# Investment Appraisal by hedongchenchen

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• pg 1
```									        Investment Appraisal
• NPV criterion – value creation for
stockholders of parent, NPVProject.
• Parent perspective is correct, subsidiary
perspective is not.
• Subsidized financing linked to project,
NPVSL.
• Overall NPV = NPVProject + NPVSL
Eccentricity in Excel’s NPV
Formula
• First cash flow encountered within the
formula is assumed to occur at the end of
the first period.
• Thus, initial outlay must be located outside
the formula.
Project Cash Flow: Two
• Project cash flow equals (after-tax income
or accounting profit) plus depreciation.
• Project cash flow equals (after-tax cash
flow ignoring depreciation) plus
(depreciation tax shield).
• Depreciation tax shield = Depreciation X
Tax rate
Cash flows and WACC
• Must be in same currency.
• Willy Corp. Case: discounting won cash
flows with U\$ WACC is nonsense.
• Apply won WACC to won CF’s.
• Apply U\$ WACC to U\$ CF’s.
• Resulting NPV’s will be the same, after FX
Consistent NPVProject’s
• Real interest parity links WACC’s.
• What real return do we require? This is
equalized across WACC’s.
forecasts) cash flows in different currencies.
• If RIP applies to WACC’s and PPP applies
to CF’s, the two NPV’s will be consistent.
Willy: NPVProject (U\$)
• U\$ WACC = 13%.
• Won cash flows translated into U\$, using
PPP projections of FX rates.
• S(U\$/won) at time t = U\$0.00127 X
((1+5%)/(1+18%))^t
• NPVProject = -U\$438,200
• 13% benchmark for won cash flows is too
low!
Willy: NPVProject (won)
• Equivalent won WACC, I.e.,requiring same
real return as greenback WACC.
• Equivalent won WACC = 27%.
• RIP applied to WACC’s: (1+13%)/(1+5%)
= (1+X)/((1+18%).
• Apply 27% to won cash flows.
• NPVProject = -346,353,280 won
Wiley: NPVProject
• NPVProject (U\$) = NPVProject (won) /
(790.4won/U\$).
• -U\$438,200 = -346,353,280won/790.4
• NPV’s are present values, ergo use spot
rates to convert NPV’s into same currency.
• Consistency of NPV’s requires: WACC’s
satisfy RIP and Cash flows satisfy PPP.
Subsidized Financing
• NPVSL, NPV of subsidized loan, is present
value of subsidized loan cash flows
discounted at the unsubsidized cost of
financing.
• Cash flows are those of subsidized
financing.
• Discount rate (benchmark) is unsubsidized
cost in the same currency.
NPVSL
• Represents the extra financing obtained at
time 0 because of ability to tap subsidized
financing.
• Extra financing is obtained with the same
debt service as that of unsubsidized loan.
• NPVSL = (Subsidized financing raised)
minus (Unsubsidized financing raised).
NPVSL 2-step calculation
• Calculate NPVSL in the same currency as
that in which the loan is denominated:
discount rate and cash flows are in the same
currency
• Convert NPVSL into reference currency
using the current spot rate
Example: U calculation &
interpretation
• Canadian firm can borrow C\$ 1 million at
6% via a bond-type loan for 3 years
• Usual (unsubsidized) loan costs are 10% in
C\$’s and 9% in U\$’s.
• Benchmark for evaluating subsidized loan
must be in the same currency.
• 10% is appropriate benchmark for
evaluating 6% loan since both in C\$’s.
U calculation & interpretation
• Generate debt service for years 1, 2, 3 of
subsidized loan: C\$0.06M;C\$0.06M;C\$1.06M.
• Discount subsidized debt service (negative cash
flows) with benchmark, then add initial financing
obtained (positive cash flow).
• Result is NPVSL, NPV of subsidized loan.
• NPVSL > 0 since borrow at 6% when we would
otherwise borrow at 10%.
U calculation & interpretation
• NPVSL=1-0.06/1.1-0.06/1.1^2-1.06/1.1^3.
• NPVSL = 1-0.9005 = 0.0995.
• 0.9005 = U = amount of financing raised
had we tapped an unsubsidized source.
• 1 = amount of financing raised via
subsidized source.
• 0.0995 = extra financing raised.
Interpreting U = C\$0.9005
• Unsubsidized loan with this loan principal
requires the following debt service:
• Year 1: 0.9005 X 10% = 0.09005
• Year 2: 0.9005 X 10% = 0.09005
• Year 3: 0.09005 + 0.9005 (principal)
= 0.99055
• Use subsidized loan debt service to pay off
this loan.
Interpreting U = C\$0.9005
Year    Paid Required            Deficiency

1      0.06 .09005              .03005

2      0.06 .09005+.03005(1.1) .0631
= 0.123
3      1.06 .99055+.0631(1.1) 0, loan is
=1.06              paid off!
Interpreting U = C\$0.9005
• Subsidized loan (borrow C\$1 at 6%) debt
service pays off unsubsidized loan (borrow
C\$0.9005 at 10%).
• C\$0.9005 is the amount of financing
elicited had we tapped an unsubsidized
source with the same debt service as
required by subsidized source.
• NPVSL>0 iff (borrow rate)<(unsub rate).
Example: Inferring unsubsidized rate

• Canadian firm has subsidized euro loan
source: can borrow EU 1 million at 4%.
• Loan is fully amortized with equal annual
debt service over 2 years.
• Unsubsidized euro cost is unknown.
• Unsubsidized C\$ cost is 9%.
• Use RIP to infer unsubsidized euro cost.
Inferring unsubsidized rate
•   Inferred unsubsidized euro cost = 10.07%.
•   (1+9%)/(1+2%) =(1+X)/(1+3%).
•   RIP applied to the unsubsidized loan costs.
•   10.07% is discount rate applied to
subsidized debt service, which = EU 0.5302
M for years 1 and 2.
Inferring unsubsidized rate
• NPVSL=1-0.5302/1.1007-0.5302/1.1007^2.
• NPVSL = 1-0.9193=0.0807
• 0.9193 = amount of financing raised had
we tapped unsubsidized source that charges
10.07%
• 0.0807 = extra amount of financing raised
since tap subsidized source that charges 4%.
Willy: NPVSL
• NPVSL = JY 680M – JY 627.9064M.
• JY 627.9064M = 161.43 X PVIFA(9%,5).
• JY 627.9064M is the amount of financing
we could elicit if we were to approach our
usual (unsubsidized) Yen financing source
with same debt service.
• JY 52.0936M is extra financing obtained.
Willy: Overall NPV
• Overall NPV = NPVProject + NPVSL
• NPVProject = -U\$438,200
• NPVSL = JY52.0936M or U\$232,200 at
spot rate of JY224.3 per U\$.
• Overall NPV must be in reference currency.
• Overall NPV = U\$(-438,200+232,200) =
- U\$206,000. Reject project!
Real Interest Parity
• Two different applications
• Normative application: What WACC
should be imposed in a currency given a
WACC imposed in another currency?
• Positive application: Assuming
unsubsidized financing is obtained in two
different currencies, what links the before-
tax costs of financing?
Case: St. John’s Fish
• Danger of adopting wrong perspective
• Correct perspective is that of parent.
• Wrong perspective is that of foreign
subsidiary
• NPV of subsidiary is positive.
• NPV of parent is negative.
Case: St. John’s Fish
• Gap in NPV’s: parent vs. subsidiary
• Parent’s tax rate is higher.
• Funds blockage: restriction on remittances
to parent. Subsidiary experiences a higher
cash flow.
• NPV lower at parent level than an
subsidiary level.
Funds Blockage: Macro-
economic Context
• Subsidiary’s currency under threat of devaluation
but central bank (of subsidiary) has insufficient
foreign currency reserves to defend.
• To conserve FX reserves, country restricts
subsidiary remittances to parent.
• Examples: New Zealand mid-80’s, Mexico mid-
90’s el efecto tequila, Chile 90’s el encaje
bancario, Asian flu late-90’s bahtulism, Argentina
2001 el corralito.
NPVparent versus NPVsub
• Higher parent tax rate
• Funds blockage: Subsidiary unable to remit
entire cash flow. But counter-trade is a way
of circumventing this.
• Inter-corporate sales: Parent sells to
subsidiary or vice-versa.
• Cannibalized sales: subsidiary’s sales
reduce those of the parent company
to Funds Blockage
• Subsidiary restricted in remitting dividends.
• Blocked funds can be used to purchase
domestically produced (produced in country of
subsidiary) good that is then sent to the parent in
lieu of dividends.
• Problem: Parent usually cannot realize full value
of the good when it liquidates same.
• Tradeoff: timely receipt of reduced cash flow
(counter-trade) versus delayed receipt of entire
cash-flow (funds blockage).
• Opportunity cost associated with shifting
from one mode of foreign business
involvement to another
• Modes: exporting, licensing, franchising,
joint ventures, wholly-owned foreign
manufacturing and marketing subsidiary
• Treatment of cannibalized export sales
• Shift from solely exporting to establishment
of wholly owned foreign subsidiary.
• Annual after-tax negative cash flows of
\$288,000 associated with cannibalization.
• Inter-corporate, parent to subsidiary, sales
result in annual after-tax cash flows of
\$72,000.
• Parent’s vs. subsidiary’s perspectives: some
items ignored at one level are relevant at the
other level.
• At subsidiary level: Cannibalized exports
and profits on inter-corporate sales are
ignored.
• NPVProject different depending on
perspective. Parent is correct perspective.
• When cannibalized sales cease to be so,
thus becoming irrelevant – current export
sales are lost regardless of decision.
Decision has no effect on exports.
• Tax depreciation (amortization) based on
historical, not opportunity, cost.
• Initial outlay based on opportunity, not
historical, cost.
• Implication of foreign tax credit mechanism:
relevant tax rate is the maximum of parent’s and
subsidiary’s tax rates.
• Analogy to Canadian tax treatment of dividends.
• Grossed up dividend similar to grossed up taxable
income. Dividend tax credit similar to foreign tax
credit.
• Parent’s tax rate is higher than subsidiary’s tax
rate (tax enticement of foreign investors).
• Remittance to parent and parent’s reinvestment in
subsidiary inferior to subsidiary retention with no
remission to parent company.
• Analogy to tax argument in corporate finance
regarding dividends.