
International Capital
Budgeting
(Eun and Resnick chapter 18)
18-1
Review of Domestic Capital Budgeting
 Identify the size and timing of all relevant cash
flows on a time line.
 Identify the riskiness of the cash flows to
determine the appropriate discount rate.
 Find NPV by discounting the cash flows at the
appropriate discount rate.
 Compare the value of competing cash flow
streams at the same point in time.
18-2
Review of Domestic Capital Budgeting
The basic net present value equation is
T
CFt
TVT
NPV  

 C0
t
T
(1  K )
t 1 (1  K )
Where:
CFt = expected incremental after-tax cash flow in year t
TVT = expected after-tax terminal value including return of
net working capital
C0 = 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
18-3
Review of Domestic Capital Budgeting
For our purposes it is necessary to expand
the NPV equation.
CFt = (Rt – OCt – Dt – It)(1 – ) + Dt + It (1 – )
Rt is incremental revenue
OCt is incremental operating
cash flow
It is incremental interest
expense
 is the marginal tax rate
Dt is incremental depreciation
18-4
Review of Domestic Capital Budgeting
We can use CFt = (OCFt)(1 – ) +  Dt
to restate the NPV equation,
T
NPV =
S (1 + K) +
t=1
CFt
t
TVT
(1 +
K)T
– C0
as:
T
NPV =
S
t=1
(OCFt)(1 – ) +  Dt
(1 +
K)t
+
TVT
(1 +
K)T
– C0
18-5
The Adjusted Present Value Model
T
NPV =
S
t=1
(OCFt)(1 – )
(1 +
K)t
T
+
 Dt
S (1 + K)
t=1
t
+
TVT
(1 +
K)T
– C0
can be converted to adjusted present value (APV)
T
S
APV =
t=1
(OCFt)(1 – )
(1 + Ku)t
+
 Dt
(1 + i)t
+
 It
(1 + i)t
+
TVT
(1 + Ku)
–
C
0
T
by appealing to Modigliani and Miller’s results.
18-6
The Adjusted Present Value Model
T
S
APV =
t=1
(OCFt)(1 – )
(1 + Ku
)t
+
 Dt
(1 +
i)t
+
 It
(1 +
i)t
+
TVT
(1 + Ku
)T
– C0
 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.
 Note that with the APV model, each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.
18-7
International Capital Budgeting from
the Parent Firm’s Perspective
T
S
APV =
t=1
(OCFt)(1 – )
(1 + Ku
)t
+
 Dt
(1 +
i)t
+
 It
(1 +
i)t
+
TVT
(1 + Ku
)T
– C0
 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.
 The APV model is NOT useful for an MNC in
analyzing foreign capital expenditure from the
parent firm’s perspective.
18-8
International Capital Budgeting from
the Parent Firm’s Perspective
 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.
T
St OCFt (1  τ ) T St τDt
St τI t
APV  


t
t
t
(
1

K
)
(
1

i
)
(
1

i
)
t 1
t 1
t 1
ud
d
d
T
T
St LPt
ST TVT

 S0C0  S 0 RF0  S0CL0  
T
t
(1  K ud )
(
1

i
)
t 1
d
18-9
APV Model of Capital Budgeting from the
Parent Firm’s Perspective
T
APV =
S
t=1
+
StOCFt(1 – )
)t
(1 + Kud
St TVT
T
+
St  Dt
T
S t  It
S (1 + i ) +S (1 + i )
t=1
d
t
t=1
– S0C0 + S0RF0 + S0CL0 T
d
t
S
T
St LPt
t
(1 + Kud)
t = 1 (1 + id)
The marginal corporate tax
OCFt represents only the
The
operatingthe
cashvalue
flows of
must beDenotes
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 the parent’s
be discounted
at the of any
currency)
parent’s
or foreign
accumulated
restricted
flows available
for remittance
firm’s currency
at thefunds
spot rate
unlevered
domestic
rate
concessionary
loans,
CL0,
subsidiary’s.
(in
the
amount
of
RF
)
that
are
expected
to prevail
0 in each
that can
be legally
remitted
toperiod.
and loan payments, LPt ,
freed
up
by
the
project.
the parent firm.
discounted at i .
d
18-10
Capital Budgeting from the Parent
Firm’s Perspective
 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.
18-11
Dorchester case
 Read the case carefully from the text
 Develop and present all the calculations in
Excel
 The goal is to calculate the APV (formula
18.7 in the text)
 Follow the methodology described for
Centralia in the text
 First exhibit summarizes the assumptions
and the simple calculations
 Prepare the same exhibits
18-12