Chapter 18

Multinational
Capital
Budgeting and
Cross-Border
Acquisitions
 Learning Objectives

• Extend the domestic capital budgeting analysis

to evaluate a greenfield foreign project
• Distinguish between the project viewpoint and
the parent viewpoint of a potential foreign
investment
• Adjust the capital budgeting analysis of a
foreign project for risk
• Examine the use of project finance to fund and
evaluate large global projects
• Introduce the principles of cross-border
mergers and acquisitions
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 Multinational Capital Budgeting

• Although the original decision to undertake

an investment in a particular foreign country
may be determined by a mix of strategic,
behavioral, and economic decisions—as well
as reinvestment decisions—it should be
justified by traditional financial analysis.
• Multinational capital budgeting, like
traditional domestic capital budgeting,
focuses on the cash inflows and outflows
associated with prospective long-term
investment projects.
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 Multinational Capital Budgeting

• Capital budgeting for a foreign project uses the

same theoretical framework as domestic capital
budgeting.
• The basic steps are:
– Identify the initial capital invested or put at risk
– Estimate cash flows to be derived from the project over
time, including an estimate of the terminal or salvage
value of the investment
– Identify the appropriate discount rate to use in valuation
– Apply traditional capital budgeting decision criteria such as
NPV and IRR

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 Complexities of Budgeting
for a Foreign Project

• Capital budgeting for a foreign project is

considerably more complex than the
domestic case:
– Parent cash flows must be distinguished from
project cash flows
– Parent cash flows often depend on the form of
financing
– Additional cash flows generated by a new
investment in one foreign subsidiary may be in
part or in whole taken away from another
subsidiary

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 Complexities of Budgeting
for a Foreign Project
– The parent must explicitly recognize remittance
of funds because of differing tax systems, legal
and political constraints on the movement of
funds, local business norms, and differences in
the way financial markets and institutions
function
– An array of nonfinancial payments can generate
cash flows from subsidiaries to the parent

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 Complexities of Budgeting
for a Foreign Project
– Managers must keep the possibility of unanticipated
foreign exchange rate changes in mind because of
possible direct effects on the value of local cash
flows, as well as indirect effects on the competitive
position of the foreign subsidiary
– Use of segmented national capital markets may
create an opportunity for financial gains or may lead
to additional financial costs
– Use of host-government-subsidized loans complicates
both capital structure and the parent’s ability to
determine an appropriate weighted average cost of
capital for discounting purposes

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 Complexities of Budgeting
for a Foreign Project
– Managers must evaluate political risk, because
political events can drastically reduce the value
or availability of expected cash flows
– Terminal value is more difficult to estimate,
because potential purchases from the host,
parent, or third countries, or from the private or
public sector, may have widely divergent
perspectives on the value to them of acquiring
the project

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 Project Versus Parent Valuation

• A strong theoretical argument exists in favor of

analyzing any foreign project from the viewpoint of
the parent (Exhibit 18.1).
• Cash flows to the parent are ultimately the basis for
dividends to stockholders, reinvestment elsewhere
in the world, repayment of corporate-wide debt,
and other purposes that affect the firm’s many
interest groups.
• However, this viewpoint violates a cardinal concept
of capital budgeting—that financial cash flows
should not be mixed with operating cash flows.

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 Exhibit 18.1 Multination Capital
Budgeting: Project and Parent Viewpoints

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 Project Versus Parent Valuation

• Evaluation of a project from the local viewpoint

serves some useful purposes, but is should be
subordinated to evaluation from the parent’s
viewpoint.
• In evaluating a foreign project’s performance
relative to the potential of a competing project in
the same host country, we must pay attention to
the project’s local return.
• Almost any project should at least be able to earn a
cash return equal to the yield available on host
government bonds (with the same maturity as the
project’s economic life).

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 Project Versus Parent Valuation

• Multinational firms should invest only if they can

earn a risk-adjusted return greater than locally
based competitors can earn on the same project.
• If they are unable to earn superior returns on
foreign projects, their stockholders would be better
off buying shares in local firms, where possible, and
letting those companies carry out the local projects.
• Most firms appear to evaluate foreign projects from
both parent and project viewpoints (to obtain
perspectives on NPV and the overall effect on
consolidated earnings of the firm).

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 Illustrative Case:
Cemex Enters Indonesia
• Cementos Mexicanos, Cemex, is considering the
construction of a cement manufacturing facility on
the Indonesian island of Sumatra.
• This project would be a wholly-owned greenfield
investment.
• The company has three main reasons for the
project:
– Initiate a productive presence in Southeast Asia
– To position Cemex to benefit from infrastructural
development in the region
– The positive prospects for Indonesia to act as a produce-
for-export site

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 Illustrative Case:
Cemex Enters Indonesia
• The first step is to construct a set of pro forma
financial statements for Semen Indonesia (in
Indonesian rupiah).
• The next step is to create two capital budgets, the
project viewpoint and parent viewpoint.
• Financial assumptions are then made about:
– Capital investment
– Method of financing
– Revenue/cost forecasts
• See Exhibit 18.2 regarding investment, financing,
and cost of capital assumptions

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Exhibit 18.2
Investment
and Financing
of the Semen
Indonesia
Project (in
000s)

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 Illustrative Case:
Cemex Enters Indonesia

• The explicit debt structures, including

repayment schedules, are presented in
Exhibit 18.3.
• Due to the expected depreciation of the
rupiah against the dollar, the Indonesian
income statement will show the foreign
exchange losses on the debt service.
• Exhibit 18.4 shows Semen Indonesia’s pro
forma income statement. Net Income
becomes positive in project year 3.

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 Exhibit 18.3 Semen Indonesia’s Debt Service
Schedules and Foreign Exchange Gains/Losses

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 Exhibit 18.4 Semen Indonesia’s Pro Forma
Income Statement (millions of rupiah)

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 Illustrative Case:
Cemex Enters Indonesia

• The capital budget for the Semen Indonesia

project from a project viewpoint is shown in
Exhibit 18.5.
• The result is an IRR of 19.1% and a
negative NPV when the project value is
discounted using the WACC of 33.257%.
• The project is not acceptable.

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 Exhibit 18.5 Semen Indonesia Capital
Budget: Project Viewpoint (millions of
rupiah)

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 Illustrative Case:
Cemex Enters Indonesia
• A foreign investor’s assessment of a project’s
returns depends on the actual cash flows that are
returned to it, in its own currency (Exhibit 18.6).
• For Cemex, this means that the investment must
be analyzed in terms of U.S. dollar cash inflows and
outflows associated with the investment over the
life of the project, after-tax, discounted at the
appropriate cost of capital.
• As we will see, the project still yields a negative
NPV.

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Exhibit 18.6
Semen
Indonesia’s
Remittance of
Income to Parent
Company
(millions of
rupiah and US$)

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 Illustrative Case:
Cemex Enters Indonesia
• We build this parent viewpoint capital budget in two
steps.
• First, we isolate the individual cash flows, adjusted
for any withholding taxes imposed by the
Indonesian government and converted to U.S.
dollars.
• The second step, that actual parent viewpoint
capital budget, combines these U.S. dollar after-tax
cash flows with the initial investment to determine
the NPV of the proposed Indonesian subsidiary in
the eyes (and pocketbook) of Cemex.

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 Illustrative Case:
Cemex Enters Indonesia

• Most corporations require that the new

investments more than cover the cost of the
capital employed in their undertaking.
• It is therefore not unusual for the firm to
require a hurdle rate of 3-6% above its cost
of capital.
• An NPV of zero means the investment is
“acceptable.”
• A positive NPV is present value of wealth
returned to the firm and its shareholders.

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 Illustrative Case:
Cemex Enters Indonesia

• At this point sensitivity analyses are run

from both the project and parent
viewpoints.
• This would include analyzing (for the
project):
– Political risks
– Foreign exchange risks
– Other business specific potentialities
• And analyzing (for the parent):
– A range of discount rates
– Varying cash flow patterns
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 Illustrative Case:
Cemex Enters Indonesia

• Portfolio risk is measured by:

– Standard deviation of expected return: risk of
the individual security
– Beta: risk of the individual security as a
component of a portfolio
• Foreign investments are motivated by two
objectives:
– Resource-seeking
– Production-seeking

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 Real Option Analysis

• The discounted cash flow (DCF) analysis used in the

valuation of Semen Indonesia, and in capital
budgeting and valuation in general, has long had its
critics.
• Importantly, when MNEs evaluate competitive
projects, traditional cash flow analysis is typically
unable to capture the strategic options that an
individual invest option may offer.
• This has led to the development of real options
analysis.
• Real options analysis is the application of the option
theory to capital budgeting decisions.

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 Real Option Analysis

• Real options is a different way of thinking about

investment values.
• At its core, it is a cross between decision-tree
analysis and pure option-based valuation.
• Real option valuation also allows us to analyze a
number of managerial decisions that in practice
characterize many major capital investment
projects:
– The option to defer
– The option to abandon
– The option to alter capacity
– The option to start up or shut down

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 Project Financing

• Project finance is the arrangement of

financing for long-term capital projects,
large in scale, long in life, and generally
high in risk.
• The following four basic properties are
critical to the success of project financing:
– Separability of a project from its investors
– Long-lived and capital-intensive singular projects
– Cash flow predictability from third party
commitments
– Finite projects with finite lives
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 Cross-Border Mergers and
Acquistions

• The driving factors behind cross-border M&A

are presented in Exhibit 18.7
– They tend to be quicker to achieve than starting
from scratch
– M&A may also be cost-effective
– International market imperfections may allow
target firms to be undervalued
• However, on the downside:
– Easy to pay too much
– Corporate cultures may clash
– Potential host government interference
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 Exhibit 18.7 Driving Forces Behind
Cross-Border Mergers and Acquisitions

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 The Cross-Border Acquisition
Process

• Acquisition is much more complex than

simply determining an appropriate price
• Exhibit 18.8 shows how the process begins
with strategic decision-making followed by
financial analysis.
• In General:
– Stage 1: Identification and Valuation
– Stage 2: Execution of the Acquisition
– Stage 3: Post-Acquisition Management
• Beware currency risks (Exhibit 18.9)

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 Exhibit 18.8 The Cross-Border
Acquisition Process

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 Exhibit 18.9 Currency Risks in
Cross-Border Acquisitions

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