Chapter 14. Multinational Capital Budgeting. Lecture Outline

Transcription

1 Chapter 14 Multinational Capital Budgeting Lecture Outline Subsidiary versus Parent Perspective Tax Differentials Restrictions on Remitted Earnings Exchange Rate Movements Input for Multinational Capital Budgeting Multinational Capital Budgeting Example Background Analysis Other Factors to Consider Exchange Rate Fluctuations Inflation Financing Arrangement Blocked Funds Uncertain Salvage Value Impact of Project on Prevailing Cash Flows Host Government Incentives Real Options Adjusting Project Assessment for Risk Risk-Adjusted Discount Rate Sensitivity Analysis Simulation different from the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

2 2 Multinational Capital Budgeting Chapter Theme This chapter identifies additional considerations in multinational capital budgeting versus domestic capital budgeting. These considerations can either be explained briefly or illustrated with the use of an example. Topics to Stimulate Class Discussion 1. Create an idea for a firm to expand its operations overseas. Provide the industry of the firm. Given this information, students should be requested to list all information that needs to be gathered in order to conduct a capital budgeting analysis. 2. How should a firm adjust the capital budgeting analysis for investment in a country where the currency is extremely volatile? 3. How should a firm adjust the capital budgeting for investment in a country where the chance of a government takeover is relatively high? POINT/COUNTER-POINT Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign Projects? POINT: Yes. An MNC s parent should use the forward rate for each year in which it will receive net cash flows in a foreign currency. The forward rate is market-determined and serves as a useful forecast for future years. COUNTER-POINT: No. An MNC should use its own forecasts for each year in which it will receive net cash flows in a foreign currency. If the forward rates for future time periods are higher than the MNC s expected spot rates, the MNC may accept a project that it should not accept. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue. ANSWER: An MNC should only use the forward rate in place of its expectations if it plans to hedge its net cash flows in future periods. Of course, it must also consider the possibility of over-hedging its future net cash flows in foreign currencies if it uses this strategy. When it assesses a project and does not hedge, it should use its expected spot rates. However, it should compare its expected spot rates to the forward rates and assess whether any large deviations of its expectations from the forward rate make sense. Answers to End of Chapter Questions 1. MNC Parent s Perspective. 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?

3 Multinational Capital Budgeting 3 ANSWER: When a parent allocates funds for a project, it should view the project s feasibility from its own perspective. It is possible that a project could be feasible from a subsidiary s perspective but be infeasible when considering a parent s perspective (due to foreign withholding taxes or exchange rate changes affecting funds remitted to the parent). Some of the more obvious factors are (1) exchange rates, (2) whether currency restrictions may exist, (3) probability of a host government takeover, and (4) foreign demand for the product. 2. Accounting for Risk. 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. Explain how simulation can be used in multinational capital budgeting. What can it do that other risk adjustment techniques cannot? ANSWER: Point estimates of exchange rates lead to a point estimate of a project s NPV. It is more desirable to have a feel for a variety of outcomes (NPVs) that could occur. The risk adjusted discount rate (RADR) is easy to use but generates only a single point estimate of the NPV. It may be more desirable to develop a distribution of possible NPVs in order to assess the probability that NPV will be positive. Sensitivity analysis and simulation could be very useful because they generate a distribution of NPVs. To use simulation, develop a range of possible values that each input variable (such as price, quantity sold, exchange rates) may take on, and apply the simulation model to these ranges to generate a distribution of NPVs. 3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter, explain the sources of uncertainty surrounding a proposed project in Hungary by a U.S. firm. In what ways is the estimated net present value of this project more uncertain than that of a similar project in a more developed European country? ANSWER: The estimated NPV is more uncertain because cash flows are more uncertain. The high degree of uncertainty surrounding the cash flows is attributed to uncertain economic conditions (especially given the shift to a market-oriented economy), and to an uncertain degree of competition (the competitive structure is changing substantially because of the removal of barriers). 4. Accounting for Risk. Your employees have estimated the net present value of project X to be $1.2 million. Their report says that they have not accounted for risk, but that with such a large NPV, the project should be accepted since even a risk-adjusted NPV would likely be positive. You have the final decision as to whether to accept or reject the project. What is your decision? ANSWER: The decision should not be made until risk has been considered. If the project has a risk of a government takeover, for example, a large estimated NPV may not be a sufficient reason to accept the project.

4 4 Multinational Capital Budgeting 5. Impact of Exchange Rates on NPV. a) Describe in general terms how future appreciation of the euro will likely affect the value (from the parent s perspective) of a project established in Germany today by a U.S.-based MNC. Will the sensitivity of the project value be affected by the percentage of earnings remitted to the parent each year? ANSWER: a. Future appreciation of the euro would benefit the parent since the euro earnings would be worth more when remitted and converted to dollars. This is especially true when a large percentage of earnings are sent to the parent. b. Repeat this question, but assume the future depreciation of the euro. The future depreciation of the euro would hurt the parent since the euro earnings would be worth less when remitted and converted to dollars. This is especially true when a large percentage of earnings are sent to the parent. 6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity of the net present value to exchange rate forecasts. ANSWER: By financing the project with the same currency that is received from the project, the firm can reduce the sensitivity of a foreign project s NPV. 7. September 11 Effects on NPV. In August 2001, Woodsen Inc. of Pittsburgh, PA considered the development of a large subsidiary in Greece. In response to the September 11, 2001 terrorist attack on the U.S., its expected cash flows and earnings from this acquisition were reduced only slightly. Yet, the firm decided to retract its offer because of an increase in its required rate of return on the project, which caused the NPV to be negative. Explain why the required rate of return on its project may have increased after the attack. ANSWER: Its cash flows were subject to more uncertainty, because the full economic effects of the terrorist attack were uncertain. Therefore, the required rate of return increased to reflect the higher risk premium. 8. Assessing a Foreign Project. 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. ANSWER: The proposed acquisition is likely to be more feasible if the euro is expected to appreciate over the long run. Huskie would like to purchase the firm when the euro is weak. Then, after the purchase, a strengthened euro will convert the French firm s earnings remitted to the parent into a larger amount of U.S. dollars. 9. Relevant Cash Flows in Disney s French Theme Park. When Walt Disney World considered establishing a theme park in France, were the forecasted revenues and costs associated with the

5 Multinational Capital Budgeting 5 French park sufficient to assess the feasibility of this project? Were there any other relevant cash flows that deserved to be considered? ANSWER: Other relevant cash flows are Walt Disney World s existing cash flows. The establishment of a theme park in France could reduce the amount of European customers that would have visited Disney s U.S. theme parks. These forgone cash flows should be considered when assessing the feasibility of the theme park in France. 10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was independent of its operations in the United States. The subsidiary s performance was well above what was expected. Consequently, when a British firm approached Athens about the possibility of acquiring the subsidiary, Athens chief financial officer implied that the subsidiary was performing so well that it was not for sale. Comment on this strategy. ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price offered for it exceeds Athens perceived present value of the subsidiary. 11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing below the cash flow projections developed before the subsidiary was established. Lehigh anticipated that future cash flows would also be lower than the original cash flow projections. Consequently, Lehigh decided to inform several potential acquiring firms of its plan to sell the subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but Lehigh accepted the offer. It justified its decision by stating that any existing project whose cash flows are not sufficient to recover the initial investment should be divested. Comment on this statement. ANSWER: Even if the project will not recover its initial outlay, it should only be divested if the price offered for it exceeds Lehigh s estimation of its present value. 12. Impact of Reinvested Foreign Earnings on NPV. 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 10 years since the interest rate earned on these securities is so high. Then, after 10 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.) ANSWER: While the funds are reinvested at high rates, they may be worth less dollars ten years from now. Flagstaff may have been better off if the earnings were remitted in the year they were generated. Even though the funds could not be invested at as high an interest rate in the U.S., the exchange rate effects are reduced when the earnings are remitted each year. 13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years. During the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.

6 6 Multinational Capital Budgeting a. Determine the NPV for this project. Should Brower build the plant? ANSWER: Cash Flows: Year Investment 9 Operating CF Salvage Value 5 Net CF Exchange rate 8,700 9,135 9,592 10,071 Cash flows to parent $1,034,483 $328, $312, $695, PV of parent cash flows $1,034,483 $280, $228, $433, NPV $1,034,483 $753, $525, $91, Since the project has a negative net present value (NPV), Brower should not undertake it. b. How would your answer change if the value of the cedi was expected to remain unchanged from its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should Brower construct the plant then? ANSWER: If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar over the course of the three years: Year Investment 9 Operating CF Salvage Value 5 Net CF Exchange rate 8,700 8,700 8,700 8,700 Cash flows to parent $1,034,483 $344, $344, $804, PV of parent cash flows $1,034,483 $294, $251, $502, NPV $1,034,483 $739, $487, $14, If the value of the cedi remains constant, the NPV is positive. Thus, Brower should undertake the project in this case. Of course, the NPV is only slightly positive. Whether or not Brower actually undertakes the project depends on the confidence it has in its exchange rate forecasts. 14. Impact of Financing on NPV. 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.

7 Multinational Capital Budgeting 7 ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity investment in the subsidiary. This would result in a larger remittance that would be favorably affected by the appreciation of the Japanese yen (as the yen are converted to dollars). If financing was provided by local banks in Japan, interest payments to these banks would reduce the amount remitted to the U.S. each year. Therefore, the effect of the yen would be less favorable because it would be applied to a smaller amount of funds. 15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering establishing a consumer products division in Germany, which would be financed by German banks. Santa Monica completed its capital budgeting analysis in August. Then, in November, the government leadership stabilized and political conditions improved in Germany. In response, Santa Monica increased its expected cash flows by 20 percent but did not adjust the discount rate applied to the project. Should the discount rate be affected by the change in political conditions? ANSWER: The risk may have declined if there is less uncertainty surrounding cash flows. However, if the political conditions also encourage more firms to do business in Germany, there may be more intense competition from other firms that could penetrate the market, which results in more risk. 16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume that several MNCs are likely to consider DFI in this country. The inflation rate in recent years has averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5 per hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting analysis for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for each of the next 10 years. The components produced are to be exported to Piedmont s headquarters in the United States, where they will be used in the production of computers. Do you think Piedmont will overestimate or underestimate the net present value of this project? Why? (Assume that LDC s currency is tied to the dollar and will remain that way.) ANSWER: The net present value will likely be overestimated because the labor costs in LDC will probably increase at a higher rate than 4 percent per year. As DFI increases, the demand for labor will be much greater than in previous years, and future wage rates will reflect the strong demand. This example is analogous to situations in South Korea, Hong Kong, and Singapore, in which the desire by MNCs to capitalize on low-cost labor caused wage rates to increase substantially in some periods. 17. PepsiCo s Project in Brazil. 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 U.S. 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. 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

8 8 Multinational Capital Budgeting investment and the exchange rate risk would have been affected if PepsiCo had financed much of the investment with loans from banks in Brazil. ANSWER: As the earnings in Brazil are remitted, they will be converted to dollars. If Brazil s currency depreciates against the dollar over time, there will be less dollar earnings received. If PepsiCo Inc. borrowed funds from banks in Brazil, the parent s initial investment would have been smaller. Also, the payments by the subsidiary on loans in Brazil would cause less remitted earnings over time, and therefore less exchange rate risk. b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of the project in Brazil. ANSWER: The demand in Brazil for the soft drinks and snacks produced by PepsiCo Inc. is dependent on the economy in Brazil, consumer habits, country regulations, and the competition. PepsiCo apparently expects an increased demand for soft drinks and snacks as the economy improves. c. What factors did PepsiCo likely consider in deriving its required rate of return on the project in Brazil? ANSWER: PepsiCo planned to use $500 million for investment in Brazil. Its funds may have been derived from retained earnings and loans from creditors. PepsiCo would have estimated a cost of each source of funds and determined the weighted average cost of those funds. It would have attached a risk premium onto the cost to reflect the risk of investment in Brazil. d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective of the U.S. parent. ANSWER: There is some uncertainty about the demand for PepsiCo s products in Brazil, because it is difficult to estimate the impact of the expansion on the demand. These products would now be more accessible to Brazil s consumers, but the precise increase in the demand for PepsiCo s products cannot be easily forecasted. This demand is affected by future economic conditions and future competition (The Coca-Cola Company planned some expansion shortly after PepsiCo began its expansion in Brazil). In addition to these factors, there is much uncertainty about the future exchange rate at which the funds will be converted into dollars. The value of Brazil s currency (called the real ) has been very volatile over time and has typically depreciated substantially against the dollar. Thus, it would be natural to estimate the dollar cash flows by assuming some degree of depreciation in Brazil s currency, but there would still be much uncertainty regarding the degree of depreciation. 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 Brazil perspective or a U.S. perspective? Explain.

9 Multinational Capital Budgeting 9 ANSWER: PepsiCo s parent uses its own funds to support expansion. Thus, it should make decisions from its own perspective. It does not make sense to assess the project from a Brazil perspective, when the dollars are used by the parent to support the project in Brazil. The project is only worthwhile if the return (from a U.S. perspective) is sufficiently large so that it exceeds the return that is required by the U.S parent that invested those dollars. 18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be financed with U.S. dollars). All cash flows generated from the project were to be reinvested in Thailand for several years. Explain how the Asian crisis would have affected the expected cash flows of this project and the required rate of return on this project. If the cash flows were to be remitted to the U.S. parent, explain how the Asian crisis would have affected the expected cash flows of this project. ANSWER: The Asian crisis would have reduced local currency cash flows (due to a weak economy), and then those cash flows would have been remitted at weak exchange rates, which would reduce the dollar cash flows received by the parent. The required rate of return would be higher to capture the higher degree of uncertainty surrounding future cash flows. 19. Tax Effects on NPV. When considering the implementation of a project in one of various possible countries, what types of tax characteristics should be assessed among the countries? (See the chapter appendix) ANSWER: Corporate taxes in the country should be considered by an MNC, along with withholding taxes, and even individual tax rates imposed on the potential employees. Excise taxes are also relevant. 20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion South Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion and 4 billion won in the two years of operation, respectively. The project has no salvage value. The current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain constant over the next two years. a. What is the NPV of this project if the required rate of return is 13 percent? b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per U.S. dollar after two years. Further assume that the funds are blocked and that the parent company will only be able to remit them back to the U.S. in two years. How does this affect the NPV of the project?

10 10 Multinational Capital Budgeting ANSWER: Year Investment 2 Operating CF 3 4 Net CF Exchange rate 1,100 1,100 1,100 Cash flows to parent $1,818, $2,727, $3,636, PV of parent cash flows $1,818, $2,413, $2,847, NPV $1,818, $595, $3,443, The NPV is $3,443, ANSWER: Year 0 2 Investment 2 Operating CF 7 Net CF 2 7 Exchange rate 1,100 1,200 Cash flows to parent $1,818, $5,833, PV of parent cash flows $1,818, $4,568, NPV $1,818, $2,750, A situation where the funds are blocked and the won is expected to depreciate reduces the NPV by $692, Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong, where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that allows for alternative exchange rate scenarios. Why would Carson use this approach rather than using the pegged exchange rate as its exchange rate forecast in every year? ANSWER: Carson recognizes that the pegged exchange rate may not remain pegged over the 10-year period. It should account for this risk by considering other exchange rate scenarios. 22. Decisions Based on Capital Budgeting. Marathon Inc. considers a one-year project with the Belgian government. Its euro revenue would be guaranteed. Its consultant states that the percentage change in the euro is represented by a normal distribution, and that based on a 95 percent confidence interval, the percentage change in the euro is expected to be between 0 percent and 6 percent. Marathon uses this information to create three scenarios: 0%, 3%, and 6% for the euro. It derives an estimated NPV based on each scenario, and then determines the mean NPV. The NPV was positive for the 3% and 6% scenarios, but was slightly negative for the 0 percent scenario. This led Marathon to reject the project. Its manager stated that it did not want to pursue a project that had a one-in-three

11 Multinational Capital Budgeting 11 chance of having a negative NPV. Do you agree with the manager s interpretation of the analysis? Explain. ANSWER: Marathon s interpretation implies that each scenario has the same probability of occurring. Yet, the probability distribution is presumed to be normal, implying a lower probability for the extremes than the middle of the range. The manager overestimated the likelihood that the NPV will be negative. 23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory in Brazil, half the initial outlay will be funded by the parent s equity and half by borrowing funds in Brazil. Assume that Nike wants to assess the project from its own perspective to determine whether the project s future cash flows will provide a sufficient return to the parent to warrant the initial investment. Why will the estimated cash flows be different from the estimated cash flows of Nike s shoe factory in New Hampshire? Why will the initial outlay be different? Explain how Nike can conduct multinational capital budgeting in a manner that will achieve its objective. ANSWER: The net cash flows to the parent will be different because they are based on the revenue received by the subsidiary in Brazil, minus the expenses incurred there (including the interest payments), and the exchange rate when the funds are remitted to the U.S., plus any tax effects. The initial outlay is dependent on the cost of creating a factory in Brazil and the amount of equity invested in the project and the exchange rate at the time of the initial outlay (only the equity investment is considered here in order to determine the project s feasibility for the parent). The debt in Brazil will be recognized within the cash flow estimates. Nike can determine whether the present value of the cash flows received by the parent (measured in the manner explained above) exceeds the initial outlay (measured in the manner explained above) of the project. Advanced Questions 24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the project will generate total operating cash flows of $3,500,000, measured in today s dollars using a required rate of return of 14 percent. What is the break-even salvage value of this project? ANSWER: SV n IO ($4,000,000 $3,500,000)(1.14) $740,772 CFt (1 k) t (1 k) n Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. It is risk-averse, but is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and

12 12 Multinational Capital Budgeting remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is 5% while the nominal one-year interest rate in the U.S. is 9%. Zistine s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect. He also believes that interest rate parity holds. He provides this information to three recent finance graduates that he just hired as managers and asks them for their input. a. The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a forward contract or are not hedged. Is this manager correct? Explain. b. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain. c. The third manager states that the project should be hedged because the forward rate contains a premium, and therefore the forward rate will generate more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain. ANSWER: a. The first manager is wrong. The project is more feasible if it hedges, because the expected dollar cash flows are the same whether Zistine hedges or not, and it can remove uncertainty surrounding the dollar cash flows if it hedges. b. The second manager is wrong. The IFE suggests an expected appreciation of the New Zealand dollar by the same percentage as the forward premium (assuming IRP). Thus, the dollar cash flows are just as high when hedged, and there is no uncertainty. c. The third manager s reasoning is wrong. The forward hedge is expected to generate the sanme dollar cash flows as if there is no hedge, because with no hedge the IFE suggests expected appreciation by the amount of the interest rate differential. The amount of dollar cash flows from hedging is equal to the expected dollar cash flows from not hedging. The decision to hedge is correct, but not because of this manager s reasoning. 26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the use of its technology to firms in Mexico. It already has received orders from Mexican firms that will generate MXP3,000,000 in revenue at the end of the next year. However, it might also receive a contract to provide this technology to the Mexican government. In this case, it will generate a total of MXP5,000,000 at the end of the next year. It will not know whether it will receive the government order until the end of the year. Today s spot rate of the peso is $.14. The one-year forward rate is $.12. Blustream expects that the spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to cover development expenses (regardless of whether the Mexican government purchases the technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent.

13 Multinational Capital Budgeting 13 Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive from the project. a. Determine the NPV if Blustream receives the government contract. ANSWER: Revenue converted to $ = MXP5,000,000 $.12 = $600,000 NPV = $600,000/(1.18) $300,000 = $208,475 b. If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government contract. ANSWER: Revenue converted to $: MXP3,000,000 $.12 = $360,000 Blustream would have an additional MXP2,000,000 in forward sales. It would need to buy MXP2,000,000 in one year at the expected spot rate, which would be used to offset the excess forward sale position. Amount paid to offset forward sales = MXP2,000,000 $.13 = $260,000 Proceeds from the excess forward sales = MXP2,000,000 $.12 = $240,000 Loss resulting from the excess forward sales = $240,000 $260,000 = $20,000 Dollar Cash flows = Dollar Revenue $360,000 Loss resulting from excess forward sales $20,000 =$340,000 NPV = $340,000/(1.18) $300,000 = $11,864 c. Now consider an alternative strategy in which Blustream only hedges the minimum peso revenue that it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the government contract. Revenue converted to $: Hedged portion: MXP3,000,000 $.12 = $360,000 Unhedged portion: MXP2,000,000 $.13 = $260,000 Total $620,000 NPV = $620,000/(1.18) $300,000 = $225,423

14 14 Multinational Capital Budgeting d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it will receive, determine the NPV assuming that it does not receive the government contract. Revenue converted to $: MXP3,000,000 $.12 = $360,000 NPV = $360,000/(1.18) $300,000 = $5,085 e. If there is a 50 percent chance that Blustream will receive the government contract, would you advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may receive? Explain. ANSWER: It should hedge the minimum amount of revenue. If it hedges the minimum, the NPV for either scenario is higher than if it had hedged the maximum amount of revenue. f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it might receive with a put option on Mexican pesos. The one-year put option has an exercise price of $.125 and a premium of $.01. Determine the NPV if Blustream uses this strategy and receives the government contract. Also, determine the NPV if Blustream uses this strategy and does not receive the government contract. Given that there is a 50 percent probability that Blustream will receive the government contract, would you use this new strategy or the strategy that you selected in question (e)? ANSWER: SCENARIO IF BLUSTREAM RECEIVES GOVERNMENT CONTRACT Portion hedged with FR: MXP3,000,000 $.12 = $360,000 Portion hedged with option: MXP2,000,000 $.125 = +$250,000 Total received in 1 year = $610,000 Premium paid for option: MXP2,000,000 $.01 = $20,000 NPV = $610,000/(1.18) $20,000 - $300,000 = $196,949 SCENARIO IF BLUSTREAM DOES NOT RECEIVE GOVERNMENT CONTRACT Portion hedged with FR: MXP3,000,000 $.12 = $360,000 Premium paid for option: MXP2,000,000 $.01 = $20,000 NPV = $360,000/(1.18) $20,000 - $300,000 = $14,915

15 Multinational Capital Budgeting 15 Overall, the NPV from this strategy is worse than the strategy of hedging the minimum revenue under the scenario that Blustream receives the government contract, and worse under the scenario that it does not receive the government contract. This strategy should not be selected. The optimal strategy is to hedge the minimum amount of revenue to be received. 27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand but is considering establishing a subsidiary there. The following information has been gathered to assess this project: The initial investment required is $50 million in New Zealand dollars (NZ$). Given the existing spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20 million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 14 percent. The loan principal is to be paid in 10 years. The project will be terminated at the end of Year 3, when the subsidiary will be sold. The price, demand, and variable cost of the product in New Zealand are as follows: Year Price Demand Variable Cost 1 NZ$500 40,000 units NZ$30 2 NZ$511 50,000 units NZ$35 3 NZ$530 60,000 units NZ$40 The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year. The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at the end of Year 2, and $.56 at the end of Year 3. The New Zealand government will impose an income tax of 30 percent on income. In addition, it will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes. All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations. The plant and equipment are depreciated over 10 years using the straight-line depreciation method. Since the plant and equipment are initially valued at NZ$50 million, the annual depreciation expense is NZ$5 million. In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the existing New Zealand loan. The working capital will not be liquidated but will be used by the acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax. Wolverine requires a 20 percent rate of return on this project.

16 16 Multinational Capital Budgeting a. Determine the net present value of this project. Should Wolverine accept this project? Capital Budgeting Analysis: Wolverine Corporation Year 0 Year 1 Year 2 Year 3 1. Demand 40,000 50,000 60, Price per unit NZ$500 NZ$511 NZ$ Total revenue = (1) (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800, Variable cost per unit NZ$30 NZ$35 NZ$40 5. Total variable cost = (1) (4) NZ$1,200,000 NZ$1,750,000 NZ$2,400, Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000, Interest expense of New Zealand loan NZ$2,800,000 NZ$2,800,000 NZ$2,800, Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000, Total expenses = (5)+(6)+(7)+(8) NZ$15,000,000 NZ$15,550,000 NZ$16,200, Before-tax earnings of subsidiary = (3) (9) NZ$5,000,000 NZ$10,000,000 NZ$15,600, Host government tax (30%) NZ$1,500,000 NZ$3,000,000 NZ$4,680, After-tax earnings of subsidiary NZ$3,500,000 NZ$7,000,000 NZ$10,920, Net cash flow to subsidiary = (12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$15,920, NZ$ remitted by sub. (100% of CF) NZ$8,500,000 NZ$12,000,000 NZ$15,920, Withholding tax imposed on remitted funds (10%) NZ$850,000 NZ$1,200,000 NZ$1,592, NZ$ remitted after withholding taxes NZ$7,650,000 NZ$10,800,000 NZ$14,328, Salvage value NZ$52,000, Exchange rate of NZ$ $.52 $.54 $ Cash flows to parent $3,978,000 $5,832,000 $37,143, PV of parent cash flows (20% of discount rate) $3,315,000 $4,050,000 $21,495, Initial investment by parent $25,000, Cumulative NPV of cash flows $21,685,000 $17,635,000 $3,860,185 ANSWER: The net present value of this project is $3,860,185. Therefore, Wolverine should accept this project. b. Assume that Wolverine is also considering an alternative financing arrangement, in which the parent would invest an additional $10 million to cover the working capital requirements so that the subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of the subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this alternative financing arrangement more feasible for the parent than the original proposal? Explain. ANSWER: This alternative financing arrangement will have the following effects. First, it will increase the dollar amount of the initial outlay to $35 million. Second, it avoids the annual interest

17 Multinational Capital Budgeting 17 expense of NZ$2,800,000. Third, it will increase the salvage value from NZ$52,000,000 to NZ$70,000,000. The capital budgeting analysis is revised to incorporate these changes. Capital Budgeting Analysis with an Alternative Financing Arrangement: Wolverine Corporation Year 0 Year 1 Year 2 Year 3 1. Demand 40,000 50,000 60, Price per unit NZ$500 NZ$511 NZ$ Total revenue = (1) (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800, Variable cost per unit NZ$30 NZ$35 NZ$40 5. Total variable cost = (1) (4) NZ$1,200,000 NZ$1,750,000 NZ$2,400, Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000, Interest expense of New Zealand loan NZ$0 NZ$0 NZ$0 8. Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000, Total expenses = (5)+(6)+(7)+(8) NZ$12,200,000 NZ$12,750,000 NZ$13,400, Before-tax earnings of subsidiary = (3) (9) NZ$7,800,000 NZ$12,800,000 NZ$18,400, Host government tax (30%) NZ$2,340,000 NZ$3,840,000 NZ$5,520, After-tax earnings of subsidiary NZ$5,460,000 NZ$8,960,000 NZ$12,880, Net cash flow to subsidiary = (12)+(8) NZ$10,460,000 NZ$13,960,000 NZ$17,880, NZ$ remitted by sub. (100% of CF) NZ$10,460,000 NZ$13,960,000 NZ$17,880, Withholding tax imposed on remitted funds (10%) NZ$1,046,000 NZ$1,396,000 NZ$1,788, NZ$ remitted after withholding taxes NZ$9,414,000 NZ$12,564,000 NZ$16,092, Salvage value NZ$70,000, Exchange rate of NZ$ $.52 $.54 $ Cash flows to parent $4,895,280 $6,784,560 $48,211, PV of parent cash flows (20% discount rate) $4,079,400 $4,711,500 $27,900, Initial investment by parent $35,000, Cumulative NPV of cash flows $30,920,600 $26,209,100 $1,691,085 The analysis shows that this alternative financing arrangement is expected to generate a lower net present value than the original financing arrangement. c. From the parent s perspective, would the NPV of this project be more sensitive to exchange rate movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent invests more of its own funds to cover the working capital? Explain. ANSWER: The NPV would be more sensitive to exchange rate movements if the parent uses its own financing to cover the working capital requirements. If it used New Zealand financing, a portion of

18 18 Multinational Capital Budgeting NZ$ cash flows could be used to cover the interest payments on debt. Thus, there would be less NZ$ to be converted to dollars and less exposure to exchange rate movements. d. Assume Wolverine used the original financing proposal and that funds are blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the end of Year 3. How is the project s NPV affected? ANSWER: The effects of the blocked funds are shown below: Year 1 Year 2 Year Net cash flow to subsidiary =(12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$ 15,920,000 NZ$ 12,720,000 NZ$ 9,550, NZ$ remitted by subsidiary NZ$0 NZ$0 NZ$ 38,190, Withholding tax imposed on remitted funds (10%) NZ$ 3,819, NZ$ remitted after withholding taxes NZ$ 34,371, Salvage value NZ$ 52,000, Exchange rate of NZ$ $ Cash flows to parent $48,368, PV of parent cash flows (20% discount rate) NZ$0 NZ$0 $27,990, Initial investment by parent $25,000, Cumulative NPV of cash flows $0 $0 $2,990,777 e. What is the break-even salvage value of this project if Wolverine uses the original financing proposal and funds are not blocked? First, determine the present value of cash flows when excluding salvage value: End of Present Value of Cash Flows Year (excluding salvage value) 1 $ 3,315, ,050, ,643,333* $ 12,008,333 *This number is determined by converting the third year NZ$ cash flows excluding salvage value (NZ$14,328,000) into dollars at the forecasted exchange rate of $.56 per New Zealand dollar: NZ$14,328,000 $.56 = $8,023,680 The present value of the $8,023,680 received 3 years from now is $4,643,333.

19 Multinational Capital Budgeting 19 Then determine the break-even salvage value: Break-even Salvage Value = [IO (present value of cash flows)](1+k) n = [$25,000,000 $12,008,333](1+.20) 3 = $22,449,601 ANSWER: Since the NZ$ is expected to be $.56 in Year 3, this implies that the break-even salvage value in terms of New Zealand dollars is: $22,449,601/$.56 = NZ$40,088,573 f. Assume that Wolverine decides to implement the project, using the original financing proposal. Also assume that after one year, a New Zealand firm offers Wolverine a price of $27 million after taxes for the subsidiary and that Wolverine s original forecasts for Years 2 and 3 have not changed. Compare the present value of the expected cash flows it Wolverine keeps the subsidiary to the selling price. Should Wolverine divest the subsidiary? Explain. ANSWER: Divestiture Analysis One Year After the Project Began End of Year 2 End of Year 3 (one year from now) (two years from now) Cash flows to parent $5,832,000 $37,143,680 PV of parent cash flows forgone if project is divested $4,860,000 $25,794,222 The present value of forgone cash flows is $30,654,222. Since this exceeds the $27,000,000 in proceeds from the divestiture, the project should not be divested. 28. Capital Budgeting With Hedging. Baxter Co. considers a project with Thailand s government. If it accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht in five years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a 5-year period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to hedge its cash flows with a forward contract. What is the dollar amount of cash flows that Baxter will receive in five years if it accepts this project?

20 20 Multinational Capital Budgeting ANSWER: The forward rate premium is: p = (1 +.04) 5 1 = (1.216 / 2.192) 1 = 44% (1 +.17) 5 Forward rate = Spot rate (1 + premium) = $.03 (.56) = $.0168 So the amount to be received is 10,000,000 units $.0168 = $168, Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the unit. It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free interest rate is 5% regardless of the maturity of the debt, and the annualized risk-free interest rate on euros is 7%, regardless of the maturity of debt. Assume that interest rate parity exists. Cantoon s cost of capital is 20%. It plans to use cash to make the acquisition. a. Determine the NPV under these conditions. b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan of 3 million euros today that would be used to cover a portion of the acquisition. In this case, it would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the loan. There are no interest payments on this debt. The way in which this financing deal is structured, none of the payment is tax-deductible. Determine the NPV if Cantoon uses the forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to partially finance the acquisition. [You need to derive the 8-year forward rate for this specific question.] ANSWER a. Discount factor based on a required return of 20% for 8 years =.232 $ to be received in 8 years = 12,000,000 euros $1.2 = $14,400,000 PV = $14,400,000 (1 +.2) 8 = $3,340,800 NPV = $3,340,800 $4,000,000 = $659,200

21 Multinational Capital Budgeting 21 b. The forward rate premium is: p = (1 +.05) 8 1 = (1.48)/1.718) 1 = 13.85% (1 +.07) 8 FR premium over 8 years =.13.85% Forecast of euro in 8 years = $1.20 [1 + ( 13.85%)] = Euros to be received in 8 years = 12 million euros 7 million euros = 5 million euros Dollars to be received in 8 years = 5 million euros $ = $5,169,000 PV of $ to be received in 8 years = $5,169,000 (1 +.20) 8 = $1,202,144 If 3 million euros are borrowed, this covers the equivalent of $3,600,000, since the euro s spot rate is equal to $1.20. Therefore, the parent needs to provide an initial outlay of $400,000 (computed as $4,000,000 $3,600,000). NPV = $1,202,144 $400,000 = $802, Sensitivity of NPV to Conditions. Burton Co., based in the U.S., considers a project in which it has an initial outlay of $3 million and expects to receive 10 million Swiss francs (SF) in one year. The spot rate of the franc is $.80. Burton Co. decides to purchase put options on Swiss francs with an exercise price of $.78 and a premium of $.02 per unit to hedge its receivables. It has a required rate of return of 20 percent. a. Determine the net present value of this project for Burton Co. based on the forecast that the Swiss franc will be valued at $.70 at the end of one year. b. Assume the same information in part (a), but with the following adjustment. While Burton expected to receive 10 million Swiss francs, assume that there were unexpected weak economic conditions in Switzerland after Burton initiated the project. Consequently, Burton received only 6 million Swiss francs at the end of the year. Also assume that the spot rate of the franc at the end of the year was $.79. Determine the net present value of this project for Burton Co. if these conditions occur. ANSWER a. [SF10,000,000 x ($.78)]/1.2=$6,500,000 premium of $200,000 (computed as $.02 x 10 million) initial outlay ($3 million) = $3,300,000.