International Capital Budgeting Chapter Fourteen Chapter Outline v

International Capital Budgeting Chapter Fourteen

Chapter Outline v. Review of Domestic Capital Budgeting v. The Adjusted Present Value Model v. Capital Budgeting from the Parent Firm’s Perspective v. Case Application: The Centralia v. Some Improvement of the APV Model

Review of Domestic Capital Budgeting v Identify the size and timing of all relevant cash flows on a time line. v Identify the riskiness of the cash flows to determine the appropriate discount rate. v Find NPV by discounting the cash flows at the appropriate discount rate. v Compare the value of competing cash flow streams at the same point in time.

Review of Domestic Capital Budgeting The basic net present value equation is Where: CFt = expected incremental after-tax cash flow in year t TVT = expected after-tax terminal value including return of net working capital C 0 = initial investment at inception K = weighted average cost of capital T = economic life of the project in years The NPV rule is to accept a project if NPV 0

Review of Domestic Capital Budgeting For our purposes it is necessary to expand the NPV equation. CFt = (Rt – OCt – Dt – It)(1 – t) + Dt + It (1 – t) Rt is incremental revenue OCt is incremental operating cash flow Dt is incremental depreciation It is incremental interest expense is the marginal tax rate

Review of Domestic Capital Budgeting We can use CFt = (OCFt)(1 – t) + t Dt to restate the NPV equation, T NPV = S (1 + K) + t=1 CFt t TVT (1 + K)T – C 0 as: T NPV = S t=1 (OCFt)(1 – t) + t Dt (1 + K)t + TVT (1 + K)T – C 0

The Adjusted Present Value Model T NPV = S t=1 (OCFt)(1 – t) (1 + K)t T + t Dt S (1 + K) t=1 t + TVT (1 + K)T – C 0 can be converted to adjusted present value (APV) T (OCF )(1 – t) t t Dt t It TVT + + + – C APV = 0 t t t T (1 + i) (1 + Ku) t = 1 (1 + Ku) S by appealing to Modigliani and Miller’s results.

The Adjusted Present Value Model T S APV = t=1 (OCFt)(1 – t) (1 + Ku)t + t Dt (1 + i)t + t It (1 + i)t + TVT (1 + Ku) – C 0 T v The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually. v Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.

Domestic APV Example Consider a project where the timing and size of the incremental after-tax cash flows for an all-equity firm are: –$1, 000 0 $125 1 $250 2 $375 3 $500 4 CF 0 = –$1000 The unlevered cost of equity is r 0 = 10%: The project would be rejected by CF 1 = $125 an all-equity firm: CF 2 = $250 I = 10 CF 3 = $375 NPV = –$56. 50 CF 4 = $500

Domestic APV Example (continued) v Now, imagine that the firm finances the project with $600 of debt at r = 8%. v The tax rate is 40%, so each year they have an interest tax shield worth $19. 20: × I =. 40 × ($600 ×. 08) =. 40 × $48 = $19. 20

-$1, 000 $125 $250 $375 $500 0 1 2 3 The APV of the project under leverage is: T S APV = t=1 APV = (OCFt)(1 – t) (1 + Ku $125 1. 10 + + $19. 20 )t + $250 (1. 10)2 + t Dt (1 + + $19. 20 (1. 08)2 i)t $375 (1. 10)3 + + t It (1 + + $19. 20 (1. 08)3 i)t 4 + TVT (1 + Ku)T – C 0 $500 (1. 10)4 + $19. 20 (1. 08)4 – $1, 000 1. 08 APV = $7. 09 The firm should accept the project if it finances with debt.

International Capital Budgeting from the Parent Firm’s Perspective T S APV = t=1 (OCFt)(1 – t) (1 + Ku )t + t Dt (1 + i)t + t It (1 + i)t + TVT (1 + Ku)T – C 0 v The APV model is useful for a domestic firm analyzing a domestic capital expenditure or for a foreign subsidiary of an MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint. v The APV model is NOT useful for an MNC in analyzing foreign capital expenditure from the parent firm’s perspective.

International Capital Budgeting from the Parent Firm’s Perspective v Donald Lessard developed an APV model for MNCs analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.

APV Model of Capital Budgeting from the Parent Firm’s Perspective T APV = S t=1 + St. OCFt(1 – t) (1 + Kud)t St TVT T + T St t Dt St t It S (1 + i ) +S (1 + i ) t=1 d t t=1 – S 0 C 0 + S 0 RF 0 + S 0 CL 0 + d T t S St LPt t (1 + Kud)T t = 1 (1 + id) The marginal corporate tax OCFt represents only the The operatingthe cashvalue flows of must be. Denotes The operating cash flows must the present value (in S RF represents rate, , is the larger of the 0 0 of operating cash portion translated back into the parent’s be discounted at the of any currency) parent’s or domestic foreign rate accumulated restricted flows available for remittance firm’s currency at thefunds spot rate unlevered concessionary loans, CL 0, (in amount RF that are expected toofprevail each 0) in thatthe can be legally remitted toperiod. subsidiary’s. and loan payments, LPt , freed up by the project. the parent firm. discounted at i. d

Capital Budgeting from the Parent Firm’s Perspective v. One recipe for international decision makers: § § Estimate future cash flows in foreign currency. Convert to the home currency at the predicted exchange rate. • Use PPP, IRP, et cetera for the predictions. § Calculate NPV using the home currency cost of capital.

Capital Budgeting from the Parent Firm’s Perspective: Example v. A U. S. -based MNC is considering a European opportunity. v. It’s a simple example: § § There is no incremental debt. There is no incremental depreciation. There are no concessionary loans. There are no restricted funds.

Capital Budgeting from the Parent Firm’s Perspective: Example v. We can use a simplified APV: T APV = S St. OCFt(1 – t) t=1 + (1 + St TVT (1 + T APV = Kud)t S t=1 Kud)T T + T St t Dt St t It S (1 + i ) +S (1 + i ) t=1 d t t=1 d – S 0 C 0 + S 0 RF 0 + S 0 CL 0 + St. OCFt(1 – t) (1 + Kud)t t T S (1 + i ) t=1 – S 0 C 0 St LPt d t no incremental debt no incremental depreciation no concessionary loans no restricted funds

Capital Budgeting from the Parent Firm’s Perspective: Example A U. S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows are: –€ 600 € 200 € 500 € 300 0 1 2 3 The inflation rate in the euro zone is € = 3%, the inflation rate in dollars is p$ = 6%, and the business risk of the investment would lead an unlevered U. S. -based firm to demand a return of Kud = i$ = 15%. The current exchange rate is S 0($/€) = $1. 25/€. Is this a good investment from the perspective of the U. S. shareholders?

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 –€ 600 $257. 28 € 200 $661. 94 € 500 $408. 73 € 300 0 1 3 2 CF 0 = (€ 600) × S 0($/€) = (€ 600) × $1. 25 € 1. 00 = $750 $1. 25 1. 06 CF 1 = € 200 × S 1($/€) = € 200 × = $257. 28 € 1. 00 1. 03 $1. 25 (1. 06)2 CF 2 = € 500 × S 2($/€) = € 500 × = $661. 94 2 € 1. 00 (1. 03) $1. 25 (1. 06)3 CF 3 = € 300 × = $408. 73 3 € 1. 00 (1. 03)

Capital Budgeting from the Parent Firm’s Perspective: Example –$750 $257. 28 $661. 94 0 1 2 $408. 73 3 Find the NPV using the cash flow menu of your financial calculator and an interest rate of i$ = 15%: CF 0 = –$750 CF 1 = $257. 28 CF 2 = $661. 94 CF 3 = $408. 73 I = 15 NPV = $242. 99

Capital Budgeting from the Parent Firm’s Perspective: Alternative v. Another recipe for international decisionmakers: § Estimate future cash flows in the foreign currency. § Estimate the foreign currency discount rate. § Calculate the foreign currency NPV using the foreign cost of capital. § Translate the foreign currency NPV into dollars using the spot exchange rate.

Foreign Currency Cost of Capital Method – € 600 € 200 € 500 € 300 0 1 2 3 € = 3% i$ = 15% p$ = 6% Let’s find i€ and use that on the euro cash flows to find the NPV in euros. Then translate the NPV into dollars at the spot rate. $1. 25 The current exchange rate is S 0($/€) = €

Finding the Foreign Currency Cost of Capital: i€ Recall that the Fisher Effect holds that: (1 + e) × (1 + $) = (1 + i$) real rate inflation rate nominal rate So, for example, the real rate in the U. S. must be 8. 49%: (1 + e) = (1 + i$) (1 + $) e= 1. 15 1. 06 – 1 = 0. 0849

Finding the Foreign Currency Cost of Capital: i€ If the Fisher Effect holds here and abroad, then: (1 + e$) = (1 + i$) (1 + $) and (1 + e€) = (1 + i€) (1 + €) If the real rates are the same in dollars and euros (e€ = e$) we have a very useful parity condition: (1 + i$) (1 + $) = (1 + i€) (1 + €)

Finding the Foreign Currency Cost of Capital: i€ If we have any three of these variables, we can find the fourth: (1 + i$) (1 + i€) = (1 + $) (1 + €) In our example, we want to find i€: (1 + i€) = i€ = (1 + i$) × (1 + €) (1 + $) (1. 15) × (1. 03) (1. 06) – 1 i€ = 0. 1175

International Capital Budgeting: Example – € 600 € 200 € 500 € 300 0 1 2 3 Find the NPV using the cash flow menu and i€ = 11. 75%: CF 0 = –€ 600 CF 1 = € 200 CF 2 = € 500 CF 3 = € 300 I = 11. 75 NPV = € 194. 39 $1. 25 = $242. 99 € 194. 39 × €

– € 600 € 200 0 1 NPV = –€ 600 + € 500 € 200 1. 1175 + € 300 2 € 500 (1. 1175)2 + 3 € 300 (1. 1175)3 = € 194. 39 $1. 25 = $242. 99 € 194. 39 × € –$750 $257. 28 0 NPV = –$750 + 1 $257. 28 1. 15 $661. 94 + 2 $661. 94 (1. 15)2 $408. 73 + 3 $408. 73 (1. 15)3 = $242. 99

International Capital Budgeting v You have two equally valid approaches: § Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the $NPV using the dollar cost of capital. § Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate. v If you watch your rounding, you will get exactly the same answer either way. v Which method you prefer is your choice.

Computing IRR Recall that a project’s Internal Rate of Return (IRR) is the discount rate that gives a project a zero NPV = –€ 600 + € 200 1+IRR€ + € 500 (1+IRR€)2 + € 300 (1+IRR€)3 = € 0 IRR€ = 28. 48% NPV = –$750 + $257. 28 1+IRR$ = 32. 23% + $661. 94 (1+IRR$) + 2 $408. 73 (1+IRR$) = $0 3

Directly Computing IRR$ and IRR€ NPV = –€ 600 + € 200 1+IRR€ + € 500 (1+IRR€)2 CF 0 = –€ 600 CF 2 = € 500 CF 1 = € 200 CF 3 = € 300 NPV = –$750 + CF 0 = –$750 $257. 28 1+IRR$ + $661. 94 (1+IRR$)2 + € 300 (1+IRR€)3 = € 0 IRR€ = 28. 48% + $408. 73 (1+IRR$)3 = $0 CF 2 = $661. 94 CF 1 = $257. 28 CF 3 = $408. 73 IRR$ = 32. 23%

Converting from IRR$ to IRR€ v Use the same IRP and PPP conditions that we used to convert from one discount rate to another. 1+IRR$ 1+IRR€ In our example, it was easy to find = IRR€. Finding IRR$ without converting (1 + $) (1 + €) all cash flows into dollars is straightforward: (1+IRR$) = (1+IRR€)(1 + $) (1 + €) € = 3%, $ = 6% i€ = (1. 2848)(1. 06) (1. 03) IRR$ = 32. 23% – 1

Back to the Full APV v. Using the intuition just developed, we can modify Lessard’s APV model as shown, if we find it convenient. S 0 T APV = S St. OCFt(1 – t) (1 + t=1 S 0 + Kud)t f St TVT (1 + Kud)T f T + S 0 T St t Dt St t It S (1 + i ) +S (1 + i ) t=1 d t t=1 d f – S 0 C 0 + S 0 RF 0 + S 0 CL 0 + t f T S (1 + i ) t=1 S 0 St LPt d t f

Case Application v. Centralia Corporation Background: A company is a kitchen appliances manufacturer, specializing in the production of microwave ovens. In recent years, the company export its products to Spain. In the Spanish market, it has annual sales of 9600 units and growing at a rate of 5%. In order to expand its EU market, the company plans to set up a wholly owned subsidiary in the northeast of Madrid's city of Zaragoza, and the Spanish Government's commit to support very attractive interest rates on the construction costs. If the subsidiary is established, then Company A has no need to export further products to Europe. Necessary information is listed as follows:

A company export products at a price of $ 180 each, and $ 35 is marginal contribution. The expected annual production is 25, 000 units, with a 12% annual growth rate, all sales are euro-denominated. The price will be set at € 200 each, and the current cost of the product is about € 160 each. Production costs and sales price changes will be consistent with the foreseeable future inflation rate of 2. 1%. In contrast, the U. S. long-term annual inflation rate is expected to be 3%. The current exchange rate is 1. 32 $ / €. The construction cost is estimated to be € 5, 500, 000. The lending capacity is $ 2, 904, 000. Madrid's sales company has already accumulated the net value of € 750, 000, which can be used as part of the construction costs. The company's marginal tax rate is 35%. The company has accumulated a lot of capital. If this part of the capital to repatriate, will have to bear the tax rate of 35%. Spanish government allows the company to have more than 8 -year. Setting up the subsidiary in Zaragoza, A company can get a interest rate of 5% with a loan amount to € 4, 000. The U. S. dollar loan rate is 8%, and the euro loan rate is 7%. The full cost of equity capital of the Company A is 12%.

v. Key points: The current exchange rate in American terms is S 0 =2. 1% =1. 32$/€ ; =3% ; The initial cost of the project in U. S. dollar is: S 0 C 0=1. 32$/€× 5, 500, 000€=$7, 260, 000 ; Incremental lost sales in units for year t equals 9, 600×(1+5%)t ; Contribution margin per unit of lost sales in year t equals ＄35×(1+3%)t ; Straight-line depreciation is assumed; Dt=€ 5, 500, 000÷ 8=€ 687, 500 Kud=12% ic=5% id=8% ;

v The cash flow 1. Calculation of the present value of the After-Tax operating cash flows:

2. Calculation of the present value of the depreciation Tax Shields

3. Calculation of the present value of the concessionary loan payments

4. Calculation of the present value of the interest tax shields

The result of Centralia budgeting v The result: § There appears litter doubt that the proposed manufacturing facility will be a profitable venture for Centralia.

Risk Adjustment in the Capital Budgeting Process v Clearly risk and return are correlated. v Political risk may exist along side of business risk, necessitating an adjustment in the discount rate. v We can measure this risk with sensitivity analysis, where different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs to give the manager a more complete picture of the planned capital investment. v Lends itself to computer simulation.

Real Options v. The application of options pricing theory to the evaluation of investment options in real projects is known as real options. § A timing option is an option on when to make the investment. § A growth option is an option to increase the scale of the investment. § A suspension option is an option to temporarily cease production. § An abandonment option is an option to quit the investment early.

Value of the Option to Delay A French firm is considering a 1 -year investment in the United Kingdom with a pound-denominated rate of return of i£ = 15%. The firm’s local cost of capital is i€ = 10%. –£ 1, 000 £ 1, 150 The current exchange rate is S 0(€|£) = € 2. 00 £ project cash flows 0 1 Complicating matters, the Bank of England is considering either tightening or loosening its monetary policy. It is believed that in one year there are only two possibilities: S 1(€|£) = € 2. 20/£ or S 1(€|£) = € 1. 80/£ Following revaluation, the exchange rate is expected to remain steady for at least another year.

Option to Delay v If S 1(€|£) = € 1. 80/£ the project will have turned out to be a loser for the French firm: v If S 1(€|£) = € 2. 20/£ the project will have turned out to be a big winner for the French firm: –€ 2, 000 € 2, 070 –€ 2, 000 € 2, 530 0 1 IRR = 3. 50% IRR = 26. 50%

Option to Delay: Example v An important thing to notice is that there is an important source of risk (exchange rate risk) that isn’t incorporated into the French firm’s local cost of capital of i€ = 10%. § That’s why there are no NPV estimates on the last slide. v Even with that, we can see that taking the project on today entails a “win big—lose big” gamble on exchange rates. v Analogous to buying an at-the-money call option on British pounds with a maturity of one year.

Option to Delay: Example v. The remaining slides assume a knowledge of the material contained in Chapter 7, especially the notion of a replicating portfolio. v. But, also basic things like a call option give the holder the right to buy a specific asset at a specific price for a specific amount of time.

Option to Delay: Example v The payoff in one year of a portfolio consisting of an at-the-money call option written on £ 2, 300 plus a risk -free bond with a future value of € 2, 070 equals the payoff of the British investment: S 1(€|£) British Call Investment = Bond + Option Replicating = Portfolio € 2. 20/£ € 2, 530 = € 2, 070 + € 460 = € 2, 530 € 1. 80/£ € 2, 070 = € 2, 070 + = € 2, 070 € 0

Option to Delay: Example v. So the present value of the project at time zero can be found by getting a quote from an option dealer on an at-the-money call on £ 2, 300 and adding to that the present value of € 2, 070 at the euro-zone risk-free rate. v. The NPV of the project is that sum less the cost of the project, –€ 2, 000: € 2, 070 NPV = –€ 2, 000 + value of option + 1+ i€

Option to Delay: Example v Suppose that our option dealer quotes an option premium of € 0. 05 per pound and our banker quotes the euro-zone risk-free rate at i€ = 6%. v The NPV of the project at time zero to the French firm is: € 2, 070 NPV 0 = –€ 2, 000 + € 115 + 1. 06 = € 67. 83 § Before we accept a positive NPV project, we should make sure that we are not bypassing alternative projects with higher NPVs. − Waiting a year to start the same project is an alternative.

Option to Delay: Example v. If the firm can wait a year to start the project, the cash flows look like: If S 1(€|£) = € 1. 80 per £ If S 1(€|£) = € 2. 20 per £ –€ 1, 800 € 2, 070 –€ 2, 200 € 2, 530 0 1 IRR = 15% NPV 1 = € 81. 82 = –€ 1, 800 + € 2, 070 1. 10 IRR = 15% NPV 1 = € 100

Option to Delay: Example v. We have a choice: invest in the project today or wait a year. v. If we jump in today, the NPV 0 is € 67. 83 and the FV of today’s NPV 0 in one year from now is NPV 1 = € 74. 61 = 1. 10 × € 67. 83. v. Clearly, it’s better to wait a year. § Worst case, NPV 1 = € 81. 82, but there is a chance that the NPV at time one is € 100. § Both of these outcomes beat € 74. 61.