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Chapter 18
Multinational
Capital Budgeting
Multinational Capital Budgeting
• Although the original decision to undertake an
investment in a particular foreign country may
be determined by a mix of strategic,
behavioral, and economic decisions – as well
as reinvestment decisions – it should be
justified by traditional financial analysis.
• Multinational capital budgeting, like
traditional domestic capital budgeting, focuses
on the cash inflows and outflows associated
with prospective long-term investment
projects.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-2
Multinational Capital Budgeting
• Capital budgeting for a foreign project uses the same
theoretical framework as domestic capital budgeting.
• The basic steps are:
– Identify the initial capital invested or put at risk
– Estimate cash flows to be derived from the project over time,
including an estimate of the terminal or salvage value of the
investment
– Identify the appropriate discount rate to use in valuation
– Apply traditional capital budgeting decision criteria such as
NPV and IRR
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-3
Complexities of Budgeting
for a Foreign Project
• Capital budgeting for a foreign project is
considerably more complex than the domestic
case:
– Parent cash flows must be distinguished from
project cash flows
– Parent cash flows often depend on the form of
financing
– Additional cash flows generated by a new
investment in one foreign subsidiary may be in part
or in whole taken away from another subsidiary
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-4
Complexities of Budgeting
for a Foreign Project
– The parent must explicitly recognize remittance of
funds because of differing tax systems, legal and
political constraints on the movement of funds,
local business norms, and differences in the way
financial markets and institutions function
– An array of nonfinancial payments can generate
cash flows from subsidiaries to the parent
– Managers must keep the possibility of unanticipated
foreign exchange rate changes in mind because of
possible direct effects on cash flows as well as
indirect effects on competitiveness
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-5
Project Versus Parent Valuation
• A strong theoretical argument exists in favor of
analyzing any foreign project from the viewpoint
of the parent.
• Cash flows to the parent are ultimately the basis
for dividends to stockholders, reinvestment
elsewhere in the world, repayment of corporatewide debt, and other purposes that affect the firm’s
many interest groups.
• However, this viewpoint violates a cardinal
concept of capital budgeting – that financial cash
flows should not be mixed with operating cash
flows.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-6
Project Versus Parent Valuation
• Evaluation of a project from the local viewpoint serves some
useful purposes, but is should be subordinated to evaluation
from the parent’s viewpoint.
• In evaluating a foreign project’s performance relative to the
potential of a competing project in the same host country, we
must pay attention to the project’s local return.
• Almost any project should at least be able to earn a cash
return equal to the yield available on host government bonds
(with the same maturity as the project’s economic life).
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-7
Project Versus Parent Valuation
• Multinational firms should invest only if they can earn
a risk-adjusted return greater than locally based
competitors can earn on the same project.
• If they are unable to earn superior returns on foreign
projects, their stockholders would be better of buying
shares in local firms, where possible, and letting those
companies carry out the local projects.
• Most firms appear to evaluate foreign projects from
both parent and project viewpoints (to obtain
perspectives on NPV and the overall effect on
consolidated earnings of the firm).
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-8
Illustrative Case:
Cemex Enters Indonesia
• It is early 1998, Cementos Mexicanos is considering
the construction of a cement manufacturing facility on
the Indonesian island of Sumatra.
• This project would be a wholly-owned greenfield
investment.
• The company has three main reasons for the project:
– Initiate a productive presence in Southeast Asia
– To position Cemex to benefit from infrastructural
development in the region
– The positive prospects for Indonesia to act as a producefor-export site
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-9
Illustrative Case:
Cemex Enters Indonesia
• The following exhibit details the complete
multinational capital budgeting analysis for
Cemex in Indonesia.
• Essentially, the parent company will invest US
dollar-denominated capital, which flows
through the creation and operation of the
Indonesian subsidiary which subsequently
generates cash flows that are returned to the
parent in various forms (in US dollars).
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-10
Exhibit 18.1 A Road-Map to the Construction
of Semen Indonesia’s Capital Budget
START
Cementos Mexicanos
(Mexico)
US$ invested in Indonesia
cement manufacturing firm
END
Is the project investment
Justified (NPV > 0)?
Parent viewpoint
Capital Budget
(U.S. dollars)
Semen Indonesia
(Sumatra, Indonesia)
Estimated cash flows
of project
Cash flows remitted
to Cemex (Rp to US$)
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
Project Viewpoint
Capital Budget
(Indonesian rupiah)
18-11
Illustrative Case:
Cemex Enters Indonesia
• The first step is to construct a set of pro forma
financial statements for Semen Indonesia (in
Indonesian Rupiah).
• The next step is to create two capital budgets,
the project viewpoint and parent viewpoint.
• Financial assumptions are then made about:
– Capital investment
– Method of financing
– Revenue/cost forecasts
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-12
Illustrative Case:
Cemex Enters Indonesia
• The project viewpoint capital budget indicates
a negative NPV and an IRR of only 15.4%
compared to the 33.3% cost of capital.
• These are the returns the project would yield to
a local or Indonesian investor in Indonesian
rupiah.
• The project, from this viewpoint, is not
acceptable.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-13
Illustrative Case:
Cemex Enters Indonesia
• A foreign investor’s assessment of a project’s
returns depends on the actual cash flows that
are returned to it, in its own currency.
• For Cemex, this means that the investment
must be analyzed in terms of US dollar cash
inflows and outflows associated with the
investment over the life of the project, aftertax, discounted at the appropriate cost of
capital.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-14
Illustrative Case:
Cemex Enters Indonesia
• We build this parent viewpoint capital budget in two
steps.
• First, we isolate the individual cash flows, adjusted for
any withholding taxes imposed by the Indonesian
government and converted to US dollars.
• The second step, that actual parent viewpoint capital
budget, combines these US dollar after-tax cash flows
with the initial investment to determine the NPV of the
proposed Indonesian subsidiary in the eyes (and
pocketbook) of Cemex.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-15
Illustrative Case:
Cemex Enters Indonesia
• Most corporations require that the new
investments more than cover the cost of the
capital employed in their undertaking.
• It is therefore not unusual for the firm to
require a hurdle rate of 3% over the cost of
capital for domestic investments, and 6% more
for international projects.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-16
Illustrative Case:
Cemex Enters Indonesia
• At this point sensitivity analyses are run from
both the project and parent viewpoints.
• This would include analyzing (for the project):
– Political risks
– Foreign exchange risks
– Other business specific potentialities
• And analyzing (for the parent):
– A range of discount rates
– Varying cash flow patterns
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
18-17
Real Options Analysis
• The discounted cash flow (DCF) analysis used in the
valuation of Semen Indonesia, and in capital budgeting and
valuation in general, has long had its critics.
• Importantly, when MNEs evaluate competitive projects,
traditional cash flow analysis is typically unable to capture
the strategic options that an individual invest option may
offer.
• This has led to the development of real options analysis.
• Real options analysis is the application of the option theory
to capital budgeting decisions.
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18-18
Real Options Analysis
• Real options is a different way of thinking about
investment values.
• At its core, it is a cross between decision-tree analysis
and pure option-based valuation.
• Real option valuation also allows us to analyze a
number of managerial decisions that in practice
characterize many major capital investment projects:
– The option to defer
– The option to abandon
– The option to alter capacity
– The option to start up or shut down
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18-19
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