International Financial ManagementBekaert 2eSolutionsCh15.docx

International Financial ManagementBekaert 2eSolutionsCh15.docx

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InternationalFinancialManagementBekaert2eSolutionsCh15

Chapter15

InternationalCapitalBudgeting

questions

1.Cananinvestmentprojectofaforeignsubsidiarythathasapositivenetpresentvaluewhenevaluatedasastand-alonefirmeverberejectedbytheparentcorporation?

Assumethattheparentacceptsallprojectswithpositiveadjustednetpresentvalues.

Answer:

Yes,weknowthatcountriesimposewithholdingtaxesonthedividendsthatarerepatriatedfromsubsidiariestoparentcorporations.Thesetaxeslowerthevalueoftheprojecttotheparent.Theparentmustalsobeawareofthepossibilityoffutureproblemsaccessingtheforeignexchangemarketfromthesubsidiary’scountry.Ingeneral,politicalriskcouldbedifferentforasubsidiaryofamultinationalcorporationversusalocalstand-alonefirm.

2.Howdolicensingagreements,royalties,andoverheadallocationfeesaffectthevalueofaforeignproject?

Answer:

Licensingagreements,royalties,andoverheadallocationfeesaretruecoststothesubsidiaryortothestand-alonefirmthatwouldbeoperatingintheforeigncountryproducingandsellingtheproductsofthemultinationalcorporation.Thus,licensingagreements,royalties,andoverheadallocationfeesreducetheincomeintheforeigncountry.Nevertheless,thesecashflowsprovideprofittotheparentcorporation.Licensingagreementsandroyaltiesprovidepureprofittotheparentasnocostsareincurred,andoverheadfeesprovidenetprofitastheycovercostsincurredbytheparent.Thus,thesecashflowsarequitevaluabletotheparent.

3.Whydoesanadjustednetpresentvalueanalysistreatthepresentvalueoffinancialsideeffectsasaseparateitem?

Isn’tinterestexpensealegitimatecostofdoingbusiness?

Answer:

Theadjustednetpresentvalueapproachtocapitalbudgetingstartsbyvaluingthefreecashflowstotheall-equitycashfirm.Itthenaddsothersourcesofvalueassociatedwithhowthefirmisfinanced.Asintheweightedaveragecostofcapital（WACC）approachinChapter16,thenumeratorcashflowsarethefreecashflowstotheallequityfirm.IncontrasttoWACCanalysis,whichdiscountsthesecashflowswithadiscountratethatisaweightedaverageoftheafter-taxrequiredreturnonthedebtandtherateofreturnontheleveredequity,theANPVanalysisusestherateofreturnontheunleveredassetstogettheall-equityvalue.Studentssometimesthinkthatthedeductibilityofinterestasabusinessexpenseisthereforemissing,andtheywanttoreducetheall-equityfreecashflowsbytheafter-taxinterestpayments.ThismissesthefactthatthevalueoftheinteresttaxshieldsisbeingaddedasaseparatesourceofvalueinANPV,whereasitisincludedinWACC.Also,itmissesthefactthatwhentheequityholdersleverthefirm,theygettheprincipalonthedebtupfrontanddon’thavetoputasmuchequityintothefirmforitsinvestments.Thepresentvalueofthefuturecashoutflowsforinterestpaymentsandrepaymentofprincipalequaltheinitialvalueoftheprincipal,inwhichcaseitisonlythetaxshieldthatneedstobevalued.ANPVdoesthisseparately.

4.Whatismeantbythenetpresentvalueofthefinancialsideeffectsofaproject?

Answer:

Generally,theseeffectsarisefromthecostsofissuingsecurities,thetaxesortaxdeductionsassociatedwiththetypeoffinancinginstrumentused（includingthetaxdeductibilityoftheinterestpaidonthedebt）,thecostsoffinancialdistress,andtheavailabilityofsubsidizedfinancingfromgovernments.

5.Whyisitcostlytoissuesecurities?

Answer:

Theinvestmentbankerswhohandletheissuingofsecuritieseithertothepublicortoprivateinvestorsarefinancialintermediaries,andtheymustbecompensatedfortheuseoftheirscarceresources.Thiscompensationincludesamonetaryfee,butitalsooftenincludesanunderwritingdiscount,orspread.Theunderwritingdiscountbetweenwhatthecorporationreceivesfromissuingthesecuritiesandwhatthepublicpaysforthesecuritiesisoftenalargepartofthecompensationoftheinvestmentbankthatunderwritestheissue.

6.Whatisaninteresttaxshield?

Howdoyoucalculateitsvalue?

Answer:

Theinteresttaxshieldonadebtisthevalueoftheabilitytodeductinterestasabusinessexpense.Therefore,atapointintimeitisequaltothecorporatetaxratetimestheamountofinterest,

.Thistaxdeductionisdiscountedatthestateddebtrate,whichisthemarketdebtrateassociatedwiththatdebt.Thus,thediscountedpresentvalueofaperpetualinteresttaxshieldis

7.Whatisaninterestsubsidy?

Howdoyoucalculateitsvalue?

Answer:

Interestsubsidiesarisewhengovernmentsarewillingtolendtocorporationsatbelowmarketinterestrates.Suchsubsidiesaddvaluetoaproject.Theappropriatediscountrateforaninterestsubsidyisthemarket’srequiredrateofreturnonthedebtofthecorporationbecausethecorporationisjustaslikelytodefaultonasubsidizedloanfromthegovernmentasitisonanormalloanatmarketinterestrates.SupposethatthegovernmentletsacorporationborrowaprincipalofDforoneperiodatasubsidizedinterestrateofrS

Thevalueofaloanatasubsidized,below-market,interestratehastwocomponents:

thepresentvalueoftheinterestsubsidy,whichisthedifferencebetweentheinterestpaidonamarketloanandtheinterestonthesubsidizedloan,plusthepresentvalueoftheactualinteresttaxshield.Inbothcases,thepresentvalueistakenatthemarket’srequiredrateofreturnonthedebt.

8.Whataregrowthoptions?

Provideanexampleofoneinaninternationalcontext.

Answer:

Agrowthoptionariseswhenafirmundertakesaprojectandobtainsanoptiontodoanotherprojectinthefuture.Theoptiontodothesecondprojectaddsvaluetothefirstproject.Agrowthoptionmightincludeafirm’sabilitytosellanewproductthatissuccessfulinthedomesticmarketintheinternationalmarketplace.Growthoptionsarespecificexamplesofrealoptionsthatalsoincludetheabilityofafirmtoshutdownaplantoramineuntiloperatingconditionsimproveortodelayanimportantoperatingdecisionuntilmoreinformationcanbegathered.Realoptionsarevaluable.

9.WhatisthedifferencebetweenEBITandNOPLAT?

Answer:

TheacronymEBITisearningsbeforeinterestandtaxes.Itrepresentsthebefore-taxoperatingprofitofthefirm.TheacronymNOPLATisnetoperatingprofitlessadjustedtaxes.ItisfoundbytakingthetaxesoutofEBITthatwouldbepaidbytheall-equityfirm.Itisthereforetheafter-taxoperatingprofitoftheall-equityfirm.

10.Whyisitimportanttounderstandandmanagenetworkingcapital?

Answer:

Thestockofnetworkingcapitalistheamountofinventory,cash,andaccountsreceivableminusaccountspayablethatthefirmmusthaveonhandtorunitsbusiness.Ifthebusinesscanberunwithalowernetworkingcapital,thisamountofassetscouldbegiventoinvestors.Conversely,increasesinnetworkingcapitaluseafter-taxprofitsthatthefirmcouldotherwiseusetofinancecapitalexpendituresorpaytoinvestors.Assuch,changesinnetworkingcapitalareinvestmentsthatthefirmmakesinitsfutureprofitability.

11.WhatdoesCAPXmean,andwhyisitafirm’sengineofgrowth?

Answer:

CAPXisanacronymthatisshortforcapitalexpenditures.Theseareinvestmentsthatthefirmismakinginphysicalplantandequipmentthatwillproduceoutputinthefuture.Consequently,ifthefirmwantstogrow,itwillhavetodoCAPX,andinthissense,CAPXisthefirm’sengineofgrowth.

12.WhyisitsometimesassumedthatCAPXequalsdepreciationinthelaterstagesofaproject?

Howdoesexpectedinflationaffectthisassumption?

Answer:

Asaprojectmatures,therearenomoreplannedinvestmentsinwhichcasethescaleoftheprojectisfixed.But,thephysicalplantandequipmenthaveaneconomiclifetimeandmustbereplaced.Ifaccountingdepreciationmatcheseconomicdepreciation,settingCAPXequaltodepreciationisappropriate.Youshouldbeawarethataccountingdepreciationoftenfailstomatcheconomicdepreciationbecauseofinflation.Thehighertherateofinflation,themoreseverethisproblemisunlesstheaccountingdepreciationisindexedtoinflationinsomeway.BecauseCAPXwillbespentonrealplantandequipment,thenominalamountofexpendituresmaybesomewhatgreaterthantheamounttheaccountsareallowedtodeductforthebookvalueofdepreciation.

13.Whatistheterminalvalueofaproject?

Howisitcalculated?

Answer:

Theterminalvalueofaprojectisthepresentdiscountedvalueofallfuturefreecashflowsintheyearsbeyondanexplicitforecastinghorizon.Ifwegenerateexplicitforecastsoffreecashflowsforthenext10years,theterminalvalueisthepresentdiscountedvalueoffreecashflowsinyears11toinfinity.Onetypicallyassumesthatfuturefreecashflowswillgrowattherateg,andthediscountratefortheseperpetualcashflowsisr.Thestartingvalueinyear11is（1+g）higherthantheexpectedfreecashflowsinyear10.Fromtheperpetuityformulaforagrowingcashflow,weknowthat

Aftercalculatingtheterminalvalueinyear10,thatquantitymustthenbediscountedtoyear0bymul