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CHAPTER 18 INTERNATIONAL CAPITAL BUDGETING
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Why is capital budgeting analysis so important to the firm?
Answer: The fundamental goal of the financial manager is to maximize shareholder wealth.
Capital investments with positive NPV or APV contribute to shareholder wealth. Additionally,
2. What is the intuition behind the NPV capital budgeting framework?
Answer: The NPV framework is a discounted cash flow technique. The methodology compares
the present value of all cash inflows associated with the proposed project versus the present
3. Discuss what is meant by the incremental cash flows of a capital project.
Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash
4. Discuss the nature of the equation sequence, Equation 18.2a to 18.2f.
Answer: The equation sequence is a presentation of incremental annual cash flows associated
with a capital expenditure. Equation 18.2a presents the most detailed expression for calculating
these cash flows; it is composed of three terms. Equation 18.2b shows that these three terms
actually available for shareholders. Equation 18.2c cancels out the after-tax interest term in
18.2a, yielding a simpler formula. Equation 18.2d shows that the first term in 18.2c is generally
5. What makes the APV capital budgeting framework useful for analyzing foreign capital
expenditures?
Answer: The APV framework is a value-additivity technique. Because international projects
6. Relate the concept of lost sales to the definition of incremental cash flow.
Answer: When a new capital project is undertaken it may compete with an existing project(s),
causing the old project(s) to experience a loss in sales revenue. From an incremental cash flow
7. What problems can enter into the capital budgeting analysis if project debt is evaluated
instead of the borrowing capacity created by the project?
Answer: If project debt is greater (less) than the borrowing capacity created by the capital
8. What is the nature of a concessionary loan and how is it handled in the APV model?
Answer: A concessionary loan is a loan offered by a governmental body at below the normal
market rate of interest as an enticement for a firm to make a capital investment that will
economically benefit the lender. The benefit to the MNC is the difference between the face
value of the concessionary loan converted into the home currency and the present value of the
9. What is the intuition of discounting the various cash flows in the APV model at specific
discount rates?
Answer: The APV model is a value-additivity technique where total value is determined by the
sum of the present values of the individual cash inflows and outflows. Each cash flow will not
10. In the Modigliani-Miller equation, why is the market value of the levered firm greater than
the market value of an equivalent unlevered firm?
Answer: The levered firm has a greater market value because less money is taken from the
11. Discuss the difference between performing the capital budgeting analysis from the parent
firm’s perspective as opposed to the subsidiary’s perspective.
Answer: The goal of the financial manager of the parent firm is to maximize its shareholders’
wealth. A capital project of a subsidiary of the parent may have a positive NPV (or APV) from
the subsidiary’s perspective yet have a negative NPV (or APV) from the parent’s perspective if
certain cash flows cannot be repatriated to the parent because of remittance restrictions by the
12. Define the concept of a real option. Discuss some of the various real options a firm can be
confronted with when investing in real projects.
Answer: A positive APV project is accepted under the assumption that all future operating
decisions will be optimal. The firm’s management does not know at the inception date of a
project what future decisions it will be confronted with because all information concerning the
The firm is confronted with many possible real options over the life of a capital asset.
For example, the firm may have a timing option as when to make the investment; it may have a
13. Discuss the circumstances under which the capital expenditure of a foreign subsidiary
might have a positive NPV in local currency terms but be unprofitable from the parent firm’s
perspective.
Answer: The project NPV might be negative from the parent firm’s perspective when it is
positive in local currency terms if all foreign cash flows cannot be legally repatriated to the
parent firm. Additionally, if the PPP assumption does not hold, such that the actual future real
PROBLEMS
1. The Alpha Company plans to establish a subsidiary in Hungary to manufacture and sell
fashion wristwatches. Alpha has total assets of $70 million, of which $45 million is equity
financed. The remainder is financed with debt. Alpha considered its current capital structure
optimal. The construction cost of the Hungarian facility in forints is estimated at
HUF2,400,000,000, of which HUF1,800,000,and 000 is to be financed at a below-market
borrowing rate arranged by the Hungarian government. Alpha wonders what amount of debt it
should use in calculating the tax shields on interest payments in its capital budgeting analysis.
Can you offer assistance?
Solution: The Alpha Company has an optimal debt ratio of .357 (= $25 million debt/$70 million
assets) or 35.7%. The project debt ratio is .75 (= HUF1,800/HUF2,400) or 75%. Alpha will
2. The current spot exchange rate is HUF250/$1.00. Long-run inflation in Hungary is estimated
at 10 percent annually and 3 percent in the United States. If PPP is expected to hold between
the two countries, what spot exchange should one forecast five years into the future?
3. The Beta Corporation has an optimal debt ratio of 40 percent. Its cost of equity capital is 12
percent and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent,
calculate (a) the weighted-average cost of capital, and (b) the cost of equity for an equivalent
all-equity financed firm.
Solution:
(a) K = (1 - .40).12 + (.40).08(1 - .35)
(b) A weighted-average cost of capital of 9.28% for a levered firm implies:
4. Zeda, Inc., a U.S. MNC, is considering making a fixed direct investment in Denmark. The
Danish government has offered Zeda a concessionary loan of DKK15,000,000 at a rate of 4
percent per annum. The normal borrowing rate is 6 percent in dollars and 5.5 percent in Danish
krone. The loan schedule calls for the principal to be repaid in three equal annual installments.
What is the present value of the benefit of the concessionary loan? The current spot rate is
DKK5.60/$1.00 and the expected inflation rate is 3% in the U.S. and 2.5% in Denmark.
Solution:
Year
(t)
St
(a)
Principal
Payment
(b)
DKK
It
(c)
DKK
StLPt
(b + c)/(a)
StLPt/(1 + id)t
The dollar value of the concessionary loan is $2,678,574 = DKK15,000,000 ÷ 5.60. The dollar
5. Delta Company, a U.S. MNC, is contemplating making a foreign capital expenditure in South
Africa. The initial cost of the project is ZAR10,000. The annual cash flows over the five year
economic life of the project in ZAR are estimated to be 3,000, 4,000, 5,000, 6000, and 7,000.
The parent firm’s cost of capital in dollars is 9.5 percent. Long-run inflation is forecasted to be 3
percent per annum in the U.S. and 7 percent in South Africa. The current spot foreign exchange
rate is ZAR/USD = 3.75. Determine the NPV for the project in USD by:
a. Calculating the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher
Effect and then converting to USD at the current spot rate.
Solution: ZAR equivalent cost of capital according to the Fisher Effect = 1.095 x [(1.07)/(1.03)] –
b. Converting all cash flows from ZAR to USD at Purchasing Power Parity forecasted exchange
rates and then calculating the NPV at the dollar cost of capital.
ZAR/USD(1) = 3.90; ZAR/USD(2) = 4.05; ZAR/USD(3) = 4.20; ZAR/USD(4) = 4.37;
and, ZAR/USD(5) = 4.54.
Are the two dollar NPVs different or the same? Explain.
The two dollar NPVs are identical as they always will be under the assumption that both PPP
c. What is the NPV in dollars if the actual pattern of ZAR/USD exchange rates is: S(0) = 3.75,
S(1) = 5.7, S(2) = 6.7, S(3) = 7.2, S(4) = 7.7, and S(5) = 8.2?
Solution:
The NPV is negative because actual exchange rates did not evolve as forecasted by PPP.
Consequently, actual NPV and forecasted NPV may be different.
6. Suppose that in the illustrated mini case in the chapter the APV for Centralia had been -
$60,000. How large would the after-tax terminal value of the project need to be before the APV
would be positive and Centralia would accept the project?
Solution: Centralia should not go ahead with its plans to build a manufacturing plant in the
Spain unless the terminal value is likely to be large enough to yield a positive APV. The terminal
7. With regards to the Centralia illustrated mini case in the chapter, how would the APV change
if:
a. The forecast of d and/or f are incorrect?
Answer: A larger or smaller d will not have any effect because a change will affect the
numerator and denominator of each APV term in an offsetting manner. Note that imbedded in
b. Deprecation cash flows are discounted at Kud instead of id?
c. The host country did not provide the concessionary loan?
Answer: The APV would be less favorable because the project would have to cover a higher
