International capital budgeting

Chapter Outline
Review of Domestic Capital Budgeting
The Adjusted Present Value Model
Capital Budgeting from the Parent Firm’s Perspective
Risk Adjustment in the Capital Budgeting Process
Sensitivity Analysis
Purchasing Power Parity Assumption
Real Options
 Review of Domestic Capital
Budgeting
Identify the size and timing of all relevant cash flows on
a time line.
Identify the riskiness of the cash flows to determine the
appropriate discount rate.
Find NPV by discounting the cash flows at the
appropriate discount rate.
Compare the value of competing cash flow streams at
the same point in time.
 Review of Domestic Capital
Budgeting
The basic net present value equation is
T
CFt TVT
NPV     C0
t 1 (1  K ) (1  K )
t T

Where:
CFt = expected incremental after-tax cash flow in year t
TVT = expected after-tax terminal value including return of net working capital
C0 = initial investment at inception
K = weighted average cost of capital
T = economic life of the project in years
The NPV rule is to accept a project if NPV  0
 Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.

CFt = (Rt – OCt – Dt – It)(1 – t) + Dt + It (1 – t)

Rt is incremental revenue It is incremental interest
OCt is incremental operating expense
cash flow  is the marginal tax rate
Dt is incremental depreciation
 Review of Domestic Capital
Budgeting
We can use CFt = (OCFt)(1 – t) + t Dt
to restate the NPV equation,
T

NPV = S (1 + K)
t=1
CFt
t
+
TVT
(1 + K)T
– C0

as:
T
(OCFt)(1 – t) + t
NPV = S
t=1
D
(1 + tK) t
+
TVT
(1 + K)T
– C0
 The Adjusted Present Value
Model
T
(OCFt)(1 – t) T
t Dt
NPV = S
t=1 (1 + K) t
+ S
t = 1 (1 + K)
t
+
TVT
(1 + K)T
– C 0

can be converted to adjusted present value (APV)

T (OCFt)(1 – t) t Dt t It
APV = S
t=1 (1 + Ku)t
+
(1 + i) t
+
(1 + i)t
+
TVT
(1 + Ku) T
– C0

by appealing to Modigliani and Miller’s results.

 The Adjusted Present Value
Model
T (OCFt)(1 – t) t Dt t It
APV = S
t=1 (1 + Ku)t
+
(1 + i)t
+
(1 + i)t
+
TVT
(1 + Ku) T
– C0

The APV model is a value additivity approach to capital

budgeting. Each cash flow that is a source of value to the firm is
considered individually.
Note that with the APV model, each cash flow is discounted at a
rate that is appropriate to the riskiness of the cash flow.
 Domestic APV Example
Consider a project where the timing and size of the
incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500
0 1 2 3 4
CF0 = –$1000 The unlevered cost of equity is r0 = 10%:
CF1 = $125 The project would be rejected by an
all-equity firm:
CF2 = $250
I = 10
CF3 = $375
NPV = –$56.50
CF4 = $500
Domestic APV Example
(continued)
Now, imagine that the firm finances the project with $600 of debt at
r = 8%.
The tax rate is 40%, so each year they have an interest tax shield
worth $19.20:
t × I = .40 × ($600 × .08)
= .40 × $48
= $19.20
 -$1,000 $125 $250 $375 $500

0 1 2 3 4
The APV of the project under leverage is:

T
(OCFt)(1 – t) t Dt t It
S
TVT
APV = + + + – C0
t=1 (1 + Ku) t
(1 + i) t
(1 + i) t
(1 + Ku) T

$125 $250 $375 $500

APV = + + +
1.10 (1.10)2 (1.10)3 (1.10)4

$19.20 $19.20 $19.20 $19.20

+ + + + – $1,000
APV = $7.09 1.08 (1.08) (1.08) (1.08)
2 3 4

The firm should accept the project if it finances with debt.

 International Capital Budgeting
from the Parent Firm’s Perspective

T
(OCFt)(1 – t) t Dt t It
APV = S
t=1 (1 + Ku)t
+
(1 + i) t
+
(1 + i)t
+
TVT
(1 + Ku)T
– C0

The APV model is useful for a domestic firm analyzing a domestic

capital expenditure or for a foreign subsidiary of an MNC
analyzing a proposed capital expenditure from the subsidiary’s
viewpoint.
The APV model is NOT useful for an MNC in analyzing foreign
capital expenditure from the parent firm’s perspective.
 International Capital Budgeting
from the Parent Firm’s Perspective

Donald Lessard developed an APV model for MNCs analyzing a

foreign capital expenditure. The model recognizes many of the
particulars peculiar to foreign direct investment.
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id )
t
t 1 (1  id )
t

T
ST TVT St LPt
  S 0C0  S 0 RF0  S 0CL0 
(1  K ud ) T
t 1 (1  id )
t
 APV Model of Capital Budgeting from
the Parent Firm’s Perspective
T T T
StOCFt(1 – t) St t Dt S t t It
APV = S
t=1 (1 + Kud) t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t

St TVT T
+
(1 + Kud)T
– S0C0 + S0RF0 + S0CL0 – S (1 + i )
t=1
St LPt
d
t
 Capital Budgeting from the
Parent Firm’s Perspective
One recipe for international decision makers:
◦ Estimate future cash flows in foreign currency.
◦ Convert to the home currency at the predicted exchange
rate.
◦ Use PPP, IRP, et cetera for the predictions.
◦ Calculate NPV using the home currency cost of capital.
 Capital Budgeting from the Parent
Firm’s Perspective: Example

A U.S.-based MNC is considering a European

opportunity.
It’s a simple example:
◦ There is no incremental debt.
◦ There is no incremental depreciation.
◦ There are no concessionary loans.
◦ There are no restricted funds.
 Capital Budgeting from the Parent
Firm’s Perspective: Example

A U.S. MNC is considering a European opportunity. The size and timing of the
after-tax cash flows are:

–€600 €200 €500 €300

0 1 2 3
The inflation rate in the euro zone is € = 3%, the inflation rate in dollars is p$ = 6%,
and the business risk of the investment would lead an unlevered U.S.-based firm to
demand a return of Kud = i$ = 15%.
The current exchange rate is S0($/€) = $1.25/€. Is this a good investment from the
perspective of the U.S. shareholders?
 Capital Budgeting from the Parent Firm’s
Perspective: Example
–€600 €200 €500 €300
–$750 $257.28 $661.94 $408.73

0 1 2 3
$1.25
CF0 = (€600) × S0($/€) = (€600) × = $750
€1.00
$1.25 1.06
CF1 = €200 × S1($/€) = €200 ×  = $257.28
€1.00 1.03
$1.25 (1.06)2
CF2 = €500 × S2($/€) = €500 ×  =2 $661.94
€1.00 (1.03)
$1.25 (1.06)3
CF3 = €300 ×  = $408.73
€1.00 (1.03)3
 Capital Budgeting from the Parent
Firm’s Perspective: Example

–$750 $257.28 $661.94 $408.73

0 1 2 3
Find the NPV using the cash flow menu of your financial calculator and an
interest rate of i$ = 15%:
CF0 = –$750
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 NPV = $242.99
 Capital Budgeting from the Parent
Firm’s Perspective: Alternative

Another recipe for international decision-makers:

◦ Estimate future cash flows in the foreign currency.
◦ Estimate the foreign currency discount rate.
◦ Calculate the foreign currency NPV using the foreign cost of capital.
◦ Translate the foreign currency NPV into dollars using the spot exchange rate.
Foreign Currency Cost of
Capital Method
– €600 €200 €500 €300

0 1 2 3

€ = 3% Let’s find i€ and use that on the euro cash flows to

find the NPV in euros.
i$ = 15%
Then translate the NPV into dollars at the spot
rate.
p$ = 6%
$1.25
The current exchange rate is S0($/€) =
€
 Finding the Foreign Currency Cost of
Capital: i€
Recall that the Fisher Effect holds that:
(1 + e) × (1 + $) = (1 + i$)

real inflation nominal

rate rate rate

So, for example, the real rate in the U.S. must be 8.49%:
(1 + i$) 1.15
(1 + e) = e= – 1 = 0.0849
(1 + $) 1.06
 Finding the Foreign Currency Cost of
Capital: i€
If the Fisher Effect holds here and abroad, then:

(1 + i$) (1 + i€)
(1 + e$) = and (1 + e€) =
(1 + $) (1 + €)

If the real rates are the same in dollars and euros (e€ = e$)
we have a very useful parity condition:

(1 + i$) (1 + i€)
=
(1 + $) (1 + €)
 Finding the Foreign Currency Cost of
Capital: i€
If we have any three of these variables, we can find the fourth:
(1 + i$) (1 + i€)
=
(1 + $) (1 + €)
In our example, we want to find i€:

(1 + i$) × (1 + €)
(1 + i€) =
(1 + $)
(1.15) × (1.03)
i€ = –1 i€ = 0.1175
(1.06)
International Capital Budgeting:
Example
– €600 €200 €500 €300

0 1 2 3
Find the NPV using the cash flow menu and i€ = 11.75%:

CF0 = –€600
I = 11.75
CF1 = €200
NPV = €194.39
CF2 = €500
$1.25 = $242.99
CF3 = €300 €194.39 ×
€
– €600 €200 €500 €300

0 1 2 3

€200 €500 €300

NPV = –€600 + + + = €194.39
1.1175 (1.1175)2 (1.1175)3
$1.25
€194.39 × = $242.99
€
–$750 $257.28 $661.94 $408.73

0 1 2 3
$257.28 $661.94 $408.73
NPV = –$750 + + + = $242.99
1.15 (1.15)2 (1.15)3
International Capital
Budgeting
You have two equally valid approaches:
◦ Change the foreign cash flows into dollars at the
exchange rates expected to prevail. Find the $NPV using
the dollar cost of capital.
◦ Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars at
the spot exchange rate.
Rounding will get exactly the same answer either
way.
Which method? your choice.
 Computing IRR
Recall that a project’s Internal Rate of Return (IRR) is
the discount rate that gives a project a zero NPV.

€200 €500 €300

NPV = –€600 + + + = €0
1+IRR€ (1+IRR€)2 (1+IRR€) 3

IRR€ = 28.48%

$257.28 $661.94 $408.73

NPV = –$750 + + + = $0
1+IRR$ (1+IRR$) (1+IRR$)
2 3

IRR$ = 32.23%
Directly Computing IRR$ and IRR€
€200 €500 €300
NPV = –€600 + + + = €0
1+IRR€ (1+IRR€) 2
(1+IRR€)3

CF0 = –€600 CF2 = €500

IRR€ = 28.48%
CF1 = €200 CF3 = €300

$257.28 $661.94 $408.73

NPV = –$750 + + + = $0
1+IRR$ (1+IRR$) 2
(1+IRR$) 3

CF0 = –$750 CF2 = $661.94

CF1 = $257.28 CF3 = $408.73 IRR$ = 32.23%
 Converting from IRR$ to IRR€
Use the same IRP and PPP conditions that we used to
convert from one discount rate to another.

1+IRR$ 1+IRR€ In our example, it was easy to find IRR€.

= Finding IRR$ without converting all cash
(1 + $) (1 + €)
flows into dollars is straightforward:

(1+IRR€)(1 + $)
(1+IRR$) = (1.2848)(1.06)
(1 + €) i€ = –1
(1.03)
€ = 3%, p$ = 6%
IRR$ = 32.23%
 Back to the Full APV
Using the intuition just developed, we can modify Lessard’s
APV model as shown, if we find it convenient.

S0 S0
T T T
StOCFt(1 – t) St t Dt S t t It
APV = S
t=1 (1 + Kud)t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t

S0 f f f
St TVT T
+
(1 + Kud)T
– S 0C 0 + S0RF0 + S 0CL0 – S (1 + i ) St LPt
t
– t=1 d
f S0 f
 Risk Adjustment in the Capital
Budgeting Process
Clearly risk and return are correlated.
Political risk may exist along side of business risk, necessitating an
adjustment in the discount rate.
We can measure this risk with sensitivity analysis, where different
estimates are used for expected inflation rates, cost and pricing
estimates, and other inputs to give the manager a more complete
picture of the planned capital investment.
Lends itself to computer simulation.