Slides prepared by April Knill, Ph.D., Florida State University Chapter 16 Additional Topics in International Capital Budgeting

Slides prepared by

April Knill, Ph.D., Florida State University

Chapter 16

Additional Topics in International

Capital Budgeting

© 2012 Pearson Education, Inc. All rights reserved. 16-2

16.1 Alternative Approaches to Capital Budgeting

• The ANPV Approach (Chapter 15)

– Value the anlevered firm

– Add financial side effects from, for example,

growth options

• WACC approach

– Most widely used

• Flow-to-equity approach

– At times, most easily calculated



• WACC approach to capital budgeting– Works well for projects with stable debt/equity ratios– Weights (for WACC) should be specific to the project not

the overall firm– Without taxes

• Modigliani and Miller (1958; 1961) find that with no taxes, debt doesn’t affect the value of the firm at all rWACC=rA

• As the leverage ratio increases, equity holders requires a higher rate of return

– With taxes• Only after-tax interest is required to be paid so this is less of a

burden to equity holders rWACC=weighted sum of after-tax required rate of return on debt and the required rate of return on firm’s equity < rA



• More on WACC– E[after-tax CFs] = Y; Start-up costs = I; fraction

financed by debt = D/VL; fraction financed by equity = E/VL

– NPV of project = 0 if PV(Y) = I

( ) ( )( ) ( )

Income paid to bondholders 1 Value of debt in the project

1

D

D L

r

r D V I

= − τ ×

= − τ ×

( ) ( )Income paid to stockholders Value of equi ty in the projectE E L Lr r E V I= × = ×

( )( ) ( ) WACCIncome from project 1D L E L Lr D V r E V I r Iτ= − + =⎡ ⎤⎣ ⎦



Suppose that the Teikiko Printing Co. is considering an investment of ¥20 billion in a modernization project. Assume that the company’s stockholders require an 8% rate of return, that the company’s bondholders require a 4% rate of return, that the Japanese corporate tax rate is 30%, and that 45% of the project will be financed by debt and 55% will be financed with equity. What is Teikiko Printing’s WACC? R = [0.45 * (1-0.30) * 0.04] + [0.55 * 0.08] = 0.0566 or 5.66%What perpetual annual income must the project generate if the project is to be viable, in the sense of being at least a zero net present value investment?0.0566 * ¥20B = ¥1.132B gives you an NPV = 0



• Deriving rA from rD and rE

– WACC uses the rates of return on traded securities (ANPV uses rate of return on the firm’s underlying assets)

• EL + D = VL = VU + τD

• VU = EL + [(1 – τ)D]

• rA {EL + [(1 – τ)D]} = [rD(1- τ)D]+[rEEL]

• rA ={D/[EL + (1 – τ)D]}*(1- τ)rD + {EL /[EL+ (1- τ)D]}*rE

ratio of debt to unlevered firm ratio of MV of equity to unlevered firm



In Example 16.1 Teikiko’s WACC was 5.66% when the required rate of return on its debt was 4% and the required rate of return on its equity was 8%. The project was zero NPV because the value of the project just equaled its cost, or ¥20 billion. Now, let’s use an ANPV analysis to check our logic.

Value of debt: 0.45 * ¥20B = ¥9B

Value of equity: ¥20B - ¥9B = ¥11B

rA = ¥9B/[¥11B + [(1-0.30) ¥9B]*(1-0.30)0.04 + ¥11B/[¥11B +

[(1-0.30) ¥9B]*(0.08) = 0.0654



• Pros and Cons of using WACC– WACC presupposes that the project will

perpetually provide the expected level of CFs– Assumes that the firm continuously monitors the

value of its debt and adjusts the debt to keep the D/VL ratio constant if this doesn’t happen could lead to valuation mistakes!

– Using same WACC for all projects is erroneous, especially in international capital budgeting applications due to the relative riskiness of foreign cash flows



• Flow-to-equity method of capital budgeting– Discounts the value of what stockholders expect

to receive once debt holders have been paid at the required rate of return on equity by discounting each cash flow (Y – (1-τ)rDD)

– Equivalent to WACC• Y=rEEL+(1-τ)rDD

• Y/VL=[rEEL+(1-τ)rDD]/VL=rWACC



Teikiko Printing Co. from the previous examples, using the flow-to-equity method of valuation. Remember that the project’s expected annual after-tax income to the all-equity firm was ¥1.132 billion and that it was zero NPV and cost ¥20 billion. The required rates of return are 4% on the debt and 8% on the equity. The firm will issue ¥9 billion of debt. With this information, what is the value of the levered equity from the FTE approach?

Expected annual after-tax income to the stockholders:

¥1.132B – (1-0.30) * 0.04 * ¥9B = ¥0.880B

Discounted PV(CFs):

¥0.880B/0.08 = ¥11B



• Pros and cons of alternative capital budgeting methods– ANPV Pro: allows managers to make informed decisions

about the economic profitability of a project versus other sources of value coming from financing and growth

– ANPV Pro: works well for international projects and demonstrates nicely the desirability of hedging foreign exchange risk

– ANPV Con: problematic if D/E ratio is going to be held constant (as in WACC)

– WACC and FTE Con: problematic if D/E ratio is going to change


16.2 Forecasting Cash Flows of Foreign Projects

• The choice of currency– Foreign currency, use appropriate foreign currency

discount rate (sometimes difficult to ascertain)– Foreign currency value of the CFs, multiply them by the

forex rate, then use domestic currency discount rate

• Reconciling the two methods for discounting foreign cash flows– The two approaches are the same when the discount rates

satisfy a parity condition like uncovered interest rate parity (Ch. 7)


Exhibit 16.1 Information on Australian and U.S. Interest Rates and Inflation Rates


16.3 Case Study: CMTC’s Australian Project

AUD47M ($63.45M) to reengineer plant with new robotics/ computerized machinery for later cost savings; S=$1.35/AUD; cost partially offset by sale of equipment for AUD11.83M; current costs of production AUD45.375M/yr (increasing at Australian inflation rate). Cost savings would be 10% the first year, 15% the second and 20% thereafter. Book value of existing equipment is AUD10.5M; corporate tax is 40%; USD equity risk premium of 5.5%

The after-tax cost savings of the projectDepreciation tax shields


Exhibit 16.2 Projected Project Cash Flows in Millions of Expected Australian Dollars


Exhibit 16.3 Forecasts of U.S. Dollar–Australian Dollar Exchange Rates from Interest Rate Parity



• Total expected after-tax cash flows in AUD• Getting USD NPV

– Forecast future spot rates– U.S. dollar discount rates

• Time value of money• Cash flows are not risk free

• USD NPV


Exhibit 16.4 Net Present Value of the Project in Millions of U.S. Dollars


Exhibit 16.5 Net Present Value of the Project in Millions of Australian Dollars



• How incorrect discounting leads to problems– Single discount rate – if you do that in this example, the NPV

would have been negative leading you to an incorrect decision

• Net present value of the project in AUD– Also possible to derive USD NPV by first discounting the E[AUD

CFs] with appropriate AUD equity discount rates (using market forecasts)

• Remember that using a single discount rate here is wrong here too!

• Expected real depreciation of the AUD


Exhibit 16.6 Forecasts of Real Depreciation of the AUD


16.4 Terminal Value When ROI Equals RWACC

• Develop explicit forecasts up to the point at which you think the firm’s ROI = rWACC

– If firm is earning ROI>rWACC, it should expand or competitors will enter the industry driving the return down

– Terminal value calculation = TV(t+10) = {NOPLAT(t+11) * [1-PB(t+11)]}/(r-g)

Setting ROI = rTV(t+10) = {NOPLAT(t+11) * [(r-g)/r]}/(r-g) =

= NOPLAT(t+11)/r



Conundrum Corporation has a WACC of 10% and a 10-year forecast for NOPLAT = $100M. If they invest just enough to offset depreciation, FCF in year t+10 will also be $100M. With no inflation and no growth, $100M will also be the forecast for all future periods. Hence,

What is Conundrum’s growth rate if NPVprojects=0 (i.e, ROI=r)

Since Conundrum invests 20% of NOPLAT, FCF(t+10) = $80M

If Conundrum grows at 2%, FCF(t+11) = $80M*1.02 = $81.6M

TV(t+10) = $81.6M/(0.10-0.02) = $1,020M

Or we can calculate the new TV directly from NOPLAT:

TV(t+10) = $102M/0.10 = $1,020M

MMMM

tTV 000,1$1.0

100$...

1.1

100$

1.1

100$)10(

2==++=+



• Terminal value with perpetual growth and expected inflation– Must modify cost of capital AND the terminal value

– 1+RWACC = (1+rWACC) * (1+πe)

– Cost of capital: if πe=10% then RWACC = 1.10 * 1.05 = 1.155

– TV:

– If the firm has a plowback rate of 20% and earns 10$ real ROI, growth will be 20% * 10%, or 2%, hence all CFs will grow at 7.10% (1.02 * 1.05 – 1)

where $85.7M – ($100M - $20M) * 1.071

MMMM

tTV 000,1$05.0155.0

105$...

155.1

3.110$

155.1

105$)10(

2=

−=++=+

MMMM

tTV 020,1$071.0155.0

7.85$...

155.1

8.91$

155.1

7.85$)10(

2=

−=++=+


Exhibit 16.7 Terminal Values in Year 10 with Inflation and Growth


Exhibit 16.7 Terminal Values in Year 10 with Inflation and Growth (cont.)


Exhibit 16.7 Terminal Values in Year 10 with Inflation and Growth (cont.)


16.5 Tax Shields on Foreign Currency Borrowing

• Tax implications of borrowing in a foreign currency (FC)– Just like in domestic currency but changes in exchange rate can

affect how much the borrower pays back• If the borrowed (foreign) currency strengthens against domestic

currency, borrower owes more• If the FC weakens against domestic currency borrower owes less

– Interest deduction at time t+1 = S(t+1) * i(FC) * D(FC)• Because high interest rate currencies are expected to depreciate

relative to lower interest rate currencies, the borrower expects to have a capital gain on the repayment of the principal

• Capital gain tax offsets the higher interest tax shield and prevents the existence of a tax incentive to borrow in high interest rate currencies



Banana Computers want to buy hard drives from a German or Japanese manufacturer. They can borrow EUR300M for 8 yrs @ 3.5% or JPY36,000M for 8 yrs @ 1.5%. Both rates are below their corresponding risk-free rates. Loans are for identical amounts based on S = JPY120/EUR.

Which loan should Banana Computers take?


Exhibit 16.8 The Value of a Dollar Loan


Exhibit 16.9 The Value of a Subsidized Euro Loan


Exhibit 16.10 The Value of a Subsidized Yen Loan



• Compare the loans by converting the expected future foreign currency CFs into expected future dollars, using expected future exchange rates– Exh. 16.9 and 16.10 use uncovered interest rate parity

• ANPV of Euro loan = $54.31M• ANPV of Yen loan = $50.75M

– Expected dollar appreciation against Euro implies that capital gains are expected on repayment of the Euro principal

– Expected dollar depreciation against Yen implies that capital losses are expected on repayment of the Yen principal

– Banana should take the Euro loan since it increases the value of the corporation by $54.31M


16.6 Conflicts Between Bondholders and Stockholders

• When a firm issues debt, potential conflicts of interest arise between bondholders and stockholders– The incentive to take risks – stockholders have the

incentive to take on risk • Bondholders want low variance projects• Equityholders want high variance projects

– The underinvestment problem – managers, who act in the interest of shareholders, don’t have the incentive to take on a +NPV project when bondholders get all of the value

• Emerging market crises

– Other managerial problems caused by financial distress• Cash distribution for shareholders • Misrepresentation of earnings


16.7 International Differences in Accounting Standards

• Makes international valuations complicated• International Accounting Standards Board (IASB)

– Voluntary for a while– Mandatory in some nations, i.e., EU since 2005– U.S. hasn’t adopted yet but allows cross-listed firms to use– Benefits

• Harmonize accounting standards• Better accounting standards may lead to better disclosure

– Costs• Benefit will be less for U.S. firms since GAAP is close to IASB• Costs for other countries will be steep (estimated $32M for

the first 3 years!)

Documents

Slides prepared by April Knill, Ph.D., Florida State University Chapter 16 Additional Topics in International Capital Budgeting