CHAPTER 17CHAPTER 17

CAPITAL BUDGETING CAPITAL BUDGETING FOR THE FOR THE

MULTINATIONAL MULTINATIONAL CORPORATIONCORPORATION

CHAPTER OVERVIEW:CHAPTER OVERVIEW:

I.I. BASIS OF CAPITAL BUDGETINGBASIS OF CAPITAL BUDGETINGII.II. ISSUES IN FOREIGN INVESTMENTISSUES IN FOREIGN INVESTMENT

ANALYSISANALYSISIII.III. POLITICAL RISK ANALYSIS POLITICAL RISK ANALYSISIV.IV. GROWTH OPTIONS AND PROJECT GROWTH OPTIONS AND PROJECT

EVALUATIONEVALUATION

I.BASICS OF CAPITAL BUDGETINGI.BASICS OF CAPITAL BUDGETING

I.I. BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

A. Basic Criterion: Net Present ValueA. Basic Criterion: Net Present Value

B.B. Net Present Value Technique:Net Present Value Technique:

1. Definition1. Definition

The present value of future cash The present value of future cash flows, discounted at the flows, discounted at the

project’s project’s cost of capital less the cost of capital less the initial net initial net cash outlay.cash outlay.

BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

2.2. NPV Formula:NPV Formula:

wherewhere I I00 = initial cash outlay = initial cash outlay

xxtt= net cash flow at t= net cash flow at t

k = cost of capitalk = cost of capital

n = investment horizonn = investment horizon

n

tt

t

k

XINPV

10 )1(

BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

3.3. Most important property of NPVMost important property of NPVtechnique:technique:-focus on cash flows with-focus on cash flows with respect to shareholder respect to shareholder wealth wealth

4.4. NPV obeys value additive NPV obeys value additive principle:principle:- the NPV of a set of projects- the NPV of a set of projects is the sum of the individual is the sum of the individual project NPV project NPV

BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

C.C. International Cash FlowsInternational Cash Flows

1.1. Important principle when Important principle when estimating: Incremental basisestimating: Incremental basis

2.2. Distinguish total from incrementalDistinguish total from incremental

flows to account forflows to account fora.a. cannibalizationcannibalizationb.b. sales creationsales creationc.c. opportunity costopportunity costd.d. transfer pricingtransfer pricinge.e. fees and royaltiesfees and royalties

BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

3.3. Getting the base case correctGetting the base case correct

Rule of thumb:Rule of thumb:

Incremental Incremental GlobalGlobal GlobalGlobalcash flowscash flows = corporate = corporate - - flowflow

cash flowcash flow without withoutwith projectwith project projectproject

BASICS OF CAPITAL BUDGETINGBASICS OF CAPITAL BUDGETING

4.4. Intangible BenefitsIntangible Benefits

a. Valuable learning experiencea. Valuable learning experience

b. Broader knowledge baseb. Broader knowledge base

II. ISSUES IN FOREIGN II. ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSISII. TWO ISSUES IN FOREIGN INVESTMENT II. TWO ISSUES IN FOREIGN INVESTMENT

ANALYSISANALYSIS

A.A. Issue #1 Parent v. Project Cash FlowIssue #1 Parent v. Project Cash Flow

-the cash flows from the project may -the cash flows from the project may

differ from those remitted to the parentdiffer from those remitted to the parent

1. Relevant cash flows become quite1. Relevant cash flows become quite

importantimportant

ISSUES IN FOREIGN ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSIS

2.2. Three Stage ApproachThree Stage Approach

-to simplify project evaluation-to simplify project evaluation

a. compute subsidiary’s projecta. compute subsidiary’s project

cash flowscash flows

b. evaluate the project to the b. evaluate the project to the parent parent

c. incorporate the indirect c. incorporate the indirect effectseffects

ISSUES IN FOREIGN ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSIS

3.3. Estimating Incremental Project FlowsEstimating Incremental Project Flows

What is the true profitability of theWhat is the true profitability of the

project?project?

a.a. Adjust for tax effects ofAdjust for tax effects of

1.)1.) transfer pricingtransfer pricing

2.)2.) fees and royaltiesfees and royalties

ISSUES IN FOREIGN ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSIS

4.4. Tax Factors:Tax Factors:

determine the amount and determine the amount and timingtiming

of taxes paid on foreign-sourceof taxes paid on foreign-source

income.income.

ISSUES IN FOREIGN ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSISB.B. Issue #2 How to adjust for increasedIssue #2 How to adjust for increased

economic and political risk of project? economic and political risk of project? 1. 1. Three Methods of Economic Three Methods of Economic

and Political Risk Adjustments:and Political Risk Adjustments:

a.a. Shortening minimum payback Shortening minimum payback periodperiod

b.b. Raising required rate of returnRaising required rate of return

c.c. Adjusting cash flowsAdjusting cash flows

ISSUES IN FOREIGN ISSUES IN FOREIGN INVESTMENT ANALYSISINVESTMENT ANALYSIS

2.2. Accounting for Exchange Rate and Accounting for Exchange Rate and Price Changes (inflationary)Price Changes (inflationary)

Two stage procedure:Two stage procedure:

a.a. Convert nominal foreign cash Convert nominal foreign cash flows into home currency termsflows into home currency terms

b.b. Discount home currency flowsDiscount home currency flows

at domestic required rate of at domestic required rate of return.return.

III. POLITICAL RISK ANALYSISIII. POLITICAL RISK ANALYSIS

III. POLITICAL RISK ANALYSISIII. POLITICAL RISK ANALYSIS

A.A. Political risksPolitical risks

can be incorporated into an NPV can be incorporated into an NPV analysis byanalysis by

- adjusting expected project cash- adjusting expected project cash

flows to reflect the risks.flows to reflect the risks.

POLITICAL RISK ANALYSISPOLITICAL RISK ANALYSIS

B. B. EXPROPRIATIONEXPROPRIATION

- the extreme form of political risk- the extreme form of political risk

C.C. BLOCKED FUNDSBLOCKED FUNDS

IV. GROWTH OPTIONS AND IV. GROWTH OPTIONS AND PROJECT EVALUATIONPROJECT EVALUATION

IV.IV. GROWTH OPTIONS AND PROJECT GROWTH OPTIONS AND PROJECT EVALUATIONEVALUATION

A. A. Options:Options:

1.1. an important component of an important component of

many many investment decisionsinvestment decisions

2.2. ignoring options will understate ignoring options will understate

the NPV of that investmentthe NPV of that investment

GROWTH OPTIONS AND GROWTH OPTIONS AND PROJECT EVALUATIONPROJECT EVALUATION

B.B. Project EvaluationProject Evaluation

1.1. Growth options require an Growth options require an

expanded NPV ruleexpanded NPV rule

2.2. Investments in emerging Investments in emerging

markets markets can be viewed as growth can be viewed as growth

optionsoptions