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SMU FINA 4329 - Domestic Capital Budgeting

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Review of Domestic Capital BudgetingMeasuring Cash FlowsSlide 3Slide 4Slide 5Slide 6Slide 7The Adjusted Present Value ModelSlide 9Capital Budgeting from the Parent Firm’s PerspectiveSlide 11Slide 12Slide 13Which Currency?Assume Subsidiary WACC=15%Suppose R($)=6% R(pound)=10%Estimating the Future Expected Exchange RatesSuppose (1+WACC($))/(1+WACC(U.K))=(1+r($))/(1+r(U.K))MoralInternational Capital BudgetingSlide 21Slide 21Risk Adjustment in the Capital Budgeting ProcessSensitivity AnalysisReal Options11. Identify the SIZE and TIMING of all relevant cash flows on a time line.2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate.3. Find NPV by discounting the cash flows at the appropriate discount rate.4. Compare the value of competing cash flow streams at the same point in time.Review of Domestic Capital Budgeting2Measuring Cash Flows•The guiding principle is to measure incremental cash flows. That is, how much the project really adds to the cash flow of the parent•But this is often easier said than done. They are often real problems in measuring incremental cash flows such as •Cross Relationship Between Parent and Subsidiary–Cannibalization–Cross Fertilization•Accounting for cash flows–Transfer pricing (especially when market prices aren’t available)–Fees royalties and other charges for overhead•Intangibles–Good will–Experience3Review of Domestic Capital BudgetingThe basic net present value equation is01)1()1(CKTVKCFNPVTTTtttWhere:CFt = expected incremental after-tax cash flow in year t,TVT = expected after tax cash flow in year T, including return of net working capital,C0 = initial investment at inception,K = weighted average cost of capital.T = economic life of the project in years.4Review of Domestic Capital BudgetingThe NPV rule is to accept a project if NPV  00)1()1(01CKTVKCFNPVTTTtttand to reject a project if NPV  0.0)1()1(01CKTVKCFNPVTTTttt5Review of Domestic Capital BudgetingFor our purposes it is necessary to expand the NPV equation.)1()1)(( τIDτIDOCRCFtttttttRt is incremental revenueCt is incremental operating cash flow Dt is incremental depreciationIt is incremental interest expense  is the marginal tax rate6Review of Domestic Capital BudgetingFor our purposes it is necessary to expand the NPV equation.)1()1)(( τIDτIDOCRCFttttttt)1( τIDNIttttttDτDτOCR  )1)((ttDτNOI  )1(tttτDτOCR  )1)((ttτDτOCF  )1(7Review of Domestic Capital BudgetingWe can usetttτDτOCFCF  )1(01)1()1(CKTVKCFNPVTTTtttto restate the NPV equation01)1()1()1(CKTVKτDτOCFNPVTTTttttas:8The Adjusted Present Value ModelCan be converted to adjusted present value (APV)01)1()1()1()1(CKTVKτDKτOCFNPVTTttTtttBy appealing to Modigliani and Miller’s results.01)1()1()1()1()1(CKTViτIiτDKτOCFAPVTuTttttTttut9The Adjusted Present Value ModelThe APV model is a value additivity approach to capital budgeting. Each cash flow that is a source of value to the firm is considered individually.Note that with the APV model, each cash flow is discounted at a rate that is appropriate to the riskiness of the cash flow.01)1()1()1()1()1(CKTViτIiτDKτOCFAPVTuTttttTttut10Capital Budgeting from the Parent Firm’s Perspective•Donald Lessard developed an APV model for a MNC analyzing a foreign capital expenditure. The model recognizes many of the particulars peculiar to foreign direct investment.TttdttTudTTTttdttTttdttTttudttiLPSCLSRFSCSKTVSiτISiτDSKτOCFSAPV1000000111)1()1()1()1()1()1(11Capital Budgeting from the Parent Firm’s PerspectiveThe operating cash flows must be translated back into the parent firm’s currency at the spot rate expected to prevail in each period.TttdttTudTTTttdttTttdttTttudttiLPSCLSRFSCSKTVSiτISiτDSKτOCFSAPV1000000111)1()1()1()1()1()1(The operating cash flows must be discounted at the unlevered domestic rate12Capital Budgeting from the Parent Firm’s Perspective OCFt represents only the portion of operating cash flows available for remittance that can be legally remitted to the parent firm.TttdttTudTTTttdttTttdttTttudttiLPSCLSRFSCSKTVSiτISiτDSKτOCFSAPV1000000111)1()1()1()1()1()1(The marginal corporate tax rate, , is the larger of the parent’s or foreign subsidiary’s.13Capital Budgeting from the Parent Firm’s Perspective S0RF0 represents the value of accumulated restricted funds (in the amount of RF0) that are freed up by the project.TttdttTudTTTttdttTttdttTttudttiLPSCLSRFSCSKTVSiτISiτDSKτOCFSAPV1000000111)1()1()1()1()1()1( Denotes the present value (in the parent’s currency) of any concessionary loans, CL0, and loan payments, LPt , discounted at id .14Which Currency?Time Period Free Cash Flow0 -£56.001 £10.402 £8.903 £9.704 £9.905 £10.40Terminal Value (Period 5) £78.0015Assume Subsidiary WACC=15%Time Period Free Cash Flowpv (15%)0 -£56.00-£56.001 £10.40£9.042 £8.90£6.733 £9.70£6.384 £9.80£5.605 £10.40£5.175 £78.00£38.78Pound NPV £15.70 $ NPV (S=1.7) $26.7016Suppose R($)=6% R(pound)=10%•Then Irp means S1=S0(1.06)/1.10Time Period Free Cash FlowS FCF ($)0 -£56.001.7 -$95.201 £10.401.638 $17.042 £8.901.579 $14.053 £9.701.521 $14.764 £9.801.466 $14.375 £10.401.413 $14.695 £78.001.413 $110.1817Estimating the Future Expected Exchange RatesWe can appeal to PPP:tftdtππSS)1()1(018Suppose (1+WACC($))/(1+WACC(U.K))=(1+r($))/(1+r(U.K))•WACC($)=(1.15)*(1.06)/(1.1)=10.8%Time PeriodFree Cash FlowS FCF ($) PV0 -£56.001.7 -$95.20 -$95.201 £10.401.638 $17.04 $15.372 £8.901.579 $14.05 $11.443 £9.701.521 $14.76 $10.844 £9.801.466 $14.37 $9.535 £10.401.413 $14.69 $8.795 £78.001.413 $110.18 $65.93NPV $26.7019Moral•If the assumptions are met, it doesn’t seen to matter what currency is used to evaluate the project•But–What if IRP doesn’t hold–What if the Wacc’s are inconsistent with the risk free rates20A recipe for international decision makers:1.

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