Chapter 14
Multinational Capital Budgeting
Lecture Outline
Subsidiary versus Parent Perspective
Tax Differentials
Restricted Remittances
Excessive Remittances
Exchange Rate Movements
Input for Multinational Capital Budgeting
Multinational Capital Budgeting Example
Background
Analysis
Factors to Consider in Multinational Capital Budgeting
Exchange Rate Fluctuations
Inflation
Financing Arrangement
Blocked Funds
Uncertain Salvage Value
Impact of Project on Prevailing Cash Flows
Host Government Incentives
Real Options
Adjusting Project Assessment for Risk
Risk-Adjusted Discount Rate
Sensitivity Analysis
Simulation
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Chapter Theme
This chapter identifies additional considerations in multinational capital budgeting versus domestic
capital budgeting. These considerations can either be explained briefly or illustrated with the use of an
example.
Topics to Stimulate Class Discussion
1. Create an idea for a firm to expand its operations overseas. Provide the industry of the firm. Given
this information, students should be requested to list all information that needs to be gathered in
order to conduct a capital budgeting analysis.
2. How should a firm adjust the capital budgeting analysis for investment in a country where the
currency is extremely volatile?
3. How should a firm adjust the capital budgeting for investment in a country where the chance of a
government takeover is relatively high?
POINT/COUNTER-POINT
Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign
Projects?
POINT: Yes. An MNC’s parent should use the forward rate for each year in which it will receive net
cash flows in a foreign currency. The forward rate is market-determined and serves as a useful forecast
for future years.
COUNTER-POINT: No. An MNC should use its own forecasts for each year in which it will receive
net cash flows in a foreign currency. If the forward rates for future time periods are higher than the
MNC’s expected spot rates, the MNC may accept a project that it should not accept.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue.
ANSWER: An MNC should only use the forward rate in place of its expectations if it plans to hedge
its net cash flows in future periods. Of course, it must also consider the possibility of over-hedging its
future net cash flows in foreign currencies if it uses this strategy. When it assesses a project and does
not hedge, it should use its expected spot rates. However, it should compare its expected spot rates to
the forward rates and assess whether any large deviations of its expectations from the forward rate
make sense.
Answers to End of Chapter Questions
1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed
from the parent’s perspective? What additional factors that normally are not relevant for a purely
domestic project deserve consideration in multinational capital budgeting?
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ANSWER: When a parent allocates funds for a project, it should view the project’s feasibility
from its own perspective. It is possible that a project could be feasible from a subsidiary’s
perspective but be infeasible when considering a parent’s perspective (due to foreign withholding
taxes or exchange rate changes affecting funds remitted to the parent).
Some of the more obvious factors are (1) exchange rates, (2) whether currency restrictions may
exist, (3) probability of a host government takeover, and (4) foreign demand for the product.
2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the
capital budgeting analysis?
List the various techniques for adjusting risk in multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
Explain how simulation can be used in multinational capital budgeting. What can it do that other
risk adjustment techniques cannot?
ANSWER: Point estimates of exchange rates lead to a point estimate of a project’s NPV. It is
more desirable to have a feel for a variety of outcomes (NPVs) that could occur.
The risk adjusted discount rate (RADR) is easy to use but generates only a single point estimate of
the NPV. It may be more desirable to develop a distribution of possible NPVs in order to assess
the probability that NPV will be positive. Sensitivity analysis and simulation could be very useful
because they generate a distribution of NPVs.
To use simulation, develop a range of possible values that each input variable (such as price,
quantity sold, exchange rates) may take on, and apply the simulation model to these ranges to
generate a distribution of NPVs.
3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter,
explain the sources of uncertainty surrounding a proposed project in Hungary by a U.S. firm. In
what ways is the estimated net present value of this project more uncertain than that of a similar
project in a more developed European country?
ANSWER: The estimated NPV is more uncertain because cash flows are more uncertain. The high
degree of uncertainty surrounding the cash flows is attributed to uncertain economic conditions
(especially given the shift to a market-oriented economy), and to an uncertain degree of
competition (the competitive structure is changing substantially because of the removal of
barriers).
4. Accounting for Risk. Your employees have estimated the net present value of project X to be
$1.2 million. Their report says that they have not accounted for risk, but that with such a large
NPV, the project should be accepted since even a risk-adjusted NPV would likely be positive. You
have the final decision as to whether to accept or reject the project. What is your decision?
ANSWER: The decision should not be made until risk has been considered. If the project has a
risk of a government takeover, for example, a large estimated NPV may not be a sufficient reason
to accept the project.
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5. Impact of Exchange Rates on NPV. Describe in general terms how future appreciation of the
euro will likely affect the value (from the parent’s perspective) of a project established in
Germany today by a U.S.-based MNC. Will the sensitivity of the project value be affected by the
percentage of earnings remitted to the parent each year?
ANSWER:
a. Future appreciation of the euro would benefit the parent since the euro earnings would be
worth more when remitted and converted to dollars. This is especially true when a large
percentage of earnings are sent to the parent.
b. Repeat this question, but assume the future depreciation of the euro.
The future depreciation of the euro would hurt the parent since the euro earnings would be worth
less when remitted and converted to dollars. This is especially true when a large percentage of
earnings are sent to the parent.
6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity of
the net present value to exchange rate forecasts.
ANSWER: By financing the project with the same currency that is received from the project, the
firm can reduce the sensitivity of a foreign project’s NPV.
7. September 11 Effects on NPV. In August 2001, Woodsen Inc. of Pittsburgh, PA considered the
development of a large subsidiary in Greece. In response to the September 11, 2001 terrorist attack
on the U.S., its expected cash flows and earnings from this acquisition were reduced only slightly.
Yet, the firm decided to retract its offer because of an increase in its required rate of return on the
project, which caused the NPV to be negative. Explain why the required rate of return on its
project may have increased after the attack.
ANSWER: Its cash flows were subject to more uncertainty, because the full economic effects of
the terrorist attack were uncertain. Therefore, the required rate of return increased to reflect the
higher risk premium.
8. Assessing a Foreign Project. Huskie Industries, a U.S.-based MNC, considers purchasing a small
manufacturing company in France that sells products only within France. Huskie has no other
existing business in France and no cash flows in euros. Would the proposed acquisition likely be
more feasible if the euro is expected to appreciate or depreciate over the long run? Explain.
ANSWER: The proposed acquisition is likely to be more feasible if the euro is expected to
appreciate over the long run. Huskie would like to purchase the firm when the euro is weak. Then,
after the purchase, a strengthened euro will convert the French firm’s earnings remitted to the
parent into a larger amount of U.S. dollars.
9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered
establishing a theme park in France, were the forecasted revenues and costs associated with the
French park sufficient to assess the feasibility of this project? Were there any other “relevant cash
flows” that deserved to be considered?
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ANSWER: Other relevant cash flows are Walt Disney World’s existing cash flows. The
establishment of a theme park in France could reduce the amount of European customers that
would have visited Disney’s U.S. theme parks. These forgone cash flows should be considered
when assessing the feasibility of the theme park in France.
10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was
independent of its operations in the United States. The subsidiary’s performance was well above
what was expected. Consequently, when a British firm approached Athens about the possibility of
acquiring the subsidiary, Athens’ chief financial officer implied that the subsidiary was
performing so well that it was not for sale. Comment on this strategy.
ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price
offered for it exceeds Athens’ perceived present value of the subsidiary.
11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing
below the cash flow projections developed before the subsidiary was established. Lehigh
anticipated that future cash flows would also be lower than the original cash flow projections.
Consequently, Lehigh decided to inform several potential acquiring firms of its plan to sell the
subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but Lehigh
accepted the offer. It justified its decision by stating that any existing project whose cash flows are
not sufficient to recover the initial investment should be divested. Comment on this statement.
ANSWER: Even if the project will not recover its initial outlay, it should only be divested if the
price offered for it exceeds Lehigh’s estimation of its present value.
12. Impact of Reinvested Foreign Earnings on NPV. Flagstaff Corp. is a U.S.-based firm with a
subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the
next 10 years since the interest rate earned on these securities is so high. Then, after 10 years, it
will remit all accumulated earnings to the United States. What is a drawback of using this
approach? (Assume the securities have no default or interest rate risk.)
ANSWER: While the funds are reinvested at high rates, they may be worth less dollars ten years
from now. Flagstaff may have been better off if the earnings were remitted in the year they were
generated. Even though the funds could not be invested at as high an interest rate in the U.S., the
exchange rate effects are reduced when the earnings are remitted each year.
13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The
construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years.
During the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion
cedi, and 2 billion cedi, respectively. Operating cash 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 third year, Brower expects to
sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently
takes 8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per
year.
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a. Determine the NPV for this project. Should Brower build the plant?
ANSWER:
Cash Flows:
Year
Investment
Operating CF
Salvage Value
Net CF
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
0
–9
–9
8,700
–$1,034,483
–$1,034,483
–$1,034,483
1
2
3
3
3
3
9,135
$328,407.23
$280,689.94
–$753,793.06
3
9,592
$312,760.63
$228,475.88
–$525,317.18
2
5
7
10,071
$695,065.04
$433,978.15
–$91,339.03
Since the project has a negative net present value (NPV), Brower should not undertake it.
b. How would your answer change if the value of the cedi was expected to remain unchanged
from its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should
Brower construct the plant then?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar
over the course of the three years:
Year
Investment
Operating CF
Salvage Value
Net CF
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
0
–9
–9
8,700
–$1,034,483
–$1,034,483
–$1,034,483
1
2
3
3
3
3
8,700
$344,827.59
$294,724.44
–$739,748.56
3
8,700
$344,827.59
$251,901.23
–$487,847.33
2
5
7
8,700
$804,597.70
$502,367.11
+$14,519.78
If the value of the cedi remains constant, the NPV is positive. Thus, Brower should undertake the
project in this case. Of course, the NPV is only slightly positive. Whether or not Brower actually
undertakes the project depends on the confidence it has in its exchange rate forecasts.
14. Impact of Financing on NPV. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiary
in Japan. It is very confident that the Japanese yen will appreciate against the dollar over time. The
subsidiary will retain only enough revenue to cover expenses and will remit the rest to the parent
each year. Will Ventura benefit more from exchange rate effects if its parent provides equity
financing for the subsidiary or if the subsidiary is financed by local banks in Japan? Explain.
ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity
investment in the subsidiary. This would result in a larger remittance that would be favorably
affected by the appreciation of the Japanese yen (as the yen are converted to dollars).
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233
If financing was provided by local banks in Japan, interest payments to these banks would reduce
the amount remitted to the U.S. each year. Therefore, the effect of the yen would be less favorable
because it would be applied to a smaller amount of funds.
15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering
establishing a consumer products division in Germany, which would be financed by German
banks. Santa Monica completed its capital budgeting analysis in August. Then, in November, the
government leadership stabilized and political conditions improved in Germany. In response,
Santa Monica increased its expected cash flows by 20 percent but did not adjust the discount rate
applied to the project. Should the discount rate be affected by the change in political conditions?
ANSWER: The risk may have declined if there is less uncertainty surrounding cash flows.
However, if the political conditions also encourage more firms to do business in Germany, there
may be more intense competition from other firms that could penetrate the market, which results
in more risk.
16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign
investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume
that several MNCs are likely to consider DFI in this country. The inflation rate in recent years has
averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5
per hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting analysis
for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for
each of the next 10 years. The components produced are to be exported to Piedmont’s
headquarters in the United States, where they will be used in the production of computers. Do you
think Piedmont will overestimate or underestimate the net present value of this project? Why?
(Assume that LDC’s currency is tied to the dollar and will remain that way.)
ANSWER: The net present value will likely be overestimated because the labor costs in LDC will
probably increase at a higher rate than 4 percent per year. As DFI increases, the demand for labor
will be much greater than in previous years, and future wage rates will reflect the strong demand.
This example is analogous to situations in South Korea, Hong Kong, and Singapore, in which the
desire by MNCs to capitalize on low-cost labor caused wage rates to increase substantially in
some periods.
17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for
expansion in Brazil. Brazil offers considerable potential because it has 150 million people and
their demand for soft drinks is increasing. However, the soft drink consumption is still only about
one-fifth of the soft drink consumption in the U.S. PepsiCo’s initial outlay was used to purchase
three production plants and a distribution network of almost 1,000 trucks to distribute its products
to retail stores in Brazil. The expansion in Brazil was expected to make PepsiCo’s products more
accessible to Brazilian consumers.
a. Given that PepsiCo’s investment in Brazil was entirely in dollars, describe its exposure to
exchange rate risk resulting from the project. Explain how the size of the parent’s initial
investment and the exchange rate risk would have been affected if PepsiCo had financed much
of the investment with loans from banks in Brazil.
ANSWER: As the earnings in Brazil are remitted, they will be converted to dollars. If Brazil’s
currency depreciates against the dollar over time, there will be less dollar earnings received.
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If PepsiCo Inc. borrowed funds from banks in Brazil, the parent’s initial investment would have
been smaller. Also, the payments by the subsidiary on loans in Brazil would cause less remitted
earnings over time, and therefore less exchange rate risk.
b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of
the project in Brazil.
ANSWER: The demand in Brazil for the soft drinks and snacks produced by PepsiCo Inc. is
dependent on the economy in Brazil, consumer habits, country regulations, and the competition.
PepsiCo apparently expects an increased demand for soft drinks and snacks as the economy
improves.
c. What factors did PepsiCo likely consider in deriving its required rate of return on the project
in Brazil?
ANSWER: PepsiCo planned to use $500 million for investment in Brazil. Its funds may have been
derived from retained earnings and loans from creditors. PepsiCo would have estimated a cost of
each source of funds and determined the weighted average cost of those funds. It would have
attached a risk premium onto the cost to reflect the risk of investment in Brazil.
d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective
of the U.S. parent.
ANSWER: There is some uncertainty about the demand for PepsiCo’s products in Brazil, because
it is difficult to estimate the impact of the expansion on the demand. These products would now be
more accessible to Brazil’s consumers, but the precise increase in the demand for PepsiCo’s
products cannot be easily forecasted. This demand is affected by future economic conditions and
future competition (The Coca-Cola Company planned some expansion shortly after PepsiCo
began its expansion in Brazil). In addition to these factors, there is much uncertainty about the
future exchange rate at which the funds will be converted into dollars. The value of Brazil’s
currency (called “the real”) has been very volatile over time and has typically depreciated
substantially against the dollar. Thus, it would be natural to estimate the dollar cash flows by
assuming some degree of depreciation in Brazil’s currency, but there would still be much
uncertainty regarding the degree of depreciation.
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already
had some existing operations in Brazil. When capital budgeting analysis was used to
determine the feasibility of this project, should the project have been assessed from a Brazil
perspective or a U.S. perspective? Explain.
ANSWER: PepsiCo’s parent uses its own funds to support expansion. Thus, it should make
decisions from its own perspective. It does not make sense to assess the project from a Brazil
perspective, when the dollars are used by the parent to support the project in Brazil. The project is
only worthwhile if the return (from a U.S. perspective) is sufficiently large so that it exceeds the
return that is required by the U.S parent that invested those dollars.
18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be
financed with U.S. dollars). All cash flows generated from the project were to be reinvested in
Thailand for several years. Explain how the Asian crisis would have affected the expected cash
Chapter 14: Multinational Capital Budgeting
235
flows of this project and the required rate of return on this project. If the cash flows were to be
remitted to the U.S. parent, explain how the Asian crisis would have affected the expected cash
flows of this project.
ANSWER: The Asian crisis would have reduced local currency cash flows (due to a weak
economy), and then those cash flows would have been remitted at weak exchange rates, which
would reduce the dollar cash flows received by the parent. The required rate of return would be
higher to capture the higher degree of uncertainty surrounding future cash flows.
19. Tax Effects on NPV. When considering the implementation of a project in one of various possible
countries, what types of tax characteristics should be assessed among the countries? (See the
chapter appendix)
ANSWER: Corporate taxes in the country should be considered by an MNC, along with
withholding taxes, and even individual tax rates imposed on the potential employees. Excise taxes
are also relevant.
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion
South Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion
and 4 billion won in the two years of operation, respectively. The project has no salvage value.
The current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to
remain constant over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per
U.S. dollar after two years. Further assume that the funds are blocked and that the parent
company will only be able to remit them back to the U.S. in two years. How does this affect
the NPV of the project?
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ANSWER:
Year
Investment
Operating CF
Net CF
0
–2
–2
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
1,100
–$1,818,181.82
–$1,818,181.82
–$1,818,181.82
1
2
3
3
4
4
1,100
$2,727,272.73
$2,413,515.69
+$595,333.87
1,100
$3,636,363.64
$2,847,806.12
+$3,443,139.99
The NPV is $3,443,139.99.
ANSWER:
Year
Investment
Operating CF
Net CF
0
–2
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
1,100
–$1,818,181.82
–$1,818,181.82
–$1,818,181.82
–2
2
7
7
1,200
$5,833,333.33
$4,568,355.65
+$2,750,173.83
A situation where the funds are blocked and the won is expected to depreciate reduces the NPV by
$692,966.16.
21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong,
where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that
allows for alternative exchange rate scenarios. Why would Carson use this approach rather than
using the pegged exchange rate as its exchange rate forecast in every year?
ANSWER: Carson recognizes that the pegged exchange rate may not remain pegged over the 10year period. It should account for this risk by considering other exchange rate scenarios.
22. Decisions Based on Capital Budgeting. Marathon Inc. considers a one-year project with the
Belgian government. Its euro revenue would be guaranteed. Its consultant states that the
percentage change in the euro is represented by a normal distribution, and that based on a 95
percent confidence interval, the percentage change in the euro is expected to be between 0 percent
and 6 percent. Marathon uses this information to create three scenarios: 0%, 3%, and 6% for the
euro. It derives an estimated NPV based on each scenario, and then determines the mean NPV.
The NPV was positive for the 3% and 6% scenarios, but was slightly negative for the 0 percent
scenario. This led Marathon to reject the project. Its manager stated that it did not want to pursue a
project that had a one-in-three chance of having a negative NPV. Do you agree with the manager’s
interpretation of the analysis? Explain.
ANSWER: Marathon’s interpretation implies that each scenario has the same probability of
occurring. Yet, the probability distribution is presumed to be normal, implying a lower probability
Chapter 14: Multinational Capital Budgeting
237
for the extremes than the middle of the range. The manager overestimated the likelihood that the
NPV will be negative.
23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory
in Brazil, half the initial outlay will be funded by the parent’s equity and half by borrowing funds
in Brazil. Assume that Nike wants to assess the project from its own perspective to determine
whether the project’s future cash flows will provide a sufficient return to the parent to warrant the
initial investment. Why will the estimated cash flows be different from the estimated cash flows of
Nike’s shoe factory in New Hampshire? Why will the initial outlay be different? Explain how
Nike can conduct multinational capital budgeting in a manner that will achieve its objective.
ANSWER: The net cash flows to the parent will be different because they are based on the
revenue received by the subsidiary in Brazil, minus the expenses incurred there (including the
interest payments), and the exchange rate when the funds are remitted to the U.S., plus any tax
effects. The initial outlay is dependent on the cost of creating a factory in Brazil and the amount of
equity invested in the project and the exchange rate at the time of the initial outlay (only the equity
investment is considered here in order to determine the project’s feasibility for the parent). The
debt in Brazil will be recognized within the cash flow estimates. Nike can determine whether the
present value of the cash flows received by the parent (measured in the manner explained above)
exceeds the initial outlay (measured in the manner explained above) of the project.
Advanced Questions
24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the
project will generate total operating cash flows of $3,500,000, measured in today’s dollars using a
required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:
⎡
CFt ⎤
SVn = ⎢ IO − ∑
(1 + k ) n
t ⎥
(1 + k ) ⎦
⎣
= ($4,000,000 − $3,500,000)(1.14) 3
= $740,772
25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it
can capitalize on its technology. It is risk-averse, but is attracted to the project because of a
government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by
the New Zealand government at the end of the year. The payment by the New Zealand
government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will
be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal oneyear interest rate in New Zealand is 5% while the nominal one-year interest rate in the U.S. is 9%.
Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly
uncertain over the next year, but his best guess is that the change in its value will be in accordance
with the international Fisher effect. He also believes that interest rate parity holds. He provides
this information to three recent finance graduates that he just hired as managers and asks them for
their input.
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International Financial Management
a. The first manager states that due to the parity conditions, the feasibility of the project will be
the same whether the cash flows are hedged with a forward contract or are not hedged. Is this
manager correct? Explain.
b. The second manager states that the project should not be hedged. Based on the interest rates,
the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the
project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a
premium, and therefore the forward rate will generate more U.S. dollar cash flows than the
expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct?
Explain.
ANSWER:
a. The first manager is wrong. The project is more feasible if it hedges, because the expected
dollar cash flows are the same whether Zistine hedges or not, and it can remove uncertainty
surrounding the dollar cash flows if it hedges.
b. The second manager is wrong. The IFE suggests an expected appreciation of the New Zealand
dollar by the same percentage as the forward premium (assuming IRP). Thus, the dollar cash
flows are just as high when hedged, and there is no uncertainty.
c. The third manager’s reasoning is wrong. The forward hedge is expected to generate the same
dollar cash flows as if there is no hedge, because with no hedge the IFE suggests expected
appreciation by the amount of the interest rate differential. The amount of dollar cash flows
from hedging is equal to the expected dollar cash flows from not hedging. The decision to
hedge is correct, but not because of this manager’s reasoning.
26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the
use of its technology to firms in Mexico. It already has received orders from Mexican firms that
will generate MXP3,000,000 in revenue at the end of the next year. However, it might also receive
a contract to provide this technology to the Mexican government. In this case, it will generate a
total of MXP5,000,000 at the end of the next year. It will not know whether it will receive the
government order until the end of the year.
Today’s spot rate of the peso is $.14. The one-year forward rate is $.12. Blustream expects that the
spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to
cover development expenses (regardless of whether the Mexican government purchases the
technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent.
Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive
from the project.
Chapter 14: Multinational Capital Budgeting
239
a. Determine the NPV if Blustream receives the government contract.
ANSWER:
Revenue converted to $ = MXP5,000,000 × $.12 = $600,000
NPV = $600,000/(1.18) – $300,000 = $208,475
b. If Blustream does not receive the contract, it will have hedged more than it needed to and will
offset the excess forward sales by purchasing pesos in the spot market at the time the forward
sale is executed. Determine the NPV of the project assuming that Blustream does not receive
the government contract.
ANSWER:
Revenue converted to $: MXP3,000,000 × $.12 = $360,000
Blustream would have an additional MXP2,000,000 in forward sales. It would need to buy
MXP2,000,000 in one year at the expected spot rate, which would be used to offset the excess
forward sale position.
Amount paid to offset forward sales = MXP2,000,000 × $.13 = $260,000
Proceeds from the excess forward sales = MXP2,000,000 × $.12 = $240,000
Loss resulting from the excess forward sales = $240,000 – $260,000 = –$20,000
Dollar cash flows = Dollar Revenue
– Loss resulting from
excess forward sales
$360,000
–$20,000
$340,000
NPV = $340,000/(1.18) – $300,000 = –$11,864
c. Now consider an alternative strategy in which Blustream only hedges the minimum peso
revenue that it will receive. In this case, any revenue due to the government contract would
not be hedged. Determine the NPV based on this alternative strategy and assume that
Blustream receives the government contract.
Revenue converted to $:
Hedged portion:
MXP3,000,000 × $.12 = $360,000
Unhedged portion: MXP2,000,000 × $.13 = $260,000
Total
$620,000
NPV = $620,000/(1.18) – $300,000 = $225,423
d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it
will receive, determine the NPV assuming that it does not receive the government contract.
240
International Financial Management
Revenue converted to $:
MXP3,000,000 × $.12 = $360,000
NPV = $360,000/(1.18) – $300,000 = $5,085
e. If there is a 50 percent chance that Blustream will receive the government contract, would you
advise Blustream to hedge the maximum amount or the minimum amount of revenue that it
may receive? Explain.
ANSWER: It should hedge the minimum amount of revenue. If it hedges the minimum, the NPV
for either scenario is higher than if it had hedged the maximum amount of revenue.
f.
Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum
amount or the maximum amount of revenue it will receive. It considers a new strategy of
hedging the minimum amount it will receive with a forward contract and hedging the
additional revenue it might receive with a put option on Mexican pesos. The one-year put
option has an exercise price of $.125 and a premium of $.01. Determine the NPV if Blustream
uses this strategy and receives the government contract. Also, determine the NPV if Blustream
uses this strategy and does not receive the government contract. Given that there is a 50
percent probability that Blustream will receive the government contract, would you use this
new strategy or the strategy that you selected in question (e)?
ANSWER:
Scenario If Blustream Receives Government Contract:
Portion hedged with FR:
MXP3,000,000 × $.12 = $360,000
Portion hedged with option: MXP2,000,000 × $.125 = + $250,000
Total received in 1 year
= $610,000
Premium paid for option:
MXP2,000,000 × $.01 =
$20,000
NPV = $610,000/(1.18) – $20,000 – $300,000 = $196,949
Scenario If Blustream Does Not Receive Government Contract:
Portion hedged with FR:
MXP3,000,000 × $.12 = $360,000
Premium paid for option:
MXP2,000,000 × $.01 = $20,000
NPV = $360,000/(1.18) – $20,000 – $300,000 = –$14,915
Overall, the NPV from this strategy is worse than the strategy of hedging the minimum revenue
under the scenario that Blustream receives the government contract, and worse under the scenario
that it does not receive the government contract. This strategy should not be selected. The optimal
strategy is to hedge the minimum amount of revenue to be received.
27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand
but is considering establishing a subsidiary there. The following information has been gathered to
assess this project:
Chapter 14: Multinational Capital Budgeting
241
•
The initial investment required is $50 million in New Zealand dollars (NZ$). Given the
existing spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25
million. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20
million is needed for working capital and will be borrowed by the subsidiary from a New
Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an
interest rate of 14 percent. The loan principal is to be paid in 10 years.
•
The project will be terminated at the end of Year 3, when the subsidiary will be sold.
•
The price, demand, and variable cost of the product in New Zealand are as follows:
Year
1
2
3
Price
NZ$500
NZ$511
NZ$530
Demand
40,000 units
50,000 units
60,000 units
Variable Cost
NZ$30
NZ$35
NZ$40
•
The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
•
The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54
at the end of Year 2, and $.56 at the end of Year 3.
•
The New Zealand government will impose an income tax of 30 percent on income. In
addition, it will impose a withholding tax of 10 percent on earnings remitted by the subsidiary.
The U.S. government will allow a tax credit on the remitted earnings and will not impose any
additional taxes.
•
All cash flows received by the subsidiary are to be sent to the parent at the end of each year.
The subsidiary will use its working capital to support ongoing operations.
•
The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ$50 million, the annual
depreciation expense is NZ$5 million.
•
In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume
the existing New Zealand loan. The working capital will not be liquidated but will be used by
the acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52 million
after subtracting capital gains taxes. Assume that this amount is not subject to a withholding
tax.
•
Wolverine requires a 20 percent rate of return on this project.
242
International Financial Management
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
Year 0
Year 1
Year 2
Year 3
Demand
40,000
50,000
60,000
Price per unit
NZ$500
NZ$511
NZ$530
Total revenue = (1) × (2)
NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
Variable cost per unit
NZ$30
NZ$35
NZ$40
Total variable cost = (1) × (4)
NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
Fixed cost
NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
Interest expense of New
Zealand loan
NZ$2,800,000 NZ$2,800,000 NZ$2,800,000
Noncash expense (depreciation)
NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
Total expenses
= (5) + (6) + (7) + (8)
NZ$15,000,000 NZ$15,550,000 NZ$16,200,000
Before-tax earnings of subsidiary
= (3) – (9)
NZ$5,000,000 NZ$10,000,000 NZ$15,600,000
Host government tax (30%)
NZ$1,500,000 NZ$3,000,000 NZ$4,680,000
After-tax earnings of subsidiary
NZ$3,500,000 NZ$7,000,000 NZ$10,920,000
Net cash flow to subsidiary
= (12) + (8)
NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
NZ$ remitted by sub.
(100% of CF)
NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
Withholding tax imposed on
remitted funds (10%)
NZ$850,000 NZ$1,200,000 NZ$1,592,000
NZ$ remitted after withholding
taxes
NZ$7,650,000 NZ$10,800,000 NZ$14,328,000
Salvage value
NZ$52,000,000
Exchange rate of NZ$
$.52
$.54
$.56
Cash flows to parent
$3,978,000
$5,832,000
$37,143,680
PV of parent cash flows
(20% of discount rate)
$3,315,000
$4,050,000
$21,495,185
Initial investment by parent –$25,000,000
Cumulative NPV of cash flows
–$21,685,000 –$17,635,000
$3,860,185
ANSWER: The net present value of this project is $3,860,185. Therefore, Wolverine should
accept this project.
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the
parent would invest an additional $10 million to cover the working capital requirements so that the
subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of the
subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is
this alternative financing arrangement more feasible for the parent than the original proposal?
Explain.
ANSWER: This alternative financing arrangement will have the following effects. First, it will
increase the dollar amount of the initial outlay to $35 million. Second, it avoids the annual interest
expense of NZ$2,800,000. Third, it will increase the salvage value from NZ$52,000,000 to
NZ$70,000,000. The capital budgeting analysis is revised to incorporate these changes.
Chapter 14: Multinational Capital Budgeting
243
Capital Budgeting Analysis with an Alternative
Financing Arrangement: Wolverine Corporation
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
Year 0
Year 1
Demand
40,000
Price per unit
NZ$500
Total revenue = (1) × (2)
NZ$20,000,000
Variable cost per unit
NZ$30
Total variable cost = (1) × (4)
NZ$1,200,000
Fixed cost
NZ$6,000,000
Interest expense of New Zealand
loan
NZ$0
Noncash expense (depreciation)
NZ$5,000,000
Total expenses
= (5 ) + (6) + (7) + (8)
NZ$12,200,000
Before-tax earnings of subsidiary
= (3) – (9)
NZ$7,800,000
Host government tax (30%)
NZ$2,340,000
After-tax earnings of subsidiary
NZ$5,460,000
Net cash flow to subsidiary
= (12) + (8)
NZ$10,460,000
NZ$ remitted by sub.
(100% of CF)
NZ$10,460,000
Withholding tax imposed on
remitted funds (10%)
NZ$1,046,000
NZ$ remitted after withholding
taxes
NZ$9,414,000
Salvage value
Exchange rate of NZ$
$.52
Cash flows to parent
$4,895,280
PV of parent cash flows
(20% discount rate)
$4,079,400
Initial investment by parent
–$35,000,000
Cumulative NPV of cash flows
–$30,920,600
Year 2
Year 3
50,000
60,000
NZ$511
NZ$530
NZ$25,550,000 NZ$31,800,000
NZ$35
NZ$40
NZ$1,750,000 NZ$2,400,000
NZ$6,000,000 NZ$6,000,000
NZ$0
NZ$5,000,000
NZ$0
NZ$5,000,000
NZ$12,750,000 NZ$13,400,000
NZ$12,800,000 NZ$18,400,000
NZ$3,840,000 NZ$5,520,000
NZ$8,960,000 NZ$12,880,000
NZ$13,960,000 NZ$17,880,000
NZ$13,960,000 NZ$17,880,000
NZ$1,396,000
NZ$1,788,000
NZ$12,564,000 NZ$16,092,000
NZ$70,000,000
$.54
$.56
$6,784,560
$48,211,520
$4,711,500
$27,900,185
–$26,209,100
$1,691,085
The analysis shows that this alternative financing arrangement is expected to generate a lower net
present value than the original financing arrangement.
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the
parent invests more of its own funds to cover the working capital? Explain.
ANSWER: The NPV would be more sensitive to exchange rate movements if the parent uses its
own financing to cover the working capital requirements. If it used New Zealand financing, a
portion of NZ$ cash flows could be used to cover the interest payments on debt. Thus, there would
be less NZ$ to be converted to dollars and less exposure to exchange rate movements.
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until
the end of Year 3. How is the project’s NPV affected?
244
International Financial Management
ANSWER: The effects of the blocked funds are shown below:
Year 1
13. Net cash flow to subsidiary
= (12) + (8)
14. NZ$ remitted by subsidiary
15. Withholding tax imposed on
remitted funds (10%)
16. NZ$ remitted after withholding
taxes
17. Salvage value
18. Exchange rate of NZ$
19. Cash flows to parent
20. PV of parent cash flows
(20% discount rate)
21. Initial investment by parent
22. Cumulative NPV of cash flows
Year 2
Year 3
NZ$8,500,000 NZ$12,000,000
→
→
NZ$0
NZ$0
NZ$
NZ$
NZ$
NZ$
15,920,000
12,720,000
9,550,600
38,190,600
NZ$ 3,819,060
NZ$ 34,371,540
NZ$ 52,000,000
$.56
$48,368,062
NZ$0
NZ$0
$27,990,777
$0
$0
$2,990,777
–$25,000,000
e. What is the break-even salvage value of this project if Wolverine uses the original financing
proposal and funds are not blocked?
First, determine the present value of cash flows when excluding salvage value:
End of
Year
1
2
3
Present Value of Cash Flows
(excluding salvage value)
$ 3,315,000
4,050,000
4,643,333*
$ 12,008,333
*This number is determined by converting the third year NZ$ cash flows excluding salvage value
(NZ$14,328,000) into dollars at the forecasted exchange rate of $.56 per New Zealand dollar:
NZ$14,328,000 × $.56 = $8,023,680
The present value of the $8,023,680 received 3 years from now is $4,643,333.
Then determine the break-even salvage value:
Break-even
Salvage
= [IO – (present value of cash flows)](1+k)n
Value
= [$25,000,000 – $12,008,333](1+.20)3
= $22,449,601
ANSWER: Since the NZ$ is expected to be $.56 in Year 3, this implies that the break-even
salvage value in terms of New Zealand dollars is:
Chapter 14: Multinational Capital Budgeting
245
$22,449,601/$.56 = NZ$40,088,573
f.
Assume that Wolverine decides to implement the project, using the original financing proposal.
Also assume that after one year, a New Zealand firm offers Wolverine a price of $27 million after
taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not
changed. Compare the present value of the expected cash flows it Wolverine keeps the subsidiary
to the selling price. Should Wolverine divest the subsidiary? Explain.
ANSWER:
Divestiture Analysis One Year After
the Project Began
Cash flows to parent
PV of parent cash
flows forgone if
project is divested
End of Year 2
End of Year 3
(one year from now) (two years from now)
$5,832,000
$37,143,680
$4,860,000
$25,794,222
The present value of forgone cash flows is $30,654,222. Since this exceeds the $27,000,000 in
proceeds from the divestiture, the project should not be divested.
28. Capital Budgeting With Hedging. Baxter Co. considers a project with Thailand’s government. If
it accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht in
five years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a 5year period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to
hedge its cash flows with a forward contract. What is the dollar amount of cash flows that Baxter
will receive in five years if it accepts this project?
ANSWER: The forward rate premium is:
p = (1 + .04)5 – 1 = (1.216 / 2.192) – 1 = –44%
(1 + .17)5
Forward rate = Spot rate × (1 + premium)
= $.03 × (.56)
= $.0168
So the amount to be received is 10,000,000 units × $.0168 = $168,000.
29. Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the
French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the
unit. It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains
taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the
future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized
U.S. risk-free interest rate is 5% regardless of the maturity of the debt, and the annualized risk-free
interest rate on euros is 7%, regardless of the maturity of debt. Assume that interest rate parity
exists. Cantoon’s cost of capital is 20%. It plans to use cash to make the acquisition.
246
International Financial Management
a. Determine the NPV under these conditions.
b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan
of 3 million euros today that would be used to cover a portion of the acquisition. In this case,
it would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the
loan. There are no interest payments on this debt. The way in which this financing deal is
structured, none of the payment is tax-deductible. Determine the NPV if Cantoon uses the
forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to
partially finance the acquisition. [You need to derive the 8-year forward rate for this specific
question.]
ANSWER:
a. Discount factor based on a required return of 20% for 8 years = .232
$ to be received in 8 years = 12,000,000 euros × $1.2 = $14,400,000
PV = $14,400,000
(1 + .2)8
= $3,340,800
NPV = $3,340,800 – $4,000,000
= –$659,200
b. The forward rate premium is:
p = (1 + .05)8 – 1 = (1.48)/1.718) – 1 = –13.85%
(1 + .07)8
FR premium over 8 years = –.13.85%
Forecast of euro in 8 years = $1.20 × [1 + (–13.85%)] = 1.0338.
Euros to be received in 8 years = 12 million euros – 7 million euros = 5 million euros
Dollars to be received in 8 years = 5 million euros × $1.0338 = $5,169,000
PV of $ to be received in 8 years =
$5,169,000
(1 + .20)8
=
$1,202,144
If 3 million euros are borrowed, this covers the equivalent of $3,600,000, since the euro’s spot
rate is equal to $1.20. Therefore, the parent needs to provide an initial outlay of $400,000
(computed as $4,000,000 – $3,600,000).
NPV = $1,202,144 – $400,000 = $802,144
Chapter 14: Multinational Capital Budgeting
247
Solution to Continuing Case Problem: Blades, Inc.
1. Should the sales and the associated costs of 180,000 pairs of roller blades to be sold in Thailand
under the existing agreement be included in the capital budgeting analysis to decide whether
Blades should establish a subsidiary in Thailand? Should the sales resulting from a renewed
agreement be included? Why or why not?
ANSWER: The sales from the existing agreement should not be included in the capital budgeting
analysis to decide whether Blades should establish a subsidiary in Thailand. Blades will generate
these sales whether or not it establishes a subsidiary in Thailand. The cost savings of 300 Thai
baht per pair of roller blades for the 180,000 pairs not previously sourced from Thailand should be
included in the capital budgeting analysis, as these savings would not occur if Blades continued to
import from Thailand. The sales resulting from the renewed agreement should be included in the
capital budgeting analysis, because Entertainment Products will not renew the agreement if Blades
simply continues to export to Thailand. Thus, this revenue is incremental to the establishment of a
subsidiary.
2. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades renews the agreement with Entertainment Products. Should Blades establish a subsidiary in
Thailand under these conditions?
ANSWER: (See spreadsheet attached.) The spreadsheet shows a positive net present value (NPV)
of $2,638,735 if Blades establishes a subsidiary in Thailand and renews the agreement with
Entertainment Products. Thus, Blades should accept the project assuming that the discount rate of
25 percent has fully accounted for the project’s risk.
3. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades does not renew the agreement with Entertainment Products. Should Blades establish a
subsidiary in Thailand under these conditions? Should Blades renew the agreement with
Entertainment Products?
ANSWER: (See spreadsheet attached.) The spreadsheet shows a positive NPV of $8,746,688 if
Blades establishes a subsidiary in Thailand and does not renew the agreement with Entertainment
Products. The higher NPV is attributable to the fact that Blades’ sales to Entertainment Products
are now tied to inflation, even though they are reduced by 175,000 units annually. Thus, Blades
should probably not renew its agreement with Entertainment Products.
4. Since future economic conditions in Thailand are uncertain, Ben Holt would like to know how
critical the salvage value is in the alternative you think is most feasible.
248
International Financial Management
ANSWER: (See spreadsheet attached.) The capital budgeting analysis in question 2 was the most
favorable. Under this scenario, even if Blades is unable to sell the subsidiary (which may occur if
the government repossesses the subsidiary in ten years), the NPV of the project is positive. Thus,
the salvage value is not critical for making this project feasible.
5. The future value of the baht is highly uncertain. Under a worst case scenario, the baht may
depreciate by as much as 5 percent annually. Revise your spreadsheet to illustrate how this would
affect Blades’ decision to establish a subsidiary in Thailand (Use the capital budgeting analysis
you have identified as the most favorable from questions 2 and 3 to answer this question.)
ANSWER: (See spreadsheet attached.) The spreadsheet shows that an annual depreciation of 5
percent of the Thai baht will result in a positive NPV of $5,620,315. Since this is a worst case
scenario, Blades should still establish a subsidiary in Thailand (without renewing its agreement
with Entertainment Products) even if it expects the baht to depreciate by 5 percent annually.
Answer to Question b:
Year 0
1. Units Sold to
Entertainment Products
2. Price per Unit (in Thai baht)
3. Revenue from Contractual
Agreement = (1) × (2)
in THB 000s
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
—
—
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
180,000
4,594
0
826,920
826,920
826,920
826,920
826,920
826,920
826,920
826,920
826,920
220,000
6,272
220,000
7,025
220,000
7,868
220,000
8,812
220,000
9,869
220,000
11,053
220,000
12,380
220,000
13,865
4. Units Sold to Other
Retailers in Thailand
5. Price per Unit (in Thai baht)
6. Revenue from Sales to Other
Retailers in Thailand = (4) × (5)
in THB 000s
120,000
5,000
120,000
5,600
600,000
672,000 1,379,840 1,545,421 1,730,871 1,938,576 2,171,205 2,431,750 2,723,559 3,050,387
7. Total Revenue = (3) + (6)
in THB 000s
600,000 1,498,920 2,206,760 2,372,341 2,557,791 2,765,496 2,998,125 3,258,670 3,550,479 3,877,307
8. Variable Cost per Unit (in
Thai baht)
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
10. Less Cost Savings from Production
of 108,000 Pairs in Thailand
in THB 000s
11. Fixed Operating
Expenses
(in Thai baht 000s)
12. Noncash Expense
(Depreciation) in THB 000s
13. Total Expenses = (9) –
(10) + (11) + (12) in THB
000s
3,500
3,920
4,390
4,917
5,507
6,168
6,908
7,737
8,666
9,706
420,000 1,176,000 1,756,160 1,966,899 2,202,927 2,467,278 2,763,352 3,094,954 3,466,348 3,882,310
32,400
—
—
—
—
—
—
—
—
—
25,000
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
442,600 1,234,000 1,817,520 2,032,022 2,272,265 2,541,337 2,842,697 3,180,221 3,558,248 3,981,637
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
THB 000s
15. Host Government Tax
(25%) in THB 000s
16. After-Tax Earnings of
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
21. Salvage Value in THB
000s
22. Exchange Rate of Baht
23. $ Cash Flow to Parent = (20) × (22)
24. PV of Parent Cash Flows
(25% Discount Rate)
25. Initial Investment by
Parent
26. Cumulative PV
157,400
264,920
389,240
340,318
285,526
224,159
155,428
78,449
(7,768) (104,331)
39,350
66,230
97,310
85,080
71,382
56,040
38,857
19,612
(1,942)
(26,083)
118,050
198,690
291,930
255,239
214,145
168,119
116,571
58,836
(5,826)
(78,248)
148,050
228,690
321,930
285,239
244,145
198,119
146,571
88,836
24,174
(48,248)
148,050
228,690
321,930
285,239
244,145
198,119
146,571
88,836
24,174
(48,248)
14,805
22,869
32,193
28,524
24,414
19,812
14,657
8,884
2,417
—
133,245
205,821
289,737
256,715
219,730
178,307
131,914
79,953
21,757
(48,248)
650,000
$0.02254 $0.02209 $0.02165 $0.02121 $0.02079 $0.02037 $0.01997 $0.01957 $0.01918 $0.01879
3,003,342 4,546,421 6,272,057 5,446,070 4,568,230 3,632,900 2,633,905 1,564,480 417,208 1,308,530
2,402,674 2,909,710 3,211,293 2,230,710 1,496,918
952,343
552,370
262,476
55,997 1,214,244
$12,650,000
(10,247,326) (7,337,617) (4,126,323) (1,895,613) (398,695)
553,648 1,106,018 1,368,494 1,424,490 2,638,735
Answer to Question c:
Year 0
1. Units Sold to
Entertainment Products
2. Price per Unit (in Thai baht)
3. Revenue from Contractual
Agreement = (1) × (2)
in THB 000s
Year 1
—
Year 2
5,000
Year 3
5,000
Year 4
5,000
Year 5
5,000
Year 6
5,000
Year 7
5,000
Year 8
5,000
Year 9
5,000
Year 10
5,000
—
5,600
6,272
7,025
7,868
8,812
9,869
11,053
12,380
13,865
0
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
220,000
6,272
220,000
7,025
220,000
7,868
220,000
8,812
220,000
9,869
220,000
11,053
220,000
12,380
220,000
13,865
4. Units Sold to Other
Retailers in Thailand
5. Price per Unit (in Thai baht)
6. Revenue from Sales to Other
Retailers in Thailand = (4) × (5)
in THB 000s
120,000
5,000
120,000
5,600
600,000
672,000 1,379,840 1,545,421 1,730,871 1,938,576 2,171,205 2,431,750 2,723,559 3,050,387
7. Total Revenue = (3) + (6)
in THB 000s
600,000
700,000 1,411,200 1,580,544 1,770,209 1,982,634 2,220,551 2,487,017 2,785,459 3,119,714
8. Variable Cost per Unit (in
Thai baht)
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
10. Less Cost Savings from Production
of 108,000 Pairs in Thailand
in THB 000s
11. Fixed Operating Expenses
(in Thai baht 000s)
12. Noncash Expense
(Depreciation) in THB 000s
13. Total Expenses = (9) –
(10) + (11) + (12) in THB
000s
3,500
3,920
420,000
490,000
32,400
—
—
—
—
—
—
—
—
—
25,000
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
442,600
4,390
4,917
5,507
6,168
6,908
7,737
8,666
9,706
987,840 1,106,381 1,239,146 1,387,844 1,554,385 1,740,912 1,949,821 2,183,800
548,000 1,049,200 1,171,504 1,308,484 1,461,903 1,633,731 1,826,179 2,041,720 2,283,126
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
THB 000s
15. Host Government Tax
(25%) in THB 000s
16. After-Tax Earnings of
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
21. Salvage Value in THB
000s
22. Exchange Rate of Baht
23. $ Cash Flow to Parent = (20) × (22)
24. PV of Parent Cash Flows
(25% Discount Rate)
25. Initial Investment by
Parent
26. Cumulative PV
157,400
152,000
362,000
409,040
461,725
520,732
586,820
660,838
743,738
836,587
39,350
38,000
90,500
102,260
115,431
130,183
146,705
165,209
185,935
209,147
118,050
114,000
271,500
306,780
346,294
390,549
440,115
495,628
557,804
627,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
14,805
14,400
30,150
33,678
37,629
42,055
47,011
52,563
58,780
65,744
133,245
129,600
271,350
303,102
338,664
378,494
423,103
473,066
529,023
591,696
$0.02254
3,003,342
$0.02209
2,862,760
$0.02165
5,874,026
650,000
$0.02121 $0.02079 $0.02037 $0.01997 $0.01957 $0.01918 $0.01879
6,430,148 7,040,890 7,711,578 8,448,054 9,256,735 10,144,659 23,334,794
2,402,674 1,832,167 3,007,501 2,633,788 2,307,159 2,021,544 1,771,685 1,553,022 1,361,593 2,505,554
$12,650,000
(10,247,326) (8,415,160) (5,407,658) (2,773,870) (466,711) 1,554,833 3,326,518 4,879,541 6,241,134 8,746,688
Answer to Question d:
Year 0
1. Units Sold to
Entertainment Products
2. Price per Unit (in Thai baht)
3. Revenue from Contractual
Agreement = (1) × (2)
in THB 000s
Year 1
—
Year 2
5,000
Year 3
5,000
Year 4
5,000
Year 5
5,000
Year 6
5,000
Year 7
5,000
Year 8
5,000
Year 9
5,000
Year 10
5,000
—
5,600
6,272
7,025
7,868
8,812
9,869
11,053
12,380
13,865
0
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
220,000
6,272
220,000
7,025
220,000
7,868
220,000
8,812
220,000
9,869
220,000
11,053
220,000
12,380
220,000
13,865
4. Units Sold to Other
Retailers in Thailand
5. Price per Unit (in Thai baht)
6. Revenue from Sales to Other
Retailers in Thailand = (4) × (5)
in THB 000s
120,000
5,000
120,000
5,600
600,000
672,000 1,379,840 1,545,421 1,730,871 1,938,576 2,171,205 2,431,750 2,723,559 3,050,387
7. Total Revenue = (3) + (6)
in THB 000s
600,000
700,000 1,411,200 1,580,544 1,770,209 1,982,634 2,220,551 2,487,017 2,785,459 3,119,714
8. Variable Cost per Unit (in
Thai baht)
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
10. Less Cost Savings from Production
of 108,000 Pairs in Thailand
in THB 000s
11. Fixed Operating Expenses
(in Thai baht 000s)
12. Noncash Expense
(Depreciation) in THB 000s
13. Total Expenses = (9) –
(10) + (11) + (12) in THB
000s
3,500
3,920
420,000
490,000
32,400
—
—
—
—
—
—
—
—
—
25,000
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
442,600
4,390
4,917
5,507
6,168
6,908
7,737
8,666
9,706
987,840 1,106,381 1,239,146 1,387,844 1,554,385 1,740,912 1,949,821 2,183,800
548,000 1,049,200 1,171,504 1,308,484 1,461,903 1,633,731 1,826,179 2,041,720 2,283,126
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
THB 000s
15. Host Government Tax
(25%) in THB 000s
16. After-Tax Earnings of
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
21. Salvage Value in THB
000s
22. Exchange Rate of Baht
23. $ Cash Flow to Parent = (20) × (22)
24. PV of Parent Cash Flows
(25% Discount Rate)
25. Initial Investment by
Parent
26. Cumulative PV
157,400
152,000
362,000
409,040
461,725
520,732
586,820
660,838
743,738
836,587
39,350
38,000
90,500
102,260
115,431
130,183
146,705
165,209
185,935
209,147
118,050
114,000
271,500
306,780
346,294
390,549
440,115
495,628
557,804
627,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
14,805
14,400
30,150
33,678
37,629
42,055
47,011
52,563
58,780
65,744
133,245
129,600
271,350
303,102
338,664
378,494
423,103
473,066
529,023
591,696
0
$0.02254 $0.02209 $0.02165 $0.02121 $0.02079 $0.02037 $0.01997 $0.01957 $0.01918 $0.01879
3,003,342 2,862,760 5,874,026 6,430,148 7,040,890 7,711,578 8,448,054 9,256,735 10,144,659 11,119,556
2,402,674 1,832,167 3,007,501 2,633,788 2,307,159 2,021,544 1,771,685 1,553,022 1,361,593 1,193,953
$12,650,000
(10,247,326) (8,415,160) (5,407,658) (2,773,870) (466,711) 1,554,833 3,326,518 4,879,541 6,241,134 7,435,087
Answer to Question e:
Year 0
1. Units Sold to
Entertainment Products
2. Price per Unit (in Thai baht)
3. Revenue from Contractual
Agreement = (1) × (2)
in THB 000s
Year 1
—
Year 2
5,000
Year 3
5,000
Year 4
5,000
Year 5
5,000
Year 6
5,000
Year 7
5,000
Year 8
5,000
Year 9
5,000
Year 10
5,000
—
5,600
6,272
7,025
7,868
8,812
9,869
11,053
12,380
13,865
0
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
220,000
6,272
220,000
7,025
220,000
7,868
220,000
8,812
220,000
9,869
220,000
11,053
220,000
12,380
220,000
13,865
4. Units Sold to Other
Retailers in Thailand
5. Price per Unit (in Thai baht)
6. Revenue from Sales to Other
Retailers in Thailand = (4) × (5)
in THB 000s
120,000
5,000
120,000
5,600
600,000
672,000 1,379,840 1,545,421 1,730,871 1,938,576 2,171,205 2,431,750 2,723,559 3,050,387
7. Total Revenue = (3) + (6)
in THB 000s
600,000
700,000 1,411,200 1,580,544 1,770,209 1,982,634 2,220,551 2,487,017 2,785,459 3,119,714
8. Variable Cost per Unit (in
Thai baht)
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
10. Less Cost Savings from Production
of 108,000 Pairs in Thailand
in THB 000s
11. Fixed Operating Expenses
(in Thai baht 000s)
12. Noncash Expense
(Depreciation) in THB 000s
13. Total Expenses = (9) –
(10) + (11) + (12) in THB
000s
3,500
3,920
420,000
490,000
32,400
—
—
—
—
—
—
—
—
—
25,000
28,000
31,360
35,123
39,338
44,059
49,346
55,267
61,899
69,327
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
442,600
4,390
4,917
5,507
6,168
6,908
7,737
8,666
9,706
987,840 1,106,381 1,239,146 1,387,844 1,554,385 1,740,912 1,949,821 2,183,800
548,000 1,049,200 1,171,504 1,308,484 1,461,903 1,633,731 1,826,179 2,041,720 2,283,126
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
THB 000s
15. Host Government Tax
(25%) in THB 000s
16. After-Tax Earnings of
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
21. Salvage Value in THB
000s
22. Exchange Rate of Baht
23. $ Cash Flow to Parent = (20) × (22)
24. PV of Parent Cash Flows
(25% Discount Rate)
25. Initial Investment by
Parent
26. Cumulative PV
157,400
152,000
362,000
409,040
461,725
520,732
586,820
660,838
743,738
836,587
39,350
38,000
90,500
102,260
115,431
130,183
146,705
165,209
185,935
209,147
118,050
114,000
271,500
306,780
346,294
390,549
440,115
495,628
557,804
627,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
657,440
14,805
14,400
30,150
33,678
37,629
42,055
47,011
52,563
58,780
65,744
133,245
129,600
271,350
303,102
338,664
378,494
423,103
473,066
529,023
591,696
650,000
$0.02185 $0.02076 $0.01972 $0.01873 $0.01780 $0.01691 $0.01606 $0.01526 $0.01450 $0.01377
2,911,403 2,690,172 5,350,920 5,678,205 6,027,194 6,399,240 6,795,781 7,218,352 7,668,585 17,099,337
2,329,123 1,721,710 2,739,671 2,325,793 1,974,991 1,677,522 1,425,179 1,211,039 1,029,260 1,836,027
$12,650,000
(10,320,877) (8,599,167) (5,859,496) (3,533,703) (1,558,712)
118,810 1,543,989 2,755,027 3,784,287 5,620,315
Chapter 14: Multinational Capital Budgeting
257
Solution to Supplemental Case: North Star Company
a. The analysis based on total parent financing is shown below using the somewhat stable exchange
rate scenario (in 1,000s):
0
S$ Cash Flows (excluding
S$ interest payments)
1
2
3
4
5
6
S$8,000
S$10,000
S$14,000
S$16,000
S$16,000
S$16,000
0
0
0
0
0
0
S$ Cash Flows (after
accounting for interest
payments)
S$8,000
S$10,000
S$14,000
S$16,000
S$16,000
S$16,000
S$ Cash Flows to be
Remitted (50% of CF)
S$4,000
S$5,000
S$7,000
S$8,000
S$8,000
S$8,000
Withholding Tax (10%)
S$400
S$500
S$700
S$800
S$800
S$800
S$3,600
S$4,500
S$6,300
S$7,200
S$7,200
S$7,200
S$ Interest Payments
S$ Cash Flows to be
Converted to $
Salvage Value
S$30,000
Exchange Rate of S$
$ Cash Flows
Present Value Interest
Factor (18%)
Present Value
Initial Outlay
$.50
$.51
$.48
$.50
$.52
$.48
$1,800
$2,295
$3,024
$3,600
$3,744
$17,856
.8475
.7182
.6086
.5158
.4371
.3704
$1,525.500 $1,648.269 $1,840.406 $1,856.880 $1,636.502 $6,613.862
$20,000
–$4,878.580
NPV
Applying the same procedure from the previous table, the NPV for each exchange rate scenario is:
Exchange Rate Scenario
I. Somewhat stable S$
II. Weak S$
III. Strong S$
Probability
60%
30%
10%
NPV
–$4,878,580
–$6,693,440
–$105,387
The analysis based on partial financing by the subsidiary is shown below using the somewhat
stable exchange rate scenario.
258
International Financial Management
0
(Cash amounts in thousands)
1
2
3
4
5
6
S$14,000
S$16,000
S$16,000
S$16,000
S$1,600
S$1,600
S$1,600
S$1,600
S$1,600
S$6,400
S$8,400
S$12,400
S$14,400
S$14,400
S$14,400
S$3,200
S$4,200
S$6,200
S$7,200
S$7,200
S$7,200
S$320
S$420
S$620
S$720
S$720
S$720
S$2,880
S$3,780
S$5,580
S$6,480
S$6,480
S$6,480
S$ Cash Flows (excluding
S$ interest payments)
S$8,000
S$10,000
S$ Interest Payments
S$1,600
S$ Cash Flows (after
accounting for interest
payments)
S$ Cash Flows to be
Remitted (50%)
Withholding Tax (10%)
S$ Cash Flows to be
Converted to $
Salvage Value
S$20,000
Exchange Rate of S$
$ Cash Flows
Present Value Interest
Factor (18%)
Present Value
Initial Outlay
$.50
$.51
$.48
$.50
$1,440
$1,927.8
$2,678.4
$3,240
.8475
.7182
.6096
.5158
$.52
$.48
$3,369.6 $12,710.4
.4371
.3704
$1,219.68 $1,384.16 $1,631.145 $1,671.84 $1,472.515 $4,702.848
$10,000
NPV
$2,086,997
Applying the same procedure from the previous table, the NPV for each exchange rate scenario is:
Exchange Rate Scenario
I. Somewhat stable S$
II. Weak S$
III. Strong S$
Probability
60%
30%
10%
NPV
$2,086,997
$649,510
$5,766,642
For each possible scenario, partial subsidiary financing leads to more favorable results. Thus, this
method of financing should be chosen.
b. The parent’s required rate of return may increase if the borrowed funds by the subsidiary create a
higher degree of financial leverage for the MNC as a whole, which could increase the risk
perception of the MNC. If so, the discount rate used should reflect the higher required rate of
return.
c. When using a 20 percent withholding tax instead of a 10 percent withholding tax, the results
change as follows (based on partial financing by the subsidiary):
Chapter 14: Multinational Capital Budgeting
Exchange Rate Scenario
I. Somewhat stable S$
II. Weak S$
III. Strong S$
259
Probability
60%
30%
10%
NPV
$1,139,090
–$196,292
$4,599,202
The results suggest that with a 20 percent withholding tax, there is a 70 percent chance that the
subsidiary will still generate a positive NPV. The potential negative NPV in the event of a weak
S$ is not as pronounced as the positive NPVs if either of the other events occur. Most managers
would likely still recommend accepting the project under these circumstances.
d. The estimate of net cash flows could be revised, which would result in a lower NPV for each
exchange rate scenario. The accept/reject decision would be based on the overall distribution of
possible NPVs.
e. As of the end of Year 2, the present value of forgone cash flows for the following 4 years
(including the forgone salvage value at the end of Year 6) is $13,203,674. Therefore, North Star
should receive at least this amount in order to divest the subsidiary as of the end of Year 2.
Small Business Dilemma
Multinational Capital Budgeting by the Sports Exports Company
1. Describe the capital budgeting steps that would be necessary to determine whether this proposed
project is feasible, as related to this specific situation.
ANSWER: Jim would need to estimate the amount of footballs that would be sold to the
distributor in Mexico each month. The revenue to be received would be equal to the number of
footballs sold times the price (in pesos) per football. This revenue would be converted into dollars,
at the prevailing exchange rate. The value of the peso can change abruptly over time. The peso’s
value must be forecasted for each month, so that the dollar cash inflows can be estimated.
The cash outflows are the expenses of hiring a full-time employee to perform the production and
the leasing of one more warehouse. These cash outflows are in dollars and therefore are not
directly affected by a change in the value of the peso.
Once the dollar cash inflows and outflows are estimated, they can be used to derive the net cash
flows. Then the net cash flows can be discounted to determine the present value of net cash flows.
This project does not have an initial outlay, other than initial lease payment on the warehouse and
perhaps a bulk purchase of material to produce the footballs. The present value of cash flows
would be compared to any initial expenses that represent the initial outlay, so that the net present
value of the project could be determined.
260
International Financial Management
2. Explain why there is uncertainty surrounding the cash flows of this project.
ANSWER: First, the number of footballs to be sold is very uncertain. The firm is attempting to
sell a product in a country where the product has not been popular. The quantity of footballs
demanded affects the peso revenue and the cost of production. Also, the value of the peso is very
uncertain. If the peso’s value is lower than anticipated in the future, the dollar revenue to be
received would likely be less than anticipated.