INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
17Chapter SeventeenInternational Capital Budgeting
Chapter Objective:
This chapter discusses the methodology that a
multinational firm can use to analyze the investment
of capital in a foreign country.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-1
Chapter Outline
? Review of Domestic Capital Budgeting
? The Adjusted Present Value Model
? Capital Budgeting from the Parent Firm’s
Perspective
? Risk Adjustment in the Capital Budgeting Process
? Sensitivity Analysis
? Real Options
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-2
1,Identify the SIZE and TIMING of all relevant cash flows
on a time line.
2,Identify the RISKINESS of the cash flows to determine
the appropriate discount rate.
3,Find NPV by discounting the cash flows at the appropriate
discount rate.
4,Compare the value of competing cash flow streams at the
same point in time.
Review of Domestic Capital
Budgeting
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-3
Review of Domestic Capital
Budgeting
The basic net present value equation is
0
1 )1()1(
CKTVKCFN P V TT
T
t
t
t ?
???? ??Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow in year T,including return
of net working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-4
Review of Domestic Capital
Budgeting
The NPV rule is to accept a project if NPV ? 0
0)1()1( 0
1
?????? ?
?
CKTVKCFN P V TT
T
t
t
t
and to reject a project if NPV ? 0
.0)1()1( 0
1
?????? ?
?
CKTVKCFN P V TT
T
t
t
t
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-5
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
)1()1)(( τIDτIDOCRCF ttttttt ????????
Rt is incremental revenue
Ct is incremental operating
cash flow
Dt is incremental depreciation
It is incremental interest expense
? is the marginal tax rate
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-6
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
)1()1)(( τIDτIDOCRCF ttttttt ????????
)1(( τIDNI ttt ????
ttt DτD τOCR ????? )1)((
tt DτN O I ??? )1(
ttt τDτOCR ???? )1)((
tt τDτO C F ??? )1(
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-7
Review of Domestic Capital
Budgeting
We can use
ttt τDτO C FCF ??? )1(
0
1 )1()1(
CKTVKCFN P V TT
T
t
t
t ?
???? ??
to restate the NPV equation
0
1 )1()1(
)1( C
K
TV
K
τDτO C FN P V
T
T
T
t
t
tt ?
???
??? ?
?
as:
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-8
The Adjusted Present Value Model
Can be converted to adjusted present value (APV)
0
1 )1()1()1(
)1( C
K
TV
K
τD
K
τO C FN P V
T
T
t
t
T
t
t
t ?
?????
?? ?
?
By appealing to Modigliani and Miller’s results.
0
1 )1()1()1()1(
)1( C
K
TV
i
τI
i
τD
K
τO C FA P V
T
u
T
t
t
t
t
T
t
t
u
t ?
???????
?? ?
?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-9
The Adjusted Present Value Model
The APV model is a value additivity approach to
capital budgeting,Each cash flow that is a source
of value to the firm is considered individually.
Note that with the APV model,each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.
0
1 )1()1()1()1(
)1( C
K
TV
i
τI
i
τD
K
τO C FA P V
T
u
T
t
t
t
t
T
t
t
u
t ?
???????
?? ?
?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-10
Capital Budgeting from the Parent
Firm’s Perspective
? Donald Lessard developed an APV model for a
MNC analyzing a foreign capital expenditure,The
model recognizes many of the particulars peculiar
to foreign direct investment.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-11
Capital Budgeting from the Parent
Firm’s Perspective
The operating cash flows must
be translated back into the
parent firm’s currency at the
spot rate expected to prevail
in each period.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
The operating cash flows
must be discounted at the
unlevered domestic rate
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-12
Capital Budgeting from the Parent
Firm’s Perspective
OCFt represents only the
portion of operating cash
flows available for remittance
that can be legally remitted to
the parent firm.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
The marginal corporate tax
rate,?,is the larger of the
parent’s or foreign
subsidiary’s.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-13
Capital Budgeting from the Parent
Firm’s Perspective
S0RF0 represents the value of
accumulated restricted funds
(in the amount of RF0) that
are freed up by the project.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
Denotes the present value
(in the parent’s currency) of
any concessionary loans,
CL0,and loan payments,
LPt,discounted at id,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-14
Estimating the Future Expected
Exchange Rates
We can appeal to PPP:
t
f
t
d
t π
πSS
)1(
)1(
0 ?
??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-15
A recipe for international decision makers:
1,Estimate future cash flows in foreign currency.
2,Convert to U.S,dollars at the predicted exchange rate.
3,Calculate APV using the U.S,cost of capital.
International Capital Budgeting
Example
– 600 200 500 300
0 1 year 2 years 3 years
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-16
Facts
International Capital Budgeting
%6
%15
$
$
?
?
π
i
Is this a good
investment from the
perspective of the
U.S,shareholders?
– 600 200 500 300
0 1 year 2 years 3 years
? = 3%
S0($/ ) = $.55265
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-17
E[St($/ )] can be found by appealing to the interest rate differential:
E[S1($/ )] = [(1.06/1.03)?S0($/ )]
International Capital Budgeting
CF0 = ( 600) S0($/ ) =( 600)($.5526/ ) = $331.6
= [(1.06/1.03)?($.5526/ ) ] = $.5687/
so CF1 = ( 200)($.5687/ ) = $113.7
CF2 = [(1.06)2/(1.03)2 ] S0($/ )?( 500) = $292.6
APV = -$331.60 + $113.7/(1.15) + $292.6/(1.15)2 + $180.7/(1.15)3
= $107.3 > 0 so accept,
CF1 = ( 200)E[St($/ )]
Similarly,
Solution
CF3 = [(1.06)3/(1.03)3 ] S0($/ )?( 300) = $180.7
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-18
Risk Adjustment in the Capital
Budgeting Process
? Clearly risk and return are correlated.
? Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-19
Sensitivity Analysis
? In the APV model,each cash flow has a
probability distribution associated with it.
? Hence,the realized value may be different from
what was expected.
? In sensitivity analysis,different estimates are used
for expected inflation rates,cost and pricing
estimates,and other inputs for the APV to give the
manager a more complete picture of the planned
capital investment,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-20
Real Options
? The application of options pricing theory to the
evaluation of investment options in real projects is
known as real options.
? A timing option is an option on when to make the
investment.
? A growth option is an option to increase the scale of the
investment.
? A suspension option is an option to temporarily cease
production.
? An abandonment option is an option to quit the
investment early.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-21
End Chapter Seventeen
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
17Chapter SeventeenInternational Capital Budgeting
Chapter Objective:
This chapter discusses the methodology that a
multinational firm can use to analyze the investment
of capital in a foreign country.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-1
Chapter Outline
? Review of Domestic Capital Budgeting
? The Adjusted Present Value Model
? Capital Budgeting from the Parent Firm’s
Perspective
? Risk Adjustment in the Capital Budgeting Process
? Sensitivity Analysis
? Real Options
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-2
1,Identify the SIZE and TIMING of all relevant cash flows
on a time line.
2,Identify the RISKINESS of the cash flows to determine
the appropriate discount rate.
3,Find NPV by discounting the cash flows at the appropriate
discount rate.
4,Compare the value of competing cash flow streams at the
same point in time.
Review of Domestic Capital
Budgeting
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-3
Review of Domestic Capital
Budgeting
The basic net present value equation is
0
1 )1()1(
CKTVKCFN P V TT
T
t
t
t ?
???? ??Where:
CFt = expected incremental after-tax cash flow in year t,
TVT = expected after tax cash flow in year T,including return
of net working capital,
C0 = initial investment at inception,
K = weighted average cost of capital.
T = economic life of the project in years.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-4
Review of Domestic Capital
Budgeting
The NPV rule is to accept a project if NPV ? 0
0)1()1( 0
1
?????? ?
?
CKTVKCFN P V TT
T
t
t
t
and to reject a project if NPV ? 0
.0)1()1( 0
1
?????? ?
?
CKTVKCFN P V TT
T
t
t
t
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-5
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
)1()1)(( τIDτIDOCRCF ttttttt ????????
Rt is incremental revenue
Ct is incremental operating
cash flow
Dt is incremental depreciation
It is incremental interest expense
? is the marginal tax rate
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-6
Review of Domestic Capital
Budgeting
For our purposes it is necessary to expand the NPV
equation.
)1()1)(( τIDτIDOCRCF ttttttt ????????
)1(( τIDNI ttt ????
ttt DτD τOCR ????? )1)((
tt DτN O I ??? )1(
ttt τDτOCR ???? )1)((
tt τDτO C F ??? )1(
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-7
Review of Domestic Capital
Budgeting
We can use
ttt τDτO C FCF ??? )1(
0
1 )1()1(
CKTVKCFN P V TT
T
t
t
t ?
???? ??
to restate the NPV equation
0
1 )1()1(
)1( C
K
TV
K
τDτO C FN P V
T
T
T
t
t
tt ?
???
??? ?
?
as:
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-8
The Adjusted Present Value Model
Can be converted to adjusted present value (APV)
0
1 )1()1()1(
)1( C
K
TV
K
τD
K
τO C FN P V
T
T
t
t
T
t
t
t ?
?????
?? ?
?
By appealing to Modigliani and Miller’s results.
0
1 )1()1()1()1(
)1( C
K
TV
i
τI
i
τD
K
τO C FA P V
T
u
T
t
t
t
t
T
t
t
u
t ?
???????
?? ?
?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-9
The Adjusted Present Value Model
The APV model is a value additivity approach to
capital budgeting,Each cash flow that is a source
of value to the firm is considered individually.
Note that with the APV model,each cash flow is
discounted at a rate that is appropriate to the
riskiness of the cash flow.
0
1 )1()1()1()1(
)1( C
K
TV
i
τI
i
τD
K
τO C FA P V
T
u
T
t
t
t
t
T
t
t
u
t ?
???????
?? ?
?
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-10
Capital Budgeting from the Parent
Firm’s Perspective
? Donald Lessard developed an APV model for a
MNC analyzing a foreign capital expenditure,The
model recognizes many of the particulars peculiar
to foreign direct investment.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-11
Capital Budgeting from the Parent
Firm’s Perspective
The operating cash flows must
be translated back into the
parent firm’s currency at the
spot rate expected to prevail
in each period.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
The operating cash flows
must be discounted at the
unlevered domestic rate
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-12
Capital Budgeting from the Parent
Firm’s Perspective
OCFt represents only the
portion of operating cash
flows available for remittance
that can be legally remitted to
the parent firm.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
The marginal corporate tax
rate,?,is the larger of the
parent’s or foreign
subsidiary’s.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-13
Capital Budgeting from the Parent
Firm’s Perspective
S0RF0 represents the value of
accumulated restricted funds
(in the amount of RF0) that
are freed up by the project.
?
???
?
???
?
????
?
?
?
?
?
?
?
?
?
T
t
t
d
tt
T
ud
TT
T
t
t
d
tt
T
t
t
d
tt
T
t
t
ud
tt
i
LPS
CLSRFSCS
K
TVS
i
τIS
i
τDS
K
τO C FS
APV
1
000000
111
)1()1(
)1()1()1(
)1(
Denotes the present value
(in the parent’s currency) of
any concessionary loans,
CL0,and loan payments,
LPt,discounted at id,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-14
Estimating the Future Expected
Exchange Rates
We can appeal to PPP:
t
f
t
d
t π
πSS
)1(
)1(
0 ?
??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-15
A recipe for international decision makers:
1,Estimate future cash flows in foreign currency.
2,Convert to U.S,dollars at the predicted exchange rate.
3,Calculate APV using the U.S,cost of capital.
International Capital Budgeting
Example
– 600 200 500 300
0 1 year 2 years 3 years
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-16
Facts
International Capital Budgeting
%6
%15
$
$
?
?
π
i
Is this a good
investment from the
perspective of the
U.S,shareholders?
– 600 200 500 300
0 1 year 2 years 3 years
? = 3%
S0($/ ) = $.55265
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-17
E[St($/ )] can be found by appealing to the interest rate differential:
E[S1($/ )] = [(1.06/1.03)?S0($/ )]
International Capital Budgeting
CF0 = ( 600) S0($/ ) =( 600)($.5526/ ) = $331.6
= [(1.06/1.03)?($.5526/ ) ] = $.5687/
so CF1 = ( 200)($.5687/ ) = $113.7
CF2 = [(1.06)2/(1.03)2 ] S0($/ )?( 500) = $292.6
APV = -$331.60 + $113.7/(1.15) + $292.6/(1.15)2 + $180.7/(1.15)3
= $107.3 > 0 so accept,
CF1 = ( 200)E[St($/ )]
Similarly,
Solution
CF3 = [(1.06)3/(1.03)3 ] S0($/ )?( 300) = $180.7
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-18
Risk Adjustment in the Capital
Budgeting Process
? Clearly risk and return are correlated.
? Political risk may exist along side of business risk,
necessitating an adjustment in the discount rate.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-19
Sensitivity Analysis
? In the APV model,each cash flow has a
probability distribution associated with it.
? Hence,the realized value may be different from
what was expected.
? In sensitivity analysis,different estimates are used
for expected inflation rates,cost and pricing
estimates,and other inputs for the APV to give the
manager a more complete picture of the planned
capital investment,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-20
Real Options
? The application of options pricing theory to the
evaluation of investment options in real projects is
known as real options.
? A timing option is an option on when to make the
investment.
? A growth option is an option to increase the scale of the
investment.
? A suspension option is an option to temporarily cease
production.
? An abandonment option is an option to quit the
investment early.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
17-21
End Chapter Seventeen
