Tutorial 9 Answers

1. Why is capital budgeting analysis so important to the firm?

ANSWER: Capital investments involve large expenditures and the decisions are difficult
to reverse, and have long-term effects. Thus, capital budgeting decisions require careful
and thorough analysis.

2. What is the intuition behind the NPV capital budgeting framework?

ANSWER: The NPV methodology compares the present value of all cash inflows
of a project versus the present value of all project outflows. Positive NPV indicates that
inflows are enough to cover all operating costs and financing costs, hence the project
adds wealth to shareholders.

3. How would you incorporate political risk into the capital budgeting process of foreign
investment projects?

ANSWER:
The standard approach is to adjust the cost of capital upward to reflect political risk, and
discount the expected future cash flows at a higher rate. Alternatively, one can subtract
insurance premium for political risk from the expected future cash flows and use the
usual cost of capital, which is applied to domestic capital budgeting.

4. Why should capital budgeting for subsidiary projects be assessed from the parent’s
perspective? What additional factors that normally are not relevant for a purely domestic
project deserve consideration in multinational capital budgeting?

ANSWER: When a parent allocates funds for a project, it should view the project’s
feasibility from its own perspective.  It is possible that a project could be feasible from a
subsidiary’s perspective but may not be feasible when considering a parent’s perspective
(due to foreign withholding taxes or exchange rate changes affecting funds remitted to
the parent).

Some of the more obvious factors are (1) exchange rates, (2) whether currency
restrictions may exist, (3) probability of a host government takeover, and (4) foreign
demand for the product.

5. a. Describe in general terms how future appreciation of the euro will likely affect the
value (from the parent’s perspective) of a project established in Germany today by a
U.S.-based MNC.  Will the sensitivity of the project value be affected by the percentage
of earnings remitted to the parent each year?
b. Repeat this question, but assume the future depreciation of the euro.
 ANSWER:

a. Future appreciation of the euro would benefit the parent since the euro earnings
would be worth more when remitted and converted to dollars.  This is especially
true when a large percentage of earnings are sent to the parent.

b. The future depreciation of the euro would hurt the parent since the euro earnings
would be worth less when remitted and converted to dollars.  This is especially true
when a large percentage of earnings are sent to the parent.

6. When considering the implementation of a project in one of various possible countries,

what types of tax characteristics should be assessed among the countries? (See the
chapter appendix)

ANSWER: Corporate taxes in the country should be considered by an MNC, along

with withholding taxes, and even individual tax rates imposed on the potential
employees. Excise taxes are also relevant.

Problems

1. Capital Budgeting Analysis. A project in South Korea requires an initial investment

of 2 billion South Korean won. The project is expected to generate net cash flows to
the subsidiary of 3 billion and 4 billion won in the two years of operation,
respectively. The project has no salvage value. The current value of the won is 1,100
won per U.S. dollar, and the value of the won is expected to remain constant over the
next two years.

a. What is the NPV of this project (parent view point) if the required rate of return is
13 percent?

b. Repeat the question, except assume that the value of the won is expected to be
1,200 won per U.S. dollar after two years. Further assume that the funds are
blocked and that the parent company will only be able to remit them back to the
U.S. in two years. How does this affect the NPV of the project?
 ANSWER:
a)
Year 0 1 2
Investment –2,000,000,000
Operating CF 3,000,000,000 4,000,000,000

Net CF (won) –2,000,000,000 3,000,000,000 4,000,000,000

Exchange rate 1,100 1,100 1,100

Cash flows to parent –$1,818,181.82 $2,727,272.73 $3,636,363.64
PV of parent cash flows –$1,818,181.82 $2,413,515.69 $2,847,806.12

The NPV is $3,443,139.99.

b)
Year 0 1 2

Net CF (won) –2,000,000,000 0 7,000,000,000*

Exchange rate 1,100 1,200

Cash flows to parent –$1,818,181.82 $5,833,333.33
PV of parent cash flows –$1,818,181.82 $4,568,355.65

The NPV is $2,750,173.83

A situation where the funds are blocked and the won is expected to depreciate reduces the
NPV by $692,966.16.

*Note: assumed that the return generated on 3,000,000,000 for the blocked period will be
NIL.

2. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next
three years, the project will generate total operating cash flows of $3,500,000, measured
in today’s dollars using a required rate of return of 14 percent. What is the break-even
salvage value of this project?

ANSWER:
Note:
 CFt  This is just the standard NPV equation
SVn  I0   t
(1  k )n (including initial investment, operating
 (1  k )  cashflows and salvage value) that has been
rearranged to solve for salvage value!
 ($4,000,000  $3,500,000 )(1.14)3
 $740,772
 3. Suppose the Taiwan government is willing to provide a loan of $10 million at 5% to
Xebec to build a factory there. The loan would be paid off in equal annual
installments over a five-year period. If the market interest rate for such an
investment is 14%, what is the before-tax value of the interest subsidy?

ANSWER. Borrowing at 5% when the market rate of interest is 14% saves Xebec 9%
annually on the principal balance outstanding. This leads to annual before-tax savings
and their associated present values as follows:

Interest PV Factor Present

Note: Year Principal Savings (@ 14%) Value
This is the principal balance
at the beginning of the year. 1 $10,000,000 $900,000 .8772 $789,480
The company gets charged 2 8,000,000 720,000 .7695 554,040
interest for the year on this
opening balance. 3 6,000,000 540,000 .6750 364,500
However, interest is actually 4 4,000,000 360,000 .5921 213,156
paid at the end of the year. 5 2,000,000 180,000 .5194 93,492
Total $2,014,668

The value of this five-year stream of cash, discounted at 14%, is $2,014,668.

4. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in

Ghana. The construction cost 9 billion Ghanian cedi. Brower intends to leave the
plant open for three years. During the three years of operation, cedi cash flows are
expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi, respectively. Operating
cash flows will begin one year from today and are remitted back to the parent at the
end of each year. At the end of the third year, Brower expects to sell the plant for 5
billion cedi. Brower has a required rate of return of 17 percent. It currently takes
8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent
per year.

a. Determine the NPV for this project. Should Brower build the plant?

b. How would your answer change if the value of the cedi was expected to remain
unchanged from its current value of 8,700 cedis per U.S. dollar over the course of
the three years? Should Brower construct the plant then?

ANSWER: a
 Cash Flows:

Year 0 1 2 3
Investment –9
Operating CF 3 3 2
Note:
The exchange rate for each
Salvage Value 5
period (F) is calculated from
the previous period spot rate Net CF (cedi billions) –9 3 3 7
(S) using:
(F-S)/S = x%
Exchange rate 8,700 9,135 9,592 10,071
However, be careful that this Cash flows to parent –$1,034,483 $328,407.23 $312,760.63 $695,065.04
formula gives you x% as the
appreciation/ depreciation of PV of parent cash flows –$1,034,483 $280,689.94 $228,475.88 $433,978.15
the base currency.
In this question you are given
NPV Just the cumulative sum –$1,034,483 –$753,793.06 –$525,317.18 –$91,339.03
the term currency depreciation. of PVs at each date
The theoretically correct way
is to take the reciprocal Since the project has a negative net present value (NPV), Brower should not undertake it.
exchange rate (since no
bid/ask spread) then apply this
formula (see assignment 1).
Alternatively you can use the
other formula for term
currency appreciation. ANSWER: b
However, in this model answer
it looks like they simply
assumed that 5% depreciation
of cedi (term) means a 5% If the cedi was expected to remain unchanged from its current value of 8700 cedis per
appreciation of US$ (base),
then they applied the base
currency formula!
U.S. dollar over the course of the three years:

Year 0 1 2 3
Investment –9
Operating CF 3 3 2
Salvage Value 5
Net CF (cedi billions) –9 3 3 7
Exchange rate 8,700 8,700 8,700 8,700
Cash flows to parent –$1,034,483 $344,827.59 $344,827.59 $804,597.70
PV of parent cash flows –$1,034,483 $294,724.44 $251,901.23 $502,367.11
NPV –$1,034,483 –$739,748.56 –$487,847.33 +$14,519.78

If the value of the cedi remains constant, the NPV is positive. Thus, Brower should
undertake the project in this case. Of course, the NPV is only slightly positive. Whether
or not Brower actually undertakes the project depends on the confidence it has in its
exchange rate forecasts.