Lecture 10: Innternational Capital Budgeting: NPV

Question 1

Define NPV. How is it calculated?

Answer 1

Net Present Value: the standard discounted cash flow (DCF) method for capital budgeting

Question 2

How is the required rate of return for the project calculated?

Answer 2

Question 3

What are the two main tax factors that need to be accounted for in the NPV model with company tax?

Answer 3

1. Tax benefit of depreciation (‘Tax depreciation shield’) - tax is levied on taxable income measured after subtracting depreciation.
2. Tax benefit on interest (‘Interest Tax Shield’) - tax is levied on taxable income which is measured after subtracting interest expense (but before div payments)

Question 4

How do you calculate the depreciation tax shield?

Answer 4

Question 5

How do you calculate the interest tax shield?

Answer 5

Question 6

What is the common objective of the two methods for evaluating foreign projects using NPV?

Answer 6

The NPV needs to be measured in domestic currency (i.e. the value of the project to the parent company/investor)

Question 7

Describe the first method for evaluating projects using the foreign NPV method.

Answer 7

1. Forecast the projects FCFs in the FC
2. Discount these FC CFs at the foreign discount rate
3. Connvert FC value to a HC value at S_t EX rate

Question 8

Describe the second method for evaluating projects using the foreign NPV method.

Answer 8

1. Forecast the proojects FCFs in the FC
2. Convert each of the FC CFs to HC CFs using the forecast future spot EX rate
3. Discount the HC CFs at the domestiv discount rate.

Question 9

What are some of the problems with both mthods?

Answer 9

Method 1: assumes that parity conditions hold when theres a good chance they dont. Possibly due to:

• EX rates not being market determined (e.g. pegged E(S₁)=S₀)
• Cash flows being restricted (e.g. blocked funds).

Method 2: considerable inaccuracy iin calculating the expected future spot rates.