Chapter - 14 (multinational Capital Budgeting) z2u5y

14

Chapter

Multinational Capital Budgeting

Chapter Objectives • To compare the capital budgeting analysis of an MNC’s subsidiary with that of its parent;

• To demonstrate how multinational capital budgeting can be applied to determine whether an international project should be implemented; and

• To explain how the risk of international projects can be assessed.

Multinational Capital Budgeting Capital Budgeting: Capital budgeting involves determining the projects net present value by estimating the present value of the project’s future cash flows and subtracting the initial outlay required for the project. Multinational capital budgeting typically uses a similar process.

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Subsidiary versus Parent Perspective Should the capital budgeting for a multi-national project be conducted from the viewpoint of the subsidiary that will ister the project, or the parent that will provide most of the financing? Some would say-

• The subsidiary’s perspective should be used because it will be responsible for istrating the project.

• The subsidiary is a subset of the MNC, so what is good for the subsidiary would appear to be good for the MNC.

Subsidiary versus Parent Perspective, cont.. ArgumentsThe parent is financing the project, then it should be evaluating the results from the parent’s point of view. The results may vary with the perspective taken because the net after-tax cash inflows to the parent can differ substantially from those to the subsidiary.

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Subsidiary versus Parent Perspective, cont.. The difference in cash inflows: The net after tax inflows to the subsidiary can differ substantially from those to the parent. Such difference can be due to several factors, such as1. Tax differentials: Usually subsidiaries’ earnings remitted to the parent periodically. If the parent’s government impose a high tax rate on the remitted funds, the project may be feasible from the subsidiaries point of view, but not from the parents point of view.

Subsidiary versus Parent Perspective, cont.. 2. Restricted remittances: The government of a country, where the potential subsidiary would be established, may impose restriction, that a percentage of the subsidiary’s earnings will remain in the country. Since, the parent may never have access to these funds, then the project is not attractive to the parent, although it may be attractive to the subsidiary.

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Subsidiary versus Parent Perspective, cont.. 3. Excessive remittances: A parent, that have a centralized management, can charge to its subsidiary very high istrative fees. To the subsidiary, the fees represents an expense and to the parent it represents revenue. In this case, the projects earnings may appear low from subsidiary’s perspective and high from parent’s perspective. 4. Exchange rate movements: When earnings are remitted to the parent, they are normally converted from the subsidiary’s local currency to the parent’s currency. The amount received by the parent is therefore influenced by the existing exchange rate. C14 - 8

Remitting Subsidiary Earnings to the Parent Cash Flows Generated by Subsidiary

Corporate Taxes Paid to Host Government

After-Tax Cash Flows to Subsidiary Retained Earnings by Subsidiary Cash Flows Remitted by Subsidiary After-Tax Cash Flows Remitted by Subsidiary Conversion of Funds to Parent’s Currency Cash Flows to Parent Parent

Withholding Tax Paid to Host Government

Subsidiary versus Parent Perspective, cont.. Summary of the factors: A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive net present value for the parent should enhance the firm’s value. However, one exception to this rule may occur when the foreign subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting The following forecasts are usually required: 1. 2. 3. 4. 5. 6. 7.

8. 9. 10. 11.

Initial investment Consumer demand Product price Variable cost Fixed cost Project lifetime Salvage (liquidation) value Fund-transfer restrictions Tax laws Exchange rates Required rate of return

Multinational Capital Budgeting Example Capital budgeting is necessary for all long-term projects that deserve consideration. One common method of performing the analysis is to estimate the cash flows and salvage value to be received by the parent, and compute the net present value (NPV) of the project. n

CashflowinYerat SalvageVal ue NPV   InitialOutlay    t n     1  k 1  k t 1 k = the required rate of return on the project n = project lifetime in of periods If NPV > 0, the project can be accepted.

Capital Budgeting Analysis Period t Demand(1) Price per unit(2) Total revenue(1)(2)=(3) Variable cost per unit(4) Total variable cost (1)(4)=(5) Annual lease expense(6) Other fixed periodic expenses(7) Noncash expense (depreciation)(8) Total expenses

1. 2. 3. 4. 5. 6. 7. 8. 9. (5)+(6)+(7)+(8)=(9) 10. Before-tax earnings of subsidiary(3)–(9)=(10) 11. Host government taxtax rate(10)=(11) 12. After-tax earnings of subsidiary(10)–(11)=(12)

Capital Budgeting Analysis Period t Net cash flow to subsidiary (12)+(8)=(13) Remittance to parent(14) Tax on remitted fundstax

13. 14. 15. rate(14)=(15) 16. Remittance after withheld tax(14)–(15)=(16) 17. Salvage value(17) 18. Exchange rate(18) 19. Cash flow to parent (16)(18)+(17)(18)=(19) 20. Investment by parent(20) 21. Net cash flow to parent (19)–(20)=(21) 22. PV of net cash flow to parent (1+k) - t(21)=(22) 23. Cumulative NPVPVs=(23)

Factors to Consider in Multinational Capital Budgeting  Exchange rate fluctuations. Different scenarios should be

considered together with their probability of occurrence.  Inflation. Although price/cost forecasting implicitly considers

inflation, inflation can be quite volatile from year to year for some countries.  Financing arrangement. Financing costs are usually captured

by the discount rate. However, many foreign projects are partially financed by foreign subsidiaries.  Blocked funds. Some countries may require that the earnings be

reinvested locally for a certain period of time before they can be remitted to the parent.

Factors to Consider in Multinational Capital Budgeting  Uncertain salvage value. The salvage value typically has a

significant impact on the project’s NPV, and the MNC may want to compute the break-even salvage value.  Impact of project on prevailing cash flows. The new

investment may compete with the existing business for the same customers.  Host government incentives. These should also be considered

in the analysis.

Impact of Multinational Capital Budgeting on an MNC’s Value Multinational Capital Budgeting Decisions

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 E  CF   E ER   

n

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m

Value =   t =1

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j 1

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j, t

1  k 

j, t

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t

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E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at