Chapter 18 Multinational Capital Budgeting 1 Multinational Capital

Chapter 18 Multinational Capital Budgeting 1

Multinational Capital Budgeting • Extension of the domestic capital budgeting analysis to evaluate a Greenfield foreign project • Distinctions between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment • Adjusting the capital budgeting analysis of a foreign project for risk • Introduction of the use of real option analysis as a complement to DCF analysis in the evaluation of potential international investments 2

Multinational Capital Budgeting • Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects • Capital budgeting follows same framework as domestic budgeting – Identify initial capital invested or put at risk – Estimate cash inflows, including the terminal value or salvage value of the investment – Identify appropriate discount rate for NPV calculation – Determine the NPV and IRR 3

Complexities of 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 – this changes the meaning of NPV – Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as a stand alone a project may provide cash flows but overall may add no value to the entire organization – Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints 4

Complexities of Budgeting for a Foreign Project • Non-financial payments can generate cash flows to parent in the form of licensing fees, royalty payments, etc. – relevant for parent’s perspective • Managers must anticipate differing rates of national inflation which can affect cash flows • Use of segmented national capital markets may create opportunity for financial gains 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 5

Project versus Parent Valuation • Most firms evaluate foreign projects from both parent and project viewpoints – The parent’s viewpoint analyzes investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments – Funds that are permanently blocked from repatriation are excluded • The parent’s viewpoint gives results closer to traditional NPV capital budgeting analysis • Project valuation provides closer approximation of effect on consolidated EPS 6

Project versus Parent Valuation START Parent Firm (US) US$ invested in overseas Particular investment END Is the project investment Justified (NPV > 0)? Parent Viewpoint Capital Budget (U. S. dollars) Foreign Investment Estimated cash flows of project Cash flows remitted to Parent (FC to US$) Project Viewpoint Capital Budget (Local Currency) 7

Project Assumptions • Financial assumptions – Capital Investment – cost to build a plant – Financing – depending on financing methods WACC should be calculated for both the project and parent – Revenues – Costs – Exchange rate assumption – parent’s cash flows are converted into home currency 8

Estimating Cash Flows from Project Viewpoint • Project Viewpoint Capital Budget – Estimate the free cash flows of the project by determining EBITDA and not EBT – Taxes are calculated based on this amount – Net Operating Cash Flow = Net Operating Profit After Tax – NOCF = NOPAT 9

Estimating Cash Flows from Project Viewpoint (Continued) • Project Viewpoint Capital Budget – Estimate and incorporate net working capital and capital spending – Free Cash Flow (FCF) = Net Operating Cash Flow – Changes in Net Working Capital – Changes in Fixed Assets 10

Estimating Cash Flows from Project Viewpoint (Continued) • Project Viewpoint Capital Budget – Terminal value is calculated for the continuing value of the project after the investment horizon • TV is calculated as a perpetual net operating cash flow after the investment horizon • All FCFs and Terminal Value is discounted using subsidiary WACC. 11

Parent Viewpoint • Parent Viewpoint Capital Budget – Cash flows estimates are constructed from parent’s viewpoint • Estimate individual cash flows to parent after adjusting for withholding taxes. These cash flows must be in parent firm’s currency • Use parent firm’s investment in subsidiary to determine NPV at parent’s WACC – Parent must now use it’s cost of capital and not the project’s – Parent may require an additional yield for international projects 12

Sensitivity Analysis • Project Valuation Sensitivity Analysis – Political risk – biggest risk is blocked funds or expropriation • Analysis should build in these scenarios and answer questions such as how, when, how much, etc. – Foreign exchange risk • Analysis should also consider appreciation or depreciation of the US dollar 13

Real Options • Real Option Analysis – DCF analysis cannot capture the value of the strategic options, yet real option analysis allows this valuation – Real option analysis includes the valuation of the project with future choices such as • • The option to defer The option to abandon The option to alter capacity The option to start up or shut down (switching) 14

Real Options (Continued) • Real Option Analysis – Real option analysis treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis) – The valuation of real options and the variables’ volatilities is similar to equity option math 15