INTERNATIONAL
FINANCIAL
MANAGEMENT
Seventh Edition
EUN / RESNICK
18-0
Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18
International Capital
Budgeting
Chapter Objective:
Chapter
Eighteen
INTERNATIONAL
FINANCIAL
MANAGEMENT
This chapter discusses the methodology that a
multinational firm can use to analyze the
Fourth Edition
investment of capital in a foreign country.
EUN / RESNICK
18-1
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
l
Review of Domestic Capital Budgeting
l
The Adjusted Present Value Model
n
n
Expected background reading
Suggested background reading
Capital Budgeting from Parent Firm’s Perspective
l  Risk Adjustment in the Capital Budgeting Process
l  Sensitivity Analysis
l  Real Options
l
18-2
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1
Review of Domestic Capital Budgeting
1.
Identify the SIZE and TIMING of all relevant cash flows
on a time line.
2. Identify the RISKINESS of the cash flows to determine
the appropriate discount rate.
3. Find NPV by discounting the cash flows at the appropriate
discount rate.
4. Compare the value of competing cash flow streams at the
same point in time.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-3
International Capital Budgeting
First possible recipe for international managers:
1. Estimate future cash flows in foreign currency
2. Convert to U.S. dollars
at the predicted exchange rate
3. Calculate NPV
using the U.S. cost of capital
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-4
International Capital Budgeting
Example
– 600€
200€
500€
300€
0
1
2
3
π€ = 3%
i$ = 15%
π$ = 6%
18-5
S0($/€) =
$.55265
€
Is this a good
investment from the
perspective of the
U.S. shareholders?
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
2
International Capital Budgeting:
Example
$331.60
– 600€
0
200€
1 year
500€
2 years
300€
3 years
CF0 = (€600)× S0($/€) =(€600)× $.55265 = $331.60
€
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-6
International Capital Budgeting:
Example
$331.60
– 600€
0
$113.70
200€
1 year
500€
2 years
300€
3 years
CF1 = (€200)×E[ S1($/€)] = ?
E[ S1($/€)] can be found by appealing to PPP:
E[S€(1)] = 1.06 × S0($/€) =
1.03
1.06 × $.55265 = $.5687/€
1.03
€
so CF1 = (€200)×($.5687/€) = $113.7
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-7
International Capital Budgeting:
Example
$331.60
– 600€
0
Similarly,
$113.70
$292.60
200€
500€
1 year
2 years
300€
3 years
CF2 = 1.06 × 1.06 × S0($/€) ×(€500) = $292.6
1.03 1.03
18-8
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
3
International Capital Budgeting:
Example
$331.60
$113.70
$292.60
$180.70
200€
500€
300€
– 600€
0
CF3 =
1 year
2 years
3 years
(1.06)3
× S ($/€) ×(€300) = $180.7
(1.03)3 0
NPV = −$331.60 +
$113.70 $292.60 $180.70
+
+
= $107.30
(1.15)
(1.15) 2
(1.15)3
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-9
International Capital Budgeting
Second possible recipe for international managers:
1. Estimate future cash flows in foreign currency
2. Estimate the foreign currency discount rate
3. Calculate the foreign currency NPV using the
foreign cost of capital
4. Translate the foreign currency NPV into
dollars using the spot exchange rate
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-10
Foreign Currency Cost of Capital
Method
– €600
€200
0
1
π€ = 3%
i$ = 15%
18-11
€300
3
2
Let’s find i€ and use that on
the euro cash flows to find
the NPV in euros.
Then translate the NPV into
dollars at the spot rate.
π$ = 6%
S0($/€) =
€500
$0.55265
€
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
4
Finding the Foreign Currency Cost of
Capital: i€
Recall that if the Fisher Effect holds here and abroad…
(1 + ρ$) ×(1 + π$) = (1 + i$)
(1 + i$)
(1 + ρ$) =
(1 + π$)
(1 + i€) = (1 + ρ€) × (1 + π€)
and if the real interest rates are the same, then:
(1 + i€) =
(1 + i$)×(1 + π€)
(1 + π$)
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-12
International Capital Budgeting
Example
– €600
€200
€500
€300
0
1
2
3
(1 + i€) =
(1 + i$)×(1 + π€)
(1 + π$)
=
π$ = 6%
18-13
= 11.75%
(1.06)
NPV @11.75% = € 194.39
π€ = 3%
i$ = 15%
(1.15)×(1.03)
$.55265
S0($/€) =
€
à € 194.39 ×
$0.55265
1€
= $107.43
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
International Capital Budgeting
l
You have two equally valid approaches:
n
n
l
l
Change the foreign cash flows into dollars at the FX rates
expected to prevail. Find the $NPV using the dollar cost
of capital.
Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars at the
spot exchange rate.
You will get the same answer either way.
Which method you prefer is your choice.
n
18-14
Caveat: sometimes easier to estimate CoC than FX rates
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5
Adjusted Present Value
l
The rest of this PDF file and the corresponding
material in the E&R’s Chapter 18 are Not Exam
Material (NEM)
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-15
Review of Domestic Capital
Budgeting
The basic net present value equation is
T
CFt
TVT
NPV = ∑
+
− C0
t
(
1
+
K
)
(
1
+ K )T
t =1
Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow in year T, 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.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-16
Review of Domestic Capital
Budgeting
The NPV rule is to accept a project if NPV ≥ 0
T
NPV = ∑
t =1
CFt
TVT
+
− C0 ≥ 0
(1 + K )t (1 + K )T
and to reject a project if NPV ≤ 0
T
NPV = ∑
t =1
18-17
CFt
TVT
+
− C0 ≤ 0.
t
(1 + K ) (1 + K )T
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ )
Rt is incremental revenue
It is incremental interest expense
OCt is incremental operating τ is the marginal tax rate
costs
Dt is incremental depreciation
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-18
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
CFt = ( Rt − OCt − Dt − I t )(1 − τ ) + Dt + I t (1 − τ )
= NI t + Dt + I t (1 − τ )
= ( Rt − OCt − Dτ )(1 − τ ) + Dt
= NOI t (1 − τ ) + Dt
= ( Rt − OCt )(1 − τ ) + τDt
= OCFt (1 − τ ) + τDt
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-19
Review of Domestic Capital
Budgeting
We can use CFt = OCFt (1 − τ ) + τDt
to restate the NPV equation
T
NPV = ∑
t =1
as:
CFt
TVT
+
− C0
t
(1 + K ) (1 + K )T
T
OCFt (1 − τ ) + τDt
TVT
+
− C0
t
(
1
+
K
)
(
1
+ K )T
t =1
NPV = ∑
18-20
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
7
The Adjusted Present Value Model
T
OCFt (1 − τ )
τDt
TVT
+
+
− C0
t
t
(
1
+
K
)
(
1
+
K
)
(
1
+ K )T
t =1
NPV = ∑
Can be converted to adjusted present value (APV)
T
OCFt (1 − τ )
τDt
τI t
TVT
+
+
+
− C0
t
t
t
(
1
+
K
)
(
1
+
i
)
(
1
+
i
)
(
1
+
K u )T
t =1
u
APV = ∑
By appealing to Modigliani and Miller’s results.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-21
The Adjusted Present Value Model
T
OCFt (1 − τ )
τDt
τI t
TVT
+
+
+
− C0
t
t
t
(
1
+
K
)
(
1
+
i
)
(
1
+
i
)
(
1
+
K u )T
t =1
u
APV = ∑
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 given the
riskiness of the cash flow.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-22
Domestic APV Example
Consider a project of the Pearson Company, the timing and size of the
incremental after-tax cash flows for an all-equity firm are:
-$1,000
0
$125
$250
$375
$500
1
2
3
4
The unlevered cost of equity is r0 = 10%:
NPV10% = −$1,000 +
$125
$250
$375
$500
+
+
+
(1.10) (1.10) 2 (1.10) 3 (1.10) 4
NPV10% = −$56.50
The project would be rejected by an all-equity firm: NPV < 0.
18-23
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8
Domestic APV Example (continued)
Now, imagine that the firm finances the project with $600
of debt at r = 8%.
l  Pearson’s tax rate is 40%, so they have an interest tax
shield worth τ×I = 0.40×$600×0.08 = $19.20 each year.
•  The net present value of the project under leverage is:
APV = NPV + NPVF
Note that with the
4
APV model, each cash
$19.20
APV = −$56.50 + ∑
flow is discounted at a
t
rate that is appropriate
t =1 (1.08)
l
APV = −$56.50 + 63.59 = $7.09
to the riskiness of the
cash flow.
•  So, Pearson should accept the project with debt.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-24
Domestic APV Example (continued)
l
Note that there are two ways to calculate the NPV of the
loan. Previously, we calculated the PV of the interest tax
shields. Now, let’s calculate the actual NPV of the loan:
4
NPVloan = $600 − ∑
t =1
$600 × .08 × (1 − .4) $600
−
(1.08) t
(1.08) 4
NPVloan = $63.59
APV = NPV + NPVloan
APV = −$56.50 + 63.59 = $7.09
Which is the same answer as before.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-25
Capital Budgeting from the Parent
Firm’s Perspective
l
Donald Lessard developed an APV model for a
MNC analyzing a foreign capital expenditure. The
model recognizes many of the particulars peculiar
to foreign direct investment.
T
APV = ∑
t =1
+
18-26
T
St OCFt (1 − τ ) T St τDt
S τI
+∑
+∑ t t t
t
t
(1 + K ud )
t =1 (1 + id )
t =1 (1 + id )
T
S LP
ST TVT
− S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t
T
(1 + K ud )
t =1 (1 + id )
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9
Capital Budgeting from the Parent
Firm’s Perspective
T
APV = ∑
t =1
+
T
St OCFt (1 − τ ) T St τDt
St τI t
+
+
∑
∑
t
t
t
(1 + K ud )
t =1 (1 + id )
t =1 (1 + id )
T
S LP
ST TVT
− S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t
T
(1 + K ud )
t =1 (1 + id )
The operating cash flows must The operating cash flows
be translated back into the
must be discounted at the
parent firm’s currency at the
unlevered domestic rate
spot rate expected to prevail
in each period.
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18-27
Capital Budgeting from the Parent
Firm’s Perspective
T
APV = ∑
t =1
+
T
St OCFt (1 − τ ) T St τDt
St τI t
+
+
∑
∑
t
t
t
(1 + K ud )
t =1 (1 + id )
t =1 (1 + id )
T
S LP
ST TVT
− S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t
T
(1 + K ud )
t =1 (1 + id )
OCFt represents only the
portion of operating cash
flows available for remittance
that can be legally remitted to
the parent firm.
The marginal corporate tax
rate, τ, is the larger of the
parent’s or foreign
subsidiary’s.
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18-28
Capital Budgeting from the Parent
Firm’s Perspective
T
APV = ∑
t =1
+
T
St OCFt (1 − τ ) T St τDt
S τI
+∑
+∑ t t t
t
t
(1 + K ud )
t =1 (1 + id )
t =1 (1 + id )
T
S LP
ST TVT
− S 0C0 + S 0 RF0 + S 0CL0 + ∑ t t t
T
(1 + K ud )
t =1 (1 + id )
S0RF0 represents the value of
accumulated restricted funds
(in the amount of RF0) that
are freed up by the project.
18-29
Denotes the present value
(in the parent’s currency)
of any concessionary loans,
CL0, and loan payments,
LPt , discounted at id .
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10
Risk Adjustment in the Capital
Budgeting Process
l
l
Clearly risk and return are correlated.
Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.
18-30
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Sensitivity Analysis
In the APV model, each cash flow has a
probability distribution associated with it.
l  Hence, the realized value may be different from
what was expected.
l  In sensitivity analysis, different estimates are used
for expected inflation rates, cost and pricing
estimates, and other inputs for the APV to give the
manager a more complete picture of the planned
capital investment.
l
18-31
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Real Options
l
The application of options pricing theory to the
evaluation of investment options in real projects is
known as real options.
A timing option is an option on when to make the
investment.
n  A growth option is an option to increase the scale of the
investment.
n  A suspension option is an option to temporarily cease
production.
n  An abandonment option is an option to quit the
investment early.
n
18-32
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11
End Chapter Seventeen
18-33
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12