FIN480 International

Financial Management

Chapter 14: Multinational

Capital Budgeting
 Chapter Objectives

 To compare the capital budgeting analysis of an MNC’s subsidiary with that of its
parent,

 To demonstrate how multinational capital budgeting can be applied to

determine whether an international project should be implemented,

 To show how multinational capital budgeting can be adapted to account for

special situation such as alternative exchange rate scenarios or when subsidiary
financing is considered, and

 To explain how the risk of international projects can be assessed.

 Subsidiary versus Parent Perspective

 Capital budgeting should be based on the parents perspective.

 Some projects might be feasible for subsidiary but not for parent.

 Net after-tax cash inflows can differ from parents to subsidiary.

The difference in cash inflows is due to

 Tax differentials – tax rate on remitted funds

 Restriction on remitted funds

 Exchange rate movements

 Summary of Factors

Cash flows generated by subsidiary

Corporate tax 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 parent

currency

Parent
 Input for Multinational Capital Budgeting

Initial investment

 Funds to start the project

 Working capital

Price and consumer demand

 Future inflation rate forecast for product price projections

 Consumer demand forecast
 Input for Multinational Capital Budgeting

Cost

 Variable cost forecast – hourly labor cost and cost of materials

• Affected by consumer demand
 Fixed cost – rent or leasing expense

Tax Laws

 On earnings generated by a foreign subsidiary.

 On earnings remitted to MNC’s parent.
 Input for Multinational Capital Budgeting

Remitted Funds

 Host government’s policy for remitted funds to MNC’s Parent

Exchange rates

 Exchange rate fluctuations.

• Foreign currency cash flows can be hedged.
 Input for Multinational Capital Budgeting

Salvage value

 The attitude of the host government toward the project

 Project lifetime

Required rate of return

 Based on the risk of that project

 Multinational Capital Budgeting Example

Spartan, Inc., is considering the development of a subsidiary in Singapore. The project

would end in 4 years. All relevant information follows

Initial investment

 20 million Singapore dollars

 Spot rate - $0.50 per Singapore dollar

S$20 million × $0.5 = $10 million

 Multinational Capital Budgeting Example

Price and consumer demand

Cost
 Multinational Capital Budgeting Example

Tax Laws

 Can depreciate plant and equipment at a maximum rate of S$2 million per year.
 Income tax – 20%
 Withholding tax – 10%

Remitted funds

 No restrictions on the cashflows to be sent back to the parent firm.

 Multinational Capital Budgeting Example

Exchange rates

 Spot exchange rate - $0.50 per Singapore dollar

Salvage value

 Singapore government will pay S$12 million to assume the ownership after 4 years.

Required rate of return

 15%
 Multinational Capital Budgeting Example

The project will be approved if the Present Value of estimated the Future Cash Flow
exceed the Initial Investment

Net Present Value  - IO  

n
CF t
 SV n

(1 k ) (1 k )
t n
t 1

Where,
IO = initial outlay (investment)
CF = cash flow in period t
t

SV n = salvage value

k = required rate of return on the project

n = lifetime of the project (number of periods)
Capital Budget Analysis: Spartan, Inc.
Capital Budget Analysis: Spartan, Inc.
 Other Factors to Consider (Spartan, Inc.)

Exchange rate Fluctuations

Singapore Dollar U.S. Dollar

Singapore Dollar U.S. Dollar

 Other Factors to Consider (Spartan, Inc.)

Exchange rate Fluctuations

 Other Factors to Consider (Spartan, Inc.)

Exchange rate Fluctuations

 Other Factors to Consider (Spartan, Inc.)

Exchange rates tied to parent currency

Hedged exchange rates - Using Forward contract

Assume, Spartan would hedge S$4,000,000 per year using the forward contract – forward rate $0.48
 Other Factors to Consider (Spartan, Inc.)

Year 1 Year 2 Year 3 Year 4

16Total S$ cash flows remitted after withholding taxes S$5,400,000 S$5,400,000 S$5,400,000 S$5,400,000
16a. Hedged S$cash flows remitted after withholding taxes S$4,000,000 S$4,000,000 S$4,000,000 S$4,000,000
16b. Unhedged cash flows = (16) -(16a.) S$1,400,000 S$1,400,000 S$1,400,000 S$13,400,000
17Salvage Value S$12,000,000
18a. Forward rate of S$ $0.48 $0.48 $0.48 $0.48
18b. Expected future spot rate of S$ $0.50 $0.50 $0.50 $0.50
19a. Hedged cash flows to parent $1,920,000 $1,920,000 $1,920,000 $1,920,000
19b. Unhedged cash flows to parent $700,000 $700,000 $700,000 $6,700,000
19c. Total cash flows to parent $2,620,000 $2,620,000 $2,620,000 $2,620,000
20PV of parent cash flows
21Initial investment by parent $10,000,000
22Cumulative NPV -$7,721,739 -$5,740,643 -$4,017,951 $910,562
 Other Factors to Consider (Spartan, Inc.)

Inflation

 Inflation fluctuation affect both cost and revenues

 Exchange rate of highly inflated countries tend to be weaken overtime .
 Other Factors to Consider (Spartan, Inc.)

Financing Arrangement

Subsidiary Financing

• Subsidiary borrows S$10 million to purchase the offices that are leased in the
initial example
 Interest payment S$1 million annually
 Will pay the principal at the end of year 4

Here,
• Lease payments of S$1 million per will not be necessary.
• Subsidiary S$10 million from the sale of the offices.
 Other Factors to Consider (Spartan, Inc.)

Financing Arrangement

Parent Financing

• Parent’s initial investment is $15 million

Here,
• Salvage value – S$22 million (S$10 million from the sale offices + S$12 million for selling
the rest of the subsidiary.
Other Factors to Consider (Spartan, Inc.)
Other Factors to Consider (Spartan, Inc.)
 Other Factors to Consider (Spartan, Inc.)
Blocked Funds
 Other Factors to Consider (Spartan, Inc.)

Impact of project prevailing cash flows

 Spartan currently exports tennis rackets from its U.S. plant to Singapore;

 Spartan, Inc., still considers establishing a subsidiary in Singapore because it expects

production costs to be lower in Singapore than in the United States; and

 Without a subsidiary, Spartan’s export business to Singapore is expected to generate net

cash flows of $1 million over the next 4 years.
 Other Factors to Consider (Spartan, Inc.)

Impact of project prevailing cash flows

 Other Factors to Consider (Spartan, Inc.)

Real Option

 Option on specified real assets such as machinery or a facility

 Adjusting Process Assessment for risk

 Risk adjusted discount rate

 Sensitivity analysis
 Simulation
 End of Chapter Problem

13.
a) –$91,339.03
b) $14,519.78
24
$740,772
26
a) $208,475
b) –$11,864
c) $225,423
d) $5,085
f) $196,949, –$14,915
 End of Chapter Problem (27 a)

Year 1 Year 2 Year 3

Demand 40,000 50,000 60,000
Price Per unit 500 511 530
Total Revenue 20,000,000 25,550,000 31,800,000
Variable cost per unit 30 35 40
Total variable cost 1,200,000 1,750,000 2,400,000
Fixed expense 6,000,000 6,000,000 6,000,000
Depreciation expense 5,000,000 5,000,000 5,000,000
Interest expense 2,800,000 2,800,000 2,800,000
Total expenses 15,000,000 15,550,000 16,200,000
Before-tax earnings of subsidiary 5,000,000 10,000,000 15,600,000
Host government tax 1,500,000 3,000,000 4,680,000
After tax earnings of subsidiary 3,500,000 7,000,000 10,920,000
Net cash flow to subsidiary 8,500,000 12,000,000 15,920,000
NZ$ remitted by subsidiary 8,500,000 12,000,000 15,920,000
Withholding tax on remitted funds 850,000 1,200,000 1,592,000
NZ$ remitted after withholding taxes 7,650,000 10,800,000 14,328,000
Salvage value 52,000,000
Exchange rate of NZ$ $ 0.52 $ 0.54 $0.56
Cash flow to parent 3,978,000 5,832,000 37,143,680
PV of parent cash flows 3,315,000 4,050,000 21,495,185
Initial investment by parent -$25,000,000
Cumulative NPV (21,685,000) (17,635,000) 3,860,185
 End of Chapter Problem (27 b)

Year 1 Year 2 Year 3

Demand 40,000 50,000 60,000
Price Per unit 500 511 530
Total Revenue 20,000,000 25,550,000 31,800,000
Variable cost per unit 30 35 40
Total variable cost 1,200,000 1,750,000 2,400,000
Fixed expense 6,000,000 6,000,000 6,000,000
Depreciation expense 5,000,000 5,000,000 5,000,000
Total expenses 12,200,000 12,750,000 13,400,000
Before-tax earnings of subsidiary 7,800,000 12,800,000 18,400,000
Host government tax 2,340,000 3,840,000 5,520,000
After tax earnings of subsidiary 5,460,000 8,960,000 12,880,000
Net cash flow to subsidiary 10,460,000 13,960,000 17,880,000
NZ$ remitted by subsidiary 10,460,000 13,960,000 17,880,000
Withholding tax on remitted funds 1,046,000 1,396,000 1,788,000
NZ$ remitted after withholding taxes 9,414,000 12,564,000 16,092,000
Salvage value 70,000,000
Exchange rate of NZ$ $ 0.52 $0.54 $0.56
Cash flow to parent 4,895,280 6,784,560 48,211,520
PV of parent cash flows 4,079,400 4,711,500 27,900,185
Initial investment by parent -$35,000,000
Cumulative NPV (30,920,600) (26,209,100) 1,691,085
 End of Chapter Problem (27 d)

Year 1 Year 2 Year 3

Net cash flow to subsidiary 8,500,000 12,000,000 15,920,000
12,720,000
9,550,600
NZ$ remitted by subsidiary 38,190,600
Withholding tax on remitted funds 3,819,060
NZ$ remitted after withholding taxes 34,371,540
Salvage value 52,000,000
Exchange rate of NZ$ $ 0.52 $ 0.54 $ 0.56
Cash flow to parent 48,368,062
PV of parent cash flows 27,990,777
Initial investment by parent -$25,000,000
Cumulative NPV 2,990,777
 End of Chapter Problem (27)

e) $22,449,601
f) The present value of forgone cash flow is $30,654,222, which is higher than the proceeds
(27,000,000) from the divestiture.

Year 2 Year 3
Cash flows to parent 5,832,000 37,143,680
PV of parent cash
flows forgone if
project is divested 4,860,000 25,794,222
 Quiz

21st March, 2019

On chapter 14

Individual Assignment

Chapter 14 Blades, Inc. Case

Submit the assignment in both soft copy and hard copy
Deadline – 21st March, 2019
Email: nafees.reza.r@gmail.com
Class Schedule
End of Chapter 14