Multinational Capital Budgeting (External)

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Multinational Capital Budgeting
International Financial Management
Dr. A. DeMaskey

Learning Objectives
 How does domestic capital budgeting differ from

 

 

multinational capital budgeting? How do incremental cash flows differ from total project cash flows? What is the difference between foreign project cash flows and parent cash flows? How does APV analysis differ from NPV analysis? How is the capital budgeting analysis adjusted for the additional economic and political risks? What is real option analysis?

Complexities of Capital Budgeting for a Foreign Project
 Several factors make budgeting for a foreign project

more complex
 

Parent cash flows must be distinguished from project Parent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as stand alone may provide cash flows but overall adds no value to entire organization Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

Complexities of Capital Budgeting for a Foreign Project
   

An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. Managers must anticipate differing rates of national inflation which can affect differing cash flows Use of segmented national capital markets may create opportunity for financial gain or additional costs Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC Managers must evaluate political risk Terminal value is more difficult to estimate because potential purchasers have widely divergent views

Traditional Capital Budgeting Analysis
 NPV Analysis

CFt TV n NPV     I0 t n (1  k ) t 1 (1  k ) 


If Projects are independent, those with a positive NPV will be accepted while those with a negative NPV will be rejected It two projects are mutually exclusive, the project with the highest NPV greater than zero will be accepted. The discount rate, k, is the expected rate of return on projects of similar risk as the riskiness of the firm as a whole.

Properties of NPV Rule
 Consistent with the goal of maximizing

shareholder wealth.  Focuses on cash flows rather than accounting profits.  Emphasizes the opportunity cost of money invested.  Obeys the additivity principle.

Incremental Cash Flows
 Only the additional cash flows generated by

the project are relevant.  The difference between total and incremental cash flows arises from:  

 

Cannibalization Sales creation Opportunity cost Transfer prices Fees and royalties

Choosing the Correct Case Base
 The base case is represented by the

worldwide corporate cash flows without the investment.  In a competitive world, the base case needs to be adjusted for competitive behavior.  

New product New production technology Intangible benefits

Adjusted Present Value (APV)
 Project risks and financial structures vary by

country, production state, and position in the life cycle of the project.  Rather than modifying the WACC, cash flows can be discounted at an all-equity rate, k*. 

Reflects only the riskiness of the project’s expected future cash flows. Abstracts from the project’s financial structure. Can be viewed as the company’s cost of capital if it were all-equity financed, that is, with zero debt.

All-Equity Rate
 The all-equity rate is based on the CAPM:

k* = rf + β* (rm – rf)
 

β* is the all-equity or unlevered beta A levered equity beta, βe, is unlevered using the following equation: *  e
1  (1  T )( D / E )

Adjusted Present Value Approach
 The value of a project is equal to the sum of

the following components:
 

PV of after-tax project cash flows...
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