2. 2
Objectives
This chapter identifies additional considerations
in multinational capital budgeting versus
domestic capital budgeting.
The specific objectives are:
• to compare the capital budgeting analysis of an MNC’s
subsidiary with that of its parent;
• to demonstrate how multinational capital budgeting
can be applied to determine whether an international
project should be implemented; and
• to explain how the risk of international projects can be
assessed.
3. 3
Subsidiary versus Parent
Perspective
• Should the capital budgeting for a multi-national
project be conducted from the viewpoint of the
subsidiary that will administer the project, or the
parent that will provide most of the financing?
• The results may vary with the perspective taken
because the net after-tax cash inflows to the
parent can differ substantially from those to the
subsidiary.
4. 4
Subsidiary versus Parent
Perspective
The difference in cash inflows is due to :
• Tax differentials
– What is the tax rate on remitted funds?
• Regulations that restrict remittances
• Excessive remittances
– The parent may charge its subsidiary very high
administrative fees.
• Exchange rate movements
Summary of factors: Exhibit 11.1
5. 5
Exhibit 11.1 Process of Remitting
Subsidiary Earnings to the Parent
Cash Flows Generated
by Subsidiary
After-Tax Cash Flows
to Subsidiary
Cash Flows remitted
by Subsidiary
After-Tax Cash Flows
Remitted by Subsidiary
Conversion of Funds to
Parent’s Currency
Parent
Corporate Taxes paid
to Host Government
Retained Earnings
by Subsidiary
Withholding Tax Paid
to Host Government
Cash Flows to Parent
6. 6
Subsidiary versus Parent
Perspective
• A parent’s perspective is appropriate when
evaluating a project, since any project
that
can create a positive net present value for
the parent should enhance the firm’s
value.
• However, one exception to this rule may
7. 7
Input for Multinational
Capital Budgeting
The following forecasts are usually required:
1. Initial investment
2. Consumer demand
3. Product price
4. Variable cost
5. Fixed cost
6. Project lifetime
7. Salvage (liquidation) value
8. 8
Input for Multinational
Capital Budgeting
The following forecasts are usually required:
8. Fund-transfer restrictions
9. Tax laws
10. Exchange rates
11. Required rate of return
9. 9
Multinational
Capital Budgeting
• Capital budgeting is necessary for all long-
term projects that deserve consideration.
• One common method of performing the
analysis is to estimate the cash flows and
salvage value to be received by the
parent,
and compute the net present value
(NPV)
10. 10
Multinational
Capital Budgeting
• NPV = – initial outlay
n
+ Σ cash flow in period t
t =1 (1 + k )t
+
salvage value
(1 + k )n
k = the required rate of return on the project
n = project lifetime in terms of periods
• If NPV > 0, the project can be accepted.
11. 11
Capital Budgeting Analysis:
Example
• Spartan, Inc., is considering the development
of a subsidiary in Singapore that would
manufacture and sell tennis rackets locally.
Spartan’s management has asked various
departments to supply relevant information for a
capital budgeting analysis. (P287-289)
The capital budgeting analysis to determine
whether Spartan, Inc., should establish the
12. 12
Capital Budgeting Analysis:
Example
1. Demand (1)
2. Price per unit(2)
3. Total revenue (1)×(2)=(3)
4. Variable cost per unit (4)
5. Total variable cost (1)×(4)=(5)
6. Annual lease expense (6)
7. Other fixed periodic expenses (7)
8. Noncash expense (depreciation) (8)
9. Total expenses (5)+(6)+(7)+(8)=(9)
10. Before-tax earnings of subsidiary (3)–(9)=(10)
11. Host government tax tax rate×(10)=(11)
12. After-tax earnings of subsidiary (10)–(11)=(12)
13. 13
Capital Budgeting Analysis:
Example
13. Net cash flow to subsidiary (12)+(8)=(13)
14. Remittance to parent (14)
15. Tax on remitted funds tax rate×(14)=(15)
16. Remittance after withheld tax (14)–(15)=(16)
17. Salvage value (17)
18. Exchange rate (18)
19. Cash flow to parent (16)×(18)+(17)×(18)=(19)
20. PV of cash flow to parent (20)
21. Initial investment (21)
22. Cumulative NPV (22)
14. 14
Factors to Consider in
Multinational Capital Budgeting
* Exchange rate fluctuations. Different
scenarios should be considered together
with their probability of occurrence.
( Example: P292 Exhibit 11.3)
* Inflation. Although price/cost forecasting
implicitly considers inflation, inflation can
be quite volatile from year to year for
some
15. 15
Factors to Consider in
Multinational Capital Budgeting
* Financing arrangement. Financing costs are usually
captured by the discount rate. However, many foreign
projects are partially financed by foreign subsidiaries.
So, a more accurate approach is to separate the
investment made by the subsidiary from the investment
made by the parent, with the focuses put on the
parent’s perspective. (P293 –P296)
* Blocked funds. Some countries may require that the
earnings be reinvested locally for a certain period
16. 16
Factors to Consider in
Multinational Capital Budgeting
* Uncertain salvage value. The salvage value typically has
a significant impact on the project’s NPV, and the MNC may want
to compute the break-even salvage value. (298)
* Impact of project on prevailing cash flows.
The new investment may compete with the existing business
for the same customers. (P299 Exhibit11.7)
* Host government incentives. These should also be considered
in the analysis.
* Real Options
Some capital budgeting projects contain real options, which
can enhance the value of a project. (P299)
17. 17
Adjusting Project Assessment
for Risk
• If an MNC is unsure of the cash flows of a
proposed project, it needs to adjust its
assessment for this risk.
• One method is to use a risk-adjusted discount
rate . The greater the uncertainty, the larger the
discount rate that is applied.
• Many computer software packages are also
available to perform sensitivity analysis and
simulation. (P300-301)
18. 18
Questions and Applications
*1. Why should capital budgeting for subsidiary projects
be assessed from the parent’s perspective? What
additional factors that normally are not relevant for a
purely domestic project deserve consideration in
multinational capital budgeting?
*2. What is the limitation of using point estimates of
exchange rates in the capital budgeting analysis?
List the various techniques for adjusting risk in
multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
19. 19
Questions and Applications
3. Huskie Industries, a U.S.-based MNC, considers purchasing a
small manufacturing company in France that sells products only
within France. Huskie has no other existing business in France and
no cash flows in euros. Would the proposed acquisition likely be
more feasible if the euro is expected to appreciate or depreciate
over the long run? Explain.
4. Flagstaff Corp. is a U.S.-based firm with a subsidiary in Mexico. It
plans to reinvest its earnings in Mexican government securities for
the next ten years since the interest rate earned on these securities
is so high. Then, after ten years, it will remit all accumulated
earnings to the United States. What is a drawback of using this
approach? Assume the securities have no default or interest rate
risk.
20. 20
Questions and Applications
5. When Walt Disney World considered establishing a theme park in
France, were the forecasted revenues and costs associated with
the French park sufficient to assess the feasibility of this project?
Were there any other “relevant cash flows” that deserve to be
considered?
6. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiary
in Japan. It is very confident that the Japanese yen will appreciate
against the dollar over time. The subsidiary will retain only enough
revenue to cover expenses and will remit the rest to the parent
each year. Will Ventura benefit more from exchange rate effects if
its parent provides equity financing for the subsidiary or if the
subsidiary is financed by local banks in Japan? Explain.
21. 21
Questions and Applications
7. PepsiCo recently decided to invest more than $300
million for expansion in Brazil. Brazil offers
considerable potential because it has 150 million
people and their demand for soft drinks is increasing.
However, the soft drink consumption is still only about
one-fifth of the soft drink consumption in the United
States. PepsiCo’s initial outlay was used to purchase
three production plants and a distribution network of
almost 1,000 trucks to distribute its products to retail
stores in Brazil. The expansion in Brazil was expected
to make PepsiCo’s products more accessible to
Brazilian consumers.
22. 22
Questions and Applications
a. Given that PepsiCo’s investment in Brazil was entirely
in dollars, describe its exposure to exchange rate risk
resulting from the project. Explain how the size of the
parent’s initial investment and the exchange rate risk
would have been affected if PepsiCo had financed
much of the investment with loans from banks in Brazil.
b. Describe the factors that PepsiCo likely considered
when estimating the future cash flows of the project in
Brazil.
c. What factors did PepsiCo likely consider in deriving its
required rate of return on the project in Brazil?
23. 23
Questions and Applications
d. Describe the uncertainty that surrounds the estimate
of future cash flows from the perspective of the U.S.
parent.
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
Brazilian perspective or a U.S. perspective? Explain.
