Chapter 17 Capital Budgeting For The Multinational Corporation

2.
NPV Formula
0 = The initial cash investment
Xt = The net cash flow in period t
k = The project’s cost of capital
- Only project with positive(+) NPV
n = The should
investment be
horizon
accepted
- If there is two project mutually exclusive, the
project with
the higher
- NPV Should be accepted
3. The most important property of NPV technique:
focus on cash flows with respect to
shareholders wealth
4. NPV obeys value additive principles: the NPV of

a set of
Examples Capital Budgeting :NPV
Present Value Cumulative
Year Cash Flow x = Present Value
Factor (10%) Present Value
0 -$4,000,000 1.00000 −$4,000,000 −$4,000,000
1 1,200,000 0.9091 1,091,000 −2,909,000
2 2,700,000 0.8264 2,231,000 −678,000
3 2,700,00 0.7513 2,029,000 1,351,000
Assuming a 10% cost of capital. The project has

a positive (+)NPV, is acceptable.
International Cash Flows
1. Important principle when
estimating :
The incremental cash flows not the project’s
total cash flow
per period
The Incremental cash flows may differ from total

cash flows
for a number of reasons
2.Distinguish total from incremental flows to
account for:
A.Cannibalization
Phenomena when a new product taking sales away from the
firm’s existing products
Example:
When Honda introduced its Acura line of cars, some customers
switched their purchases from the Honda Accord to the new
models
B.Sales Creation
A new project creates additional sales for existing product
(The opposite of cannibalization)
Example:
Black & Decker, the U.S. power tool company, significantly
expanded its exports to Europe after investing in
European production facilities that gave it a strong
C. Opportunity Cost
Project costs must include the true economic cost of any resource
required for the project, regardless of whether the firm already
owns the resource or has to go out and acquire it. This true cost
is the opportunity cost, the maximum amount of cash the asset
could generate for the firm should it be sold or put to some other
productive use
D.Transfer Pricing
The transfer prices at which goods and services are traded internally
can significantly distort the profitability of a proposed investment.
Whenever possible, the prices used to evaluate project inputs or
outputs should be market prices. If no market exists for the
product, then the firm must evaluate the project based on the cost
savings or additional profits to the corporation of going ahead with
the project.
C. Fees and Royalties
Often companies will charge projects for various items such as
legal
counsel,power,lighting,heat,rent,researchanddevelopment,headqua
3.Getting the Base Case Right:
worldwide
= -
Incremental Post Investment
Corporate Cash
Cash Flows Corporate Cash
Flow Without
Flow with Project
The Investment
4. Intangible benefits
A. Valuable learning experience
B. Broader knowledge base
2 Issues in Foreign Investment Analysis
Issue 1
Parent vs project cash flows
The cash flows from the project may differ from
those remitted to the parent.
•Relevant cash flow become quite important
•Three Stage Approach ( to simplify project
evaluation)
a. Compute subsidiary’s project cash flows
b. Evaluate the project to the parent
c. Incorporate the indirect effects
• Estimating Incremental Project Flows.
What is the true profitability of the project?
True profitability is an amorphous concept, but
basically it involves determining the marginal
revenue and marginal costs associated with the
project.
This estimating entails the following:

1. Adjust for the effects of transfer pricing and fees
and royalties
2. Adjust for global costs/benefits that are not
reflected in the project’s financial statements
• Tax Factors
Determine the amount and timing of taxes paid
on foreign source income
Issue 2
How to adjust for political and economic
risk of the Project ?
Three methods for incorporating the
additional political/economic risks:
1. Shortening minimum payback period
2. Raising required rate of return of the
Investment
3. Adjusting cash flows
Exchange rate changes and Inflation
The Present Value of future cash flows from a foreign
project can be calculated using 2 stages procedure :
Approach A •Discount theApproach

nominalB foreign
• Convert nominal foreign currency cash flows at the nominal
currency cash flows into foreign currency required rate of
nominal home currency terms, return
• Discount those nominal cash •Convert the resulting foreign
flows at the nominal domestic currency present value into the
required rate of return home currency using the current
spot rate
CASE Foreign Project Appraisal:
The Case of International Diesel Corporation
International Diesel Corporation(IDC-U.S.),aU.S.-based multinational firm, is
trying to decide whether to establish a diesel manufacturing plant in the United
Kingdom (IDC-U.K.).IDC-U.S. expects to boost significantly its European sales of
small diesel engines (40–160 hp) from the 20,000 it is currently exporting there.
At the moment, IDC-U.S. is unable to increase exports because its domestic
plants are producing to capacity. The 20,000 diesel engines it is currently
shipping to Europe are the residual output that it is not selling domestically
IDC-U.S. has made a strategic decision to increase its presence and sales
overseas. A logical first target of this international expansion is the European
Union (EU). Market growth seems assured by large increases in fuel costs and the
ongoing effects of Europe 1992 and the European Monetary Union. IDC-U.S.
executives believe that manufacturing in England will give the firm a key
advantage with customers in England and throughout the rest of the EU
To simplify its investment analysis,
IDC-U.S. uses a five year capital budgeting horizon and
then calculates a terminal value for the remaining life of
the project. If the project has a positive net present value
for the first five years, there is no need to engage in
costly and uncertain estimates of future cash flows. If the
initial net present value is negative, then IDC-U.S. can
calculate a break even terminal value at which the net
present value
We now apply thewill just
three beinvestment
stage positive. analysis
This break even
outlined value
in the
is then used
preceding as a benchmark against which to measure
section:
(1) Estimatecash
projected project cash beyond
flows flows; the first five years.
(2) forecast the amounts and timing of cash flows to the parent;
and
(3) Add to, or subtract from, these parent cash flows the indirect
benefits or costs
that this project provides the remainder of the multinational
firm.
Estimation of Project Cash Flows
IDC U.K. has cash inflows from its sales in England and other EU
countries. It also has cash inflows from three other sources:
1. The tax shield provided by depreciation and interest
charges
2. Interest subsidies
3. The terminal value of its investment, net of any capital
gains taxes owed upon liquidation
Recapture of working capital is not assumed until eventual

liquidation because this working capital is necessary to
maintain an ongoing operation after the fifth year
Initial Investment Outlay
Financing IDC-U.K
The debt ratio for IDC-U.K. is

33:53, or 62%. Note that this
debt ratio could vary from 25%, if
the parent’s total investment was
in the form of equity, all the way
up to 100%, if IDC-U.S. provided
all of its $40 million investment
for plant and equipment as debt.
Estimated Present Value of Project to IDC-U.S.
All the various cash flows are added
up, net of tax and interest subsidies
on debt; and their present value is
calculated at $13.0 million. Adding
the $5 million in debt-related
subsidies ($2.4 million for the interest
tax shield and $2.6 million for the NEB
loan subsidy) brings this value up to
$18.0 million. It is apparent that,
despite the additional taxes that must
be paid to England and the United
States, IDC-U.K. is more valuable to its
parent than it would be to another
owner on a stand-alone basis. This
situation is due primarily to the
various licensing and overhead
allocation fees received and the
incremental earnings on exports to
IDC-U.K.
Lost Sales
Suppose the incremental after-tax cash flow per unit to IDC-U.S. on its exports to the EU equals
$180 at present and that this contribution is expected to maintain its value in current dollar
terms over time. Then, in nominal dollar terms, this margin grows by 3% annually. If we assume
lost sales of 20,000 units per year, beginning in year 2 and extending through year 10, and a
discount rate of 12%, the present value associated with these lost sales equals $19.5 million.
The calculations are presented in Exhibit 17.7. Subtracting the present value of lost sales from
the previously calculated present value of $18.0 million yields a net present value of IDC-U.K. to
its parent equal to −$1.5 million (−$6.5 million ignoring the interest tax shield and subsidy).
Political Risk Analysis
The preferred method is to adjust the cash flows of the
project (rather than its required rate of return) to
reflect the impact of a particular political event on the
present value of the project to the parent
The biggest risk :

•Expropriation
Is an obvious case where project and parent
company cash flows diverge.
•Blocked Funds
It must be pointed out that if all funds are
expected to be blocked in perpetuity, then the
value of the project is zero.
Growth Options and Project Evaluation
Growth Options
The opportunities a firm may have to invest capital to increase the
profitability of its existing product lines and benefit from
expanding into new products or markets
Examples :
demonstrates the fallacy of always using
expected cash flows to judge an
investment’s merits.
Suppose there are only two possible gold

prices next year: $300/ounce and
$500/ounce, each with probability 0.5.
The expected gold price is $400/ounce,

but this expected price is irrelevant to
the optimal mining decision rule: Mine
gold if, and only if, the price of gold at
year’s end is $500/ounce.
The discretion to invest or not invest in a project depends
on the following:
• The length of time the

project can be deferred:
• The risk of the project
• The level of interest rates:
• The proprietary nature of
the option

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2.

4. NPV obeys value additive principles: the NPV of

Assuming a 10% cost of capital. The project has

The Incremental cash flows may differ from total

This estimating entails the following:

Approach A •Discount theApproach

Recapture of working capital is not assumed until eventual

The debt ratio for IDC-U.K. is

The biggest risk :

Suppose there are only two possible gold

The expected gold price is $400/ounce,

• The length of time the

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