IBUS 302: International Finance

1. IBUS 302: International Finance Topic 16-International Capital Budgeting Lawrence Schrenk, Instructor

2. Learning Objectives • Explain the process of capital budgeting▪ • Discuss how the process changes in an international environment. • Calculate a cross-border NPV from the parent firm’s perspective. • Describe some uses of real options in capital budgeting.▪

3. Domestic Capital Budgeting

4. NPV • NPV is the present value of future cash flows minus the initial net cash outlay for the project discounted at the project’s cost of capital. • Assuming the goal of maximizing shareholder wealth, any project with a positive NPV should be pursued. • Generally, the source of financing is irrelevant to the investment decision.

5. NPV Advantages • Evaluates investment in the same manner as a company’s shareholders. • Focuses in on cash and not accounting profits • Emphasizes the opportunity cost of the money invested.

6. NPV Difficulties • Estimating cash flows. • The cost of the project • The cash inflows during the life of the project (especially hard where there are relevant spillovers–cannibalization or sales creation) • The terminal or ending values of the project.

7. “Domestic” NPV Calculations 1. Estimate Future Cash Flows E[CFt] • Include only incremental cash flows • Include all opportunity costs The algebra of cross-border investment analysis

8. “Domestic” NPV Calculations 2. Identify Risk-Adjusted Discount Rate • Discount nominal CFs at nominal discount rates and real CFs at real discount rates • Discount equity CFs at equity discount rates and debt CFs at debt discount rates • Discount CFs to debt and equity at the WACC • Discount cash flows in a particular currency at a discount rate in that currency The algebra of cross-border investment analysis

9. “Domestic” NPV Calculations 3. Calculate net present value NPV • Based on expected future cash flows and the appropriate risk-adjusted discount rate The algebra of cross-border investment analysis

10. International Capital Budgeting

11. New Issues • Which Currency to Use • Exchange Rate Risk • Does Purchasing Power Parity Hold • Foreign & Domestic Tax Rates • Cost of Capital • Special elements: • Political Risk • Subsidies

12. Two Valuation Methods • NPV • Traditional NPV analysis extended to int’l projects • APV (valuation by parts) • APV = PV[OCF] + PV[Project costs & benefits] • Project costs & benefits: • PV of tax shields • PV of financial subsidies

13. Net Present Value

14. International Capital Budgeting • Foreign projects generate cash flows in a foreign currency. • Two Approaches • Approach 1: Foreign Project • Approach 2: Parent Firm

15. Approach 1: Project’s (Local) Perspective • Estimate cash flows in foreign currency • Discount in the foreign currency • Find the foreign currency NPV • Convert foreign currency NPV to a domestic currency value at the spot exchange rate. The algebra of cross-border investment analysis

16. Approach 2: Parent’s Perspective • Estimate cash flows in foreign currency • Convert foreign cash flows into the domestic currency at expected future spot rates • Discount in the domestic currency • Find the domestic NPV The algebra of cross-border investment analysis

17. Approach 1: Discount in the Foreign Currency 1. Estimate future cash flows E[CFtf] 2. Identify discount rate 3. Calculate net present value Calculate NPV Convert to the domestic currency E[CF1f ] E[CF2f ] NPV0f if NPV0d= S0d/f NPV0f The algebra of cross-border investment analysis

18. Approach 2: Discount in the Domestic Currency 1. Estimate E[CFtd] = E[Std/f ] E[CFtf ] 2. Identify discount rate 3. Calculate net present value NPV E[CF1f ] E[CF2f ] E[CFtd ] = E[Std/f ] E[CFtf ] NPV0 The algebra of cross-border investment analysis

19. Two Approaches • You should have two equally valid approaches: • Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the $NPV using the dollar cost of capital. • Find the foreign currency NPV using the foreign currency cost of capital. Translate that into dollars at the spot exchange rate.

20. PPP • PPP must hold. • Over the life of the project • Differential Inflation • FX rates must change to compensate

21. WACC • If PPP holds:

22. Approach 2: Simple Example • U.S. parent considers building a Swiss factory (millions) • Initial cost: $50 • S($/SF): .50 • Projected SF cash flows • Year 1: 10 SF net revenues • Years 2-5: revenue growth @ 2% • Year 5 100 SF Salvage/Terminal Value of Factory

23. Approach 2: Simple Example • Exchange rate forecast: PPP • Swiss inflation forecast: 2%/year • U.S. inflation forecast: 3%/year • Predicted SF appreciation: 1%/year

24. NPV Calculation

25. NPV Calculation

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27. NPV Calculation

28. NPV Calculation

29. NPV Calculation

30. Political Risk Adjustment • Political Risk • Clearly risk and return are correlated. • Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

31. 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.

32. Real Options • The application of options pricing theory to the evaluation of investment options in real projects is known as real options. • A timing option is an option on when to make the investment. • A growth option is an option to increase the scale of the investment. • A suspension option is an option to temporarily cease production. • An abandonment option is an option to quit the investment early.