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Chapter 18

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Chapter 18
Multinational Capital Budgeting
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Multinational Capital Budgeting
Extension of the domestic capital budgeting analysis to evaluate a Greenfield foreign projectDistinctions between the project viewpoint & the parent viewpoint when analyzing a potential foreign investmentAdjusting the capital budgeting analysis of a foreign project for riskIntroduction of the use of real option analysis as a complement toDCFanalysis in the evaluation of potential international investments
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Multinational Capital Budgeting
Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projectsCapital budgeting follows same framework as domestic budgetingIdentify initial capital invested or put at riskEstimate cash inflows, including the terminal value or salvage value of the investmentIdentify appropriate discount rate forNPVcalculationDetermine theNPVandIRR
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Complexities of Budgeting for a Foreign Project
Several factors make budgeting for a foreign project more complexParent cash flows must be distinguished from projectParent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing – this changes the meaning ofNPVAdditional cash flows from new investment may in part or in whole take away from another subsidiary; thus as a stand alone a project may provide cash flows but overall may add no value to the entire organizationParent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints
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Complexities of Budgeting for a Foreign Project
Non-financial payments can generate cash flows to parent in the form of licensing fees, royalty payments, etc. – relevant for parent’s perspectiveManagers must anticipate differing rates of national inflation which can affect cash flowsUse of segmented national capital markets may create opportunity for financial gains or additional costsUse of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACCManagers must evaluate political riskTerminal value is more difficult to estimate because potential purchasers have widely divergent views
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Project versus Parent Valuation
Most firms evaluate foreign projects from both parent and project viewpointsThe parent’s viewpoint analyzes investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest paymentsFunds that are permanently blocked from repatriation are excludedThe parent’s viewpoint gives results closer to traditionalNPVcapital budgeting analysisProject valuation provides closer approximation of effect on consolidated EPS
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Project versus Parent Valuation
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Foreign Investment
US$ invested in overseas
Particular investment
Project ViewpointCapital Budget(Local Currency)
Estimated cash flowsof project
Parent ViewpointCapital Budget(U.S. dollars)
Cash flows remitted
to Parent (FC to US$)
ENDIs the project investmentJustified (NPV > 0)?
Parent Firm (US)
START
Project Assumptions
Financial assumptionsCapital Investment – cost to build a plantFinancing – depending on financing methods WACC should be calculated for both the project and parentRevenuesCostsExchange rate assumption – parent’s cash flows are converted into home currency
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Estimating Cash Flows from Project Viewpoint
Project Viewpoint Capital BudgetEstimate the free cash flows of the project by determining EBITDA and notEBTTaxes are calculated based on this amountNet Operating Cash Flow = Net Operating Profit After TaxNOCF=NOPAT
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Estimating Cash Flows from Project Viewpoint (Continued)
Project Viewpoint Capital BudgetEstimate and incorporate net working capital and capital spendingFree Cash Flow (FCF) = Net Operating Cash Flow – Changes in Net Working Capital – Changes in Fixed Assets
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Estimating Cash Flows from Project Viewpoint (Continued)
Project Viewpoint Capital BudgetTerminal value is calculated for the continuing value of the project after the investment horizonTV is calculated as a perpetual net operating cash flow after the investment horizonAllFCFsand Terminal Value is discounted using subsidiary WACC.
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Parent Viewpoint
Parent Viewpoint Capital BudgetCash flows estimates are constructed from parent’s viewpointEstimate individual cash flows to parent after adjusting for withholding taxes. These cash flows must be in parent firm’s currencyUse parent firm’s investment in subsidiary to determineNPVat parent’s WACCParent must now use it’s cost of capital and not the project’sParent may require an additional yield for international projects
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Sensitivity Analysis
Project Valuation Sensitivity AnalysisPolitical risk – biggest risk is blocked funds or expropriationAnalysis should build in these scenarios and answer questions such as how, when, how much, etc.Foreign exchange riskAnalysis should also consider appreciation or depreciation of the US dollar
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Real Options
Real Option AnalysisDCFanalysis cannot capture the value of the strategic options, yet real option analysis allows this valuationReal option analysis includes the valuation of the project with future choices such asThe option to deferThe option to abandonThe option to alter capacityThe option to start up or shut down (switching)
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Real Options (Continued)
Real Option AnalysisReal option analysis treats cash flows in terms of future value in a positive sense whereasDCFtreats future cash flows negatively (on a discounted basis)The valuation of real options and the variables’ volatilities is similar to equity option math
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Chapter 18