Chapter

Multinational Capital Budgeting

 Chapter Objectives

• 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.

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 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.

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 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

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 Remitting Subsidiary Earnings to the Parent
Cash Flows Generated by Subsidiary Corporate Taxes Paid to
Host Government

After-Tax Cash Flows to Subsidiary

Retained Earnings
by Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax Paid to
Host Government
After-Tax Cash Flows Remitted by Subsidiary

Conversion of Funds
to Parent’s Currency
Cash Flows to Parent

Parent
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 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 occur when the

foreign subsidiary is not wholly owned by the parent.

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 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
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 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

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 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) of the
project.

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 Multinational
Capital Budgeting
• NPV = – initial outlay
n
+  cash flow in tperiod t
t =1 (1 + k )

+
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.
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 Capital Budgeting Analysis
Period t
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)

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 Capital Budgeting Analysis
Period t
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.Investment by parent (20)
21. Net cash flow to parent (19)–(20)=(21)
22. PV of net cash flow to parent (1+k) - t(21)=(22)
23.Cumulative NPV PVs=(23)

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 Factors to Consider in
Multinational Capital Budgeting
 Exchange rate fluctuations. Different scenarios should be
considered together with their probability of occurrence.
 Inflation. Although price/cost forecasting implicitly
considers inflation, inflation can be quite volatile from
year to year for some countries.

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 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.
 Blocked funds. Some countries may require that the
earnings be reinvested locally for a certain period of time
before they can be remitted to the parent.

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 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.
 Impact of project on prevailing cash flows. The new investment
may compete with the existing business for the same customers.
 Host government incentives. These should also be considered in
the analysis.

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 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.

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 Multinational Restructuring
• Building a new subsidiary, acquiring a company, selling an
existing subsidiary, downsizing operations, or shifting
production among subsidiaries, are all forms of
multinational restructuring.
• MNCs continually assess possible forms of multinational
restructuring to capitalize on changing economic, political,
and industrial conditions across countries.

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 International Acquisitions
• Through an international acquisition, a firm can
immediately expand its international business since the
target is already in place, and benefit from already-
established customer relationships.
• However, establishing a new subsidiary usually costs less,
and there will not be a need to integrate the parent
management style with that of the acquired company.

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Value of International Acquisitions

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Value of International Acquisitions

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 International Acquisitions
• Like any other long-term project, capital budgeting analysis
can be used to determine whether a firm should be acquired.
• Hence, the acquisition decision can be based on a
comparison of the benefits and costs as measured by the net
present value (NPV).

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 International Acquisitions
• NPV = – initial outlay
n
+  cash flow in period t
(1 + k )t
t =1
salvage value
+
(1 + k )n
k = the acquisition’s required rate of return
n = the lifetime of the acquired firm
• If NPV > 0, the firm can be acquired.

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 International Acquisitions
• Note that the relevant exchange rate, taxes, and
blocked-funds restriction, should be taken into account.
• The cost of overcoming the barriers that may be imposed
by the government agencies that monitor mergers and
acquisitions should be taken into consideration too.

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 International Acquisitions
• Examples of such barriers include laws against
hostile takeovers, restricted foreign majority
ownership, “red tape,” and special requirements.

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 International Acquisitions
• In Europe, the adoption of the euro as the local
currency by several countries simplifies the analysis
that an MNC has to perform when comparing various
possible target firms in the participating countries.

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Factors that Affect the Expected
Cash Flows of the Foreign Target
Target-Specific Factors
 Target’s previous cash flows. These may serve as an
initial base from which future cash flows can be estimated.
 Managerial talent of the target. The acquiring firm may
allow the acquired firm to be managed as it was before the
acquisition, downsize the firm, or restructure its
operations.

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Factors that Affect the Expected
Cash Flows of the Foreign Target
Country-Specific Factors
 Target’s local economic conditions. Demand is likely to
be higher when the economic conditions are strong.
 Target’s local political conditions. Cash flow shocks are
less likely when the political conditions are favorable.

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Factors that Affect the Expected
Cash Flows of the Foreign Target
Country-Specific Factors
 Target’s industry conditions. Industries with high growth
potential and non-excessive competition are preferred.

 Target’s currency conditions. A currency that is expected

to strengthen over time will usually be preferred.

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Factors that Affect the Expected
Cash Flows of the Foreign Target
Country-Specific Factors
 Target’s local stock market conditions. When the local stock
market prices are generally low, the target’s acceptable bid
price is also likely to be low.

 Taxes applicable to the target. What matters to the acquiring

firm is the after-tax cash flows that it will ultimately receive in
the form of remitted funds.

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 The Valuation Process
• Prospective targets are first screened to identify those that
deserve a closer assessment.
• Capital budgeting analysis is then applied to each of the
targets that passed the initial screening process.
• Only those targets that are priced lower than their
perceived net present values may be worth acquiring.

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 Why Valuations of a Target
May Vary Among MNCs
 Estimated cash flows of the foreign target.
¤ Different MNCs will manage the target’s operations
differently.
¤ Each MNC may have a different plan for fitting the target
within the structure of the MNC.
¤ Acquirers based in certain countries may be subjected to
less taxes on remitted earnings.

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 Why Valuations of a Target
May Vary Among MNCs
 Exchange rate effects on remitted funds.
¤ Different MNCs have different schedules for
remitting funds from the target to the acquirer.

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 Why Valuations of a Target
May Vary Among MNCs
 Required rate of return of the acquirer.
¤ Different MNCs may have different plans for the target,
such that the perceived risk of the target will be different.

¤ The local risk-free interest rate may differ for MNCs

based in different countries.

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 Other Types of
Multinational Restructuring
International Partial Acquisitions
• An MNC may purchase a substantial portion of the
existing stock of a foreign firm, so as to gain some
control over the target’s management and operations.
• The valuation of the firm depends on whether the MNC
plans to acquire enough shares to control the firm (and
hence influence its cash flows).

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 Other Types of
Multinational Restructuring
International Acquisitions of Privatized Businesses
• Many MNCs have acquired businesses from foreign
governments.
• These businesses are usually difficult to value because the
transition entails many uncertainties - cash flows, benchmark
data, economic and political conditions, exchange rates,
financing costs, etc.

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 Other Types of
Multinational Restructuring
International Alliances
• MNCs commonly engage in alliances, such as joint ventures
and licensing agreements, with foreign firms.
• The initial outlay is typically smaller, but the cash flows to be
received will typically be smaller too.

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 Other Types of
Multinational Restructuring
International Divestitures
• An MNC should periodically reassess its DFIs to determine
whether to retain them or to sell (divest) them.
• The MNC can compare the present value of the cash flows from
the project if it is continued, to the proceeds that would be
received (after taxes) if it is divested.

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 Restructuring Decisions
As Real Options
• Restructuring decisions may involve real options, or
implicit options on real assets.
• If a proposed project carries an option to pursue an
additional venture, then the project has a call option on
real assets.
• If a proposed project carries an option to divest part or all
of itself, then the project has a put option on real assets.

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 Restructuring Decisions
As Real Options
• The expected NPV of a project with real options may be
estimated as the sum of the products of the probability of
each scenario and the respective NPV for that scenario.
E(NPV) = S pi  NPVi
i
pi = probability of scenario i
NPVi = NPV for scenario i

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 Impact of Multinational Restructuring
on an MNC’s Value
Multinational Restructuring
Decisions

 m 
n 
E CF j, t  E ER j, t 
 j 1 
Value =   
t =1  1  k  t


 

E (CFj,t ) = expected cash flows in currency j to be
received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency
j can be converted to dollars at the end of period t
k = weighted average cost of capital of the C14 - 40
 Chapter Review
• Introduction to Multinational
Restructuring
• International Acquisitions
¤ Trends in International Acquisitions
¤ Model for Valuing a Foreign Target
¤ Barriers to International Acquisitions
¤ Assessing Potential Acquisitions in Asia
and Europe
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 Chapter Review
• Factors that Affect the Expected Cash
Flows of the Foreign Target
¤ Target-Specific Factors
¤ Country-Specific Factors

• The Valuation Process

¤ International Screening Process
¤ Estimating the Target’s Value

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 Chapter Review

• Why a Target’s Value May Vary Among

MNCs
¤ Expected Cash Flows of the Target
¤ Exchange Rate Effects on Remitted Funds
¤ Required Return of the Acquirer

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 Chapter Review
• Other Types of Multinational Restructuring
¤ International Partial Acquisitions
¤ International Acquisitions of Privatized
Businesses
¤ International Alliances
¤ International Divestitures

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 Chapter Review
• Restructuring Decisions as Real Options
¤ Call and Put Options on Real Assets
• Impact of Multinational Restructuring on
an MNC’s Value

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