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Chapter 7 Cross-Border Capital Budgeting

Chapter 7 Cross-Border Capital Budgeting. Table of contents 7.1 The Algebra of Cross-Border Investment Analysis 7.2 An Example: Wendy’s Restaurant in Neverland 7.3 The Parent vs Local Perspective on Project Valuation 7.4 Special Circumstances in Cross-Border Investments 7.5 Summary.

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Chapter 7 Cross-Border Capital Budgeting

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  1. Chapter 7Cross-Border Capital Budgeting Table of contents 7.1 The Algebra of Cross-Border Investment Analysis 7.2 An Example: Wendy’s Restaurant in Neverland 7.3 The Parent vs Local Perspective on Project Valuation 7.4 Special Circumstances in Cross-Border Investments 7.5 Summary

  2. “Domestic” NPV calculations NPV0 = St E[CFt ] / (1+i )t 1.Estimate expected future cash flows E[CFt] Include only incremental cash flows Include all opportunity costs 2. Identify a risk-adjusted discount rate Discount nominal (real) CFs at nominal (real) discount rates Discount equity (debt) CFs at equity (debt) discount rates Discount CFs to debt and equity at the WACC Discount cash flows in a particular currency at a discount rate in that currency 3.Find NPV0

  3. Cross-border capital budgeting Foreign projects generate foreign currency cash flows. Recipe #1: Discount in the foreign currency and convert the foreign currency NPV to a domestic currency value at the spot exchange rate. Recipe #2: Convert expected future cash flows into domestic currency cash flows at expected future exchange rates and then discount in the domestic currency.

  4. Recipe #1: Discount in the foreign currency NPV0d = S0d/f [NPV0f ] = S0d/f [St E[CFtf ] / (1+if )t ] 1. Estimate CFtf 2. Identify if 3. Find NPV0d a. Calculate NPV0f by discounting E[CFtf] at if b. Convert NPV0f to NPV0d at S0d/f CF1f CF2f NPV0f if NPV0d = S0d/f NPV0f

  5. Recipe #2: Discount in the domestic currency NPV0d = St E[CFtd] / (1+id )t = St Ftd/f E[CFtf] / (1+id )t 1. Estimate CFtd a. Estimate CFtf b. Estimate Std/f = Ftd/f c. Convert CFtf to CFtd at Ftd/f 2 Identify id 3. Calculate NPV0d E[CF1f] E[CF2f] E[CFtd] . . . = Ftd/f E[CFtf] NPV0d id

  6. Equivalence of the two recipes NPV0d = St E[CFtd ] / (1+id )t plus E[CFtd ] = E[CFtf ] E[Std/f ] = E[CFtf ] Ftd/f yields NPV0d = St Ftd/f E[CFtf ] / (1+id )t Rule #2: Convert expected foreign currency cash flows to domestic cash flows and discount in the domestic currency. plus (1+id )t = (1+if )t (Ftd/f / S0d/f ) yields NPV0d = St Ftd/f E[CFtf ]/ {(1+if )t (Ftd/f / S0d/f )} = (S0d/f )St E[CFtf ] / {(1+if )t = (S0d/f )(NPV0f) Rule #1: Discount in the foreign currency and then convert into domestic currency at the spot exchange rate.

  7. An example: Wendy in Neverland U.S. Neverland Nominal government T-bill rate iF$ = 10% iFCr = 37.5% Real required return on T-bills rF$ = 1% rFCr = 1% Expected inflation p$» 8.91% pCr» 36.14% Nominal risk-adjusted required return i$ = 20% iCr = 50% Real risk-adjusted required return r$» 10.18% rCr» 10.18% Spot exchange rate S0Cr/$ = Cr4/$

  8. Suppose the int’l parity conditions hold If the international parity conditions hold, then (1+iCr) = (1+pCr)(1+rCr) Þ iFCr = (1.3614)(1.0100) -1 = 37.5% Þ iWACCCr = (1.3614)(1.1018) -1 = 50.0% (1+i$) = (1+p$)(1+r$) Þ iF$ = (1.0891)(1.0100) -1 = 10.0% Þ iWACC$ = (1.0891)(1.1018) -1 = 20.0% F1Cr/$/S0Cr/$ = (1+pCr) / (1+p$) = (1.3614) / (1.0891) = (1+iCr) / (1+i$) = (1.50) / (1.20) = (1+iFCr) / (1+iF$) = (1.3750) / (1.1000) = E[S1Cr/$] / S0Cr/$ = 1.25 Þ the dollar should sell at a 25% forward premium.

  9. Wendy’s expected future spot exchange rates Expected future spot exchange rates should reflect the 25% difference in inflation (or nominal interest rates) Time Date E[S1Cr/$] 0 12/31/97 Cr4.0000/$ 1 12/31/98 Cr5.0000/$ 2 12/31/99 Cr6.2500/$ 3 12/31/00 Cr7.8125/$ 4 12/31/01 Cr9.7656/$

  10. Details of the Neverland project • Investment of $10,000 (Cr40,000) for the ship at time t=0 • Investment of $6,000 (Cr24,000) for inventory at time t=0 • Expected revenues of Cr30,000, Cr60,000, Cr90,000, and Cr60,000 in years 1 through 4 • Variable operating costs are 20% of sales • Fixed operating costs are Cr2,000 at the end of the first year and increase at the rate of inflation thereafter • The ship is owned by the foreign affiliate and depreciated straight-line to a zero salvage value • Inventory is sold at the end of the project for Cr24,000 in real terms • The ship is expected to retain its Cr40,000 real value • Income and capital gains taxes are 50% in each country • All cash flows occur at the end of the year

  11. Wendy’s investment/disinvestment cash flows End-of-year CFs in crocs t=0 t=1 t=2 t=3 t=4 Purchase ship -Cr40,000 Purchase inventory -24,000 Sale of ship +Cr137,400 - Tax on sale of ship -68,700 Sale of inventory +82,440 - Tax on sale of inventory -29,220

  12. Wendy’s operating cash flows t=0 t=1 t=2 t=3 t=4 Revenues Cr30,000 Cr60,000 Cr90,000 Cr60,000 -Variable costs -6,000 -12,000 -18,000 -12,000 -Fixed cost -2,000 -2,723 -3,707 -5,046 -Depreciation -10,000 -10,000 -10,000 -10,000 Taxable income 12,000 35,277 58,293 32,954 - Taxes - 6,000 -17,639 -29,147 -16,477 Net income 6,000 17,639 29,147 16,477 +Depreciation 10,000 10,000 10,000 10,000 NCF from operations 16,000 27,639 39,147 26,477 E[CFtCr] -64,000 16,000 27,639 39,147 148,397 NPV0Cr = -Cr137 at iCr=50% or NPV0$ = -$34 at S0Cr/$ = Cr4/$

  13. Discount in the domestic currency

  14. Valuation when the international parity conditions do not hold NPVd < 0 NPVd > 0 Look for better projects in the foreign currency NPVf < 0 Reject Try to lock in the value NPVf in the foreign currency NPVf > 0 Accept

  15. Special circumstances • VPROJECT WITH SIDE EFFECT • = VPROJECT WITHOUT SIDE EFFECT + VSIDE EFFECT • Blocked funds • Subsidized financing • Negative-NPV tie-in projects • Expropriation risk • Tax holidays

  16. Blocked fundsExample: ½ of cash flow blocked in each of the first 3 years Market rate Hook’s rate (37½%) (0%) 20,797.0 8,000.0 26,127.0 13,819.5 26,914.019,573.5 Cr8,000 13,819.5 19,573.5 Cr20,657 73,838.0 41,393.0 Cr11,580 discounted at 37½% for four years Opportunity cost of blocked funds = Cr20,657-Cr11,580 = Cr9,077 VPROJECT W/ SIDE EFFECT = VPROJECT W/O SIDE EFFECT + VSIDE EFFECT = -Cr137-Cr9,077 = -Cr9,214 or -$2,303.5 at Cr4/$

  17. Subsidized financingExample: a below-market-rate loan of Cr40,000 at 37.5% Base Case: Suppose Wendy can borrow Cr40,000 at the prevailing croc corporate bond rate of 40% (0.40)(Cr40,000) = Cr16,000 in annual interest Alternative: Suppose Hook will loan Wendy Cr40,000 at the government borrowing rate of 37½% (0.375)(Cr40,000) = Cr15,000 in annual interest Net result: Cr1,000 in annual pre-tax interest savings or Cr500 in annual after-tax interest savings Valuing Wendy’s after-tax interest savings at the after-tax cost of 40%(1-0.5) = 20%, this is worth Cr1,295 today.

  18. Expropriation riskExample: a 50% chance of losing the time t=4 cash flow Alternative #1: Discounting at the croc required return iCr = 50% E[loss from expropriation] = [(0.5) [Cr148,397) / (1.50)4 ] / (Cr4.00/$)] = $3,664 the Cr4.00/$ spot exchange rate Alternative #2: Discounting at the dollar required return i$ = 20% E[loss from expropriation] = [ (0.5) [ (Cr148,397) / (Cr9.7656/$)] ] / (1.20)4 = $3,664 at the 10% U.S. discount rate

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