Tutorial Week 12: International Capital Budgeting Shapiro: Chapters 16 + 17

Tutorial
Week 12
International Capital Budgeting
Shapiro: Chapters 16 + 17
B&H: Chapters 15 + 16
\
from SHAPIRO – Multinational Financial Management (10E)
from BEKAERT & HODRICK – International Financial Management (2E)
YOUR TUTOR & TUTOR IN CHARGE
Peter Kjeld Andersen
peter.andersen@unsw.edu.au
PARENT’S PERSPECTIVE
(i.e. when cash flows are first converted to the parent’s domestic currency
at the expected future spot rates and then discounted)
NPV IS NEGATIVE NPV IS POSITIVE
REJECT ALSO!
This is a BAD project when evaluated as
NPV IS REJECT! from the project’s perspective. But it
looks good from the parent perspective
NEGATIVE (duh!) purely because of expected favourable
currency movements. This is basically
PROJECT’S just using a project as an excuse for
PRESPECTIVE currency speculation.
(when cash flows are

discounted in the ACCEPT! (maybe…) ACCEPT!
project’s domestic
This is a GOOD project when evaluated Assuming you’ve factored in all side
currency and then the from the project’s perspective. But effects and opportunity costs into your
NPV is converted at future adverse exchange rate changes incremental cash flows and NPV, then
today’s spot rate to the are expected to hurt the parent firm’s this is just a GOOD project.
parent’s currency) NPV IS captured value.
POSITIVE The firm should try to find a way to But do we hedge currency risk or not?!?
hedge the currency risk now to capture IT DEPENDS!
the NPV. Finance in the local currency, If NPVParent > NPVProject, maybe not**
use currency forwards, swapping debt If NPVParent < NPVProject, then YES.
to the foreign currency, sell project to a
local investor, etc. **depends on our risk tolerance
FINS3616 — Peter Kjeld Andersen (2018-S2)

You work for a Brazilian firm that is considering a foreign investment in the United States. The investment
yields expected after-tax United States dollar (USD) cash flows (in millions) as follows:
YEAR 0 YEAR 1 YEAR 2 YEAR 3
CF –USD 1,700 USD 650 USD 650 USD 650
Expected inflation is 6.0% in the Brazilian real and 2.0% in the United States dollar. Assume that the
international parity conditions hold.
Required returns for projects in this risk class are:
BRL
rWACC = 19.0% in Brazilian real
USD
rWACC = 14.509% in United States dollars
The spot exchange rate is:
SBRL/USD
0 = BRL 3.8735/USD
Q. What is the NPV of the investment from the project’s perspective? That is, calculate NPV0BRL | rWACC
USD
Q. What is the NPV of the investment from the parent’s perspective? That is, calculate NPV0BRL | rWACC
BRL
Q. Compare the results. Why do we observe the results that we do?

Q. What is the NPV of the investment from the project’s perspective?
A. To find the NPV from the project’s perspective, we:
I. Discount the United States dollar cash flows at the appropriate risk-adjusted United States dollar
discount rate; and then
II. Convert this value into Brazilian real at the today’s current spot rate
Step I: Discount the USD cash flows using the risk-appropriate USD discount rate
CF1USD CF2USD CF3USD
NPV USD
= CF
USD
+ + +
(1 + r ) (1 + r ) (1 + r )
0 0 1 2 3
USD USD USD
WACC WACC WACC
USD 650 USD 650 USD 650

= −USD 1,700 + + + = −USD 203.73
( 1 + 0.14509 ) ( 1 + 0.14509 ) ( 1 + 0.14509 )
1 2 3
Step II: Convert the NPV from the project currency (USD) at today’s spot rate to the parent currency (BRL)
NPV0BRL = NPV0USD  SBRL/USD
0
= ( −USD 203.73 )  BRL3.8735/USD

= −BRL 789.2

Q. What is the NPV of the investment from the parent’s perspective?
A. To find the NPV from the parent’s perspective, we:
I. Calculate the expected future spot rates based off of Relative Purchasing Power Parity
II. Convert the United States dollar project cash flows into the parent company’s currency at the
expected future spot rates; and then
III. Discount the Brazilian real cash flows at the appropriate risk-adjusted Brazilian real discount rate
Step I: Find the expected future spot rates based off of Relative PPP
1 1
 1 +  BRL   1 + 0.06 
E  S BRL/USD
 = S BRL/USD
 USD 
= BRL 3.8735/USD   = BRL 4.0254/USD
1 0
 1 +    1 + 0.02 
2 2
BRL/USD  1 +    1 + 0.06 
BRL
E  S 2
BRL/USD
 = S0   = BRL 3.8735/USD  1 + 0.02  = BRL 4.1833/USD
 1 +  USD
  
3 3
 1 +  BRL   1 + 0.06 
E  S BRL/USD
 = S BRL/USD
 USD 
= BRL 3.8735/USD  1 + 0.02  = BRL 4.3473/USD
1+ 
3 0
 

A. Continued…
Step II: Convert the USD project cash flows at the spot rates to the BRL:
CF0BRL = CF0USD  SBRL/USD
0
= ( −USD 1,700 )  BRL 3.8735/USD = −BRL 6,584.95

CF1BRL = CF1USD  E  SBRL/USD
1

= USD 650  BRL 4.0254/USD = BRL 2,616.51
2

= USD 650  BRL 4.1833/USD = BRL 2,719.12
3

= USD 650  BRL 4.3473/USD = BRL 2,825.75
Step III: Discount the BRL cash flows using the risk-appropriate BRL discount rate
CF1BRL CF2BRL CF3BRL
NPV BRL
= CFBRL
+ + +
(1 + r ) (1 + r ) (1 + r )
0 0 1 2 3
BRL BRL BRL
WACC WACC WACC
BRL 2,616.51 BRL 2,719.12 BRL 2,825.75

= −BRL 6,584.95 + + + = −BRL 789.2
( 1 + 0.19 ) ( 1 + 0.19 ) ( 1 + 0.19 )
1 2 3

Q. Compare the results. Why do we observe the results that we do?
A. The NPV of the project via both the project perspective and parent perspective methods is –$789.2 million.
This is the case because the international parity conditions hold.
We used the inflation rates to estimate the expected future spot rates based off of Relative PPP.
And if we were to remove those same inflation rates from the nominal risk-appropriate discount rates in
each currency using the Fisher Equation, we would find the real risk-appropriate discount rates as:
1 + rnom = ( 1 + rreal )( 1 +  ) → rreal =
( 1 + rnom ) − 1
After removing the effects of each
(1 +  ) country’s inflation from the nominal
In Brazil: discount rates, we see that investments
BRL
r =
( 1+r BRL
) − 1 = ( 1 + 0.19 ) − 1 = 0.1226 = 12.26%
WACC(nom)
of this risk class have the same real
discount rate of 12.26% in both
WACC(real)
(1 +  ) BRL
( 1 + 0.06 ) currencies.
In the United States:
This implies that uncovered interest rate
USD
rWACC(real) =
( 1 + rWACC(nom)
USD
) − 1 = ( 1 + 0.14509 ) − 1 = 0.1226 = 12.26% parity must also hold (& international
(1 +  )USD
( 1 + 0.02 ) fisher effect, etc.), which is why both
methods resulted in the same NPV.
You work for a Swedish firm that is considering a foreign investment in Denmark. The investment yields
expected after-tax Danish krone (DKK) cash flows (in millions) as follows:
CF –DKK 1,700 DKK 650 DKK 650 DKK 650
Expected inflation is 16.0% in the Swedish krona and 3.0% in the Danish krone.
SEK
rWACC = 13.5% in Swedish krona
DKK
rWACC = 13.1% in Danish krone
S0SEK/DKK = SEK 1.3696/DKK
Q. What is the correct course of action for the managers to take?

A. To find the NPV from the project’s perspective, we:
I. Discount the Danish krone cash flows at the appropriate risk-adjusted Danish krone discount rate; and
then
II. Convert this value into Swedish krona at today’s current spot rate
Step I: Discount the DKK cash flows using the risk-appropriate DKK discount rate
CF1DKK CF2DKK CF3DKK
NPV DKK
= CFDKK
+ + +
(1 + r ) (1 + r ) (1 + r )
0 0 1 2 3
DKK DKK DKK
WACC WACC WACC
DKK 1,050 DKK 1,050 DKK 1,050

= −DKK 2,800 + + + = −DKK 324.99
( 1 + 0.1310 ) ( 1 + 0.1310 ) ( 1 + 0.1310 )
1 2 3
Step II: Convert the NPV from the project currency (DKK) at today’s spot rate to the parent currency (SEK)
NPV0SEK = NPV0DKK  S0SEK/DKK
= ( −DKK 324.99 )  SEK1.3696/DKK
= − SEK 445.11

A. To find the NPV from the parent’s perspective, we:
I. Calculate the expected future spot rates based off of Relative Purchasing Power Parity
II. Convert the Danish krone project cash flows into the parent company’s currency at the expected
future spot rates; and then
III. Discount the Swedish krona cash flows at the appropriate risk-adjusted Swedish krona discount rate
Step I: Find the expected future spot rates based off of Relative PPP
1 1
 1 +  SEK   1 + 0.16 
E  S SEK/DKK
 = S SEK/DKK
 DKK 
= SEK 1.3696/DKK   = SEK 1.5425/DKK
1 0
 1 +    1 + 0.03 
2 2
SEK/DKK  1 +    1 + 0.16 
SEK
E  S 2
SEK/DKK
 = S0   = SEK 1.3696/DKK  1 + 0.03  = SEK 1.7371/DKK
 1 +  DKK
  
3 3
 1 +  SEK   1 + 0.16 
E  S SEK/DKK
 = S SEK/DKK
 DKK 
= SEK 1.3696/DKK  1 + 0.03  = SEK 1.9564/DKK
1+ 
3 0
 

A. Continued…
Step II: Convert the DKK project cash flows at the spot rates to the SEK:
CF0SEK = CF0DKK  S0SEK/DKK
= ( −DKK 2,800 )  SEK 1.3696/DKK = −SEK 3,834.88
CF1SEK = CF1DKK  E  S 1SEK/DKK 
= DKK 1,050  SEK 1.5425/DKK = SEK 1,619.59
= DKK 1,050  SEK 1.7371/DKK = SEK 1,824.00
= DKK 1,050  SEK 1.9564/DKK = SEK 2,054.21
Step III: Discount the BRL cash flows using the risk-appropriate BRL discount rate
CF1SEK CF2SEK CF3SEK
NPV SEK
= CF SEK
+ + +
(1 + r ) (1 + r ) (1 + r )
0 0 1 2 3
SEK SEK SEK
WACC WACC WACC
SEK 1,619.59 SEK 1,824.00 SEK 2,054.21

= − SEK 3,834.88 + + + = SEK 412.91
( 1 + 0.1350 ) ( 1 + 0.1350 ) ( 1 + 0.1350 )
1 2 3

Q. What is the correct course of action for the managers of the firm?
A. The NPV of the project:
• was NEGATIVE from the project’s perspective at –SEK 445.11 million
• was POSITIVE from the parent’s perspective at SEK 412.91 million
This is a bad project that should be REJECTED.
The only reason that it looks positive from the parent’s perspective is due to the favourable exchange
forecasts. Specifically, the forecast real appreciation of the project currency (the Danish krone) against the
parent company’s currency (the Swedish krona).
If the firm wanted to speculate on the SEK/DKK exchange rate, there are cheaper and more efficient ways of
doing so than investing in a capital budgeting project (…such as through derivatives).
Instead, the firm should keep looking for positive NPV projects in Denmark.

You work for an Indian firm that is considering a foreign investment in the United States. The investment
yields expected after-tax United States dollar (USD) cash flows (in millions) as follows:
CF –USD 1,400 USD 675 USD 675 USD 675
Expected inflation is 9.0% in the Indian rupee and 6.0% in the United States dollar. Assume that the
international parity conditions hold.
INR
rWACC = 14.0% in Indian rupee USD
rWACC = 10.862% in United States dollar

SINR/USD
0 = INR 79.648/USD
The U.S. government has USD-denominated bonds outstanding that currently yield 7.70% per annum.
Your firm pays a marginal corporate tax rate to the U.S. government of 35%, which is the same marginal
tax rate that your firm pays on its parent company profits in India.
Q. Suppose that all of the USD cash flows generated by the project must be loaned to the U.S. government at
an interest rate of 0% per annum until one year after the completion of the project (i.e. until t=4).
Factoring in the opportunity cost of these blocked funds, what is the NPV of the project in Indian rupees?
Q. Suppose that all of the USD cash flows generated by the project must be loaned to the U.S. government at
an interest rate of 0% per annum until one year after the completion of the project (i.e. until t=4).
Factoring in the opportunity cost of these blocked funds, what is the NPV of the project in Indian rupees?
A. As the parity conditions hold, it is easiest to take the “project perspective” approach. We must:
I. Discount the USD cash flows at the appropriate risk-adjusted USD rate to get the USD value of the
project without any side effects
II. Calculate the opportunity cost today of the blocked funds in USD by taking the difference between the
value of those funds as though they are not blocked and their value when they are blocked.
III. Calculate the value of the project with this blocked fund side effect by subtracting the opportunity
cost of the blocked funds from the value of the project without any side effects
IV. Convert this final value into Indian rupee at today’s current spot rate
Step I: Discount the USD cash flows as normal to find the value of the project without any side effects
NPV USD
= CF
USD
+ + +
( ) ( ) ( )
0, no side effects 0 1 2 3
1+rUSD
WACC 1+rUSD
WACC 1 + rWACC
USD
USD 675 USD 675 USD 675

= −USD 1,400 + + + = USD 253.47
( 1 + 0.10862 ) ( 1 + 0.10862 ) ( 1 + 0.10862 )
1 2 3

Step II: Calculate the opportunity cost today of the blocked funds in USD
First, find the after-tax risk-free rate from the USD government bond yield:
(
rRFUSD(after-tax) = rRFUSD  1 − Tax USD
% )
= 7.70%  ( 1 − 0.35 ) = 5.005%
Then use that after-tax risk-free rate to value both the unblocked and the blocked funds:
Value Unblocked USD
= + +
(1 + r ) (1 + r ) (1 + r )
0 1 2 3
USD USD USD
RF (after-tax) RF (after-tax) RF (after-tax)
USD 675 USD 675 USD 675

= + + = USD 1,838.02
( 1 + 0.05005 ) ( 1 + 0.05005 ) ( 1 + 0.05005 )
1 2 3
CF1USD + CF2USD + CF3USD USD 675 + USD 675 + USD 675

Value Blocked USD
= = = USD 1,665.66
(1 + r ) ( 1 + 0.05005 )
0 4 4
USD
RF (after-tax)
And take the difference between the unblocked and blocked values to calculate the opportunity cost:
0 = Value Unblocked0 − Value Blocked0
Opportunity Cost USD USD USD
= USD 1,838.02 − USD 1,665.66

= USD 172.36
Step III: Find the value of the project with the blocked fund side effects in USD
NPV0,USDwith side effects = NPV0,USDno side effects − Opportunity Cost 0USD
= USD 253.47 − USD 172.36
= USD 81.11
Step IV: Convert this final value into Indian rupee at today’s current spot rate
NPV0,INRwith side effects = NPV0,USDwith side effects  SINR/USD
0
= USD 81.11  INR 79.648/USD

= INR 6,460.22 million

It will cost AUD47m to reengineer your plant with new robotics / computerized machinery for later cost
savings. The new equipment will be depreciated straight line over 10 years.
The cost of the new robotics / machinery will be partially offset by the sale of the old robotics into the
market for AUD11.83m cash.
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.
The book value of existing equipment is AUD10.5m and has five years of straight-line depreciation
remaining.
The corporate tax is 40% and the USD equity risk premium is 5.5%.
Q. What are the annual incremental cash flows associated with acquiring the new robotics / machinery
and disposing of the old robotics / machinery?

A. First, let’s calculate the total cash flow at time t=0.
• We spend AUD47m on buying the new equipment.
• We dispose the old equipment for AUD11.83m.
• HOWEVER, when we dispose of a capital asset, we may need to pay capital gains tax. So we work out
the Net Salvage Value.
Net Salvage Value = Salvage Value − Capital Gains Tax
= Salvage Value − ( Salvage Value − Book Value )  Tc 
= AUD11.83m − ( AUD11.83m − AUD10.5m )  0.40 
= AUD11.298m
• Since we’re only selling the old machinery at a slight profit relative to it’s book value (AUD11.83m
relative to AUD10.5m), we only have to pay a bit of capital gains tax and we get to keep the rest
(AUD11.298m).
• So we spend AUD47m on the new machinery and receive AUD11.298m from disposing of the old
machinery, for a net cash outflow at t=0 of: AUD47m – AUD11.298m = AUD35.702m

A. Next, let’s look at the effect on profit for years 1 through 10.
• First, the project the costs of the old machine at the forecast rates of inflation given in the text (or
lecture slides).
– Year 0 costs of AUD45.375m grow at the Year 1 inflation of 7% to AUD 48.55125m
• Then, multiply the costs of the old machine by the forecast % cost savings for each year to get the
impact on pre-tax profit of replacing the old machines with the new machines.
YEAR 1 2 3 4 5 6 7 8 9 10
Forecast inflation 7.00% 5.50% 5.00% 4.75% 4.60% 4.50% 4.43% 4.38% 4.33% 4.30%
AUD running cost of
48.55 51.22 53.78 56.34 58.93 61.58 64.31 67.12 70.03 73.04
old machine
% cost saving 10% 15% 20% 20% 20% 20% 20% 20% 20% 20%
Pre-Tax AUD Cost
4.86 7.68 10.76 11.27 11.79 12.32 12.86 13.42 14.01 14.61
Savings

A. Then, consider the effects of depreciation on pre-tax profit CASH FLOW CALCULATIONS
• The old machine has a Book Value of AUD10.5m and 5 Revenue
years of depreciable life. Less: Variable Costs
– Annual depreciation in years 1 to 5 would have been AUD10.5m = Gross Profit

/ 5 = AUD2.1m/yr Less: Fixed Costs
– And there’d be no depreciation for the old machine in years 6-
= EBITDA
10, even though we’re still using it. It’s already been fully
depreciated in the eyes of the government. Less: Depreciation
• The new machinery we’re buying for AUD47m will be = EBIT
depreciated over 10 years. Less: Taxes on EBIT @ ??%
– Annual depreciation would be AUD47m / 10 = AUD4.7m/yr = NOPLAT
• The basic FCFF calculation is to the right. In this question Add: Depreciation
we have decreased costs, increased depreciation on one = Operating Cash Flows

thing while decreased depreciation on the other thing. Less: Δ Non-cash Working Capital
Less: Capital Expenditure
Add: After-Tax Savage Value

= Project Net Free Cash Flows
A. Then combine it all together and work out the impact on FCFs
YEAR 1 2 3 4 5 6 7 8 9 10
Add: Pre-Tax AUD
+4.86 +7.68 +10.76 +11.27 +11.79 +12.32 +12.86 +13.42 +14.01 +14.61
Cost Savings
Less: New Dep –4.7 –4.7 –4.7 –4.7 –4.7 –4.7 –4.7 –4.7 –4.7 –4.7
Add: Lost Old Dep +2.1 +2.1 +2.1 +2.1 +2.1 0 0 0 0 0
= Effect on EBIT =2.26 =5.08 =8.16 =8.67 =9.19 =7.62 =8.16 =8.72 =9.31 =9.91
Less: Tax @ 40% –0.90 –2.03 –3.26 –3.47 –3.68 –3.05 –3.26 –3.49 –3.72 –3.96
= Effect on NOPAT =1.36 =3.05 =4.90 =5.20 =5.51 =4.57 =4.90 =5.23 =5.59 =5.95
Add Back: New Dep +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70 +4.70
Less: Old Dep –2.10 –2.10 –2.10 –2.10 –2.10
= Effect on CFs =3.96 =5.65 =7.50 =7.80 =8.11 =9.27 =9.60 =9.93 =10.29 =10.65

A. So to plot out ALL of the AUD cash flows from t=0 to t=10, we have:
YEAR 0 1 2 3 4 5 6 7 8 9 10
Effect on FCFFs
–35.702 +3.96 +5.65 +7.50 +7.80 +8.11 +9.27 +9.60 +9.93 +10.29 +10.65
(millions of AUDs)
Then at this stage you have two options for working out the NPV in your domestic currency (the USD):
1. Work out the NPV at t=0 in AUD by discounting the AUD cash flows above using an AUD discount rate. And then convert that
NPV at t=0 at today’s spot exchange rate (S0) from AUD to USD.
2. Convert all of the AUD cash flows from t=0 to t=10 at the appropriate spot rates (S0 to S10) into USD equivalents. And then
present value those USD cash flows to work out the USD NPV directly.
If all of the international parity conditions hold, the two methods should give you the same USD answer.
But if the parity conditions DON’T hold they might give you either:
1. A different sized positive USD NPVs to each other (so which is the real USD NPV?)
2. A positive USD NPV via one method and negative via the other (so accept or reject?)

Tax shields won’t always be the same every year in perpetuity (like when you’re paying the same
coupon interest every year on a perpetual bond).
Tax shields could be the same every year for a FINITE number of years (for example, if you’ve got a 10
year bond with annual coupons. Then you only have 10 years of interest payments that you can deduct
from your profits.
Or, as we’ll see in the coming example, you might have a different interest charge every year over the
life of your debt (because it’s a loan whose principal amortizes each year), which means your tax shield
will get smaller and smaller each year over the loan’s life also!

Suppose Banana Computers, a U.S. company, wants to buy some computer hard drives from either a
German manufacturer or a Japanese manufacturer. From Banana’s perspective, the hard drives are the
same, but the financing is different.
The German company has arranged for Banana to borrow €300 million for 8 years at an annual interest
rate of 3.5%. This rate is below the 8-year, risk-free euro interest rate of 5%.
The Japanese manufacturer has also arranged for Banana to borrow ¥36b for 8 years at 1.5%, which is
below the Japanese risk-free rate of 2.5%.
At the current exchange rate of ¥120/€, the principals on the loans are identical because €300m x
¥120/€ = ¥36,000m. Both exporters require repayment with equal annual instalments.
Q. If the hard drives are identical, which foreign loan should Banana take? Alternatively, should Banana
borrow in dollars at its market rate of 6% when the risk-free dollar interest rate is 4%? At the spot
exchange rate of $1.0909/€, the dollar principal would be $1.0909/€ * €300m = $327.27m

Q. How do we work out the size of the 8 annual repayments on the $327.27m loan at an interest rate of 6
percent? Hint: They’re equal!! :)
A. We use the good-ol’ annuity formula! :)
n is the number of times that we’ll pay CF1
as a repayment to the bank over the life
PV0 is the principal amount
of money we’re borrowing  1 − ( 1 + R )− n  of the loan to fully pay it off
with the loan at t=0 PV0 = CF1  

 R 
CF1 is our equal periodic R is our periodic interest rate. In this case,
annuity repayment over since we’re making annual repayments, it
the life of the loan (in this has to be an interest rate compounded
year, made annually) annually (i.e. an EAR)
Re-arranging to solve for our annual repayment...

PV0 $327.27m
CF1 = = = $52.7022m per year
 1 − ( 1 + R )− n   1 − ( 1 + 0.06 )−8 
   
 R   0.06 
So 8 equal annual payments of $52.7022m each year will fully and exactly pay off the $327.27m principal
we borrow for the loan at t=0 and the interest accumulated each year over it’s life.

Q. So what is that $52.70m repayment actually paying off in Year 1?
A. Well, the $327.27m principal we borrowed at t=0 would accrue 6% interest over the first year from t=0
until t=1.
That is… the $327.7m balance would increase by $327.27 x 6% = $19.64m to $346.91m if we didn’t make
any repayments at the end of the year.
But we DO have to make the $52.70m repayment at t=1 (the end of the first year).
That $346.91m principal + interest balance gets reduced by $52.70m to a closing loan balance for the year
(at t=1) of $294.20m.
So, in year 1, your first $52.70m loan repayment covers $19.64m of interest expense for the year. The
remaining $33.06m effectively goes to repaying your principal down from the initial $327.27m at t=0 to
$294.20m at t=1.
In each subsequent year, your lower opening principal balance will attract a smaller interest charge for that
year, so more of your $52.70m repayment will be used to pay off the principal balance each year until it
hits $0 at t=8.
See over slide :)

Let’s look at how the $327.27m loan amortizes down to $0 over the 8 years.
YEAR 0 1 2 3 4 5 6 7 8
Opening Principal Balance 327.27 294.20 259.15 222.00 182.62 140.87 96.62 49.72
Add: Interest Charged on
+$19.64 +$17.65 +$15.55 +$13.32 +$10.96 +$8.45 +$5.80 +$2.98
Opening Balance at 6%
Less: Mandatory loan
–$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70
repayment
= Closing Principal Bal $327.27 $294.20 $259.15 $222.00 $182.62 $140.87 $96.62 $49.72 $0.00
Principal repaid in year $33.07 $35.05 $37.15 $39.38 $41.75 44.25 $46.90 $49.72
(total repayment – interest repaid)
Mandatory loan
–$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70 –$52.70
repayment
Interest Tax Shield +$6.68 +$6.00 +$5.29 +$4.53 +$3.73 +$2.87 +$1.97 +$1.01
(Interest Charged x 34% tax rate)
= Total Dollar Cash Flows +$327.27 –$46.03 –$46.70 –$47.42 –$48.17 –$48.98 –$49.83 –$50.73 –$51.69
$46.03 $46.70 $47.42 $48.17 $48.98 $49.83 $50.73 $51.69

NPV0 = +$327.27 − − − − − − − − = $26.42
( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 )
1 2 3 4 5 6 7 8

Moving onto the €300m loan…
Q. How much are the annual repayments on this € loan if it’s at a rate of 3.5%?
A. PV0 €300m
CF1 = = = €43.6430m per year
 1 − ( 1 + R )− n   1 − ( 1 + 0.035 )−8 
   
 R   0.03 5 
Q. What does the amortization schedule of this €300m loan look like?
YEAR 0 1 2 3 4 5 6 7 8
Opening Principal Balance 300.00 266.86 232.55 197.05 160.30 122.27 82.91 42.17
+€10.50 +€9.34 +€8.14 +€6.90 +€5.61 +€4.28 +€2.90 +€1.48
Opening Balance at 3.5%
–€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64 –€43.64
repayment
= Closing Principal Bal €300.00 €266.86 €232.55 €197.05 €160.30 €122.27 €82.91 €42.17 €0.00
Principal repaid in year €33.14 €34.30 €35.50 €36.75 €38.03 €39.36 €40.74 €42.17

Then use Uncovered Interest Rate Parity to forecast $...../€ future spot rates.
Q. What is our basic UIRP equation? Use it to forecast the next 8 spot rates.
T
A.  1 + iRF
$

Note that the correct rate to use when forecasting is
the RISK FREE rates for each currency.
E  S $/ €
 = S $/ €
 €  You do NOT use your company’s own borrowing cost
 1 + iRF 
T 0
in each currency when forecasting exchange rates in
the general market. That would be dumb dumb.
1
 1 + 0.04 
E  S $/ €
 = $1.0909/€   = $1.0805/€
+
1
 1 0.05 
2
 1 + 0.04 
E  S $/ €
 = $1.0909/€   = $1.0702/€
+
2
 1 0.05 
7
 1 + 0.04 
E  S $/€
 = $1.0909 /€  = $1.0202/€
 1 + 0.05 
7
8
 1 + 0.04 
E  S $/€
 = $1.0909/€  = $1.0105/€
 1 + 0.05 
8

Converting the €300 loan’s repayments from € to $ and factoring in tax…
YEAR 0 1 2 3 4 5 6 7 8
Interest Payment in € €10.50 €9.34 €8.14 €6.90 €5.61 €4.28 €2.90 €1.48
Principal Repayment in € €33.14 €34.30 €35.50 €36.75 €38.03 €39.36 €40.74 €42.17
Spot and Forecast Spots $1.0909/€ $1.0805/€ $1.0702/€ $1.0600/€ $1.0499/€ $1.0399/€ $1.0300/€ $1.0202/€ $1.0105/€
Less: Interest Payment in $ –$11.35 –$10.00 –$8.63 –$7.24 –$5.83 –$4.41 –$2.96 –$1.49
(Interest paid in € x Spot Rate )
Less: Principal Payment in

$ –$35.81 –$36.71 –$37.63 –$38.58 –$39.55 –$40.55 –$41.56 –$42.61
(Principal paid in € x Spot Rate )
Add: Interest Tax Shield +$3.86 +$3.40 +$2.93 +$2.46 +$1.98 +$1.50 +$1.01 +$0.51
(Interest paid in $ x 34% tax rate)
Less: Capital Gains Tax –$0.12 –$0.24 –$0.37 –$0.51 –$0.66 –$0.81 –$0.98 –$1.15
(€ Principal PaidT x (S0–ST) x 34%)
$43.42 $43.55 $43.70 $43.87 $44.06 $44.27 $44.50 $44.75

NPV0 = +$327.27 − − − − − − − − = $54.31
( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 )
1 2 3 4 5 6 7 8

Let’s examine more closely how the Capital Gains Tax in each year works.
First, Year 1’s Capital Gains Tax:
• At the time you borrowed the €300m at 3.5%, you knew your first principal payment would be
€33.14m
• And at that time (t=0), the exchange rate was S0 = $1.0909/€.
– If the exchange rate stayed there, that euro principal repayment SHOULD have cost you €33.14m MULTIPLIED BY
$1.0909/€ = $36.16m to pay in dollars
• HOWEVER, we’re forecasting that the exchange rate will change to $1.0805/€.
– At this NEW exchange rate, your principal repayment will cost you €33.14m MULTIPLIED BY $1.0805/€ = $35.81m
– So, this change in the exchange rate means its costing you…
$36.16 – $35.81m = $0.34m LESS to pay off your scheduled principal payment in Year 1 because of an exchange rate
change in your favour.
• In the eyes of the government, this is a capital gain on which you must pay tax of 34%.
– So your Capital Gains Tax is 34% x $0.34m = $0.12m tax paid

Now… jumping forward to Year 8’s Capital Gains Tax:
• At the time you borrowed the €300m at 3.5%, you knew your eighth principal payment would be
€42.17m
• And at that time (t=0), the exchange rate was again S0 = $1.0909/€.
– If the exchange rate stayed there, that euro principal repayment SHOULD have cost you €42.17m MULTIPLIED BY
$1.0909/€ = $46.00m to pay in dollars
• HOWEVER, we’re forecasting that the exchange rate will change to $1.0105/€.
– At this NEW exchange rate, your principal repayment will cost you €42.17m MULTIPLIED BY $1.0105/€ = $42.61m
$46.00m – $42.61m = $3.39m LESS to pay off your scheduled principal payment in Year 8 because of an exchange rate
change in your favour.
• In the eyes of the government, this is AGAIN a capital gain on which you must pay tax of 34%.
– So your Capital Gains Tax is 34% x $3.39m = $1.15m tax paid

Simplifying the Capital Gains Tax with a formula:
(
Capital Gains Tax in $ Year T = Principal Paid in € Year T  S0$/€ − E  S $/€  )
T   TC
So for Year 1’s Capital Gains Tax:

( )
Capital Gains Tax in $ Year 1 = Principal Paid in € Year 1  S0$/€ − E  S 1$/€   TC
= €33.14m  ( $1.0909/€ − $1.0805/€ )  34%
= $0.12m (positive implying tax paid)
And then for Year 8’s Capital Gains Tax:

( )
Capital Gains Tax in $ Year 8 = Principal Paid in € Year 8  S0$/€ − E  S 8$/€   TC
= €42.17m  ( $1.0909/€ − $1.0105/€ )  34%
= $1.15m (positive implying tax paid)
IMPORTANT NOTE: See how for year 8 we’re still comparing the Year 8 spot rate to the original Year 0 spot rate. We DON’T look at
the change in the spot from t=7 to t=8, but rather we look at the WHOLE change in the spot rate from the time we borrowed the
money at t=0 to the time that piece of the principal is repaid at t=8.

Moving onto the ¥36,000m (or ¥36b) loan…
Q. How much are the annual repayments on this ¥ loan if it’s at a rate of 1.5%?
A. PV0 ¥36b
CF1 = = = ¥4.8090b per year
 1 − ( 1 + R )− n   1 − ( 1 + 0.015 )−8 
   
 R   0.01 5 
Q. What does the amortization schedule of this ¥36b loan look like?
YEAR 0 1 2 3 4 5 6 7 8
Opening Principal Balance ¥36.00 ¥31.73 ¥27.40 ¥23.00 ¥18.54 ¥14.00 ¥9.41 ¥4.74
+¥0.54 +¥0.48 +¥0.41 +¥0.34 +¥0.28 +¥0.21 +¥0.14 +¥0.07
Opening Balance at 1.5%
–¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81 –¥4.81
repayment
= Closing Principal Bal ¥36.00 ¥31.73 ¥27.40 ¥23.00 ¥18.54 ¥14.00 ¥9.41 ¥4.74 ¥0.00
Principal repaid in year ¥4.27 ¥4.33 ¥4.40 ¥4.46 ¥4.53 ¥4.60 ¥4.67 ¥4.74

Q. Since the question doesn’t give us a ¥…../$ spot exchange rate today, how do we work one out?
A. S0¥ / € ¥120/€
S ¥/$
0 = $/ € = = ¥110.00/€
S0 $1.0909/€
Then, applying UIRP again to forecast the future ¥…/$ spot rates:
T
¥/$  1 + iRF 
¥
E  S T  = S0  $ 
¥/$
 1 + iRF 
1
 1 + 0.025 
E  S ¥/$
 = ¥110/$  = ¥108.41/$
 1 + 0.04 
1
2
 1 + 0.025 
E  S ¥/$
 = ¥110/$  = ¥106.85/$
 1 + 0.04 
2
7
 1 + 0.025 
E  S ¥/$
 = ¥110/$   = ¥99.36/$
+
7
 1 0.04 
8
 1 + 0.025 
E  S ¥/$
 = ¥110/$   = ¥97.93/$
+
8
 1 0.04 

Converting the ¥36b loan’s repayments from ¥ to $ and factoring in tax…
YEAR 0 1 2 3 4 5 6 7 8
Interest Payment in ¥b ¥0.54 ¥0.48 ¥0.41 ¥0.34 ¥0.28 ¥0.21 ¥0.14 ¥0.07
Principal Repayment in ¥b ¥4.27 ¥4.33 ¥4.40 ¥4.46 ¥4.53 ¥4.60 ¥4.67 ¥4.74
Spot and Forecast Spots ¥110.00/$ ¥108.41/$ ¥106.85/$ ¥105.31/$ ¥103.79/$ ¥102.29/$ ¥100.82/$ ¥99.36/$ ¥97.93/$
Less: Interest Payment in $ –$4.98 –$4.45 –$3.90 –$3.32 –$2.72 –$2.08 –$1.42 –$0.73
(Interest paid in ¥ ÷ Spot Rate )
Less: Principal Payment in

$ –$39.38 –$40.55 –$41.76 –$43.01 –$44.29 –$45.62 –$46.98 –$48.38
(Principal paid in ¥ ÷ Spot Rate )
Add: Interest Tax Shield +$1.69 +$1.51 +$1.33 +$1.13 +$0.92 +$0.71 +$0.48 +$0.25
(Interest paid in $ x 34% tax rate)
Add: Capital Gains Subsidy +$0.19 +$0.39 +$0.61 +$0.83 +$1.06 +$1.29 +$1.54 +$1.80
(See over slide)
$42.27 $43.10 $43.73 $44.38 $45.03 $45.70 $46.37 $47.05

NPV0 = +$327.27 − − − − − − − − = $50.75m
( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 ) ( 1.06 )
1 2 3 4 5 6 7 8

Let’s examine more closely how the Capital Gains SUBSIDY in each year works.
First, Year 1’s Capital Gains Subsidy:
• At the time you borrowed the ¥36b at 1.5%, you knew your first principal payment would be ¥4.27b
• And at that time (t=0), the exchange rate was S0 = ¥110/$.
– If the exchange rate stayed there, that euro principal repayment SHOULD have cost you ¥4.27b DIVIDED BY ¥110/$ =
$38.81m to pay in dollars
• HOWEVER, we forecast that the exchange rate will change to ¥108.41/$
– At this NEW exchange rate, your principal repayment will cost you ¥4.27b DIVIDED BY ¥108.41/$ = $39.38m
$39.38m – $38.81m = $0.57m MORE to pay off your scheduled ¥ principal payment in Year 1 because of an exchange
rate change AGAINST your favour.
• In the eyes of the government, this is a capital LOSS on which you receive a Capital Gains Subsidy (or a
shield on your loss) at a tax rate of 34%.
– So your Capital Gains Subsidy (or Tax Shield) is 34% x $0.57m = $0.19m tax SAVED

Now… jumping forward to Year 8’s Capital Gains Subsidy (or Tax Shield):
• At the time you borrowed the ¥36b at 1.5%, you knew your eighth principal payment would be ¥4.74b
• And at that time (t=0), the exchange rate was again S0 = ¥110/$.
– If the exchange rate stayed there, that euro principal repayment SHOULD have cost you ¥4.74b DIVIDED BY ¥110/$ =
$43.07m to pay in dollars
• HOWEVER, we’re forecasting that the exchange rate will change to ¥97.93/$ at t=8.
– At this NEW exchange rate, your principal repayment will cost you ¥4.74b DIVIDED BY ¥97.93/$ = $48.38m
$48.38m – $43.07m = $5.31m MORE to pay off your scheduled ¥ principal payment in Year 8 because of an exchange
rate change AGAINST your favour.
• In the eyes of the government, this is AGAIN a capital LOSS on which you collect a Capital Gains Subsidy
(or tax shield) at a tax rate of 34%.
– So your Capital Gains Subsidy (or tax shield) is 34% x $5.31m = $1.80m tax SAVED

Simplifying the Capital Gains Subsidy with a formula:
 1 1 
Capital Gains Subsidy in $ Year T = Principal Paid in ¥ Year T  ¥ / $ −   TC
 0
S E 
 T  
S ¥ /$

So for Year 1’s Capital Gains Subsidy:
 1 1 

Capital Gains Subsidy in $ Year 1 = Principal Paid in ¥ Year 1 ¥/$ −   TC
 S0 E  S 1  
¥/$
 1 1 
= ¥4.27b  −   34% = −$0.19m (negative implying tax subsidy)
 ¥110/$ ¥1 0 8 .41 /$ 
And then for Year 8’s Capital Gains Subsidy:

 1 1 

Capital Gains Subsidy in $ Year 8 = Principal Paid in ¥ Year 8 ¥/$ −   TC
 S0 E  S 8  
¥/$
 1 1 
= ¥4.74b  −   34% = −$1.80m (negative implying tax subsidy)
 ¥110/$ ¥ 9 7 .93/$ 
NOTE: In the solutions on each slide to this ¥ loan I have automatically converted from billions of ¥ to millions of $ without showing
the addition division factor of 1,000. Just be careful :)
SUMMARY: Comparing the three loans:
• Borrowing $327.27m directly in your domestic USD has a NPV of $26.42m
• Borrowing €300m from your German supplier has a NPV of $54.31m
• Borrowing ¥36b from your Japanese supplier has a NPV of $50.75m
Banana should take the subsidized German loan of €300m as it adds the most value to the firm.
Both the German and Japanese loans have much higher NPVs than just borrowing domestically, as the
Hard Disk suppliers are offering us those loans at a subsidized interest rate BELOW their domestic risk-free
rate to entice us to borrow from them. But our domestic U.S. bank isn’t generous like that.
The expected depreciation of the € over the 8 year loan term makes it easier and cheaper to repay the
principal & interest repayments on the € loan.
Whereas the expected appreciation of the ¥ makes it harder and more costly to repay the principal and
interest on the ¥ loan each year.

Q. When evaluating international project cash flows, which of the following factors is relevant?
A. Answers:
a) Future inflation
b) Blockage of funds
c) Remittance provisions
d) All of the above
e) a + b only

Q. Expected future cash flows are estimated by ______ only incremental cash flows and _____ all
opportunity costs?
A. Answers:
a) including; including
b) including; excluding
c) excluding; including
d) excluding; excluding
e) None of the above

Q. Which of steps a. through d. is inappropriate when discounting foreign currency cash flows using the
parent’s perspective?
A. Answers:
a) Estimate expected future cash flows from the project in the foreign currency and put them on a time line
b) Convert expected future cash flows into the domestic currency at the current spot exchange rate
c) Identify the appropriate risk-adjusted discount rate in the domestic currency for the project
d) Calculate the NPV in the domestic currency
e) Each of the above is appropriate

Q. If a project has a positive NPV from the parent’s perspective but a negative NPV from the project’s
perspective, then the parent firm should ______.
A. Answers:
a) Accept the project
b) Reject the project
c) Accept the project and try to capture the value in the foreign currency today
d) Reject the project and continue to look for positive-NPV projects in the foreign currency
e) Do none of the above

Q. If a project has a negative NPV from the parent’s perspective but a positive NPV from the project’s
perspective, then the parent firm should ______.
A. Answers:
a) Accept the project
b) Reject the project
c) Accept the project and try to capture the value in the foreign currency today
d) Reject the project and continue to look for positive-NPV projects in the foreign currency
e) Do none of the above

A project has a net present value of NPVPS = PS10,000. In order to invest in the project, the Argentinian
government requires that you undertake another project with the following cash flow stream:
• CF0PS = –PS5,000
• E[CF1PS] = PS1,000
• E[CF2PS] = PS1,000
• E[CF3PS] = PS1,000
The appropriate discount rate for this project is iPS = 10%.
Q. What effect does this tie-in project have on your original NPVPS estimate?
A. Answers:
a) It increases NPVPS from PS10,000 to PS12,513.15
b) It increases NPVPS from PS10,000 to PS17,486.85
c) It decreases NPVPS from PS10,000 to PS7,486.85
d) It increases NPVPS from PS10,000 to PS2,513.15
e) It is a separate project and has no effect on NPV

Q. Can an investment project of a foreign subsidiary that has a positive net present value when evaluated as
a stand-alone firm ever be rejected by the parent corporation? Assume that the parent accepts all
projects with positive adjusted net present values?
A. Yes, we know that countries impose withholding taxes on the dividends that are repatriated from
subsidiaries to parent corporations.
These taxes lower the value of the project to the parent. The parent must also be aware of the possibility of
future problems accessing the foreign exchange market from the subsidiary’s country.
In general, political risk could be different for a subsidiary of a multinational corporation versus a local stand-
alone firm.

Q. How does the role of underwriting affect the issuing of securities?
A. The investment bankers who handle the issuing of securities either to the public or to private investors are
financial intermediaries, and they must be compensated for the use of their scarce resources.
This compensation includes a monetary fee, but it also often includes an underwriting discount, or spread.
The underwriting discount between what the corporation receives from issuing the securities and what the
public pays for the securities is often a large part of the compensation of the investment bank that
underwrites the issue.

Q. Based on their computation what is the difference between EBIT and NOPLAT?
A. The acronym EBIT is earnings before interest and taxes. It represents the before-tax operating profit of the
firm.
The acronym NOPLAT is net operating profit less adjusted taxes. It is found by taking the taxes out of EBIT
that would be paid by the all-equity firm. It is therefore the after-tax operating profit of the all-equity firm.

CASH FLOW CALCULATIONS
Revenue
In questions that use accounting terminology,
Less: Variable Costs
you’ll often see “COGS” (Cost of Goods Sold) and
“SG&A” (Selling, General, and Administrative) up
= Gross Profit here instead of Variable & Fixed costs
Less: Fixed Costs
= EBITDA EBITDA: Earnings Before Interest, Taxes, Depreciation & Amortization
Less: Depreciation
= EBIT EBIT: Earnings Before Interest & Taxes aka “Pre-Tax Operating Income”
Less: Taxes on EBIT @ ??%
= NOPLAT NOPAT: Net Operating Profit Less Adjusted Taxes
Add: Depreciation
= Operating Cash Flows In addition to your OCF (aka “Gross Cash Flow”), in any year of the
project you could also have changes in working capital AND capital
Less: Δ Non-cash Working Capital
expenditure occurring. These things can happen anytime, not just
Less: Capital Expenditure at the start/end of the project. Similarly you could dispose of
assets and have an after-tax salvage value at any point in time;
Add: After-Tax Savage Value NOT just at the end. It always depends on the particulars of the
project in question.
= Project Net Free Cash Flows
Q. What is meant by the cannibalization of an export market?
A. When you choose to change how you service a market to which you are exporting, either because you are
building a new plant in the foreign country or you are expanding production in an existing plant, you would
like to know the incremental profitability of this new project.
Cannibalization of exports refers to the lost exports in this market that you are now serving differently if no
market can be found for the goods that were formerly being exported to that country.
These lost exports could be from the parent or from another one of its foreign subsidiaries in a different
country. The lost profits on these exports must be considered to be a cost of accepting the new project.
If the exports that were formerly being sent to the country can be sold elsewhere in the world, there is no
cannibalization.

Q. Fees and royalties represent costs to a project but are benefits from the viewpoint of the parent firm.
A. True.
Q. Projects with different risks are likely to have different debt capacities, which require the same capital
structure.
A. False. The capital structures should be allowed to be separate for each project, and so allow differences.
Q. The additional economic and political risks faced by the MNC should be incorporated into the capital
budgeting analysis by adjusting the discount rate instead of the cash flows.
A. False. The cash flows should be adjusted in preference to changing the discount rate.

Q. The option to invest or not invest in a follow-up project associated with an investment must be
considered when estimating the project cash flows.
A. True.
Q. The discount rate should always be in the parent firm’s functional currency.
A. False. The discount rate should be in the currency in which the cash flows are received.
Q. In capital budgeting, repatriation occurs when expatriate employees return to the parent firm.
A. False. Repatriation is the act of remitting cash flows to the parent firm.

Q. Blocked funds in a foreign country should be discounted at the risk-free rate of interest in the foreign
currency.
A. False. The discount rate should depend on the riskiness of the asset(s) in which they are invested.
Q. Emerging countries sometimes require that foreign companies investing capital locally take on additional
development or infrastructure projects.
A. True.

Q. Which of the following is not true regarding multinational capital budgeting?
A. Answers:
a) The capital budgeting analysis should always be conducted from the subsidiary’s perspective, since it will
be responsible for administering the project.
b) If the parent is financing the project, then it should probably be evaluating the project from its point of
view.
c) The feasibility of a project can vary with the perspective because the after-tax net cash flows to the
parent of not necessarily equal to the after-tax net cash flows of the subsidiary.
d) All of the above are true

Q. Which of the following is not a factor that can cause the parent’s after-tax net cash flows to differ from
the after-tax net cash flows of the subsidiary per se?
A. Answers:
a) Withholding taxes
b) Blocked funds
c) The earnings before interest and taxes (EBIT) of the subsidiary
d) All of the above can cause net after-tax cash flows to differ

Q. ___________ is an input required for a multinational capital budgeting analysis, given that it is conducted
from the parent’s viewpoint?
A. Answers:
a) Salvage value.
b) Price per unit sold.
c) Initial investment.
d) Consumer demand.
e) All of the above are inputs required for capital budgeting analysis.

Q. Which of the following is true regarding the inputs of a multinational capital budgeting analysis?
A. Answers:
a) Fixed costs are not normally sensitive to changes in demand
b) The salvage value can almost always be estimated with perfect accuracy
c) Forecasting demand in a foreign country is relatively simple due to the abundance of historical data
d) Variable costs of the lifetime of the project generally remain constant and can easily be estimated

Q. An Australian-based MNC has just established a subsidiary in Algeria. Shortly after the plant was built,
the MNC determined that its exchange rate forecasts, which had previously indicated a slight appreciation
in the Algerian dinar (DZD), were probably false. Instead of a slight appreciation, the MNC now expects
that the dinar will depreciate substantially due to political turmoil in Algeria. This new development
would likely cause the MNC to _____________ its estimate of the previous computed net present value.
A. Answers:
a) lower
b) increase
c) lower, but not necessarily if the MNC invests enough in Algeria to offset the decrease in NPV
d) increase, but not necessarily if the MNC reduces its investment in Algeria by an offsetting amount
e) use none of the above

Q. Unlike domestic capital budgeting projects, and especially if a foreign subsidiary partially finances a
foreign project, ______________should probably be explicitly included in the cash flow analysis?
A. Answers:
a) inflation adjustments
b) salvage values
c) tax savings from depreciation
d) interest payments

Q. A good starting place to forecast demand for a project is to project the expected market share.
A. True.
Q. When forecasting the price at which products can be sold in the foreign country, domestic prices should
be used as the most likely estimate.
A. False. The likely selling price for products in the foreign country may have no relation to domestic prices
(different inflation, market share, industrial structure) and so information from the foreign country should
be used.
Q. Because funds rest with the subsidiary and are therefore a part of the MNC, fund-transfer restrictions are
irrelevant in multinational capital budgeting.
A. False. A key measure of the value of a project in the foreign country is the value of cash flows from the
project that can be repatriated to the parent (domestic) country. Restrictions on the transfer of funds from
the subsidiary to the parent may change project value for the parent.

Q. The required rate of return used to discount the relevant cash flows from a foreign project may differ from
the MNC’s cost of capital because of that particular project’s risk.
A. True.
Q. In multinational capital budgeting, depreciation is treated as a cash flow.

A. False. Depreciation is not a cash flow in valuing projects regardless of country of origin.
Q. Because inflation is only one of many factors that influence exchange rates, there is no guarantee that a
currency will depreciate when the local inflation rate is relatively high.
A. True.

Q. If partial financing is provided by the foreign subsidiary, including foreign interest payments in the cash
flow analysis may avoid overstatement of the estimated foreign cash flows.
A. True.
Q. Blocked funds always penalize a foreign project.

A. False. Blocked funds may help an MNC by adversely affecting or discouraging a potential competitor in the
foreign market, and may also add value to the project by channelling investment funds into other domestic
projects which have larger positive NPVs, especially if subsidized by the foreign government.
Q. The greater the uncertainty about a project’s forecast cash flows, the larger should be the discount rate
applied to cash flows, other things being equal.
A. True.

Q. Why does an adjusted net present value analysis treat the present value of financial side effects as a
separate item? Isn’t interest expense a legitimate cost of doing business?
A. The ANPV approach to capital budgeting starts by valuing the FCFFs to the all-equity cash firm.
It then adds other sources of value associated with how the firm is financed.
As in the weighted average cost of capital (WACC) approach, the numerator cash flows are the free cash
flows to the all-equity firm (i.e. basically FCFF).
In contrast to WACC analysis, which discounts these cash flows with a discount rate that is a weighted
average of the after-tax required return on the debt and the rate of return on the levered equity, the ANPV
analysis uses the rate of return on the unlevered assets to get the all-equity value.
Students sometimes think that the deductibility of interest as a business expense is therefore missing, and
they want to reduce the all-equity free cash flows by the after-tax interest payments.

A. Continued…
This misses the fact that the value of the interest tax shields is being added as a separate source of value in
ANPV, whereas it is included in WACC.
Also, it misses the fact that when the equity holders lever the firm, they get the principal on the debt up
front and don’t have to put as much equity into the firm for its investments.
The present value of the future cash outflows for interest payments and repayment of principal equal the
initial value of the principal, in which case it is only the tax shield that needs to be valued.
ANPV does this separately.

Q. What is meant by the NPV of the financial side effects of a project?
A. Generally, these effects arise from the costs of issuing securities, the taxes or tax deductions associated with
the type of financing instrument used (including the tax deductibility of the interest paid on the debt), the
costs of financial distress, and the availability of subsidized financing from governments.

FINANCIAL
PV OF INTEREST DISTRESS COSTS
TAX SHIELDS PVBC
 VL:LEVERED FIRM VALUE
Find VL directly by
discounting FCFFs
at WACC
Find MVD by
discounting
coupons at YTM. MARKET VALUE
OF DEBT
YTM should be
ABOVE the risk- D or MVD
free now, as the
UNLEVERED company has risk
FIRM VALUE of bankruptcy
that must be
VU compensated for
MARKET VALUE
OF EQUITY
E or MVE
Find VU by discounting …or find directly by

FCFFs at RA discounting FCFEs
at RE
Q. Why is it sometimes assumed that CAPX equals depreciation in the later stages of a project? How does
expected inflation affect this assumption?
A. As a project matures, there are no more planned investments in which case the scale of the project is fixed.
FCFF = EBIT ( 1 − TC ) + Depreciation − Capital Expenditure − Working Capital
= EBIT ( 1 − TC ) + $0 − $0 − $0 = NOPAT
But, the physical plant and equipment have an economic lifetime and must be replaced. If accounting
depreciation matches economic depreciation, setting CAPEX equal to depreciation is appropriate.
You should be aware that accounting depreciation often fails to match economic depreciation because of
inflation.
The higher the rate of inflation, the more severe this problem is unless the accounting depreciation is
indexed to inflation in some way.
Because CAPEX will be spent on real plant and equipment, the nominal amount of expenditures may be
somewhat greater than the amount the accounts are allowed to deduct for the book value of depreciation.

Q. Why should the required rate of return for a capital budgeting problem be project specific? Doesn’t the
firm just have to satisfy an overall cost-of-capital requirement?
A. The required rate of return for a capital budgeting problem is project specific because the firm is viewed as a
portfolio of projects owned by the shareholders.
It is the shareholder’s perspective that matters, and it is their opportunity cost that gives the required rate
of return for a project.
The question that the managers should ask is the following: If the shareholders were to receive the cash
flows from the project directly, what risk would they associate with the cash flows?
Notice that this immediately suggests that the required rate of return should be project specific and that it
should reflect the market risk that continues to be present when an investor holds a large, well-diversified
portfolio.

Q. Should a firm ever accept a project that has a negative NPV when discounted at the weighted average
cost of capital?
A. One reason we like the adjusted net present value approach to valuation is that it specifies all of the possible
sources of value for a project.
The WACC approach works well for projects that will support a certain percentage of leverage and that have
no other associated features, such as interest subsidies or growth options that might add value to the
project.
If the only cash flows from the project are the ones that are being discounted and there are no other sources
of value, other than the interest tax shields that are included in the WACC analysis, then the WACC approach
finds the market value of the levered project.
If this is negative, the project should be rejected.

Q. Can you do capital budgeting for a foreign project using a domestic currency discount rate? Explain your
answer?
A. YES; you certainly can do capital budgeting for a foreign project using a domestic currency discount rate.
You just have to be careful to match the cash flows with the discount rate.
One fundamental principle of capital budgeting is that the discount rate should reflect the currency of
denomination of the expected cash flows that are being discounted.
If a foreign project is providing expected future foreign currency cash flows, these can be discounted to the
present using a foreign currency discount rate that reflects the riskiness of the project.
The domestic currency present value of this foreign currency present value can then be determined by
converting from the present value of foreign currency into the present value of domestic currency using the
spot exchange rate.

A. Continued…
Alternatively, one can generate expected future domestic currency cash flows in future years by converting
expected future foreign currency cash flows into expected future domestic currency cash flows using
expected future spot exchange rates.
These expected future domestic currency cash flows should then be discounted to the present using an
appropriate domestic currency discount rate.

Q. Why might it be important to use period-specific discount rates when doing capital budgeting?
A. We know that risk-free spot interest rates are the appropriate discount rates for cash flows from risk free
pure discount bonds.
If the term structure of spot interest rates is not flat, that is, if it is upward sloping or downward sloping,
using the same discount factor for all the cash flows of a risky project will not be correct.
If the term structure is upward sloping, and you use the single long-term rate as the base for your risk
adjusted discount rate, you will needlessly penalize the earlier cash flows from the project because short-
term spot interest rates are lower than long-term spot interest rates.
Conversely, if the term structure is downward sloping, and you use the single long-term rate as the base for
your risk adjusted discount rate, you will be incorrectly enhancing the value of the earlier cash flows from
the project because the short-term interest rates that should be used to discount near-term cash flows are
higher than the long-term rates that should be used to discount longer-term cash flows.

Q. Why might a manager accept a high-variance/low-value project instead of a low-variance-high-value
project?
A. Shareholders only gain in good states of the world, and if the variance of the firm is higher, they gain more in
those good states.
Holders of debt get paid their full amount in good states of the world, and they get the value of the firm in
the bad states of the world.
By accepting a high variance project, managers may be able to shift some value from bondholders to
shareholders.
In such a situation the manager is said to have engaged in asset substitution.
THINK BACK TO THE HEDGING WEEK!

• Firms that were near bankruptcy would NOT hedge because the decrease of risk transferred value
FROM SHAREHOLDERS TO BONDHOLDERS.
• Similarly, firms can potentially transfer value FROM BONDHOLDERS TO SHAREHOLDERS by INCREASING
THE RISK of their firm.
Q. If the risk-free rate is 5%, the firm’s required rate of return on its debt is 6%, the equity beta is 1.4, the
equity risk premium is 5.5%, the corporate tax rate is 34%, and the debt–equity ratio is 0.5, what is the
expected rate of return on the assets of the firm that is predicted by the capital asset pricing model
(CAPM)?
This question is in the M&M w/ taxes AND w/
bankruptcy costs section (i.e. Trade Off Theory)
A. First, work out RE from CAPM. because the firm’s cost of debt = 6%, which is greater
RE = RRF +  ( RPM ) = 5% + 1.4 ( 5.5% ) = 12.7%

than the risk-free rate of 5%. This implies that the
debt is NOT riskless (i.e. the Beta of the debt > 0)
Since a D/E ratio of 0.5 means you have $0.5 of debt for every $1.0 of equity... or $50 of debt for every $100
of equity… or $0.5b of debt per $1.0b of equity (etc.), you can apply our re-arranged M&M w/ taxes
equation to find RA:
MVEquity MVDebt
RA = RE + R D ( 1 − TC )
VU VU
MVEquity MVDebt
= RE + R D ( 1 − TC )
MVEquity + MVDebt ( 1 − TC ) MVEquity + MVDebt ( 1 − TC )
$1.00 $0.50
= 12.7% + 6% ( 1 − 0.34 )
$1.00 + $0.50 ( 1 − 0.34 ) $1.00 + $0.50 ( 1 − 0.34 )
= 11.0376%
FINANCIAL
PV OF INTEREST DISTRESS COSTS
TAX SHIELDS PVBC
 VL:LEVERED FIRM VALUE
Find VL directly by
discounting FCFFs
at WACC
Find MVD by
discounting
coupons at YTM. MARKET VALUE
OF DEBT
YTM should be
ABOVE the risk- D or MVD
free now, as the
UNLEVERED company has risk
FIRM VALUE of bankruptcy
that must be
VU compensated for
MARKET VALUE
OF EQUITY
E or MVE
Find VU by discounting …or find directly by

FCFFs at RA discounting FCFEs
at RE
Q. It might be TEMPTING to unlever the firm’s Beta using the Hamada equation and substitute that
unlevered Beta into CAPM in an attempt to find RA. Try it:
A. First, work out βU from Hamada:
 L =  U  1 + ( 1 − TC )( D E )  → 1.4 =  U  1 + ( 1 − 0.34 )( $0.5 $1 ) 
 U = 1.05263
Next, substitute into CAPM:
R ? = R RF +  U ( RPM )
= 5% + 1.05263 ( 5.5% ) = 10.79% (i.e. LESS THAN the R A calculated previously)
What’s going on? Well… notice the cost of debt is 6% and the risk-free rate is 5%, this means that the debt
NOT risk-free. So let’s find the implied βD:
R D = R RF +  D ( RPM ) → 6% = 5% +  D ( 5.5% ) →  D = 0.18
And then use this in the Beta-fied version of M&M’s Prop II to find βA:
E =  A + (  A − D )( D E )( 1 − TC ) (
→ 1.4 =  A +  A − 0.18 )( $0.5 $1.0 )( 1 − 0.34 )
 A = 1.09774
And substituting this beta into CAPM:
R A = R RF +  A ( RPM ) = 5% + 1.09774 ( 5.5% ) = 11.0376% (i.e. same as on last slide)
Suppose that the UK Motors Ltd. is considering an investment of £30 million to develop a new factory.
Assume that the company’s stockholders require a 22% rate of return, that the company’s bondholders
require a 9% rate of return, that the UK corporate tax rate is 40%, and that 35% of the project will be
financed with debt and 65% with equity. Find the project’s annual income if it is to be a zero-NPV
investment.
Q. When is NPV = £0?
A. NPV = £0 when the IRR of 22% = the WACC. Thus we need to find WACC.
Q. What is the firm’s WACC?

MVEquity MVDebt
A. WACC = RE + R D ( 1 − Tc ) = 0.65  22% + 0.35  9%  ( 1 − 0.40 ) = 16.19%
VL VL
Q. So what “annual income” (i.e. Free Cash Flow to Firm) gives NPV=£0?
FCFF1
A. NPV0 = − CF0
R WACC
FCFF1
£0 = − £30m → FCFF1 = £30m  0.1619 = £4.857m of cash flow annually
0.01619

Q. What is the firm’s Unlevered Cost of Capital (RA)?
A. We find RA as follows.
MVEquity MVDebt
RA = RE + R D ( 1 − TC )
VU VU
It looks similar to WACC, but with VU as the denominator instead of VL.
Q. So how do we find VU?

A. We use our MM w/ Taxes Proposition I equation and re-arrange it:
VL = VU + TC D & VL = E + D  VU + TC D = E + D
 VU = E + D − TC D = E + D(1 − TC )
 VU = ( 0.65  £30b ) + ( 0.35  £30b )(1 − 0.40) = £25.8b

Thus RA is:
MVEquity MVDebt
RA = RE + R D ( 1 − TC )
VU VU
0.65  £30b 0.35  £30b
= 22% + 9% ( 1 − 0.40 ) = 18.83%
£25.8b £25.8b
LEVERED FIRM VALUE: VL →
Find VL directly by PRESENT VALUE
discounting FCFFs at WACC OF INTEREST TAX MARKET VALUE
of 16.19% SHIELDS £4.2m
OF DEBT
D or MVD
35% of £30m
= £10.5m
UNLEVERED
FIRM VALUE
MARKET VALUE
VU OF EQUITY
= £25.8m E or MVE
65% of £30m
= £19.5m
Find VU by discounting …or find directly

FCFFs at RA of 18.83% discounting FCFEs
at RE of 22%
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.
Q. What is the firm’s WACC?
MVEquity MVDebt
A. WACC = RE + R D ( 1 − Tc )
VL VL
= 0.55  8% + 0.45  4%  ( 1 − 0.30 ) = 5.66%
AGAIN, double-check that RA
Q. What is the firm’s Unlevered Cost of Capital (RA)? is bigger than the firm’s
WACC. It ALWAYS should be
A. MVEquity MVDebt
RA = RE + R D ( 1 − TC ) for a levered firm.
VU VU 6.5434% > 5.66%
So yes, RA > WACC
MVEquity MVDebt
= RE + R D ( 1 − TC )
 MVEquity + MVDebt ( 1 − TC )   MVEquity + MVDebt ( 1 − TC ) 
¥11b ¥9b
= 8% + 4% ( 1 − 0.30 )
 ¥11b + ¥9b ( 1 − 0.30 )   ¥11b + ¥9b ( 1 − 0.30 ) 
= 6.5434%
Continued…
Q. 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?
A. CF1
NPV0 = − CF0 for a perpetuity that has an initial cost generally
R
FCFF1
NPV0 = − CF0 for this project
WACC
FCFF1
¥0 = − ¥20b → FCFF1 = ¥20b  0.0566 = ¥1.132b of cash flow annually
0.0566

Q. With this same set of information, what is the value of the levered equity from the FTE or “Flow to
Equity” approach? (FTE is the same as FCFE or Free Cash Flow to Equity)
A. With no changes in working capital or capital expenditure each year, the annual FCFF of ¥1.132b calculative
above would just be EBIT(1 – TC).
FCFF = EBIT ( 1 − TC ) + Depreciation − Capital Expenditure − Working Capital
¥1.132b = EBIT ( 1 − 0.30 ) + ¥0 − ¥0 − ¥0
Therefore, we can re-arrange to solve for EBIT as:
FCFF + NWC + CapEx − Dep ¥1.132b + ¥0 + ¥0 − ¥0
EBIT = = = ¥1,617,142,857.14
( 1 − TC ) ( 1 − 0.30 )
On ¥9b of debt at 4%, the yearly interest expense would be ¥9b x 4% = ¥0.36b.
So then calculate FCFE (or “FTE”):
FCFE = ( EBIT − Interest Expense )( 1 − TC ) + Dep − CapExp − NWC + Net Debt Issued
= ( ¥1.617b − ¥0.36 )( 1 − 0.30 ) + ¥0 − ¥0 − ¥0 + ¥0
= ¥0.88b of cash flow available for EQUITY holders every year

A. As shown earlier the levered value of equity (aka MVEquity) is just the present value of the FCFEs (or “FTEs”)
at the levered cost of equity (aka RE).
FCFE1 ¥0.88b
MVEquity = = = ¥11b
RE 0.08
Oh look! We’re financing our project with ¥11b of equity. Which is just the 55% of the ¥20b project size that
the question itself TOLD US is coming from equity anyway! All roads lead to Rome :)
For curiosity (and to align with the lecture slides), another way to calculate FCFE (or “FTE”) from FCFF
(without going back to EBIT first like I did) is as follows:
FCFE = FCFF − Interest Expense ( 1 − TC ) + Net Debt Issued
= ¥1.132b − ¥0.36 ( 1 − 0.30 ) + $0 = ¥1.132b − ¥0.252
= ¥0.88b of cash flow available for EQUITY holders every year

Free Cash Flow to FIRM:
• The same as your incremental FCF for a SINGLE project in Capital Budgeting
• Summing the FCF from EVERY project gives us the FCFF for the ENTIRE firm
FCFF = EBIT ( 1 − TC ) + Depreciation − CapEx − WC
= NOPAT + Depreciation − CapEx − WC
• A lot of problems (& lectures) in the M&M topic will assume the firm has no capital expenditure,
depreciation, or change in working capital. This means FCFF = EBIT(1–TC) = NOPAT in THOSE problems, but
NOT in general
Free Cash Flow to EQUITY:
• This is the cash flow available to be paid to JUST equity holders, after accounting for the in-&-outflows
associated with other capital (i.e. debt):
FCFE = EBIT − Int ( 1 − TC ) + Depreciation − CapEx − WC + NetDebtIssued
= NPAT + Depreciation − CapEx − WC + (Principal Issued − Principal Repaid )
• Many M&M problems will often assume no new debt issued nor repaid in future years, so the only
difference from FCFF will be after-tax interest:
FCFE = FCFF − Int ( 1 − TC ) + ( Principal Issued − Principal Repaid )
• So in many problems FCFF = NOPAT whereas FCFE = NPAT

Tutorial Week 12: International Capital Budgeting Shapiro: Chapters 16 + 17

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Tutorial

NPV IS NEGATIVE NPV IS POSITIVE

(when cash flows are

FINS3616 — Peter Kjeld Andersen (2018-S2)

Q. Compare the results. Why do we observe the results that we do?

USD 650 USD 650 USD 650

= ( −USD 203.73 )  BRL3.8735/USD

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

= ( −USD 1,700 )  BRL 3.8735/USD = −BRL 6,584.95

BRL 2,616.51 BRL 2,719.12 BRL 2,825.75

FINS3616 — Peter Kjeld Andersen (2018-S2)

Q. What is the NPV of the investment from the parent’s perspective?

Q. What is the correct course of action for the managers to take?

FINS3616 — Peter Kjeld Andersen (2018-S2)

DKK 1,050 DKK 1,050 DKK 1,050

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

SEK 1,619.59 SEK 1,824.00 SEK 2,054.21

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

The spot exchange rate is:

USD 675 USD 675 USD 675

FINS3616 — Peter Kjeld Andersen (2018-S2)

USD 675 USD 675 USD 675

CF1USD + CF2USD + CF3USD USD 675 + USD 675 + USD 675

= USD 1,838.02 − USD 1,665.66

= USD 81.11  INR 79.648/USD

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

• The old machine has a Book Value of AUD10.5m and 5 Revenue

years of depreciable life. Less: Variable Costs

– Annual depreciation in years 1 to 5 would have been AUD10.5m = Gross Profit

• The new machinery we’re buying for AUD47m will be = EBIT

depreciated over 10 years. Less: Taxes on EBIT @ ??%

– Annual depreciation would be AUD47m / 10 = AUD4.7m/yr = NOPLAT

we have decreased costs, increased depreciation on one = Operating Cash Flows

Less: Capital Expenditure

Add: After-Tax Savage Value

Add: Lost Old Dep +2.1 +2.1 +2.1 +2.1 +2.1 0 0 0 0 0

Less: Old Dep –2.10 –2.10 –2.10 –2.10 –2.10

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

with the loan at t=0 PV0 = CF1  

Re-arranging to solve for our annual repayment...

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

$46.03 $46.70 $47.42 $48.17 $48.98 $49.83 $50.73 $51.69

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

Less: Principal Payment in

$43.42 $43.55 $43.70 $43.87 $44.06 $44.27 $44.50 $44.75

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

FINS3616 — Peter Kjeld Andersen (2018-S2)

So for Year 1’s Capital Gains Tax:

And then for Year 8’s Capital Gains Tax: