Chapter 18

1. Chapter 18 Multinational Capital Budgeting

2. Multinational Capital Budgeting: Learning Objectives • Extend the domestic capital budgeting analysis to evaluate a Greenfield foreign project • Distinguish between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment • Adjust the capital budgeting analysis of a foreign project for risk • Introduce the use of real option analysis as a complement to DCF analysis in the evaluation of potential international investments

3. Multinational Capital Budgeting • Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects • Capital budgeting follows same framework as domestic budgeting • Identify initial capital invested or put at risk • Estimate cash inflows, including a terminal value or salvage value of investment • Identify appropriate discount rate for PV calculation • Apply traditional NPV or IRR analysis

4. Complexities of Budgeting for a Foreign Project • Several factors make budgeting for a foreign project more complex • Parent cash flows must be distinguished from project • Parent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing • Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as stand alone may provide cash flows but overall adds no value to entire organization • Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

5. Complexities of Budgeting for a Foreign Project • An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. • Managers must anticipate differing rates of national inflation which can affect differing cash flows • Use of segmented national capital markets may create opportunity for financial gain or additional costs • Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC • Managers must evaluate political risk • Terminal value is more difficult to estimate because potential purchasers have widely divergent views

6. Project versus Parent Valuation • Most firms evaluate foreign projects from both parent and project viewpoints • The parent’s viewpoint analyses investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments • The parent’s viewpoint gives results closer to traditional NPV capital budgeting analysis • Project valuation provides closer approximation of effect on consolidated EPS

7. Illustration: Cemex Goes Abroad • Cementos Mexicanos (Cemex) is considering construction of plant in Indonesia (Semen Indonesia) as a Greenfield project • Cemex is listed on both US and Mexican markets but most of its capital is US dollar denominated so evaluation of project is in US dollars

8. START Cementos Mexicanos (Mexico) Semen Indonesia (Sumatra, Indonesia) US$ invested in Indonesia cement manufacturing firm END Is the project investment Justified (NPV > 0)? Estimated cash flows of project Parent viewpoint Capital Budget (U.S. dollars) Project Viewpoint Capital Budget (Indonesian rupiah) Cash flows remitted to Cemex (Rp to US$) Illustration: Cemex Goes Abroad

9. Illustration: Cemex Goes Abroad • Financial assumptions • Capital Investment – cost to build plant estimated at $150/tonne but Cemex believes it can build the plant at a cost of $110/tonne • Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is estimated at Rp22 trillion • With straight line depreciation on equipment values at Rp17.6 trillion costing 1.76 trillion per year

10. Illustration: Cemex Goes Abroad • Financial assumptions • Financing – plant would be financed with 50% equity (all from Cemex) and 50% debt • Debt is broken down, with Cemex providing 75% and a bank consortium providing the remaining 25% • Cemex’s WACC (in US dollars) is 11.98% • For the local project (in rupiah) the WACC is 33.257%

11. Illustration: Cemex Goes Abroad

12. Illustration: Cemex Goes Abroad • Financial assumptions • Revenues – sales are based on export and the plant will operate at 40% capacity producing 8 million tonnes per year • Cement will be sold in export market at $58/tonne • Costs – cost per ton is estimated at Rp115,000 in 1999 and rising at the rate of inflation (30%) per year • For export costs, loading costs of $2.00/tonne and shipping costs of $10/tonne must also be added

13. Illustration: Cemex Goes Abroad

14. Illustration: Cemex Goes Abroad

15. 457 Illustration: Cemex Goes Abroad • Project Viewpoint Capital Budget • Semen Indonesia’s free cash flows are found by looking at EBITDA and not EBT • Taxes are calculated based on this amount • Terminal value is calculated for the continuing value of the plant after year 5 • TV is calculated as a perpetual net operating cash flow after year 5

16. Illustration: Cemex Goes Abroad

17. Illustration: Cemex Goes Abroad

18. Illustration: Cemex Goes Abroad • Parent Viewpoint Capital Budget • Now cash flows estimates are constructed from parent’s viewpoint • Cemex must now use it’s cost of capital and not the project’s • Recall that Cemex’s WACC was 11.98% • However, Cemex requires an additional yield of 6% for international projects, thus the discount rate will be 17.98% • This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint

19. Illustration: Cemex Goes Abroad • Sensitivity Analysis: Project Viewpoint Measurement • Political risk – biggest risk is blocked funds or expropriation • Analysis should build in these scenarios and answer questions such as how, when, how much, etc. • Foreign exchange risk • Analysis should also consider appreciation or depreciation of the US dollar

20. Illustration: Cemex Goes Abroad • Sensitivity Analysis: Parent Viewpoint Measurement • When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways; • Adjusting the discount rates • Adjusting the cash flows

21. Illustration: Cemex Goes Abroad • Adjusting discount rates • The first method is to treat all foreign risk as a single problem, by adjusting the discount rate applicable to foreign projects relative to the rate used for domestic projects to reflect the greater foreign exchange risk, political risk, agency costs, asymmetric information and other uncertainties • However, adjusting the discount rate applied to a foreign project’s cash flow to reflect these uncertainties does not penalize NPV in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time

22. Illustration: Cemex Goes Abroad • Adjusting cash flows • In the second method, we incorporate foreign risks in adjustments to forecasted cash flows of the project • The discount rate for the foreign project is risk-adjusted only for overall business and financial risk, in the same manner as for domestic projects • It is important to remember that the process of forecasting cash flows is extremely subjective – humility is key!

23. Illustration: Cemex Goes Abroad • Shortcomings of each • In many cases, neither adjusting the discount rate nor adjusting cash flows is optimal • For example, political uncertainties are a threat to the entire investment, not just the annual cash flows • Apart from anticipated political and foreign exchange risks, MNEs sometimes worry that taking on foreign projects may increase the firm’s overall cost of capital because of investor’s perceptions of foreign risk; in these cases diversification is a risk mitigant

24. Illustration: Cemex Goes Abroad • Real Option Analysis • DCF analysis cannot capture the value of the strategic options, yet real option analysis allows this valuation • Real option analysis includes the valuation of the project with future choices such as • The option to defer • The option to abandon • The option to alter capacity • The option to start up or shut down (switching)

25. Illustration: Cemex Goes Abroad • Real Option Analysis • Real option analysis treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis) • The valuation of real options and the variables’ volatilities is similar to equity option math

26. Summary of Learning Objectives • The proposed greenfield investment in Indonesia by Cemex was analyzed within the traditional capital budgeting framework • Foreign complications, including foreign exchange and political risks, were introduced to the analysis

27. Summary of Learning Objectives • Parent cash flows must be distinguished from project cash flows. Each contributes to a different view of value • Parent cash flows often depend on the form of financing, thus cash flows cannot be clearly separated from financing decisions • Additional cash flows generated by new investments may be in part or wholly taken away from another foreign subsidiary – thus the net result may be negative or flat

28. Summary of Learning Objectives • Remittance of funds to the parent must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, and local business and capital market norms • Cash flows from subsidiaries to parent can be generated by an array of non-financial payments • Differing rates of national inflation must be anticipated because of their importance in causing changes in cash flows

29. Summary of Learning Objectives • A foreign project’s capital budgeting analysis should be adjusted for potential foreign exchange and political risks • Alternative methods are used for adjusting for risk, including adding an additional risk premium to the discount factor used, decreasing expected cash flows and conducting detailed sensitivity analysis

30. Summary of Learning Objectives • Real options is a different way of thinking about investment values – it is a cross between decision tree analysis and pure option valuation • Real option valuation also allows evaluation of the option to defer, to abandon, to alter capacity or the option of switching

31. Trident’s Chinese Market Entry – Real Options • Trident is evaluating the possibility of entering the Chinese market • As part of the management team’s analysis of a potential market entry strategy, the corporate finance team estimated the expected gross profits of the venture ($10 million) • However, this estimate did not cover the initial capital investment in research and development required to implement the market entry plan ($15 million)

32. Trident’s Chinese Market Entry – Real Options • It was determined that the research and development effort could shed more light on the actual costs that would be incurred in the market entry project • After the investment (expenditure of the $15 million) the firm would know which cost path it would be on and would therefore provide more information as to the ending gross profit of the firm (which could actually be $50 million in a low cost scenario) • The team began to think of the $15 million as a purchase of a call option on the project

33. Trident’s Chinese Market Entry – Real Options • This is an example of Real Option Analysis • Real Options, like DCF and other analyses, is a tool used by management teams to evaluate investments • In fact, these methods are complementary, each showing sources of value from a potential investment • Real Option analysis is gaining in use and popularity as its structure acknowledges the time sequence of a project, describing cash inflows and outflows at different points in time

34. Trident’s Option Analysis of Chinese Market Entry If the firm invests an additional $15 million in market research and development, it will be able to identify market development cost Identified Development Cost Estimated Gross Operating Profit High Cost ($120) Decide to Stop: $90 - $120 = ($30) Invest in R&D ($15) Medium Cost ($80) Decide to Proceed: $90 - $80 = $10 Low Cost ($40) Decide to Proceed: $90 - $40 = $50 Time Investing in the market R&D is equivalent to Buying A Call Option

35. Trident’s Chinese Market Entry – Real Options • How does real option analysis differ from traditional expected value analysis? • How does real option analysis use information gathering differently from discounted cash flow analysis? • Recalculate both the expected return analysis and the real option analysis for the Chinese market entry assuming that the revenue probabilities were 25% high and 75% low • Is the project acceptable under either of the decision-making methodologies?

36. Exhibit 18.1 A Roadmap to the Construction of Semen Indonesia’s Capital Budget

37. Exhibit 18.2 Investment and Financing of the Semen Indonesia Project (all values in 000s unless otherwise noted)

38. Exhibit 18.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses

39. Exhibit 18.4 Semen Indonesia’s Pro Forma Income Statement (Millions of Rupiah)

40. Exhibit 18.5 Semen Indonesia’s Capital Budget: Project Viewpoint (Millions of Rupiah)

41. Exhibit 18.6 Semen Indonesia’s Remittance and Capital Budget: Parent Viewpoint (Millions of Rp and US$)

42. Exhibit 1 Trident’s Analysis of Chinese Market Entry

43. Exhibit 2 Trident’s Option Analysis of Chinese Market Entry