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Chapter 19
Multinational Capital
Budgeting
Multinational Business Finance
Contents
• Complexities of Budgeting for a Foreign
Project
• Project versus Parent Valuation
• Illustrative Case : Cemex Enters Indonesia
• Real Option Analysis
• Project Financing
16-2
Multinational Capital Budgeting
• The original decision to undertake an investment in a
particular foreign country may be determined by a mix
of strategic, behavioral, and economic decisions.
• The specific project, 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.
19-3
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
19-4
19.1 Complexities of Budgeting for a Foreign Project
• Capital budgeting for a foreign project is considerably
more complex than the domestic case:
1) Parent cash flows must be distinguished from project
cash flows
2) Parent cash flows often depend on the form of
financing
3) Additional cash flows generated by a new investment in
one foreign subsidiary may be in part or in whole taken
away from another subsidiary
4) The parent must explicitly recognize remittance of
funds
5) An array of nonfinancial payments can generate cash
flows from subsidiaries to the parent
19-5
19.1 Complexities of Budgeting for a Foreign Project
6) Managers must anticipate differing rates of national
inflation
7) Managers must keep the possibility of unanticipated
foreign exchange rate
8) Use of segmented national capital markets may create
an opportunity for financial gains or may lead to
additional financial costs
9) Use of host-government-subsidized loans complicates
both capital structure and the parent’s ability to
determine an appropriate weighted average cost of
capital for discounting purposes
10)Managers must evaluate political risk
11)Terminal value is more difficult to estimate
19-6
19.2 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 corporate-wide debt, and
other purposes that affect the firm’s many interest
groups.
19-7
19.2 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).
19-8
19.2 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).
19-9
19.3 Illustrative Case: Cemex Enters Indonesia
Overview
• 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
19-10
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.1 A Roadmap to the Construction of Semen
Indonesia’s Capital Budget
19-11
19.3 Illustrative Case: Cemex Enters Indonesia
Overview
• 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
19-12
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.2 Investment and Financing of the Semen Indonesia
Project (all values in 000s unless otherwise noted)
Cemex
Cost of Equity=6%+7%*1.5=16.5%
WACC=16.5%*60%+5.2%*40%=11.98%
1.287
Semen Indonesia
Cost of Equity=33%+6%*1.287=40.72%
WACC=(40.72%*0.7*0.25+27.184%*0.75)*
0.5 +39%*0.5=33.257%
19-13
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.3 Semen Indonesia’s Debt Service Schedules and
Foreign Exchange Gains/Losses
Exchange rate
Spot rate(Year 1)=10,000*1.3/1.03=12,621
Spot rate(Year 2)=12,621*1.3/1.03=15,930
Fully amortized
10% Annual interest rate
Repayment Per Year*PVIFA(35%,8)=2,750,000
Repayment /Y=1,058,439
Year 1
Interest Payment=2,750,000*35%=962,500
Principal Payment=1,058,439-962,500=95,939
Year 2
Interest Payment=(2,750,000-95,939)*35%
=928,921
Principal Payment=1,058,439-928,921=129,518
19-14
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.4 Semen Indonesia’s Pro Forma Income Statement
(millions of rupiah)
1 Gross profit/Total revenues
1
Licenses fees Paid to parent company
(2% of sales)
Interest on parent company debt
2
2 Tax(Year 4)=(1,507,145+1,120,846-
170,256-1,138,965)*0.3
3
3 Net income(US$)/Total revenues(US$)
19-15
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.5 Semen Indonesia’s Capital Budget: Project
Viewpoint (millions of rupiah)
1
2
1 TV 
NOCF (1 g) 7,075,059( 1 0)
5

 21,274,102
K
g
0.33257  0
WACC
2 NPV  224,000,00 0 
2,372,650
1.33257

3,538,319 4,645,438 5,707,736 27,722,847



4
1.33257 5
1.33257 2 1.33257 3 1.33257
19-16
19.3 Illustrative Case: Cemex Enters Indonesia
Project Viewpoint
• The terminal value of the project represents the
continuing value of the cement manufacturing facility
in the years after year 5.
• The project viewpoint capital budget indicates a
negative NPV and an IRR of only 15.4% compared to
the 33.257% 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.
19-17
19.3 Illustrative Case: Cemex Enters Indonesia
Parent Viewpoint
• 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, after-tax, discounted at the appropriate
cost of capital.
19-18
19.3 Illustrative Case: Cemex Enters Indonesia
Parent Viewpoint
• 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.
19-19
19.3 Illustrative Case: Cemex Enters Indonesia
Exhibit 19.6 Semen Indonesia’s Remittance and Capital Budget:
Parent Viewpoint (millions of rupiah and U.S. dollars)
Equity 1,100 + Debt 825
•
The parent viewpoint
capital budget indicates
a negative NPV and an
IRR of only -1.84%
compared to the
11.98% cost of capital
and 6% foreign
investment premium.
•
The project, from
parent’s viewpoint, is
not acceptable.
19-20
19.3 Illustrative Case: Cemex Enters Indonesia
Sensitivity Analysis
• At this point sensitivity analyses are run from both the
project and parent viewpoints.
• Project viewpoint measurement:
– Political risks
– Foreign exchange risks
– Other business specific potentialities
• Parent viewpoint measurement:
– Adjusting discount rates
– Adjusting cash flows
19-21
19.4 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.
19-22
19.4 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
19-23
19.5 Project Financing
• Project finance is the arrangement of financing for
long-term capital projects, large in scale, long in life,
and generally high in risk.
• The following four basic properties are critical to the
success of project financing:
– Separability of a project from its investors
– Long-lived and capital-intensive singular projects
– Cash flow predictability from third party commitments
– Finite projects with finite lives
19-24