Challenges in Multinational Capital Budgeting

 
Chapter 18
 
Multinational Capital Budgeting
 
1
 
Multinational Capital Budgeting
 
Extension of the domestic capital budgeting
analysis to evaluate a Greenfield foreign project
Distinctions between the project viewpoint & the
parent viewpoint when analyzing a potential
foreign investment
Adjusting the capital budgeting analysis of a
foreign project for risk
Introduction of the use of real option analysis as
a complement to DCF analysis in the evaluation
of potential international investments
 
2
 
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 the terminal value or
salvage value of the investment
Identify appropriate discount rate for NPV calculation
Determine the NPV and IRR
 
3
 
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 –
this changes the meaning of NPV
Additional cash flows from new investment may in part or
in whole take away from another subsidiary; thus as a
stand alone a project may provide cash flows but overall
may add no value to the entire organization
Parent must recognize remittances from foreign
investment because of differing tax systems, legal and
political constraints
 
4
 
Complexities of Budgeting for a
Foreign Project
 
Non-financial payments can generate cash flows to parent
in the form of licensing fees, royalty payments, etc. –
relevant for parent’s perspective
Managers must anticipate differing rates of national
inflation which can affect cash flows
Use of segmented national capital markets may create
opportunity for financial gains or additional costs
Use of host government subsidies complicates capital
structure and parent’s ability to determine appropriate
WACC
Managers must evaluate political risk
Terminal value is more difficult to estimate because
potential purchasers have widely divergent views
 
5
 
Project versus Parent Valuation
 
Most firms evaluate foreign projects from both parent
and project viewpoints
The parent’s viewpoint analyzes investment’s cash flows as
operating cash flows instead of financing due to
remittance of royalty or licensing fees and interest
payments
Funds that are permanently blocked from repatriation are
excluded
The parent’s viewpoint gives results closer to
traditional NPV capital budgeting analysis
Project valuation provides closer approximation of
effect on consolidated EPS
 
6
Project versus Parent Valuation
7
 
Project Assumptions
 
Financial assumptions
Capital Investment – cost to build a plant
Financing – depending on financing methods
WACC should be calculated for both the project
and parent
Revenues
Costs
Exchange rate assumption – parent’s cash flows
are converted into home currency
 
8
 
Estimating Cash Flows from Project
Viewpoint
 
Project Viewpoint Capital Budget
Estimate the free cash flows of the project by
determining  EBITDA and not EBT
Taxes are calculated based on this amount
 
 
 
Net Operating Cash Flow = Net Operating Profit
After Tax
NOCF = NOPAT
 
9
 
Estimating Cash Flows from Project
Viewpoint (Continued)
 
Project Viewpoint Capital Budget
Estimate and incorporate net working capital and
capital spending
Free Cash Flow (FCF) = Net Operating Cash Flow –
Changes in Net Working Capital – Changes in Fixed
Assets
 
10
Estimating Cash Flows from Project
Viewpoint (Continued)
Project Viewpoint Capital Budget
Terminal value is calculated for the continuing value of
the project after the investment horizon
TV is calculated as a perpetual net operating cash flow after
the investment horizon
All FCFs and Terminal Value is discounted  using
subsidiary WACC.
11
 
Parent Viewpoint
 
Parent Viewpoint Capital Budget
Cash flows estimates are constructed from parent’s
viewpoint
Estimate individual cash flows to parent after adjusting for
withholding taxes.  These cash flows must be in parent firm’s
currency
Use parent firm’s investment in subsidiary to determine NPV
at parent’s WACC
Parent must now use it’s cost of capital and not the
project’s
Parent may require an additional yield for
international projects
 
12
 
Sensitivity Analysis
 
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
 
13
 
Real Options
 
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)
 
14
 
Real Options (Continued)
 
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
 
15
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Multinational Capital Budgeting extends the domestic analysis to evaluate foreign projects, focusing on cash flows, risk adjustments, and real option analysis. It involves complexities such as distinguishing parent cash flows from project cash flows, dealing with differing tax systems, political constraints, and estimating terminal values. Managers must navigate non-financial payments, varying national inflation rates, segmented capital markets, subsidies, and political risks when budgeting for foreign projects.


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  1. Chapter 18 Multinational Capital Budgeting 1

  2. Multinational Capital Budgeting Extension of the domestic capital budgeting analysis to evaluate a Greenfield foreign project Distinctions between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment Adjusting the capital budgeting analysis of a foreign project for risk Introduction of the use of real option analysis as a complement to DCF analysis in the evaluation of potential international investments 2

  3. 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 the terminal value or salvage value of the investment Identify appropriate discount rate for NPV calculation Determine the NPV and IRR 3

  4. 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 this changes the meaning of NPV Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as a stand alone a project may provide cash flows but overall may add no value to the entire organization Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints 4

  5. Complexities of Budgeting for a Foreign Project Non-financial payments can generate cash flows to parent in the form of licensing fees, royalty payments, etc. relevant for parent s perspective Managers must anticipate differing rates of national inflation which can affect cash flows Use of segmented national capital markets may create opportunity for financial gains or additional costs Use of host government subsidies complicates capital structure and parent s ability to determine appropriate WACC Managers must evaluate political risk Terminal value is more difficult to estimate because potential purchasers have widely divergent views 5

  6. Project versus Parent Valuation Most firms evaluate foreign projects from both parent and project viewpoints The parent s viewpoint analyzes investment s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments Funds that are permanently blocked from repatriation are excluded The parent s viewpoint gives results closer to traditional NPV capital budgeting analysis Project valuation provides closer approximation of effect on consolidated EPS 6

  7. Project versus Parent Valuation START US$ invested in overseas Foreign Investment Parent Firm (US) Particular investment END Is the project investment Justified (NPV > 0)? Estimated cash flows of project Project Viewpoint Capital Budget (Local Currency) Parent Viewpoint Capital Budget (U.S. dollars) Cash flows remitted to Parent (FC to US$) 7

  8. Project Assumptions Financial assumptions Capital Investment cost to build a plant Financing depending on financing methods WACC should be calculated for both the project and parent Revenues Costs Exchange rate assumption parent s cash flows are converted into home currency 8

  9. Estimating Cash Flows from Project Viewpoint Project Viewpoint Capital Budget Estimate the free cash flows of the project by determining EBITDA and not EBT Taxes are calculated based on this amount = operating Net cash flow (NOCF) Operating = profits Taxes - operating Net cash flow (NOCF) EBITDA Taxes = + + + operating Net cash flow (NOCF) EBT Depreciati on Amortizati on Interest Taxes Net Operating Cash Flow = Net Operating Profit After Tax NOCF = NOPAT 9

  10. Estimating Cash Flows from Project Viewpoint (Continued) Project Viewpoint Capital Budget Estimate and incorporate net working capital and capital spending Free Cash Flow (FCF) = Net Operating Cash Flow Changes in Net Working Capital Changes in Fixed Assets 10

  11. Estimating Cash Flows from Project Viewpoint (Continued) Project Viewpoint Capital Budget Terminal value is calculated for the continuing value of the project after the investment horizon TV is calculated as a perpetual net operating cash flow after the investment horizon + NOCF ( 1 g) Last year of holding = Terminal Value k g WACC where is g the growth rate of NOCF. All FCFs and Terminal Value is discounted using subsidiary WACC. 11

  12. Parent Viewpoint Parent Viewpoint Capital Budget Cash flows estimates are constructed from parent s viewpoint Estimate individual cash flows to parent after adjusting for withholding taxes. These cash flows must be in parent firm s currency Use parent firm s investment in subsidiary to determine NPV at parent s WACC Parent must now use it s cost of capital and not the project s Parent may require an additional yield for international projects 12

  13. Sensitivity Analysis 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 13

  14. Real Options 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) 14

  15. Real Options (Continued) 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 15

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