14

Chapter

Multinational Capital Budgeting

Chapter Objectives
To compare the capital budgeting analysis of an MNCs
subsidiary with that of its parent;

To demonstrate how multinational capital budgeting can

be applied to determine whether an international project
should be implemented; and

To explain how the risk of international projects can be

assessed.

Multinational Capital Budgeting

Capital Budgeting:
Capital budgeting involves determining the projects net present
value by estimating the present value of the projects future cash
flows and subtracting the initial outlay required for the project.
Multinational capital budgeting typically uses a similar process.

C14 - 3

Subsidiary versus Parent Perspective

Should the capital budgeting for a multi-national project be
conducted from the viewpoint of the subsidiary that will
administer the project, or the parent that will provide most of the
financing?
Some would say-

The subsidiarys perspective should be used because it will be

responsible for administrating the project.

The subsidiary is a subset of the MNC, so what is good for the

subsidiary would appear to be good for the MNC.

Subsidiary versus Parent Perspective, cont..

ArgumentsThe parent is financing the project, then it should be evaluating
the
results from the parents point of view.
The results may vary with the perspective taken because the net
after-tax cash inflows to the parent can differ substantially from
those to the subsidiary.

C14 - 5

Subsidiary versus Parent Perspective, cont..

The difference in cash inflows:
The net after tax inflows to the subsidiary can differ substantially
from those to the parent. Such difference can be due to several
factors, such as1. Tax differentials:
Usually subsidiaries earnings remitted to the parent periodically. If
the parents government impose a high tax rate on the remitted
funds, the project may be feasible from the subsidiaries point of
view, but not from the parents point of view.

Subsidiary versus Parent Perspective, cont..

2. Restricted remittances:
The government of a country, where the potential subsidiary would
be established, may impose restriction, that a percentage of the
subsidiarys earnings will remain in the country. Since, the parent
may never have access to these funds, then the project is not
attractive to the parent, although it may be attractive to the
subsidiary.

C14 - 7

Subsidiary versus Parent Perspective, cont..

3. Excessive remittances:
A parent, that have a centralized management, can charge to its
subsidiary very high administrative fees. To the subsidiary, the fees
represents an expense and to the parent it represents revenue. In this
case, the projects earnings may appear low from subsidiarys
perspective and high from parents perspective.
4. Exchange rate movements:
When earnings are remitted to the parent, they are normally
converted from the subsidiarys local currency to the parents
currency. The amount received by the parent is therefore influenced
by the existing exchange rate.
C14 - 8

Remitting Subsidiary Earnings to the Parent

Cash Flows Generated by Subsidiary

Corporate Taxes
Paid to Host
Government

After-Tax Cash Flows to Subsidiary

Retained Earnings
by Subsidiary
Cash Flows Remitted by Subsidiary
After-Tax Cash Flows Remitted by Subsidiary
Conversion of Funds
to Parents Currency
Cash Flows to Parent
Parent

Withholding Tax
Paid to Host
Government

Subsidiary versus Parent Perspective, cont..

Summary of the factors:
A parents perspective is appropriate when evaluating a project,
since any project that can create a positive net present value for the
parent should enhance the firms value.
However, one exception to this rule may occur when the foreign
subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting

The following forecasts are usually required:
1.
2.
3.
4.
5.
6.
7.

8.
9.
10.
11.

Initial investment
Consumer demand
Product price
Variable cost
Fixed cost
Project lifetime
Salvage (liquidation) value
Fund-transfer restrictions
Tax laws
Exchange rates
Required rate of return

Multinational Capital Budgeting Example

Capital budgeting is necessary for all long-term projects that deserve
consideration.
One common method of performing the analysis is to estimate the
cash flows and salvage value to be received by the parent, and
compute the net present value (NPV) of the project.
n

CashflowinYerat SalvageVal ue
NPV InitialOutlay

t
n

k
1

k
t 1
k = the required rate of return on the project
n = project lifetime in terms of periods
If NPV > 0, the project can be accepted.

Capital Budgeting Analysis

Period t
Demand(1)
Price per unit(2)
Total revenue(1)(2)=(3)
Variable cost per unit(4)
Total variable cost (1)(4)=(5)
Annual lease expense(6)
Other fixed periodic expenses(7)
Noncash expense (depreciation)(8)
Total expenses

1.
2.
3.
4.
5.
6.
7.
8.
9.
(5)+(6)+(7)+(8)=(9)
10.
Before-tax earnings of subsidiary(3)(9)=(10)
11.
Host government taxtax
rate(10)=(11)
12.
After-tax earnings of subsidiary(10)(11)=(12)

Capital Budgeting Analysis

Period t
Net cash flow to subsidiary (12)+(8)=(13)
Remittance to parent(14)
Tax on remitted fundstax

13.
14.
15.
rate(14)=(15)
16.
Remittance after withheld tax(14)(15)=(16)
17.
Salvage value(17)
18.
Exchange rate(18)
19.
Cash flow to parent
(16)(18)+(17)(18)=(19)
20.
Investment by parent(20)
21. Net cash flow to parent
(19)(20)=(21)
22. PV of net cash flow to parent
(1+k) - t(21)=(22)
23.
Cumulative NPVPVs=(23)

Factors to Consider in Multinational Capital

Budgeting
Exchange rate fluctuations. Different scenarios should be

considered together with their probability of occurrence.

Inflation. Although price/cost forecasting implicitly considers

inflation, inflation can be quite volatile from year to year for

some countries.
Financing arrangement. Financing costs are usually captured

by the discount rate. However, many foreign projects are

partially financed by foreign subsidiaries.
Blocked funds. Some countries may require that the earnings be

reinvested locally for a certain period of time before they can be

remitted to the parent.

Factors to Consider in Multinational Capital

Budgeting
Uncertain salvage value. The salvage value typically has a

significant impact on the projects NPV, and the MNC may want
to compute the break-even salvage value.
Impact of project on prevailing cash flows. The new

investment may compete with the existing business for the same
customers.
Host government incentives. These should also be considered

in the analysis.

Impact of Multinational Capital Budgeting

on an MNCs Value
Multinational Capital Budgeting
Decisions

E CF E ER

Value =
t =1

j 1

j, t

1 k

j, t

E (CFj,t )
=
expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at