International Capital

Budgeting (Ch18)

Learning Objectives
The Adjusted Present Value (APV) Model
Capital Budgeting from the Parent Firms Perspective
Risk Adjustment in the Capital Budgeting Process
Sensitivity Analysis

MM Proposition
Modigliani and Miller (1963): the market value of a levered
firm is greater than an equivalent unlevered firm earning
the same net operating income (NOI=R-OC-D):
VL=Vu+t*Debt
Because the levered firm has tax savings from the tax
deductibility of interest payments to bondholders that do not
go to the government.

E.g. Exhibit 18.1

The Adjusted Present Value (APV) Model

By direct analogy to the MM proposition, the basic NPV
equation can be extended to the adjusted present value
(APV) model:
T (Rt-OCt)(1 )
Dt
It
APV =
+
+
t
t
(1 + ku)
(1 + i)
(1 + i)t
t=1

TVT
(1 + ku)

C0

Where Ku is the all-equity cost of capital and i is the cost the

debt.

APV
The APV model is a value additivity approach to capital
budgeting:
Each cash flow that is a source of value to the firm is
discounted at a rate that reflects the riskiness of the cash
flow.

APV =

t=1

(Rt- OCt)(1 ) D
It
TVT
t
+
+
+
C0
t
t
t
T
(1 + ku)
(1 + i) (1 + i)
(1 + ku)

APV Example
The timing and size of the after-tax operating cash flows for
an all-equity firm are:

-$1,000
0

$125
1

CF0

= $1000

CF1

= $125

CF2

= $250

CF3

= $375

CF4

= $500

$250
2

$375
3

$500

The unlevered cost of equity is 10%.

I
NPV

= 10
= $56.50

The project would be rejected by an all-equity

firm. 6

APV Example (continued)

Now, imagine that the firm finances the project with $600 of
debt at 8%.
If tax rate is 40%, the interest tax shield is $19.2
(=40%$6008%) per year.
The APV of the project is &7.09
The firm should accept the project if it finances the project with
debt.

APV =

$125
1.10

$19.20
1.08

$250
(1.10)

$19.20
(1.08)

$375
(1.10)

$19.20
(1.08)

$500
(1.10)4

$19.20
(1.08)4

$1,000

APV for International Capital Budgeting

Donald Lessard developed an APV model for a MNC
analyzing a foreign capital expenditure from the parent
firms perspective.
The model recognizes many of the particulars peculiar to
foreign direct investment, such as:
Subsidy by host country
Restricted fund
Extra tax for remittances
Different tax rates in two countries
T

T
T
St (Rt OCt )(1 t)
S t tDt
St tI t
APV

(1 i ) t (1 i ) t
t
(1

k
)
ud
d
d
t 1
t 1
t 1
T
ST TVT
S t LPt

S
C

S
RF

S
CL

(1 i ) t
0
0
0
0
0
0
(1 k ud )T
d
t 1

APV for International Capital Budgeting

T

T
T
St (Rt OCt )(1 t)
St tDt
St tI t
APV

t
t
t
(1

k
)
(1

i
)
(1

i
)
ud
d
d
t 1
t 1
t 1
T
ST TVT
St LPt

S
C

S
RF

S
CL

0
0
0
0
0
0
T
t
(1 k ud )
(1

i
)
d
t 1

The operating cash flows must be

measured by parent firms home currency.
The expected future spot rate can be
measured with PPP or IRP.

The operating cash flows must

be discounted at the
domestic all-equity cost of
capital.

APV for International Capital Budgeting

T

T
T
St (Rt OCt )(1 t)
St tDt
St tI t
APV

t
t
t
(1
k
)
(1
i
)
(1
i
)
ud
d
d
t1
t1
t1
T
ST TVT
St LPt

S0C0 S0 RF0 S0CL0

T
t
(1 k ud )
(1
i
)
d
t1

Represents only the portion

that is available for remittance
that can be legally remitted to
the parent firm.

The marginal corporate tax

rate, , is the larger of the
parents or foreign subsidiarys.

10

APV for International Capital Budgeting

T

T
St (Rt OCt )(1 t) T St tDt
St tIt
APV

t
t
t
(1
k
)
(1
i
)
(1
i
)
ud
d
d
t1
t1
t1
T
ST TVT
St LPt

S0C0 S0 RF0 S0CL0

T
t
(1 k ud )
(1
i
)
d
t1

S0RF0 represents the value of

accumulated restricted funds
(in the amount of RF0) that are
freed up by the project.

The difference represents the

benefit of concessionary loan (the
loan with a lower than normal
interest rate), i.e. the subsidy
offered by the host country.
11

Borrowing Capacity & Optimal Capital

Structure
When a capital project is undertaken, the firms asset base
increases.
As a result, the firm can handle more debt in its capital
structure, i.e. the borrowing capacity of the firm will be
increased by the project.

The increased borrowing capacity is determined by the

firms optimal capital structure.
Please notice that the increased borrowing capacity may be
different from the actual amount of debt used to finance the
project.

12

APV for International Capital Budgeting

St (Rt OCt )(1 t)

St tDt
St tI t
APV

t
t
t
(1

k
)
(1

i
)
(1

i
)
ud
d
d
t 1
t 1
t 1
T
ST TVT
St LPt

S
C

S
RF

S
CL

(1 i ) t
0
0
0
0
0
0
(1 k ud )T
d
t 1

Interest tax shield are based on the borrowing capacity created

by the project regardless of how the project is financed.
Therefore, only the portion of the interest that is consistent with
the optimal capital structure will be used.

13

Risk Adjustment in the Capital Budgeting

APV is suitable for projects with average riskiness.
Adjust for risk in the APV framework:
Risk-adjusted discount rate method
Certainty equivalent method

14

Sensitivity Analysis
In sensitivity analysis, different estimates are used as
inputs for APV calculation.
Sensitivity analysis gives the manager a more complete
picture of the planned capital investment.

15

Case Study: Centralia Corporation

A US manufacturer of small kitchen electrical appliances
currently sells microwaves in Spain through an affiliate.
Current sales are 9,600 units/year and increasing at a rate
of 5%.
Price is $180 per unit, of which $35 represents the profit
margin and expected to increase with inflation.

16

Centralias Capital Expenditure

Project: To build a manufacturing facility in Zaragoza, Spain
Cost of plant is 5,500,000
Creates a borrowing capacity $2,904,000;
New plant will be depreciated over 8 years;

Centralia will get a special financing deal:

4,000,000 at 5% per year;
Normal borrowing rate is 8% in dollars and 7% in ;
Principal to be repaid in eight equal installments;

Sales to EU forecast at 25,000 units in the first year and

expect to increase by 12% per year
Sales price is 200/unit and production cost is 160/unit in the
1st year
Both are expected to increase with inflation.
17

Other Information
Madrid sales affiliate accumulated a net amount of
750,000 from its operations, which can be used to
partially finance construction cost (this is an example of
RF);
The accumulated funds (750,000) were earned under special
tax concessions and taxed at a marginal rate of 20%.

Expected inflation: 2.1% in Spain; 3% in the U.S

The current exchange rate: $1.32/.
Marginal tax rate in Spain and the U.S.: 35%
Dollar all-equity cost of capital: 12%
Should Centralia take the project?

18

Calculating APV
Initial cost of the project in $:

S 0 C 0 1.32 * 5,500,000 $7,260,000

Use PPP to forecast future spot rates:

St S 0 * (

1.03 t
)
1.021

Calculate the PV of the after-tax operating cash flows

(Exhibit 18.2)
Incremental CFs should be used:
Operating CFs generated by the new manufacturing facility
Minus: Lost sales and contribution margin by the existing
sales
Discount the incremental operating cash flows at the $ allequity cost of capital
19

PV of the after-tax operating cash flows

(Exhibit 18.2)
Year

0
1
2
3
4
5
6

St

New
New Sales Sales

Lost
Lost Sales Sales

Beforetax OCF

PV of
Afterafter-tax
tax OCF OCF

Units

Units

1.32

$ (i=12%)

9,600

1.3316 25,000

1,331,63
6 10,080

363,384 968,252

1.3434 28,000

1,536,17
5 10,584

393,000 1,143,175 743,064 592,366

1.3552 31,360

1,772,13
1 11,113

425,029 1,347,102 875,616 623,246

1.3672 35,123

2,044,33
1 11,669

459,669 1,584,662 1,030,030

654,603

1.3792 39,338

2,358,34
0 12,252

497,132 1,861,208 1,209,785

686,465

1.3914 44,059

2,720,58
1 12,865

537,648 2,182,932 1,418,906718,862

3,138,46

629,364 561,932

20

PV of the depreciation tax shields

(Exhibit 18.3)

Year

St

(t)
1
2
3
4
5
6
7
8

1.3316
1.3434
1.3552
1.3672
1.3792
1.3914
1.4036
1.4160

Dt

tDt

PV of tDt

( id=8%)

687,500
687,500
687,500
687,500
687,500
687,500
687,500
687,500

320,425
323,249
326,099
328,973
331,873
334,799
337,750
340,727

296,690
277,134
258,868
241,805
225,867
210,980
197,074
184,084
1,892,502

21

PV of the concessionary loan payments

(Exhibit 18.4)
Year

St

Loan
Outstanding Principal

Interest

Total Loan
PMT

(t)

PV of LP
(id=8%)

1.3200

4,000,000

1.3316

3,500,000

500,000

200,000

932,145

863,097

1.3434

3,000,000

500,000

175,000

906,777

777,415

1.3552

2,500,000

500,000

150,000

880,890

699,279

1.3672

2,000,000

500,000

125,000

854,476

628,065

1.3792

1,500,000

500,000

100,000

827,528

563,202

1.3914

1,000,000

500,000

75,000

800,038

504,160

1.4036

500,000

500,000

50,000

771,999

450,454

1.4160

- 500,000

25,000

743,404

401,638

22

PV of the benefit from the concessionary

loan (Exhibit 18.5)
T

S0CL0

(1 + i )

t=1

St LPt

S0CL0 : $ amount of concessionary loan= $1.32*4,000,000

The 2nd item represents the size of the equivalent loan
available (in $) from borrowing at the normal borrowing
rate with a debt service schedule equivalent to that of the
concessionary loan.
The difference $392,689 represents the PV of the benefit
of the below market rate financing of the concessionary
loan.
23

PV of interest tax shields (Exhibit 18.6)

Year

St

(t)

Interest

Interest

Interest tax PV of Interest

Shields ($) tax shields ($)

(id=8%)

1.3316

200,000

266,327

0.55

51,268

47,470

1.3434

175,000

235,090

0.55

45,255

38,799

1.3552

150,000

203,282

0.55

39,132

31,064

1.3672

125,000

170,895

0.55

32,897

24,181

1.3792

100,000

137,921

0.55

26,550

18,069

1.3914

75,000

104,353

0.55

20,088

12,659

1.4036

50,000

70,182

0.55

13,510

7,883

1.4160

25,000

35,400

0.55

6,815

3,682

183,807
24

Not all interest payments are used for tax

shield calculation!!
The concessionary loan (4 million) represents 72.73% of
the project cost of 5.5 million.
The projects debt ratio is 72.73%.

By comparison, the created borrowing capacity is

$2,904,000, which indicates an optimal debt ratio of 40%.
40%=$2,904,000/$7,260,000

Therefore, only 55% (=40%/72.73%) of the interest

payments are used for tax shield calculation.

25

Calculate the amount of the freed-up

restricted remittances
The after-tax accumulation of 750,000 is generated by the
Spain sales affiliate which pays a 20% tax rate in Spain.
Therefore, the before-tax income is 937,500 (= 750,000/(120%)).

If Centralia does not establish the facility in Spain,

750,000 will be repatriated to the parent firm.
Given US tax rate is 35%, Centralia is required to pay
additional taxes in the US in the amount of $185,625 (=(35%20%)*937,500*$1.32/).

If the manufacturing facility is built in Spain, the additional

tax will not occur.
The freed-up funds is $185,625 resulting from the tax
savings.
26

Calculating APV
APV=5,374,685+1,892,502+392,689+183,807+185,6257,260,000
=$769,308
Accept this project!
Note: if the APV is negative or close to zero, we would need
to consider the PV of the after-tax terminal cash flow.

27

Learning Outcomes
Discuss why the APV capital budgeting framework is
useful for analyzing foreign capital expenditures
Discuss how to handle a concessionary loan in the APV
model
Conduct APV analysis