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Topic 9: International Capital Budgeting

(Shapiro, Chapter 16-17)


I. FOREIGN DIRECT INVESTMENT (FDI)
II. BASIS OF CAPITAL BUDGETING
III. ISSUES IN FOREIGN INVESTMENT
ANALYSIS
IV. POLITICAL RISK ANALYSIS
V. GROWTH OPTIONS AND PROJECT
EVALUATION

I. FOREIGN DIRECT INVESTMENT (FDI)


THE THEORY OF THE MNC
A.The MNC as an Oligopolist: Why FDI?
1. When is FDI justified?
2. Internalization
3. Market Integration
a. Vertical
b. Horizontal
B.Financial Market Imperfections
1. Hypothesis
2. Diversification Effect of the MNC

THE STRATEGY OF THE MNC


A. Three strategies:
1. The Innovation-based MNC
2. The Mature MNC
a. the importance of economies of scal
b. economies of scope
3.

The Senescent MNC


a. global scanning capability
b. the role of rationalization and
integration.

4. FDI and Survival


a. Cost reduction
b. Economies of scale
c. Multiple sourcing
d. Keeping domestic customers
DESIGNING A GLOBAL EXPANSION STRATEGY
5 Necessary Elements:
1. Awareness of profitable investments
- building competitive advantage
2. Selecting a mode of entry
- evaluate systematically the entry
strategies in foreign market
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3. Adjusting the effectiveness of the entry


mode, ie., continual auditing
4. Using appropriate evaluation criteria
5. Estimating the longevity of competitive
advantage:
a. Develop competitive strength
transferable overseas.
b. Not easily duplicated

II. BASICS OF CAPITAL BUDGETING


A. Basic Criterion: Net Present Value
B. Net Present Value Technique:
1. Definition: The present value of future
cash flows, discounted at the projects
cost of capital less the initial net cash
outlay. In simple English, NPV is the net
addition to the wealth of a firm if the
project is taken.

2. NPV Formula:
n

Xt
NPV I 0
t
(
1

k
)
t 1
where I0 = initial cash outlay, n =
investment horizon, xt = net cash
flow at t, k = cost of capital,
3. Most important property of NPV technique:
- focus on incremental cash flows with
respect to shareholder wealth
4. NPV obeys value additive principle:
- the NPV of a set of projects is the sum of
the individual project NPV
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C. International Cash Flows


1. Important principle when estimating:
Incremental basis
2. Distinguish total from incremental flows
to account for
a. cannibalization
b. sales creation
c. opportunity cost
d. transfer pricing
e. fees and royalties

3.

Getting the base case correct


Rule of thumb:
Incremental
Global
Global
cash flows = corporate
- flow
cash flow
without
with project
project

4. Intangible Benefits

a. Valuable learning experience


b. Broader knowledge base

Alternative capital budgeting frameworks


An adjusted present value (APV) approach

k * rf * (rm rf )
where k* is the all-equity rate and * is the all-equity
beta.
Recall that

* 1(1t ) D / E

where e is the firms stock price beta, t is the firms


marginal tax rate, and D/E is the firms debt-equity
ratio.
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The adjusted present value (APV) with this


approach is
PV of
PV of
PV of
PV of
APV= investment + operating + interest + interest
outlay
cash flows Tax shield subsidies
n

APV I 0 (1 k * )t (1i )t (1i


t 1

Xt

t 1

Tt

t 1

St
d

)t

where Tt is tax savings in year t due to the specific financing


package, St is before-tax dollar (home currency) value of
interest subsidies (penalty) in year t due to projectspecific
financing, and id is before-tax cost of dollar (home currency)
debt.
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III. ISSUES IN FOREIGN INVESTMENT


ANALYSIS
TWO ISSUES IN FOREIGN INVESTMENT ANALYSIS
A. Issue #1 Parent vs Project Cash Flow
-the cash flows from the project may
differ from those remitted to the parent
1. Relevant cash flows become quite
important

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2. Three Stage Approach: to simplify project


evaluation
a. compute subsidiarys project cash flows
b. evaluate the project to the parent
c. incorporate the indirect effects
3. Estimating Incremental Project Flows
What is the true profitability of the project?
a. Adjust for tax effects of
i) transfer pricing
ii) fees and royalties

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4. Tax Factors:
determine the amount and timing of taxes
paid on foreign-source income.
B. Issue #2 How to adjust for increased
economic and political risk of project?
1. Three Methods of Economic
and Political Risk Adjustments:
a. Shortening minimum payback period
b. Raising required rate of return
c. Adjusting cash flows

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2. Accounting for Exchange Rate and


Price Changes (inflationary)
Two stage procedure:
a. Convert nominal foreign cash flows into
home currency terms
b. Discount home currency flows at
domestic required rate of return.

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IV. POLITICAL RISK ANALYSIS


POLITICAL RISK ANALYSIS
A. Political risks
can be incorporated into an NPV
analysis by adjusting expected project
cash flows to reflect the risks.
B. Expropriation
- the extreme form of political risk
C. Blocked funds

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V. GROWTH OPTIONS & PROJECT


EVALUATION
A. Options:
1. an important component of many
investment decisions
2. ignoring options will understate the NPV
of that investment
B. Project Evaluation
1. Growth options require an expanded NPV
rule
2. Investments in emerging markets can be
viewed as growth option
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