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Multinational Capital BudgetingMultinational Capital Budgeting

(or parts of chapter 16)(or parts of chapter 16)

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Agenda Multinational capital budgeting.

Project vs. parent capital budgeting?

Adjust capital budgeting analysis of foreign project for risk.

Case study: evaluate a greenfield foreign project

Real option analysis vs. DCF analysis.

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Multinational Capital Budgeting Analysis of cash in- & out- flows associated w/

prospective long-term investment projects. Follows same steps as domestic budgeting:

1. Identify initial capital invested at risk.

2. Estimate cash flows over time (including terminal value/ salvage value).

3. Identify appropriate discount rate for PV.

4. Apply traditional NPV or IRR analysis.

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Capital Budgeting for foreign projects Parent cash flows must be distinguished from project’s.

Parent cash flows often depend on form of financing => cannot separate operating & financing cash flows.

Stand alone subsidiary cash-flow can be worth, but add no value overall.

Non-financial payments can generate cash flows to parent, e.g. licensing fees.

Need to evaluate political risk, forex risk & differing inflation rates.

Segmented national capital markets create financial gain /costs.

Host government subsidies complicates WACC computation.

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Project vs. Parent Valuation? Most firms evaluate foreign projects from both parent & project

viewpoints.

Rule of thumb: parent valuation shall have priority.

MNE shall invest only if it can earn a risk-adjusted return greater than local competitors.

Project valuation provides closer approximation of effect on consolidated EPS• US firms consolidate subsidiaries w/ 50%+ ownership/• If ownership b/n 20% & 49% (I.e. affiliate) => consolidate on pro-rate

basis.• Subsidiaries w/ <20% ownership considered unconsolidated investment.

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Case Study: Cemex in Indonesia Cementos Mexicanos (Cemex) considers greenfield

investment in Indonesia plant (Cemex Indonesia)– Presence in Southeast Asia.

– Strong prospects for infrastructure growth.

– Benefit from depreciation of Indonesian Rupiah (RP)

Cemex functional currency: US$. Time to build: 1 year Inflation rates: 30% (Indonesia), 3% (US)

• Notice that we use the US inflation, not Mexico’s one!

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Semex Indonesia(Sumatra, Indonesia)

US$ invested in Indonesia

cement manufacturing firm

Project ViewpointCapital Budget

(Indonesian rupiah)

Estimated cash flowsof project

Parent viewpointCapital Budget

(U.S. $)

Cash flows remitted

to Cemex (RP -> US$)

ENDENDIs project investmentjustified (NPV > 0)?

Cementos Mexicanos(Mexico)

STARTSTART

Investment FinancingAverage forex rate, RP/$ 10,000 Equity (in RP) 11,000,000,000Cost installed capacity ( per ton) $110 DebtInstalled capacity (tons) 20,000 RP debt 2,750,000,000Investment in US$ 2,200,000 US$ debt 8,250,000,000Investment in RP 22,000,000,000 Total 22,000,000,000PPE (in RP) 17,600,000,000Annual depreciation (RP) 1,760,000,000

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Step I: Cost of Capital ComputationCost of Capital: CEMEX (Mexico)Risk-free rate 6% Cemex Beta 1.5Credit spread 2% Equity premium 7%Cost of debt 8% Cost of equity 16.500%Cost of debt, after-tax 5.20% % equity 60%% debt 40% WACC 11.9800%

Cost of Capital: CEMEX INDONESIARisk-free rate 33% Cemex Indonesia 1Credit Premium 2% Equity premium 7%Cost of debt in Rupiah 35% Cost of equity 40%Cost of debt, after-tax 5.20% % equity 50%Cost of US$ debt 39%Cost of US$ debt, after-tax 27.18%% debt 50% WACC 33.59%

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Debt Service &Forex Gain/LossIndonesian Loan @ 35% for 8 years (million Rp)

Loan Principal 2,750,000 2,654,061 2,524,543 2,349,694 2,113,648 1,794,985Interest Payment (962,500) (928,921) (883,590) (822,393) (739,777)Principal Payment (95,939) (129,518) (174,849) (236,046) (318,662)Total Payment (1,058,439) (1,058,439) (1,058,439) (1,058,439) (1,058,439)

Cemex Loan @ 10% for 5 years (million US$)Loan Principal 825 689.9 541.2 377.7 197.8 0.0Interest Payment (82.5) (69.0) (54.1) (37.8) (19.8)Principal Payment (135.1) (148.6) (163.5) (179.9) (197.8)Total Payment (217.6) (217.6) (217.6) (217.6) (217.6)

Cemex loan converted to Rp (million Rp)Scheduled @ Rp10,000/$Interest Payment (825,000) (689,867) (541,221) (377,710) (197,848)Principal Payment (1,351,329) (1,486,462) (1,635,108) (1,798,619) (1,978,481)Total Payment (2,176,329) (2,176,329) (2,176,329) (2,176,329) (2,176,329)

Actual (@ current spot rate)Interest Payment (1,041,262) (1,098,949) (1,088,160) (958,480) (633,669)Principal Payment (1,705,561) (2,367,915) (3,287,494) (4,564,190) (6,336,691)Total Payment (2,746,823) (3,466,864) (4,375,654) (5,522,670) (6,970,360)

Cash flow in RP on Cemex Loan (million RP)Total Actual Cash Flow 8,250,000 (2,746,823) (3,466,864) (4,375,654) (5,522,670) (6,970,360)IRR of cash flow: 39%

Foreign Exchange Losses on Cemex Loan (million RP)Forex Loss on Interest: (216,262) (409,082) (546,940) (580,770) (435,821)Forex Loss on Principal: (354,232) (881,453) (1,652,385) (2,765,571) (4,358,210)Total Forex Loss on Debt: (570,494) (1,290,535) (2,199,325) (3,346,341) (4,794,031)

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Income Statement Assumptions Revenues

– Sales based on export.

– Cement will be sold in export market at $58/ton.

Costs – Direct cost RP 115,000/ton & rising @ rate of inflation (30% p.a.).

– Additional production cost of RP20,000/ton & rising @ rate of inflation (30% p.a.).

– Loading costs $2.00/ton rising @ inflation (3% p.a.).

– Shipping costs $10/ton rising @ inflation (3% p.a.).

– License fee: 2% sales

– Sales, General, & Admin Expenses: 8% (growing @ 1% p.a.)

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Project Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Spot Rate (Rp/$) 10,000 12,621 15,930 20,106 25,376 32,028Sales Volume 8,000 10,000 12,000 12,000 12,000Sales Price ($) 58 58 58 58 58Sales Price (RP) 732,039 923,933 1,166,128 1,471,813 1,857,627Total Revenue ('000) 5,856,311 9,239,325 13,993,541 17,661,751 22,291,530

Cash costs ('000) (920,000) (1,495,000) (2,332,200) (3,031,860) (3,941,418)Additional production costs ('000) (160,000) (260,000) (405,600) (527,280) (685,464)Loading costs ('000) (201,942) (328,155) (511,922) (665,499) (865,149)Shipping costs ('000) (1,009,709) (1,640,777) (2,559,612) (3,327,495) (4,325,744)Total (2,291,650) (3,723,932) (5,809,334) (7,552,134) (9,817,774)

Gross Profit 3,564,660 5,515,393 8,184,207 10,109,617 12,473,756

License Fees (117,126) (184,787) (279,871) (353,235) (445,831)General & Admin Expenses (468,505) (831,539) (1,399,354) (1,942,793) (2,674,984)EBITDA 2,979,029 4,499,067 6,504,982 7,813,589 9,352,941

Depreciation & Amortization (1,760,000) (1,760,000) (1,760,000) (1,760,000) (1,760,000)EBIT 1,219,029 2,739,067 4,744,982 6,053,589 7,592,941

Interest on Cemex Debt (825,000) (689,867) (541,221) (377,710) (197,848)Forex Losses on Debt (570,494) (1,290,535) (2,199,325) (3,346,341) (4,794,031)Interest on Local Debt (962,500) (928,921) (883,590) (822,393) (739,777)EBT (1,138,965) (170,256) 1,120,846 1,507,145 1,861,285

Income taxes (30%) 0 0 0 395,631 558,386Net Income (RP) (1,138,965) (170,256) 1,120,846 1,111,514 1,302,900Net Income ($ million) (90) (11) 56 44 41

Pro-forma Income Statement

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Project Viewpoint Capital Budget Cemex Indonesia free cash flows found by looking @

EBITDA, not EBT!• Taxes calculated based on EBITDA.

• Terminal value (TV) calculated for continuing value of plant after year # 5.

• TV calculated as perpetual net operating cash flow after year 5:

58RP19,686,2033257.0

)01(059,547,6

gk

g)1(NOCFValue Terminal

WACC

5

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Capital Budget: Project Viewpoint

Project Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Spot Rate (Rp/$) 10,000 12,621 15,930 20,106 25,376 32,028EBITDA 2,979,029 4,499,067 6,504,982 7,813,589 9,352,941Recalculated taxes (@30%) (893,709) (1,349,720) (1,951,495) (2,344,077) (2,805,882)Net Operating cashflow 2,085,320 3,149,347 4,553,487 5,469,512 6,547,059

Additions to NWC (240,670) (139,028) (436,049) (289,776) (625,314)Initial Investment (22,000,000)Terminal Value 19,686,258

Free Cash Flow (FCF) (22,000,000) 1,844,650 3,010,319 4,117,438 5,179,736 25,608,003

NPV @ 33.257% ($9,443,460)IRR 15.4%

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Parent Viewpoint Capital Budget• Cash flows estimates are constructed from parent’s

viewpoint

• Cemex must use its cost of capital, not project’s one!

• Cemex WACC 11.98%

• Cemex requires additional 6% for international projects => discount rate will be 17.98%

• This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint

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Capital Budget: Parent ViewpointProject Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Spot Rate (Rp/$) 10,000 12,621 15,930 20,106 25,376 32,028

Dividend RemittanceDividends paid (RP) 0 0 560,423 555,757 651,450

Withholding tax @ 15% 0 0 (84,063) (83,364) (97,717)Net dividend remitted (RP) 0 0 476,360 472,393 553,732

Net dividend remitted ($) 0 0 24 19 17License Fees Remittance

Fees remitted 117,126 184,787 279,871 353,235 445,831Withholding tax @ 5% (5,856) (9,239) (13,994) (17,662) (22,292)

Net dividend remitted (RP) 111,270 175,547 265,877 335,573 423,539Net license fees remitted ($) 8.8 11.0 13.2 13.2 13.2

Debt Service RemittancePromised interest paid ($) 82.5 69.0 54.1 37.8 19.8Withholding tax @ 10% (8.25) (6.90) (5.41) (3.78) (1.98)Net interest remitted ($) 74.3 62.1 48.7 34.0 17.8

Principal payments remitted ($) 135.1 148.6 163.5 179.9 197.8Capital Budget: Parent Viewpoint (US$ million)Dividends 0.0 0.0 23.7 18.6 17.3License fees 8.8 11.0 13.2 13.2 13.2Debt service 209.4 210.7 212.2 213.9 215.7Total 218.2 221.8 249.1 245.7 246.2Initial Investment (1,925)Terminal Value 614.70Free Cash Flow (FCF) (1,925) 218.2 221.8 249.1 245.7 860.9

NPV @ 17.98% (925.60)IRR -1.8%

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Sensitivity Analysis Political risk

– Risk of blocked funds.

– Risk of expropriation.

Foreign exchange risk– appreciation of US $.

– depreciation of US $.

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Real Option Analysis DCF analysis cannot capture value of strategic options, yet real option

analysis allows this valuation

Real option analysis includes valuation of project w/ future choices:– option to defer or abandon (timing option).– option to alter capacity (expansion options).– option to start up/ shut down (switching).– option to learn.

Real option analysis treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis)

The valuation of real options and the variables’ volatilities is similar to equity option math

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Things to remember… Multinational capital budgeting.

Project vs. parent capital budgeting?

Adjust capital budgeting analysis of foreign project for risk.

Case study: evaluate a greenfield foreign project

Real option analysis vs. DCF analysis.