The Investment Decision in the International Context

1
The Investment Decision in the International
Context
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Topics

• Basic capital budgeting (review)
• Special problems evaluating international
  projects
• Technical issue
• Adjusted Present Value (APV)
• Cash Flow issues

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Basic Capital Budgeting (review)
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Basic Capital Budgeting (review)

• I. Steps in Capital Budgeting
• Project Cash Flow
• Calculate NPV
• II. Key Issues
• Predicting cash flows
• Choosing approriate discount factor

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Basic Capital Budgeting (review)

• I. Cash flow projection
• Calculate Net Operating Cash Flows
• Tax Calculation
• depreciation
• taxable income
• tax

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Basic Capital Budgeting (review)

• I. Cash flow projection (continuation)
• After Tax Income
• After Tax Cash Flows (add back depreciation)
• Investment Cash Flows
• Net after-tax Cash Flows

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Basic Capital Budgeting (review)

• II. PV Calculation and Decision
• Compute NPV (or IRR etc.) and make decision
• based on net cash flows
• normally use WACC

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Example Wilcox Enterprises

• Initial investment 10 M
• Net after-tax CF 1.75M / year perpetuity
• Expected return to equity 21
• Expected return to debt 14
• Effective marginal tax rate 35
• Debt/Value ratio 50

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Discussion Discount factor issues

• Why use WACC of the firm to evaluate a specific
  project?
• WACC is valid under the assumption
• The project replicates the firm.

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Discussion Discount factor issues

• WACC is valid if the project replicates the firm
  with respect to
• Risk expected return required by market
• Components of WACC formula
• Debt ratio
• Effective marginal tax rate

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Weighted average cost of capital
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Discussion Discount factor issues

• WACC is appropriate discount factor when
• The new project has the same risk profile as the
  firm as a whole
• The new project uses the same financial structure
  as the firm as a whole
• No special financing connected to the project
• Financing for the project is taxed the same way
  as all other financing for the firm

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Discussion Cash flow issues

• Most cash flow issues do not affect validity of
  WACC as a discount factor. (Unless they raise
  one of the above issues.)
• However, if WACC must be abandoned, it does have
  implications for cash flows considered.
  Specifically cash flows related to financing
  (which are normally ignored) must be considered.

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Cash flows ignored using WACC

• Financing for the project
• Example Financing for the previous WE example
  involved receiving 5M in proceeds of a bond
  issue annual interest payments (at 14) of
  700,000 and an ultimate repayment of the 5M.
• Why are these cash flows ignored?

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Cash flows ignored using WACC

• Tax shields from financing
• Example In addition, deducting these interest
  payments from income results (at a 35 tax rate)
  in a savings of 245,000 per year.
• Why are these cash flows ignored in evaluating
  the project?

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Conclusion on WACC

• If the assumptions required for WACC to be valid
  do not hold,
• It may be necessary to use a different discount
  factor
• Cash flows associated with the financing of the
  project must also be considered explicitly

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Special problems evaluating international projects
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Special problemsLocal cash flows

• Sovereign Risk risk of
• sudden regulatory change
• even expropriation
• Opportunity for
• concessionary financing
• tax holiday
• Guaranteed markets or supplies

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Special problemsLocal cash flows

• Opportunities for special financial structure
• for example project finance
• Differences in tax treatment

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Special problemsGetting Funds Home

• Currency value (exchange rate risk)
• Possible funds blockage (political risk)
• Tax consequences

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Other issues particularly common in international
projects

• Spillover effects impacting rest of MNE
• Real options
• for example follow-on projects

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Consequences of special problems for
international capital budgeting

• Virtually all of these issues affect estimation
  of cash flows
• Those that affect the risk of the project, offer
  opportunities for special financial structure, or
  affect tax treatment of financing invalidate the
  WACC approach
• In these cases APV should be used.

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Adjusted Present Value
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Calculating APV

• Determine after-tax cash flows for the project
  itself.
• Find cash flows (positive and negative) of
  financing including value of tax shields
• Calculate NPV of these net cash flows using the
  opportunity cost of capital for the project.

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Calculating APV(continued)

• Determine the amount of additional debt that must
  now be issued (or liquidated) to restore the
  parent to its target debt ratio.
• Calculate the value of the tax shield created
  (lost) as a result of the additional debt.
• Calculate the present value of the tax shield
  using the after-tax cost of debt.

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Calculating APV(continued)

• 7. Add the PV of the tax shields from the
  adjustment to the PV of the project and its
  financing to obtain APV

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Example Wilcox Enterprises

• Suppose the expansion project of the previous
  example is to be built in Taiwan instead of at
  home. All facts about the cost and cash flows of
  the project as well as about the cost of capital
  to WE continue to apply.

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Example Wilcox EnterprisesAdditional Information

• If the project is built in Taiwan, the
  opportunity cost of capital (the cost when
  all-equity financing is used) is 18
• The effective marginal tax rate for operations in
  Taiwan is 20.

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Example Wilcox EnterprisesAdditional Information

• The Taiwanese government has offered a loan of
  7M at 5 interest if the project is built.
  Interest is to be paid in annual installments
  with the principal repaid at the end of five years

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Cash Flow Issues
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Three-stage cash flow projections

• Project cash flows from the subsidiarys point of
  view. (local currency)
• Project cash transfers to parent and their costs
  including tax consequences
• Adjust for spillovers affecting the rest of the
  global enterprise

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Local Cash Flows

• Allow for effects of local regulations, legal
  system, culture etc. in estimating cash flows
• Political Risk (Scenario analysis)

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Transfers and their Cost

• Exchange rates (use forward rates where possible
• Risk of currency blockage (political risk)
• Taxes
• Local Dividend withholding or other taxes owed
  when repatriating profits
• U.S. The project generates foreign tax credits
  usable against other foreign income or additional
  U.S. taxes will be due on the repatriated income.

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Impact on the rest of the MNE

• Adjust for spillovers and intangible
  cost/benefits that are not reflected in the
  projects financial statements
• Remove misleading effects of transfer pricing,
  fees and royalties
• Adjust for value of real options generated

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Global cost/benefits

• Spillovers
• Cannibalization of sales of other units
• Creation of incremental sales by other units
• Intangible benefits
• Diversification of production facilities
• Diversification of markets
• Provision of a key link in a global service
  network
• Knowledge of competitors, technology, markets, or
  products

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Transfer prices

• Transfer prices are internal prices used for
  transfers of goods within the MNE.
• If they do not reflect market value, using them
  to calculate cash flows can distort the value of
  a project

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Remove misleading effects of Transfer Pricing

• Use market costs/prices for goods, services and
  capital transferred internally.
• Add back fees and royalties to project cash
  flows, because they are benefits to the parent.
• Remove the fixed portion of such costs as
  corporate overhead.

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Real Options

• Example

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The Goldmine

• This year
• Cost to prepare mine 1 million
• Gold that will be made accessible 40,000 oz.
• Next year
• Cost to extract gold 390/oz.
• Expected price of gold 400/oz.
• Question To prepare the mine or not
• Required return 15

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Expected NPV calculation

• Resoundingly rejects the project
• Expected CF next year
• 40,000(400-390) 400,000
• Expected NPV
• 400,000/1.15 -1,000,000 -652,174
• Fallacy This approach ignores the option not to
  produce next year.

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Next years gold market

• The gold market will be either good or bad with
  equal probability
• If good, gold will be worth 500/oz.
• If bad, gold will be worth 300/oz.
• Note expected value of gold is still 400/oz.

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The decision tree

• Preparing the gold mine buys you a (real) option
  because you get to wait until you know the price
  of gold before deciding whether to extract it or
  not.

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If gold market is bad

• Clearly you will not choose to spend 390/oz. to
  extract gold worth 300/oz.
• Instead, the mine will stand idle.
• Thus, cash flows will be zero if the market turns
  out to be bad.

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If gold market is good

• Extracting the gold will be worthwhile
• PV40,000(500-390)/1.15
• 4,400,000/1.15
• 3,826,000

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Value of the option

• Thus the value of the real option is
• 0.50 0.5 3,826,000 1,913,000
• In fact it is worth spending the 1 million to
  acquire this option

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NoteVolatility increases option value

• Suppose gold price were even more volatile (but
  with same expected value)
• In good market price 600
• In bad market price 200
• Present value of cash flow in good market
  increases to
• 8,400/1.15 7,304,000

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Volatility effect (continued)

• In bad market, cash flows remain zero
• The value of the option thus increases to 0.50
  0.5 7,304,000 3,652,000
• Investing the initial 1 million is even more
  attractive