International Capital Budgeting by liaoqinmei


									Evaluating International
  Investment Projects
      Basic Capital Budgeting
I. Steps in Capital Budgeting
  – Project Cash Flow
  – Calculate NPV
II. Key Issues
  – Predicting cash flows
  – Choosing approriate discount factor
      1. Cash Flow Issues
Special problems evaluating international
Three-stage cash flow projections
1. Project cash flows from the subsidiary’s
   point of view. (local currency)
2. Project cash transfers to parent and their
   costs including tax consequences
3. Adjust for spillovers affecting the rest of
   the global enterprise
            Special problems:
           Local cash flows

• Sovereign Risk: risk of
  – sudden regulatory change
  – even expropriation
• Opportunity for
  – concessionary financing
  – tax holiday
  – Guaranteed markets or supplies
             Special problems:
             Local cash flows
• Opportunities for special financial structure
  – for example project finance
• Differences in tax treatment
                Special problems:
            Getting Funds Home
1. Exchange rates (use forward rates where
2. Risk of currency blockage (political risk)
3. Taxes
   –   Local: Dividend withholding or other taxes owed
       when repatriating profits
   –   U.S.: The project generates foreign tax credits usable
       against other foreign income or additional U.S. taxes
       will be due on the repatriated income.
  Impact on the rest of the MNE
• Adjust for spillovers and intangible
  cost/benefits that are not reflected in the
  project’s financial statements
• Remove misleading effects of transfer
  pricing, fees and royalties
• Adjust for value of real options generated
             Global cost/benefits
• Spillovers
   – Cannibalization of sales of other units
   – Creation of incremental sales by other units
• Intangible benefits
   –   Diversification of production facilities
   –   Diversification of markets
   –   Provision of a key link in a global service network
   –   Knowledge of competitors, technology, markets, or
             Transfer prices

• Transfer prices are internal prices used for
  transfers of goods within the MNE.
• If they do not reflect market value, using
  them to calculate cash flows can distort the
  value of a project
  Remove misleading effects of
       Transfer Pricing
1. Use market costs/prices for goods,
   services and capital transferred internally.
2. Add back fees and royalties to project
   cash flows, because they are benefits to
   the parent.
3. Remove the fixed portion of such costs as
   corporate overhead.
Real Option: Definitions

(Financial) option: Right – but not obligation
  - to buy (to sell if a put) at a set price. An
  option is acquired at a cost, the “option
A real option results when an investment
  project creates the possibility (but not the
  requirement) to execute a further project.
Real options occur with some
 frequency in international business.

For example, initial market entry (retail distribution
  in Rio) lowers cost of the next step (distribution in
  Sao Paulo).

Key point: Rio entry creates value beyond that
  evident in numbers for Rio alone.
Real options numerical example:

          See appendix
2. Discount factor issues
Example: Wilcox Enterprises
Initial investment: $10 M
Net after-tax CF: $1.75M / year perpetuity
Expected return to equity: 21%
Expected return to debt: 14%
Effective marginal tax rate: 35%
Debt/Value ratio: 50%
Wilcox Enterprises: Solution
Weighted average cost of capital
                     D     E
  WACC  rD (1  Tc )  rE
                     V     V

  WACC = .14 (1-.35)(.5) + .21(.5)
  WACC = .1505         (15.05%)
    Wilcox: Net Present Value

PV of cash flows = ($1.75M/.1505) = 11.628
Initial investment cost            -10.0
NPV                                  1.628

Accept project.
 Discussion: Discount factor issues

Why use WACC of the firm to evaluate a
 specific project?

WACC is valid under the assumption:
   The project replicates the firm.
Weighted average cost of capital

                      D     E
   WACC  rD (1  Tc )  rE
                      V     V
 Discussion: Discount factor issues
WACC is appropriate discount factor when:
  – The new project has the same risk profile as the
    firm as a whole
  – The new project uses the same financial
    structure as the firm as a whole
     • No special financing connected to the project
  – Financing for the project is taxed the same way
    as all other financing for the firm
   Discussion: Cash flow issues
• Most cash flow issues do not affect validity
  of WACC as a discount factor. (Unless
  they raise one of the above issues.)
• However, if WACC must be abandoned, it
  does have implications for cash flows
  considered. Specifically cash flows related
  to financing (which are normally ignored)
  must be considered.
Cash flows ignored using WACC
• Financing for the project
Example: Financing for the previous WE
  example involved receiving $5M in
  proceeds of a bond issue; annual interest
  payments (at 14%) of $700,000 and an
  ultimate repayment of the $5M.
Why are these cash flows ignored?
Cash flows ignored using WACC
• Tax shields from financing
Example: In addition, deducting these interest
  payments from income results (at a 35% tax
  rate) in a savings of $245,000 per year.

Why are these cash flows ignored in
 evaluating the project?
       Conclusion on WACC
If the assumptions required for WACC to be
   valid do not hold,
• It may be necessary to use a different
   discount factor
• Cash flows associated with the financing of
   the project must also be considered
   In international projects WACC
    assumptions are less plausible
• Inherent risk of the project more likely to
• Local tax structure likely to differ.
• Financial structure may differ
  – Concessionary financial terms offered
  – Opportunity for “project finance”
     Application to international
       investment decisions

• Where WACC is inappropriate, APV
  should be used.
Adjusted Present Value
              Calculating APV
1. Determine after-tax cash flows for the
   project itself.
2. Find cash flows (positive and negative) of
   financing including value of tax shields
3. Calculate NPV of these net cash flows
   using the opportunity cost of capital for the
           Calculating APV
4. Determine the amount of additional debt
   that must now be issued (or liquidated) to
   restore the parent to its target debt ratio.
5. Calculate the value of the tax shield
   created (lost) as a result of the additional
6. Calculate the present value of the tax
   shield using the after-tax cost of debt.
           Calculating APV
7. Add the PV of the tax shields from the
   adjustment to the PV of the project and its
   financing to obtain APV
  Example: Wilcox Enterprises
Suppose the expansion project of the previous
  example is to be built in Taiwan instead of
  at home. All facts about the cost and cash
  flows of the project as well as about the cost
  of capital to WE continue to apply.
    Example: Wilcox Enterprises
          Additional Information
• If the project is built in Taiwan, the
  opportunity cost of capital (the cost when
  all-equity financing is used) is 18%
• The effective marginal tax rate for
  operations in Taiwan is 20%.
    Example: Wilcox Enterprises
          Additional Information
• The Taiwanese government has offered a
  loan of $7M at 5% interest if the project is
  built. Interest is to be paid in annual
  installments with the principal repaid at the
  end of five years
Real Options

              The Goldmine
• This year
  – Cost to prepare mine = $1 million
  – Gold that will be made accessible = 40,000 oz.
• Next year
  – Cost to extract gold = $390/oz.
  – Expected price of gold = $400/oz.
• Question: To prepare the mine or not
  – Required return = 15%
     Expected NPV calculation
• Resoundingly rejects the project
  – Expected CF next year
           40,000*(400-390) = $400,000
  – Expected NPV
      $400,000/1.15 -$1,000,000 = -$652,174
• Fallacy: This approach ignores the option
  not to produce next year.
      Next year’s gold market
• The gold market will be either good or bad
  with equal probability
  – If good, gold will be worth $500/oz.
  – If bad, gold will be worth $300/oz.
  – Note: expected value of gold is still $400/oz.
           The decision tree
• Preparing the gold mine buys you a (real)
  option because you get to wait until you
  know the price of gold before deciding
  whether to extract it or not.
         If gold market is bad
• Clearly you will not choose to spend
  $390/oz. to extract gold worth $300/oz.
• Instead, the mine will stand idle.

• Thus, cash flows will be zero if the market
  turns out to be bad.
       If gold market is good
• Extracting the gold will be worthwhile
          Value of the option
• Thus the value of the real option is
    0.5*0 + 0.5* 3,826,000 = $1,913,000

• In fact it is worth spending the $1 million to
  acquire this option
 Note:Volatility increases option
• Suppose gold price were even more volatile
  (but with same expected value)
  – In good market price = $600
  – In bad market price = $200
• Present value of cash flow in good market
  increases to
          $8,400/1.15 = $7,304,000
    Volatility effect (continued)
• In bad market, cash flows remain zero
• The value of the option thus increases to
  0.5*0 + 0.5* 7,304,000 = $3,652,000

• Investing the initial $1 million is even more

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