Multinational Capital Budgeting

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Multinational Capital Budgeting
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Capital Budgeting in Foreign Subsidiaries

• MNCs evaluate international projects by using
  multinational capital budgeting, which compares
  the costs and benefits of these projects.
• Many international projects are irreversible and
  cannot be easily sold to other corporations at a
  reasonable price. Proper use of multinational
  capital budgeting can identify the international
  projects worthy of implementation.

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Subsidiary versus Parent Perspective

• Should the capital budgeting for a multi-national
  project be conducted from the viewpoint of the
  subsidiary that will administer the project, or
  the parent that will provide most of the
  financing?
• The results may vary with the perspective taken
  because the net after-tax cash inflows to the
  parent can differ substantially from those to the
  subsidiary.

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Subsidiary versus Parent Perspective

• Since the subsidiary is a subset of the MNC, what
  is good for the subsidiary would appear to be
  good for the MNC.

WRONG!
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Subsidiary versus Parent Perspective

• The difference in cash inflows is due to
• Tax differentials
• What is the tax rate on remitted funds?
• If the parents government imposes a high tax
  rate on the remitted funds, the project may be
  feasible from the subsidiarys point of view, but
  NOT from the parents point of view!

Parent should NOT consider!
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• Regulations that restrict remittances
• Where host government restrictions require a
  percentage of the subsidiary earnings to remain
  in the host country and parent may never have
  access to these funds, the project is NOT
  attractive to the parent.

This may be considered though since the portion
of funds not allowed to be sent to the parent can
be used to cover the financing costs over time.
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• Excessive remittances
• The parent may charge its subsidiary very high
  administrative fees.
• Consider a parent that charges the subsidiary
  very high administrative fees because management
  is centralized at the headquarters, the fees
  represent an expense for the subsidiary and for
  the parent, the fees represent revenue that may
  substantially exceed the actual cost of managing
  the subsidiary.

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• Exchange rate movements
• When earnings are remitted to the parent, they
  are normally converted from the subsidiarys
  local currency to the parents currency. The
  amount received by the parent is therefore
  influenced by the existing exchange rate.

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Subsidiary versus Parent Perspective

• A parents perspective is appropriate when
  evaluating a project, since any project that can
  create a positive net present value for the
  parent should enhance the firms value.
• However, one exception to this rule may occur
  when the foreign subsidiary is not wholly owned
  by the parent.

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Cash Flows Generated by Subsidiary
Corporate Taxes Paid to Host Government
After-Tax Cash Flows to Subsidiary
Retained Earnings by Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax Paid to Host Government
After-Tax Cash Flows Remitted by Subsidiary
Conversion of Funds to Parents Currency
Process of Remitting Subsidiary Earnings to the
Parent
PARENT
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Input for MultinationalCapital Budgeting

• The following forecasts are usually required
• 1. Initial investment
• 2. Consumer demand
• 3. Product price
• 4. Variable cost
• 5. Fixed cost
• 6. Project lifetime
• 7. Salvage (liquidation) value

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Input for MultinationalCapital Budgeting
The following forecasts are usually required
8. Fund-transfer restrictions

• 9. Tax laws
• 10. Exchange rates
• 11. Required rate of return

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Initial Investment

• This may constitute the major source of funds to
  support a particular project. Funds initially
  invested in a project may include not only
  whatever is necessary to start the project but
  also additional funds, such as working capital,
  to support the project over time. Such funds are
  needed to finance inventory, wages, and other
  expenses until the project starts to generate
  revenue. Because cash inflows will not always be
  sufficient to cover upcoming cash outflows,
  working capital is needed throughout a projects
  lifetime.

14
Consumer Demand

• An accurate forecast of consumer demand for a
  product is quite valuable, but future demand is
  often difficult to forecast. Demand forecasts
  can sometimes be aided by historical data on the
  market share other MNCs in the industry pulled
  when they entered this market, but historical
  data are not always an accurate indicator of the
  future.

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Price

• The price at which the product could be sold can
  be forecasted using competitive products in the
  markets as a comparison. The future prices will
  most likely be responsive to the future inflation
  rate of the host country, but the future
  inflation rate is NOT known. Thus, future
  inflation rates must be forecasted in order to
  develop projections of the product price over
  time.

16
Variable Cost

• Like the price estimate, variable-cost forecasts
  can be developed from assessing prevailing
  comparative costs of the components (i.e. hourly
  labor costs). Such costs should normally move in
  tandem with the future inflation rate of the host
  country. Even if the VC/u can be accurately
  predicted, the projected total variable cost may
  be wrong if the demand is inaccurately forecasted.

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Fixed Cost

• Fixed cost is sensitive to any change in the host
  countrys inflation rate from the time the
  forecast is made until the time the FC are
  incurred.

18
Project Lifetime

• Some projects have indefinite lifetimes that can
  be difficult to assess, while other projects have
  designated specific lifetimes, at the end of
  which they will be liquidated. This makes the
  capital budgeting analysis easier to apply.
• An MNC does not always have complete control over
  the lifetime decision. In some cases, certain
  events (i.e. Political) may force the firm to
  liquidate the project earlier than planned.

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Salvage (liquidation) Value

• The after-tax salvage value of most projects is
  difficult to forecast. It will depend on several
  factors, including the success of the project and
  the attitude of the host government toward the
  project. As an extreme possibility, the host
  government could take over the project without
  adequately compensating the MNC.

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Restriction on Fund Transfers

• In some cases, a host government will prevent a
  subsidiary from sending its earnings to the
  parent. This restriction may reflect an attempt
  to encourage additional local spending or to
  avoid excessive sales of the local currency in
  exchange for some other currency.

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Tax Laws

• The tax laws on earnings generated by a foreign
  subsidiary or remitted to the MNCs parent vary
  among countries. Because after-tax cash flows
  are necessary for an adequate capital budgeting
  analysis, international tax effects must be
  determined on any proposed foreign projects.

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Exchange Rates

• Any international project will be affected by
  exchange rate fluctuations during the life of the
  project, but these movements are often very
  difficult to forecast.
• Though hedging techniques can be used to cover
  short and long-term positions (through forward
  contracts and swaps), the MNC has no way of
  knowing the amount of funds that it should hedge.

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Required Rate of Return

• Once the relevant cash flows of a proposed
  project are estimated, they can be discounted at
  the projects required rate of return, which may
  differ from the MNCs cost of capital because of
  the at particular projects risk.

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MultinationalCapital Budgeting

• Capital budgeting is necessary for all long-term
  projects that deserve consideration.
• One common method of performing the analysis is
  to estimate the cash flows and salvage value to
  be received by the parent, and compute the net
  present value (NPV) of the project.

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MultinationalCapital Budgeting

• NPV initial outlay
• n
• S 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 gt 0, the project can be accepted.

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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 tax tax rate?(10)(11)
• 12. After-tax earnings of subsidiary (10)(11)(1
  2)

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Capital Budgeting Analysis

• 
  Period t
• 13. Net cash flow to subsidiary (12)(8)(13)
• 14. Remittance to parent (14)
• 15. Tax on remitted funds tax 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 (1k) -
  t?(21)(22)
• 23. Cumulative NPV ?PVs(23)

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Factors to Consider in Multinational Capital
Budgeting

• Exchange rate fluctuations. Different scenarios
  should be considered together with their
  probability of occurrence.
• Inflation. Although price/cost forecasting
  implicitly considers inflation, inflation can be
  quite volatile from year to year for some
  countries.

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Factors to Consider in Multinational Capital
Budgeting

• Financing arrangement. Financing costs are
  usually captured by the discount rate. However,
  many foreign projects are partially financed by
  foreign subsidiaries.
• Blocked funds. Some countries may require that
  the earnings be reinvested locally for a certain
  period of time before they can be remitted to the
  parent.

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Factors to Consider in Multinational Capital
Budgeting

• Uncertain salvage value. The salvage value
  typically has a significant impact on the
  projects NPV, and the MNC may want to compute
  the break-even salvage value.
• Impact of project on prevailing cash flows. The
  new investment may compete with the existing
  business for the same customers.
• Host government incentives. These should also be
  considered in the analysis.

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Adjusting Project Assessmentfor Risk

• If an MNC is unsure of the cash flows of a
  proposed project, it needs to adjust its
  assessment for this risk.
• One method is to use a risk-adjusted discount
  rate. The greater the uncertainty, the larger the
  discount rate that is applied.
• Many computer software packages are also
  available to perform sensitivity analysis and
  simulation.

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Impact of Multinational Capital Budgetingon an
MNCs Value