To Accompany

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Chapter 16 Multinational Capital Budgeting
To Accompany
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Chapter 16Multinational Capital Budgeting

• Learning Objectives
• Extend the domestic capital budgeting analysis to
  evaluate a Greenfield foreign project
• Distinguish between the project viewpoint the
  parent viewpoint when analyzing a potential
  foreign investment
• Adjust the capital budgeting analysis of a
  foreign project for risk
• Introduce the use of real option analysis as a
  complement to DCF analysis 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 projects
• Capital budgeting follows same framework as
  domestic budgeting
• Identify initial capital invested or put at risk
• Estimate cash inflows, including a terminal value
  or salvage value of investment
• Identify appropriate discount rate for PV
  calculation
• Apply traditional NPV or IRR analysis

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Complexities of Budgeting for a Foreign Project

• Several factors make budgeting for a foreign
  project more complex
• Parent cash flows must be distinguished from
  project
• Parent cash flows often depend on the form of
  financing, thus cannot clearly separate cash
  flows from financing
• 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
• Parent 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

• An array of non-financial payments can generate
  cash flows to parent in form of licensing fees,
  royalty payments, etc.
• Managers must anticipate differing rates of
  national inflation which can affect differing
  cash flows
• Use of segmented national capital markets may
  create opportunity for financial gain or
  additional costs
• Use of host government subsidies complicates
  capital structure and parents ability to
  determine appropriate WACC
• Managers must evaluate political risk
• Terminal 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 viewpoints
• The parents viewpoint analyses investments cash
  flows as operating cash flows instead of
  financing due to remittance of royalty or
  licensing fees and interest payments
• The parents viewpoint gives results closer to
  traditional NPV capital budgeting analysis
• Project valuation provides closer approximation
  of effect on consolidated EPS

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Illustration Cemex Goes Abroad

• Cementos Mexicanos (Cemex) is considering
  construction of plant in Indonesia (Semen
  Indonesia) as a Greenfield project
• Cemex is listed on both US and Mexican markets
  but most of its capital is US dollar denominated
  so evaluation of project is in US dollars

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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad

• Financial assumptions
• Capital Investment cost to build plant
  estimated at 150/tonne but Cemex believes it can
  build the plant at a cost of 110/tonne
• Assuming exchange rate of Rp10,000/ and a 20
  year life, cost is estimated at Rp22 trillion
• With straight line depreciation on equipment
  values at Rp17.6 trillion costing 1.76 trillion
  per year

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Illustration Cemex Goes Abroad

• Financial assumptions
• Financing plant would be financed with 50
  equity (all from Cemex) and 50 debt
• Debt is broken down, with Cemex providing 75 and
  a bank consortium providing the remaining 25
• Cemexs WACC (in US dollars) is 11.98
• For the local project (in rupiah) the WACC is
  33.257

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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad

• Financial assumptions
• Revenues sales are based on export and the
  plant will operate at 40 capacity producing 8
  million tonnes per year
• Cement will be sold in export market at 58/tonne
• Costs cost per ton is estimated at Rp115,000 in
  1999 and rising at the rate of inflation (30)
  per year
• For export costs, loading costs of 2.00/tonne
  and shipping costs of 10/tonne must also be added

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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad

• Project Viewpoint Capital Budget
• Semen Indonesias free cash flows are found by
  looking at EBITDA and not EBT
• Taxes are calculated based on this amount
• Terminal value is calculated for the continuing
  value of the plant after year 5
• TV is calculated as a perpetual net operating
  cash flow after year 5

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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad

• Parent Viewpoint Capital Budget
• Now cash flows estimates are constructed from
  parents viewpoint
• Cemex must now use its cost of capital and not
  the projects
• Recall that Cemexs WACC was 11.98
• However, Cemex requires an additional yield of 6
  for international projects, thus the discount
  rate will be 17.98
• This yields an NPV of -925.6 million (IRR
  1.84) which is unacceptable from the parents
  viewpoint

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Illustration Cemex Goes Abroad
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Illustration Cemex Goes Abroad

• Project Valuation Sensitivity Analysis
• Political risk biggest risk is blocked funds or
  expropriation
• Analysis should build in these scenarios and
  answer questions such as how, when, how much,
  etc.
• Foreign exchange risk
• Analysis should also consider appreciation or
  depreciation of the US dollar

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Illustration Cemex Goes Abroad

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

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Illustration Cemex Goes Abroad

• Real Option Analysis
• Real 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)
• The valuation of real options and the variables
  volatilities is similar to equity option math

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Summary of Learning Objectives

• Parent cash flows must be distinguished from
  project cash flows. Each contributes to a
  different view of value
• Parent cash flows often depend on the form of
  financing, thus cash flows cannot be clearly
  separated from financing decisions
• Additional cash flows generated by new
  investments may be in part or wholly taken away
  from another foreign subsidiary thus the net
  result may be negative or flat

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Summary of Learning Objectives

• Remittance of funds to the parent must be
  explicitly recognized because of differing tax
  systems, legal and political constraints on the
  movement of funds, and local business and capital
  market norms
• Cash flows from subsidiaries to parent can be
  generated by an array of non-financial payments
• Differing rates of national inflation must be
  anticipated because of their importance in
  causing changes in cash flows

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Summary of Learning Objectives

• A foreign projects capital budgeting analysis
  should be adjusted for potential foreign exchange
  and political risks
• Alternative methods are used for adjusting for
  risk, including adding an additional risk premium
  to the discount factor used, decreasing expected
  cash flows and conducting detailed sensitivity
  analysis
• Real options is a different way of thinking about
  investment values it is a cross between
  decision tree analysis and pure option valuation

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Summary of Learning Objectives

• Real option valuation also allows evaluation of
  the option to defer, to abandon, to alter
  capacity or the option of switching