AJA4604.12 Multinational Capital Budgeting, Cost of Capital and Capital Structure

1. AJA4604.12Multinational Capital Budgeting, Cost of Capital and Capital Structure An Outline: (a)Inputs into a Capital Budgeting Decision (b) Additional Factors in Multinational Capital Budgeting. (c) Adjusted Present Value Method (d) Cost of Capital (e) Capital Structure

2. A. Basics of Capital Budgeting Definition: Capital budgeting is the decision-making process with respect to investment in fixed assets. Inputs into the Capital Budgeting Decision • Initial investment • Consumer demand • Price • Variable cost • Fixed cost • Project lifetime • Salvage value • Tax-laws • Required rate of return

3. Other Factors in Multinational Capital Budgeting • Exchange rate fluctuations • Relative inflation • Financing arrangements – subsidies /penalties • Blocked funds • Remittance provisions • Uncertain salvage values • Impact of project on prevailing cash flows • Government incentives • Social costs / Externalities • Political risk /Country risk.

4. Transfer prices • Treatment of fees, royalties, etc. • Aggregating the cash flows and assigning applicable discount rate to each component.

5. Basics of Capital Budgeting … Popular Techniques 1. Payback Period: Is the length of time needed to recoup the initial investment. This equals the length of time it takes for cumulative nominal cash inflows to equal the initial outlay. Discounted Payback Periodis a modified form of the Standard Payback Period which incorporates time value. 2. Net Present Value: Is the expected value, in today's dollars, after considering all costs, of cash flows from a project. k = required rate of return on "project." Cost of capital is the cost of long-term funds for the firm.

6. Decision Rule: When NPV > 0, accept the project. • When NPV < 0, reject the project. • When each of two mutually exclusive projects has • positive NPV, the project with the higher NPV • should be selected.

7. 3.Profitability Index (PI): Considers the ratio of present value of a project's cash flows to its initial outlay. • CFt = cash flow at time t • I0 = initial outlay • k = required rate of return (cost of capital) • Decision Rule: When PI > 1, accept the project. • When PI < 1, reject the project.

8. 4. Internal Rate of Return (IRR): Is the rate of return that the firm expects to earn on the project. Mathematically, it is the "discount rate" that equates the present value of cash flows to the initial outlay, so that • Decision Rule: • When IRR > required rate of return, accept project. • When IRR < required rate of return, reject project.

9. 5.Modified Internal Rate of Return (MIRR): • This is given by: • PV Cost = PV of Terminal Value (TV) • I0 I1 I2 Ij CFt CFt+1 CFt+2 CFn-t • |--------|--------|----------|----------------|-------|--------|-----------------| • 0 1 2 j t t+1 t+2 n • where: It = cash outflows, COF; CFt = cash inflows

10. Incremental Cash Flows and Factors Affecting Cash Flows • Shareholders’ wealth maximization is the primary objective. • Shareholders are interested in how many additional dollars they will receive in the future for the dollars invested today. • Hence, incremental, not total cash flow, is what matters.

11. Differences Between “Incremental” and “Total” Cash Flows • Effects of sales from the (new) investment on existing divisions: • Cannibalization: New product taking away sales from the firm's existing products, e.g., substituting foreign production for parent company exports. • Sales Creation: New investment creates additional sales for existing products. The benefits of additional sales (or lost sales) and associated incremental (decreased) cash flows should be attributed to the project.

12. Transfer Pricing: Prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment. • As far as possible prices of a project's inputs and outputs should be market prices.

13. Other Factors: • Opportunity Costs: Project costs must include the true economic cost of any resource required for the project - already owned or just acquired. • Sunk Costs: Cash outlay already incurred, and which cannot be recovered regardless of whether project is accepted or rejected, e.g., site analysis, feasibility studies, etc. Exclude sunk costs from cost considerations.

14. Fees and Royalties: These are costs to the project but are benefits to the parent, e.g., legal counsel, power, lighting, heat, rent, R&D, H.Q. cost, and management costs, etc. • A project should be charged only for additional expenditures that are attributable to the project. • In general, incremental cash flows associated with an investment can be found by subtracting worldwide corporate cash flows without the new investment from "with" the new investment cash flows.

15. Foreign Complexities and Opportunities Capital budgeting analysis for a foreign project is considerably more complex than domestic case for a number of reasons including: • Parent Cash Flows Vs. Project Cash Flows: Parent cash flows often depend on the form of financing - so that cash flows cannot be clearly separated from financing decisions as is practicable in a purely domestic capital budgeting exercise.

16. Remittance of funds to parent is compounded by differences in tax systems and financial markets and institutions as well as legal and political constraints on funds movement. • Cash flows from affiliate to parent can be generated by an array of operational, financial or non-financial payments, e.g., fees, royalties, transfer pricing, etc. • Different rates of national inflation introduce changes in competitive position.

17. Unanticipated changes in foreign exchange rates have direct and indirect effects on costs, prices, and sales volume. • Transaction across segmented national markets may create opportunities for financial gains or lead to additional costs. • Benefits of enhanced global service network. • Diversification of production facilities. • Market diversification.

18. Availability of host government subsidized loans may complicate capital structure decisions and the appropriate WACC. • Political risks must be evaluated, and costs may be involved in the management of political risks. • Terminal value is more difficult to estimate, i.e., uncertain salvage value. • Foreign complexities must be “quantified” as modifications to either expected cash flows or the rate of discount.

19. International Capital Budgeting Decision Model • Multinational capital budgeting problems can be solved by appealing to the principle of “value additivity”. This states that the whole value of a project is equal to the sum of its parts. • The Adjusted Present Value (APV) rule divides up the present value terms and focuses on each component to maximize the development and use of information. • Each present value term employs an appropriatediscount rate for its level of systematic risk.

20. Lessard (1981) extends this approach to dealwith foreign investment projects as follows: APV= -PV of capital outlays +PV of remittable after tax operating cash flows +PV of tax savings from depreciation +PV of financial subsidies +PV of other tax savings +PV of extra (indirect) remittances +PV of project’s contribution to corporate debt capacity +PV of residual plant and equipment (salvage) • Multinational Capital Budgeting Examples. (See sample problem set III, part B)

21. Multinational Cost of Capital & Capital Structure A firm’s capital consists of: • Retained Earnings • Equity (existing or newly issued) • Preferred Stock • Debt (borrowed funds) • The firm’s cost ofretained earnings reflects the opportunity cost - what existing shareholders could have earned if they invested the funds themselves.

22. The firm’s cost ofnew equity also reflects an opportunity cost - what the new shareholders could have earned if they had invested their funds elsewhere. • The cost of new equity exceeds the cost of retained earnings by the floatation costs. • The firm’s cost of debt increases with the level of debt. Increases in the level of debt also increases the probability of default.

23. Tax deductibility of interest payments on debts enhances the attractiveness of debt financing. • A firm must maintain a proper balance between the tax advantage of debt and its disadvantage (greater probability of bankruptcy). • The firm’s weighted average cost of capital (WACC) can be computed as: (Total Capital = Debt + Equity + Pref. Stock) WACC = WdKd (1-t) + WpKp + WeKe

24. Assuming that the firm’s capital is made up ofdebt and equity, then: where: D = Proportion of capital (D+E) made up of debt, E = The proportion of equity, Kd = Cost of debt, Ke = Cost of Equity and t = tax rate.

25. Factors in Multinational Cost of Capital • Size of the Firm: The larger the size of the firm, the larger the amount that is borrowed. In addition, larger issues of stocks or bonds allow for reduced percentage flotation costs. • Access to International Capital Markets: Access to international capital markets allows MNCs to attract funds at lower costs than purely domestic firms. • International Diversification: Diversified cash flow sources result in more stable cash inflows for MNCs which may reduce the probability of bankruptcy and therefore reduce the cost of capital.

26. Exposure to Exchange Rate Risk: Firms that are highly exposed to exchange rate risk may experience greater cash inflow volatility. • However, exposure to a basket of currencies will mitigate or eliminate such a problem. • Exposure to Country Risks: To the extent to which country risks are not diversifiable, increased cash inflow volatility may result with attendant higher cost of capital.

27. Cost of Capital Across Countries: • Variations in the cost of capital across countries may help to explain why MNCs are able to adjust their international operations and sources of funds. • Differences in the cost of each capital component across countries may explain why MNCs based in some countries use more debt-intensive capital structure than MNCs based elsewhere. • Differences in the Risk-Free Interest Rate: The risk-free rate is frequently proxied by the yield on 3-month T-bills. • The rate is determined by supply and demand conditions in each country, tax laws, monetary policies, demographics, and economic conditions.

28. Differences in the Risk Premium: • The risk premium is affected by the relationship between borrowers and creditors (e.g.. Japan’s Keiretsu), and the propensity of governments to intervene and rescue ailing or failing firms (compare US. to UK). • Also firms in some countries have greater borrowing capacity because creditors are tolerant of higher degrees of financial leverage (e.g. Japanese and German firms have higher degrees of financial leverage than US. firms). • Country Differences in the Cost of Equity: • The cost of equity is related to investment opportunities in each country. • In a country with many investment opportunities, potential returns may be relatively high resulting in a relatively high opportunity cost of funds.

29. International Differences in Cost of Equity Capital • Effectiveness of a Country’s Legal Institutions: • Well-functioning legal systems protect investors, reduce monitoring and enforcement costs to investors, reduces a firms’ cost of capital by leveling the playing field among investors. • Differences in Securities Regulation: • Requirement of, and enforcement of, certain financial disclosures help to reduce asymmetric information between the firm and its investors and among investors.

30. Multinational Capital Structure: Some of the firm specific characteristics that affect MNCs’ capital structure include: • Stability of MNCs cash flows. • MNC credit risk - a MNC with assets acceptable as collateral has greater access to loans. • Level of retained earnings.

31. Influence of Country Characteristics • Entry and cross-border barriers to investing. • Interest rates in host countries are affected by capital controls, tax rates & country risks. • A MNC’s preference for debt or equity may depend on relative costs in a particular country. • Host country currency innovations. • Country risks. • Relative tax laws.

32. Multinational Target Capital Structure • MNCs may deviate from their target capital structure in host countries but still able to achieve their target capital structure on a consolidated basis. i.e., MNCs may ignore “local” target capital structure in favor of a “global” target capital structure.

33. Partially Owned Subsidiaries : • When MNCs allow (or are forced to allow) foreign subsidiaries to issue stocks to local investors, such a subsidiary becomes partially owned by the parent. This can affect MNCs’ capital structure. • In some countries, a MNC will be allowed to establish a subsidiary only if it meets the minimum percentage of ownership by local investors. • A minority interest in a subsidiary by local investors may, however, offer some protection against threats of any adverse action by the host government.

34. Capital Structure Across Countries • Firms in Japan and Germany tend to use a higherdegree of financial leverage than U.S or U.K firms. • The system of interlocking ownership in Japan may encourage a greater use of leverage. • Other International Factors…… • Stock restrictions in host countries • Interests rates in host countries • Strength of host country currencies • Country risk in host countries • Tax laws in host countries

35. Qu. 1: The following are major factors in multinational cost of capital except: • Size of the firm • Access to international capital markets • International diversification of firm • Exposure to exchange risk • Exposure to country risk Qu. 2: Which of the following is not a factor accounting for variations in the cost of capital across countries: • Differences in risk free interest rate • Differences in risk premium • Differences in cost of equity