IBUS 302:
International Finance
Topic 16-International
Capital Budgeting
Lawrence Schrenk, Instructor
1 (of 30)
Learning Objectives
1.
2.
3.
4.
Explain the process of capital budgeting▪
Discuss how the process changes in an
international environment.
Calculate a cross-border NPV from the
parent firm’s perspective.
Describe some uses of real options in
capital budgeting.▪
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Domestic Capital
Budgeting
3 (of 30)
NPV

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
NPV is the present value of future cash flows
minus the initial net cash outlay for the
project discounted at the project’s cost of
capital.
Assuming the goal of maximizing shareholder
wealth, any project with a positive NPV
should be pursued.
Generally, the source of financing is
irrelevant to the investment decision.
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NPV Advantages

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Evaluates investment in the same manner as
a company’s shareholders.
Focuses in on cash and not accounting
profits
Emphasizes the opportunity cost of the
money invested.
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NPV Difficulties

Estimating cash flows.

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The cost of the project
The cash inflows during the life of the
project (especially hard where there are
relevant spillovers–cannibalization or
sales creation)
The terminal or ending values of the
project.
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“Domestic” NPV Calculations
1. Estimate Future Cash Flows E[CFt]


Include only incremental cash flows
Include all opportunity costs
The algebra of cross-border investment analysis
“Domestic” NPV Calculations
2. Identify Risk-Adjusted Discount Rate


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Discount nominal CFs at nominal discount rates and
real CFs at real discount rates
Discount equity CFs at equity discount rates and
debt CFs at debt discount rates
Discount CFs to debt and equity at the WACC
Discount cash flows in a particular currency at a
discount rate in that currency
The algebra of cross-border investment analysis
“Domestic” NPV Calculations
3. Calculate net present value NPV

Based on expected future cash flows and the
appropriate risk-adjusted discount rate
The algebra of cross-border investment analysis
International Capital
Budgeting
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New Issues

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Which Currency to Use
Exchange Rate Risk
Does Purchasing Power Parity Hold
Foreign & Domestic Tax Rates
Cost of Capital
Special elements:


Political Risk
Subsidies
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Two Valuation Methods

NPV


Traditional NPV analysis extended to int’l projects
APV (valuation by parts)


APV = PV[OCF] + PV[Project costs & benefits]
Project costs & benefits:


PV of tax shields
PV of financial subsidies
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Net Present Value
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International Capital
Budgeting


Foreign projects generate cash flows in a
foreign currency.
Two Approaches


Approach 1: Foreign Project
Approach 2: Parent Firm
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Approach 1: Project’s (Local)
Perspective

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Estimate cash flows in foreign
currency
Discount in the foreign currency
Find the foreign currency NPV
Convert foreign currency NPV to a
domestic currency value at the spot
exchange rate.
The algebra of cross-border investment analysis
Approach 2: Parent’s
Perspective

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

Estimate cash flows in foreign
currency
Convert foreign cash flows into the
domestic currency at expected future
spot rates
Discount in the domestic currency
Find the domestic NPV
The algebra of cross-border investment analysis
Approach 1: Discount in the
Foreign Currency
1. Estimate future cash flows E[CFtf]
2. Identify discount rate
3. Calculate net present value
Calculate NPV
Convert to the domestic currency
E[CF1f ]
NPV0f
NPV0d= S0d/f NPV0f
The algebra of cross-border investment analysis
E[CF2f ]
if
Approach 2: Discount in the
Domestic Currency
1. Estimate E[CFtd] = E[Std/f ] E[CFtf ]
2. Identify discount rate
3. Calculate net present value NPV
E[CF1f ]
E[CF2f ]
E[CFtd ] = E[Std/f ] E[CFtf ]
NPV0
The algebra of cross-border investment analysis
Two Approaches

You should have two equally valid
approaches:


Change the foreign cash flows into dollars at the
exchange rates expected to prevail. Find the
$NPV using the dollar cost of capital.
Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars
at the spot exchange rate.
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PPP
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PPP must hold.
Over the life of the project
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
Differential Inflation
FX rates must change to compensate
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WACC

If PPP holds:
1  W ACC$
1 W ACCx

1 $
1  x
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Approach 2: Simple Example

U.S. parent considers building a Swiss
factory (millions)

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Initial cost:
S($/SF):
$50
.50
Projected SF cash flows
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Year 1:
Years 2-5:
Year 5
10 SF net revenues
revenue growth @ 2%
100 SF Salvage/Terminal
Value of Factory
Approach 2: Simple Example

Exchange rate forecast:

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
Swiss inflation forecast:
U.S. inflation forecast:
Predicted SF appreciation:
PPP
2%/year
3%/year
1%/year
NPV Calculation
Year
0
Cash Flows ($)
($50.00)
1
2
3
4
5
Cash Flows (SF)
S($/SF)
Cash Flows ($)
PV(Cash Flows
$)
NPV
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NPV Calculation
Year
0
Cash Flows ($)
($50.00)
Cash Flows (SF)
1
2
3
SFr. 10.00 SFr. 10.20 SFr. 10.40
4
5
SFr. 10.61 SFr. 110.82
S($/SF)
Cash Flows ($)
PV(Cash Flows
$)
NPV
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NPV Calculation
Year
0
Cash Flows ($)
($50.00)
Cash Flows (SF)
S($/SF)
1
2
3
SFr. 10.00 SFr. 10.20 SFr. 10.40
$0.5000
$0.5050
$0.5101
$0.5152
4
5
SFr. 10.61 SFr. 110.82
$0.5203
$0.5255
Cash Flows ($)
PV(Cash Flows
$)
NPV
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NPV Calculation
Year
0
Cash Flows ($)
($50.00)
Cash Flows (SF)
1
2
3
SFr. 10.00 SFr. 10.20 SFr. 10.40
4
5
SFr. 10.61 SFr. 110.82
S($/SF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
Cash Flows ($)
PV(Cash Flows
$)
($50.00)
$5.05
$5.20
$5.36
$5.52
$58.24
NPV
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NPV Calculation
Year
0
Cash Flows ($)
($50.00)
Cash Flows (SF)
1
2
3
SFr. 10.00 SFr. 10.20 SFr. 10.40
4
5
SFr. 10.61 SFr. 110.82
S($/SF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
Cash Flows ($)
PV(Cash Flows
$)
($50.00)
$5.05
$5.20
$5.36
$5.52
$58.24
($50.00)
$4.59
$4.30
$4.03
$3.77
$36.16
NPV
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NPV Calculation
Year
0
Cash Flows ($)
($50.00)
Cash Flows (SF)
1
2
3
SFr. 10.00 SFr. 10.20 SFr. 10.40
4
5
SFr. 10.61 SFr. 110.82
S($/SF)
$0.5000
$0.5050
$0.5101
$0.5152
$0.5203
$0.5255
Cash Flows ($)
PV(Cash Flows
$)
($50.00)
$5.05
$5.20
$5.36
$5.52
$58.24
($50.00)
$4.59
$4.30
$4.03
$3.77
$36.16
NPV
$2.85
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Political Risk Adjustment

Political Risk


Clearly risk and return are correlated.
Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.
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Sensitivity Analysis

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
In the APV model, each cash flow has a
probability distribution associated with it.
Hence, the realized value may be different
from what was expected.
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.
Real Options

The application of options pricing theory to
the evaluation of investment options in real
projects is known as real options.


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A timing option is an option on when to make the
investment.
A growth option is an option to increase the scale
of the investment.
A suspension option is an option to temporarily
cease production.
An abandonment option is an option to quit the
investment early.