Multinational Capital Budgeting

1
Multinational Capital Budgeting
14
Chapter
2
Chapter Objectives

• To compare the capital budgeting analysis of an
  MNCs subsidiary with that of its parent
• To demonstrate how multinational capital
  budgeting can be applied to determine whether an
  international project should be implemented and
• To explain how the risk of international projects
  can be assessed.

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Subsidiary versus Parent Perspective

• Should the capital budgeting for a multi-national
  project be conducted from the viewpoint of the
  subsidiary that will administer the project, or
  the parent that will provide most of the
  financing?
• The results may vary with the perspective taken
  because the net after-tax cash inflows to the
  parent can differ substantially from those to the
  subsidiary.

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Subsidiary versus Parent Perspective

• Such differences can be due to
• Tax differentials
• What is the tax rate on remitted funds?
• Regulations that restrict remittances
• Excessive remittances
• The parent may charge its subsidiary very high
  administrative fees.
• Exchange rate movements

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Remitting Subsidiary Earnings to the Parent
6
Subsidiary versus Parent Perspective

• A parents perspective is appropriate when
  evaluating a project, since any project that can
  create a positive net present value for the
  parent should enhance the firms value.
• However, one exception to this rule occurs when
  the foreign subsidiary is not wholly owned by the
  parent.
• So, the way to decide the project to be either
  subsidiary perspective or Parent perspective is
  look upon the share holder. If share holders are
  from subsidiary country, it would be subsidiary
  perspective unless otherwise.

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Input for MultinationalCapital Budgeting

• The following forecasts are usually required
• 1. Initial investment
• 2. Consumer demand over time
• 3. Product price over time
• 4. Variable cost over time
• 5. Fixed cost over time
• 6. Project lifetime
• 7. Salvage (liquidation) value

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Input for MultinationalCapital Budgeting
The following forecasts are usually required
8. Restrictions on fund transfers

• 9. Tax payments and credits
• 10. Exchange rates
• 11. Required rate of return

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MultinationalCapital Budgeting Techniques

• Capital budgeting is necessary for all long-term
  projects that deserve consideration.
• One common method of performing the analysis
  involves estimating the cash flows and salvage
  value to be received by the parent, and then
  computing the net present value (NPV) of the
  project.

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MultinationalCapital Budgeting

• NPV initial outlay
• n
• S cash flow in period t
• t 1 (1 k )t
• salvage value
• (1 k )n
• k the required rate of return on the project
• n project lifetime in terms of periods
• If NPV gt 0, the project can be accepted.

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Example

• Spartan, Inc. is considering the development of a
  subsidiary in Singapore that will manufacture and
  sell tennis rackets locally.
• Initial investment 20 million Singapore dollars
  (S) which is 10 million at .50 per Singapore
  dollar. Project life 4 years. Price and demand
  1st yr, 2nd, 3rd, 4th yrs price S S 350, S
  350, S 360, S 380 and demand 60000, 60000,
  100000,100000 units respectively.
• Costs Variable cost per unit of 1st ,2nd, 3rd,
  4th are S 200, S 200, S 250, S 260.The
  expense of leasing extra office space is S 1
  million per year and other annual overhead
  expenses are expected to be S1 million per year.
• Exchange rate Spot rate is .50 which will be
  assumed same over the years. Host country taxes
  on income earned by subsidiary 20 percent tax
  rate on income. Also have withholding tax of 10.
  And the remitted fund will not be taxed further
  in US. Depreciation at a maximum rate of 2
  million per year. Salvage Value S 12 million.
  Required rate of return 15.

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Capital Budgeting Analysis Spartan, Inc.
13
Capital Budgeting Analysis Spartan, Inc.
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Capital Budgeting Analysis

• 
  Period t
• 1. Demand (1)
• 2. Price per unit (2)
• 3. Total revenue (1)?(2)(3)
• 4. Variable cost per unit (4)
• 5. Total variable cost (1)?(4)(5)
• 6. Annual lease expense (6)
• 7. Other fixed annual expenses (7)
• 8. Noncash expense (depreciation) (8)
• 9. Total expenses (5)(6)(7)(8)(9)
• 10. Before-tax earnings of subsidiary (3)(9)(10
  )
• 11. Host government tax tax rate?(10)(11)
• 12. After-tax earnings of subsidiary (10)(11)(1
  2)

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Capital Budgeting Analysis

• 
  Period t
• 13. Net cash flow to subsidiary (12)(8)(13)
• 14. Remittance to parent (14)
• 15. Tax on remitted funds tax rate?(14)(15)
• 16. Remittance after withheld tax (14)(15)(16)
• 17. Salvage value (17)
• 18. Exchange rate (18)
• 19. Cash flow to parent (16)?(18)(17)?(18)(19)
• 20. PV of net cash flow to parent (1k) -
  t?(19)(20)
• 21. Initial investment by parent (21)
• 22. Cumulative NPV ?PVs(21)(22)

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Factors to Consider in Multinational Capital
Budgeting

• Exchange rate fluctuations
• Since it is difficult to accurately forecast
  exchange rates, different scenarios can be
  considered together with their probability of
  occurrence.

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Analysis Using Different Exchange Rate Scenarios
Spartan, Inc.
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Sensitivity of the Projects NPV to Different
Exchange Rate Scenarios Spartan, Inc.
19
Factors to Consider in Multinational Capital
Budgeting

• Inflation
• Although price/cost forecasting implicitly
  considers inflation, inflation can be quite
  volatile from year to year for some countries.

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Factors to Consider in Multinational Capital
Budgeting

• Financing arrangement
• Financing costs are usually captured by the
  discount rate.
• However, when foreign projects are partially
  financed by foreign subsidiaries, a more accurate
  approach is to separate the subsidiary investment
  and explicitly consider foreign loan payments as
  cash outflows.

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Factors to Consider in Multinational Capital
Budgeting

• Blocked funds
• Some countries require that the earnings
  generated by the subsidiary be reinvested locally
  for at least a certain period of time before they
  can be remitted to the parent.

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Capital Budgeting with Blocked Funds Spartan,
Inc.
Assume that all funds are blocked until the
subsidiary is sold.
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Factors to Consider in Multinational Capital
Budgeting

• Uncertain salvage value
• Since the salvage value typically has a
  significant impact on the projects NPV, the MNC
  may want to compute the break-even salvage value.
• Impact of project on prevailing cash flows
• The new investment may compete with the existing
  business for the same customers.

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Factors to Consider in Multinational Capital
Budgeting

• Host government incentives
• These should also be incorporated into the
  analysis.
• A low-rate host government loan or a reduced
  tax rate offered to the subsidiary will enhance
  periodic cash flow.
• If the government subsidizes the initial
  establishment of the subsidiary, the MNCs
  initial investment will be reduced.

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Adjusting Project Assessmentfor Risk

• When an MNC is unsure of the estimated cash flows
  of a proposed project, it needs to incorporate an
  adjustment for this risk.
• One method is to use a risk-adjusted discount
  rate. The greater the uncertainty, the larger the
  discount rate that should be applied to the cash
  flows.

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Adjusting Project Assessmentfor Risk

• An MNC may also perform sensitivity analysis or
  simulation using computer software packages to
  adjust its evaluation.
• Sensitivity analysis involves considering
  alternative estimates for the input variables,
  while simulation involves repeating the analysis
  many times using input values randomly drawn from
  their respective probability distributions.

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Problem-1

• Brower, Inc., just constructed a manufacturing
  plant in Ghana. The construction cost 9 billion
  Ghanaian 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.It currently takes 8700 cedi to buy
  one US dollar, and the cedi is expected to
  depreciate by 5 percent per year.
• Determine the NPV for this project .Should Brower
  build the plant?
• How would your answer change if the value of the
  cedi was expected to remain unchanged from its
  current value of 8700 cedi per US over the course
  of the three years? Should Brower construct the
  plant then?

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Problem-2

• A project A project in South Korea requires an
  initial invvestment 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. Thee project has no
  salvage value. The current value of the won is
  1100won per US 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 1200 won per
  US dollar after two yeas. Further assume that the
  funds are blocked and the parent company will
  only be able to remit them back to the united
  states in two years. How does this affect the NPV
  of the project.