Multinational Capital Budgeting ❖ 1
Chapter 14
Multinational Capital Budgeting
Lecture Outline
Subsidiary versus Parent Perspective
Tax Differentials
Restrictions on Remitted Earnings
Exchange Rate Movements
Summary of Factors That Distinguish the Parent Perspective
Input for Multinational Capital Budgeting
Multinational Capital Budgeting Example
Background
Analysis
Other Factors to Consider
Exchange Rate Fluctuations
Inflation
Financing Arrangement
Blocked Funds
Uncertain Salvage Value
Impact of Project on Prevailing Cash Flows
Multinational Capital Budgeting ❖ 2
Chapter Theme
This chapter identifies additional considerations in multinational capital budgeting versus domestic capital budgeting. These considerations can either be
illustrated with the use of an example. The analysis in this chapter is also applied in subsequent chapters and therefore is very important.
Topics to Stimulate Class Discussion
2. How should a firm adjust the capital budgeting analysis for investment in a country where the currency is extremely volatile?
3. How should a firm adjust the capital budgeting for investment in a country where the chance of a government takeover is relatively high?
POINT/COUNTER-POINT
Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign Projects?
POINT: Yes. An MNC’s parent should use the forward rate for each year in which it will receive net cash flows in a foreign currency. The forward rate is
market-determined and serves as a useful forecast for future years.
COUNTER-POINT: No. An MNC should use its own forecasts for each year in which it will receive net cash flows in a foreign currency. If the forward
rates for future time periods are higher than the MNC’s expected spot rates, the MNC may accept a project that it should not accept.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.
Answers to End of Chapter Questions
Multinational Capital Budgeting ❖ 7
the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy
one U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.
Multinational Capital Budgeting ❖ 8
a. Determine the NPV for this project. Should Brower build the plant?
ANSWER:
Salvage Value 5
Net CF –9 3 3 7
b. How would your answer change if the value of the cedi was expected to remain unchanged from its current value of 8,700 cedis per U.S. dollar over
the course of the three years? Should Brower construct the plant in that scenario?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar over the course of the three years:
Multinational Capital Budgeting ❖ 11
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already had some existing operations in Brazil. When capital
budgeting analysis was used to determine the feasibility of this project, should the project have been assessed from a Brazil perspective or a U.S.
perspective? Explain.
18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be financed with U.S. dollars). All cash flows generated
from the project were to be reinvested in Thailand for several years. Explain how the Asian crisis would have affected the expected cash flows of this
project and the required rate of return on this project. If the cash flows were to be remitted to the U.S. parent, explain how the Asian crisis would have
affected the expected cash flows of this project.
19. Tax Effects on NPV. When considering the implementation of a project in one of various possible countries, what types of tax characteristics should be
assessed among the countries? (See the chapter appendix)
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion South Korean won. The project is expected to generate
net cash flows to the subsidiary of 3 billion won and 4 billion won in the two years of operation, respectively. The project has no salvage value. The
current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain constant over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat part (a), except assume that the value of the won is expected to be 1,200 won per U.S. dollar after two years. Further assume that the funds
are blocked and that the parent company will only be able to remit them back to the U.S. only after two years. How does this affect the NPV of the
project?
Multinational Capital Budgeting ❖ 12
ANSWER:
Year 0 1 2
Investment –2
Operating CF 3 4
ANSWER:
Year 0 2
Investment –2
Operating CF 7
21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong, where the Hong Kong dollar is tied to the U.S. dollar.
Carson Co. uses sensitivity analysis that allows for alternative exchange rate scenarios. Why would Carson use this approach rather than using the
pegged exchange rate as its exchange rate forecast in every year?
Multinational Capital Budgeting ❖ 14
Advanced Questions
24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the project will generate total operating cash flows of
$3,500,000, measured in today’s dollars using a required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:
772,740$
=
25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. Although the company
is generally risk-averse, it is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue,
paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank.
The cash flows earned on the project will be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal one-year interest
rate in New Zealand is 5% whereas the nominal one-year interest rate in the U.S. is 9%. Zistine’s chief executive officer believes that the movement in
the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the
international Fisher effect. He also believes that interest rate parity holds. He provides this information to three recent finance graduates whom he just
hired as managers and asks them for their input.
a. The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a
forward contract or are not hedged. Is this manager correct? Explain.
b. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the
future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a premium, and therefore the forward rate will generate
more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain.
ANSWER:
Multinational Capital Budgeting ❖ 15
a. The first manager is wrong. The project is more feasible if it hedges, because the expected dollar cash flows are the same whether Zistine hedges or
26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the use of its technology to firms in Mexico. It already
has received orders from Mexican firms that will generate 3 million Mexican pesos (MXP) in revenue at the end of the next year. However, it might also
receive a contract to provide this technology to the Mexican government. In this case, it will generate a total of MXP5,000,000 at the end of the next
year. It will not know whether it will receive the government order until the end of the year.
Today’s spot rate of the peso is $.14, and the one-year forward rate is $.12. Blustream expects that the spot rate of the peso will be $.13 one year from
now. Its only initial outlay with the proposed project will be $300,000 to cover development expenses (regardless of whether the Mexican government
purchases the technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax effects. Blestream
decides to hedge the maximum amount of revenue that it will receive from the project.
a. Determine the NPV if Blustream receives the government contract.
b. If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in
the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government
contract.
ANSWER:
Multinational Capital Budgeting ❖ 16
c. Now consider an alternative strategy in which Blustream hedges only the minimum peso revenue that it will receive. In this case, any revenue due
to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the
government contract.
d. If Blustream uses the alternative strategy of only hedging only the minimum peso revenue that it will receive, determine the NPV assuming that it
does not receive the government contract.
Multinational Capital Budgeting ❖ 17
e. If there is a 50 percent chance that Blustream will receive the government contract, would you advise the company to hedge the maximum amount
or the minimum amount of revenue that it may receive? Explain.
f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will
receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it
might receive with a put option on Mexican pesos. The one-year put option has an exercise price of $.125 and a premium of $.01. Determine the
NPV if Blustream uses this strategy and receives the government contract. Also, determine the NPV if Blustream uses this strategy and does not
receive the government contract. Given that there is a 50 percent probability that Blustream will receive the government contract, would you use this
new strategy or the strategy that you selected in question (e)?
ANSWER:
SCENARIO IF BLUSTREAM RECEIVES GOVERNMENT CONTRACT
Portion hedged with FR: MXP3,000,000 × $.12 = $360,000
Portion hedged with option: MXP2,000,000 × $.125 = +$250,000
Multinational Capital Budgeting ❖ 19
• In three years, Wolverine plans to sell the subsidiary. The parent plans to let the acquiring firm assume the existing New Zealand loan. The
working capital will not be liquidated, but rather will be used by the acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52
million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
• Wolverine requires a 20 percent rate of return on this project.
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1) × (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
4. Variable cost per unit NZ$30 NZ$35 NZ$40
5. Total variable cost = (1) × (4) NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
6. Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
7. Interest expense of New
Zealand loan NZ$2,800,000 NZ$2,800,000 NZ$2,800,000
8. Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
9. Total expenses = (5)+(6)+(7)+(8) NZ$15,000,000 NZ$15,550,000 NZ$16,200,000
10. Before-tax earnings of subsidiary
= (3)–(9) NZ$5,000,000 NZ$10,000,000 NZ$15,600,000
11. Host government tax (30%) NZ$1,500,000 NZ$3,000,000 NZ$4,680,000
12. After-tax earnings of subsidiary NZ$3,500,000 NZ$7,000,000 NZ$10,920,000
13. Net cash flow to subsidiary
= (12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
14. NZ$ remitted by sub.
(100% of CF) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
15. Withholding tax imposed on
remitted funds (10%) NZ$850,000 NZ$1,200,000 NZ$1,592,000
16. NZ$ remitted after withholding
taxes NZ$7,650,000 NZ$10,800,000 NZ$14,328,000
17. Salvage value NZ$52,000,000
18. Exchange rate of NZ$ $.52 $.54 $.56
