Multinational Capital

Budgeting

Capital Budgeting in
Foreign Subsidiaries

MNCs evaluate international projects by

using multinational capital budgeting,
which compares the costs and benefits
of these projects.
Many international projects are
irreversible and cannot be easily sold to
other corporations at a reasonable price.
Proper use of multinational capital
budgeting can identify the international
projects worthy of implementation.

Subsidiary versus Parent

Perspective

Should the capital budgeting for a multinational project be conducted from the
viewpoint of the subsidiary that will
administer the project, or the parent that will
provide most of the financing?
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.

Subsidiary versus Parent

Perspective

Since the subsidiary is a subset of the

MNC, what is good for the subsidiary
would appear to be good for the MNC.

WRONG!

Subsidiary versus Parent

Perspective
The difference in cash inflows is due to :
Tax differentials
What is the tax rate on remitted funds?
If the parents government imposes a high

tax rate on the remitted funds, the project

may be feasible from the subsidiarys point
of view, but NOT from the parents point of
view!
Parent should NOT consider!

Regulations that restrict remittances

Where host government restrictions

require a percentage of the subsidiary

earnings to remain in the host country
and parent may never have access to
these funds, the project is NOT attractive
to the parent.
This may be considered though since the
portion of funds not allowed to be sent to
the parent can be used to cover the
financing costs over time.

Excessive remittances
The parent may charge its subsidiary

very high administrative fees.

Consider a parent that charges the
subsidiary very high administrative fees
because management is centralized at
the headquarters, the fees represent an
expense for the subsidiary and for the
parent, the fees represent revenue that
may substantially exceed the actual
cost of managing the subsidiary.

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.

Subsidiary versus Parent

Perspective

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.

Cash Flows Generated

by Subsidiary
After-Tax Cash Flows to
Subsidiary
Cash Flows Remitted by
Subsidiary
After-Tax Cash Flows
Remitted by Subsidiary
Conversion of
Funds to Parents
Currency
PARENT

Corporate Taxes Paid to

Host Government
Retained Earnings by
Subsidiary
Withholding Tax Paid to
Host Government

Process of Remitting
Subsidiary Earnings to
the Parent

Input for Multinational

Capital Budgeting
The following forecasts are usually
required:
1.
Initial investment
2.
Consumer demand
3.
Product price
4.
Variable cost
5.
Fixed cost
6.
Project lifetime
7.
Salvage (liquidation) value

Input for Multinational

Capital Budgeting
The following forecasts are usually required:
8.
9.
10.
11.

Fund-transfer restrictions
Tax laws
Exchange rates
Required rate of return

Initial Investment

This may constitute the major source of funds

to support a particular project. Funds initially
invested in a project may include not only
whatever is necessary to start the project but
also additional funds, such as working capital,
to support the project over time. Such funds
are needed to finance inventory, wages, and
other expenses until the project starts to
generate revenue. Because cash inflows will
not always be sufficient to cover upcoming cash
outflows, working capital is needed throughout
a projects lifetime.

Consumer Demand

An accurate forecast of consumer demand

for a product is quite valuable, but future
demand is often difficult to forecast.
Demand forecasts can sometimes be aided
by historical data on the market share other
MNCs in the industry pulled when they
entered this market, but historical data are
not always an accurate indicator of the
future.

Price

The price at which the product could be sold

can be forecasted using competitive
products in the markets as a comparison.
The future prices will most likely be
responsive to the future inflation rate of the
host country, but the future inflation rate is
NOT known. Thus, future inflation rates
must be forecasted in order to develop
projections of the product price over time.

Variable Cost

Like the price estimate, variable-cost

forecasts can be developed from assessing
prevailing comparative costs of the
components (i.e. hourly labor costs). Such
costs should normally move in tandem with
the future inflation rate of the host country.
Even if the VC/u can be accurately
predicted, the projected total variable cost
may be wrong if the demand is inaccurately
forecasted.

Fixed Cost

Fixed cost is sensitive to any change in the

host countrys inflation rate from the time the
forecast is made until the time the FC are
incurred.

Project Lifetime

Some projects have indefinite lifetimes that

can be difficult to assess, while other
projects have designated specific lifetimes,
at the end of which they will be liquidated.
This makes the capital budgeting analysis
easier to apply.
An MNC does not always have complete
control over the lifetime decision. In some
cases, certain events (i.e. Political) may
force the firm to liquidate the project earlier
than planned.

Salvage (liquidation) Value

The after-tax salvage value of most projects

is difficult to forecast. It will depend on
several factors, including the success of the
project and the attitude of the host
government toward the project. As an
extreme possibility, the host government
could take over the project without
adequately compensating the MNC.

Restriction on Fund
Transfers

In some cases, a host government will

prevent a subsidiary from sending its
earnings to the parent. This restriction may
reflect an attempt to encourage additional
local spending or to avoid excessive sales of
the local currency in exchange for some
other currency.

Tax Laws

The tax laws on earnings generated by a

foreign subsidiary or remitted to the MNCs
parent vary among countries. Because
after-tax cash flows are necessary for an
adequate capital budgeting analysis,
international tax effects must be determined
on any proposed foreign projects.

Exchange Rates

Any international project will be affected by

exchange rate fluctuations during the life of
the project, but these movements are often
very difficult to forecast.
Though hedging techniques can be used to
cover short and long-term positions (through
forward contracts and swaps), the MNC has
no way of knowing the amount of funds that
it should hedge.

Required Rate of Return

Once the relevant cash flows of a proposed

project are estimated, they can be
discounted at the projects required rate of
return, which may differ from the MNCs cost
of capital because of the at particular
projects risk.

Multinational
Capital Budgeting

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.

Multinational
Capital Budgeting

NPV = initial outlay

n

cash flow in tperiod t

t =1

(1 + k )

+ salvage value
(1 + k )n
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
1.
Demand(1)
2.
Price per unit(2)
3.
Total revenue(1)(2)=(3)
4.
Variable cost per unit(4)
5.
Total variable cost (1)(4)=(5)
6.
Annual lease expense(6)
7.
Other fixed periodic expenses(7)
8.
Noncash expense (depreciation)(8)
9.
Total expenses
(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.

Factors to Consider in
Multinational Capital
Budgeting
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.

Adjusting Project
Assessment
for
If anRisk
MNC is unsure of the cash flows of

a proposed project, it needs to adjust its

assessment for this risk.
One method is to use a risk-adjusted
discount rate. The greater the
uncertainty, the larger the discount rate
that is applied.
Many computer software packages are
also available to perform sensitivity
analysis and simulation.

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 parent at the end
of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at