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International Financial Management

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x ow does domestic capital budgeting differ from
multinational capital budgeting?
x ow do incremental cash flows differ from total
project cash flows?
x What is the difference between foreign project cash
flows and parent cash flows?
x ow does APV analysis differ from NPV analysis?
x ow is the capital budgeting analysis adjusted for the
additional economic and political risks?
x What is real option analysis?

  

 
  
x ueveral factors make budgeting for a foreign project
more complex
x Parent cash flows must be distinguished from project
x Parent cash flows often depend on the form of
financing, thus cannot clearly separate cash flows from
financing
x Additional cash flows from new investment may in part
or in whole take away from another subsidiary; thus as
stand alone may provide cash flows but overall adds
no value to entire organization
x Parent must recognize remittances from foreign
investment because of differing tax systems, legal and
political constraints

  

 
  
x An array of non-financial payments can generate cash
flows to parent in form of licensing fees, royalty
payments, etc.
x Managers must anticipate differing rates of national
inflation which can affect differing cash flows
x Use of segmented national capital markets may create
opportunity for financial gain or additional costs
x Use of host government subsidies complicates capital
structure and parent¶s ability to determine appropriate
WACC
x Managers must evaluate political risk
x Terminal value is more difficult to estimate because
potential purchasers have widely divergent views

 

 


x NPV Analysis


 

  
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x If Projects are independent, those with a positive NPV

will be accepted while those with a negative NPV will
be rejected
x It two projects are mutually exclusive, the project with
the highest NPV greater than zero will be accepted.
x The discount rate, k, is the expected rate of return on
projects of similar risk as the riskiness of the firm as a
whole.
  

x Consistent with the goal of maximizing
shareholder wealth.
x Focuses on cash flows rather than
accounting profits.
x Emphasizes the opportunity cost of money
invested.
x Obeys the additivity principle.
2  

 
x Only the „

„ cash flows generated by
the project are „
„.
x The difference between total and incremental
cash flows arises from:
x Cannibalization
x uales creation
x Opportunity cost
x Transfer prices
x Fees and royalties
   

x The „ 
„  is represented by the
worldwide corporate cash flows without the
investment.
x In a competitive world, the base case needs
to be adjusted for competitive behavior.
x New product
x New production technology
x Intangible benefits
    


x Project risks and financial structures „ by
country, production state, and position in the
life cycle of the project.
x üather than modifying the WACC, cash flows
can be discounted at an „ 

„, k*.
„ 

„
x üeflects only the riskiness of the project¶s
expected future cash flows.
x Abstracts from the project¶s financial structure.
x Can be viewed as the company¶s cost of
capital if it were all-equity financed, that is,
with zero debt.


!"# 
x The all-equity rate is based on the CAPM:

k* = rf + ȕ* (rm ± rf)

x ȕ* is the all-equity or unlevered beta

x A levered equity beta, ȕe, is unlevered using
the following equation:



 ·

  

    
 
x The value of a project is equal to the sum of
the following components:
x PV of after-tax project cash flows but before
financing costs discounted at k*.
x PV of tax savings on debt financing
discounted at the before-tax dollar cost of
debt, id.
x PV of any savings or penalties on interest
costs associated with project-specific financing
discounted at the before-tax dollar cost of
debt, id.
    
 

  

 

· 2 - 

 
 

 
 

 


x Tt = tax savings in year t due to the specific

financing package
x ut = before-tax dollar value of interest
subsidies (penalties)
x id = before-tax dollar cost of debt
2  2  

x uhould cash flows be measured from the
viewpoint of the project or that of the parent?

x uhould the additional economic and political

risks that are uniquely foreign be reflected in
cash flow or discount rate adjustments?
    

x Most firms evaluate foreign projects from both
parent and project viewpoints
x The parent¶s viewpoint analyses investment¶s
cash flows as operating cash flows instead of
financing due to remittance of royalty or
licensing fees and interest payments
x The parent¶s viewpoint gives results closer to
traditional NPV capital budgeting analysis
x Project valuation provides closer
approximation of effect on consolidated EPu
    
 
x Project and parent cash flows can

significantly due to:
x Tax regulations
x Exchange controls
x Fees and royalties
x Transfer pricing
x Other factors
 !$  
x utage1:
x Project cash flows are computed from the
subsidiary¶s perspective.
x utage 2:
x Project cash flows to the parent are evaluated
on the basis of specific forecasts concerning
the amount, timing, and form of remittance.
x utage 3:
x Account for the additional benefits and costs
of the project.
2  
 
 
x Estimating a project¶s true profitability
requires various adjustments to the project
cash flows:
x Adjust for the effects of transfer pricing and
fees and royalties.
x Adjust for global costs/benefits that are not
reflected in the project¶s financial statements.
x Cannibalization
x uales creation
x Additional taxes
x Diversification of production facilities and markets

x Only „
„ „ cash flows are relevant.
x Actual taxes paid are a function of:
x Time of remittance
x Form of remittance
x Foreign income tax rate
x Withholding taxes
x Tax treaties
x Foreign tax credits

x Computing the tax liabilities of foreign
investments assumes that:
x The maximum amount of funds are available
for remittance each year.
x The tax rate applied is the higher of the home
or host country rate.
%2


x uuppose that an affiliate will remit after-tax earnings
of $120,000 to its U.u. parent in the form of a
dividend. Assume the foreign tax rate is 20%, the
withholding tax on dividends is 4%, and excess
foreign tax credits are unavailable.
x What is the additional tax owed to the U.u.
government?
x What is the marginal rate of additional taxation?


"&

x There are  main methods for
incorporating the additional political and
economic risks into a foreign investment
analysis:
x uhortening the payback period
x üaising the required rate of return of the
investment
x Adjusting the cash flows to reflect the specific
impact of a given risk.
x Uncertainty absorption
x Adjusting the expected value of future cash flows
"   2

x The analysis should also consider the appreciation or
depreciation of the Uu dollar.
x Approach A:
x Convert nominal foreign currency cash flows into
nominal home currency terms.
x Discount those nominal cash flows at the nominal
domestic required rate of return.
x Approach B:
x Discount the nominal foreign currency cash flows at
the nominal foreign currency required rate of return.
x Convert the resulting foreign currency present value
into the home currency using the current spot rate.


&

x The preferred method is to adjust the cash
flows of the project to reflect the impact of a
particular political event on the present value
of the project to the parent.

x The biggest risk is:

x Expropriation
x Blocked funds
"  %2


x uuppose a firm projects a $5 million perpetuity from
an investment of $20 million in upain. If the required
return on this investment is 20%, how large does the
probability of expropriation in year 4 have to be
before the investment has a negative NPV? Assume
that all cash flows occur at the end of the year and
that the expropriation, if it occurs, will occur prior to
the year 4 cash inflows or not at all. There is no
compensation in the event of expropriation.
 
 

x DCF analysis cannot capture the value of the
strategic options, yet real option analysis
allows this valuation.
x üeal option analysis includes the valuation of
the project with future choices such as:
x The option to defer
x The option to abandon
x The option to alter capacity
x The option to start up or shut down (switching)
 
 

x üeal option analysis treats cash flows in
terms of future value in a positive sense
whereas DCF treats future cash flows
negatively (on a discounted basis).
x The valuation of real options and the
variables¶ „


 is similar to equity option
math.
x An expanded NPV rule consists of the
traditional DCF analysis a the value of an
option.