International Capital Budgeting: Chapter Eighteen

International Capital Budgeting
Chapter Eighteen
Copyright © 2018 by the McGraw-Hill Companies,
Inc. All rights reserved.
Chapter Outline
• Review of Domestic Capital Budgeting
• The Adjusted Present Value Model
• Capital Budgeting from the Parent Firm’s
Perspective
• Risk Adjustment in the Capital Budgeting Process
• Sensitivity Analysis
• Purchasing Power Parity Assumption
• Real Options

Inc. All rights reserved. 18-2
Review of Domestic Capital Budgeting
• Identify the size and timing of all relevant cash
flows on a time line.
• Identify the riskiness of the cash flows to
determine the appropriate discount rate.
• Calculate the NPV by discounting the cash flows
at the appropriate discount rate.
• Compare the value of competing cash flow
streams at the same point in time.

The basic net present value equation is
T
CFt TVT
NPV     C0
t 1 (1  K ) (1  K )
t T
Where:
CFt = expected incremental after-tax cash flow in year t
TVT = expected after-tax terminal value including return of net working
capital
C0 = initial investment at inception
K = weighted average cost of capital
T = economic life of the project in years
The NPV rule is to accept a project if NPV  0
For our purposes it is necessary to expand the
NPV equation.
CFt = (Rt – OCt – Dt – It)(1 – ) + Dt + It (1 – )
Rt is incremental revenue It is incremental interest
expense
OCt is incremental
operating cash flow  is the marginal tax rate
Dt is incremental
depreciation
We can use CFt = (OCFt)(1 – ) +  Dt
to restate the NPV equation,
T
NPV = S (1 + K) +
t=1
CFt
t (1 +
TVT
K)T
– C0
as:
T (OCFt)(1 – ) +  Dt
NPV = S
t=1 (1 + K)t
+
TVT
(1 + K)T
– C0

The Adjusted Present Value Model
T (OCFt)(1 – ) T
 Dt
NPV = S
t=1 (1 + K)t
+ S (1 + K)
t=1
t
+
(1 +
TVT
K)T
– C0
can be converted to adjusted present value (APV)
T (OCFt)(1 – )  Dt  It
APV = S
t=1 (1 + Ku)t
+
(1 + i)t
+
(1 + i)t
+
TVT
(1 + Ku )T
– C0
by appealing to Modigliani and Miller’s results.

The Adjusted Present Value Model
T (OCFt)(1 – )  Dt  It
APV =S
t=1 (1 + Ku)t
+
(1 + i)t
+
(1 + i)t
+
TVT
(1 + Ku )T
– C0
• The APV model is a value additivity approach to capital

budgeting. Each cash flow that is a source of value to the
firm is considered individually.
• Note that with the APV model, each cash flow is
discounted at a rate that is appropriate to the riskiness of
the cash flow.

Domestic APV Example
Consider a project where the timing and size of the
incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500
0 1 2 3 4
CF0 = –$1000 The unlevered cost of equity is r0 = 10%:
CF1 = $125 The project would be rejected by an
all-equity firm:
CF2 = $250
I = 10
CF3 = $375
NPV = –$56.50
CF4 = $500 Copyright © 2018 by the McGraw-Hill Companies,
Domestic APV Example (continued)
• Now, imagine that the firm finances the
project with $600 of debt at r = 8%.
• The tax rate is 40%, so each year they
have an interest tax shield worth $19.20:
 × I = .40 × ($600 × .08)
= .40 × $48
= $19.20

-$1,000 $125 $250 $375 $500
0 1 2 3 4
The APV of the project under leverage is:
T (OCFt)(1 – )  Dt  It
S
TVT
APV = + + + – C0
t=1 (1 + Ku )t (1 + i)t (1 + i)t (1 + Ku )T
$125 $250 $375 $500

APV = + + +
1.10 (1.10)2 (1.10)3 (1.10)4
$19.20 $19.20 $19.20 $19.20

+ + + + – $1,000
1.08 (1.08)2 (1.08)3 (1.08)4
APV = $7.09 The firm should accept the project if it finances with debt.
International Capital Budgeting from
the Parent Firm’s Perspective
T (OCFt)(1 – )  Dt  It
APV = S
t=1 (1 + Ku)t
+
(1 + i)t
+
(1 + i)t
+
TVT
(1 + Ku )T
– C0
• The APV model is useful for a domestic firm analyzing a

domestic capital expenditure or for a foreign subsidiary
of an MNC analyzing a proposed capital expenditure
from the subsidiary’s viewpoint.
• The APV model is NOT useful for an MNC in analyzing
foreign capital expenditure from the parent firm’s
perspective.
International Capital Budgeting from
the Parent Firm’s Perspective
• Donald Lessard developed an APV model for MNCs
analyzing a foreign capital expenditure. The model
recognizes many of the particulars peculiar to foreign direct
investment.
T
St OCFt (1  τ ) T St τDt T
St τI t
APV    
t 1 (1  K ud ) t
t 1 (1  id ) t
t 1 (1  id ) t
T
ST TVT St LPt
  S0C0  S0 RF0  S0CL0  
(1  K ud ) T
t 1 (1  id ) t

APV Model of Capital Budgeting from the Parent Firm’s
Perspective: Translating and Discounting Operating
Cash Flows
StOCFt(1 – ) St  Dt S t  It
T T T
APV = S
t=1 (1 + Kud )t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t
S (1 + i )
St TVT T
St LPt
+ – S0C0 + S0RF0 + S0CL0 +
(1 + Kud )T t=1
t
d
The operating cash flows must be The operating cash flows must
translated back into the parent be discounted at the
firm’s currency at the spot rate unlevered domestic rate
expected to prevail in each period.
APV Model of Capital Budgeting from the Parent
Firm’s Perspective: Tax Rate
T T T
APV = S
t=1 (1 + Kud )t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t
S (1 + i )
St TVT T
St LPt
+ T
– S0C0 + S0RF0 + S0CL0 +
(1 + Kud) t=1
t
d
OCFt represents only the The marginal corporate tax
portion of operating cash rate, , is the larger of the
flows available for remittance parent’s or foreign
that can be legally remitted to subsidiary’s.
the parent firm.
APV Model of Capital Budgeting from the Parent Firm’s
Perspective: Restricted Funds and Concessionary Loans
T T T
APV = S
t=1 (1 + Kud )t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t
S (1 + i )
St TVT T
St LPt
+ T
– S0C0 + S0RF0 + S0CL0 +
(1 + Kud) t=1
t
d
S0RF0 represents the value of Denotes the present value (in

accumulated restricted funds the parent’s currency) of any
(in the amount of RF0) that are concessionary loans, CL0,
freed up by the project. and loan payments, LPt ,
discounted at id .
Capital Budgeting from the Parent Firm’s
Perspective: Translate to Home Currency
• One recipe for international decision makers:
– Estimate future cash flows in foreign currency.
– Convert to the home currency at the predicted
exchange rate.
• Use PPP, IRP, et cetera for the predictions.
– Calculate NPV using the home currency cost of
capital.

Capital Budgeting from the Parent
Firm’s Perspective: Example
• A U.S.-based MNC is considering a European
opportunity.
• It’s a simple example:
– There is no incremental debt.
– There is no incremental depreciation.
– There are no concessionary loans.
– There are no restricted funds.

Perspective: Example (continued)
• We can use a simplified APV:
T T T
StOCFt(1 – ) St  Dt St  It
APV = S
t=1 (1 + Kud )t
+ S (1 + i ) +S (1 + i )
t=1 d
t
t=1 d
t
St TVT
S (1 + i )
T
St LPt
+ – S0C0 + S0RF0 + S0CL0 +
(1 + Kud )T t=1
t
d
no incremental debt

T
–
S
APV = S tOCFt(1 ) – S0C0 no incremental depreciation
no concessionary loans
t = 1 (1 + K )t
ud no restricted funds
Perspective: Example Foreign Cash Flows
A U.S. MNC is considering a European opportunity. The size and timing
of the after-tax cash flows are:
–€600 €200 €500 €300
0 1 2 3
The inflation rate in the euro zone is € = 3%, the inflation rate in dollars is p$
= 6%, and the business risk of the investment would lead an unlevered U.S.-
based firm to demand a return of Kud = i$ = 15%.
The current exchange rate is S0($/€) = $1.25/€. Is this a good investment from
the perspective of the U.S. shareholders?
Perspective: Example Converting Cash Flows
–€600 €200 €500 €300
–$750 $257.28 $661.94 $408.73
0 1 2 3
$1.25
CF0 = (€600) × S0($/€) = (€600) × = $750
€1.00
$1.25 1.06
CF1 = €200 × S1($/€) = €200 ×  = $257.28
€1.00 1.03
$1.25 (1.06)2
CF2 = €500 × S2($/€) = €500 ×  = $661.94
€1.00 (1.03)2
$1.25 (1.06)3
CF3 = €300 ×  = $408.73
€1.00 (1.03) 3
Capital Budgeting from the Parent
Firm’s Perspective: Example Dollar NPV
–$750 $257.28 $661.94 $408.73
0 1 2 3
Find the NPV using the cash flow menu of your financial calculator and
an interest rate of i$ = 15%:
CF0 = –$750
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 NPV = $242.99
Perspective: Alternative Method of Converting
the Discount Rate
• Another recipe for international decision-makers:
– Estimate future cash flows in the foreign currency.
– Estimate the foreign currency discount rate.
– Calculate the foreign currency NPV using the foreign
cost of capital.
– Translate the foreign currency NPV into dollars using
the spot exchange rate.

Foreign Currency Cost of Capital
Method
– €600 €200 €500 €300
0 1 2 3
€ = 3% Let’s find i€ and use that on the euro cash

flows to find the NPV in euros.
i$ = 15%
Then translate the NPV into dollars at the
$ = 6% spot rate.
$1.25
The current exchange rate is S0($/€) =
€
Finding the Foreign Currency Cost of Capital: i€
Recall that the Fisher Effect holds that:

(1 + e) × (1 + $) = (1 + i$)
real inflation nominal

rate rate rate
So, for example, the real rate in the U.S. must be 8.49%:
(1 + i$) 1.15
(1 + e) = e= – 1 = 0.0849
(1 + $) 1.06
Finding the Foreign Currency Cost of Capital: i€
Parity Condition
If the Fisher Effect holds here and abroad, then:
(1 + i$) (1 + i€)
(1 + e$) = and (1 + e€) =
(1 + $) (1 + €)
If the real rates are the same in dollars and euros (e€ = e$)
we have a very useful parity condition:
(1 + i$) (1 + i€)
=
(1 + $) (1 + €) Copyright © 2018 by the McGraw-Hill Companies,
Solving for the Foreign Currency Cost of Capital: i€
If we have any three of these variables, we can find the fourth:
(1 + i$) (1 + i€)
=
(1 + $) (1 + €)
In our example, we want to find i€:
(1 + i$) × (1 + €)
(1 + i€) =
(1 + $)
(1.15) × (1.03)
i€ = –1 i€ = 0.1175
(1.06)
International Capital Budgeting:
Example
– €600 €200 €500 €300
0 1 2 3
Find the NPV using the cash flow menu and i€ = 11.75%:
CF0 = –€600
I = 11.75
CF1 = €200
NPV = €194.39
CF2 = €500
$1.25 = $242.99
CF3 = €300 €194.39 ×
€
– €600 €200 €500 €300
0 1 2 3
€200 €500 €300

NPV = –€600 + + + = €194.39
1.1175 (1.1175)2 (1.1175)3
$1.25
€194.39 × = $242.99
€
–$750 $257.28 $661.94 $408.73
0 1 2 3
$257.28 $661.94 $408.73
NPV = –$750 + + + = $242.99
1.15 (1.15)2 (1.15)3
International Capital Budgeting
• You have two equally valid approaches:
– Change the foreign cash flows into dollars at the
exchange rates expected to prevail. Find the $NPV
using the dollar cost of capital.
– Find the foreign currency NPV using the foreign
currency cost of capital. Translate that into dollars at
the spot exchange rate.
• If you watch your rounding, you will get exactly
the same answer either way.
• Which method you prefer is your choice.

Computing IRR
Recall that a project’s Internal Rate of Return (IRR)
is the discount rate that gives a project a zero
NPV.
€200 €500 €300
NPV = –€600 + + 2
+ 3
= €0
1+IRR€ (1+IRR€) (1+IRR€)
IRR€ = 28.48%
$257.28 $661.94 $408.73

NPV = –$750 + + 2
+ 3
= $0
1+IRR$ (1+IRR$) (1+IRR$)
IRR$ = 32.23%
Directly Computing IRR$ and IRR€
€200 €500 €300
NPV = –€600 + + + = €0
1+IRR€ (1+IRR€)2 (1+IRR€)3
CF0 = –€600 CF2 = €500 IRR€ = 28.48%
CF1 = €200 CF3 = €300
$257.28 $661.94 $408.73

NPV = –$750 + + 2 + 3
= $0
1+IRR$ (1+IRR$) (1+IRR$)
CF0 = –$750 CF2 = $661.94
CF1 = $257.28 CF3 = $408.73 IRR$ = 32.23%
Converting from IRR$ to IRR€
• Use the same IRP and PPP conditions that we used to
convert from one discount rate to another.
1+IRR$ 1+IRR€ In our example, it was easy to find
= IRR€. Finding IRR$ without converting
(1 + $) (1 + €) all cash flows into dollars is
straightforward:
(1+IRR€)(1 + $)
(1+IRR$) = (1.2848)(1.06)
(1 + €) i€ = –1
(1.03)
€ = 3%, $ = 6% IRR$ = 32.23%
Back to the Full APV
• Using the intuition just developed, we can modify
Lessard’s APV model as shown, if we find it convenient.
S0 S0 S0
T T T
APV = S
t=1 (1 + Kud )t
+
t=1
S (1 + i ) +S (1 + i )
d
t
t=1 d
t
S0 f f f
S (1 + i )
St TVT T
St LPt
+ T
– S0C0 + S0RF0 + S0CL0 +
(1 + Kud) t=1
t
d
f f
S0
Risk Adjustment in the Capital
Budgeting Process
• Clearly risk and return are correlated.
• Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.
• We can measure this risk with sensitivity analysis, where
different estimates are used for expected inflation rates,
cost and pricing estimates, and other inputs to give the
manager a more complete picture of the planned capital
investment.
• Lends itself to computer simulation.

Real Options
• The application of options pricing theory to the
evaluation of investment options in real projects
is known as real options.
– A timing option is an option on when to make the
investment.
– A growth option is an option to increase the scale of
the investment.
– A suspension option is an option to temporarily cease
production.
– An abandonment option is an option to quit the
investment early.

Value of the Option to Delay
A French firm is considering a 1-year investment in the United Kingdom
with a pound-denominated rate of return of i£ = 15%.
The firm’s local cost of capital is i€ = 10%.
€2.00
–£1,000 £1,150
The current exchange rate is S0(€|£) =
£ project cash flows
0 1
Complicating matters, the Bank of England is considering either
tightening or loosening its monetary policy.It is believed that in one year
there are only two possibilities:
S1(€|£) = €2.20/£ or S1(€|£) = €1.80/£
Following revaluation, the exchange rate is expected to remain steady for
at least another year.

Option to Delay the Start of the Project
• If S1(€|£) = €1.80/£ the • If S1(€|£) = €2.20/£ the
project will have turned out project will have turned
to be a loser for the French out to be a big winner for
firm: the French firm:
–€2,000 €2,070 –€2,000 €2,530
0 1 0 1
IRR = 3.50% IRR = 26.50%

Option to Delay: Example
• An important thing to notice is that there is an
important source of risk (exchange rate risk) that
isn’t incorporated into the French firm’s local
cost of capital of i€ = 10%.
– That’s why there are no NPV estimates on the last
slide.
• Even with that, we can see that taking the
project on today entails a “win big—lose big”
gamble on exchange rates.
• Analogous to buying an at-the-money call option
on British pounds with a maturity of one year.

Option to Delay: Option Valuation
• The remaining slides assume a knowledge
of the material contained in Chapter 7,
especially the notion of a replicating
portfolio.
• But, also basic things like a call option give
the holder the right to buy a specific asset
at a specific price for a specific amount of
time.
Valuation of the Option to Delay: Example
• The payoff in one year of a portfolio consisting of an
at-the-money call option written on £2,300 plus a
risk-free bond with a future value of €2,070 equals
the payoff of the British investment:
British Call Replicating
S1(€|£) Investment = Bond + Option = Portfolio
€2.20/£ €2,530 = €2,070 + €460 = €2,530
€1.80/£ €2,070 = €2,070 + €0 = €2,070

Valuation of the Option to Delay Using
Price Quotes from an Options Dealer
• So the present value of the project at time zero
can be found by getting a quote from an option
dealer on an at-the-money call on £2,300 and
adding to that the present value of €2,070 at the
euro-zone risk-free rate.
• The NPV of the project is that sum less the cost
of the project, –€2,000:
€2,070
NPV = –€2,000 + value of option +
1+ i€
Option to Delay: Example (continued)
• Suppose that our option dealer quotes an option
premium of €0.05 per pound and our banker quotes the
euro-zone risk-free rate at i€ = 6%.
• The NPV of the project at time zero to the French firm is:
€2,070
NPV0 = –€2,000 + €115 + = €67.83
1.06
• Before we accept a positive NPV project, we should make
sure that we are not bypassing alternative projects with
higher NPVs.
• Waiting a year to start the same project is an
alternative.
Option to Delay: Example continues
• If the firm can wait a year to start the
project, the cash flows look like:
If S1(€|£) = €1.80 per £ If S1(€|£) = €2.20 per £
–€1,800 €2,070 –€2,200 €2,530
0 1 0 1
IRR = 15%
€2,070 IRR = 15%
NPV1 = €81.82 = –€1,800 +
1.10 NPV1 = €100
Option to Delay: conclusion
• We have a choice: invest in the project today or
wait a year.
• If we jump in today, the NPV0 is €67.83 and the
FV of today’s NPV0 in one year from now is
NPV1 = €74.61 = 1.10 × €67.83.
• Clearly, it’s better to wait a year.
– Worst case, NPV1 = €81.82, but there is a chance that
the NPV at time one is €100.
– Both of these outcomes beat €74.61.

Summary
• The APV model separates the operating cash flows from
the cash flows due to financing.
– Additionally, each cash flow is discounted at a rate of discount
commensurate with the inherent risk of the individual cash flow.
• The APV model was further expanded to make it
amenable for use by a MNC parent analyzing a capital
project of a foreign subsidiary.
– The cash flows were converted into the parent firm’s home
currency, and additional terms were added to the model to
handle cash flows that are frequently encountered in
international capital projects.
– You can also adjust the discount rate from domestic to foreign.


International Capital Budgeting: Chapter Eighteen

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International Capital Budgeting

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Copyright © 2018 by the McGraw-Hill Companies,

can be converted to adjusted present value (APV)

by appealing to Modigliani and Miller’s results.

Copyright © 2018 by the McGraw-Hill Companies,

• The APV model is a value additivity approach to capital

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

$125 $250 $375 $500

$19.20 $19.20 $19.20 $19.20

• The APV model is useful for a domestic firm analyzing a

Copyright © 2018 by the McGraw-Hill Companies,

S0RF0 represents the value of Denotes the present value (in

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

€ = 3% Let’s find i€ and use that on the euro cash

Recall that the Fisher Effect holds that:

real inflation nominal

€200 €500 €300

Copyright © 2018 by the McGraw-Hill Companies,

$257.28 $661.94 $408.73

$257.28 $661.94 $408.73

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

€2.20/£ €2,530 = €2,070 + €460 = €2,530

€1.80/£ €2,070 = €2,070 + €0 = €2,070

–€1,800 €2,070 –€2,200 €2,530

Copyright © 2018 by the McGraw-Hill Companies,

Copyright © 2018 by the McGraw-Hill Companies,

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