Eiteman/Stonehill/MoffettMultinationalBusinessFinance,SixteenthEdition

Chapter18:MultinationalCapitalBudgetingandCross-BorderAcquisitions

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Copyright?2023PearsonEducation,Inc.

Chapter18

MultinationalCapitalBudgetingandCross-BorderAcquisitions

18.1 CapitalBudgetingTheoreticalFramework.Capitalbudgetingforaforeignprojectusesthesametheoreticalframeworkasdomesticcapitalbudgeting.Whatarethebasicstepsindomesticcapitalbudgeting?

Multinationalcapitalbudgeting,liketraditionaldomesticcapitalbudgeting,focusesonthecashinflowsandoutflowsassociatedwithprospectivelong-terminvestmentprojects.MultinationalcapitalbudgetingtechniquesareusedintraditionalFDIanalysis,suchastheconstructionofamanufacturingplantinanothercountry,aswellasinthegrowingfieldofinternationalmergersandacquisitions.

Capitalbudgetingforaforeignprojectusesthesametheoreticalframeworkasdomesticcapitalbudgeting—withafewveryimportantdifferences.Thebasicstepsareasfollows:

1. Identifytheinitialcapitalinvestedorputatrisk.

2. Estimatecashflowstobederivedfromtheprojectovertime,includinganestimateoftheterminalorsalvagevalueoftheinvestment.

3. Identifytheappropriatediscountratefordeterminingthepresentvalueoftheexpectedcashflows.

4. Applytraditionalcapitalbudgetingdecisioncriteriasuchasnetpresentvalue(NPV)andinternalrateofreturn(IRR)todeterminetheacceptabilityoforpriorityrankingofpotentialprojects.

18.2 ForeignComplexities.Capitalbudgetingforaforeignprojectisconsiderablymorecomplexthanthedomesticcase.Whatarethefactorsthataddcomplexity?

Severalfactorscontributetothisgreatercomplexity:

Parentcashflowsmustbedistinguishedfromprojectcashflows.Eachofthesetwotypesofflowscontributestoadifferentviewofvalue.

Parentcashflowsoftendependontheformoffinancing.Thuswecannotclearlyseparatecashflowsfromfinancingdecisions,aswecanindomesticcapitalbudgeting.

Additionalcashflowsgeneratedbyanewinvestmentinoneforeignsubsidiarymaybeinpartorinwholetakenawayfromanothersubsidiary,withthenetresultthattheprojectisfavorablefromasinglesubsidiary’spointofviewbutcontributesnothingtoworldwidecashflows.

Theparentmustexplicitlyrecognizeremittanceoffundsbecauseofdifferingtaxsystems,legalandpoliticalconstraintsonthemovementoffunds,localbusinessnorms,anddifferencesinthewayfinancialmarketsandinstitutionsfunction.

Anarrayofnonfinancialpaymentscangeneratecashflowsfromsubsidiariestotheparent,includingpaymentoflicensefeesandpaymentsforimportsfromtheparent.

Managersmustanticipatedifferingratesofnationalinflationbecauseoftheirpotentialtocausechangesincompetitiveposition,andthuschangesincashflowsoveraperiodoftime.

Managersmustkeepthepossibilityofunanticipatedforeignexchangeratechangesinmindbecauseofpossibledirecteffectsonthevalueoflocalcashflows,aswellasindirecteffectsonthecompetitivepositionoftheforeignsubsidiary.

Useofsegmentednationalcapitalmarketsmaycreateanopportunityforfinancialgainsormayleadtoadditionalfinancialcosts.

Useofhost-governmentsubsidizedloanscomplicatesbothcapitalstructureandtheparent’sabilitytodetermineanappropriateweightedaveragecostofcapitalfordiscountingpurposes.

Managersmustevaluatepoliticalriskbecausepoliticaleventscandrasticallyreducethevalueoravailabilityofexpectedcashflows.

Terminalvalueismoredifficulttoestimatebecausepotentialpurchasersfromthehost,parent,orthirdcountries,orfromtheprivateorpublicsector,mayhavewidelydivergentperspectivesonthevaluetothemofacquiringtheproject.

18.3 ProjectversusParentValuation.Whyshouldaforeignprojectbeevaluatedbothfromaprojectandparentviewpoint?

Astrongtheoreticalargumentexistsinfavorofanalyzinganyforeignprojectfromtheviewpointoftheparent.Cashflowstotheparentareultimatelythebasisfordividendstostockholders,reinvestmentelsewhereintheworld,repaymentofcorporate-widedebt,andotherpurposesthataffectthefirm’smanyinterestgroups.However,sincemostofaproject’scashflowstoitsparent,ortosistersubsidiaries,arefinancialcashflowsratherthanoperatingcashflows,theparentviewpointusuallyviolatesacardinalconceptofcapitalbudgeting,namely,thatfinancialcashflowsshouldnotbemixedwithoperatingcashflows.Oftenthedifferenceisnotimportantbecausethetwoarealmostidentical,butinsomeinstancesasharpdivergenceinthesecashflowswillexist.

Evaluationofaprojectfromthelocalviewpointservessomeusefulpurposes,butitshouldbesubordinatedtoevaluationfromtheparent’sviewpoint.Inevaluatingaforeignproject’sperformancerelativetothepotentialofacompetingprojectinthesamehostcountry,wemustpayattentiontotheproject’slocalreturn.Almostanyprojectshouldatleastbeabletoearnacashreturnequaltotheyieldavailableonhostgovernmentbondswithamaturitythesameastheproject’seconomiclife,ifafreemarketexistsforsuchbonds.Hostgovernmentbondsordinarilyreflectthelocalrisk-freerateofreturn,includingapremiumequaltotheexpectedrateofinflation.Ifaprojectcannotearnmorethansuchabondyield,theparentfirmshouldbuyhostgovernmentbondsratherthaninvestinariskierproject.

18.4 ViewpointandNetPresentValue.Whichviewpoint,projectorparent,givesresultsclosertothetraditionalmeaningofnetpresentvalue(NPV)incapitalbudgeting?

Multinationalfirmsshouldinvestonlyiftheycanearnarisk-adjustedreturngreaterthanlocallybasedcompetitorscanearnonthesameproject.Iftheyareunabletoearnsuperiorreturnsonforeignprojects,theirstockholderswouldbebetteroffbuyingsharesinlocalfirms,wherepossible,andlettingthosecompaniescarryoutthelocalprojects.Apartfromthesetheoreticalarguments,surveysoverthepast35yearsshowthatinpracticemultinationalfirmscontinuetoevaluateforeigninvestmentsfromboththeparentandprojectviewpoint.

18.5 ViewpointandConsolidatedEarnings.Whichviewpointgivesresultsclosertotheeffectonconsolidatedearningspershare?

Theattentionpaidtoprojectreturnsinvarioussurveysprobablyreflectsemphasisonmaximizingreportedconsolidatednetearningspershareasacorporatefinancialgoal.Aslongasforeignearningsarenotblocked,theycanbeconsolidatedwiththeearningsofboththeremainingsubsidiariesandtheparent.Asmentionedpreviously,U.S.firmsmustconsolidateforeignsubsidiariesthatareover50%owned.Ifafirmisownedbetween20%and49%byaparent,itiscalledanaffiliate.Affiliatesareconsolidatedwiththeparentowneronaproratabasis.Subsidiarieslessthan20%ownedarenormallycarriedasunconsolidatedinvestments.Eveninthecaseoftemporarilyblockedfunds,someofthemostmatureMNEsdonotnecessarilyeliminateaprojectfromfinancialconsideration.Theytakeaverylong-runviewofworldbusinessopportunities.

18.6 OperatingandFinancingCashFlows.Capitalprojectsprovidebothoperatingcashflowsandfinancialcashflows.Whyareoperatingcashflowspreferredfordomesticcapitalbudgetingbutfinancialcashflowsgivenmajorconsiderationininternationalprojects?

Ifreinvestmentopportunitiesinthecountrywherefundsareblockedareatleastequaltotheparentfirm’srequiredrateofreturn(afteradjustingforanticipatedexchangeratechanges),temporaryblockageoftransfermayhavelittlepracticaleffectonthecapitalbudgetingoutcome,becausefutureprojectcashflowswillbeincreasedbythereturnsonforcedreinvestment.Sincelargemultinationalsholdaportfolioofdomesticandforeignprojects,corporateliquidityisnotimpairedifafewprojectshaveblockedfunds;alternatesourcesoffundsareavailabletomeetallplannedusesoffunds.Furthermore,along-runhistoricalperspectiveonblockedfundsdoesindeedlendsupporttothebeliefthatfundsarealmostneverpermanentlyblocked.However,waitingforthereleaseofsuchfundscanbefrustrating,andsometimestheblockedfundslosevaluewhileblockedbecauseofinflationorunexpectedexchangeratedeterioration,eventhoughtheyhavebeenreinvestedinthehostcountrytoprotectatleastpartoftheirvalueinrealterms.

18.7 RiskAdjustedReturn.Shouldtheanticipatedinternalrateofreturn(IRR)foraproposedforeignprojectbecomparedto(a)alternativehomecountryproposals,(b)returnsearnedbylocalcompaniesinthesameindustryand/orriskclass,or(c)both?Justifyyouranswer.

Thekeytodistinctionis“risk-adjusted.”Foreignprojectswillbe,bymostmethodologies,beofhigherriskthanadomesticorhomecountryproject.Theanticipatedreturnsshouldthereforetakethisintoconsideration.Atthesametime,comparingexpectedreturnswiththoseearnedbylocalcompaniesinthetargetmarketswillnotcapturethecross-borderrisks(suchasblockedfunds)whichaforeigninvestormayexperience.Intheend,theansweris(c),bothoftheabove,andmore.

18.8 BlockedCashFlows.Intheevaluationofapotentialforeigninvestment,howshouldamultinationalfirmevaluatecashflowsinthehostforeigncountrythatareblockedfrombeingrepatriatedtothefirm’shomecountry?

Theimpactofblockedfundsontherateofreturnfromtheinvestor’sperspectivewoulddependonwhentheblockageoccurs,whatreinvestmentopportunitiesexistfortheblockedfundsinthecaptivecountry,andwhentheblockedfundswouldeventuallybereleasedtotheinvestor.Aswithallcashflow-basedfinancialanalyses,thecriticalelementiswhentheparentinvestorwillregaintheabilitytomovetheblockedfundsfreely.

18.9 HostCountryInflation.HowshouldanMNEfactorhostcountryinflationintoitsevaluationofaninvestmentproposal?

Inflationisfactoredintotheexpectedcashflowsoftheprojectrateofreturn.Relativeinflationaffectstheexpectedexchangerateduetopurchasingpowerparity.

18.10 CostofEquity.Aforeignsubsidiarydoesnothaveanindependentcostofcapital.However,inordertoestimatethediscountrateforacomparablehostcountryfirm,theanalystshouldtrytocalculateahypotheticalcostofcapital.Howisthisdone?

Aspartofthisprocess,theanalystcanestimatethesubsidiary’sproxycostofequitybyusingthetraditionalequation:ke=krf+β(km–krf).DefineeachvariableinthisequationandexplainhowthevariablemightbedifferentforaproxyhostcountryfirmcomparedtotheparentMNE.

Thecostofcapitalandequityofaspecificprojectorsubsidiarysuchasthiswouldbeexpressedinlocalcurrencyterms,whiletheparentcompanywillultimatelymeasuretheproject’sexpectedreturnsandrisksbasedonitsownparentcurrencyterms.Therefore,therisk-freeratewouldbealocalcurrencygovernmentbond.Themarketreturnwouldbetheexpectedreturnonthemarketportfoliointhelocalmarket(typicallybasedonrecenthistoricalreturns).Thelocalproject’sbetawouldbefirstbasedonotherlikefirmsinthelocalmarketandtheirhistoricalcovariancewiththevarianceofthemarket.

18.11 ViewpointCashFlows.Whatarethedifferencesinthecashflowsusedinaprojectpointofviewanalysisandaparentpointofviewanalysis?

Theprojectviewpointfocusesonthecashflowswhicharetraditionallyisolatedandanalyzedbyanyprospectiveinvestment—theoperationalcashflowsoftheproposedproject(initialinvestment,operatingcashflows,terminalvalue).Theparentviewpointanalysis,musthoweverfocusonthosecashflowswhichflowbetweentheparentandtheprojectofanykind—includingoperatingcashflows(operatingreturns,intra-firmsalesandmargins,etc.)aswellasfinancingcashflows(dividendsasdistributedtotheparentfromtheproject).

18.12 ForeignExchangeRiskandCapitalBudgeting.Howisforeignexchangerisksensitivityfactoredintothecapitalbudgetinganalysisofaforeignproject?

Inthechapterproblem,theprojectteamassumedthattheIndonesianrupiahwoulddepreciateversustheU.S.dollaratthepurchasingpowerparity“rate”(approximately26.2%peryearinthebaselineanalysis).Whatiftherateofrupiahdepreciationweregreater?AlthoughthiseventwouldmaketheassumedcashflowstoCemexworthlessindollars,operatingexposureanalysiswouldbenecessarytodeterminewhetherthecheaperrupiahmadeSemenIndonesiamorecompetitive.

Forexample,sinceSemenIndonesia’sexportstoTaiwanaredenominatedinU.S.dollars,aweakeningoftherupiahversusthedollarcouldresultingreaterrupiahearningsfromthoseexportsales.ThisservestosomewhatoffsettheimportedcomponentsthatSemenIndonesiapurchasesfromtheparentcompanythatarealsodenominatedinU.S.dollars.SemenIndonesiaisrepresentativeoffirmstodaywhichhavebothcashinflowsandoutflowsdenominatedinforeigncurrencies,providingapartialnaturalhedgeagainstcurrencymovements.

Whatiftherupiahshouldappreciateagainstthedollar?Thesamekindofeconomicexposureanalysisisneeded.InthisparticularcasewemightguessthattheeffectwouldbepositiveonbothlocalsalesinIndonesiaandthevalueindollarsofdividendsandlicensefeespaidtoCemexbySemenIndonesia.Note,however,thatanappreciationoftherupiahmightleadtomorecompetitionwithinIndonesiafromfirmsinothercountrieswithnow-lowercoststructures,lesseningSemenIndonesia’ssales.

18.13 ExpropriationRisk.Howisexpropriationriskfactoredintothecapitalbudgetinganalysisofaforeignproject?

Thisistypicalofthecomplexityofcapturingpoliticalriskanditsrepercussionsonfinancialperformanceinaprospectiveprojectanalysis.Again,ifexpropriationriskisconsideredhighlypossible,therisk-adjustedreturnmustcaptureitinsomemanner.

Manyexpropriationseventuallyresultinsomeformofcompensationtotheformerowners.Thiscompensationcancomefromanegotiatedsettlementwiththehostgovernmentorfrompaymentofpoliticalriskinsurancebytheparentgovernment.Negotiatingasettlementtakestime,andtheeventualcompensationissometimespaidininstallmentsoverafurtherperiodoftime.Thusthepresentvalueofthecompensationisoftenmuchlowerthanitsnominalvalue.Furthermore,mostsettlementsarebasedonbookvalueofthefirmatthetimeofexpropriationratherthanthefirm’smarketvalue.

18.14 RealOptionAnalysis.Whatisrealoptionanalysis?Howisitabettermethodofmakinginvestmentdecisionsthantraditionalcapitalbudgetinganalysis?

Realoptionsisadifferentwayofthinkingaboutinvestmentvalues.Atitscore,itisacrossbetweendecision-treeanalysisandpureoption-basedvaluation.Itisparticularlyusefulwhenanalyzinginvestmentprojectsthatwillfollowverydifferentvaluepathsatdecisionpointsintimewheremanagementdecisionsaremaderegardingprojectpursuit.Thiswiderangeofpotentialoutcomesisattheheartofrealoptiontheory.Realoptionvaluationalsoallowsustoanalyzeanumberofmanagerialdecisionswhichinpracticecharacterizemanymajorcapitalinvestmentprojects:

1. Theoptiontodefer

2. Theoptiontoabandon

3. Theoptiontoaltercapacity

4. Theoptiontostartuporshutdown(switching)

Realoptionanalysistreatscashflowsintermsoffuturevalueinapositivesense,whereasDCFtreatsfuturecashflowsnegatively(onadiscountedbasis).Realoptionanalysisisaparticularlypowerfuldevicewhenaddressingpotentialinvestmentprojectswithextremelylonglifespans,orinvestmentsthatdonotcommenceuntilfuturedates.Realoptionanalysisacknowledgesthewayinformationisgatheredovertimetosupportdecisionmaking.Managementlearnsfrombothactive(searchingitout)andpassive(observingmarketconditions)knowledgegatheringandthenusesthisknowledgetomakebetterdecisions.

18.15 MergersandAcquisitionsBusinessDrivers.Whataretheprimarydrivingforcesthatmotivatecross-bordermergersandacquisitions?

ThedriversofM&Aactivityarebothmacroinscope—theglobalcompetitiveenvironment—andmicroinscope—thevarietyofindustryandfirmlevelforcesandactionsdrivingindividualfirmvalue.Theprimaryforcesofchangeintheglobalcompetitiveenvironment—technologicalchange,regulatorychange,andcapitalmarketchange—createnewbusinessopportunitiesforMNEs,whichtheypursueaggressively.

Asopposedtogreenfieldinvestment,acrossborderacquisitionhasanumberofsignificantadvantages.Firstandforemost,itisquicker.Greenfieldinvestmentfrequentlyrequiresextendedperiodsofphysicalconstructionandorganizationaldevelopment.Byacquiringanexistingfirm,theMNEshortensthetimerequiredtogainapresenceandfacilitatecompetitiveentryintothemarket.Second,acquisitionmaybeacosteffectivewayofgainingcompetitiveadvantages,suchastechnology,brandnamesvaluedinthetargetmarket,andlogisticalanddistributionadvantages,whilesimultaneouslyeliminatingalocalcompetitor.Third,specifictocrossborderacquisitions,internationaleconomic,political,andforeignexchangeconditionsmayresultinmarketimperfections,allowingtargetfirmstobeundervalued.

18.16 ThreeStagesofCross-BorderAcquisitions.Whatarethethreestagesofacross-borderacquisition?Whatarethecorefinancialelementsintegraltoeachstage?

Theprocessofacquiringanenterpriseanywhereintheworldhasthreecommonelements