, and corporate treasury calculates a WACC which must then be used throughout
the firm as the companywide cost of capital. Assuming projects have same risks.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the FCF of the investment using
the WACC

→ WACC is simple and straightforward, therefore most used in practice. WACC heavily relies on the assumption of a constant debt-
to-equity ratio over time. Otherwise, results are wrong. Small changes are okay.

Is a constant debt-equity ratio a reasonable assumption?:

When profits are generated, equity increases. In order to maintain the capital structure, equity would have to be raised in parallel. Does
this make sense?
- Often no more FK needed, why then raise it? Use leverage effect
- Depends on life cycle: Startups will have a more difficult time.
- Every company has optimal composition of equity and FC to maximize value. → Argues FOR constant capital structure if no
restructuring.
→ In a survey WACC method was inaccurate if FCF was discounted with a constant WACC over time.

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WACC: Implementing a Constant Debt-Equity Ratio:
Example Avco:
Avco currently has a debt-to-value ratio of 50%. To maintain, any new investment must be financed with 50% debt
Implementation:
- Idea 1: Finance 50% of initial investment in equipment ($28 mio) with debt. → Not sufficient
- Idea 2: Finance 50% of market value of the investment with debt
o By undertaking the RFX project, Avco adds new assets to the firm with initial market value of $61.25 mio.
o To maintain its debt-to-value ratio, Avco must add 50%*61.25=$30.625 mio in new debt
o Avco can add this debt either by reducing cash or by borrowing and increasing debt
o Assume Avco decides to spend its $20 mio in cash and borrow an additional $10.625 mio. (debt)

What happens over the lifetime of the project?

- Debt capacity: The amount of debt at a particular date that is required to maintain the firm’s target debt-to-value ratio
- The debt capacity at date t is calculated as:
𝐷𝑡 = 𝑑 ∗ 𝑉𝑡𝐿
𝑉𝑡𝐿 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
𝑑 = 𝑑𝑒𝑏𝑡 − 𝑡𝑜 − 𝑣𝑎𝑙𝑢𝑒 𝑟𝑎𝑡𝑖𝑜

- 𝑉𝑡𝐿 is calculated as:

𝐿
𝐹𝐶𝐹𝑡+1 + 𝑉𝑡+1
𝑉𝑡𝐿 =
1 + 𝑟𝑊𝐴𝐶𝐶

Value of FCF in year t+2 and beyond

APV: Adjusted Present Value – General idea:

- A valuation method to determine the levered value of an investment by first calculating its unlevered value and then adding
the value of the interest tax shield.
- 𝑉 𝐿 = 𝐴𝑃𝑉 = 𝑉 𝑈 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)

- In Addition to the value of the interest tax shield, other financial side effects can be added as well, e.g. value of a subsidized
loan, real options
- The first step in the APV method is to calculate the value of the FCF using the projects cost of capital if it were financed
without leverage
o = Unlevered = assuming 100% is equity financed → debt is not important
But: Debt is important for tax shield
Risk of tax saving equals the risk of the project itself.
- Assumption of a constant debt-equity ratio is not necessary

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APV: Unlevered Cost of Capital:
- The cost of capital of a firm, were it unlevered:
If a firm maintains a target leverage ratio, it can be estimated as the weighted average cost of capital computed without
taking into account taxes (pre-tax WACC).

𝐸 𝐷
𝑟𝑈 = ∗𝑟 + ∗ 𝑟 = 𝑃𝑟𝑒𝑡𝑎𝑥 𝑊𝐴𝐶𝐶
𝐸 +𝐷 𝐸 𝐸 +𝐷 𝐷

- We value the interest tax shield separately.

- The firm’s unlevered cost of capital equals its pretax WACC because it represents investors’ required return for holding the
entire firm (equity and debt). On perfect capital markets (=no taxes), the overall costs will always stay the same, no matter
what capital structure.
- This argument relies on the assumption that the overall risk of the firm is independent of the choice of leverage.

Excursus: Relationship of Pretax WACC and unlevered cost of capital:

Green lines: Example at 50% debt-to-value ratio

APV: Unlevered Cost of Capital:

Target Leverage Ratio:
- Debt will always be a certain percentage of the firms/project value, where the percentage does not have to remain constant.
- A constant market debt-equity ratio is a special case.
→ The previous rationale that the unlevered cost of capital equals the pretax WACC relies on the assumption that the firm
maintains a target leverage ratio.
- If firms follow other leverage policies, then formulas have to be adjusted → see later

APV: Example Avco

→ Same value of levered project as with WACC method.

APV: Summary:
1. Determine the investments value without leverage by discounting FCFs at the unlevered cost of capital.
2. Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield.
b. Discount the interest tax shield.
3. Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage.
→ APV is more complex, however it can be applied in situations in which the firm does not maintain a constant debt-equity ratio, e.g.
fixed debt level. → Main advantage!

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FTE: General idea:
- Ultimately, we are interested in the value of a project for shareholders. → Flow-to-equity method focuses on the cash flows
to shareholders (Flow-to-equity as we only consider equity)
- FTE is a valuation method that calculates the FCF available to equity holders taking into account all payments to and from
debt holders
- The CF to equity holders are then discounted using the (levered) equity cost of capital
- Free Cash Flow to Equity (FCFE): The CF that remains after adjusting for interest payments, debt issuance and debt
repayments
- The first step in the FTE method is to determine the projects FCFE

FTE: Example Avco:

Note: After 4th year debt is repaid.

- Because the FCFE represent payments to equity holders, they should be discounted at the projects equity cost of capital.
Given that risk and leverage of the RFX project are the same as for Avco overall, we can use Avcos equity cost of capital of
10% to discount the projects FCFE.
9.98 9.76 9.52 9.27
𝑁𝑃𝑉 (𝐹𝐶𝐹𝐸) = 2.62 + + + + = $33.25 𝑚𝑖𝑜.
1.10 1.102 1.103 1.104

- The value of the projects FCFE represents the gain to shareholders from the project and it is identical to the NPV computed
using the WACC and APV methods. (NPV of debt issuance is 0 if debt is fairly priced). Raising capital is always a zero
NPV transaction if there are fair interest rates.

FTE: Summary:
1. Determine the free cash flow to equity of the investment.
2. Determine the levered equity cost of capital. If project has same risk as firm, just use overall equity cost of capital.
3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital.
→ FTE relies on the assumption that the firms equity cost of capital remains constant. This is reasonable only if the firm maintains a
constant debt-equity ratio.
→ Same restrictive assumptions as with WACC method → not very flexible (main problem). Because if capital structure is not
constant, every dollar of debt you add adds risk for equity holders.
→ If not perfectly constant capital structure but narrow, WACC and FTE are still reliable.

Advantages:
- It may be simpler to use when calculating the value of equity for the entire firm, if the firms capital structure is complex and
the market values of other securities in the firms capital structure are not known. In practice often mixed ways of financing
(e.g. Mezzanine), more complex.
- It may be viewed as a more transparent method for discussing a projects benefit to shareholders by emphasizing a projects
implication for equity.
Disadvantage:
- One must compute the projects debt capacity to determine the interest and net borrowing before capital budgeting decisions
can be made.

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Special Cases: Project-Based Costs of Capital:
- In the real world, a specific project may have different market risk than the average project of the firm
- Different projects may vary in the amount of leverage they will support
- Suppose Avco launches a new plastics manufacturing division that faces different market risks than its main packaging
business.
o The unlevered cost of capital for the plastics division can be estimated by looking at other single-division plastics
firms that have similar business risks.
- Assume two firms are comparable to the plastics division and have the following characteristics:

If comparable firms have other leverage ratios than our project, adjustments have to be made.

APV:
- Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital can be estimated by their pretax
WACC. Use one of those or average.

Competitor 1: 𝑟𝑈 = 0.60 ∗ 12.0% + 0.40 ∗ 6.0% = 9.6%

Competitor 2: 𝑟𝑈 = 0.75 ∗ 10.7% + 0.25 ∗ 5.5% = 9.4%

WACC/FTE:
- To use WACC or FTE method, the projects equity cost of capital is required (which depends on incremental debt that the
company will take on as a result of the project). Equity cost of capital depends on leverage, therefore don’t use competitors
equity cost of capital.
- A projects equity cost of capital may differ from the firms equity cost of capital if the project uses a different target leverage
ratio than for the firm.
𝐷
𝑟𝐸 = 𝑟𝑈 + (𝑟𝑈 − 𝑟𝐷 )
𝐸

- Based on the equity cost of capital, the WACC can be determined.

- Now assume that Avco plans to maintain an equal mix of debt and equity financing as it expands into plastics manufacturing,
and it expects its borrowing cost to be 6%.
Given the unlevered cost of capital estimate of 9.5%, the plastics divisions equity cost of capital is estimated to be:
0.50
𝑟𝐸 = 9.5% + (9.5% − 6%) = 13.0%
0.50

- The divisions WACC can now be estimated to be:

𝑟𝑊𝐴𝐶𝐶 = 0.50 ∗ 13.0% + 0.50 ∗ 6.0% ∗ (1 − 0.40) = 8.3%

- To determine the equity or weighted average cost of capital for a project, the incremental financing that results if the firm
takes on the project need to be calculated.
- In other words, what is the change in the firms total debt (net of cash) with the project versus without the project.
o Note: The incremental financing of a project need not correspond to the financing that is directly tied to the
project.
- The following important concepts should be considered when determing a project’s incremental financing:
o Cash is negative debt
o A fixed equity payout policy implies 100% debt financing
o Optimal leverage depends on project and firm characteristics
o Safe cash flows can be 100% debt financed

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Special Cases: APV with other leverage policies:
- Up to this point, it has been assumed the firm wishes to maintain a constant debt-equity ratio.
- If the debt-equity ratio changes over time, the equity cost of capital and the WACC will change over time.
→ WACC and FTE method are difficult to implement
→ APV is straightforward and should be preferred
- Two alternative leverage policies:
o Constant interest coverage: When a firm keeps its interest payments equal to a target fraction of its FCFs. =
Interest payment is % of FCF.
→ If the target fraction is k, then: Interest paid in Year t: 𝑡 = 𝑘 ∗ 𝐹𝐶𝐹𝑡
o Predetermined debt levels: When a firm adjusts its debt according to a fixed schedule that is known in advance.

Special Cases: APV with Constant Interest Coverage:

- To implement the APV approach, the present value of the tax shield under this policy need to be computed:

𝑃𝑉 (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = 𝑃𝑉(𝜏𝑐 𝑘 ∗ 𝐹𝐶𝐹) = 𝜏𝑐 𝑘 + 𝑃𝑉(𝐹𝐶𝐹) = 𝜏𝑐 𝑘 ∗ 𝑉 𝑈

𝜏𝑐 = 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝑘 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜/𝑓𝑟𝑎𝑐𝑡𝑖𝑜𝑛
o Since the tax shield is proportional to the projects FCF it has the same risk as the project and should be discounted
at the same rate.
o With a constant interest coverage policy, the value of the interest tax shield is proportional to the projects
unlevered value.
- The value of the levered project, using the APV method is:
𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑) = 𝑉 𝑈 + 𝜏𝑐 𝑘 ∗ 𝑉 𝑈 = (1 + 𝜏𝑐 𝑘) ∗ 𝑉 𝑈
→ If FCF grow at a constant rate, then assumption of constant interest coverage is equivalent to a constant debt-equity ratio.
The interest paid grow the same, then if debt cost of capital stays the same, the amount of debt grows. Total value grows the
same.

Example:

Special Cases: APV with Predetermined Debt Levels:

- Rather than set debt according to a target debt-equity ratio or interest coverage level, a firm may adjust its debt according to a
fixed schedule that is known in advance.

Example Avco:
- Assume now that Avco plans to borrow $30.62 mio and then will reduce debt on a fixed schedule.

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 - When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt
cost of capital (because the tax shield is just as risky as the debt itself)

- Cautionary Note: When debt levels are predetermined, the risk of the tax shield differs from the risk of the cash flows. → In
this case the unlevered cost of capital no longer coincides with the firms pretax WACC.
- If debt levels are predetermined, the tax shield reduces the (risk increasing) effect of leverage on the risk of the equity
- Tax shield is effectively a reduction in debt level just as cash and has to be subtracted from net debt.

Comparison of Methods:
WACC:
- The WACC method is the easiest to use and
therefore is the most common method used
in practice
- However, in its basic form it relies on the
assumption of a fixed debt-to-value ratio
over the life of the investment
APV:
- Most straightforward approach with
alternative leverage policies
- Categorizes the sources of value and allows
to include additional side effects
- However: Leverage policy must be
considered when determining unlevered cost
of capital
FTE:
- Shareholder perspective
- Typically used only in complicated settings
where the values in the firms capital
structure or the interest tax shield are
difficult to determine

→ If applied consistently, then each method produces the same valuation

Exercise:

→ Solution see Excel Sheet + Video 9

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 IV. International Aspects of Capital Budgeting

i. Parent vs. subsidiary perspective

Idea:

Parent vs. Subsidiary Perspective: Approach:

1. Determine Free Cas Flow from subsidiary perspective (see previous chapter)
2. Determine value of dividend payments to parent
i. Determine dividend payments to parent
ii. Subtract withholding taxes
iii. Subtract local taxes on dividends (incl. potential tax credits)
iv. Determine present value of dividends
3. Determine value of other payments from subsidiary to parent (considering potential withholding taxes), e.g.
i. Royalty payments
ii. Licensing fees
iii. Profits from sale of intermediate products
iv. Overhead allocation
v. …
4. Consider potential cannibalization of exports
5. Add other potential source of value (e.g. subsidized financing)
6. Add all values to determine overall net present value of investment

Case Application:
→ See slides 82-90

ii. Choice of currency

Methods:
→ CFs of projects are often in foreign currency, therefore different methods.

Spot rate approach:

→ Home currency NPV
- Forecast future foreign currency cash flows
- Discount cash flows using appropriate foreign currency discount rate
- Current value of project in domestic currency determined by multiplying present value in foreign currency by current spot
exchange rate
- Key advantage: No worries about future exchange rate changes as everything is calculated in foreign currency.
- Key problem: You need foreign currency discount rates. Sometimes not easy to determine.

Forward rate approach:

→ Foreign currency NPV?
- Forecast future foreign currency cash flows
- Convert future foreign currency cash flows to domestic currency by multiplying them with forecasts of future exchange rates

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 - Calculate present value in domestic currency by discounting converted cash flows with appropriate domestic currency
discount rate
- Key problem: Complicated because you have to make forecasts on exchange rates.

→ If interest rate parity holds then both methods lead to the same values in domestic currency (realistic assumption)

Predicting exchange rates: Purchase power parity:

Idea: Exchange rate between currencies of two countries should be equal to the ratio of the countries price levels.

Absolute PPP:
Standard commodity basket is $300 in the US and €150 in Germany.

𝑃 $300
→ 𝑆($/€) = 𝑃$ = €150 = 2$/€
€

If $1=€1 basket in US would be overpriced, therefore offering an arbitrage opportunitiy (buy in Germany, sell in US).

Absolute PPP does not hold in reality! E.g. driven by market frictions.

Relative PPP:
Suppose the inflation rate in the US is expected to be 3% and 5% in the euro zone.

𝑃 ∗1.03 1+𝜋
→ 𝐹($/€) = 𝑃$∗1.05 = 𝑆($/€) ∗ 1+𝜋 $
€ €
𝐹($/€) 1+𝜋
→ 𝑆($/€) = 1+𝜋$
€

Exchange rate changed according to differences in inflation.

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Predicting exchange rates: Interest rate parity – Idea:

Case Application:
→ See slides 97-102

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