FINC3240FINC3240International FinanceInternational Finance

Chapter 14 Chapter 14

Multinational Capital BudgetingMultinational Capital Budgeting

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Capital Budgeting Decision Capital Budgeting Decision

Capital budgeting: the process of Capital budgeting: the process of analyzing projects and decide which ones analyzing projects and decide which ones to invest in. to invest in.

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Capital budgeting rulesCapital budgeting rules

We will learn to apply 2 capital budgeting We will learn to apply 2 capital budgeting

rules:rules: Net present value (NPV)Net present value (NPV)

Internal rate of return (IRR)Internal rate of return (IRR)

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Net present value (NPV) ruleNet present value (NPV) rule

Accept project if Accept project if

Net present value > 0Net present value > 0

What is Net present value? What is Net present value?

Net present value Net present value

= Benefits minus Costs = Benefits minus Costs

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How do we measure How do we measure benefits & costs?benefits & costs?

BenefitsBenefits= Present value of all cash inflows = Present value of all cash inflows from the projectfrom the project

Costs= Present value of all cash outflows Costs= Present value of all cash outflows from the projectfrom the project

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NPV = B – C =NPV = B – C =

N

ttt

N

ttt

r

COF

r

CIF

00 11

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Internal rate of return (IRR) 1Internal rate of return (IRR) 1

IRR: the discount rate that will make the PV IRR: the discount rate that will make the PV of cash inflows equal to the PV of cash of cash inflows equal to the PV of cash outflows.outflows.• In other words, IRR is the discount rate such In other words, IRR is the discount rate such

that the NPV is 0. that the NPV is 0.

0

11 00

N

tt

tN

tt

t

IRR

COF

IRR

CIF

PV of cash inflows, discounted at IRR

PV of cash outflows, discounted at IRR

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Internal rate of return (IRR) 2Internal rate of return (IRR) 2

Accept project if Accept project if

IRR > cost of capital IRR > cost of capital

Intuitively, think of the IRR as the return from Intuitively, think of the IRR as the return from the project. the project.

Then the project should be accepted if the return Then the project should be accepted if the return is greater than the required rate of return / cost is greater than the required rate of return / cost of capital.of capital.

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Apply the NPV and IRR Apply the NPV and IRR

A firm is considering investment in a A firm is considering investment in a project that costs $1,200 and yields project that costs $1,200 and yields cash flows of $500 in the first year, cash flows of $500 in the first year, $600 in the second year and $700 in $600 in the second year and $700 in the third year. Compute the NPV and the third year. Compute the NPV and IRR of this project. The appropriate IRR of this project. The appropriate discount rate (cost of capital) for this discount rate (cost of capital) for this project is 10 percent.project is 10 percent.

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Computing NPV using BA II PlusComputing NPV using BA II Plus

Press CF, press -1200 and then press ENTER for CF0. Press CF, press -1200 and then press ENTER for CF0.

Next press “Next press “” and enter 500 for C01. ” and enter 500 for C01. Press “Press “” and enter 1 for F01. ” and enter 1 for F01. Similarly enter C02 = 600, F02 = 1, C03 = 700, and Similarly enter C02 = 600, F02 = 1, C03 = 700, and

F03 = 1. Make sure that all the cash flows later F03 = 1. Make sure that all the cash flows later than C03 are zero.than C03 are zero.

Press NPV. Enter the discount rate of 10 percent by Press NPV. Enter the discount rate of 10 percent by pressing 10 and then ENTER. pressing 10 and then ENTER.

The display will show that I = 10. The display will show that I = 10. Next press the “Next press the “” and press CPT. The calculator will ” and press CPT. The calculator will display the display the NPV of 276.33NPV of 276.33. Decision: Accept project. Decision: Accept project

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Computing IRR using BA II PlusComputing IRR using BA II Plus

In order to compute the IRR, follow In order to compute the IRR, follow the same steps as above for entering the same steps as above for entering the cash flows. the cash flows.

Then instead of pressing NPV, press Then instead of pressing NPV, press the IRR button and then press CPT. the IRR button and then press CPT.

The calculator will display the The calculator will display the IRR as IRR as 21.92 percent. 21.92 percent.

Decision: Accept projectDecision: Accept project

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Normal cash flows Normal cash flows

In the previous problem, there is ONE cash In the previous problem, there is ONE cash outflow at the beginning. After that, we outflow at the beginning. After that, we have all cash inflows. have all cash inflows.

A project with such a cash flow pattern is a A project with such a cash flow pattern is a project with project with normal cash flows.normal cash flows.

So what?So what? For independent projects with For independent projects with NORMAL CASH FLOWS, the NPV, IRR rules NORMAL CASH FLOWS, the NPV, IRR rules will give the SAME decision. This is exactly will give the SAME decision. This is exactly what happened in the problem we solved.what happened in the problem we solved.

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Apply NPV, IRRApply NPV, IRR

Assume a discount rate of 11%. Compute Assume a discount rate of 11%. Compute the NPV, IRR and decide whether the the NPV, IRR and decide whether the project should be accepted or rejected.project should be accepted or rejected.

Project C0 C1 C2 C3 C4 C5

T=0 T=1 T=2 T=3 T=4 T=5

A -1000 400 400 400 500 500

Verify that NPV = 603.58, IRR = 31.79%,

Since NPV>0, IRR>11%, accept the project

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Another questionAnother questionA five-year project, if taken, will require an initial investment of A five-year project, if taken, will require an initial investment of

$120,000$120,000. The expected end-of-year cash inflows are as . The expected end-of-year cash inflows are as follows:follows:

If the appropriate cost of capital for this project is If the appropriate cost of capital for this project is 11%,11%, which of which of the following is a correct decision?the following is a correct decision?

a. Reject the project because NPV = -$30,507, which is less than a. Reject the project because NPV = -$30,507, which is less than 0.0.

b. Reject the project because IRR is 10.04%, which is less than b. Reject the project because IRR is 10.04%, which is less than the cost of capital, 11%.the cost of capital, 11%.

c. Both a and b are correct.c. Both a and b are correct.d. Accept the project because IRR is positive.d. Accept the project because IRR is positive.e. None of the above is correct.e. None of the above is correct.

C1 C2 C3 C4 C5

30,000 42,000 42,000 28,000 12,000

Multinational Capital BudgetingMultinational Capital Budgeting

Assumption:Assumption:

The subsidiary is wholly owned by the The subsidiary is wholly owned by the parent company. Therefore, the feasibility of parent company. Therefore, the feasibility of the project depends on the cash flows that the project depends on the cash flows that the parent ultimately receives.the parent ultimately receives.

14.114.1

Process of Remitting Subsidiary Earnings to Parent

Input for Multinational Capital Input for Multinational Capital BudgetingBudgeting

1. Economic and Financial Characteristics 1. Economic and Financial Characteristics InvolvedInvolved

a. Initial Investmenta. Initial Investmentb. Price and Consumer Demand (and b. Price and Consumer Demand (and

inflation) inflation)c. Costs (variable and fixed)c. Costs (variable and fixed)d. Taxd. Taxe. Remitted Fundse. Remitted Fundsf. Exchange Ratesf. Exchange Ratesg. Salvage Valueg. Salvage Valueh. Required Rate of Returnh. Required Rate of Return

Example 1Example 1

Spartan, Inc. on page 425.Spartan, Inc. on page 425.

read the textbookread the textbook

the cash flows received by the parent should be the cash flows received by the parent should be US$.US$.

How to estimate the cash flows? See How to estimate the cash flows? See Exhibit 14.2

Financing ArrangementFinancing Arrangement Domestic capital budgeting problems would not include Domestic capital budgeting problems would not include

debt payments in the measurement of cash flows because debt payments in the measurement of cash flows because all financing costs are captured by the discount rate. all financing costs are captured by the discount rate.

When the parent finances the whole foreign project, debt When the parent finances the whole foreign project, debt payments does not count. payments does not count.

When the foreign subsidiary partially finances the foreign When the foreign subsidiary partially finances the foreign project, we should separate the investment made by the project, we should separate the investment made by the subsidiary from the investment made by the parent. The subsidiary from the investment made by the parent. The capital budgeting should focus on the present value of cash capital budgeting should focus on the present value of cash flows received by the parent and the initial investment by flows received by the parent and the initial investment by the parent.the parent.

Adjusting for RiskAdjusting for Risk

1. Risk-Adjusted Discount Rate1. Risk-Adjusted Discount Rate

the greater the uncertainty about the forecasted cash the greater the uncertainty about the forecasted cash flows, the larger should be the discount rate, other things flows, the larger should be the discount rate, other things being equal.being equal.

2. Sensitivity Analysis2. Sensitivity Analysis

forecast the cash flows under different possible scenarios, forecast the cash flows under different possible scenarios, such as different level of sales, expenses, exchange rate, such as different level of sales, expenses, exchange rate, etc.etc.

3. Simulation3. Simulation

using software and computer to generate millions of using software and computer to generate millions of possible outcomes and calculate the average.possible outcomes and calculate the average.

Exhibit 14.3 Analysis Using Different Exchange Exhibit 14.3 Analysis Using Different Exchange Rate Scenarios: Spartan, Inc.Rate Scenarios: Spartan, Inc.

Example 2Example 2

Your employees have estimated the net present Your employees have estimated the net present value of project XP to be $1.2 million. Their report value of project XP to be $1.2 million. Their report says that they have not accounted for any risk, but says that they have not accounted for any risk, but that with such a large NPV, the project should be that with such a large NPV, the project should be accepted since even a risk-adjusted NPV would accepted since even a risk-adjusted NPV would likely be positive. You have the final decision as to likely be positive. You have the final decision as to whether to accept or reject the project. What is whether to accept or reject the project. What is your decision?your decision?

ANSWER: The decision should not be made until risk has ANSWER: The decision should not be made until risk has been considered. If the project has a risk of a government been considered. If the project has a risk of a government take over, for example, a large estimated NPV may not be a take over, for example, a large estimated NPV may not be a suffi cient reason to accept the project. suffi cient reason to accept the project.

Example 3Example 3 Brower, Inc, is considering constructing a manufacturing Brower, Inc, is considering constructing a manufacturing

plant in Ghana. The construction cost 9 billion Ghanian plant in Ghana. The construction cost 9 billion Ghanian Cedi. Brower intends to leave the plant open for 3 years. Cedi. Brower intends to leave the plant open for 3 years. During the 3 years of operation, cash flows are expected to During the 3 years of operation, cash flows are expected to be 3, 3, and 2 billion cedi, respectively. Operating cash be 3, 3, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back flows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17%. It currently Brower has a required rate of return of 17%. It currently takes 8,700 cedi to buy one US dollar, and the cedi is takes 8,700 cedi to buy one US dollar, and the cedi is expected to depreciate by 5% per year. Should Brower expected to depreciate by 5% per year. Should Brower build the plant?build the plant?

SolutionSolution

NPV=-91,339.03<0, so reject.NPV=-91,339.03<0, so reject.

Year 0 1 2 3 Investment –9 Operating CF 3 3 2 Salvage Value 5 Net CF –9 3 3 7 Exchange rate 8,700 9,135 9,592 10,071 Cash flows to parent –$1,034,483 $328,407.23 $312,760.63 $695,065.04 PV of parent cash flows –$1,034,483 $280,689.94 $228,475.88 $433,978.15

Homework 9Homework 9

Chapter 14 Questions and Chapter 14 Questions and applications:applications:

5,10,11,205,10,11,20