INTERNATIONAL CAPITAL BUDGETING Sources: Internatonal Fnancal Management; Eun and Resnck Multnatonal Fnancal Management; Shapro Modern Corporate Fnance; Shapro Internatonal Fnancal Management; P G Apte
EVALUATING FINANCING OPTIONS The cost of debt ncludes nterest payments, floataton costs, other charges. To fnd effectve cost of debt IRR approach s used; referred as All-n cost. The cost has to be measured n terms of local currency, hence cash flows attached wth the borrowng depend upon the exchange rates prevalng durng the tenure of the loan. COMPARE COST OF 25 M US $ loan wth 7.5% coupon wth bullet repayment 20 M Euro loan wth 5.5% coupon wth perodc payment 15 M FRN at L + 100 wth bullet repayment 2
ALL IN COST US $ BOND A 3 year US $ denomnated bond of 25 M wth 7.5% coupon payable sem annually Floataton cost of 3% wth bullet repayment Current spot rate (Rs./$) 44.00 Dollar to apprecate at 5% per annum Perod O/S Int. Rate Exp. & Int Repayment Cash flow (FC) Ex Rate Cash flow (Rs.) 0 25.00 0.75 0.00 24.25 44.00 1,067.00 1 25.00 0.94 0.00-0.94 45.10-42.28 2 25.00 0.94 0.00-0.94 46.23-43.34 3 25.00 0.94 0.00-0.94 47.38-44.42 4 25.00 0.94 0.00-0.94 48.57-45.53 5 25.00 0.94 0.00-0.94 49.78-46.67 6 25.00 0.94 25.00-25.94 51.03-1,323.50 Internal Rate of Return 4.33% 6.94% Annuallsed All n Cost 8.84% 14.35% 3
ALL-IN COST - EURO LOAN A 3 year Euro denomnated loan of 20 M wth 5.5% coupon payable sem annually Upfront Fee of 2% wth repayment 4 semannual nstallments; moratorum of 1 year. Current spot rate (Rs/Euro) 53.00 Euro to apprecate at 6% per annum Perod O/S Int. Rate Exp. & Int Repayment Cash flow (FC) Ex Rate Cash flow (Rs.) 0 20.00 0.40 0.00 19.60 53.00 1,038.80 1 20.00 0.55 0.00-0.55 54.59-30.02 2 20.00 0.55 0.00-0.55 56.23-30.93 3 20.00 0.55 5.00-5.55 57.91-321.43 4 15.00 0.41 5.00-5.41 59.65-322.87 5 10.00 0.28 5.00-5.28 61.44-324.10 6 5.00 0.14 5.00-5.14 63.28-325.13 Internal Rate of Return 3.24% 6.33% Annuallsed 6.58% 13.07% 4
ALL-IN COST - POUND FRN A 3 year Brtsh pound denomnated FRN of 15 M at L+100 bp wth sem annual reset. Floataton cost of 3% wth bullent repayment Current spot rate (Rs/Pound) 73.00 Pound to apprecate at 7% per annum Perod O/S LIBOR % Exp. & Int Repayment Cash flow (FC) Ex Rate Cash flow (Rs.) 0 15.00 4.00 0.45 0.00 14.55 73.00 1,062.15 1 15.00 4.25 0.38 0.00-0.38 75.56-28.33 2 15.00 4.20 0.39 0.00-0.39 78.20-30.79 3 15.00 4.30 0.39 0.00-0.39 80.94-31.57 4 15.00 4.40 0.40 0.00-0.40 83.77-33.30 5 15.00 4.25 0.41 0.00-0.41 86.70-35.11 6 15.00 0.39 15.00-15.39 89.74-1,381.37 Internal Rate of Return 3.17% 6.78% Annuallsed 6.44% 14.02% 5
COST OF FC LOANS Must be done on All-n cost bass Cost of fundng r for loan n Foregn currency s 1+r = (1+I) x (1+g); I = Interest rate n FE and g = apprecaton of foregn currency Approxmately = I+g Explct nterest rates of the currency ± expected apprecaton/ deprecaton of the currency. Currency Interest rate Apprecaton Cost US $ 7.5% 5.0% 12.50% Euro 5.5% 6.0% 11.50% Brtsh Pound 4.5% (Av) 7.0% 11.50% 6
CAPITAL BUDGETING Golden rule of captal budgetng: Standard captal budgetng prncple of acceptng all projects wth postve NPV. NPV = CF t (1 + r) CF t = Cash flow for perod t r = Dscount rate, normally WACC TV = Termnal Value I 0 = Intal Investment; n = Lfe of the project t + TV (1 + r) 7 n I 0
ISSUES IN INTERNATIONAL CAPIAL BUDGETING 1. Whose cash flows: Subsdary vs. Parent 2. Whose dscount rate SUBSIDIARY: Responsble for admnsterng and managng the project What s good for subsdary s also good for parent PARENT Captal budgetng exercse s vewed from the perspectve of nvestor. Parent beng nvestor the cash flow should be vewed from parent s perspectve. Debatable f subsdary s not wholly owned?? 8
DIFFERENCES IN CASH FLOWS Cash flows to parent may dffer sgnfcantly from those of subsdary: Tax dfferental, Restrctons on dvdend, Exchange rate, Concessonary loans, Restrctons of fund remttance to parent, etc 9
ADDITIONAL INFORMATION Addtonal parameters needed: Exchange rates for the lfe of the project Cost of captal of parent for dscount factors Cost of debt for the parent 10
CASH FLOWS - PARENT Some cash flows accrue to parent drectly; Expense tems for the project (Royaltes, techncal fees etc.); to be added back for parent s cash flow. Cannbalsaton Addtonal sales creaton Include opportunty cost Tax rate to be used for after accountng for any addtonal tax mposed on remttances apart from normal corporate tax. 11
APV APPROACH MM Poston V L = V U + Value of Tax Sheld = V U + T x Debt V L and V U are the values of the levered and unlevered frm. V U needs to be found usng all equty dscount rate and value of the tax sheld for the debt to be found usng cost of debt. 12
WHY NOT WACC WACC s conceptually easy to apply: But can be used only when fnancal rsk faced by the project s smlar to that of the parent. Dffcult assumpton to fulfll n the nternatonal scenaro. Use all equty approach to dscount the operatng cash flows. βo β = e 1 + (1 T)D / E where β e and β 0 are all equty beta and observed beta respectvely, T s margnal tax rate, and D/E s the debt equty rato usng market values. Can be used only when D/E rato s constant 13
WHY APV APV makes captal structure adjustment separately. Internatonal project fundng has more fnancng optons than local. APV provdes flexblty for the adjustment of dfferent means of fnancng to the NPV of all equty cash flows e.g. project specfc fundng, ncludng subsdsed loans that may be avalable to the MNC. Allows measurement of benefts of each fnancng opton. 14
EXAMPLE APV METHOD A frm ABCL s up for sale. ABCL s a proftable debt free company generatng cash flows of Rs 5 mllon a year at present that are expected to grow at 3%. The owner of the frm wants Rs 30 mllon. The cost of equty for ABCL s reckoned to be 17%. You are a professonal and can generate Rs 2 mllon only. A bank s prepared to lend the remanng Rs 28 mllon at 10% (Leveraged Buy Out). 15
COMPUTING APV Fnd out NPV assumng no leverage (100% equty fnancng) NPV = 5 x 1.03/(0.17-0.03) - 30 = 6.786m Wth fnancng by debt the value wll ncrease by the amount of tax sheld the debt provdes. APV = NPV (all equty) + PV of debt tax sheld 16
PV OF TAX SHIELD Year O/S Interest Tax saved Repayment PV Of Tax Saved 10% 35% 1 28.000 2.800 0.980 2.800 0.891 2 25.200 2.520 0.882 2.800 0.729 3 22.400 2.240 0.784 2.800 0.589 4 19.600 1.960 0.686 2.800 0.469 5 16.800 1.680 0.588 2.800 0.365 6 14.000 1.400 0.490 2.800 0.277 7 11.200 1.120 0.392 2.800 0.201 8 8.400 0.840 0.294 2.800 0.137 9 5.600 0.560 0.196 2.800 0.083 10 2.800 0.280 0.098 2.800 0.038 PRESENT VALUE OF TAX SHIELD 3.778 APV = 6.786+3.778 = 10.564 mllon 17
VALUING SUBSIDISED LOAN A loan of 125 mllon s avalable to IBM for settng up a plant n Skkm at nterest of 8% wth bullet repayment after 10 years. What s the value of the loan f debt otherwse s avalable at 15% and the tax rate s 40%. Interest on subsdsed loan = 125 x 0.08 x 0.6 = 6.00 Interest saved = (0.15 0.08) x 125 = 8.75 Tax Saved = 0.4 x 0.08 x 125 = 4.00 NPV = 125 Conssts PV of PV of of 10 6 125 = 63.99 n 10 1 (1.15) 1.15 two parts )Interest subsdy and )Taxsheld Interest Subsdy Tax Sheld = 10 1 = 10 1 4.0 (1.15) 8.75 (1.15) n n = 20.07 = 43.91 18
Lessard s APV MODEL APV = n 1 S S OCF(1 0 C 0 (1 + r + S 0 0 ) RF T) + 0 + S 0 n 1 CL S TD 0 (1 + r d n 1 ) + n 1 S LP (1 + r d ) S TI (1 + r d ) + S TV (1 + r 0 ) n PV of Termnal value Intal cost and retaned funds Concessonary Loan beneft PV of Post Tax operatng cash flows PV of Deprecaton and Interest Tax shelds 19
DISCOUNT RATES Operatng Cash flows = EBDIT to be dscounted at cost of equty assumng no debt. Tax shelds on deprecaton and nterest are dscounted at cost of debt. Restrcted funds released must be vewed before tax as MNC saves taxes f funds are retaned for fundng the project. All rates used for dscountng: parent s home land. ADJUSTING FOR RISK: All equty beta to be used for arrvng at approprate dscount rate only for the projects of same rsk class. Unlever beta of competng frm f project s not of the same rsk class 20