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 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 ((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 • 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 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. Always adopt this perspective! • 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 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 $72,000. 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 ignored. • 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 credit. 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.
Pages to are hidden for
"Investment Appraisal"Please download to view full document