Chapter 8: International Capital Budgeting
MBA 2022
Major: International Business Management,
Course: 508
Department of Management, University of Chittagong
Conceptual background
• Subsidiary vs parent perspective (Should capital budgeting for a multinational
project be conducted from the viewpoint of the subsidiary that will administer
the project or the parent that will most likely finance much of the project?)
• Inputs (What economic and financial characteristics will an MNC normally require
forecasts of for a project?)
• Factors to be considered ( What factors are usually ignored but may affect the
capital budgeting analysis?)
Problem 1: South Korean Project NPV Calculation
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 2 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 2 years.
1. What is the NPV of this project if the required rate of return is 13 percent?
2. Repeat the question, except assume that the value of the won is expected to be
1,200 won per U.S. dollar after 2 years. Further assume that the funds are blocked
and that the parent company will only be able to remit them back to the United
States in 2 years. How does this affect the NPV of the project?
Problem 2: Blustream, Inc. Project Analysis
Blustream, Inc., considers a project in which it will sell the use of its technology to firms
in Mexico. It already has received orders from Mexican firms that will generate MXP 3
million in revenue at the end of the next year. However, it might also receive a contract
to provide this technology to the Mexican government. In this case, it will generate a
total of MXP 5 million at the end of the next year. It will not know whether it will
receive the government order until the end of the year. Today’s spot rate of the peso
is $0.14. The one-year forward rate is $0.12. Blustream expects that the spot rate of
the peso will be $0.13 one year from now. The only initial outlay will be $300,000 to
cover development expenses (regardless of whether the Mexican government purchases
the technology). Blustream will pursue the project only if it can satisfy its required rate
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of return of 18 percent. Ignore possible tax effects. It decides to hedge the maximum
amount of revenue that it will receive from the project.
1. Determine the NPV if Blustream receives the government contract.
2. If Blustream does not receive the contract, it will have hedged more than it needed
to and will offset the excess forward sales by purchasing pesos in the spot market at
the time the forward sale is executed. Determine the NPV of the project assuming
that Blustream does not receive the government contract.
3. Now consider an alternative strategy in which Blustream only hedges the minimum
peso revenue that it will receive. In this case, any revenue due to the govern-
ment contract would not be hedged. Determine the NPV based on this alternative
strategy and assume that Blustream receives the government contract.
4. If Blustream uses the alternative strategy of only hedging the minimum peso rev-
enue that it will receive, determine the NPV assuming that it does not receive the
government contract.
5. If there is a 50 percent chance that Blustream will receive the government con-
tract, would you advise Blustream to hedge the maximum amount or the minimum
amount of revenue that it may receive? Explain.
6. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the
minimum amount or the maximum amount of revenue it will receive. It considers
a new strategy of hedging the minimum amount it will receive with a forward
contract and hedging the additional revenue it might receive with a put option
on Mexican pesos. The one-year put option has an exercise price of $0.125 and a
premium of $0.01. Determine the NPV if Blustream uses this strategy and receives
the government contract. Also, determine the NPV if Blustream uses this strategy
and does not receive the government contract. Given that there is a 50 percent
probability that Blustream will receive the government contract, would you use
this new strategy or the strategy that you selected in question (e)?
Problem 3: Capital Budgeting and Financing Analysis
for Cantoon Co.
Cantoon Co. is considering the acquisition of a unit from the French government. Its
initial outlay would be $4 million. It will reinvest all the earnings in the unit. It expects
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that at the end of 8 years, it will sell the unit for 12 million euros after capital gains
taxes are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro
in the future years. Cantoon has no plans to hedge its exposure to exchange rate risk.
The annualized U.S. risk-free interest rate is 5 percent regardless of the maturity of the
debt, and the annualized risk-free interest rate on euros is 7 percent, regardless of the
maturity of the debt. Assume that interest rate parity exists. Cantoon’s cost of capital
is 20 percent. It plans to use cash to make the acquisition.
(a) Determine the NPV under these conditions.
(b) Rather than use all cash, Cantoon could partially finance the acquisition. It could
obtain a loan of 3 million euros today that would be used to cover a portion of the
acquisition. In this case, it would have to pay a lump-sum total of 7 million euros
at the end of 8 years to repay the loan. There are no interest payments on this
debt. The way in which this financing deal is structured, none of the payment is
tax deductible. Determine the NPV if Cantoon uses the forward rate instead of
the spot rate to forecast the future spot rate of the euro, and elects to partially
finance the acquisition. You need to derive the 8-year forward rate for this specific
question.
Problem 4: Wolverine Corp. Project Analysis in New Zealand
Wolverine Corp. currently has no existing business in New Zealand but is considering
establishing a subsidiary there. The following information has been gathered to assess
this project:
• The initial investment required is NZ$50 million in New Zealand dollars (NZ$).
Given the existing spot rate of $0.50 per New Zealand dollar, the initial investment
in U.S. dollars is $25 million. In addition to the NZ$50 million initial investment
for plant and equipment, NZ$20 million is needed for working capital and will be
borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary
will pay interest only on the loan each year, at an interest rate of 14 percent. The
loan principal is to be paid in 10 years.
• The project will be terminated at the end of Year 3, when the subsidiary will be
sold.
• The price, demand, and variable cost of the product in New Zealand are as follows:
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Year Price (NZ$) Demand (units) Variable Cost (NZ$)
1 500 40,000 30
2 511 50,000 35
3 530 60,000 40
• The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per
year.
• The exchange rate of the New Zealand dollar is expected to be $0.52 at the end of
Year 1, $0.54 at the end of Year 2, and $0.56 at the end of Year 3.
• The New Zealand government will impose an income tax of 30 percent on income.
In addition, it will impose a withholding tax of 10 percent on earnings remitted
by the subsidiary. The U.S. government will allow a tax credit on the remitted
earnings and will not impose any additional taxes.
• All cash flows received by the subsidiary are to be sent to the parent at the end of
each year. The subsidiary will use its working capital to support ongoing operations.
• The plant and equipment are depreciated over 10 years using the straight-line de-
preciation method. Since the plant and equipment are initially valued at NZ$50
million, the annual depreciation expense is NZ$5 million.
• In 3 years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm
assume the existing New Zealand loan. The working capital will not be liquidated
but will be used by the acquiring firm that buys the subsidiary. Wolverine expects
to receive NZ$52 million after subtracting capital gains taxes. Assume that this
amount is not subject to a withholding tax.
• Wolverine requires a 20 percent rate of return on this project.
(a) Determine the net present value of this project. Should Wolverine accept this
project?
(b) Assume that Wolverine is also considering an alternative financing arrangement, in
which the parent would invest an additional $10 million to cover the working capital
requirements so that the subsidiary would avoid the New Zealand loan. If this
arrangement is used, the selling price of the subsidiary (after subtracting any capital
gains taxes) is expected to be NZ$18 million higher. Is this alternative financing
arrangement more feasible for the parent than the original proposal? Explain.
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(c) From the parent’s perspective, would the NPV of this project be more sensitive to
exchange rate movements if the subsidiary uses New Zealand financing to cover the
working capital or if the parent invests more of its own funds to cover the working
capital? Explain.
(d) Assume Wolverine used the original financing proposal and that funds are blocked
until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6
percent (after taxes) until the end of Year 3. How is the project’s NPV affected?
(e) What is the break-even salvage value of this project if Wolverine uses the original
financing proposal and funds are not blocked?
(f) Assume that Wolverine decides to implement the project, using the original financ-
ing proposal. Also assume that after one year, a New Zealand firm offers Wolverine
a price of $27 million after taxes for the subsidiary and that Wolverine’s original
forecasts for Years 2 and 3 have not changed. Compare the present value of the
expected cash flows if Wolverine keeps the subsidiary to the selling price. Should
Wolverine divest the subsidiary? Explain.
Reference
• Jeff Madura, International Finncial Management, 9th Ed, Chapter 14 (Mutinational
capital Budgeting)