Course Code and Title: FINE 6 – Global Finance with Electronic Banking

Professor: Dave Kieth J. Lappay

Neil Patrick John M. Martin
Brandy I. Valdez
Lesson Number: 10
Topic: International Capital Budgeting (1)

Learning Objectives:

At the end of this lesson, the student should be able to:

1. Explain the concept of international capital budgeting,
2. Discuss the approaches to international capital budgeting, and
3. Compare the three approaches in international capital budgeting.

Pre-Assessment
Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.

1. What are the three approaches in international capital budgeting?

2. What approach best suits for domestic firms’ capital expenditure?
3. Why is Weighted Average Cost of Capital is importance in the concept of debt-to-equity ratio?

Lesson Presentation:

Capital budgeting is the process a

business undertakes to evaluate
potential major projects or investments.
Construction of a new plant or a big
investment in an outside venture are
examples of projects that would require
capital budgeting before they are
approved or rejected (Kenton, Capital
budgeting, 2020).

As part of capital budgeting, a company

might assess a prospective project's
lifetime cash inflows and outflows to
determine whether the potential returns
that would be generated meet a sufficient
target benchmark. The capital budgeting
process is also known as investment
Photo Credit: By Yurii Kibalnik, Capital Budgeting phrase on the page.
appraisal. Link: https://www.dreamstime.com/capital-budgeting-phrase-page-image185309979

International capital budgeting is defined as the process for the selection of long-term capital investments. Our
objective is to provide an in-depth discussion of the methodologies that multinational firms can use to analyze
long-term capital investments in foreign projects. The objective of international capital budgeting is to maximize
the current wealth of shareholders of the parent firm from various multinational corporations.

Approaches to International Capital Budgeting

1. Adjusted Present Value (APV)

a. The adjusted present value is the net present value (NPV) of a project or company if financed
solely by equity plus the present value (PV) of any financing benefits, which are the additional
effects of debt. By taking into account financing benefits, APV includes tax shields such as those
provided by deductible interest (HARGRAVE, 2021).
b. The for APV is: Adjusted Present Value = Unlevered Firm Value + NE. Where NE is the Net
Effect of debt. The net effect of debt includes tax benefits that are created when the interest on a
company's debt is tax-deductible. This benefit is calculated as the interest expense times the tax
rate, and it only applies to one year of interest and tax. The present value of the interest tax shield
is therefore calculated as: (tax rate * debt load * interest rate) / interest rate.
c. For example, assume a multi-year projection calculation finds that the present value of Company
ABC’s free cash flow (FCF) plus terminal value is $100,000. The tax rate for the company is 30%
and the interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000
* 30% * 7%) / 7%. Thus, the adjusted present value is $115,000, or $100,000 + $15,000.
 2. Weighted Average Cost of Capital
(WACC) – It is a calculation of a firm's cost
of capital in which each category of capital
is proportionately weighted. All sources of
capital, including common stock, preferred
stock, bonds, and any other long-term debt,
are included in a WACC calculation.
WACC is calculated by multiplying the cost
of each capital source (debt and equity) by
its relevant weight, and then adding the
products together to determine the value. In
the above formula, E/V represents the
proportion of equity-based financing, while
D/V represents the proportion of debt-
based financing.

Photo Credit: By Yurii Kibalnik, Capital Budgeting phrase on the page.

Link: https://www.dreamstime.com/capital-budgeting-phrase-page-image185309979

3. Flow-to-equity Approach – The after-tax cash flows to stockholders are discounted at the levered cost of
equity. This approach requires the estimation of residual cash flows to equity as well as other adjustments; when
used to value foreign projects or subsidiaries using the parent company’s perspective. Free cash flow to equity
(FCFE) is a measure of how much cash is available to the equity shareholders of a company after all expenses,
reinvestment, and debt are paid. FCFE is a measure of equity capital usage.

Free cash flow to equity is composed of net income, capital expenditures, working capital, and debt. Net income
is located on the company income statement. Capital expenditures can be found within the cash flows from the
investing section on the cash flow statement.
Working capital is also found on the cash flow statement; however, it is in the cash flows from the operations
section. In general, working capital represents the difference between the company’s most current assets and
liabilities. The formula is the difference between cash from operations and Capital expenditures. Then, to
computed for the value of equity: The following formula is used:

Parent Versus Subsidiary Cash Flows

There can be significant differences between the cash flows that accrue directly to the foreign subsidiary from a
project, and the cash flows received by the parent firm. Since the parent company’s perspective is the most
important, the analysis must determine the portions of the foreign project’s cash flow that will be received by the
parent company.

Comparison of the Three Approaches

The Adjusted Present Value (APV) and the Weighted Average Cost of Capital (WACC) approaches are useful
for determining the value added by a foreign project from the perspective of the subsidiary of the Multinational
Corporations (MNC). If the manager knows the level of debt used by the foreign project in all future periods,
then the APV approach is indicated for determining the stand-alone value of a foreign project Also, the value of
real options can be accounted for by using this approach.
If the manager is planning on keeping a constant debt-to-equity ratio in the future, as it is assumed in the
Weighted Average Cost of Capital (WACC), then the WACC approach is the better method to value the project
on stand-alone basis, or from the perspective of the foreign subsidiary. In addition, with the changing levels in
the future, both Adjusted Present Value (APV) and WACC are difficult to apply. The Flow-to-equity is ideal for
the parent company perspective for the reasons stated in the Free Cash Flow (FCF).

Capital Budgeting from the Parent Firm’s Perspective

The Adjusted Present Value (APV) model is useful for a domestic firm analyzing a domestic capital expenditure
or for a foreign subsidiary of a multinational corporations analyzing a proposed capital expenditure from the
subsidiary’s viewpoint. The APV model is not useful for a multinational corporation in analyzing a foreign capital
expenditure from the parent firm’s perspective.

The cash flow received by the parent company can differ from the cash flow available to the subsidiary due to:
• Withholding taxes imposed on remitted cash flow.
• Other tax policies may differ from country to country such as U.S. corporate taxes imposed on the
earnings of the subsidiary in addition to foreign taxes paid to host government.
• Changes in exchange rates.
• Blocked Funds
• Repayment of local currency

Application:

Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.
1. What would possibly happen when we prioritize the cash flow from the foreign subsidiary than the parent
company?

Evaluation:

Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.
1. How can you prove that APV is better be used in domestic corporations?

Generalization:

Capital budgeting is important because it creates accountability and measurability of the company’s success.
Any business in international settings that seeks to invest its resources in a project without understanding the
risks and returns involved would be held as irresponsible by its owners or shareholders. Businesses (aside from
non-profits) exist to earn profits. Therefore, it is fundamental for the business owners to analyze the various
approaches in capital budgeting.

Reinforcement:
Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.

1. Cite some companies that uses Adjusted Present Value (APV) in their cash flow analysis.

References:

Online:

HARGRAVE, M. (2021, April 24). Adjusted present value. Retrieved from Investopedia:
https://www.investopedia.com/terms/a/apv.asp
Kenton, W. (2021, April 25). Balance of payments (BOP). Retrieved from Investopedia:
https://www.investopedia.com/terms/b/bop.asp

Books:

Madura, J (2008). International Financial Management, Ninth Edition. U.S.: Thomson South-Western

Brigham, E (2007). Financial Management: Theory and Practice, 10 th Edition. Florida, U.S.: The Dryden Press,
Hardcourt Brace College Publishers.

Brigham, E (2007). Fundamentals of Financial Management, Concise Edition. U.S.: The Dryden Press,
Hardcourt Brace College Publishers.

Gitman, L (2007). Principles of Managerial Finance. Pearson Education, Inc.