chapter 17 international capital budgeting. chapter outline review of domestic capital budgeting the...

Chapter 17

International Capital Budgeting

Chapter Outline

Review of Domestic Capital BudgetingThe Adjusted Present Value ModelCapital Budgeting from the Parent Firm’s PerspectiveRisk Adjustment in the Capital Budgeting ProcessSensitivity AnalysisReal Options

Review of Domestic Capital Budgeting

1. Identify the SIZE and TIMING of all relevant cash flows on a time line.

2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate discount rate.

4. Compare the value of competing cash flow streams at the same point in time.

One recipe for international decision makers:1. Estimate future cash flows in foreign currency.2. Convert to U.S. dollars at the predicted exchange rate.3. Calculate NPV using the U.S. cost of capital.


International Capital Budgeting Example

Is this a good investment from the perspective of the U.S. shareholders?

€ = 3%

i$ = 15%

$ = 6%

– 600€

0

200€

1

500€

2

300€

3

€$.55265

S0($/€) =

International Capital Budgeting: Example

– 600€ 200€ 500€ 300€

0 1 year 2 years 3 years

$331.60

CF0 = (€600)× S0($/€) =(€600)× = $331.60€

$.55265


– 600€ 200€ 500€ 300€


CF1 = (€200)×E[ S1($/€)] =

E[ S1($/€)] can be found by appealing to the interest rate differential:

$331.60 $113.70

1.031.06E[S€(1)] = S0($/€)

1.031.06=

€$.55265 = $.5687/€

so CF1 = (€200)×($.5687/€) = $113.7


– 600€ 200€ 500€ 300€


$331.60 $113.70 $292.60

Similarly,

CF2 = × S0($/€) (€500) = $292.61.031.06

1.031.06×


– 600€ 200€ 500€ 300€


$331.60 $113.70 $292.60 $180.70

30.107$)15.1(

70.180$

)15.1(

60.292$

)15.1(

70.113$60.336$

32NPV

CF3 = × S0($/€) (€300) = $180.7(1.03)3

(1.06)3

Another recipe for international decision makers:1. Estimate future cash flows in foreign currency.2. Estimate the foreign currency discount rate.3. Calculate the foreign currency NPV using the foreign cost of capital.4. Translate the foreign currency NPV into dollars using the spot exchange rate


Foreign Currency Cost of Capital Method

Let’s find i€ and use that on the euro cash flows to find the NPV in euros.

Then translate the NPV into dollars at the spot rate.

– €600

0

€200

1

€500

2

€300

3

€$.55265

S0($/€) =

€ = 3%

i$ = 15%

$ = 6%

Finding the Foreign Currency Cost of Capital: i€

Recall that if Fisher Effect holds here and abroad…

(1 + i€) = (1 + i$)×(1 + €)

(1 + $)

(1 + i€) = (1 + e) × (1 + €)

(1 + e) = (1 + i$)

(1 + $)

and if the real rates are the same, then

(1 + e)×(1 + $) = (1 + i$)

International Capital Budgeting Example

NPV 11.75% = € 194.39

– €600

0

€200

1

€500

2

€300

3

(1 + i€) = (1 + i$)×(1 + €)

(1 + $)

(1.15)×(1.03)

(1.06)= = 11.75%

= $107.43

€ 194.39× €$.55265

€$.55265

S0($/€) =

€ = 3%

i$ = 15%

$ = 6%


You have two equally valid approaches:– Change the foreign cash flows into dollars at the exchange

rates expected to prevail. Find the $NPV using the dollar cost of capital.

– Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate.

If you watch your rounding, you will get exactly the same answer either way.Which method you prefer is your choice.


The basic net present value equation is0

1 )1()1(C

K

TV

K

CFNPV

TT

T

tt

t

Where:

CFt = expected incremental after-tax cash flow in year t,

TVT = expected after tax cash flow in year T, including return of net working capital,

C0 = initial investment at inception,

K = weighted average cost of capital.

T = economic life of the project in years.


The NPV rule is to accept a project if NPV 0

0)1()1( 0

1

CK

TV

K

CFNPV

TT

T

tt

t

and to reject a project if NPV 0

.0)1()1( 0

1

CK

TV

K

CFNPV

TT

T

tt

t


For our purposes it is necessary to expand the NPV equation.

)1()1)(( τIDτIDOCRCF ttttttt

Rt is incremental revenue

Ct is incremental operating cash flow

Dt is incremental depreciation

It is incremental interest expense

is the marginal tax rate


For our purposes it is necessary to expand the NPV equation.

)1()1)(( τIDτIDOCRCF ttttttt )1(( τIDNI ttt

ttt DτDτOCR )1)((

tt DτNOI )1(

ttt τDτOCR )1)((

tt τDτOCF )1(


We can use ttt τDτOCFCF )1(

01 )1()1(

CK

TV

K

CFNPV

TT

T

tt

t

to restate the NPV equation

01 )1()1(

)1(C

K

TV

K

τDτOCFNPV

TT

T

tt

tt

as:

The Adjusted Present Value Model

Can be converted to adjusted present value (APV)

01 )1()1()1(

)1(C

K

TV

K

τD

K

τOCFNPV

TT

tt

T

tt

t

By appealing to Modigliani and Miller’s results.

01 )1()1()1()1(

)1(C

K

TV

i

τI

i

τD

K

τOCFAPV

Tu

Tt

tt

tT

tt

u

t

The Adjusted Present Value Model

The APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually.

Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.

01 )1()1()1()1(

)1(C

K

TV

i

τI

i

τD

K

τOCFAPV

Tu

Tt

tt

tT

tt

u

t

Domestic APV ExampleConsider a project of the Pearson Company, the timing and size of the

incremental after-tax cash flows for an all-equity firm are:

0 1 2 3 4

-$1,000 $125 $250 $375 $500

50.56$

)10.1(

500$

)10.1(

375$

)10.1(

250$

)10.1(

125$000,1$

%10

432%10

NPV

NPV

The unlevered cost of equity is r0 = 10%:

The project would be rejected by an all-equity firm: NPV < 0.

Domestic APV Example (continued)Now, imagine that the firm finances the project with $600 of debt at r = 8%. Pearson’s tax rate is 40%, so they have an interest tax shield worth ×I = .40×$600×.08 = $19.20 each year.

NPVFNPVAPV The net present value of the project under leverage is:

4

1 )08.1(

20.19$50.56$

tt

APV

09.7$59.6350.56$ APV

So, Pearson should accept the project with debt.

Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.

Domestic APV Example (continued)Note that there are two ways to calculate the NPV of the loan. Previously, we calculated the PV of the interest tax shields. Now, let’s calculate the actual NPV of the loan:

loanNPVNPVAPV

09.7$59.6350.56$ APVWhich is the same answer as before.

59.63$

)08.1(

600$

)08.1(

)4.1(08.600$600$

4

4

1

loan

ttloan

NPV

NPV

Capital Budgeting from the Parent Firm’s Perspective

Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.

T

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(


The operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period.

T

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(

The operating cash flows must be discounted at the unlevered domestic rate


OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.

T

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(

The marginal corporate tax rate, , is the larger of the parent’s or foreign subsidiary’s.


S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.

T

tt

d

ttT

ud

TT

T

tt

d

ttT

tt

d

ttT

tt

ud

tt

i

LPSCLSRFSCS

K

TVS

i

τIS

i

τDS

K

τOCFSAPV

1000000

111

)1()1(

)1()1()1(

)1(

Denotes the present value (in the parent’s currency) of any concessionary loans, CL0, and loan payments, LPt , discounted at id .

Risk Adjustment in the Capital Budgeting Process

Clearly risk and return are correlated.Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

Sensitivity Analysis

In the APV model, each cash flow has a probability distribution associated with it.Hence, the realized value may be different from what was expected.In sensitivity analysis, different estimates are used for expected inflation rates, cost and pricing estimates, and other inputs for the APV to give the manager a more complete picture of the planned capital investment.

Real Options

The application of options pricing theory to the evaluation of investment options in real projects is known as real options.– A timing option is an option on when to make the investment.– A growth option is an option to increase the scale of the

investment.– A suspension option is an option to temporarily cease

production.– An abandonment option is an option to quit the investment

early.

chapter 17 international capital budgeting. chapter outline review of domestic capital budgeting the...

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