Chapter 17

International
Capital Budgeting
 Chapter Outline

Review of Domestic Capital Budgeting

The Adjusted Present Value Model
Capital Budgeting from the Parent Firm’s
Perspective
Risk Adjustment in the Capital Budgeting Process
Sensitivity Analysis
Real Options
 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.
 International Capital Budgeting

One recipe for international decision makers:

1. Estimate future cash flows in foreign currency.
2. Convert to U.S. dollars at the predicted
exchange rate.
3. Calculate NPV using the U.S. cost of capital.
 International Capital Budgeting
Example
– 600€ 200€ 500€ 300€

0 1 2 3

€ = 3%
$.55265 Is this a good
i$ = 15% S0($/€) =
€ investment from the
$ = 6% perspective of the
U.S. shareholders?
 International Capital Budgeting:
Example
$331.60

– 600€ 200€ 500€ 300€

0 1 year 2 years 3 years

CF0 = (€600)× S0($/€) =(€600)× $.55265 = $331.60

€
 International Capital Budgeting:
Example
$331.60 $113.70

– 600€ 200€ 500€ 300€

0 1 year 2 years 3 years

CF1 = (€200)×E[ S1($/€)] =
E[ S1($/€)] can be found by appealing to the interest rate
differential:
E[S€(1)] = 1.06  S0($/€) = 1.06  $.55265 = $.5687/€
1.03 1.03 €
so CF1 = (€200)×($.5687/€) = $113.7
 International Capital Budgeting:
Example
$331.60 $113.70 $292.60

– 600€ 200€ 500€ 300€

0 1 year 2 years 3 years

Similarly,

CF2 = 1.06 × 1.06 × S0($/€) (€500) = $292.6

1.03 1.03
 International Capital Budgeting:
Example
$331.60 $113.70 $292.60 $180.70

– 600€ 200€ 500€ 300€

0 1 year 2 years 3 years

(1.06)3
CF3 = 3
× S0($/€) (€300) = $180.7
(1.03)

$113.70 $292.60 $180.70

NPV  $336.60   2
 3
 $107.30
(1.15) (1.15) (1.15)
 International Capital Budgeting

Another recipe for international decision makers:

1. Estimate future cash flows in foreign currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the
foreign cost of capital.
4. Translate the foreign currency NPV into
dollars using the spot exchange rate
 Foreign Currency Cost of Capital
Method
– €600 €200 €500 €300

0 1 2 3
Let’s find i€ and use that on
€ = 3% the euro cash flows to find
the NPV in euros.
i$ = 15%
Then translate the NPV into
$ = 6% dollars at the spot rate.
$.55265
S0($/€) =
€
 Finding the Foreign Currency Cost of
Capital: i€
Recall that if Fisher Effect holds here and abroad…
(1 + e)×(1 + $) = (1 + i$)
(1 + i$)
(1 + e) =
(1 + $)

(1 + i€) = (1 + e) × (1 + €)
and if the real rates are the same, then
(1 + i$)×(1 + €)
(1 + i€) =
(1 + $)
 International Capital Budgeting
Example
– €600 €200 €500 €300

0 1 2 3

(1 + i$)×(1 + €) (1.15)×(1.03)

(1 + i€) = = = 11.75%
(1 + $) (1.06)
€ = 3% NPV 11.75% = € 194.39

i$ = 15% $.55265
€ 194.39×
$.55265 €
$ = 6% S0($/€) =
€ = $107.43
 International Capital Budgeting
You 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.
If you watch your rounding, you will get exactly the same
answer either way.
Which method you prefer is your choice.
 Review of Domestic Capital
Budgeting
The basic net present
T value equation is
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 cash flow in year T, 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.
 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     C0  0.
t 1 (1  K ) (1  K )
t T
 Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
CFt  ( Rt  OCt  Dt  I t )(1  τ )  Dt  I t (1  τ )
Rt is incremental revenue It is incremental interest expense
Ct is incremental operating  is the marginal tax rate
cash flow
Dt is incremental depreciation
 Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
CFt  ( Rt  OCt  Dt  I t )(1  τ )  Dt  I t (1  τ )
 ( NIt  Dt  I t (1  τ )
 ( Rt  OCt  Dτ )(1  τ )  Dt
 NOI t (1  τ )  Dt
 ( Rt  OCt )(1  τ )  τDt
 OCFt (1  τ )  τDt
 Review of Domestic Capital
Budgeting
CFt  OCFt (1  τ )  τDt
We can use
to restate the NPV equation
T
CFt TVT
NPV     C0
t 1 (1  K ) (1  K )
t T

as:
T
OCFt (1  τ )  τDt TVT
NPV     C0
t 1 (1  K ) t
(1  K ) T
 The Adjusted Present Value Model
T
OCFt (1  τ ) τDt TVT
NPV      C0
t 1 (1  K ) t
(1  K ) (1  K )
t T

Can be converted to adjusted present value (APV)

T
OCFt (1  τ ) τDt τIt TVT
APV       C0
t 1 (1  K u ) (1  i) (1  i) (1  Ku )
t t t T

By appealing to Modigliani and Miller’s results.

 The Adjusted Present Value Model
T
OCFt (1  τ ) τDt τIt TVT
APV       C0
t 1 (1  K u ) (1  i) (1  i) (1  Ku )
t t t T

The APV model is a value additivity approach to

capital budgeting. Each cash flow that is a source
of value to the firm is considered individually.
Note that with the APV model, each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.
 Domestic APV Example
Consider a project of the Pearson Company, 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%:
$125 $250 $375 $500
NPV10%  $1,000    
(1.10) (1.10) 2 (1.10) 3 (1.10) 4
NPV10%  $56.50

The project would be rejected by an all-equity firm: NPV < 0.

 Domestic APV Example (continued)
Now, imagine that the firm finances the project with $600 of debt
at r = 8%.
Pearson’s tax rate is 40%, so they have an interest tax shield
worth ×I = .40×$600×.08 = $19.20 each year.
 The net present value of the project under leverage is:
APV  NPV  NPVF Note that with the
4
$19.20 APV model, each cash
APV  $56.50   t
flow is discounted at a
t 1 (1.08) rate that is appropriate
to the riskiness of the
APV  $56.50  63.59  $7.09 cash flow.

 So, Pearson should accept the project with debt.

 Domestic APV Example (continued)
Note that there are two ways to calculate the NPV of the loan.
Previously, we calculated the PV of the interest tax shields.
Now, let’s calculate the actual NPV of the loan:
4
$600  .08  (1  .4) $600
NPVloan  $600   t
 4
t 1 (1 .08) (1.08)
NPVloan  $63.59
APV  NPV  NPVloan
APV  $56.50  63.59  $7.09
Which is the same answer as before.
 Capital Budgeting from the Parent
Firm’s Perspective
Donald Lessard developed an APV model for a MNC
analyzing a foreign capital expenditure. The model
recognizes many of the particulars peculiar to foreign
direct investment.
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id ) t
t 1 (1  id ) t

T
ST TVT St LPt
  S0C0  S0 RF0  S0CL0  
(1  K ud ) T
t 1 (1  id ) t
 Capital Budgeting from the Parent
Firm’s Perspective
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id ) t
t 1 (1  id ) t

T
ST TVT St LPt
  S0C0  S0 RF0  S0CL0  
(1  K ud ) T
t 1 (1  id ) t

The operating cash flows must The operating cash flows

be translated back into the must be discounted at the
parent firm’s currency at the unlevered domestic rate
spot rate expected to prevail
in each period.
 Capital Budgeting from the Parent
Firm’s Perspective
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id ) t
t 1 (1  id ) t

T
ST TVT St LPt
  S0C0  S0 RF0  S0CL0  
(1  K ud ) T
t 1 (1  id ) t

OCFt represents only the portion The marginal corporate tax

of operating cash flows available rate, , is the larger of the
for remittance that can be legally parent’s or foreign
remitted to the parent firm. subsidiary’s.
 Capital Budgeting from the Parent
Firm’s Perspective
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id ) t
t 1 (1  id ) t

T
ST TVT St LPt
  S0C0  S0 RF0  S0CL0  
(1  K ud ) T
t 1 (1  id ) t

S0RF0 represents the value of Denotes the present value

accumulated restricted funds (in (in the parent’s currency) of
the amount of RF0) that are freed any concessionary loans,
up by the project. CL0, and loan payments,
LPt , discounted at id .
 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.
 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.
 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.