Multinational Capital Budgeting 19
Then determine the break-even salvage value:
f. Assume that Wolverine decides to implement the project, using the original financing proposal. Also
assume that after one year, a New Zealand firm offers Wolverine a price of $27 million after taxes
for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not changed.
Compare the present value of the expected cash flows it Wolverine keeps the subsidiary to the selling
price. Should Wolverine divest the subsidiary? Explain.
ANSWER:
Divestiture Analysis One Year After
the Project Began
28. Capital Budgeting With Hedging. Baxter Co. considers a project with Thailand’s government. If it
accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht in five
years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a 5–year
period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to hedge its
cash flows with a forward contract. What is the dollar amount of cash flows that Baxter will receive
in five years if it accepts this project?
20 Multinational Capital Budgeting
ANSWER: The forward rate premium is:
29. Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the
French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the unit.
It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes
are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years.
Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free
interest rate is 5% regardless of the maturity of the debt, and the annualized risk-free interest rate on
euros is 7%, regardless of the maturity of debt. Assume that interest rate parity exists. Cantoon’s cost
of capital is 20%. It plans to use cash to make the acquisition.
a. Determine the NPV under these conditions.
b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan of
3 million euros today that would be used to cover a portion of the acquisition. In this case, it
would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the
loan. There are no interest payments on this debt. The way in which this financing deal is
structured, none of the payment is tax-deductible. Determine the NPV if Cantoon uses the
forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to
partially finance the acquisition. [You need to derive the 8-year forward rate for this specific
question.]
ANSWER
a. Discount factor based on a required return of 20% for 8 years = .232
Multinational Capital Budgeting 21
b. The forward rate premium is:
30. Sensitivity of NPV to Conditions. Burton Co., based in the U.S., considers a project in which it
has an initial outlay of $3 million and expects to receive 10 million Swiss francs (SF) in one year.
The spot rate of the franc is $.80. Burton Co. decides to purchase put options on Swiss francs with an
exercise price of $.78 and a premium of $.02 per unit to hedge its receivables. It has a required rate of
return of 20 percent.
a. Determine the net present value of this project for Burton Co. based on the forecast that the Swiss
franc will be valued at $.70 at the end of one year.
b. Assume the same information in part (a), but with the following adjustment. While Burton
expected to receive 10 million Swiss francs, assume that there were unexpected weak economic
conditions in Switzerland after Burton initiated the project. Consequently, Burton received only 6
million Swiss francs at the end of the year. Also assume that the spot rate of the franc at the end of
the year was $.79. Determine the net present value of this project for Burton Co. if these conditions
occur.
ANSWER
22 Multinational Capital Budgeting
31. Hedge Decision on a Project. Carlotto Co. (a U.S. firm) will definitely receive 1 million British
pounds in one year based on a business contract it has with the British government. Like most firms,
Carlotto Co. is risk-averse and only takes risk when the potential benefits outweigh the risk. It has no
other international business, and is considering various methods to hedge its exchange rate risk.
Assume that interest rate parity exists. Carlotto Co. recognizes that exchange rates are very difficult
to forecast with accuracy, but it believes that the one-year forward rate of the pound yields the best
forecast of the pound’s spot rate in one year. Today the pound’s spot rate is $2.00, while the one-year
forward rate of the pound is $1.90. Carlotto Co. has determined that a forward hedge is better than
alternative forms of hedging. Should Carlotto Co. hedge with a forward contract or should it remain
unhedged? Briefly explain.
ANSWER: The project is more feasible if it hedges, because the expected dollar cash flows are the
32. NPV of Partially Hedged Project. Sazer Co. (a U.S. firm) is considering a project in which it
produces special safety equipment. It will incur an initial outlay of $1 million for the research and
development of this equipment. It expects to receive 600,000 euros in one year from selling the
products in Portugal where it already does much business. In addition, it also expects to receive
300,000 euros in one year from sales to Spain, but these cash flows are very uncertain because it has
no existing business in Spain. Today’s spot rate of the euro is $1.50 and the one-year forward rate is
$1.50. It expects that the euro’s spot rate will be $1.60 in one year. It will pursue the project only if
it can satisfy its required rate of return of 24 percent. It decides to hedge all the expected receivables
due to business in Portugal, and none of the expected receivables due to business in Spain. Estimate
the net present value (NPV) of the project.
ANSWER:
Multinational Capital Budgeting 23
Solution to Continuing Case Problem: Blades, Inc.
1. Should the sales and the associated costs of 180,000 pairs of roller blades to be sold in Thailand
under the existing agreement be included in the capital budgeting analysis to decide whether Blades
should establish a subsidiary in Thailand? Should the sales resulting from a renewed agreement be
included? Why or why not?
2. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades renews the agreement with Entertainment Products. Should Blades establish a subsidiary in
Thailand under these conditions?
ANSWER: (See spreadsheet attached.) The spreadsheet shows a positive net present value (NPV) of
3. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades does not renew the agreement with Entertainment Products. Should Blades establish a
subsidiary in Thailand under these conditions? Should Blades renew the agreement with
Entertainment Products?
ANSWER: (See spreadsheet attached.) The spreadsheet shows a positive NPV of $8,746,688 if
4. Since future economic conditions in Thailand are uncertain, Ben Holt would like to know how
critical the salvage value is in the alternative you think is most feasible.
ANSWER: (See spreadsheet attached.) The capital budgeting analysis in question 2 was the most
24 Multinational Capital Budgeting
5. The future value of the baht is highly uncertain. Under a worst case scenario, the baht may depreciate
by as much as 5 percent annually. Revise your spreadsheet to illustrate how this would affect Blades’
decision to establish a subsidiary in Thailand (Use the capital budgeting analysis you have identified
as the most favorable from questions 2 and 3 to answer this question.)
ANSWER: (See spreadsheet attached.) The spreadsheet shows that an annual depreciation of 5
Multinational Capital Budgeting 25
Answer to Question b:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 7
Year 8
Year 9
Entertainment Products
—
4. Units Sold to Other
Retailers in Thailand
1. Units Sold to
8. Variable Cost per Unit (in
Thai baht)
3,500
3,920
4,390
4,917
5,507
6,908
7,737
8,666
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
420,000
1,176,000
1,756,160
1,966,899
2,202,927
2,763,352
3,094,954
3,466,348
32,400
12. Noncash Expense
(Depreciation) in THB 000s
26 Multinational Capital Budgeting
THB 000s
15. Host Government Tax
(25%) in THB 000s
39,350
66,230
97,310
85,080
71,382
38,857
19,612
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
148,050
228,690
321,930
244,145
146,571
88,836
24,174
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
148,050
228,690
321,930
285,239
244,145
146,571
88,836
24,174
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
14,805
22,869
32,193
28,524
24,414
14,657
8,884
2,417
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
133,245
205,821
289,737
256,715
219,730
131,914
79,953
21,757
21. Salvage Value in THB
000s
$0.02254
3,003,342
24. PV of Parent Cash Flows
25. Initial Investment by
Parent
$12,650,000
Multinational Capital Budgeting 27
Answer to Question c:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 7
Year 8
Year 9
1. Units Sold to
Entertainment Products
—
5,000
5,000
5,000
5,000
5,000
5,000
5,000
2. Price per Unit (in Thai baht)
—
5,600
6,272
7,025
7,868
9,869
11,053
12,380
4. Units Sold to Other
Retailers in Thailand
120,000
120,000
220,000
220,000
5. Price per Unit (in Thai baht)
5,600
6,272
7,025
7,868
9,869
11,053
12,380
8. Variable Cost per Unit (in
Thai baht)
3,500
3,920
4,390
4,917
5,507
6,908
7,737
8,666
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
420,000
490,000
987,840
1,106,381
1,239,146
1,554,385
1,740,912
1,949,821
11. Fixed Operating Expenses
(in Thai baht 000s)
25,000
28,000
31,360
35,123
12. Noncash Expense
(Depreciation) in THB 000s
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
30,000
28 Multinational Capital Budgeting
14. Before-Tax Earnings of
152,000
362,000
409,040
461,725
586,820
660,838
743,738
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
148,050
144,000
301,500
336,780
376,294
470,115
525,628
587,804
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
14,805
14,400
30,150
33,678
37,629
47,011
52,563
58,780
$0.02254
Multinational Capital Budgeting 29
Answer to Question d:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 7
Year 8
Year 9
1. Units Sold to
Entertainment Products
—
5,000
5,000
5,000
5,000
5,000
5,000
5,000
4. Units Sold to Other
Retailers in Thailand
7. Total Revenue = (3) + (6)
in THB 000s
600,000
700,000
1,411,200
1,580,544
1,770,209
2,220,551
2,487,017
2,785,459
8. Variable Cost per Unit (in
Thai baht)
3,500
3,920
4,390
4,917
5,507
6,908
7,737
8,666
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
11. Fixed Operating Expenses
(in Thai baht 000s)
25,000
28,000
31,360
35,123
30 Multinational Capital Budgeting
Subsidiary = (7) – (13) in
THB 000s
15. Host Government Tax
(25%) in THB 000s
39,350
38,000
90,500
102,260
115,431
146,705
165,209
185,935
Subsidiary in THB 000s
346,294
440,115
495,628
557,804
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
148,050
144,000
301,500
336,780
376,294
470,115
525,628
587,804
14. Before-Tax Earnings of
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
148,050
144,000
301,500
336,780
376,294
470,115
525,628
587,804
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
14,805
14,400
30,150
33,678
37,629
47,011
52,563
58,780
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
133,245
129,600
271,350
303,102
338,664
423,103
473,066
529,023
000s
$0.02254
24. PV of Parent Cash Flows
25. Initial Investment by
Parent
21. Salvage Value in THB
Multinational Capital Budgeting 31
Answer to Question e:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 7
Year 8
Year 9
1. Units Sold to
Entertainment Products
—
5,000
5,000
5,000
5,000
5,000
5,000
5,000
2. Price per Unit (in Thai baht)
—
5,600
6,272
7,025
7,868
9,869
11,053
12,380
4. Units Sold to Other
Retailers in Thailand
5. Price per Unit (in Thai baht)
5,600
6,272
7,025
7,868
9,869
11,053
12,380
7. Total Revenue = (3) + (6)
in THB 000s
600,000
700,000
1,411,200
1,580,544
1,770,209
2,220,551
2,487,017
2,785,459
8. Variable Cost per Unit (in
Thai baht)
3,500
3,920
4,390
4,917
5,507
6,908
7,737
8,666
9. Total Variable Cost = [(1) +
(4)] × (8) in THB 000s
420,000
490,000
987,840
1,106,381
1,239,146
1,554,385
1,740,912
1,949,821
in THB 000s
32,400
11. Fixed Operating Expenses
(in Thai baht 000s)
25,000
28,000
31,360
35,123
32 Multinational Capital Budgeting
14. Before-Tax Earnings of
Subsidiary = (7) – (13) in
THB 000s
157,400
152,000
362,000
409,040
461,725
586,820
660,838
743,738
15. Host Government Tax
(25%) in THB 000s
Subsidiary in THB 000s
17. Net Cash Flow to Subsidiary
= (16) + (12) in THB 000s
148,050
144,000
301,500
336,780
376,294
470,115
525,628
587,804
18. Thai Baht Remitted by
Subsidiary (100% of CF)
in THB 000s
148,050
144,000
301,500
336,780
376,294
420,549
470,115
525,628
587,804
19. Withholding Tax on Remitted
Funds (10%) in THB 000s
14,805
14,400
30,150
33,678
37,629
42,055
47,011
52,563
58,780
20. Thai Baht Remitted After
Withholding Taxes in THB 000s
133,245
129,600
271,350
303,102
338,664
378,494
423,103
473,066
529,023
21. Salvage Value in THB
000s
22. Exchange Rate of Baht
$0.02185
23. $ Cash Flow to Parent = (20) × (22)
2,911,403
25. Initial Investment by
Parent
26. Cumulative PV
118,810
Multinational Capital Budgeting 33
Solution to Supplemental Case: North Star Company
a. The analysis based on total parent financing is shown below using the somewhat stable exchange
rate scenario (in 1,000s):
0 1 2 3 4 5 6
S$ Cash Flows (excluding
S$ interest payments) S$8,000 S$10,000 S$14,000 S$16,000 S$16,000 S$16,000
S$ Cash Flows to be
Converted to $ S$3,600 S$4,500 S$6,300 S$7,200 S$7,200 S$7,200
Salvage Value S$30,000
Exchange Rate of S$ $.50 $.51 $.48 $.50 $.52 $.48
$ Cash Flows $1,800 $2,295 $3,024 $3,600 $3,744 $17,856
Applying the same procedure from the previous table, the NPV for each exchange rate scenario is:
Exchange Rate Scenario Probability NPV
I. Somewhat stable S$ 60% –$4,878,580
34 Multinational Capital Budgeting
(Cash amounts in thousands)
0 1 2 3 4 5 6
Converted to $ S$2,880 S$3,780 S$5,580 S$6,480 S$6,480 S$6,480
Salvage Value S$20,000
Exchange Rate of S$ $.50 $.51 $.48 $.50 $.52 $.48
$ Cash Flows $1,440 $1,927.8 $2,678.4 $3,240 $3,369.6 $12,710.4
Present Value Interest
method of financing should be chosen.
b. The parent’s required rate of return may increase if the borrowed funds by the subsidiary creates a
higher degree of financial leverage for the MNC as a whole, which could increase the risk
perception of the MNC. If so, the discount rate used should reflect the higher required rate of
return.
Multinational Capital Budgeting 35
c. When using a 20 percent withholding tax instead of a 10 percent withholding tax, the results
change as follows (based on partial financing by the subsidiary):
Exchange Rate Scenario Probability NPV
d. The estimate of net cash flows could be revised, which would result in a lower NPV for each
exchange rate scenario. The accept/reject decision would be based on the overall distribution of
possible NPVs.
Small Business Dilemma
Multinational Capital Budgeting by the Sports Exports Company
1. Describe the capital budgeting steps that would be necessary to determine whether this proposed
project is feasible, as related to this specific situation.
ANSWER: Jim would need to estimate the amount of footballs that would be sold to the
2. Explain why there is uncertainty surrounding the cash flows of this project.
ANSWER: First, the number of footballs to be sold is very uncertain. The firm is attempting to