© 2018 Cambridge University Press 15-1
Michala Moravcová
Department of Finance, Masaryk University
International Finance
International Capital Budgeting
International Finance
© 2018 Cambridge University Press 15-2
• ANPV used for:
• capital budgeting when corporations make investment decisions and determine the valuations
of international projects.
• valuing a project done by a foreign subsidiary
• ANPV approach lends itself to international applications most easily.
1. Adjusted Net Present Value
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© 2018 Cambridge University Press 15-3
• Adjusted Net Present Value
• Adjusted Net Present Value is the sum of three things:
• 𝐴𝑁𝑃𝑉 = 𝑁𝑃𝑉 + 𝑁𝑃𝑉𝐹 + 𝑅𝑂
• Discounted cash flows of the all-equity firm
• The sum of all discounted expected future revenues minus the sum of current and discounted
expected future costs and investments.
• Revenues and costs measured on an incremental, after-tax cash flows (same currency!) basis
• Discount rate must be appropriate for the currency of denomination of the cash flow (time premium
+ risk)
• Net present value of financial side effects (NPVF)
• Examples: costs of issuing securities; tax implications of financing; costs of financial distress (if
applicable); subsidized financing from governments
• Value the real options (RO)
• The ability to adjust the scale of the project in response to future information
• For a movie, this would be a sequel
• Decision: accept only (+) ANPV projects (the one with the highest ANPV should be accepted)
1. An Overview of Adjusted Net Present Value
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© 2018 Cambridge University Press 15-4
• Vincenzo Uno has a project with the cash flows:
• If the discount rate for the project is 20%, the PV of these perpetual expected profits is:
•
!"#,%%%
&.!%
+
!"#,%%%
&.!%! +
!"#,%%%
&.!%" + ⋯ =
!"#,%%%
%.!%
= 1,320,000
• If the initial investment needed is €1,350,000, the NPV of this project is therefore negative (€30,000)
and the project should be rejected.
1. An Overview of Adjusted Net Present Value
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© 2018 Cambridge University Press 15-5
• Incremental profits
• Flows that result from the project alone
• Export cannibalization
• Revenues
• Forecasts depend on future economic environment
• Costs
• Measures cost of goods sold
• Depreciation
• Legal tax shield; subtracted out before taxes are calculated
• Capital expenses
• Money spent on property, plant and equipment (PPE)
• Net working capital
• Inventory and cash on hand to run business
2. Deriving the NPV of Free Cash Flow
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2. Deriving Free Cash Flow
All flows to be denominated in the same currency, which involves forecasting exchange rates
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• Earnings Before Interest and Taxes (EBIT)
• Pretax operating income without debt
• Net Operating Profit Less Adjusted Taxes (NOPLAT)
• Equals EBIT minus taxes paid
• Gross Cash Flow - NOPLAT plus depreciation
• CAPX is capital expenditures (CEPEX)
• Large in initial stages of project
• Investment later when repairs become costly
2. Deriving the NPV of Free Cash Flow
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© 2018 Cambridge University Press 15-8
• Discounting Free Cash Flows
• 𝑁𝑃𝑉 𝑡 = ∑!"#
$ %!['('(*+!)]
(.+/)"
• r = Discount rate and k = number of years beyond time t
• Calculating the terminal value of a project
• In theory, the all-equity firm will “live” forever
• The growth rate of g should primarily reflect the expected rate of inflation in the currency of the
forecasts
2. Deriving the NPV of Free Cash Flow
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© 2018 Cambridge University Press 15-9
• The costs of issuing securities
• Monetary fee
• Underwriting discount:
• The spread between what the firm receives from issuing securities and what the public pays for
the securities
• Data on costs
• Lee, Lockhead, Ritter and Zhao (1996)
• The percentage cost decreases as the amount of money raised increases (i.e., there are economies
of scale)
• In their sample, the monetary fee ≈ 3.69% and the discount ≈ 7.31%
3. Financial Side Effects
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© 2018 Cambridge University Press 15-10
• Tax shields for certain securities
• Interest tax shield - the value of the ability to deduct interest expense for tax purposes
• 𝐷 −
&()# *
(&()#)
+
-)#*
(&()#)
• Interest tax shield =
-)#*
(&()#)
• 𝜏 – corporate income tax rate, 𝜏𝑟* - tax deduction, 𝑟* - market interest rate as the discount rate, D
- loan
• For a perpetuity: this equation becomes 𝜏𝐷
• With a corporate tax rate of 34%, the value of Vincenzo Uno’s tax shield for a €500,000 issue of
debt calculated as perpetuity is:
• 0.34×€500,000 = €170,000
3. Financial Side Effects
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© 2018 Cambridge University Press 15-11
• The proper discount rate
• Rate should reflect the appropriate riskiness of the project’s cash flows
• Costs of financial distress
• If these costs did not exist, firms would be financed by debt only
• Direct costs of financial distress (bankruptcy), e.g., legal consulting, and accounting fees ≈ 3%
• The indirect costs of financial distress
• Loss of value due to the expectation of failure
• Customers not wanting to buy because after-sales service is not guaranteed or creditors unwilling to
extend more credit
• Inability to attract high-quality, skilled labor
• The equilibrium amount of debt
• Where the marginal benefit of the tax shield equals the marginal costs of financial distress
3. Financial Side Effects
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© 2018 Cambridge University Press 15-12
3. Benefits and Costs of Debt
How issuing debt adversely affects the ability
of the firm to operate in world markets.
The rectangle ABCD is the total benefit of the
debt. The shaded area under the marginal cost
curve is the total cost of the debt.
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© 2018 Cambridge University Press 15-13
• Subsidized financing
• Interest subsidies
• Add value to the project
• Appropriate discount rate is the market’s required rate of return on the debt since the firm is just
as likely to default on a subsidized loan
3. Financial Side Effects
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© 2018 Cambridge University Press 15-14
• Real-world example
• Proctor & Gamble purchasing Brazilian company Phebo
• Value in learning about how to operate in Brazil (thus enabling them to expand further)
• Abandonment options
4. Real Options
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© 2018 Cambridge University Press 15-15
• ANPV of parent versus Subsidiary
• Very different, so you must be clear which one you are valuing
• Foreign exchange controls, royalty payments, licensing agreements, overhead management
fees, and profits from intermediate goods sold to subsidiary can make a difference
5. Parent Versus Subsidiary Cash Flows
International Finance
© 2018 Cambridge University Press 15-16
• A three-step approach to determining the value of a foreign subsidiary (i.e., from
perspective of parent company)
• NPV cash flow analysis on the foreign subsidiary as if it were independent of parent
• Cash flow from parent’s perspective
• After-withholding-tax dividends project will yield to parent
• After-tax value of royalty payments, licensing / management fees, sales of intermediate goods
• Watch for cannibalization of exports
• Adjust the value of the project for the NPV of financing side effects and possible growth
options
5. Parent Versus Subsidiary Cash Flows
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© 2018 Cambridge University Press 15-17
• IWPI is considering whether to acquire a Spanish manufacturing facility to serve
its European market
• Initial Investments (plant, equipment, inventory):
• €100𝑀 + €73𝑀 + €5.66𝑀 = €178.66𝑀 𝑜𝑟 $250.12 𝑀
• Forecasting total revenue
• Only half of 44,000 units demanded will be produced in Spain the 1st year but all thereafter
• Current price of furniture is $3,430 (or at S = € 1.40/$ à €2,450) and will grow at expected
inflation
6. The Case of International Wood Products
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6. Revenue Forecasts for IWPI-Spain
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• Forecasting NWC, capital expenditures, and depreciation
• Change in NWC:
• D𝑁𝑊𝐶 = 𝑁𝑊𝐶. − 𝑁𝑊𝐶./&
• CAPX: economic depreciation requires 3% replacement
• CAPX will be 0.03×0.58 + 0.10×0.42 = 5.94% of initial CAPX for 1st year, or €10.28M
• 𝐶𝐴𝑃𝑋.(0 = 𝐶𝐴𝑃𝑋.(0/&×(1 + 𝜋.(0,€)
• Depreciation: straight-line
• 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛.(0 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛.(0/& + 0.0594×𝐶𝐴𝑃𝑋.(0/&
6. The Case of International Wood Products
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6. Forecasts of Additions to Net Working Capital and
Capital Expenditures for IWPI-Spain
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6. Cost Forecasts for IWPI-Spain
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• Forecasting total costs
• Royalty Fees – paid by subsidiary to parent
• Overhead allocation – paid to parent for help with accounting and management
• Variable costs and overhead expenses – increase at € rate of inflation
• US costs are included here based on PPP
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-23
6. Forecasts of After-Tax Profit for IWPI-Spain
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6. Net Present Value of Project Free Cash Flows for IWPI-Spain
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• Discount rate:
• 𝑟0 + (𝛽 x 𝑟1)
• 𝑟0 - 4.5% (interest rate on German government bonds)
• 1.2 (beta)
• 5.5% (equity risk premium) - 𝑟1
• 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟for year k in the future is = 1/(1 + 0.111)!
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-26
• Terminal value
• Discounted present value of all expected future free cash flows in years 11 and beyond
• Calculate the terminal value in the last year of the project as a growing perpetuity:
• [(€25.6𝑀)×(1 + 0.02)]/(0.111 – 0.02) = €286.95𝑀
• €25.6𝑀 − free cash flow in year 10 is taken to be a perpetuity that is growing at the long-run euro rate
of inflation of 2%
• Discount terminal value from the terminal year to year 0:
• €286.95𝑀/(1 + 0.111)#$= €100.17𝑀
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-27
• The parent company’s perspective
• Forecasting the dividends received by IWPI-US
• IWPI-Spain will pay all of its FCF to parent (dividend)
• The parent will have to pay a 10% withholding tax to the Spanish government but they will get a
tax credit from the U.S. government
• This additional profit substantially enhances the parent’s value of the project
6. The Case of International Wood Products
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6. Calculation of Foreign Tax Credit for IWPI-US
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• If the ratio of the dividend paid by IWPI-Spain to the after-tax income of the
subsidiary is < 1 (i.e., if they don’t send everything home), only a fraction of the
income tax paid is allowed as a credit
• e.g., Year 1:
• The US government realizes that only a fraction of the income earned was paid to the parent
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-30
• Grossed-up dividend:
• After-tax dividend + tax credit
• Potential U.S. tax on dividend:
• Hence, for U.S. tax purposes, the grossed-up dividend is €2.72 million + €1.93 million =
€ 4.65 million
• 0.34×€4.65𝑀 = €1.58𝑀
• If this is less than the tax credit (1.93 in this case):
• US taxes = 0
6. The Case of International Wood Products
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6. Calculation of U.S. Tax Liability of IWPI-US
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6. Net Present Value of After-Tax Dividends for IWPI-US
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• Terminal value of dividends calculated in same way as other terminal value
• PV of after-tax dividends is less than the cost of the project
• €160.84𝑀 < €178.66𝑀
• However, there are other sources of value
• Royalty fees
• Overhead allocation fees
• After-tax profits of intermediate goods
6. The Case of International Wood Products
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6. Net Present
Value of After-Tax
Royalty and
Overhead
Allocation Fees
Received by IWPI-
US
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6. Net Present Value of After-tax Profit on Intermediate Goods
Sold by IWPI-US to IWPI-Spain
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• Valuing the financial side effects
• Subsidized loan by Spanish Government (€30M; 10 yrs; int. rate = 3%)
• Interest tax shields: 0.35× 0.03×€30𝑀 = €0.315𝑀
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-37
• Valuing the financial side effects
• Subsidized loan by Spanish Government (€30M; 10 yrs; int. rate = 3%)
• Interest subsidies: 0.06×€30𝑀 − €0.9𝑀 = €0.9𝑀
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-38
6. The Case of International Wood Products
Initial costs – €178.66M
Dividends + €160.84M
Royalties + €102.26M
Exports + €31.91M
Interest tax shield + €11.29M
Interest subsidy + €6.62M
ANPV of IWPI-Spain €134.26M > 0
(or $187.97M @ €1.40/$)
Decision Accept
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6. Net Present Value of After-Tax Profit on Lost Export Sales by IWPI-US
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• Cannibalization of export sales
• Lost sales in first year are:
• (40,000 − 22,000) = 18,000 (produced in Spanish facility)
• ANPV falls because of this
• (€134.26𝑀 − €114.95𝑀) = €19.31𝑀
• However, as it is still positive it does not change the decision to accept the project
6. The Case of International Wood Products
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© 2018 Cambridge University Press 15-41
• Can an investment project of a foreign subsidiary that has a positive net present value when evaluated as a
stand-alone firm ever be rejected by the parent corporation? Assume that the parent accepts all projects with
positive adjusted net present values.
• How do licensing agreements, royalties, and overhead allocation fees affect the value of a foreign project?
• What is meant by the net present value of the financial side effects of a project?
• What is an interest tax shield? How do you calculate its value?
• What are growth options? Provide an example of one in an international context.
• What is the difference between EBIT and NOPLAT?
• What is meant by the cannibalization of an export market?
• What is the terminal value of a project? How is it calculated?
• Why is it sometimes assumed that CAPX equals depreciation in the later stages of a project? How does
expected inflation affect this assumption?
Questions:
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