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Chapter 08

Capital Budgeting

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.)

000

750

150

000

D NWC = 275 000 – 250,000 = 25,000

E = 5,000 ´ 80 + 100,000 = 500,00

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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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NWC

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NWC

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110

TWD

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750

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1373

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280

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200

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CAD

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824

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NPV

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CADUSD

213