2ObjectivesThis chapter identifies additional considerationsin multinational capital budgeting versusdomestic capital budgeting.The specific objectives are:• to compare the capital budgeting analysis of an MNC’ssubsidiary with that of its parent;• to demonstrate how multinational capital budgetingcan be applied to determine whether an internationalproject should be implemented; and• to explain how the risk of international projects can beassessed.
3Subsidiary versus ParentPerspective• Should the capital budgeting for a multi-nationalproject be conducted from the viewpoint of thesubsidiary that will administer the project, or theparent that will provide most of the financing?• The results may vary with the perspective takenbecause the net after-tax cash inflows to theparent can differ substantially from those to thesubsidiary.
4Subsidiary versus ParentPerspectiveThe difference in cash inflows is due to :• Tax differentials– What is the tax rate on remitted funds?• Regulations that restrict remittances• Excessive remittances– The parent may charge its subsidiary very highadministrative fees.• Exchange rate movementsSummary of factors: Exhibit 11.1
5Exhibit 11.1 Process of RemittingSubsidiary Earnings to the ParentCash Flows Generatedby SubsidiaryAfter-Tax Cash Flowsto SubsidiaryCash Flows remittedby SubsidiaryAfter-Tax Cash FlowsRemitted by SubsidiaryConversion of Funds toParent’s CurrencyParentCorporate Taxes paidto Host GovernmentRetained Earningsby SubsidiaryWithholding Tax Paidto Host GovernmentCash Flows to Parent
6Subsidiary versus ParentPerspective• A parent’s perspective is appropriate whenevaluating a project, since any projectthatcan create a positive net present value forthe parent should enhance the firm’svalue.• However, one exception to this rule may
7Input for MultinationalCapital BudgetingThe following forecasts are usually required:1. Initial investment2. Consumer demand3. Product price4. Variable cost5. Fixed cost6. Project lifetime7. Salvage (liquidation) value
8Input for MultinationalCapital BudgetingThe following forecasts are usually required:8. Fund-transfer restrictions9. Tax laws10. Exchange rates11. Required rate of return
9MultinationalCapital Budgeting• Capital budgeting is necessary for all long-term projects that deserve consideration.• One common method of performing theanalysis is to estimate the cash flows andsalvage value to be received by theparent,and compute the net present value(NPV)
10MultinationalCapital Budgeting• NPV = – initial outlayn+ Σ cash flow in period tt =1 (1 + k )t+salvage value(1 + k )nk = the required rate of return on the projectn = project lifetime in terms of periods• If NPV > 0, the project can be accepted.
11Capital Budgeting Analysis:Example• Spartan, Inc., is considering the developmentof a subsidiary in Singapore that wouldmanufacture and sell tennis rackets locally.Spartan’s management has asked variousdepartments to supply relevant information for acapital budgeting analysis. (P287-289)The capital budgeting analysis to determinewhether Spartan, Inc., should establish the
12Capital Budgeting Analysis:Example1. Demand (1)2. Price per unit(2)3. Total revenue (1)×(2)=(3)4. Variable cost per unit (4)5. Total variable cost (1)×(4)=(5)6. Annual lease expense (6)7. Other fixed periodic expenses (7)8. Noncash expense (depreciation) (8)9. Total expenses (5)+(6)+(7)+(8)=(9)10. Before-tax earnings of subsidiary (3)–(9)=(10)11. Host government tax tax rate×(10)=(11)12. After-tax earnings of subsidiary (10)–(11)=(12)
13Capital Budgeting Analysis:Example13. Net cash flow to subsidiary (12)+(8)=(13)14. Remittance to parent (14)15. Tax on remitted funds tax rate×(14)=(15)16. Remittance after withheld tax (14)–(15)=(16)17. Salvage value (17)18. Exchange rate (18)19. Cash flow to parent (16)×(18)+(17)×(18)=(19)20. PV of cash flow to parent (20)21. Initial investment (21)22. Cumulative NPV (22)
14Factors to Consider inMultinational Capital Budgeting* Exchange rate fluctuations. Differentscenarios should be considered togetherwith their probability of occurrence.( Example: P292 Exhibit 11.3)* Inflation. Although price/cost forecastingimplicitly considers inflation, inflation canbe quite volatile from year to year forsome
15Factors to Consider inMultinational Capital Budgeting* Financing arrangement. Financing costs are usuallycaptured by the discount rate. However, many foreignprojects are partially financed by foreign subsidiaries.So, a more accurate approach is to separate theinvestment made by the subsidiary from the investmentmade by the parent, with the focuses put on theparent’s perspective. (P293 –P296)* Blocked funds. Some countries may require that theearnings be reinvested locally for a certain period
16Factors to Consider inMultinational Capital Budgeting* Uncertain salvage value. The salvage value typically hasa significant impact on the project’s NPV, and the MNC may wantto compute the break-even salvage value. (298)* Impact of project on prevailing cash flows.The new investment may compete with the existing businessfor the same customers. (P299 Exhibit11.7)* Host government incentives. These should also be consideredin the analysis.* Real OptionsSome capital budgeting projects contain real options, whichcan enhance the value of a project. (P299)
17Adjusting Project Assessmentfor Risk• If an MNC is unsure of the cash flows of aproposed project, it needs to adjust itsassessment for this risk.• One method is to use a risk-adjusted discountrate . The greater the uncertainty, the larger thediscount rate that is applied.• Many computer software packages are alsoavailable to perform sensitivity analysis andsimulation. (P300-301)
18Questions and Applications*1. Why should capital budgeting for subsidiary projectsbe assessed from the parent’s perspective? Whatadditional factors that normally are not relevant for apurely domestic project deserve consideration inmultinational capital budgeting?*2. What is the limitation of using point estimates ofexchange rates in the capital budgeting analysis?List the various techniques for adjusting risk inmultinational capital budgeting. Describe anyadvantages or disadvantages of each technique.
19Questions and Applications3. Huskie Industries, a U.S.-based MNC, considers purchasing asmall manufacturing company in France that sells products onlywithin France. Huskie has no other existing business in France andno cash flows in euros. Would the proposed acquisition likely bemore feasible if the euro is expected to appreciate or depreciateover the long run? Explain.4. Flagstaff Corp. is a U.S.-based firm with a subsidiary in Mexico. Itplans to reinvest its earnings in Mexican government securities forthe next ten years since the interest rate earned on these securitiesis so high. Then, after ten years, it will remit all accumulatedearnings to the United States. What is a drawback of using thisapproach? Assume the securities have no default or interest raterisk.
20Questions and Applications5. When Walt Disney World considered establishing a theme park inFrance, were the forecasted revenues and costs associated withthe French park sufficient to assess the feasibility of this project?Were there any other “relevant cash flows” that deserve to beconsidered?6. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiaryin Japan. It is very confident that the Japanese yen will appreciateagainst the dollar over time. The subsidiary will retain only enoughrevenue to cover expenses and will remit the rest to the parenteach year. Will Ventura benefit more from exchange rate effects ifits parent provides equity financing for the subsidiary or if thesubsidiary is financed by local banks in Japan? Explain.
21Questions and Applications7. PepsiCo recently decided to invest more than $300million for expansion in Brazil. Brazil offersconsiderable potential because it has 150 millionpeople and their demand for soft drinks is increasing.However, the soft drink consumption is still only aboutone-fifth of the soft drink consumption in the UnitedStates. PepsiCo’s initial outlay was used to purchasethree production plants and a distribution network ofalmost 1,000 trucks to distribute its products to retailstores in Brazil. The expansion in Brazil was expectedto make PepsiCo’s products more accessible toBrazilian consumers.
22Questions and Applicationsa. Given that PepsiCo’s investment in Brazil was entirelyin dollars, describe its exposure to exchange rate riskresulting from the project. Explain how the size of theparent’s initial investment and the exchange rate riskwould have been affected if PepsiCo had financedmuch of the investment with loans from banks in Brazil.b. Describe the factors that PepsiCo likely consideredwhen estimating the future cash flows of the project inBrazil.c. What factors did PepsiCo likely consider in deriving itsrequired rate of return on the project in Brazil?
23Questions and Applicationsd. Describe the uncertainty that surrounds the estimateof future cash flows from the perspective of the U.S.parent.e. PepsiCo’s parent was responsible for assessing theexpansion in Brazil. Yet, PepsiCo already had someexisting operations in Brazil. When capital budgetinganalysis was used to determine the feasibility of thisproject, should the project have been assessed from aBrazilian perspective or a U.S. perspective? Explain.