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Topic 9: International Capital Budgeting (Shapiro, Chapter 16-17)

I. FOREIGN DIRECT INVESTMENT (FDI)

II. BASIS OF CAPITAL BUDGETING

III. ISSUES IN FOREIGN INVESTMENT

ANALYSIS

IV. POLITICAL RISK ANALYSIS

V. GROWTH OPTIONS AND PROJECT

EVALUATION

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I. FOREIGN DIRECT INVESTMENT (FDI)

THE THEORY OF THE MNC

A. The MNC as an Oligopolist: Why FDI?1. When is FDI justified?

2. Internalization

3. Market Integration

a. Vertical

b. Horizontal

B. Financial Market Imperfections

1. Hypothesis

2. Diversification Effect of the MNC

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THE STRATEGY OF THE MNC

A. Three strategies:

1. The Innovation-based MNC2. The Mature MNC

a. the importance of economies of scal

b. economies of scope

3. The Senescent MNC

a. global scanning capability

b. the role of rationalization and

integration.

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3. Adjusting the effectiveness of the entry

mode, ie., continual auditing

4. Using appropriate evaluation criteria

5. Estimating the longevity of competitiveadvantage:

a. Develop competitive strength

transferable overseas.

b. Not easily duplicated

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II. BASICS OF CAPITAL BUDGETING

A. Basic Criterion: Net Present Value

B. Net Present Value Technique:1. Definition: The present value of future

cash flows, discounted at the projects

cost of capital less the initial net cashoutlay. In simple English, NPV is the net

addition to the wealth of a firm if the

project is taken.

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2. NPV Formula:

where I0= initial cash outlay, n =

investment horizon, xt

= net cash

flow at t, k = cost of capital,

3. Most important property of NPV technique:

- focus on incremental cash flows with

respect to shareholder wealth4. NPV obeys value additive principle:

- the NPV of a set of projects is the sum of

the individual project NPV

7

n

tt

t

k

XINPV

10 )1(

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C. International Cash Flows

1. Important principle when estimating:

Incremental basis

2. Distinguish total from incremental flows

to account fora. cannibalizationb. sales creation

c. opportunity costd. transfer pricinge. fees and royalties

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3. Getting the base case correct

Rule of thumb:

Incremental Global Globalcash flows = corporate - flow

cash flow withoutwith project project

4. Intangible Benefits

a. Valuable learning experience

b. Broader knowledge base

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Alternative capital budgeting frameworks

An adjusted present value (APV) approach

where k*is the all-equity rate and * is the all-equity

beta.

Recall that

where eis the firms stock price beta, t is the firmsmarginal tax rate, and D/E is the firms debt-equity

ratio.

10

)(** fmf rrrk

EDt

e

/)1(1*

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The adjusted present value (APV) with this

approach is

PV of PV of PV of PV ofAPV= investment + operating + interest + interest

outlay cash flows Tax shield subsidies

where Tt is tax savings in year t due to the specific financing

package, St is before-tax dollar (home currency) value ofinterest subsidies (penalty) in year t due to projectspecific

financing, and id is before-tax cost of dollar (home currency)

debt.

11

n

ti

Sn

ti

Tn

tk

X

td

t

td

t

t

tIAPV1

)1(1

)1(1

)1(0 *

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III. ISSUES IN FOREIGN INVESTMENT

ANALYSIS

TWO ISSUES IN FOREIGN INVESTMENT ANALYSIS

A. Issue #1 Parent vs Project Cash Flow

-the cash flows from the project may

differ from those remitted to the parent

1. Relevant cash flows become quite

important

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2. Three Stage Approach: to simplify projectevaluation

a. compute subsidiarys project cash flows

b. evaluate the project to the parent

c. incorporate the indirect effects

3. Estimating Incremental Project Flows

What is the true profitability of the project?a. Adjust for tax effects of

i) transfer pricing

ii) fees and royalties

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4. Tax Factors:

determine the amount and timing of taxes

paid on foreign-source income.

B. Issue #2 How to adjust for increased

economic and political risk of project?

1. Three Methods of Economic

and Political Risk Adjustments:

a. Shortening minimum payback period

b. Raising required rate of return

c. Adjusting cash flows

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2. Accounting for Exchange Rate andPrice Changes (inflationary)

Two stage procedure:a. Convert nominal foreign cash flows into

home currency terms

b. Discount home currency flows at

domestic required rate of return.

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IV. POLITICAL RISK ANALYSIS

POLITICAL RISK ANALYSISA. Political risks

can be incorporated into an NPV

analysis by adjusting expected project

cash flows to reflect the risks.

B. Expropriation

- the extreme form of political risk

C. Blocked funds

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V. GROWTH OPTIONS & PROJECT

EVALUATION

A. Options:1. an important component of many

investment decisions

2. ignoring options will understate the NPVof that investment

B. Project Evaluation

1. Growth options require an expanded NPVrule

2. Investments in emerging markets can be

viewed as growth option17