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 BUDGETINGA. Basic Criterion: Net Present ValueA. Basic Criterion: Net Present ValueB.B. Net Present Value Technique:Net Present Value Technique:

1. Definition1. DefinitionThe 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

kXINPV

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 Flows1.1. Important principle when Important principle when estimating: estimating: Incremental basisIncremental basis2.2. Distinguish total from incrementalDistinguish total from incrementalflows 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 correctRule 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

ANALYSISANALYSISA.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 parent1. 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 evaluationa. compute subsidiary’s projecta. compute subsidiary’s project

cash flowscash flowsb. evaluate the project to the b. evaluate the project to the parent parentc. 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 FlowsWhat is the true profitability of theWhat is the true profitability of theproject?project?a.a. Adjust for tax effects ofAdjust for tax effects of

1.)1.) transfer pricingtransfer pricing2.)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

timingtimingof taxes paid on foreign-sourceof taxes paid on foreign-sourceincome.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? 1. economic and political risk of project? 1. Three Methods of Economic Three Methods of Economic and and Political Risk Adjustments:Political Risk Adjustments:a.a. Shortening minimum payback Shortening minimum payback periodperiodb.b. Raising required rate of returnRaising required rate of returnc.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 termsb.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 ANALYSISA.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 EVALUATIONIV.IV. GROWTH OPTIONS AND PROJECT GROWTH OPTIONS AND PROJECT

EVALUATIONEVALUATIONA. 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 EVALUATIONB.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