Eun and Resnick chapter 18 Identify the size and timing of all relevant cash flows on a time line Identify the riskiness of the cash flows to determine the appropriate discount rate ID: 634891
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Slide1
International Capital Budgeting
(Eun and Resnick chapter 18)Slide2
Identify the size and timing of all relevant cash flows on a time line.Identify the
riskiness of the cash flows to determine the appropriate discount rate.Find NPV by discounting the cash flows at the appropriate discount rate.Compare the value of competing cash flow streams at the same point in time. Review of Domestic Capital BudgetingSlide3
Review of Domestic Capital Budgeting
The basic net present value equation isWhere: 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 yearsThe NPV rule is to accept a project if NPV
0Slide4
Review of Domestic Capital Budgeting
For our purposes it is necessary to expand the NPV equation.Rt is incremental revenueOCt is incremental operating costsDt is incremental depreciation
I
t
is incremental interest expense
is the marginal tax rate
CF
t
=
(
R
t
– OC
t
– D
t
– I
t
)(1
–
t
)
+ D
t
+ I
t
(1
–
t
)Slide5
Review of Domestic Capital BudgetingWe can use
CFt = (OCFt)(1 – t) + t Dtto restate the NPV equation,
as:
NPV =
S
t
= 1
T
CF
t
(1
+ K
)
t
–
C
0
TV
T
(1
+ K
)
T
+
NPV =
S
t
= 1
T
(
OCF
t
)(1
–
t
)
+
t
Dt
(1 + K)t
– C0
TV
T
(1 + K)T
+Slide6
The Adjusted Present Value Model can be converted to
adjusted present value (APV) by appealing to Modigliani and Miller’s results.NPV =S
t
= 1
T
(
OCF
t
)(1
–
t
)
(1
+ K
)
t
C
0
TV
T
(1
+ K
)
T
+
t
D
t
(1
+ K
)
t
+
–
S
t
= 1
T
APV =
S
t = 1
T
(
OCFt)(1 – t)
(1
+ K
u
)
t
C
0
TV
T
(1
+
K
u
)
T
+
t
D
t
(1
+
i
)
t
+
–
t
I
t
(1
+
i
)
t
+Slide7
The Adjusted Present Value ModelThe 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.APV =S
t
= 1
T
(
OCF
t
)(1
–
t
)
(1
+ K
u
)
t
C
0
TV
T
(1
+
K
u
)
T
+
t Dt
(1
+ i)t
+
–
t
It
(1 +
i)t+Slide8
International Capital Budgeting from the Parent Firm’s Perspective
The APV model is useful for a domestic firm analyzing a domestic capital expenditure or for a foreign subsidiary of an MNC analyzing a proposed capital expenditure from the subsidiary’s viewpoint.The APV model is NOT useful for an MNC in analyzing foreign capital expenditure from the parent firm’s perspective.APV =S
t
= 1
T
(
OCF
t
)(1
–
t
)
(1
+ K
u
)
t
C
0
TV
T
(1
+
K
u
)
T
+
t Dt
(1
+ i)t
+
–
t
It
(1 +
i)t+Slide9
International Capital Budgeting from the Parent Firm’s Perspective
Donald Lessard developed an APV model for MNCs analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.Slide10
Denotes the present value (in the parent’s currency) of any
concessionary loans, CL0, and loan payments, LPt , discounted at id . S0RF0 represents the value of accumulated restricted funds (in the amount of
RF
0
)
that are freed up by the project
.
The marginal corporate tax rate,
,
is the larger of the parent’s or foreign subsidiary’s.
OCF
t
represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.
The operating cash flows must be discounted at the unlevered domestic rate
The operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period.
APV Model of Capital Budgeting from the Parent Firm’s Perspective
APV =
S
t
= 1
T
(1
+ K
ud
)
t
TV
T
(1
+
K
ud
)
T
+
t Dt
(1 + id)t
+
–
S
tOCFt(1 – t)
S
0
C
0
+ S
0
RF
0
+
S
0
CL
0
-
S
t
= 1
T
S
t
t
I
t
(1
+
i
d
)
t
S
S
t
+
t
= 1
T
S
t
LP
t
(1
+
i
d
)
t
S
S
t
t
= 1
TSlide11
One recipe for international decision makers:Estimate future cash flows in foreign currency.Convert to the home currency at the predicted exchange rate.
Use PPP, IRP, et cetera for the predictions.Calculate NPV using the home currency cost of capital.Capital Budgeting from the Parent Firm’s PerspectiveSlide12
Dorchester caseRead the case carefully from the textDevelop and present all the calculations in Excel
The goal is to calculate the APV (formula 18.7 in the text)Follow the methodology described for Centralia in the textFirst exhibit summarizes the assumptions and the simple calculationsPrepare the same exhibits