International Capital

Budgeting 18
Chapter Eighteen

Chapter Objective:
This chapter discusses the methodology that a
multinational firm can use to analyze the
Fifth Edition
investment of capital in a foreign country.
EUN / RESNICK

18-1
Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows on a
time line.

2. Identify the RISKINESS of the cash flows to determine the

appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate

discount rate.

4. Compare the value of competing cash flow streams at the

same point in time.

18-2
Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows on a
time line.

2. Identify the RISKINESS of the cash flows to determine the

appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate

discount rate.

4. Compare the value of competing cash flow streams at the

same point in time.

18-3
 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.

18-4
Review of Domestic Capital Budgeting
The NPV rule is to accept a project if NPV  0
T
CFt TVT
NPV     C0  0
t 1 (1  K ) (1  K )
t T

and to reject a project if NPV  0

T
CFt TVT
NPV     C0  0.
t 1 (1  K ) (1  K )
t T

18-5
Review of Domestic Capital Budgeting
For our purposes it is necessary to expand the NPV
equation.

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

Rt is incremental revenue
OCt is incremental operating
cost
Dt is incremental depreciation
It is incremental interest
expense
 is the marginal tax rate

18-6
Alternative Formulations CFt

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

CFt = (NIt + Dt + It (1 – )
CFt = (Rt – OCt – Dt(1 – ) + Dt
CFt = (NOIt)(1 – ) + Dt

18-7
Review of Domestic Capital Budgeting
We can use CFt = (OCFt)(1 – ) +  Dt

to restate the NPV equation

T

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

as:
T
(OCFt)(1 – ) +  Dt
NPV = 
t=1 (1 + K)t
+
TVT
(1 + K) T
– C0

18-8
 The Adjusted Present Value Model
T
(OCFt)(1 – ) T
 Dt
NPV = 
t=1 (1 + K) t
+ 
t = 1 (1 + K)
t
+
TVT
(1 + K)T
– C0

Can be converted to adjusted present value (APV)

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

By appealing to Modigliani and Miller’s results.

18-9
 The Adjusted Present Value Model
T
(OCFt)(1 – )  Dt  It
APV = 
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.

18-10
Capital Budgeting from the Parent
Firm’s Perspective: Example
One recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Convert to the home currency at the predicted
exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost
of capital.

18-11
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

18-12
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

18-13
Capital Budgeting from the Parent
Firm’s Perspective: Example
–€600 €200 €500 €300

0 1 2 3
$1.25
The current exchange rate is S0($/€) =
€

Is this a good investment from the perspective of the

U.S. shareholders?
To address that question, let’s convert all of the cash
flows to dollars and then find the NPV at i$ = 15%.
18-14
Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750
–€600 €200 €500 €300

0 1 2 3

CF0 = (€600)× S0($/€) =(€600)× $1.25 = $750

€

Finding the dollar value of the initial cash

$1.25
flow is easy; convert at the spot rate: S0($/€) =
€
18-15
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28
–€600 €200 €500 €300

0 1 2 3
The exchange rate expected to prevail in the first year, S1($/€),
can be found with PPP:
1 + $ 1.06 $1.25
S1($/€) = 1 +   S0($/€) =  = $1.2864/€
€ 1.03 €

18-16
Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 $1.25

CF2 =    €500 = $661.94
1.03 1.03 €

18-17
Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94 $408.73
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 1.06 $1.25

CF3 =     €300 = $408.73
1.03 1.03 1.03 €

18-18
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 and interest rate i$ = 15%:
CF0 = –$750
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 NPV
18-19
 Capital Budgeting from the Parent
Firm’s Perspective: Alternative
Another recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the
foreign cost of capital.
4. Translate the foreign currency NPV into
dollars using the spot exchange rate
There is no “$” key on your calculator
18-20
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
$ = 6% at the spot rate.
$1.25
The current exchange rate is S0($/€) =
€
18-21
Foreign Currency Cost of Capital
Method

 Before we find i€ let’s use our intuition.

 Since the euro-zone inflation rate is 3% lower
than the dollar inflation rate, our euro
denominated discount rate should be lower than
our dollar denominated discount rate.

18-22
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
18-23
Finding the Foreign Currency Cost of
Capital: i€
If 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 + €)
18-24
Finding the Foreign Currency Cost of
Capital: i€
If we have any three of these variables, we can find the fourth:

(1 + i$) (1 + i€)
= In our example, we want to find i€
(1 + $) (1 + €)
(1 + i$) × (1 + €)
(1 + i€) =
(1 + $)
(1.15) × (1.03)
i€ = –1
(1.06)
i€ = 0.1175

18-25
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 ×
€
18-26
 – €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 = $242.99
€194.39 ×
€

–$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

18-27
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.
 If you watch your rounding, you will get exactly
the same answer either way.
 Which method you prefer is your choice.

18-28
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.

18-29
Sensitivity Analysis
 In sensitivity analysis, 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.

18-30