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Ch 21 International Capital Budgeting

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					International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-1




             Ch. 21. International Capital Budgeting




        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
                 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




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-2



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.


P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-3




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




P. Sercu and R. Uppal                     Version January 1994                    Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-4



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




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-5




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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-6




                        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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-7



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




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-8




     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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting          page 21-9




                  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


P. Sercu and R. Uppal                    Version January 1994                     Printout: Tamuz 23, 5770
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-10



• risk-sharing (in JVs)




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-11




         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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-12




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




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-13




      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").




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-14




       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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-15




                   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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-16




    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. •




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-17




   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




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-18




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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-19




                                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.


P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-20




• 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




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-21




• 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




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-22




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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-23




       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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-24




                        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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-25



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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-26




          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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010
International Financial Markets and the FirmCh. 21: International Capital Budgeting         page 21-27




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.




P. Sercu and R. Uppal                    Version January 1994                     Printout: July 5, 2010

				
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