International Capital Budgeting

18-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows
on a time line.

2. Identify the RISKINESS of the cash flows to determine

the appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate

discount rate.

4. Compare the value of competing cash flow streams at the

same point in time.
18-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Review of Domestic Capital
Budgeting
The basic net present value equation is
T
CFt TVT
NPV     C0
t 1 (1  K ) (1  K )
t T
Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax terminal value including return of net working
capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.

18-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Review of Domestic Capital
Budgeting
The NPV rule is to accept a project if NPV  0
T
CFt TVT
NPV     C0  0
t 1 (1  K ) (1  K )
t T

and to reject a project if NPV  0

T
CFt TVT
NPV     C 0  0.
t 1 (1  K ) (1  K )
t T

18-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Domestic APV Example
Consider this project, the timing and size of the
incremental after-tax cash flows for an all-equity firm
are:-$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is r0 = 10%:
CF0 = –$1000 The project would be rejected by
CF1 = $125 an all-equity firm:

CF2 = $250 I = 10
CF3 = $500 NPV = –$56.50
18-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective
One recipe for international decision makers:
1. Estimate future cash flows in foreign
currency.
2. Convert to the home currency at the predicted
exchange rate.
Use PPP, IRP et cetera for the predictions.
3. Calculate NPV using the home currency cost
of capital.

18-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
A U.S. MNC is considering a European opportunity.
The size and timing of the after-tax cash flows are:
–€600 €200 €500 €300

0 1 2 3

The inflation rate in the euro zone is € = 3%, the inflation

rate in dollars is $ = 6%, and the business risk of the
investment would lead an unlevered U.S. based firm to
demand a return of Kud = i$ = 15%.
18-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–€600 €200 €500 €300

0 1 2 3
$1.25
The current exchange rate is S0($/€) =
€

Is this a good investment from the perspective of the

U.S. shareholders?
To address that question, let’s convert all of the cash
flows to dollars and then find the NPV at i$ = 15%.
18-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750
–€600 €200 €500 €300

0 1 2 3

CF0 = (€600)× S0($/€) =(€600)× $1.25 = $750

€

Finding the dollar value of the initial cash

$1.25
flow is easy; convert at the spot rate: S0($/€) =
€
18-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28
–€600 €200 €500 €300

0 1 2 3
The exchange rate expected to prevail in the first year, S1($/€),
can be found with PPP:
1 + $ 1.06 $1.25
S1($/€) = 1 +   S0($/€) =  = $1.2864/€
€ 1.03 €

CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28

18-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 $1.25

CF2 =    €500 = $661.94
1.03 1.03 €

18-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94 $408.73
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 1.06 $1.25

CF3 =     €300 = $408.73
1.03 1.03 1.03 €

18-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94 $408.73

0 1 2 3
Find the NPV using the cash flow menu of your financial
calculator and and interest rate i$ = 15%:
CF0 = –$750
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 NPV = $242.99
18-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
–$750 $257.28 $661.94 $408.73

0 1 2 3

Without a financial calculator, the NPV can be found as:

$257.28 $661.94 $408.73

NPV = –$750 + + + = $242.99
1.15 (1.15) 2
(1.15) 3

18-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 International Capital Budgeting:
Example
– €600 €200 €500 €300

0 1 2 3

Find the NPV using the cash flow menu and i€ = 11.75%:
CF0 = –€600 I = 11.75
CF1 = €200 NPV = €194.39
CF2 = €500
$1.25 = $242.99
CF3 = €300 €194.39 ×
€
18-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Capital Budgeting from the Parent
Firm’s Perspective: Example
– €600 €200 €500 €300

0 1 2 3

Without a financial calculator, the NPV can be found as:

€200 €500 €300
NPV = –€600 + + + = €194.39
1.1175 (1.1175) 2
(1.1175) 3

$1.25 = $242.99
€194.39 ×
€
18-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Risk Adjustment in the Capital
Budgeting Process
 Clearly risk and return are correlated.
 Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.

18-17 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Sensitivity Analysis
 In the APV model, each cash flow has a
probability distribution associated with it.
 Hence, the realized value may be different from
what was expected.
 In sensitivity analysis, different estimates are used
for expected inflation rates, cost and pricing
estimates, and other inputs for the APV to give the
manager a more complete picture of the planned
capital investment.
18-18 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.