Weeks 9-12 Flashcards
What is FDI?
- Investment in another country which is
carried out by companies or individuals
– rather than using, financial instruments, FDI
involves investment in plant and equipment - World Bank Definition
- For the investor, the goal is to add value
– the project should offer a positive NPV.
Alternatives to FDI
– Exporting
– Importing
– Licensing
– Technology Sales
– Management Contracting
– Turnkey Projects
– Portfolio Investment
If Alternatives Exist…
- Why do firms move abroad as direct
investors?
– Why enter a foreign country using FDI instead of
exporting or licensing? - After all - how can direct-investing
overseas firms be expected to compete
successfully with local firms in the host
country?
– They have a natural disadvantage of
operating in unfamiliar foreign territory
Why use FDI?
Market imperfections to overcome.
MNC needs:
– advantages
– to be able to transfer them
Consider:
– Costs
– Benefits
* Direct Cash-flow Benefits (see over)
* Indirect Cash-flow Benefits
– Leverage
– Information
– Perceptions (supply & service)
– Risks
FDI Direct Cash-flow Effects
- Cost Related Motives
- Revenue Related Motives
- International Portfolio Diversification
– Cash-flow stability (uncorrelated cash-flows)
Cost Related Motives
▪ Fully benefit from economies of scale
Lower average cost per unit resulting from increased production.
▪ Use foreign factors of production
Labor and land costs can vary dramatically among countries.
▪ Use foreign raw materials
Develop the product in the country where the raw materials are
located.
▪ Use foreign technology
▪ React to exchange rate movements
When a firm perceives that a foreign currency is undervalued, the firm
may consider FDI in that country, as the initial outlay should be
relatively low.
Revenue-Related Motives
▪ Attract new sources of demand
MNCs commonly pursue FDI in countries experiencing economic
growth so that they can benefit from the increased demand for products
and services there.
▪ Enter profitable markets
When similar industries are generating very high earnings in a particular
country, an MNC may decide to sell its own products in those markets.
▪ Exploit monopolistic advantages
Firms possessing resources or skills not available to competing firms
may attempt to exploit it internationally.
▪ React to trade restrictions
MNCs may pursue FDI to circumvent trade barriers
International
Portfolio Diversification
By diversifying sales (and even production) internationally, a
firm can potentially make its net cash flows less volatile.
Diversification Analysis of International Projects
* Select foreign projects whose performance levels are not highly
correlated over time.
Conditions facilitating
successful FDI
- Economies of scale
- Managerial and marketing expertise
- Technology
- Financial strength
- Differentiated product line
- Competitive home market
FDI & Politics
Pros
▪ for LDC’s, FDI introduces investments “that have worked”
elsewhere
▪ positive externalities
▪ the ideal FDI solves problems such as unemployment and
lack of technology without taking business away from local
firms.
Incentives to encourage FDI
▪ Governments are particularly willing to offer incentives for
FDI that will result in the employment of local citizens or an
increase in technology.
Cons
* Economic colonialism/exploitation
* Country reliant on foreign firms
* Retard development of local firms
Indirect Barriers to FDI
* Ethical differences — A business practice that is perceived to
be unethical in one country may be ethical in another.
* Political instability — If a country is susceptible to abrupt
changes in government and political conflicts, the feasibility
of FDI may be dependent on the outcome of those conflicts.
Direct Government Barriers to FDI
- Regulatory barriers — Each country enforces its own regulatory
constraints pertaining to taxes, currency convertibility, earnings
remittance, employee rights, and other policies. - Protective barriers — Agencies may prevent an MNC from
acquiring companies if they believe employees will be laid off - “Red Tape” barriers — Procedural and documentation
requirements - Industry barriers — Local firms may have substantial influence
on the government and may use their influence to prevent
competition from MNCs - Environmental barriers — Building codes, disposal of
production waste materials, and pollution controls
What is Country Risk?
- Country risk vs. Political risk. Is there a difference?
- Country Risk focuses on the
– Political and
– Financial factors
Characteristics of the host country, including political and
financial conditions, that can affect a MNC’s cash flows.
(Madura, page 698)
An MNC conducts country risk analysis when it applies
capital budgeting to determine whether to implement a
new project in a particular country or to continue
conducting business in a particular country.
Political Risk
Political actions taken by the host government or the
public that affect the MNC’s cash flows.
(Madura, page 701)
Social factors are hard to quantify
* political stability
* protection of property rights
* respect for the law
* democracy, dictatorship and kleptocracy
* corruption
– corruption indices - an attempt to quantify
Political Risk Characteristics
Attitude of consumers in the host country
* A tendency of residents to purchase only locally produced
goods.
Actions of the host government
* A host government might impose pollution control standards
and additional corporate taxes, as well as withholding taxes
and fund transfer restrictions.
Blockage of fund transfers
* A host government may block fund transfers, which could
force subsidiaries to undertake projects that are not optimal
(just to make use of the funds).
Currency inconvertibility
* Some governments do not allow the home currency to be
exchanged into other currencies.
War
* Conflicts with neighbouring countries or internal turmoil can
affect the safety of employees hired by an MNC’s subsidiary or
by salespeople who attempt to establish export markets for the
MNC.
Inefficient bureaucracy
* Bureaucracy can delay a MNC’s efforts to establish a new
subsidiary or expand business in a country.
Corruption
* Corruption can occur at the firm level or with firm-government
interactions. Transparency International has derived a
corruption index for most countries (next slide)
Measuring Country Risk
Macro-assessment of country risk
* represents an overall risk assessment of a country and
considers all variables that affect country risk except
those that are firm-specific.
Micro-assessment of country risk
* involves assessment of a country as it relates to the
MNC’s type of business.
Techniques to Assess Country Risk
Checklist approach:
* Ratings assigned to various factors
Delphi technique:
* Collection of independent opinions without group discussion
Quantitative analysis:
* Use of models such as regression analysis
Inspection visits:
* Meetings with government officials, business executives, and
consumers to clarify risk
Combination of techniques:
* Many MNCs have no formal method but use a combination of
methods
Country risk: Economic Factors
- Factors to consider:
– government fiscal irresponsibility
– unproductive spending
– controlled versus fixed exchange rates systems
– the country’s resource base
– adjustment process to external shocks
– market-orientated policies
Other factors to consider:
Country risk: Economic Factors
Other factors to consider:
– interest rates: higher interest rates tend to slow growth and reduce
demand for MNC products
– exchange rates: strong currency may reduce demand for the country’s
exports, increase volume of imports, and reduce production and
national income.
– inflation: inflation can affect consumers’ purchasing power and their
demand for MNC goods.
– balance of payments
– unemployment
– reliance on export income
Deriving A Country Risk Rating
An overall country risk rating using a checklist approach can
be developed from separate ratings for political and financial
risk
* First, the political factors are assigned values within some
range.
* Next, these political factors are assigned weights. The assigned
values of the factors times their respective weights can then be
summed to derive a political risk rating.
* The process is then repeated to derive the financial risk rating.
* Once the political and financial ratings have been derived, a
country’s overall country risk rating as it relates to a specific
project can be determined by assigning weights to the political
and financial ratings according to importance.
Governance of the
Country Risk Assessment
- MNCs need a proper governance system to ensure that managers
fully consider country risk when assessing potential projects. - One solution is to require that major long-term projects use input
from an external source (such as a consulting firm) regarding the
country risk assessment of a specific project and that this
assessment be directly incorporated in the analysis of the project.
Analysis of Existing Projects - An MNC should not only consider country risk when assessing a
new project but should also review the country risk periodically
after a project has been implemented. - If an MNC has a subsidiary in a country that experiences adverse
political conditions, it may need to reassess the feasibility of
maintaining this subsidiary.
Incorporating Country Risk
in Capital Budgeting
Adjustment of the discount rate:
* Lower risk rating implies higher risk and higher
discount rate.
* Risks arguably unsystematic
Adjustment of the estimated cash flows:
* Could account for the uncertainty of country risk
characteristics while also allowing for uncertainty in
the other variables as well.
* Adjust estimates for the probability that cash flows
may not be realised. (See next exhibits)
What to do about country risk
- Avoidance
- Insurance
– In Australia, try EFIC (like U.S. DFC)
– Cost issues arising from information asymmetry - Negotiating with the Host Government
– to affect returns - Controlling the environment
– Structuring the Investment (to affect risk) - Short-Term Horizon
- Unique Supplies or Technology
- Hire Local Labour
- Borrow Local Funds
International Acquisitions
Motives for International Acquisitions
* Form of foreign direct investment
– Market for corporate control is a means for MNCs to
achieve market expansion goals
* Economies of scale / synergies
* Resource access
* Gaining competitive advantage
Trends in International Acquisitions
* Traditionally, MNCs tend to focus on geographic regions and
use stocks or cash to make their purchases
* Recent developments: Emerging markets expansion, geo-
political tensions, national security, rise in private equity,
industry consolidations.
Model for Valuing a Foreign Target
When an MNC subsequently engages in restructuring, it
affects the structure of its assets, which will ultimately affect
the present value of its cash flows.
Control Decisions as Real Options
Real Assets
* Physical / Tangible assets
Real Options on Real Assets
* Management decision-making flexibility
* Can be seen as the ability to defer / gather information
Call option on real assets
* Expansion: Represents a proposed project that contains an
option of pursuing an additional venture.
Put option on real assets
* Abandonment: Represents a proposed project that contains an
option of divesting part, or all, of the project.
International partial acquisitions
A partial international acquisition requires less funds because
only a portion of the foreign target’s shares are purchased.
Issues
* Reliance on local management
* Unable to fully integrate / standardise
* Conflicting interests
* Dividend policies
* Lack of liquidity in minority stakes
* Lack of knowledge sharing
When an MNC considers a partial acquisition, it must take the
perspective of a passive investor rather than as a decision maker
International Acquisition
Valuation Challenges
- Potential conflict between government control and acquirers
may exist - Political conditions can be volatile
- Economic conditions are uncertain in transitional economies
- Future cash flows are uncertain due to potential introduction of
competition - Exchange rate forecasting
- Taxation / Legal system differences
- Privatised businesses
– Data regarding value and benchmarks are limited - Unanticipated business integration challenges
International Divestitures
The valuation of a proposed international divestiture requires
comparing the present value of the cash flows if the project is
continued to the proceeds that would be received (after taxes) if the
project is divested.
External forces that could reduce the present value:
* a weakening economy in the host country could reduce expected
cash flows to be generated by the subsidiary
* a reduction in the foreign currency could reduce the exchange
rate at which cash flows are converted to the home currency
* higher taxes imposed by the host government would reduce the
expected cash flows of the subsidiary
* an increase in the MNC parent’s cost of capital would increase
the discount rate at which expected future cash flows are
discounted when determining the present value of the subsidiary
International Corporate Governance
The system of controls, regulations and incentives designed to
control corporations across countries.
Legal Framework Emphasis
* Shareholders v Stakeholder Balanced Approach v CSR
* Compliance: Sarbanes-Oxley & EU Directives
Governance by Board Members
* Board members who are employees of a foreign subsidiary may
maximise the benefits to the subsidiary
Governance by Institutional Investors
* Institutional investors commonly hold a large proportion of a
firm’s shares (incentives to be active)
Cultural Differences
* Attitudes towards authority, collectivism and individualism.
Market for Corporate Control
If managers make decisions that destroy value, the MNC could be
subject to takeover, and managers could lose their jobs.
* Hostile takeovers are a governance mechanism
Barriers to International Corporate Control
* Anti-takeover amendments implemented by target: Target may
implement an anti-takeover amendment that requires a large
proportion of shareholders to approve the takeover.
* Poison pills implemented by target: Grants special rights to
managers or shareholders under specified conditions.
* Host government barriers: Governments of some countries
restrict foreign firms from taking control of local firms, or they
may allow foreign ownership of local firms only if specific
guidelines are satisfied.
External Sources of Equity
Components of Capital
- Domestic Equity Offering (public)
– MNCs can engage in a domestic equity offering in their
home country in which the funds are denominated in their
local currency. - Global Equity Offering (public)
– Some MNCs pursue a global equity offering in which they
can simultaneously access equity from multiple countries. - Private Placement (domestic / international)
– Offer a private placement of equity to financial institutions /
private investors in their home country or in the foreign
country where they are expanding.
External Sources of Debt
Components of Capital
- Domestic Bond Offering
– MNCs commonly engage in a domestic bond offering in their home
country in which the funds are denominated in their local currency. - Global Bond Offering
– MNCs can engage in a global bond offering, in which they
simultaneously sell bonds denominated in the currencies of multiple
countries. - Private Placement of Bonds
– MNCs may offer a private placement of bonds to financial institutions in
their home country or in the foreign country where they are expanding. - Loans from Financial Institutions
– An MNC’s parent commonly borrows funds from financial institutions.
Establishing a World-Wide
Capital Structure
- What factors influence capital structure?
- component costs of capital
- taxes
- interactions of components
- The Goal:
- to determine the mix of debt and equity that
maximises shareholder wealth - But is capital structure relevant?
Modigliani and
Miller
- The irrelevancy statement (MM1)
The market value of any firm is
independent of its capital structure - The cost of capital (MM2)
1.Financial Distress
Why don’t we see 100%
debt funded firms?
Optimal capital structure considers:
1.Financial Distress
Financial Distress
*Loss of value caused by the risk of bankruptcy.
*Bankruptcy itself is an additional cost.
2.Agency costs
Why don’t we see 100%
debt funded firms?
Optimal capital structure considers:
1.Financial Distress
2.Agency costs
Agency cost is roughly defined as “difference
between the value of the firm in what would be an
ideal contracting situation and what is viable through
negotiation” Amaro de Matos, J., Theoretical Foundations
of Corporate Finance (Princeton University, Press, Princeton
NJ, 2001), p. 61.
3. Costs due to information asymmetry
Why don’t we see 100%
debt funded firms?
Optimal capital structure considers:
1. Financial Distress
2. Agency costs
3. Costs due to information asymmetry
Information asymmetry comes about when parties
have different information.
It is normally assumed that managers (insiders) have the
best information about the firm.
Capital Structure of the MNC
EQUITY (Ownership / Control)
MNC’s parent:
– may invest its own cash into the subsidiary.
– The cash infusion in the subsidiary represents an equity investment by
the parent, so that the parent is the sole owner of the subsidiary.
MNC Subsidiary:
– An alternative method by which the subsidiary can build more equity
is to offer its own stock to the public.
DEBT (Is the Parent Responsible?)
– Fully responsible
* Overall Financial Structure
– Prepared to allow default
* Subsidiaries Financial Structure
* Consequences?
Financing Foreign Subsidiaries
Conform to the capital structure of the parent
company
* Financial structures are generally not independent
* This approach is not consistent with minimising the parent’s
overall cost of capital
Reflect the capitalisation norms in each foreign
country
* Not consistent with a strategic approach
* May reduce criticism if doing as everyone else does
* but doesn’t exploit MNC’s comparative advantages in financing
Implication:
* Vary judiciously
Subsidiary vs Parent Capital Structure
Some subsidiaries are subject to conditions that favour debt
financing, while other subsidiaries are subject to conditions that
favour equity financing.
Impact of Increased Subsidiary Debt Financing
* When a subsidiary relies heavily on debt financing, its need for
internal equity financing (retained earnings) is reduced.
Impact of Reduced Subsidiary Debt Financing
* The subsidiary will need to use more internal financing, will
remit fewer funds to the parent, and will reduce the amount of
internal funds available to the parent.
Limitations in Offsetting a Subsidiary’s Leverage
* Foreign creditors may charge higher loan rates to a subsidiary
that uses a highly leveraged local capital structure because they
believe that the subsidiary may be unable to meet repayments.
Influence of Corporate Characteristics
▪ MNC’s Cash Flow Stability — MNCs with more stable cash
flows can handle more debt because there is a constant stream of
cash inflows to cover periodic interest payments on debt.
**▪ MNC’s Credit Risk **— MNCs that have lower credit risk have
more access to credit.
▪ MNC’s Access to Retained Earnings — Highly profitable MNCs
may be able to finance most of their investment with retained
earnings and therefore use an equity-intensive capital structure.
**▪ MNC’s Guarantees on Debt **— If the parent backs the debt of its
subsidiary, the subsidiary’s borrowing capacity might be increased.
▪ MNC’s Agency Problems — If a subsidiary in a foreign country
cannot easily be monitored by investors from the parent’s country,
agency costs are higher => incentives to use debt financing
Influence of Host Country Characteristics
▪ Potential for Blocked Funds
▪ Equity Valuations
▪ Interest Rates in Host Countries
▪ Strength of Host Country Currencies
▪ Expected weakness => borrow locally
▪ Expected appreciation => retain / reinvest earnings
▪ Country Risk in Host Countries
▪ Higher expropriation risk => local debt financing
▪ Tax Laws in Host Countries
▪ e.g. withholding taxes
Stulz (1996) - Integration
- The argument depends on
– Market integration - Difficult issue as to whether this is the case
- No barriers to transfer of funds between
countries
– Is this true?
– Home country bias - Integration of capital markets (pre-tax
resolution)
Stulz (1996) – Taxes
A tax-based explanation.
* Stulz considered an investment in Germany that is risk-free
– U.S. company with 36% tax rate
– Liechtenstein company with 0% tax rate
* U.S. company would seek 100% debt funding, but the
Liechtenstein company would not
* Tax may explain capital structure
* Risk effect on the use of debt? – Alternative tax shields?
Note: This does not explain differences in required
compensation for risk.
Agency Costs, Ownership
Concentration & Cross Listings
- Traditional NPV analysis assumes
– Managers seek to maximise shareholder wealth
– Ignores costs of managerial discretion - Myers and Majluf (1984)
– Pecking order hypothesis - Issuing equities makes investors suspicious, lowering value of the
company. If relying on equity, some projects may not go ahead
(costs too high). - Internal funds have intrinsic value. No agency costs and all
positive NPV projects could proceed.
– No information transfer costs - Jensen (1986)
– “free-cash” flow undesirable
– Investors prefer high debt and low cash levels
Stulz (1996) – Cost of Capital
Stulz concludes that “neo-classical” cost of
capital should not differ but “agency adjusted”
cost of capital differs.
Testable hypotheses:
1. An increased ability to monitor will reduce
cost of capital.
2. Managers can reduce cost of capital by
reducing agency problems.
Legal families:
- Civil law (Romano-
Germanic)
a) French
b) German
c) Scandinavian - Common-law countries
* These countries give strongest protection to
creditors and shareholders
La Porta et al. conclude:
- Laws differ markedly around the world
- Investors seem better protected in common law
countries - Concentration of ownership is a compensation
for poorer protection. - Law enforcement is critical
* Accounting standards are important in this respect
* The richer you are, the better the laws are enforced - There is a link between legal systems and
economic development
Multinational Cost of Capital
* MNC’s Cost of Debt:
– An MNC’s cost of debt is dependent on the interest rate
that it pays when borrowing funds.
* MNC’s Cost of Equity:
– An MNC creates equity by retaining earnings or by
issuing new stock. An MNC’s cost of equity contains a
risk premium (above the risk-free interest rate) that
compensates the equity investors for their willingness to
invest in the equity.
Multinational Cost of Capital
- There is an advantage to using debt rather than
equity as capital because the interest payments on
debt are tax deductible. - The greater the use of debt, however, the greater the
interest expense and the higher the probability that
the firm will be unable to meet its expenses. - As an MNC increases its proportion of debt, the rate
of return required by potential new shareholders or
creditors will increase to reflect the higher
probability of bankruptcy.
Cost of Capital for
MNCs versus Domestic Firms
May differ because of:
* Size of firm
– An MNC that often borrows substantial amounts may receive
preferential treatment from creditors, thereby reducing its cost
of capital.
* Access to international capital markets
– MNC’s access to the international capital markets may allow
it to obtain funds at a lower cost than that paid by domestic
firms.
* International diversification
– If a firm’s cash inflows come from sources all over the world,
those cash inflows may be more stable because the firm’s
total sales will not be highly influenced by a single economy.
* Exposure to exchange rate risk
– An MNC’s cash flows could be more volatile than those of a
domestic firm in the same industry if it is highly exposed to
exchange rate risk.
* Exposure to country risk
– An MNC that establishes foreign subsidiaries is subject to the
possibility that a host country government may seize a
subsidiary’s assets.
Country differences in the cost of debt
Differences in the risk-free rate
– The risk-free rate is the
interest rate charged on loans
to a country’s government
that is perceived to have no
risk of defaulting on the
loans.
Differences in the Credit Risk
Premium
– The credit risk premium paid
by an MNC must be large
enough to compensate
creditors for taking the risk
that the MNC may not meet
its payment obligations.
Comparative costs of debt across
countries
– There is some positive
correlation between country
cost-of-debt levels over time
Finding the Cost of Equity
- Capital asset pricing model
- International capital asset pricing model
- Global capital asset pricing model
- Dividend discount model
- Gordon growth model
- Fama-French three-factor model
- Arbitrage pricing theory model
MNC and the Cost of Equity
- We’re operating in a global economy
- CAPM:
- How can the Capital Asset Pricing Model be
used to determine the cost of capital in an
international setting?
implications
Cost of Equity Comparison
Implications of the CAPM for an MNC’s risk:
* MNC may be able to reduce its beta by increasing its international
business.
Implications of the CAPM for an MNC’s projects:
* For MNC with many projects in foreign countries, their cash flows
are less sensitive to general home market conditions leading to
lower project betas.
differences
Cost of Equity Comparison
Country differences in the cost of equity
* Differences in the risk-free rate
– When the country’s risk-free interest rate is high, local investors would only
invest in equity if the potential return is sufficiently higher than that they
can earn at the risk-free rate.
* Differences in the Equity Risk Premium
– Based on investment opportunities in the country of concern; a second
factor that can influence the equity risk premium is the country risk.
What is beta
- Beta represents systematic risk
- Measure of risk that cannot be diversified
– compare with unsystematic risk - you can remove unsystematic risk by diversification
- Beta Source
– History
– Proxy
Estimating Beta
-Source of Data-
1 Foreign Proxy Companies
2 Home proxy companies
Correlation foreign vs. home market
Upwardly biased estimate
3 Foreign proxy industries
4 Adjusted home industry beta
Segmentation / Integration
- Segmented Markets
– Market Imperfections - Government constraints
- Investor Perceptions & Regulations
- Integrated Markets
– Assets priced by un-diversifiable world risk
=> Use Global CAPM
Stulz (1995). Local vs. global
market in calculating B
- Stulz considers the cost of capital in
smaller, but globally integrated markets
– he focuses on Switzerland, but the case could
be made for Australia, Singapore etc…
– Does the U.S. have to worry about this
problem? - the U.S. market is closely correlated with the World
Index anyway
segmented market integrated market
Local vs. global
market in calculating B
- Segmented market
– Less diversification
– C. of C. will be higher (relative to the world)
– Lower share prices
– Domestic CAPM assumes segmentation - Integrated market
– Applying CAPM with a World Market Index:
– Use world, rather than local, market as the benchmark
(even Americans!)
Emerging Markets
Dealing with additional risk:
View 1
Extra Premium
View 2
Global CAPM not applicable
Project Cost of Capital
Firm comes across a new project
* What discount is used for evaluation?
Discount rate k reflects:
1. Operating (business) risk of the project
2. Capital structure (financing)
Appropriate Discount Rate
Basic Scenarios:
1. Expansion Project (Same risk)
+ Same Capital Structure
2. Expansion Project (Same risk)
+ Change in Cap Structure
3&4. Project of Different Risk
(Same / Different Cap Structure)
Scenario 1Expansion Project (Same risk)
+ Same Capital Structure
- assume that
– the risk of the foreign project is no different
from the risk of other projects being undertaken
by the parent
– the capital structure of the company (the
mixture of debt and equity) remains the same
and they continue to use domestic funds
solution * the international WACC
Scenario 2Expansion Project (Same risk)
+ Change in Cap Structure
- assume that
– the risk of the foreign project is no different
from the risk of other projects being undertaken
by the parent
– the company uses new sources of funds - for example, local currency (LC) debt
solution:
kI = discount rate for international project
Foreign Project Risk using
CAPM in an international context
Adjusting Measured Risk
* Use an all-equity beta to estimate discount rate
reflective of business risk
Direct use of CAPM inputting a beta reflective of the foreign
subsidiary’s risk
* Financing effects are placed in the cash flows!
Adjusting Business Risk
Traditional finance
▪The analysis of business proposals
▪To accept projects that add value
Decision Rules
Financial Metrics
▪Internal rate of return
▪Payback period
▪Discounted payback period
▪Accounting rate of return
average profit / average investment
▪Net present value
NPV Complications
Challenges
▪Unequal Lives
▪Leasing
▪Real Options
Assumptions
▪Base Case
▪Fisher’s separation theorem
◦ Independence from consumption preferences
◦ Independence from financing decisions
Why Projects Generate Positive
NPV in an Imperfect Market
In imperfect markets firm can generate projects with positive NPVs from competitive advantages
Imperfections
▪High barriers to entry
▪Economies of scale
▪Product differentiation / premium pricing
▪Competitor cost disadvantages
▪Exclusive access to distribution channels
▪Favourable government policy
sunk costs, initial outlay, working capital
Incremental Cash Flow
Key Components
Sunk costs
▪Irrecoverable past expenses, excluded from future project decisions
Initial outlay
▪The upfront cash investment required to start the project
Working capital
▪Funds required for daily operations, often fluctuating throughout the project.
▪Some working capital may be recovered at project
termination
general costs, depreciation and tax
Incremental Cash Flow
Key Components
General costs
▪ Variable-cost forecasts can be developed from costs of components and depend on the level of output.
▪ Fixed costs can be estimated without an estimate of consumer
demand.
▪ Beware allocated overhead costs, which may not represent additional cash flows
e.g. Management salaries may not be an extra expense
Depreciation and Tax
▪ Tax is a cash flow
▪ Depreciation reduces taxable inco
potential benefits, salvage values, opportunity costs
Incremental Cash Flow
Key Components
Potential Benefits
▪ Future demand is usually influenced by uncertain economic
conditions
Salvage (Liquidation) Values
▪ Depends on several factors, including the success of the project and
the attitude of the host government toward the project.
▪ Consider scenario analysis to estimate NPV at various salvage values.
▪ Consider estimating break-even salvage value at zero NPV.
Opportunity costs
▪ Include opportunity costs, the value of the next best alternative.
▪ Can be difficult to estimate – market price as a benchmark
shorten payback period, adjust discount rate
Country Risk Management
Shorten payback period
▪ Shortening the payback period reduces the project’s exposure to
long-term uncertainties in high-risk countries
Adjust the discount rate
▪ Higher country risk increases the uncertainty of future cash flows,
justifying a higher discount rate to account for that risk
▪ The greater the uncertainty the larger should be the discount rate
applied to cash flows
▪ Estimating an appropriate discount rate can be challenging
▪ Fluctuations in country risk over time can lead to inconsistencies in
applying the discount rate
Adjusting expected values
Country Risk Management
▪ Sensitivity analysis
◦ Examines how variables impact project outcomes
◦ More useful than simple point estimates because it reassesses
the project based on various circumstances that may occur
▪ Simulation
◦ Simulations generate a range of possible outcomes for NPV by
modeling input variables. This technique is typically performed
using specialized software to assess how changes in factors
affect project viability
Parent vs. Project Cash Flow
A three-stage process
Project cash flows estimated from subsidiary’s viewpoint
▪ Treating the project as standalone helps to isolate cash flows
directly attributable to the subsidiary’s operations, without
considering broader corporate effects
Examine project from parent’s viewpoint
▪ The parent must account for additional complexities, including
foreign exchange fluctuations, tax implications, and potential
repatriation issues, all of which can affect the overall cash flow
Indirect benefits and costs
▪ Broader corporate effects, such as cannibalization of other
revenue streams or potential synergy gains
Parent versus
Subsidiary Perspective
Parent’s 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
Subsidiary perspective
▪ 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
▪ The subsidiary’s perspective may prioritise local market dynamics
and operational needs, which can differ from the parent’s broader
focus on shareholder value
remitted funds, cannibalisation, sales creation
Differences between
Parent and Project Cash Flows
Remitted Funds
▪ Remittance policies can affect cash flow timing and availability,
potentially leading to delays or restrictions that impact the parent’s
financial forecasts
Cannibalisation
▪ Cannibalisation occurs when new projects reduce the sales or
profitability of existing operations. For example, opening a subsidiary
in a new region could reduce sales in the parent’s existing markets
Sales Creation
▪ Sales creation occurs when the new project leads to increased sales
for the parent company, such as when a new subsidiary boosts
overall market share
fees and royalties, transfer pricing
Differences between
Parent and Project Cash Flow
Fees and Royalties
▪ If the parent company charges fees to the subsidiary, then a
project may appear favourable from a parent perspective, but not
from a subsidiary’s perspective
Transfer Pricing
▪ Transfer pricing refers to the prices charged between related
entities for goods, services, or intellectual property.
▪ It can influence cash flows, as companies may adjust transfer
prices to optimize tax efficiency or manage profits across
subsidiaries
tax issues
Differences between
Parent and Project Cash Flows
Tax Issues
▪International tax effects must be determined on any
proposed foreign projects
▪Withholding Taxes, Corporate Income Taxes, Tax Credits,
Intercompany Transfers
▪Different tax rates may make a project feasible from a
subsidiary’s perspective, but not from a parent’s perspective.
▪Tax treaties or double taxation agreements may mitigate the
tax burden and affect the project’s feasibility for both the
subsidiary and the parent
Foreign Exchange Considerations
Differences between
Parent and Project Cash Flows
Foreign Exchange Considerations
▪ Fluctuations in exchange rates can lead to a significant variance in
cash flows, affecting profitability when converted to the parent’s
currency.
▪ Foreign exchange forecasts required
e.g. parity conditions
▪ Multinational capital budgeting analysis can incorporate potential
scenarios for exchange rate movements
▪ Hedging
Hedging allows companies to reduce the risk of currency
fluctuations, which could affect project viability. If hedging is
used, evaluate the project based on the hedged exchange rate
Blocked Funds
Differences between
Parent and Project Cash Flows
Blocked Funds
▪ 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
Multinational Capital Budgeting:
Other Factors to Consider
Inflation
▪ Should affect both costs and revenues
▪ Highly inflated countries tend to weaken (FX) over time
▪ The impact of inflation and exchange rate fluctuations may be
partially offsetting from the viewpoint of the parent
Host Government Incentives
▪ Low-rate host government loans
▪ Reduced tax rates for subsidiary
▪ Government subsidies of initial investment
Real Options
▪ Real options provide flexibility, allowing firms to make future
investment decisions contingent on market developments
