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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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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: Tevet 2, 5771
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
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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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 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: December 9, 2010
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