TOPIC 3: FOREIGN

INVESTMENT AND FINANCING

DECISIONS
Capital Budgeting and Foreign Direct Investment
INTRODUCTION
• Multinational capital budgeting focuses on cash inflows and outflows
associated with future long-term investment projects.
• The basic steps taken to perform capital budgeting for foreign project
are as follows:
1. Identify the initial capital invested or put at risk
2. Estimate cash flows to be derived from the project including the terminal or
salvage value of the investment
3. Identify the appropriate discount rate for determining the PV of expected
cash flows
4. Apply NPV or IRR rule to determine the acceptability of project

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Subsidiary vs. Parent Perspective
• Multinational Capital Budgeting should be based on the parent’s
perspective, unless the subsidiary or the foreign project is not wholly
owned by the parent or partially financed by the parent.
• Some projects may be acceptable for a subsidiary (i.e. positive NPV)
but not acceptable for the parent (i.e. negative NPV) due to several
factors.

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Factors that cause difference in capital budgeting results
for subsidiary and parent firms
1. Tax differentials
• Corporate tax paid to host government
• Withholding tax paid to host government
• Tax to home government
2. Restrictions on remitted earnings
• Retained earnings by subsidiary
• Blocked funds
3. Exchange rate movements
• Conversion of funds to parent’s currency

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PROCESS OF REMITTING
EARNINGS FROM SUBSIDIARY
FIRM TO PARENT FIRM

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INPUT FOR MULTINATIONAL CAPITAL
BUDGETING
1. Initial investment
2. Price and consumer demand
3. Costs : fixed and variable costs
4. Tax laws
5. Remitted funds
6. Exchange rates
7. Salvage value (liquidation value) : after tax salvage value
8. Required rate of return (cost of capital)
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EXAMPLE: SPARTAN INC.
• Spartan, Inc., is considering the development of a subsidiary in
Singapore that would manufacture and sell tennis rackets locally.
Spartan’s financial managers have asked the
manufacturing, marketing, and financial departments to provide them
with relevant input so they can apply a capital budgeting analysis to
this project. In addition, some Spartan executives have met with
government officials in Singapore to discuss the proposed subsidiary.
The project would end in four years. All relevant information follows.

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SPARTAN INC. (continued)
• Initial investment. The project would require an initial investment of
20 million Singapore dollars (S$), which includes funds to support
working capital. Given the existing spot rate of $.50 per Singapore
dollar, the U.S. dollar amount of the parent’s initial investment is
S$20 million x $.50 = $10 million.
• Price and consumer demand. The estimated price and demand
schedules during each of the next four years are shown here:

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SPARTAN INC. (continued)
• Costs. The variable costs (for materials, labour, etc.) per unit have
been estimated and consolidated as shown here:

The expense of leasing extra office space is S$1 million per year.
Other annual overhead expenses are expected to be S$1 million per
year.
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SPARTAN INC. (continued)
• Tax laws. The Singapore government will allow Spartan’s subsidiary
to depreciate the cost of the plant and equipment at a maximum rate of
S$2 million per year, which is the rate the subsidiary will use. The
Singapore government will impose a 20 percent tax rate on income. In
addition, it will impose a 10 percent withholding tax on any funds
remitted by the subsidiary to the parent.

The U.S. government will allow a tax credit on taxes paid in

Singapore; therefore, earnings remitted to the U.S. parent will not be
taxed by the U.S. government.
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SPARTAN INC. (continued)
• Remitted funds. The Spartan subsidiary plans to send all net cash flows received
back to the parent firm at the end of each year. The Singapore government
promises no restrictions on the cash flows to be sent back to the parent firm but
does impose a 10 percent withholding tax on any funds sent to the parent, as
mentioned previously.
• Exchange rates. The spot exchange rate of the Singapore dollar is $.50. Spartan
uses the spot rate as its forecast for all future periods.
• Salvage value. The Singapore government will pay the parent S$12 million to
assume ownership of the subsidiary at the end of four years. Assume that there is
no capital gains tax on the sale of the subsidiary.
• Required rate of return. Spartan, Inc., requires a 15 percent return on this project.
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 Required: Calculate the NPV for the project and determine if Spartan
should proceed with this subsidiary investment.
Solution will be discussed in lecture session

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Impact of exchange rates
What will happen to your analysis if:
1. Singapore dollar strengthened by 5% per year beginning at the end
of year 1.
2. Singapore dollar weakened by 3% per year beginning at the end of
year 1.
Discuss.

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Impact of financing arrangement
• What will happen to your analysis if:
Instead of leasing office space as in the initial example, the subsidiary borrows
S$10 million to purchase the office building. Assume that the subsidiary will
make interest payments on this loan (of S$1 million) annually and will pay the
principal (S$10 million) at the end of year 4, when the project is terminated.
Because the Singapore government permits a maximum of S$2 million per year
in depreciation for this project, the subsidiary’s depreciation rate will remain
unchanged. Assume the office building is expected to be sold for S$10 million
after taxes at the end of year 4.
Also assume the original exchange rate projections of $.50 per Singapore dollar
for each period.

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Impact of financing arrangement (continued)
• Domestic capital budgeting problems would not include debt payments in
the measurement of cash flows because all financing costs are captured by
the discount rate.
• However, it is important to account for debt payments in multinational
capital budgeting in order to accurately estimate the amount of cash flows
that are ultimately remitted to the parent and converted into the parent’s
home currency.
• When a subsidiary uses a portion of its funds to pay interest expenses on
its debt, the amount of funds to be converted into the parent’s currency
will be overstated if the payment of foreign interest expenses is not
explicitly considered. Discuss.
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Impact of Parent Financing
• Consider one more alternative financing arrangement in which
the parent uses its own funds to purchase the office building (instead of
having the subsidiary lease the offices or borrow funds to purchase the
building).
• Thus the parent’s initial investment would be $15 million, which consists
of the original $10 million investment as explained before plus an
additional $5 million needed to obtain an extra S$10 million to purchase
the offices.
• Assume that the parent can sell the office building for S$10 million after
taxes in four years. Also assume the original exchange rate projections of
$.50 per Singapore dollar for each period. Discuss.
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 End of Topic 3
Thank you
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