Multinational Capital
Budgeting
Chapter Fourteen
Eitman, Stonehill, & Moffett
July 17, 2016
Chapter 18 - Capital Budgeting
1
Relevant cash flows
Incremental cash flows
 Book definition:
The incremental cash flows for a project
evaluation consist of any and all changes
to the firm’s future cash flows that are a
direct consequence of taking on the
project.
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Chapter 18 - Capital Budgeting
2
Incremental Cash Flows
 incremental Cash inflow
 revenues generated specific to a project
 incremental Cash outflow
 direct costs accrued specific to a project
 opportunity costs of foregone opportunities
 sunk costs
 cost already incurred, not incremental costs
 Externalities (cannibalization
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Chapter 18 - Capital Budgeting
3
Capital expense - not included
 Accountants count capital expenses
 For capital budgeting one must
deduct the actual cash flow when it
occurs
Capital versus Current Expense
t0
t1
t2
t3
Capital
0
(33,333) (33,333) (33,334)
Current (100,000
0
0
0
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Chapter 18 - Capital Budgeting
4
Tax effects of capital expenses
 CCA - capital cost allowances or
Depreciation
 these are capital expenses, not cash
expenses
 Since these affect Taxable income
 deducted before taxes
 added back in after taxes
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Chapter 18 - Capital Budgeting
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Net Working Capital - included
 Incremental change in CA
 cash
 accounts receivable to support additional sales
 inventories
 Input inventories
 output inventories
 Financed by an incremental change in CL
 increase in payables (more input inventories)
 increase in accruals (more labor)
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Chapter 18 - Capital Budgeting
6
Net Working Capital con’t
 NWC = CA - CL must be financed through
Debt or Equity
 Change in NWC
 at t = 0, negative CF, CA are obtained prior to
production
 at t = 1 . . ., negative or positive
 negative added CA needed because or
increased production
 positive CA released because of reduced
production
 at t = T, NWC returned to the firm for use
elsewhere
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Chapter 18 - Capital Budgeting
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Opportunity Costs - included as
foregone possibilities
 cash flows from land or buildings
which could be leased if not used
 cost of a manager that must be hired
to replace someone reallocated to the
project
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Chapter 18 - Capital Budgeting
8
Sunk Costs - not included
 costs already incurred
 the cost of a feasibility study
 cost of building already owned
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Chapter 18 - Capital Budgeting
9
Side Effects - externalities
 try to include these, if possible
 potential positive cash flows
 marketing advantages of an existing network
 salvage value of the of machines or plants
 potential negative cash flows
 pollution
 adjust for potential effects of inflation
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Chapter 18 - Capital Budgeting
10
Example - assumptions
 Project operating cash flows









46,000 units will be sold first year
$5.20/unit
15% growth in demand per year
3-year project
COGS = 58% of sales
Administrative costs = $20,000
CCA category 30%
Marginal tax rate = 40%
rw = 12.4%
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Chapter 18 - Capital Budgeting
11
Depreciation
UCC
CCA
t0
t1
t2
t3
115,000
97,750
68,425
47,897
(17,250) (29,325) (20,528)
 1st year’s CCA 50% of 30% of previous UCC
 2nd year’s CCA 30% of previous UCC
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Chapter 18 - Capital Budgeting
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Earnings Before Interest &
Taxes
t1
t2
t3
Revenue
230,000
264,500
304,175
(COGS)
(133,400) (153,410) (176,422)
(Op costs) (20,000)
(20,000)
(20,000)
(CCA)
(17,250)
(29,325)
(20,528)
EBIT
July 17, 2016
59,350
61,765
Chapter 18 - Capital Budgeting
87,225
13
Operating Cash Flows
EBIT
(Taxes)
CCA
t1
59,350
(23,740)
17,250
t2
61,765
(24,706)
29,325
t3
87,225
(34,890)
20,528
Oper CF
52,860
66,380
72,863
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Chapter 18 - Capital Budgeting
14
Working Capital requirements
1st year
Current Assets
Current Liabilities
Cash
Securities
Receivables
Input Inv
Output Inv
Payables
Notes
Labor Acc
Tax Acc
CA
2,600
0
3,950
2,880
4,130
13,560
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CL
Chapter 18 - Capital Budgeting
3,150
1,500
2,250
1,240
8,140
15
Capital Expenditures
• Investment cost = $115,000
•
•
•
•
•
•
•
Purchase price
Installation cost
Salvage = $53,000
UCC = $47,897
Capital Gain = 5,103
Tax = 5,103*0.7*0.4=$1,429
Gain net of tax = $3,674
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Chapter 18 - Capital Budgeting
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Net Working Capital &
Capital Spending
t0
t1
t2
NWC needed
(5,420)
Current NWC
0
5,420
6,233
7,168
Change NWC
(5,420)
(813)
(935)
7,168
Capital Exp
(115,000)
July 17, 2016
(6,233) (7,168)
t3
Chapter 18 - Capital Budgeting
0
3,674
17
Total Cash Flows
t0
Oper CFs
(5,420)
Cap Exp
(115,000)
July 17, 2016
t2
t3
52,860 66,230 72,863
Chg NWC
NCFs
t1
(813)
(935)
7,168
3,674
(120,420) 52,047 65,295 83,705
Chapter 18 - Capital Budgeting
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Net Present Value
NPV  I 
3

t 1
 120,420 
NCFt

t
1  rw 
83,705
65,295
52,047



3
2
1.124
1.124
1.124
 120,420  46,305  51,683  58,946 
36,514
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Chapter 18 - Capital Budgeting
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NPV – benefits
 Adjusts for time value of money
 Adjust for risk
 wacc
 Uses all incremental cash flows
 Uses economically justified
benchmark
 All the investors in the firm receive their
required rate of return
 wacc
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Chapter 18 - Capital Budgeting
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Cost cutting proposals
 incremental CFs only
 Cost of the upgrade
 Cost savings from upgrade
 Cost and installation = $35,000





CCA rate 30%
Tax rate = 40%
r = 12.4%
Cost savings annually = $15,000 for 4 years
Salvage = $10,000 (70%)
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Chapter 18 - Capital Budgeting
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Cost cutting proposals con’t
Savings
(CCA)
t0
t1
15,000
(5,250)
Op Inc
(Tax)
CCA
Salvage
(35,000)
NCF
(35,000)
July 17, 2016
9,750
(3,900)
5,250
11,100
t2
15,000
(8,925)
t3
15,000
(6,248)
t4
15,000
(4,373)
6,075
(2,430)
8,925
8,752
(3,501)
6,248
10,627
(4,251)
4,373
147
12,570
11,499
10,896
Chapter 18 - Capital Budgeting
22
NPV cost cutting proposal
11,100 12,570 11,499 10,896
NPV   35,000 




2
3
4
1.124 1.124
1.124
1.124
 35,000  9,875  9,950  8,098  6,827   251
36,514
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Chapter 18 - Capital Budgeting
23
Incremental CFs

Cost cutting




Replacing an asset





Change to oper inc
Cost of new machine
Salvage
Salvage of old machine
Change to oper inc
Cost of new machine
Salvage of new machine
Start with operating income



Net of COGS, Operating Costs, taxes
CCAs have already been deducted before taxes
CCAs have already been added back after taxes
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Chapter 18 - Capital Budgeting
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Complexities


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
Different tax laws
Regulatory environment


Market protection
Environmental regulation


Calculated in foreign currency terms
Calculated in home currency terms



Nationalization
Capital controls (rules against repatriation of profits)
Sale and repatriation

Affect weighted average cost of capital
Real exchange rate changes (operating & transaction exposure)
Net Present Value
Political risk
Segmented capital markets
Separability of capital budgeting and financing decisions
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Chapter 18 - Capital Budgeting
25