I need part 5 completed
Chapter 08
Capital Budgeting
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objectives
Describe the Capital Budgeting process in MNCs and how this process generates stockholder value.
Discuss the general conditions under which cross-border projects are valuable.
List and define various types of international projects.
Estimate cash flows for international projects and discuss how this process is different from that for domestic projects.
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Learning Objectives (cont.)
Calculate the NPV of a typical international project and demonstrate the equivalence of the domestic and foreign cash flows methods (Approaches I and II).
Evaluate the impact of currency risk on project NPV. Demonstrate a method to integrate capital budgeting and exposure management.
Define country risk. Evaluate its impact on project NPV. Evaluate purchase of country risk insurance.
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A. The Capital Budgeting Process
- Capital Budgeting is the comprehensive set of activities where firms:
- Define their long-term strategy and goals
- Identify and define activities (projects) that will help achieve goals
- Determine the cash flows for the proposed projects
- Determine NPV or other value indicators
- Choose the optimal mix of projects
- Execute projects
- Track the performance of on-going projects
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A. The Capital Budgeting Process (cont.)
- Overall goal is maximize shareholder wealth
- Key component is cash flow (CF) analysis
- Decentralization and teamwork important in CB
- Role of CFO is vital in understanding big picture implications
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B. Advantages of International Projects
- Foreign labor: specialized and cost effective
- Revenue Enhancement: more opportunity to sell, large potential market
- Diversification of CF: protection against downturn in any one market
- Counter threat of adverse regulations: create foreign stakeholders who will protect the firm’s interests
- Create flexibility for future actions: create real options
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C. Types of Overseas Projects
- International Outsourcing: also called offshoring, usually straightforward to analyze, pertains to component or product (cost implications)
- International Production: more complex, also pertains to cost-side but involves multiple considerations
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C. Types of Overseas Projects (cont.)
- International Sales: even more complex, requires forecast of market size, market share, prices.
- International Production & Sales: as complex as valuing a standalone firm.
- International Joint Venture (JV): incorporate in analysis the terms of the contract between the two partners.
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D1. Project Cash Flows
D = depreciation
T = tax rate
= change (or investment) in working capital
= change in fixed assets or capital expenditure (net out taxes if any)
E = expenses (direct expenses + overheads and other fixed expenses)
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D2. Project CF Example
- During a particular year, a firm records the following transactions in its subsidiary in Taiwan:
- Produced 5,000 units of a product at a direct (labor and raw materials and other variable costs) of (Taiwanese dollar) TWD 80 per unit
- Incurred fixed costs of TWD 100,000
- Depreciated fixed assets for TWD 50,000
- Sold all units at a unit price of TWD 150
- Paid taxes at a rate of 20%
- Increased working capital from TWD 250,000 to TWD 275,000
- Invested TWD 75,000 in fixed assets
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D2. Project CF Example (cont.)
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E1. Sunbeam Project NPV (Inputs)
- Capital Requirements: Sunbeam’s 5-year project requires an initial investment of MXP 25 million for equipment. The salvage value of the equipment is MXP 8 million. The working capital requirement is 25% of the following year’s sales .
- Unit Sales/Production Forecast: 200,000 each year for the first two years, rising to 300,000 in the following two and falling to 200,000 in the final year.
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E1. Sunbeam Project NPV (Inputs)
cont.
- Margins: The selling price is MXP 200 per unit. Direct costs, labor and raw materials are MXP 120 per unit. Overhead costs are MXP 10 million annually.
- Discount Rate: WACC equals 9%.
- Other Information:
- The tax rate in Mexico is 30%.
- Mexico allows straight-line depreciation for tax purposes.
- The spot rate is MXPUSD = 0.10.
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E2. Project NPV (CF Calculations)
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| Sunbeam’s Mexican Project: Calculation of Foreign Currency Cash Flows | |||||||
| MXP Cash Flows (000s) | |||||||
| Item | t=0 | t=1 | t=2 | t=3 | t=4 | t=5 | |
| Units and NWC: | |||||||
| 1 | Units 000s | 200 | 200 | 300 | 300 | 200 | |
| 2 | Revenues = Units × 200 | 40,000 | 40,000 | 60,000 | 60,000 | 40,000 | |
| 3 | NWC | 10,000 | 10,000 | 15,000 | 15,000 | 10,000 | 0 |
| Investment CF: | |||||||
| 4 | Capital Expenditure | 25,000 | |||||
| 5 | Salvage | 8,000 | |||||
| 6 | Taxes (Salvage) | 2400 | |||||
| 7 | Change in NWC | 10000 | 0 | 5000 | 0 | -5000 | -10000 |
| 8 | Investment CF = -4 + 5 -6 - 7 | -35,000 | 0 | -5,000 | 0 | 5,000 | 15,600 |
| Operating CF: | |||||||
| 9 | Revenues | 40,000 | 40,000 | 60,000 | 60,000 | 40,000 | |
| 10 | Direct Expenses = Units × 120 | 24,000 | 24,000 | 36,000 | 36,000 | 24,000 | |
| 11 | Fixed Expenses | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | |
| 12 | Depreciation | 5,000 | 5,000 | 5,000 | 5,000 | 5,000 | |
| 13 | Pre-tax income | 1,000 | 1,000 | 9,000 | 9,000 | 1,000 | |
| 14 | Taxes | 300 | 300 | 2,700 | 2,700 | 300 | |
| 15 | NOPAT | 700 | 700 | 6,300 | 6,300 | 700 | |
| 16 | Operating CF = 15 + 12 | 5,700 | 5,700 | 11,300 | 11,300 | 5,700 | |
| CF = 8 + 16 | -35,000 | 5,700 | 700 | 11,300 | 16,300 | 21,300 |
E3. Project NPV (Constant FX)
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| Sunbeam’s Mexican Project USD Cash Flows and NPV (constant MXPUSD assumption) | ||||||
| t=0 | t=1 | t=2 | t=3 | t=4 | t=5 | |
| CF (MXP 000s) | -35,000 | 5,700 | 700 | 11,300 | 16,300 | 21,300 |
| × MXPUSD | 0.10 | 0.10 | 0.10 | 0.10 | 0.10 | 0.10 |
| = CF (USD 000s) | -3,500 | 570 | 70 | 1,130 | 1,630 | 2,130 |
| NPV@ 9% (USD 000s) | 493.51 |
E4. Project NPV (Changing FX)
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| Sunbeam’s Mexican Project USD Cash Flows and NPV (declining MXPUSD assumption) | ||||||
| t=0 | t=1 | t=2 | t=3 | t=4 | t=5 | |
| CF (MXP 000s) | -35,000 | 5,700 | 700 | 11,300 | 16,300 | 21,300 |
| Assumption: USD inflation = 2%, MXP inflation = 4% | ||||||
| Using PPP, MXPUSD forecast = | ||||||
| × MXPUSD | 0.10000 | 0.09808 | 0.09619 | 0.09434 | 0.09253 | 0.09075 |
| = CF (USD 000s) | -3,500.00 | 559.04 | 67.33 | 1,066.05 | 1,508.19 | 1,932.92 |
| NPV@ 9% (USD 000s) | $217.44 |
E5. Project NPV (Alternate Approach)
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| Sunbeam’s Mexican Project MXP Cash Flows and NPV (differential inflation assumption) | ||||||
| t=0 | t=1 | t=2 | t=3 | t=4 | t=5 | |
| CF (MXP 000s) | -35,000 | 5,700 | 700 | 11,300 | 16,300 | 21,300 |
| Assumption: USD inflation = 2%, MXP inflation = 4% | ||||||
| Using , MXP discount rate = | ||||||
| NPV@ 11.1373% (MXP 000s) | $2174.40 |
E6. Sensitivity Analysis
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F1. Currency Risk Analysis
A US firm considers an investment of USD 16,000 in Canada. This is a 4-year investment. The firm expects to sell 1,000 units of the product each year at a price of CAD 20. Direct expenses are CAD 10 per unit and indirect expenses are CAD 1,200 a year. Depreciation is straight line to zero. Canadian taxes are 40% and there are no additional taxes (withholding or repatriation) when cash flows are repatriated. The WACC of the firm is 12%. The CADUSD spot rate is 0.80. The firm expects the CAD to depreciate against the USD and is interested in determining the break-even rate of depreciation.
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F1. Currency Risk Analysis (cont.)
The initial investment of USD 16,000 is equivalent to CAD 20,000 at the spot rate implying a depreciation of CAD 5,000 a year.
At the spot rate of USD 0.80, this annual cash flow is equivalent to USD 5,824.
By setting the above value to zero we determine the break-even value of g to equal negative 4.213%.
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F2. Integrating CB and Exposure Management
- Determine break-even currency values by year and purchase options by setting strike prices equal to break-even currency values.
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| Year (t) | Break-even CADUSD |
| 1 | 0.7663 |
| 2 | 0.7340 |
| 3 | 0.7031 |
| 4 | 0.6735 |
G1. Country Risk
- Country Risk = Economic Risk + Political Risk
- Economic risk: This risk arises from changes in the macro-economic environment and manifests itself in factors such as national growth, inflation and interest rates.
- Political risk: This risk arises from the socio-political environment of a country. In certain countries political turmoil can lead to a deterioration of the potential market for a firm and can increase the cost of operations.
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G2. Country Risk Ratings
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| Fitch Sovereign Risk Ratings: Examples in Various Categories | ||
| AAA | AA | A |
| Canada | Australia | China |
| Germany | Hong Kong | Chile |
| Singapore | Japan | Czech Republic |
| UK | Italy | Taiwan |
| US | Kuwait | Malaysia |
| BBB | BB | B/C/D |
| Mexico | Brazil | Iran |
| Russia | Columbia | Dominican Republic |
| S. Africa | Sri Lanka | Bolivia |
| Kazakhstan | Turkey | Ecuador |
| India | Vietnam | Argentina |
| Ratings as of March 2008 obtained from www.fitchratings.com |
G3. Country Risk and NPV (Inputs)
- A U.S. based firm considers an investment in a developing country (India) where there is some level of political risk. The project parameters are as follows:
- The capital expenditure is INR 100 million.
- The project is a 3-year project producing annual operating cash flows of INR 40 million.
- At the end of 3-years, the assets of the firm will be sold (salvage) for INR 60 million to a foreign (i.e., local) firm.
- The WACC of 12% is used as the discount rate in NPV computations involving the domestic currency (i.e., USD).
- USDINR = 50. Assume constant currency value.
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G3. Country Risk and NPV (Inputs)
cont.
Assume that because of political risk there is a 60% probability of expropriation of assets in year-3 (i.e., salvage value is expropriated). Assume zero taxes. Calculate project NPV.
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G4. Country Risk and NPV (Solution)
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G5. Political Risk Insurance
- Now widely available from private and public sources.
- Insurance premium is a negative CF and decreases project NPV.
- But if insurance is purchased, expropriation is avoided.
- Insurance premium costs can be benchmarked against the expected costs of expropriation.
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G6. Political Risk Premium Calculations
- Consider previous problem, additional consideration is premium of INR 12 million
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| Insurance coverage for Expropriation | ||||
| Cash Flows (000s) | ||||
| t=0 | t=1 | t=2 | t=3 | |
| Capital Expenditure | -100,000 | |||
| Salvage | 60,000 | |||
| Operating Cash Flows | 40,000 | 40,000 | 40,000 | |
| Insurance Premium | -12,000 | |||
| CF (INR) | -112,000 | 40,000 | 40,000 | 100,000 |
| ÷ USDINR | 50 | 50 | 50 | 50 |
| = CF (USD) | -2,240 | 800 | 800 | 2,000 |
| NPV @ 12% | 535.601 |
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