Multinational Capital Budgeting
Multinational Capital Budgeting
Capital Budgeting in ForeignSubsidiaries
MNCs evaluate international projects byusing multinational capital budgeting,which compares the costs and benefitsof these projects.
Many international projects areirreversible and cannot be easily sold toother corporations at a reasonable price.Proper use of multinational capitalbudgeting can identify the internationalprojects worthy of implementation.
Subsidiary versus ParentPerspective
Should the capital budgeting for a multi-national project be conducted from theviewpoint of the subsidiary that willadminister the project, or the parent that willprovide most of the financing?
The results may vary with the perspectivetaken because the net after-tax cash inflowsto the parent can differ substantially fromthose to the subsidiary.
Subsidiary versus ParentPerspective
Since the subsidiary is a subset of theMNC, what is good for the subsidiarywould appear to be good for the MNC.
WRONG!
Subsidiary versus ParentPerspective
The difference in cash inflows is due to :
Tax differentials
What is the tax rate on remitted funds?
If the parent’s government imposes a hightax rate on the remitted funds, the projectmay be feasible from the subsidiary’s pointof view, but NOT from the parent’s point ofview!
Parent should NOT consider!
Regulations that restrict remittances
Where host government restrictionsrequire a percentage of the subsidiaryearnings to remain in the host countryand parent may never have access tothese funds, the project is NOT attractiveto the parent.
This may be considered though since theportion of funds not allowed to be sent tothe parent can be used to cover thefinancing costs over time.
Excessive remittances
The parent may charge its subsidiaryvery high administrative fees.
○Consider a parent that charges thesubsidiary very high administrative feesbecause management is centralized atthe headquarters, the fees represent anexpense for the subsidiary and for theparent, the fees represent revenue thatmay substantially exceed the actualcost of managing the subsidiary.
Exchange rate movements
When earnings are remitted to theparent, they are normally converted fromthe subsidiary’s local currency to theparent’s currency. The amount receivedby the parent is therefore influenced bythe existing exchange rate.
Subsidiary versus ParentPerspective
A parent’s perspective is appropriatewhen evaluating a project, since anyproject that can create a positive netpresent value for the parent shouldenhance the firm’s value.
However, one exception to this rule mayoccur when the foreign subsidiary is notwholly owned by the parent.
Cash Flows Generatedby Subsidiary
After-Tax Cash Flows toSubsidiary
Cash Flows Remitted bySubsidiary
After-Tax Cash FlowsRemitted by Subsidiary
Corporate Taxes Paid toHost Government
Retained Earnings bySubsidiary
Withholding Tax Paid toHost Government
Conversion ofFunds to Parent’sCurrency
PARENT
Process of RemittingSubsidiary Earnings tothe Parent
Input for MultinationalCapital Budgeting
The following forecasts are usuallyrequired:
1.Initial investment
2.Consumer demand
3.Product price
4.Variable cost
5.Fixed cost
6.Project lifetime
7.Salvage (liquidation) value
The following forecasts are usually required:
Input for MultinationalCapital Budgeting
9.Tax laws
10.Exchange rates
11.Required rate of return
8.Fund-transfer restrictions
Initial Investment
This may constitute the major source of fundsto support a particular project. Funds initiallyinvested in a project may include not onlywhatever is necessary to start the project butalso additional funds, such as working capital,to support the project over time. Such fundsare needed to finance inventory, wages, andother expenses until the project starts togenerate revenue. Because cash inflows willnot always be sufficient to cover upcoming cashoutflows, working capital is needed throughouta project’s lifetime.
Consumer Demand
An accurate forecast of consumer demandfor a product is quite valuable, but futuredemand is often difficult to forecast.Demand forecasts can sometimes be aidedby historical data on the market share otherMNCs in the industry pulled when theyentered this market, but historical data arenot always an accurate indicator of thefuture.
Price
The price at which the product could be soldcan be forecasted using competitiveproducts in the markets as a comparison.The future prices will most likely beresponsive to the future inflation rate of thehost country, but the future inflation rate isNOT known. Thus, future inflation ratesmust be forecasted in order to developprojections of the product price over time.
Variable Cost
Like the price estimate, variable-costforecasts can be developed from assessingprevailing comparative costs of thecomponents (i.e. hourly labor costs). Suchcosts should normally move in tandem withthe future inflation rate of the host country.Even if the VC/u can be accuratelypredicted, the projected total variable costmay be wrong if the demand is inaccuratelyforecasted.
Fixed Cost
Fixed cost is sensitive to any change in thehost country’s inflation rate from the time theforecast is made until the time the FC areincurred.
Project Lifetime
Some projects have indefinite lifetimes thatcan be difficult to assess, while otherprojects have designated specific lifetimes,at the end of which they will be liquidated.This makes the capital budgeting analysiseasier to apply.
An MNC does not always have completecontrol over the lifetime decision. In somecases, certain events (i.e. Political) mayforce the firm to liquidate the project earlierthan planned.
Salvage (liquidation) Value
The after-tax salvage value of most projectsis difficult to forecast. It will depend onseveral factors, including the success of theproject and the attitude of the hostgovernment toward the project. As anextreme possibility, the host governmentcould take over the project withoutadequately compensating the MNC.
Restriction on Fund Transfers
In some cases, a host government willprevent a subsidiary from sending itsearnings to the parent. This restriction mayreflect an attempt to encourage additionallocal spending or to avoid excessive sales ofthe local currency in exchange for someother currency.
Tax Laws
The tax laws on earnings generated by aforeign subsidiary or remitted to the MNC’sparent vary among countries. Becauseafter-tax cash flows are necessary for anadequate capital budgeting analysis,international tax effects must be determinedon any proposed foreign projects.
Exchange Rates
Any international project will be affected byexchange rate fluctuations during the life ofthe project, but these movements are oftenvery difficult to forecast.
Though hedging techniques can be used tocover short and long-term positions (throughforward contracts and swaps), the MNC hasno way of knowing the amount of funds thatit should hedge.
Required Rate of Return
Once the relevant cash flows of a proposedproject are estimated, they can bediscounted at the project’s required rate ofreturn, which may differ from the MNC’s costof capital because of the at particularproject’s risk.
MultinationalCapital Budgeting
Capital budgeting is necessary for alllong-term projects that deserveconsideration.
One common method of performing theanalysis is to estimate the cash flowsand salvage value to be received by theparent, and compute the net presentvalue (NPV) of the project.
MultinationalCapital Budgeting
NPV=– initial outlay
n
+ cash flow in period t
t =1 (1 + k )t
+ salvage value
(1 + k )n
k = the required rate of return on the project
n = project lifetime in terms of periods
If NPV > 0, the project can be accepted.
Capital Budgeting Analysis
Period t
1.Demand(1)
2.Price per unit(2)
3.Total revenue(1)(2)=(3)
4.Variable cost per unit(4)
5.Total variable cost (1)(4)=(5)
6.Annual lease expense(6)
7.Other fixed periodic expenses(7)
8.Noncash expense (depreciation)(8)
9.Total expenses(5)+(6)+(7)+(8)=(9)
10.Before-tax earnings of subsidiary(3)–(9)=(10)
11.Host government taxtax rate(10)=(11)
12.After-tax earnings of subsidiary(10)–(11)=(12)
Capital Budgeting Analysis
Period t
13.Net cash flow to subsidiary (12)+(8)=(13)
14.Remittance to parent(14)
15.Tax on remitted fundstax rate(14)=(15)
16.Remittance after withheld tax(14)–(15)=(16)
17.Salvage value(17)
18.Exchange rate(18)
19.Cash flow to parent(16)(18)+(17)(18)=(19)
20.Investment by parent(20)
21.Net cash flow to parent(19)–(20)=(21)
22.PV of net cash flow to parent(1+k) - t(21)=(22)
23.Cumulative NPVPVs=(23)
Factors to Consider inMultinational Capital Budgeting
Exchange rate fluctuations. Differentscenarios should be considered togetherwith their probability of occurrence.
Inflation. Although price/cost forecastingimplicitly considers inflation, inflation canbe quite volatile from year to year forsome countries.
Factors to Consider inMultinational Capital Budgeting
Financing arrangement. Financing costsare usually captured by the discountrate. However, many foreign projects arepartially financed by foreign subsidiaries.
Blocked funds. Some countries mayrequire that the earnings be reinvestedlocally for a certain period of time beforethey can be remitted to the parent.
Factors to Consider inMultinational Capital Budgeting
Uncertain salvage value. The salvagevalue typically has a significant impact onthe project’s NPV, and the MNC may wantto compute the break-even salvage value.
Impact of project on prevailing cash flows.The new investment may compete with theexisting business for the same customers.
Host government incentives. These shouldalso be considered in the analysis.
Adjusting Project Assessmentfor Risk
If an MNC is unsure of the cash flows ofa proposed project, it needs to adjust itsassessment for this risk.
One method is to use a risk-adjusteddiscount rate. The greater theuncertainty, the larger the discount ratethat is applied.
Many computer software packages arealso available to perform sensitivityanalysis and simulation.
Impact of Multinational Capital Budgetingon an MNC’s Value
E (CFj,t )=expected cash flows in currency j to be receivedby the parent at the end of period t
E (ERj,t )=expected exchange rate at which currency j canbe converted to dollars at the end of period t
k=weighted average cost of capital of the parent
Multinational Capital BudgetingDecisions