Multinational Capital Budgeting PDF

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Multinational Capital Budgeting Tzvetomir Tzanov, Ph.D. UNWE, IFM Course Reference...

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Multinational Capital Budgeting Tzvetomir Tzanov, Ph.D. UNWE, IFM Course References: Madura, J., IFM, 9e © © © Tzvetomir T.Tzanov, Tzanov, Ph.D. Ph.D, UNWE  International Financial Management Outline To explain multinational capital budgeting; To compare the capital budgeting analysis of an MNC’s subsidiary with that of its parent; To demonstrate how multinational capital budgeting can be applied to determine whether an international project should be implemented; To explain how the risk of international projects can be assessed. © T.Tzanov, Ph.D, UNWE  International Financial Management Multinational Capital Budgeting (1) Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions – as well as reinvestment decisions – it should be justified by traditional financial analysis. Multinational capital budgeting like traditional domestic capital budgeting focuses on the cash inflows and outflows associated with prospective long-term investment projects. Note: Capital budgeting is necessary for all long-term projects that deserve consideration. © T.Tzanov, Ph.D, UNWE  International Financial Management Multinational Capital Budgeting (2) Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. The basic steps are: Identify the initial capital invested or put at risk; Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment; Identify the appropriate discount rate to use in valuation; Apply traditional capital budgeting decision criteria such as NPV and IRR, considering the payback period as well. © T.Tzanov, Ph.D, UNWE  International Financial Management Multinational Capital Budgeting (3) Capital budgeting for a foreign project is considerably more complex than the domestic case: Parent/subsidiary cash flows must be distinguished from project cash flows. Parent/subsidiary cash flows often depend on the form of financing. Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary. Unexpected changes in ER, taxes, affecting remittances. © T.Tzanov, Ph.D, UNWE  International Financial Management Subsidiary versus Parent perspective Should the capital budgeting for a multinational project be conducted from the viewpoint of the subsidiary that will administer the project, or the parent that will provide most of the financing? Thus – centralized vs. decentralized decision setting. 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. © T.Tzanov, Ph.D, UNWE  International Financial Management Subsidiary versus Parent perspective (2) The difference in cash inflows is 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 fluctuations affecting CF © T.Tzanov, Ph.D, UNWE  International Financial Management Subsidiary versus Parent perspective (3) The influence on discount rate: Managers must consider/evaluate country risk influencing discount rates, because political, macroeconomic and events can drastically reduce the value or availability of expected cash flows. country risk premium affecting the discount rate. Uncertain terminal value: Terminal value is more difficult to estimate, because potential purchases from the host, parent, or third countries, or from the private or public sector, may have widely divergent perspectives on the value to them of acquiring the project. © T.Tzanov, Ph.D, UNWE  International Financial Management Remitting subsidiary earnings to the parent Cash Flows Generated by Subsidiary Corporate Taxes Paid to Host Government After-Tax Cash Flows to Subsidiary Retained Earnings by Subsidiary Cash Flows Remitted by Subsidiary Withholding Tax Paid to Host After-Tax Cash Flows Remitted by Subsidiary Government Conversion of Funds to Parent’s Currency Cash Flows to Parent Parent © T.Tzanov, Ph.D, UNWE  International Financial Management Subsidiary versus Parent perspective A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive net present value for the parent should enhance the firm’s value. However, one exception to this rule may occur when the foreign subsidiary is not wholly owned by the parent. Comparison – centralized vs. decentralized. Evaluation of a project from the local viewpoint useful, but it should be subordinated to evaluation from the parent’s viewpoint. Thus, estimate the cash flows and salvage value to be received by the parent, and compute the net present value (NPV) of the project. © T.Tzanov, Ph.D, UNWE  International Financial Management Multinational capital budgeting (MCB) NPV = – Co (initial outlay) n +  cash flow in period t t =1 (1 + k )t salvage value + (1 + k )n Whereas, k = the required rate of return on the project n = project lifetime in terms of periods If NPV > 0, the project can be accepted. © T.Tzanov, Ph.D, UNWE  International Financial Management Input for Multinational capital budgeting The following forecasts are usually processed/ required: 1. Initial investment 2. Consumer demand 3. Product price 4. Variable cost 5. Fixed cost 6. Project lifetime 7. Salvage (liquidation) value 8. Fund-transfer restrictions 9. Tax laws 10. Exchange rates 11. Required rate of return © T.Tzanov, Ph.D, UNWE  International Financial Management Capital budgeting analysis (Parent) 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 (if any) (6) 7. Other fixed periodic 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)=(12) © T.Tzanov, Ph.D, UNWE  International Financial Management 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. Investment by parent (20) 21. Net cash flow to parent (19)–(20)=(21) 22. PV of net CF to parent (21)/(1+k) t=(22) 23. Cumulative NPV PVs=(23) © T.Tzanov, Ph.D, UNWE  International Financial Management Adjusting project assessment for risk If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its assessment for this risk. One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that is applied. Computer software packages are also available to perform ✓ Sensitivity analysis, and ✓ Simulation – modelling in a repetitive way cashflows, thus establishing probability distribution of project yields. © T.Tzanov, Ph.D, UNWE  International Financial Management Project vs. Parent valuation A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world… Pay attention to the project’s local return! Any local project should at least be able to earn a cash return equal to the yield available on host government bonds (with the same maturity as the project’s economic life) – risk free return. © T.Tzanov, Ph.D, UNWE  International Financial Management Project vs. Parent valuation (2) Most firms appear to evaluate foreign projects from both parent and project/subsidiary viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm). There are two different procedures/methods for evaluating foreign projects in this respect: ❑Decentralized capital budgeting; ❑Centralized capital budgeting. Centralization and decentralization refer to the perspective of analyzing a project, hence the location of decision- making. Thus – centralized (center, parent), decentralized (subsidiary). © T.Tzanov, Ph.D, UNWE  International Financial Management Project vs. Parent valuation (3) Both focus on nominal values of cash flows, spot exchange rates and ER expectations, respective cost of capital/discount rate from local and parent currency perspectives. Both methods begin with estimating project’s local currency cash flows. Long horizon, so projections based on comparative and competitive advantages towards the market/industry. Estimated cash flows must be net of tax payments. In reality more difficult than it sounds. Corporate taxes are based on accounting profits not on CF. CF differ for many reasons such as DA. © T.Tzanov, Ph.D, UNWE  International Financial Management Decentralized Capital Budgeting ✓ Forecast cash flows in local currency ✓ Discount the cash flows at the foreign cost of capital ✓ Convert the NPV into home (parent currency) at spot rate. 𝒏 𝑬𝟎 𝑪𝑭𝒏 𝑵𝑷𝑽 = ෍ 𝒏 𝑺𝟎 𝟏+𝒌 𝒕=𝟏 Whereas, ▪ E(CF) – expected cash flows in number of periods n; ▪ k – cost of capital in the local currency; ▪ S0 – current (spot) exchange rate. © T.Tzanov, Ph.D, UNWE  International Financial Management Centralized Capital Budgeting ✓ Forecast cash flows in local currency; ✓ Convert cash flows into home (parent) currency at expected annual exchange rate; ✓ Discount using the domestic cost of capital. 𝒏 𝑬𝟎 𝑪𝑭𝒕 𝑺𝒕 𝑵𝑷𝑽 = ෍ 𝟏 + 𝒌∗ 𝒏 𝒕=𝟏 Whereas, ▪ E(CF) – expected cash flow; ▪ k* – cost of capital in the home currency; ▪ St – expected annual exchange rate in the period t. © T.Tzanov, Ph.D, UNWE  International Financial Management Centralized vs. Decentralized Concluding remarks: Most firms engaged in foreign investment appear to evaluate foreign projects from both parent and project/subsidiary viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm). Anyway, the final decision – taken/ at least sanctioned/ by the parent. Even decentralized financial management – regional HQ/ direct parent or group level parent company. © T.Tzanov, Ph.D, UNWE  International Financial Management Multinational Capital Budgeting & MNC’s Value Multinational Capital Budgeting Decisions  n  n  E (CFj, n ) E (ER j,n )  j =1  Value =    t =1  (1 + r )n    E (CFj,n ) = expected cash flows denominated in currency j to be received by the parent for the number of periods n E (ERj,n ) = expected exchange rate at which currency j can be converted at the end of period t r = weighted average cost of capital of the parent © T.Tzanov, Ph.D, UNWE  International Financial Management THANK YOU FOR YOUR ATTENTION! © T.Tzanov, Ph.D, UNWE