Chapter 14 - Multinational Capital Budgeting Flashcards
Chapter Objectives
Compare the capital budgeting analysis of an M N C’s subsidiary versus its parent.
Demonstrate how multinational capital budgeting can be applied to determine whether an international project should be implemented.
Show how multinational capital budgeting can be adapted to account for special situations such as alternative exchange rate scenarios or when subsidiary financing is considered.
Explain how the risk of international projects can be assessed.
Subsidiary versus Parent Perspective
*In most cases, multinational capital budgeting should be based on the parent company’s perspective, rather than the subsidiary’s perspective.
*Some projects might be feasible for a subsidiary but not feasible for the parent, as net after-tax cash inflows to the subsidiary can differ substantially from those to the parent.
*Such differences in cash flows between the subsidiary and the parent can be due to several factors
Tax Differentials: If the parent’s government imposes a high tax rate on the remitted funds, the project may be feasible from the subsidiary’s point of view but not from the parent’s point of view.
Restrictions on Remitted Earnings:
–> Host country governments may place restrictions on whether earnings must remain in country.
–> Excessive Remittances: If the parent company charges fees to the subsidiary, then a project may appear favorable from a parent perspective, but not from a subsidiary’s perspective.
Exchange Rate Movements: When earnings are remitted to the parent, the amount received by the parent is influenced by the existing exchange rate. Therefore, a project that appears to be feasible to the subsidiary may not be feasible to the parent if the subsidiary’s currency is expected to weaken substantially over time.
Summary of Factors That Distinguish the Parent Perspective
The parent’s perspective is appropriate when evaluating a project since the parent’s shareholders are the owners and any project should generate sufficient cash flows to the parent to enhance shareholder wealth.
One exception is when the foreign subsidiary is not wholly owned by the parent and the foreign project is partially financed with retained earnings of the parent and of the subsidiary.
Input for Multinational Capital Budgeting:
An M N C will normally require forecasts of the financial characteristics that influence the initial investment or cash flows of the project. Each of these characteristics is briefly described here:
- Initial investment — Funds initially invested include whatever is necessary to start the project, and additional funds, such as working capital, to support the project over time.
- Price and consumer demand — The price at which the product could be sold can be forecast using competitive products in the markets as a comparison. The future prices will most likely reflect the future inflation rate in the host country (where the project is to take place), but that rate is not known.Future demand is usually influenced by economic conditions, which are uncertain.
- Costs — Variable-cost (labor, materials) forecasts can be developed from comparative costs of the components. Such costs usually move in tandem with the future inflation rate of the host country.Fixed costs can be estimated without an estimate of consumer demand. Nevertheless, it remains sensitive to any change in the host country’s inflation rate
- Tax laws — Because after-tax cash flows are necessary for an adequate capital budgeting analysis, international tax effects must be determined on any proposed foreign projects.
- Remitted funds — The M N C policy for remitting funds to the parent influences estimated cash flows. Some host governments might prevent a subsidiary from remitting its earnings to the parent for some specified period of time.
- Exchange rates — These movements are often very difficult to forecast.
- Salvage (liquidation) values — The after-tax salvage value of most projects willdepend on several factors, including the success of the project and the attitude of the host government toward the project. Political events may sometimes force a firm to liquidate a project earlier than planned
- Required rate of return — The M N C should first estimate its cost of capital, and then it can derive its required rate of return on a project based on the risk of that project.
The challenge of multinational capital budgeting is to accurately forecast the financial variables just described that are used to estimate cash flows.
Analysis
Calculation of Net Present Value
Where:
I O = initial outlay (investment)
C Ft = cash flow in period t
S Vn = salvage value
k = required rate of return on the project
n = lifetime of the project (number of periods)
Multinational Capital Budgeting Example
Background
Spartan, Inc., is considering the development of a subsidiary in Singapore that would manufacture and sell tennis rackets locally.
Spartan’s financial managers have asked the manufacturing, marketing, and financial departments to provide them with relevant input so they can apply a capital budgeting analysis to this project.
In addition, some Spartan executives have met with government officials in Singapore to discuss the proposed subsidiary.
The project would end in 4 years. All relevant information follows.
Initial investment: S$20 million (S$ = Singapore dollars)
Price and consumer demand:
Year 1 and 2: 60,000 units @ S$350/unit
Year 3: 100,000 units @ S$360/unit
Year 4: 100,000 units @ S$380/unit
cOSTS:
Variable costs: Years 1 & 2 S$200/unit, Year 3 S$250/unit, Year 4 S$260/unit
Fixed costs: S$2 million per year
The expense of leasing extra office space isS$1millionper year. Other annual overhead expenses are expected to totalS$1millionper year.
Depreciation: S$2 million per year
Tax laws: 20% income tax
Remitted funds: 10% withholding tax on remitted funds
Exchange rates: Spot exchange rate of $0.50 for Singapore dollar
Salvage values: S$12 million
Analysis
The capital budgeting analysis is conducted from the parent’s perspective, based on the assumption that the subsidiary would be wholly owned by the parent and created to enhance the value of the parent.
The capital budgeting analysis to determine whether Spartan, Inc., should establish the subsidiary is provided in Exhibit 14.2.
Results: Spartan, Inc.
N P V = $2,229,867
Results
Because the N P V is positive, Spartan, Inc., may accept this project if the discount rate of 15% has fully accounted for the project’s risk.
If the analysis has not yet accounted for risk, however, Spartan may decide to reject the project.
Other Factors to Consider
1.Exchange rate fluctuations
2.Inflation
3.Financing arrangement
4.Blocked funds
5.Uncertain salvage value
6.Impact of project on prevailing cash flows
7.Host government incentives
8.Real options
- Exchange Rate Fluctuations (Exhibits 14.3 and 14.4)
Though exchange rates are difficult to forecast, a multinational capital budgeting analysis could incorporate other scenarios for exchange rate movements, such as a pessimistic scenario and an optimistic scenario.
Exchange Rates Tied to Parent Currency — Some M N Cs consider projects in countries where the local currency is tied to the dollar.
Hedged Exchange Rates — Some M N Cs may hedge the expected cash flows of a new project, so they should evaluate the project based on hedged exchange rates. (Exhibit 14.5)
- Inflation
Should affect both costs and revenues.
Exchange rates of highly inflated countries tend to weaken over time.
The joint impact of inflation and exchange rate fluctuations may be partially offsetting effect from the viewpoint of the parent.
- Financing Arrangement (Subsidiary)
Subsidiary financing
Assume, subsidiary borrows S$10 million to purchase the previously leased offices. Subsidiary will make interest payments on this loan (of S$1 million) annually and will pay the principal (S$10 million) at the end of Year 4, at termination. Singapore government permits a maximum of S$2 million per year in depreciation for this project, the subsidiary’s depreciation rate will remain unchanged. Assume the offices are expected to be sold for S$10 million after taxes at the end of Year 4.
–> The annual cash outflows for the subsidiary are still the same (pay interest S$1 mil rather than leasing $1 mil. Max depreciation of S$ 2 mil unchanged).
–> The subsidiary must pay the S$10 million in loan principal at the end of 4 years. However, since it receives S$10 million from the sale of the offices, it can use the proceeds of the sale to pay the loan principal.
- Financing Arrangement
Parent financing
Parent financing
Instead of the subsidiary leasing or purchasing with borrowed funds, the parent uses its own funds to purchase the offices. Thus, its initial investment is $15 million, composed of the original $10 million investment, plus an additional $5 million to obtain an extra $5 mil / 0.5=S$10 million to purchase the offices.
–> The subsidiary will not have any loan or lease payments.
–> The parent’s initial investment is $15 million instead of $10 million.
–> The salvage value to be received by the parent is S$22 million instead of S$12 million because the offices are assumed to be sold for S$10 million after taxes at the end of Year 4.
- Financing Arrangement (continued)
Comparison of parent and subsidiary financing
–> This revised example shows that the increased investment by the parent increases its exchange rate exposure for the following reasons.
——>. First, since the parent provides the entire investment, no foreign financing is required. Consequently, the subsidiary makes no interest payments and therefore remits larger cash flows to the parent.
—–>. Second, the salvage value to be remitted to the parent is larger. Given the larger payments to the parent, the cash flows ultimately received by the parent are more susceptible
Comparison of parent and subsidiary financing (continued)
Financing with Other Subsidiaries’ Retained Earnings — Some foreign projects are completely financed with retained earnings of one or more existing foreign subsidiaries of the M N C. This type of financing is unusual because the parent does not make an initial investment. The parent can evaluate the feasibility of this financing arrangement by viewing a subsidiary’s investment in the new project as an opportunity cost, because those funds could have been remitted to the parent rather than invested in the foreign project. Thus, the initial outlay for the new project from the parent’s perspective is the amount of funds that the parent would have received from the subsidiary if the funds had been remitted rather than invested in the project.
- Blocked Funds (Exhibit 14.7)
In some cases, the host country may block funds that the subsidiary attempts to send to the parent.
Some countries require that earnings generated by the subsidiary be reinvested locally for at least 3 years before they can be remitted.
Suppose the subsidiary uses the blocked funds to purchase marketable securities that are expected to yield5%annually after taxes.
- Uncertain Salvage Value
Breakeven Salvage Value:
The salvage value of an M N C’s project typically has a significant impact on the project’s N P V.
—> Consider scenario analysis to estimate N P V at various salvage values.
—-> Consider estimating break-even salvage value at zero N P V.
- Impact of Project on Prevailing Cash Flows (Exhibit 14.8)
Impact can be favorable if sales volume of parent increases following establishment of project.
Impact can be unfavorable if existing cash flows decline following establishment of project.
