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INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICKSecond Edition

17ChapterSeventeenInternational

Capital Budgeting

Chapter Objective:

This chapter discusses the methodology that a

multinational firm can use to analyze the investment

of capital in a foreign country.

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Chapter Outline

Review of Domestic Capital Budgeting

The Adjusted Present Value Model

Capital Budgeting from the Parent FirmsPerspective

Risk Adjustment in the Capital Budgeting Process

Sensitivity Analysis Real Options

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1. Identify the SIZE and TIMING of all relevant cash flowson a time line.

2. Identify the RISKINESS of the cash flows to determinethe appropriate discount rate.

3. FindNPVby discounting the cash flows at the appropriate

discount rate.

4. Compare the value of competing cash flow streams at thesame point in time.

Review of Domestic Capital

Budgeting

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Review of Domestic Capital

Budgeting

The basic net present value equation is

0

1 )1()1(C

K

TV

K

CFNPV

T

TT

t

t

t

Where:

CFt= expected incremental after-tax cash flow in year t,

TVT= expected after tax cash flow in year T, 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.

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Review of Domestic Capital

Budgeting

TheNPVrule is to accept a project ifNPV 0

0

)1()1(

0

1

C

K

TV

K

CFNPV

T

TT

t

t

t

and to reject a project ifNPV 0

.0)1()1(

0

1

CK

TVK

CFNPVT

TT

tt

t

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Review of Domestic Capital

Budgeting

For our purposes it is necessary to expand theNPV

equation.

)1()1)(( IDIDOCRCF ttttttt

Rtis incremental revenue

Ct is incremental operating

cash flow

Dt is incremental depreciation

Itis incremental interest expense

is the marginal tax rate

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Review of Domestic Capital

Budgeting

For our purposes it is necessary to expand the NPV

equation.

)1()1)(( IDIDOCRCF ttttttt )1(( IDNI ttt

ttt DDOCR )1)((

tt DNOI )1(

ttt DOCR )1)((

tt DOCF )1(

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Review of Domestic Capital

Budgeting

We can usettt DOCFCF )1(

0

1 )1()1(C

K

TV

K

CFNPV

T

TT

tt

t

to restate theNPVequation

0

1 )1()1(

)1(C

K

TV

K

DOCFNPV

T

TT

tt

tt

as:

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The Adjusted Present Value Model

Can be converted to adjusted present value (APV)

0

1 )1()1()1(

)1(C

K

TV

K

D

K

OCFNPV

T

T

t

tT

tt

t

By appealing to Modigliani and Millers results.

0

1 )1()1()1()1(

)1(C

K

TV

i

I

i

D

K

OCFAPV

T

u

T

t

t

t

tT

tt

u

t

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The Adjusted Present Value Model

The APV model is a value additivity approach tocapital 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.

0

1 )1()1()1()1(

)1(C

K

TV

i

I

i

D

K

OCFAPV

T

u

T

t

t

t

tT

tt

u

t

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Capital Budgeting from the Parent

Firms Perspective

Donald Lessard developed an APV model for aMNC analyzing a foreign capital expenditure. Themodel recognizes many of the particulars peculiar

to foreign direct investment.

T

tt

d

tt

T

ud

TT

T

t

t

d

ttT

t

t

d

ttT

t

t

ud

tt

i

LPSCLSRFSCS

K

TVSi

IS

i

DS

K

OCFSAPV

1

000000

111

)1()1(

)1()1()1(

)1(

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Capital Budgeting from the Parent

Firms Perspective

The operating cash flows must

be translated back into theparent firms currency at thespot rate expected to prevailin each period.

T

tt

d

tt

T

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

iLPSCLSRFSCS

KTVS

i

IS

i

DS

K

OCFSAPV

1

000000

111

)1()1(

)1()1()1(

)1(

The operating cash flows

must be discounted at theunlevered domestic rate

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Capital Budgeting from the Parent

Firms Perspective

OCFtrepresents only the

portion of operating cashflows available for remittancethat can be legally remitted tothe parent firm.

T

tt

d

tt

T

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

iLPSCLSRFSCS

KTVS

i

IS

i

DS

K

OCFSAPV

1

000000

111

)1()1(

)1()1()1(

)1(

The marginal corporate tax

rate,, is the larger of theparents or foreign

subsidiarys.

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Capital Budgeting from the Parent

Firms Perspective

S0RF0 represents the value of

accumulated restricted funds(in the amount ofRF0) that

are freed up by the project.

T

tt

d

tt

T

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

iLPSCLSRFSCS

KTVS

i

IS

i

DS

K

OCFSAPV

1

000000

111

)1()1(

)1()1()1(

)1(

Denotes the present value

(in the parents currency) ofany concessionary loans,CL0, and loan payments,

LPt, discounted at id.

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Estimating the Future Expected

Exchange Rates

We can appeal to PPP:

t

f

t

dt

SS

)1(

)1(0

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A recipe for international decision makers:

1. Estimate future cash flows in foreign currency.

2. Convert to U.S. dollars at the predicted exchange rate.

3. CalculateAPVusing the U.S. cost of capital.

International Capital Budgeting

Example

600 200 500 300

0 1 year 2 years 3 years

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Facts

International Capital Budgeting

%6

%15

$

$

iIs this a good

investment from the

perspective of theU.S. shareholders?

600 200 500 300

0 1 year 2 years 3 years

= 3%

S0($/ )= $.55265

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E[St($/ )]can be found by appealing to the interest rate differential:

E[S1($/ )]= [(1.06/1.03)S0($/ )]

International Capital Budgeting

CF0 = ( 600) S0($/ )=( 600)($.5526/ ) = $331.6

= [(1.06/1.03)($.5526/ ) ] = $.5687/

so CF1 = ( 200)($.5687/ ) = $113.7

CF2 = [(1.06)

2

/(1.03)

2

] S0($/ )

( 500) = $292.6

APV = -$331.60 + $113.7/(1.15) + $292.6/(1.15)2 + $180.7/(1.15)3= $107.3 > 0 so accept.

CF1 = ( 200)E[St($/ )]

Similarly,

Solution

CF3 = [(1.06)3/(1.03)3 ] S0($/ )( 300) = $180.7

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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.

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Sensitivity Analysis

In theAPVmodel, each cash flow has a

probability distribution associated with it.

Hence, the realized value may be different from

what was expected.

In sensitivity analysis, different estimates are used

for expected inflation rates, cost and pricing

estimates, and other inputs for theAPVto give themanager a more complete picture of the planned

capital investment.

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Real Options

The application of options pricing theory to theevaluation of investment options in real projects isknown as real options.

A timing option is an option on when to make theinvestment.

A growth option is an option to increase the scale of theinvestment.

A suspension option is an option to temporarily ceaseproduction.

An abandonment option is an option to quit theinvestment early.

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End Chapter Seventeen