Multinational Capital Budgeting or parts of chapter 16

Multinational Capital Budgeting (or parts of chapter 16)

Agenda § Multinational capital budgeting. § Project vs. parent capital budgeting? § Adjust capital budgeting analysis of foreign project for risk. § Case study: evaluate a greenfield foreign project § Real option analysis vs. DCF analysis.

Multinational Capital Budgeting § § Analysis of cash in- & out- flows associated w/ prospective long-term investment projects. Follows same steps as domestic budgeting: 1. Identify initial capital invested at risk. 2. Estimate cash flows over time (including terminal 3. 4. value/ salvage value). Identify appropriate discount rate for PV. Apply traditional NPV or IRR analysis.

Capital Budgeting foreign projects § Parent cash flows must be distinguished from project’s. § Parent cash flows often depend on form of financing => cannot separate operating & financing cash flows. § Stand alone subsidiary cash-flow can be worth, but add no value overall. § Non-financial payments can generate cash flows to parent, e. g. licensing fees. § Need to evaluate political risk, forex risk & differing inflation rates. § Segmented national capital markets create financial gain /costs. § Host government subsidies complicates WACC computation.

Project vs. Parent Valuation? § Most firms evaluate foreign projects from both parent & project viewpoints. § Rule of thumb: parent valuation shall have priority. § MNE shall invest only if it can earn a risk-adjusted return greater than local competitors. § Project valuation provides closer approximation of effect on consolidated EPS • US firms consolidate subsidiaries w/ 50%+ ownership/ • If ownership b/n 20% & 49% (I. e. affiliate) => consolidate on • pro-rate basis. Subsidiaries w/ <20% ownership considered unconsolidated investment.

Case Study: Cemex in Indonesia § Cementos Mexicanos (Cemex) considers greenfield investment in Indonesia plant (Cemex Indonesia) – Presence in Southeast Asia. – Strong prospects for infrastructure growth. – Benefit from depreciation of Indonesian Rupiah (RP) § Cemex functional currency: US$. § Time to build: 1 year § Inflation rates: 30% (Indonesia), 3% (US) • Notice that we use the US inflation, not Mexico’s one!

START Cementos Mexicanos (Mexico) US$ invested in Indonesia cement manufacturing firm END Is project investment justified (NPV > 0)? Parent viewpoint Capital Budget (U. S. $) Semex Indonesia (Sumatra, Indonesia) Estimated cash flows of project Cash flows remitted to Cemex (RP -> US$) Project Viewpoint Capital Budget (Indonesian rupiah)

Step I: Cost of Capital Computation

Debt Service &Forex Gain/Loss

Income Statement Assumptions § Revenues – Sales based on export. – Cement will be sold in export market at $58/ton. § Costs – Direct cost RP 115, 000/ton & rising @ rate of inflation (30% p. a. ). – Additional production cost of RP 20, 000/ton & rising @ rate of inflation (30% p. a. ). – Loading costs $2. 00/ton rising @ inflation (3% p. a. ). – Shipping costs $10/ton rising @ inflation (3% p. a. ). – License fee: 2% sales – Sales, General, & Admin Expenses: 8% (growing @ 1% p. a. )

Pro-forma Income Statement

Project Viewpoint Capital Budget § Cemex Indonesia free cash flows found by looking @ EBITDA, not EBT! • Taxes calculated based on EBITDA. • Terminal value (TV) calculated for continuing value of plant after year # 5. • TV calculated as perpetual net operating cash flow after year 5:

Capital Budget: Project Viewpoint

Parent Viewpoint Capital Budget • Cash flows estimates are constructed from parent’s • • viewpoint Cemex must use its cost of capital, not project’s one! Cemex WACC 11. 98% Cemex requires additional 6% for international projects => discount rate will be 17. 98% This yields an NPV of -$925. 6 million (IRR – 1. 84%) which is unacceptable from the parent’s viewpoint

Capital Budget: Parent Viewpoint

Sensitivity Analysis § Political risk – Risk of blocked funds. – Risk of expropriation. § Foreign exchange risk – appreciation of US $. – depreciation of US $.

Real Option Analysis § DCF analysis cannot capture value of strategic options, yet real option analysis allows this valuation § Real option analysis includes valuation of project w/ future choices: – – option to defer or abandon (timing option). option to alter capacity (expansion options). option to start up/ shut down (switching). option to learn. § 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

Things to remember… § Multinational capital budgeting. § Project vs. parent capital budgeting? § Adjust capital budgeting analysis of foreign project for risk. § Case study: evaluate a greenfield foreign project § Real option analysis vs. DCF analysis.