Lecture 7 INTERNATIONAL CAPITAL BUDGETING

Cost of capital for international investment • Estimating cost of capital for international investment complicated and controversial.
• Applying same cost of capital for international project as for domestic project probably conservative – may understate diversification benefit.
Cash Flows • Focus on incremental CFs • CF due to project • Base case: • Incremental CF = Global CF with project – Global CF without project.
Cannibalisation • New product/operation taking sales away from firm‟s existing products?
Estimating risk of foreign project:
• Ideally use local company as proxy • Alternatively, estimate risk of proxy industry in local market. • Third (least preferred) alternative – home industry beta adjusted for foreign country beta. • E.g., US firm e 1.2, rf 4% and expected risk premium 5%. Considering investment in Switzerland. re?
Opportunity costs • Alternative use of resources?
Transfer pricing • May distort project profitability. • For investment appraisal purposes, use transfer pricing at market prices.
Against LT bonds Geo UK US 4.4 5.0 Arith 5.6 7.0 Geo 4.8 5.8 Arith 6.5 7.7 Against ST bills
World
4.6
5.6
4.9
6.2
• Geometric or arithmetic average?
o Geometric possibly more appropriate for describing LT realised returns, and more consistent with IRR o But is historic risk premium suitable predictor for future risk premium? • Risk premium non-stable, • Survivorship bias, based on index of successful firms, etc. • Forecast Rp: 3-5%?? • (Was that too low?)
Investment appraisal and political risk
• Interest rate (rf). • CAPM theoretically single-period (ST?) model, but LT interest rate may be more appropriate when estimating cost of capital for LT investment.
• Sales that would have been lost anyway (e.g., competition) should not be counted as cannibalisation.
Sales creation • Increased sales of existing products if project accepted?
• Focus on non-diversifiable risk • Economic and political risk largely diversifiable • High project risk may be offset by diversification benefit if low correlation between foreign market and home (or global) market index. • Beta of foreign project may be lower than risk of domestic project.
• Does project open up future investment opportunities – growth options?
Parent vs Project cash flows • Value of project = NPV of CFs available to investors • Parent rather than subsidiary incremental CFs determine project value.
Fees and Royalties • Transfers from sub to parent do not affect MNCs overall CFs? Starbucks?
• Only incremental fixed costs and overheads relevant
• Global CF without project seldom status quo. • Existing products cannibalised by others if not by you?
Three-stage approach to evaluation:
• Incremental project CF from subsidiary‟s perspective • Forecast amount, timing and form of transfers from subsidiary to parent, after tax. • Account for indirect benefits and costs (cannibalisation and sales creation, etc).
• Using parent debt ratio (future debt structure) • Weights at MV, not BV.
• But WACC only appropriate if new project:
o Same risk o Same capital structure o Finance elements same cost as company overall
• If US against world portfolio 1 and Swz 0.83. • re US: 4%+1.2*5% 10% • re Swz: 4%+1.2*0.83*5% 9%
• Equity risk premium (rp). • rp = rm - rf Dimson et al. (2002) in Buckley (2004): • Historical percentage equity risk premium, 1900 – 2000.
Cash Flows to Parent
Factors that need to be considered…
• • • • • • • • • • • Initial Investment Consumer demand Price Variable Cost Fixed Cost Project Life Salvage Value Restrictions on find transfer Tax laws Exchange rates Required rate of return
Subsidiary Vs Parent Perspective
o o o o Tax Differentials Restricted Remittanchange rate movements
Process of remitting earnings to the parent
• • Unlikely to be the case in international investment
• Beta • • Are world markets segmented or integrated? Use either home- or world- market portfolio. • E.g., w/Global CAPM: •
• £ cost of local currency loan = interest cost + exchange rate change.
• If parity theories hold, expected exchange rate change match interest differential home country cost of local (foreign) debt ≈ cost of home debt? • (But, tax differences and subsidies may cause net costs to differ).
INTERNATIONAL CAPITAL BUDGETING