Investment Appraisal by hedongchenchen


									        Investment Appraisal
• NPV criterion – value creation for
  stockholders of parent, NPVProject.
• Parent perspective is correct, subsidiary
  perspective is not.
• Subsidized financing linked to project,
• Overall NPV = NPVProject + NPVSL
     Eccentricity in Excel’s NPV
• 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
      Computational Paradigms
• 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
  adjustment, under certain conditions.
      Consistent NPVProject’s
• Real interest parity links WACC’s.
• What real return do we require? This is
  equalized across WACC’s.
• Purchasing power parity links (FX
  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
• NPVProject = -U$438,200
• 13% benchmark for won cash flows is too
     Willy: NPVProject (won)
• Equivalent won WACC, I.e.,requiring same
  real return as greenback WACC.
• Equivalent won WACC = 27%.
• RIP applied to WACC’s: (1+13%)/(1+5%)
  = (1+X)/((1+18%).
• Apply 27% to won cash flows.
• NPVProject = -346,353,280 won
         Wiley: NPVProject
• NPVProject (U$) = NPVProject (won) /
• -U$438,200 = -346,353,280won/790.4
• NPV’s are present values, ergo use spot
  rates to convert NPV’s into same currency.
• Consistency of NPV’s requires: WACC’s
  satisfy RIP and Cash flows satisfy PPP.
       Subsidized Financing
• NPVSL, NPV of subsidized loan, is present
  value of subsidized loan cash flows
  discounted at the unsubsidized cost of
• Cash flows are those of subsidized
• Discount rate (benchmark) is unsubsidized
  cost in the same currency.
• Represents the extra financing obtained at
  time 0 because of ability to tap subsidized
• Extra financing is obtained with the same
  debt service as that of unsubsidized loan.
• NPVSL = (Subsidized financing raised)
  minus (Unsubsidized financing raised).
     NPVSL 2-step calculation
• Calculate NPVSL in the same currency as
  that in which the loan is denominated:
  discount rate and cash flows are in the same
• Convert NPVSL into reference currency
  using the current spot rate
      Example: U calculation &
• Canadian firm can borrow C$ 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
•   Inflation rates: Canada=2%, EuroZone=3%.
•   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
• 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.
  Always adopt this perspective!
• Wrong perspective is that of foreign
• 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
Counter-trade: Potential Solution
      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).
    Case: Pasadena Electronics
• 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
     Pasadena: Shifting Modes
• 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
   Pasadena: Two Perspectives
• 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
• NPVProject different depending on
  perspective. Parent is correct perspective.
     Pasadena: Complications
• 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.
   Pasadena: Foreign Tax Credit
• 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
   Pasadena: 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.
    Case: Pasadena Electronics
• Funds blockage induces a lower NPV when
  blocked funds’ reinvestment rate < WACC.
• Counter trade (aka barter) as a maneuver to
  circumvent blockage.
• Financial assessment of counter trade vs.
  suffer blockage alternatives.
• Trade-off: delayed vs. reduced receipt of
  cash flow.

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