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Ch International Capital Budgeting

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            Ch. 21. International Capital Budgeting


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       1.      Domestic Capital Budgeting: A Quick Review
               1.1.   Net Present Value
               1.2.   Adjusted Net Present Value
               1.3.   The Interest Tax Shield Controversy
               1.4.   Why we use ANPV rather than the Weighted
                      Average Cost of Capital
       2.      Forms of Foreign Activity
               2.1.   Modes of Operation: a Managerial Perspective
               2.2.   Modes of Operation: a Legal Perspective
       3.      Taxes, and Three-Step International Capital Budgeting
               3.1.   Step 1: The ‘Branch’ Scenario or ‘Bundled’
                      Approach
               3.2.   Step 2: The ‘Unbundling’ Stage
               3.3.   Step 3: The Implications of External Financing
       4.      Transfer Risks
               4.1.   Pro-Active Management of Transfer Risk
               4.2.   Management of Transfer Risk After the Imposition
                      of Capital Controls

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      4.3.   How to Account for Transfer Risk in NPV-
             Calculations
 5.   Other Political Risks
 6.   Incremental Cashflows, and Parent versus Project Point
      of View
 7.   Exchange Risk and Market Segmentation
 8.   A Checklist for an NPV Analysis




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Capital budgeting

• NPV: accept if NPV > 0 (or highest positive NPV of
  mutually exclusive projects)

• option pricing based (CH 25).




          1. Domestic Capital Budgeting
                        1.1.    Net Present Value



1.1.1. Discounted Cashflows
• Cashflows vs. profits: a timing difference

  • Upfront investment vs. depreciation

  • Investments in working capital


  order raw
  materials         produce     inventory

          pay A/P         pay wages                sell   customer pays
               – 0.5       – 0.4                         + 0.25




• Discounting at a risk-adjusted rate—assuming constant or,
  at least, known risk per period.


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1.1.2. Base Case NPV Computations: an Illustration

  Example
  Weltek's 5-year project:

  • Investment up front: takes 1 year
    Land:     ESP 100m       no depreciation; E0(V6) = 130m
    P&E:      ESP 350m       5-year linear depr., zero scrap
    Entry: ESP 250m          5-year linear depr
    Total I0: ESP 700m       paid at time 0.5, on average

  • Timing operational cashflows for the t-th year:
                             pay fixcosts
             pay varcosts        sell             cash in       pay tax    >
               t + 0.25        7 + 0.5            t + 0.75       t+1

 • Discounting of operating cashflows at 20% p.a.,
   compound; discounting of I0 at 12% p.a.


             (a1)      (a2)      (b)      (c)           (d)    (e)      (5)
           goods    sale of variable    over-       depre- taxable      tax
    year (t) sold     land     costs    head        ciation          (35%)

    1       650         —       260         105        120    165          58
    2      1000         —       400         110        120    370         129
    3      1100         —       440         116        120    424         148
    4       600         —       240         122        120    118          41
    5       300         —       120         128        120    -68         -24
    6        —         130       —           —          —      30           8

    PV     1993         38      872         311          —     —          198




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                                700
NPV = 1993 – 872 – 311 – 198 – 1.12(.5) + 38 = ESP -13 •




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1.1.3. Incremental Cashflows
Cashflows not found in project P&L include
• sales lost by other units
• profits on deliveries to new unit

  Example
  New unit buys coating from existing unit. New unit's costs
  are based on arm's length price, which includes profit by
  other unit.
       t=1                   t=1               t=1
             ICsalest              varcostst         taxest
       ∑           (t+.25)   -∑            t   -∑          (t+1)   = ESP 71m.
       5     1.2              5      1.2        5    1.2



  true NPV:

  • NPV of cashflows realized in new unit                              -13m
  • NPV of cashflows realized by supplying unit                         71m

  Total:                                                            ESP 58m




1.1.4. Sensitivity analysis
Vary sales, varcosts, fixcosts, discount rate, E(S) if required.




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              1.2.   Adjusted Net Present Value

Two-step NPV:

• Step 1: 100%-equity finances, no issuing cost, asset 

  Focus is on the inherent economic value of the project

• Step 2: financing aspects of the project: issuing costs,
  capital grants or interest subsidies

 Example
 Weltek raises new equity at a cost of 15, and obtains a
 capital grant of 40

              ANPV = ESP 58 – 15 + 40 = ESP 83. •



       1.3.     The Interest Tax Shield Controversy

Debt financing typically reduces corporate taxes.
          T
              [∆ borrowing capacity]  Rd  c
    PV = ∑                        t            ?? — but:
          t=0            (1 + Rd)

• Not all tax shields can be used every year: postponed, or
  lost.

• Personal taxes may partly/wholly undo the corporate tax
  gain.



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• Even if we would know the total subsidy, we would not
  know how much accrues to the shareholders.




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   1.4.    Why we use ANPV rather than the Weighted
                    Average Cost of Capital
             Debt                           Equity
  WACC = Equity + Debt  RDEBT (1 - ) + Equity + Debt  E(R EQUITY)
                                                           ˜


This assumes, heroically, that

• corporate tax savings are not offset by any fiscal
  discrimination at the personal level.

• all of these savings to the shareholders.
• a one-period project or for a perpetuity.
• if equity is based on existing stock data: project has same
  risk as other activities.




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            2. Forms of Foreign Activity
  2.1.     Modes of Operation: a Managerial Perspective

 i) Pure exports:
               product,
      skills 
           marketing                     | foreign sales revenue



ii) International product marketing:

       skills  product  | foreign marketing and sales
                      production,
 skills  | foreign {
                marketing                                  sales revenue



iii) Selling of skills

                    sell skills | foreign income

    Includes licensing, franchising, management contracts.
    Income is fixed up-front fee and/or fixed annual fee
    and/or royalty.



Note: the three approaches are often combined:
• tax considerations
• political risk considerations

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• risk-sharing (in JVs)




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     2.2.    Modes of Operation: a Legal Perspective

• Exports via independent agents without legal ownership
  link with the parent.



• Exports via a dependent agent abroad. The exporter is not
  legally present in the host country.



• Opening a foreign branch:
  • the company establishes a legal presence in the foreign
    country.
  • no separate accounting system. All its profits and losses
    are immediately and automatically part of the overall
    profits and losses of the company.


• incorporate the foreign unit as a separate company: wholly
   owned subsidiary or joint venture
  • separate accounts
  • WOS or JV can pay out dividends, royalties, or interest
    to its parent(s), lend money to its owner(s), obtain loans,
    or subscribe to the parent's stock and so on.




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International issues:


• Incremental cashflows. often many interactions with the
  cashflows of the company's other units, and tax
  complications.



• Political risks. blocked funds (transfer risk), expropriation
  risk.



• Exchange risk and capital market segmentation.

  • Legal restrictions        on      inward/outward   portfolio
    investment

  • (Pervasive) restrictions on foreign ownership through
    by-laws (CH, Scandinavia)



• International taxation.
  • Transfer pricing, or profit allocation across branches?
  • remittance policy: equity transactions, loans, dividends
     (and their timing), interest payments, royalties, or
     management fees




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   3. Taxes, and Three-Step International
             Capital Budgeting


Issues to be settled before or during capital budgeting
process:
• Transfer pricing, or profit allocation across branches?
• remittance policy: equity transactions, loans, dividends
   (and their timing), interest payments, royalties, or
   management fees.



Proposed procedure:

• Step 1 ("branch stage"): focus on the cashflows from the
  operations and their economic value. Ignore tax games.



• Step 2 ("unbundling stage"): consider tax effects of the
  optimal remittance policy. Focus on intra-group financial
  arrangements.



• Step 3 ("external financing").




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    3.1.   Step 1: The ‘Branch’ Scenario or ‘Bundled’
                           Approach

• A branch has no remittance policy, and the scope for tax
  planning is very limited.



• Focus on the economics of the project: sales, costs,
  differences between cashflows realized by the project and
  overall incremental cashflows, exchange risks, political
  risks, etc.



• Practical implication: remove interest payments to outside
  lenders or to other companies in the group, royalties paid to
  a related company, etc.

  This helps avoiding two common pitfalls:

  • recognize the royalties or interests on an intra-company
    loan as a 'cost' to the subsidiary, while forgetting that
    these payments also represent an income to the parent.

  • focus on the reduction of corporate taxes in the host
    country, while forgetting that the parent is taxed on this
    royalty or interest income.




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           3.2.   Step 2: The ‘Unbundling’ Stage

• Why separate analysis of intra-group financing from of
  external financing?

  • we know exactly who the beneficiaries are and how they
    are currently taxed; and

  • the benefits clearly accrue to the group as a whole.



• Why separate the intra-group financing from the pure
  economics of the project?

  • division of labor: leave taxes to experts, managers focus
    on project itself.

  • estimation of tax effects requires tenuous assumptions
    about the size and timing of dividend payouts.

  • hoped-for savings from fiscal planning may disappear
    when tax codes are changed.

Thus, the safer procedure is to accept a project on the basis of
its economic merits, and consider any additional gains from
tax planning as a welcome but non-essential boon.




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Example
Weltek UK invests in Spain. Tax saving when Weltek Spain
pays a royalty equal to 6% of its Spanish sales? Data:

• Weltek pays no taxes on dividends received from Weltek
  Spain ('exclusion' rule; actual UK rules are different),

• UK income from licensing is taxed in the UK at 30%

• Spanish tax rate is 35%
                                      5
                                           salest
        PV tax saving = 0.06  ∑                     )  .05
                                     t=1 1.18(t +.5)

                      = .06  2234  .05

                         = ESP 6.7m.

The step-2 adjusted NPV therefore is ESP 68m + 6.7m =
74.7m. •




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  3.3.    Step 3: The Implications of External Financing

3.3.1. Who should borrow?
Is it optimal for the parent to borrow if the home country
corporate tax is higher than the host country rate, and vice
versa?

• look at total taxation, not just (local) corporate tax rate.

  Example
  • Corporate tax rates: 16% in Hong Kong, 40% in
    Belgium.

  • HK withholding tax on divs is 5.

  • Full double taxation of divs in Belgium



  Total tax burden in                 Hong Kong       Belgium
  Initial amount                        100.0          100.0
  corptax (16%)                         <16.0>          40.0
  After corptax                          84.0           60.0
  Withholding tax (5%)                   <4.3>
  Net cash income Belgium                79.8
  Belgian tax (40%)                     <31.2>
  After taxes                            48.7
  Total tax burden                       51.3           40.0




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3.3.2. Which currency should one borrow in?
Section 4.5 of Chapter 4:

• In terms of risk-adjusted expectations, the capital gains or
  losses are exactly offset by the difference between the
  interest rates.

• Thus, still in terms of risk-adjusted expectations, the taxes
  on the capital gains or losses are exactly offset by the taxes
  on the difference between the interest rates, as long as taxes
  do not discriminate between interest and capital gains.




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                     4. Transfer Risks
Parent may not be able to repatriate the interest, dividends, or
royalties it earned abroad, or the funds held in a foreign bank
account opened by a branch office.



     4.1.       Pro-Active Management of Transfer Risk

Risks depend on remittance policy: some forms of
remittances are more liable to be blocked than others.

• Transactions on capital account (equity transfers, intra-
  group loans): highest risk.

  Trick: disguised loans via leading-lagging

   Example
          old payment schedule              new payment schedule
      …                                 …
      July       1m for May order       July           1m for May order
      August     1m for June order      August         1m for June order
                                                       1m for order July
      Sept.      1m for July order      Sept.          1m for August order
      October    1m for order August    October        1m for Sept. order

   This is equivalent to keeping the credit period at 60 days
   and making an interest-free loan from the subsidiary to
   the parent for USD 1m without a stated expiration date.


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• Dividends: next on list

  • Limitations —say 5% of equity.

    Tricks: increase the capital base
    • take over a local company with a huge nominal capital
      but a low market value
    • bring in equipment as equity-in-kind, at a rather
      generous valuation.

  • Blocking of dividends:

    Trick: include the parent's own government, a
    government agency, or the IFC, as a minority
    shareholder of the subsidiary.



• Interest payments and license fees

  Tricks:

  • Use bank as a front—with right of offset

             Parent  International bank  Subsidiary

      Parent  International bank  Local bank  Subsidiary

  • Disguise loan as (bearer) Eurobond issue




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• Finally, management fees and payments for intra-company
  trade and for technical assistance are only blocked in
  extreme circumstances.

  Notes:

  • start charging high transfer prices, or asking fees or
    royalties, long before the exchange controls are imposed.

  • Arm's length rules




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4.2.   Management of Transfer Risk After the Imposition
                     of Capital Controls

• Circumvent controls: start leading/lagging, increase
  transfer prices and management fees or charge more for
  technical assistance—if you get away with it.



• Limit the damage: (blocked funds are not irrevocably lost):

  • invest in the local money or capital markets, new
    projects, or inventory (e.g. internationally traded goods)

  • spend the funds as wisely as possible, by buying local
    goods or services that would otherwise have been bought
    elsewhere, by organizing executive meetings and
    conferences in the host country or by buying airline
    tickets from the local carrier.

  There will almost certainly be some loss of value.




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    4.3.    How to Account for Transfer Risk in NPV-
                         Calculations

Three conceivable approaches:



• Add an extra risk premium (for transfer risk)?

  Evaluation: what premium?



• Estimate probability of the funds being blocked as well as
  extent of loss if the funds are actually blocked, and correct
  expected cashflows for expected losses.

  Evaluation: not easy at all



• Use the (present value of the after-tax) insurance premia as
  the risk-adjusted expected value of the transfer risks.

  Evaluation: uses readily available information and is an
  implementable strategy.




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              5. Other Political Risks
Other risks include

• possible expropriation of a company

• imposition of minimal local ownership rules  "distress"
  sales of equity

• nationalization of entire economic sectors.



Use insurance fees as ex ante cost? But:

• compensation is typically based on accounting values, not
  true values

• takes some time before the damage is recognized and
  assessed; so there is a loss of time value.

• Doesn't cover you against covert expropriation.




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7. Exchange Risk and Market Segmentation
Can Weltek UK compute the NPV of its foreign investment in
units of the host currency, the Peseta—as if it were a Spanish-
owned project?

(+) This is natural: sales prices and production costs are
    normally first estimated in host currency.

(–) The valuation of a project by a local investor may differ
    from the valuation by a foreign investor if the host and
    home capital markets are not well integrated.

   If investors are not free to buy and sell any asset they
   would like, the cost of capital is not equalized
   internationally.




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     8. A Checklist for an NPV Analysis
1. Incremental Cashflows

  (+) profits when a related company sells to the new
  subsidiary, or when it buys from the new subsidiary and
  then re-sells the goods to other customers.

  (–) project may take away sales and profits from an
  existing business.



2. Integrated or segmented markets

  When the host and home capital markets are well
  integrated, the value of the project is the same to all
  investors in these countries.

  In segmented markets, however, one has to discount CFs
  in the parent's currency, at the rate required in the home
  market.



3. Taxes

  Analysis should include also withholding taxes and the
  home-country corporate taxes—not found in the
  subsidiary's pro forma P&L statements.




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4. Separate the operating and financing issues

5. Inflation

  Notes:
  • it is not necessary for the rate to be constant over time
  • inflation is not necessarily the same for all cashflow
    items

6. Profits versus cashflows: think of investments in working
   capital.

7. Terminal value

  • set equal to the book value? simple, and likely to be
    conservative.

  • value the WOS as a going concern, using a long-term
    average price/cashflow ratio for comparable firms.

  • Compute, by trial-and-error, the break-even liquidation
    value.

8. Sensitivity analysis

9. NPV is just one element

   NPV ignores non-quantifiable aspects.




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