FINC3240 International Finance. Chapter 14 Multinational Capital Budgeting. Capital Budgeting Decision . Capital budgeting: the process of analyzing projects and decide which ones to invest in. . Capital budgeting rules. We will learn to apply 2 capital budgeting rules:
Multinational Capital Budgeting
Accept project if
Net present value > 0
What is Net present value?
Net present value
= Benefits minus Costs
Benefits= Present value of all cash inflows from the project
Costs= Present value of all cash outflows from the project
IRR: the discount rate that will make the PV of cash inflows equal to the PV of cash outflows.
PV of cash outflows, discounted at IRR
PV of cash inflows, discounted at IRR
Accept project if
IRR > cost of capital
Verify that NPV = 603.58, IRR = 31.79%,
Since NPV>0, IRR>11%, accept the project
A five-year project, if taken, will require an initial investment of $120,000. The expected end-of-year cash inflows are as follows:
If the appropriate cost of capital for this project is 11%, which of the following is a correct decision?
a. Reject the project because NPV = -$30,507, which is less than 0.
b. Reject the project because IRR is 10.04%, which is less than the cost of capital, 11%.
c. Both a and b are correct.
d. Accept the project because IRR is positive.
e. None of the above is correct.
The subsidiary is wholly owned by the parent company. Therefore, the feasibility of the project depends on the cash flows that the parent ultimately receives.
1. Economic and Financial Characteristics Involved
a. Initial Investment
b. Price and Consumer Demand (and inflation)
c. Costs (variable and fixed)
e. Remitted Funds
f. Exchange Rates
g. Salvage Value
h. Required Rate of Return
Spartan, Inc. on page 425.
read the textbook
the cash flows received by the parent should be US$.
How to estimate the cash flows? See Exhibit 14.2
Domestic capital budgeting problems would not include debt payments in the measurement of cash flows because all financing costs are captured by the discount rate.
When the parent finances the whole foreign project, debt payments does not count.
When the foreign subsidiary partially finances the foreign project, we should separate the investment made by the subsidiary from the investment made by the parent. The capital budgeting should focus on the present value of cash flows received by the parent and the initial investment by the parent.
1. Risk-Adjusted Discount Rate
the greater the uncertainty about the forecasted cash flows, the larger should be the discount rate, other things being equal.
2. Sensitivity Analysis
forecast the cash flows under different possible scenarios, such as different level of sales, expenses, exchange rate, etc.
using software and computer to generate millions of possible outcomes and calculate the average.
Your employees have estimated the net present value of project XP to be $1.2 million. Their report says that they have not accounted for any risk, but that with such a large NPV, the project should be accepted since even a risk-adjusted NPV would likely be positive. You have the final decision as to whether to accept or reject the project. What is your decision?
ANSWER: The decision should not be made until risk has been considered. If the project has a risk of a government takeover, for example, a large estimated NPV may not be a sufficient reason to accept the project.
Brower, Inc, is considering constructing a manufacturing plant in Ghana. The construction cost 9 billion Ghanian Cedi. Brower intends to leave the plant open for 3 years. During the 3 years of operation, cash flows are expected to be 3, 3, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17%. It currently takes 8,700 cedi to buy one US dollar, and the cedi is expected to depreciate by 5% per year. Should Brower build the plant?
NPV=-91,339.03<0, so reject.
Chapter 14 Questions and applications: