Dorchester Ltd is considering building a new manufacturing plant in the US to expand its candy production and sales in North America. The initial cost of the plant would be $7 million. Local debt financing of $1.5 million at 7.75% interest would be provided. Dorchester must decide whether to issue additional debt in pounds sterling at 10.75% or US dollars at 9.5%.
Building the new plant would allow Dorchester to serve the entire North American market and realize higher profits of $4.40 per pound sold. However, the analysis of costs, revenues, tax rates, debt financing, and exchange rates is complex given the international dimensions. A full capital budgeting analysis is required to
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquis.docxcravennichole326
CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions
When it comes to finances, remember that there are no withholding taxes on the wages of sin.
—Mae West (1892–1980), Mae West on Sex, Health and ESP, 1975.
LEARNING OBJECTIVES
■Extend the domestic capital budgeting analysis to evaluate a greenfield foreign project
■Distinguish between the project viewpoint and the parent viewpoint of a potential foreign investment
■Adjust the capital budgeting analysis of a foreign project for risk
■Examine the use of project finance to fund and evaluate large global projects
■Introduce the principles of cross-border mergers and acquisitions
This chapter describes in detail the issues and principles related to the investment in real productive assets in foreign countries, generally referred to as multinational capital budgeting. The chapter first describes the complexities of budgeting for a foreign project. Second, we describe the insights gained by valuing a project from both the project’s viewpoint and the parent’s viewpoint using an illustrative case involving an investment by Cemex of Mexico in Indonesia. This illustrative case also explores real option analysis. Next, the use of project financing today is discussed, and the final section describes the stages involved in affecting cross-border acquisitions. The chapter concludes with the Mini-Case, Elan and Royalty Pharma, about a hostile takeover (acquisition) attempt that played out in the summer of 2013.
Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic factors, the specific project should be justified—as should all reinvestment decisions—by traditional financial analysis. For example, a production efficiency opportunity may exist for a U.S. firm to invest abroad, but the type of plant, mix of labor and capital, kinds of equipment, method of financing, and other project variables must be analyzed with traditional discounted cash flow analysis. The firm must also consider the impact of the proposed foreign project on consolidated earnings, cash flows from subsidiaries in other countries, and on the market value of the parent firm.
Multinational capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting—with a few very important differences. The basic steps are as follows:
■Identify the initial capital invested or put at risk.
■Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment.
■Identify the appropriate discount rate for determining the present value of the expected cash flows.
■Use traditional capital budgeting methods, such as net present value (NPV) and internal rate of return (IRR), to assess and rank potential projects.
Complexities of Budgeting for a Foreign Project
Capital budgeting for a foreign project is considerably more complex than the ...
1. Projects S and L have the following cash flows, and both have a.docxjackiewalcutt
1. Projects S and L have the following cash flows, and both have an 11% cost of capital. What is L's NPV?
a. $167.06
b. $172.29
c. $178.88
d. $183.19
e. $185.41
2. The cash flows for Projects SSS and LLL are shown below. Each project has a cost of capital equal to 11%. What is LLL's IRR?
a. 12.75%
b. 13.48%
c. 14.11%
d. 15.61%
e. 16.43%
3. If you draw NPV profiles for two mutually exclusive projects on a single graph, and if the profile lines do not cross in the upper right quadrant, then there is no meaningful conflict between the projects—either one dominates the other or neither should be accepted at any positive cost of capital. True or false?
a. True
b. False
4.One important difference between capital budgeting and security analysis is that in security analysis the analyst must generally take the projected cash flows as given rather than something the analyst can influence, whereas firms can often influence the cash flows from projects by making operating changes. True or false?
a. True
b. False
5.Project X has the following cash flows. If the firm's WACC is 15%, what is Project X's discounted payback?
a. 1.73 years
b. 2.25 years
c. 2.66 years
d. 3.11 years
e. 3.50 years
6. If S and L were mutually exclusive, both should be accepted. True or false?
a. True
b. False
7. Project L has the following cash flows, and its cost of capital is 10%. What is L's MIRR?
a. 21.66%
b. 22.53%
c. 23.17%
d. 24.29%
e. 25.40%
8. If a firm does not have good access to external capital, and if it has many potential projects with high IRRs, it might be reasonable to assume that a project's cash flows could be reinvested at a rate close to its IRR. However, that situation rarely exists: Firms with good investment opportunities generally do have good access to capital markets. True or false?
a. True
b. False
9. Given the data in the previous questions, which of the following statements is true?
a. If Projects SSS and LLL are independent, then according to the IRR decision criterion both should be accepted because both have an IRR that exceeds the cost of capital.
b. If these projects are mutually exclusive, then according to the IRR decision criterion Project SSS should be accepted because it has the larger IRR.
c. Both statements are true.
10. If two mutually exclusive projects are being compared, there may be a conflict between the projects' NPVs and their regular IRRs, but there can be no conflict between the projects' NPVs and MIRRs. True or false?
a. True
b. False
11. The inputs used in most capital budgeting analyses are not known with certainty; hence, the results of a quantitative analysis may be quite different from the actual, after-the-fact results. Also, five capital budgeting criteria are commonly used, and each provides a somewhat different bit of information. Therefore, it is rational for a firm to calculate and give some considerat ...
Chapter 8Cost of CapitalAssociated PressLearning O.docxmccormicknadine86
Chapter 8
Cost of Capital
Associated Press
Learning Objectives
A�er studying this chapter, you should be able to:
Show how the discount rate is calculated and used.
Explain how the weighted average cost of capital is calculated, and outline the significance of its components.
Describe how to es�mate the discount rate for individual projects and how risk factors into the process.
Processing math: 0%
Ch. 8 Introduction
Chapter 6 described the various capital budge�ng techniques employed by corporate managers. Among the techniques, net present value (NPV) emerges as the best measure
of a project's contribu�on to shareholder wealth. In NPV analysis, the present value of a project's expected future cash flows is compared to the ini�al investment, and the
project is accepted if the present value exceeds the ini�al investment. Calcula�on of NPV requires the analyst to es�mate cash flows and an appropriate discount rate.
Techniques for es�ma�ng cash flows were covered in Chapter 6. In this chapter, you will learn how to es�mate the discount rate. The same es�mates of cash flows and
discount rate are also used in internal rate of return analysis. Used in IRR, the discount rate becomes a hurdle rate against which to compare the project's IRR.
Processing math: 0%
Financing mix and cash flows for the Pogo harness project.
8.1 Estimating the Discount Rate
To illustrate the calcula�on and use of the discount rate, we elaborate on the Chapter 6 example of Pacific Offshore Ltd. (POL). Recall the NPV of POL's Pogo harness project
is $9,110, which was found by discoun�ng the project's net cash flows by 12.5% (the required rate of return). The project's internal rate of return of 17.2% is greater than
the 12.5% required rate of return on the harness project; therefore, whether we use NPV or IRR, the harness project appears to be acceptable because it meets the
respec�ve decision criteria. Had the required return been 20%, for example, the project would have been rejected using either criterion. Table 8.1 reviews the details of
POL's Pogo harness project from Chapter 6.
Table 8.1: Review of POL's Pogo harness project details
Data Category Value
Project cost $64,384
Required rate of return 12.5%
Internal rate of return 17.2%
Net present value $9,110
We have referred to the 12.5% as the harness project's required rate of return. To be more specific, 12.5% is the weighted average return demanded by the company's
investors. The weigh�ngs reflect the propor�onal values of their investments. From Chapter 6, the cost of the harness project is $64,384, meaning that Paula Bauer must
raise that amount from her inves ...
Learning ObjectivesUpon completion of Chapter 10, you will.docxSHIVA101531
Learning Objectives
Upon completion of Chapter 10, you will be able to:
• Understand the meaning of the weighted average cost of capital (WACC).
• Be able to estimate the weights in the WACC.
• Be able to estimate the cost of debt and how it is affected by taxes.
• Be able to estimate the cost of preferred stock.
• Know three approaches for estimating the cost of equity.
• Understand flotation costs and how they affect the WACC.
• Know when the WACC is the appropriate approach for estimating the required return for a project.
• Know an alternative approach for estimating a project’s required return when the WACC is not
the appropriate measure.
Cost of Capital
10
Nina Mourier/Getty Images
byr80656_10_c10_245-270.indd 245 3/28/13 3:35 PM
CHAPTER 10Section 10.1 Estimating the Discount Rate
Corporate managers use various capital budgeting techniques. Among these tech-niques, net present value (NPV) emerges as the best measure of a project’s con-tribution to shareholder wealth. In NPV analysis, the present value of a project’s
expected future cash flows is compared to the initial investment, and the project is accepted
if the present value exceeds the initial investment. Calculation of NPV requires the analyst
to estimate cash flows and an appropriate discount rate. Techniques for estimating cash
flows were covered in Chapter 6. In this chapter you will learn how to estimate the dis-
count rate. The same estimates of cash flows and discount rate are also used in internal
rate of return analysis. Used in IRR, the discount rate becomes a hurdle rate against which
to compare the project’s IRR.
10.1 Estimating the Discount Rate
To illustrate the calculation and use of the discount rate, we introduce a case study of Pacific Offshore Ltd. (POL). POL is considering the manufacture and sale of har-nesses to be used by sailors who must be tethered to their boats in the high seas.
The harnesses can save the lives of sailors who are washed overboard in rough water and
storms. The NPV of POL’s harness project is $9,110, which was found by discounting the
project’s net cash flows by 12.5%. The project’s internal rate of return of 17.2% is greater
than the 12.5% required rate of return on the harness project. Therefore, whether we use
NPV or IRR, the harness project appears to be acceptable because it meets the respective
decision criteria. Had the required return been 20%, for example, the project would have
been rejected using either criterion.
We have referred to the 12.5% as the harness project’s required rate of return. To be more
specific, 12.5% is the weighted average return demanded by the company’s investors. The
weightings reflect the proportional values of their investments. The cost of the harness
project is $64,384, meaning that the owners must raise that amount from their investors
to fund tools, equipment, and working capital and to pay the cost of reconfiguring the
plant. The owners decided to fund futu ...
Question 1 Which one of the following is not an ownership right .docxIRESH3
Question 1
Which one of the following is not an ownership right of a stockholder in a corporation?
To share in assets upon liquidation.
To share in corporate earnings.
To declare dividends on the common stock.
To vote in the election of directors.
Question 2
A corporation has the following account balances: Common stock, $1 par value, $30,000; Paid-in Capital in Excess of Par Value, $1,350,000. Based on this information, the
average price per share issued is $4.60.
number of shares outstanding are 1,380,000.
number of shares issued are 30,000.
legal capital is $1,380,000.
Question 3
If stock is issued for a noncash asset, the asset should be recorded on the books of the corporation at
fair market value.
a nominal amount.
cost.
zero.
Question 4
Which of the following represents the largest number of common shares?
Outstanding shares
Treasury shares
Issued shares
Authorized shares
Question 5
A corporation purchases 20,000 shares of its own $20 par common stock for $35 per share, recording it at cost. What will be the effect on total stockholders' equity?
Increase by $400,000
Increase by $700,000
Decrease by $700,000
Decrease by $400,000
Question 6
The acquisition of treasury stock by a corporation
has no effect on total assets and total stockholders' equity.
requires that a gain or loss be recognized on the income statement.
increases its total assets and total stockholders' equity.
decreases its total assets and total stockholders' equity.
Question 7
Which of the following is not a right or preference associated with preferred stock?
First claim to dividends.
Preference to corporate assets in case of liquidation.
The right to vote.
To receive dividends in arrears before common stockholders receive dividends.
Question 8
If preferred stock is cumulative, the
preferred dividends not declared in a given year are called dividends in arrears.
preferred shareholders and the common shareholders receive equal dividends.
preferred shareholders and the common shareholders receive the same total dollar amount of dividends.
common shareholders will share in the preferred dividends.
Question 9
When common stock is issued for services or non-cash assets, cost should be
either the fair market value of the consideration given up or the consideration received, whichever is more clearly evident.
the book value of the common stock issued.
only the fair market value of the consideration given up.
only the fair market value of the consideration received.
Question 10
Common Stock Dividends Distributable is classified as a(n)
asset account.
stockholders' equity account.
expense account.
liability account.
Question 11
Indicate the respective effects of the declaration of a cash dividend on the following balance sheet sections:
Total Assets Total Liabilities Total Stockholders' Equity
Increase Decrease No change
Decrease No change Increase
No change Increase Decrease
Decrease Increase Decrease
Question 12
Which of the following show the proper effect of a s ...
UNIVERSITY OF LA VERNEECBU 500D – BUSINESS FINANCEFINAL EXAM.docxouldparis
UNIVERSITY OF LA VERNE
ECBU 500D – BUSINESS FINANCE
FINAL EXAM
DECEMBER 3, 2019
“STUDENT NAME”
A key difference between replacement and expansion project analyses is that with replacement, the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets.
True / False
The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.
True / False
Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and it will have a beta which is greater than 1.0.
True / False
Other things held constant, an increase in financial leverage will increase a firm's market risk as measured by its beta coefficient.
True / False
The post-audit is a simple process in which actual results are compared to forecasted results and any discrepancy indicates a change in factors that are completely under management's control.
True / False
Short-term financing might be riskier than long-term financing because, during periods of tight credit, the firm might not be able to rollover (renew) its debt.
True / False
Effective capital budgeting can improve the timing of asset acquisition and the quality of assets purchased, thereby providing an opportunity to purchase and install assets before they are needed.
True / False
Since the degree of total leverage is equal to the degree of operating leverage times the degree of financial leverage, the degree of total leverage must always be greater than or equal to positive 1.0.
True / False
If the information content, or signaling, hypothesis is correct, then changes in dividend policy can be important with respect to firm value and capital costs.
True / False
A just-in-time system of inventory control requires that manufacturers coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process. The main objective of such a system is to reduce carrying costs.
True / False
The best and most comprehensive picture of a firm's liquidity position is obtained by examining its cash budget.
True / False
A firm’s goal should be to lengthen the cash conversion cycle since shorter cash conversion cycles leads firms to increase their dependence on costly external financing.
True / False
Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favor of the project with the higher NPV.
True / False
The primary goal of inventory management is to provide sufficient incentives to ensure that the firm never suffers a stock-out (i.e., runs out of an inventory item).
True / False
The ex-dividend date is the date on which a firm actually mails (funds) divid ...
What website can I sell pi coins securely.DOT TECH
Currently there are no website or exchange that allow buying or selling of pi coins..
But you can still easily sell pi coins, by reselling it to exchanges/crypto whales interested in holding thousands of pi coins before the mainnet launch.
Who is a pi merchant?
A pi merchant is someone who buys pi coins from miners and resell to these crypto whales and holders of pi..
This is because pi network is not doing any pre-sale. The only way exchanges can get pi is by buying from miners and pi merchants stands in between the miners and the exchanges.
How can I sell my pi coins?
Selling pi coins is really easy, but first you need to migrate to mainnet wallet before you can do that. I will leave the what'sapp contact of my personal pi merchant to trade with.
+12349014282
Financial Assets: Debit vs Equity Securities.pptxWrito-Finance
financial assets represent claim for future benefit or cash. Financial assets are formed by establishing contracts between participants. These financial assets are used for collection of huge amounts of money for business purposes.
Two major Types: Debt Securities and Equity Securities.
Debt Securities are Also known as fixed-income securities or instruments. The type of assets is formed by establishing contracts between investor and issuer of the asset.
• The first type of Debit securities is BONDS. Bonds are issued by corporations and government (both local and national government).
• The second important type of Debit security is NOTES. Apart from similarities associated with notes and bonds, notes have shorter term maturity.
• The 3rd important type of Debit security is TRESURY BILLS. These securities have short-term ranging from three months, six months, and one year. Issuer of such securities are governments.
• Above discussed debit securities are mostly issued by governments and corporations. CERTIFICATE OF DEPOSITS CDs are issued by Banks and Financial Institutions. Risk factor associated with CDs gets reduced when issued by reputable institutions or Banks.
Following are the risk attached with debt securities: Credit risk, interest rate risk and currency risk
There are no fixed maturity dates in such securities, and asset’s value is determined by company’s performance. There are two major types of equity securities: common stock and preferred stock.
Common Stock: These are simple equity securities and bear no complexities which the preferred stock bears. Holders of such securities or instrument have the voting rights when it comes to select the company’s board of director or the business decisions to be made.
Preferred Stock: Preferred stocks are sometime referred to as hybrid securities, because it contains elements of both debit security and equity security. Preferred stock confers ownership rights to security holder that is why it is equity instrument
<a href="https://www.writofinance.com/equity-securities-features-types-risk/" >Equity securities </a> as a whole is used for capital funding for companies. Companies have multiple expenses to cover. Potential growth of company is required in competitive market. So, these securities are used for capital generation, and then uses it for company’s growth.
Concluding remarks
Both are employed in business. Businesses are often established through debit securities, then what is the need for equity securities. Companies have to cover multiple expenses and expansion of business. They can also use equity instruments for repayment of debits. So, there are multiple uses for securities. As an investor, you need tools for analysis. Investment decisions are made by carefully analyzing the market. For better analysis of the stock market, investors often employ financial analysis of companies.
What price will pi network be listed on exchangesDOT TECH
The rate at which pi will be listed is practically unknown. But due to speculations surrounding it the predicted rate is tends to be from 30$ — 50$.
So if you are interested in selling your pi network coins at a high rate tho. Or you can't wait till the mainnet launch in 2026. You can easily trade your pi coins with a merchant.
A merchant is someone who buys pi coins from miners and resell them to Investors looking forward to hold massive quantities till mainnet launch.
I will leave the what's app number of my personal pi vendor to trade with.
+12349014282
The secret way to sell pi coins effortlessly.DOT TECH
Well as we all know pi isn't launched yet. But you can still sell your pi coins effortlessly because some whales in China are interested in holding massive pi coins. And they are willing to pay good money for it. If you are interested in selling I will leave a contact for you. Just what'sapp this number below. I sold about 3000 pi coins to him and he paid me immediately.
+12349014282
how to sell pi coins effectively (from 50 - 100k pi)DOT TECH
Anywhere in the world, including Africa, America, and Europe, you can sell Pi Network Coins online and receive cash through online payment options.
Pi has not yet been launched on any exchange because we are currently using the confined Mainnet. The planned launch date for Pi is June 28, 2026.
Reselling to investors who want to hold until the mainnet launch in 2026 is currently the sole way to sell.
Consequently, right now. All you need to do is select the right pi network provider.
Who is a pi merchant?
An individual who buys coins from miners on the pi network and resells them to investors hoping to hang onto them until the mainnet is launched is known as a pi merchant.
debuts.
I'll provide you the what'sapp number.
+12349014282
Understanding how timely GST payments influence a lender's decision to approve loans, this topic explores the correlation between GST compliance and creditworthiness. It highlights how consistent GST payments can enhance a business's financial credibility, potentially leading to higher chances of loan approval.
This presentation poster infographic delves into the multifaceted impacts of globalization through the lens of Nike, a prominent global brand. It explores how globalization has reshaped Nike's supply chain, marketing strategies, and cultural influence worldwide, examining both the benefits and challenges associated with its global expansion.
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BONKMILLON Unleashes Its Bonkers Potential on Solana.pdfcoingabbar
Introducing BONKMILLON - The Most Bonkers Meme Coin Yet
Let's be real for a second – the world of meme coins can feel like a bit of a circus at times. Every other day, there's a new token promising to take you "to the moon" or offering some groundbreaking utility that'll change the game forever. But how many of them actually deliver on that hype?
BONKMILLON Unleashes Its Bonkers Potential on Solana.pdf
Chapter18 International Finance Management
1. CHAPTER 18 INTERNATIONAL CAPITAL BUDGETING
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Why is capital budgeting analysis so important to the firm?
Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital
investments with positive NPV or APV contribute to shareholder wealth. Additionally, capital
investments generally represent large expenditures relative to the value of the entire firm. These
investments determine how efficiently and expensively the firm will produce its product. Consequently,
capital expenditures determine the long-run competitive position of the firm in the product marketplace.
2. What is the intuition behind the NPV capital budgeting framework?
Answer: The NPV framework is a discounted cash flow technique. The methodology compares the
present value of all cash inflows associated with the proposed project versus the present value of all
project outflows. If inflows are enough to cover all operating costs and financing costs, the project adds
wealth to shareholders.
3. Discuss what is meant by the incremental cash flows of a capital project.
Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash outflows
that can be traced directly to the project under analysis.
2. 4. Discuss the nature of the equation sequence, Equation 18.2a to 18.2f.
Answer: The equation sequence is a presentation of incremental annual cash flows associated with a
capital expenditure. Equation 18.2a presents the most detailed expression for calculating these cash
flows; it is composed of three terms. Equation 18.2b shows that these three terms are: i) incremental net
profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental after-tax
interest expense associated with the borrowing capacity created by the project. Note, the incremental “net
profit” is not accounting profit but rather net cash actually available for shareholders. Equation 18.2c
cancels out the after-tax interest term in 18.2a, yielding a simpler formula. Equation 18.2d shows that the
first term in 18.2c is generally called after-tax net operating income. Equation 18.2e yields yet a
computationally simpler formula by combining the depreciation terms of 18.2c. Equation 18.2f shows
that the first term in 18.2e is generally referred to as after-tax operating cash flow.
5. What makes the APV capital budgeting framework useful for analyzing foreign capital expenditures?
Answer: The APV framework is a value-additivity technique. Because international projects frequently
have cash flows not encountered in domestic projects, the APV technique easily allows the analyst to add
terms to the model that represent the special cash flows.
6. Relate the concept of lost sales to the definition of incremental cash flow.
Answer: When a new capital project is undertaken it may compete with an existing project(s), causing
the old project(s) to experience a loss in sales revenue. From an incremental cash flow standpoint, the
new project’s incremental revenue is the total sales revenue associated with the new project minus the lost
sales revenue from the old project(s).
7. What problems can enter into the capital budgeting analysis if project debt is evaluated instead of the
borrowing capacity created by the project?
Answer: If project debt is greater (less) than the borrowing capacity created by the capital project, and
tax shields on the actual new debt are used in the analysis, the APV will be overstated (understated)
making the project unjustly appear more (less) attractive than it actually is.
3. 8. What is the nature of a concessionary loan and how is it handled in the APV model?
Answer: A concessionary loan is a loan offered by a governmental body at below the normal market rate
of interest as an enticement for a firm to make a capital investment that will economically benefit the
lender. The benefit to the MNC is the difference between the face value of the concessionary loan
converted into the home currency and the present value of the similarly converted concessionary loan
payments discounted at the MNC’s normal domestic borrowing rate. The loan payments will yield a
present value less than the face amount of the concessionary loan when they are discounted at the higher
normal rate. This difference represents a subsidy the host country is willing to extend to the MNC if the
investment is made. The benefit to the MNC of the concessionary loan is handled in the APV model via a
separate term.
9. What is the intuition of discounting the various cash flows in the APV model at specific discount
rates?
Answer: The APV model is a value-additivity technique where total value is determined by the sum of
the present values of the individual cash inflows and outflows. Each cash flow will not necessarily have
the same amount of risk associated with it. To account for risk differences in the analysis, each cash flow
is discounted at a rate commensurate with the inherent riskiness of the cash flow.
10. In the Modigliani-Miller equation, why is the market value of the levered firm greater than the market
value of an equivalent unlevered firm?
Answer: The levered firm has a greater market value because less money is taken from the firm by the
government in taxes due to tax-deductible interest payments. Thus, there is more cash left for investor
groups than when the firm is financed with all-equity funds.
11. Discuss the difference between performing the capital budgeting analysis from the parent firm’s
perspective as opposed to the project perspective.
4. Answer: The goal of the financial manager of the parent firm is to maximize its shareholders’ wealth. A
capital project of a subsidiary of the parent may have a positive NPV (or APV) from the subsidiary’s
perspective yet have a negative NPV (or APV) from the parent’s perspective if certain cash flows cannot
be repatriated to the parent because of remittance restrictions by the host country, or if the home currency
is expected to appreciate substantially over the life of the project, yielding unattractive cash flows when
converted into the home currency of the parent. Additionally, a higher tax rate in the home country may
cause the project to be unprofitable from the parent’s perspective. Any of these reasons could result in
the project being unattractive to the parent and the parent’s stockholders.
12. Define the concept of a real option. Discuss some of the various real options a firm can be confronted
with when investing in real projects.
Answer: A positive APV project is accepted under the assumption that all future operating decisions will
be optimal. The firm’s management does not know at the inception date of a project what future
decisions it will be confronted with because all information concerning the project has not yet been
learned. Consequently, the firm’s management has alternative paths, or options, that it can take as new
information is discovered. The application of options pricing theory to the evaluation of investment
options in real projects is known as real options.
The firm is confronted with many possible real options over the life of a capital asset. For
example, the firm may have a timing option as when to make the investment; it may have a growth option
to increase the scale of the investment; it may have a suspension option to temporarily cease production;
and, it may have an abandonment option to quit the investment early.
5. 13. Discuss the circumstances under which the capital expenditure of a foreign subsidiary might have a
positive NPV in local currency terms but be unprofitable from the parent firm’s perspective.
Answer: The project NPV might be negative from the parent firm’s perspective when it is positive in
local currency terms if all foreign cash flows cannot be legally repatriated to the parent firm.
Additionally, if the PPP assumption does not hold, such that the actual future real exchange rate has
depreciated in foreign currency terms, the after-tax cash flows will yield less units of home currency from
the parent firm’s perspective than expected, possibly resulting in a negative NPV.
6. PROBLEMS
1. The Alpha Company plans to establish a subsidiary in Hungary to manufacture and sell fashion
wristwatches. Alpha has total assets of $70 million, of which $45 million is equity financed. The
remainder is financed with debt. Alpha considered its current capital structure optimal. The construction
cost of the Hungarian facility in forints is estimated at HUF2,400,000,000, of which HUF1,800,000,and
000 is to be financed at a below-market borrowing rate arranged by the Hungarian government. Alpha
wonders what amount of debt it should use in calculating the tax shields on interest payments in its capital
budgeting analysis. Can you offer assistance?
Solution: The Alpha Company has an optimal debt ratio of .357 (= $25 million debt/$70 million assets)
or 35.7%. The project debt ratio is .75 (= HUF1,800/HUF2,400) or 75%. Alpha will overstate the tax
shield on interest payments if it uses the 75% figure because the proposed project will only increase
borrowing capacity by HUF856,800,000 (=HUF2,400,000,000 x .357).
2. The current spot exchange rate is HUF250/$1.00. Long-run inflation in Hungary is estimated at 10
percent annually and 3 percent in the United States. If PPP is expected to hold between the two countries,
what spot exchange should one forecast five years into the future?
Solution: HUF250(1 + .10)5/(1 + .03)5 = HUF347.31/$1.00.
3. The Beta Corporation has an optimal debt ratio of 40 percent. Its cost of equity capital is 12 percent
and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent, calculate (a) the
weighted-average cost of capital, and (b) the cost of equity for an equivalent all-equity financed firm.
Solution:
(a) K = (1 - .40).12 + (.40).08(1 - .35)
= .0928 or 9.28%
(b) A weighted-average cost of capital of 9.28% for a levered firm implies:
K =.0928 = Ku (1-(.35)(.40)). Solving for Ku yields .1079 or 10.79%.
7. 4. Zeda, Inc., a U.S. MNC, is considering making a fixed direct investment in Denmark. The Danish
government has offered Zeda a concessionary loan of DKK15,000,000 at a rate of 4 percent per annum.
The normal borrowing rate is 6 percent in dollars and 5.5 percent in Danish krone. The loan schedule
calls for the principal to be repaid in three equal annual installments. What is the present value of the
benefit of the concessionary loan? The current spot rate is DKK5.60/$1.00 and the expected inflation rate
is 3% in the U.S. and 2.5% in Denmark.
Solution:
Principal
Year St Payment It StLPt StLPt/(1 + id)t
(t) (a) (b) (c) (b + c)/(a)
DKK DKK
1 5.57 5,000,000 600,000 1,005,386 948,477
2 5.55 5,000,000 400,000 972,973 865,943
3 5.52 5,000,000 200,000 942,029 790,946
15,000,000 2,605,366
The dollar value of the concessionary loan is $2,678,574 = DKK15,000,000 ÷ 5.60. The dollar present
value of the concessionary loan payments is $2,605,366. Therefore, the present value of the benefit of the
concessionary loan is $73,208 = $2,678,574 – 2,605,366.
5. Suppose that in the illustrated mini case in the chapter the APV for Centralia had been -$60,000. How
large would the after-tax terminal value of the project need to be before the APV would be positive and
Centralia would accept the project?
8. Solution: Centralia should not go ahead with its plans to build a manufacturing plant in the Spain unless
the terminal value is likely to be large enough to yield a positive APV. The terminal value of the project
must be $299,010 in order for the APV to equal zero. This is calculated as follows. Set
STTVT/(1+Kud)T = $60,000. This implies
TVT = ($60,000/ST)(1+Kud)T
= ($60,000/.7261)(1.11)8
= €190,431.
6. With regards to the Centralia illustrated mini case in the chapter, how would the APV change if:
a. The forecast of d and/or f are incorrect?
Answer: A larger or smaller d will not have any effect because a change will affect the numerator and
denominator of each APV term in an offsetting manner. Note that imbedded in each domestic discount
rate is the inflation premium d. A larger (smaller) f, however, will decrease (increase) the project APV
because the foreign currency received will buy less (more) parent country currency upon repatriation.
b. Deprecation cash flows are discounted at Kud instead of id?
Answer: The APV would be less favorable because Kud is a larger discount rate than id.
c. The host country did not provide the concessionary loan?
Answer: The APV would be less favorable because the project would have to cover a higher finance
charge, i.e., there would be no benefit received from below market financing.
9. MINI CASE ONE: DORCHESTER, LTD.
Dorchester Ltd., is an old-line confectioner specializing in high-quality chocolates. Through its
facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout Western
Europe and North America (United States and Canada). With its current manufacturing facilities,
Dorchester has been unable to supply the U.S. market with more than 225,000 pounds of candy per year.
This supply has allowed its sales affiliate, located in Boston, to be able to penetrate the U.S. market no
farther west than St. Louis and only as far south as Atlanta. Dorchester believes that a separate
manufacturing facility located in the United States would allow it to supply the entire U.S. market and
Canada (which presently accounts for 65,000 pounds per year). Dorchester currently estimates initial
demand in the North American market at 390,000 pounds, with growth at a 5 percent annual rate. A
separate manufacturing facility would, obviously, free up the amount currently shipped to the United
States and Canada. But Dorchester believes that this is only a short-run problem. They believe the
economic development taking place in Eastern Europe will allow it to sell there the full amount presently
shipped to North America within a period of five years.
Dorchester presently realizes £3.00 per pound on its North American exports. Once the U.S.
manufacturing facility is operating, Dorchester expects that it will be able to initially price its product at
$7.70 per pound. This price would represent an operating profit of $4.40 per pound. Both sales price and
operating costs are expected to keep track with the U.S. price level; U.S. inflation is forecast at a rate of 3
percent for the next several years. In the U.K., long-run inflation is expected to be in the 4 to 5 percent
range, depending on which economic service one follows. The current spot exchange rate is $1.50/£1.00.
Dorchester explicitly believes in PPP as the best means to forecast future exchange rates.
The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount
by a combination of equity capital and debt. The plant will increase Dorchester’s borrowing capacity by
£2,000,000, and it plans to borrow only that amount. The local community in which Dorchester has
decided to build will provide $1,500,000 of debt financing for a period of seven years at 7.75 percent.
The principal is to be repaid in equal installments over the life of the loan. At this point, Dorchester is
uncertain whether to raise the remaining debt it desires through a domestic bond issue or a Eurodollar
bond issue. It believes it can borrow pounds sterling at 10.75 percent per annum and dollars at 9.5
percent. Dorchester estimates its all-equity cost of capital to be 15 percent.
10. The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven-
year period. After that time the confectionery equipment, which accounts for the bulk of the investment,
is expected to have substantial market value.
Dorchester does not expect to receive any special tax concessions. Further, because the corporate tax
rates in the two countries are the same--35 percent in the U.K. and in the United States--transfer pricing
strategies are ruled out.
Should Dorchester build the new manufacturing plant in the United States?
Suggested Solution to Dorchester Ltd.
Summary of Key Information
The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.
The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) =
£4,666,900.
The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range. The U.S.
inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds S t =
.6667(1.045)t/(1.03)t.
The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.
It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently
sells to North America in Eastern Europe the first year the new manufacturing facility is in operation;
two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.
The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.
Terminal value will initially be assumed to equal zero.
Straight line depreciation over the seven year economic life of the project is assumed: Dt = $1,000,000 =
$7,000,000/7 years.
The marginal tax rate, , is the U.K. (or U.S.) rate of 35%.
Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum. Optimally,
Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because according
to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for borrowing dollars:
5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus
6.31% or .0631 = (1.095)/(1.03) - 1.0.
Kud = 15%.
11. Calculation of the Present Value of the After-Tax Operating Cash Flows
St x
Quantity
Yea St Quantity Quantity Quantity S t OCF t S t OCF t ( 1 - )
r t
(t)
x $4.40
Lost Lost Sales
( 1+ K ud )
t-1
x (1.03)
Sales x £3.00
x (1.045)t
(a) (b) (a + b)
£ £ £ £
1 .6764 390,000 1,160,702 (232,000) (727,320) 433,382 244,955
2 .6863 409,500 1,273,673 (174,000) (570,037) 703,636 345,832
3 .6963 429,975 1,397,548 (116,000) (397,126) 1,000,422 427,566
4 .7064 451,474 1,533,373 (58,000) (207,498) 1,325,875 492,748
5 .7167 474,048 1,682,524 0 0 1,682,524 543,733
6 .7271 497,750 1,846,053 0 0 1,846,053 518,765
7 .7377 522,638 2,025,613 0 0 2,025,613 494,977
3,068,576
12. Calculation of the Present Value of the Depreciation Tax Shields
Year St Dt S t Dt
(t) t
( 1+ i d )
$ £
1 .6764 1,000,000 213,761
2 .6863 1,000,000 195,837
3 .6963 1,000,000 179,404
4 .7064 1,000,000 164,340
5 .7167 1,000,000 150,552
6 .7271 1,000,000 137,911
7 .7377 1,000,000 126,340
1,168,146
13. Calculation of the Present Value of the Concessionary Loan Payments
Year St Principal It S t LPt
(t) Payment S t LPt
t
(1+ i d )
(a) (b) (c) (a) x (b + c)
$ $ £
£
1 .6764 214,286 116,250 223,574 201,873
2 .6863 214,286 99,643 215,449 175,654
3 .6963 214,286 83,036 207,025 152,402
4 .7064 214,286 66,429 198,297 131,808
5 .7167 214,286 49,821 189,286 113,605
6 .7271 214,286 33,214 179,957 97,523
7 .7377 214,286 16,607 170,330 83,346
1,500,000 956,211
Calculation of the Present Value of the Benefit from the Concessionary Loan
T
S t LP t =£0.6667 x $1,500,000 - £956,211 = £43,839
S o CL o - t
t =1 ( 1 + i d )
14. Calculation of the Present Value of the Interest Tax Shields
from the $1,500,000 Concessionary Loan
Year St It St I t St I t
(t) t
(b)
(1+ i d )
(a) (a x b x )
$
£ £
1 .6764 116,250 27,521 24,850
2 .6863 99,643 23,935 19,514
3 .6963 83,036 20,236 14,897
4 .7064 66,429 16,424 10,917
5 .7167 49,821 12,497 7,501
6 .7271 33,214 8,452 4,581
7 .7377 16,607 4,288 2,098
84,357
15. Calculation of the Present Value of the Interest Tax Shields
from the £1,000,000 Bond Issue
Year Outstanding Principal Interest It
(t) Loan Payment Payment
( 1 + i d )t
Balance
£ £ £ £
1 1,000,000 0 107,500 33,973
2 1,000,000 0 107,500 30,675
3 1,000,000 0 107,500 27,698
4 1,000,000 0 107,500 25,009
5 1,000,000 0 107,500 22,582
6 1,000,000 0 107,500 20,390
7 1,000,000 1,000,000 107,500 18,411
178,738
16. Without considering the terminal value of the project, the APV of the project is negative:
APV = £3,068,576 + 1,168,146 + 43,839 + 84,357 + 178,738 - 4,666,900 =
-£123,244.
Dorchester should not go ahead with its plans to build a manufacturing plant in the U.S. unless the
terminal value is likely to be large enough to yield a positive APV. The terminal value of the project
must be $444,397 in order for the APV to equal zero. This is calculated as follows. Set
STTVT/(1+Kud)T = £123,244. This implies
TVT = (£123,244/ST)(1+Kud)T
= (£123,244/.7377)(1.15)7
= $444,397.
Since the terminal value is expected to be substantial, and the initial cost of the project is
$7,000,000, it appears likely that the terminal value will be sufficient to yield a positive APV. Thus,
Dorchester should go ahead with its plans to build a manufacturing plant in the U.S.
17. MINI-CASE: STRIK-IT-RICH GOLD MINING COMPANY
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will need
to purchase land that its geologists believe is rich in gold. Strik-it-Rich’s management believes that the
expansion will allow it to mine and sell an additional 2,000 troy ounces of gold per year. The expansion,
including the cost of the land, will cost $500,000. The current price of gold bullion is $425 per ounce and
one-year gold futures are trading at $450.50 = $425(1.06). Extraction costs are $375 per ounce. The
firm’s cost of capital is 10%. At the current price of gold, the expansion appears profitable: NPV =
($425 – 375) x 2,000/.10 - $500,000 = $500,000. Strik-it-Rich’s management is, however, concerned
with the possibility that large sales of gold reserves by Russia and the United Kingdom will drive the
price of gold down to $390 for the foreseeable future. On the other hand, management believes there is
some possibility that the world will soon return to a gold reserve international monetary system. In the
latter event, the price of gold would increase to at least $460 per ounce. The course of the future price of
gold bullion should become clear within a year. Strik-it-Rich can postpone the expansion for a year by
buying a purchase option on the land for $25,000. What should Strik-it-Rich’s management do?
Suggested Solution to Strik-it-Rich Gold Mining Company
There is considerable risk in expanding operations at the present time, even though the NPV based on the
current price of gold is a positive $500,000. If the price of gold falls to $390 per ounce, the NPV = ($390
– 375) x 2000/.10 - $500,000 = -$200,000. On-the-other-hand, if the price of gold increases to $460, the
NPV is a very attractive NPV= ($460 – 375) x 2000/.10 - $500,000 = $1,200,000. The purchase option
for $25,000 on the land is a relatively small amount to have the opportunity to postpone the decision until
additional information is learned. Obviously, Strik-it-Rich’s management will only invest if the NPV is
positive. The risk-neutral probability of gold increasing to $460 per ounce is:
q = (F0 - S0·d)/S0(u – d) = (450.50 – 390)/(460 – 390) = .8643.
Thus, the value of the timing option to postpone the decision one year is:
C = .8643($1,200,000)/(1.06) = $978,453.
Since this amount is substantially in excess of the $25,000 cost of the purchase option on the land, Strik-
it-Rich’s management should definitely take advantage of the timing option it is confronted with to wait
and see what the price of gold is in one year before it makes a decision to expand operations.