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Chapter 18

Multinational Capital Budgeting

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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

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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 the terminal value or

salvage value of the investment– Identify appropriate discount rate for NPV calculation– Determine the NPV and IRR

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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 – 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

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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

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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

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Project versus Parent Valuation

Foreign InvestmentUS$ invested in overseas

Particular investment

Project ViewpointCapital Budget(Local Currency)

Estimated cash flowsof project

Parent ViewpointCapital Budget(U.S. dollars)

Cash flows remitted

to Parent (FC to US$)

ENDIs the project investmentJustified (NPV > 0)?

Parent Firm (US)

START

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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

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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

TaxesInterestonAmortizationDepreciatiEBT(NOCF) flowcash operatingNet

TaxesEBITDA(NOCF) flowcash operatingNet

Taxes - profits Operating (NOCF) flowcash operatingNet

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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

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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.

NOCF. of rate growth the is g where

gk

g)1(NOCFValue Terminal

WACC

holding of year Last

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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

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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

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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)

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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