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CHAPTER 17

CAPITAL BUDGETING FOR THE MULTINATIONAL

CORPORATION
This chapter focuses on three aspects of foreign investment analysis that are infrequently considered in evaluating
domestic projects: the difference between project and parent cash flows; incorporating political risks such as
expropriation and currency controls; and factoring in inflation and exchange rate changes in cash flow estimates. It also
evaluates the various methods used to incorporate in the investment analysis the additional risks encountered overseas.
These points are brought out in the process of working through the International Diesel Corporation Case. The ability
to perform a capital budgeting analysis is one of the most valuable skills we can provide our students; this case is
designed to make them aware of many of the intricacies involved in doing such an analysis. At the back of the chapter
I have included a set of questions (2-13) that students should bear in mind while reading the case. Addressing these
questions will help them to get more out of the case. I have found that a quick review of capital budgeting basics, given
in the first section, is useful for most students.

The key point made in Appendix 17A is that a firm's exposure to political risk is a function of government actions and
the impact of those actions on the firm's cash flows. The corollary is that a firm can take actions, preferably before
making an investment, to reduce its susceptibility to political risk. Thus, much of political risk is firm-specific rather
than county-specific. I discuss general principles as well as specific tactics that MNCs can use to reduce their political
risk exposure. A key point here is that a firm's political risk is not independent of the ways in which the firm is
structured and financed. The chapter illustrate the application of these principles and tactics by showing how American
Motors dealt with the risk it faced at its Jeep factory in Communist China and how Anaconda and Kennecott prepared
for the risk of having their Chilean copper mines expropriated by the government.

Although several cases are available to give students experience in applying to actual numbers the analytical techniques
presented in this chapter, my favorite case remains "Ghana Fertilizers," in Raymond Vernon and Louis Wells, Manager
in the International Economy (Third edition), Prentice-Hall. It forces students to calculate cash flows, to analyze
various political and economic risks, and to think in terms of the firm's overall strategy. Although quite old, this case
is a classic.

SUGGESTED ANSWERS TO CHAPTER 17 QUESTIONS

1. A foreign project that is profitable when valued on its own will always be profitable from the parent firm's
standpoint. True or false. Explain.

ANSWER . There are many reasons why project cash flows can diverge from the incremental cash flows accruing to
the parent. Therefore, the correct answer is false.

2. What are the principal cash outflows associated with the IDC-U.K. project?

ANSWER . The principal cash outflows associated with the IDC-U.K. project are

a) The initial investment outlay, consisting of the plant purchase, equipment expenditures, and working capital
requirements

b) Operating expenses

c) Later additions to working capital as sales expand

d) Taxes paid on its net income.

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3. What are the principal cash inflows associated with the IDC-U.K. project?

ANSWER . The principal cash inflows associated with the IDC-U.K. project include
a) Cash inflows from sales in England and other EC countries
b)The tax shield provided by depreciation and interest charges
c) Interest subsidies
d)The terminal value of its investment, net of any capital gains taxes owed upon liquidation. This figure includes
recapture of working capital.

4. In what ways do parent and project cash flows differ on the IDC- U.K. project? Why?

ANSWER . Parent and project cash flows differ on the IDC-U.K. project in several ways:

a) Funds remitted to IDC-U.S. may lead to additional taxes paid to England or the United States. These are cash
outflows from the view of IDC-U.S. but not IDC-U.K.

b)IDC-U.S. owes tax to the U.S. Internal Revenue Service on gains associated with the sale for $5 million of
equipment having a book value of zero.

c) IDC-U.S. receives licensing and overhead allocation fees each year, for which it incurs no additional expenses.
These fees are costs to IDC-U.K.

d)IDC-U.S. also profits from exports to IDC-U.K.

e) If sales of IDC-U.K. just substitute for exports from IDC-U.S., then IDC-U.K.'s profits are overstated by an
amount equal to the incremental cash flow that IDC-U.S. would have earned on these lost exports.

5. Suppose the real value of the pound declines. How would this decline likely affect the economics of the IDC-U.K.
project?

ANSWER . If the real value of the pound declines, the dollar value of revenues on sales in England will undoubtedly
decline. At the same time, however, dollar costs of production will also decline. The net effect on IDC-U.K. depends
on what would have been done absent this project. If IDC-U.S. would have continued to service the U.K. market, then
any reduction in revenues from the pound devaluation is irrelevant since it would not be incremental from the project's
standpoint. In this case, we are left with the cost reduction and the net impact of pound devaluation on the project is
unambiguously positive. In contrast, if export sales would have ceased in the absence of the IDC-U.K. project, then
the net impact of a pound devaluation must take into account both the revenue decline and the cost reduction. The net
impact depends critically on the price elasticity of demand. The odds are that the impact will be negative but only
slightly. The reason for the word "slightly" is that dollar costs of production decline on 100% of IDC-U.K.'s output but
sales of only half the output are affected by pound devaluation (the other half is sold to other EEC nations).

6. Describe the alternative ways to treat the interest subsidy provided by the British government.

ANSWER . The interest subsidy provided by the British government can be incorporated in the investment analysis
in one of two ways:

a) Employ a weighted cost of capital, where the interest rate used in this cost figure is the subsidized rate.

b)Explicitly include the subsidy (equal to the difference between the market interest rate and the subsidized rate
multiplied by the subsidized principal amount) as one of the cash flows.
CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION 233

7. Suppose England raised its corporate tax rate by one percentage point. How would this affect the economics of
the IDC-U.K. project?

ANSWER . If the U.K. raised its corporate tax rate by one percentage point, the project's NPV would be minimally
affected because IDC-U.S. can use all available foreign tax credits from IDC-U.K.

8. Why are IDC-U.S. earnings on exports to IDC-U.K. credited to the project?

ANSWER . IDC-U.S. earnings on exports to IDC-U.K. are credited to the project because these earnings would be lost
without the project. This assumes that by next year, IDC-U.S. will be producing at capacity to supply the U.S. market.

9. Why are loan repayments by IDC-U.K. to Lloyds and NEB treated as a cash inflow to the parent company?

ANSWER . Loan repayments by IDC-U.K. to Lloyds and NEB are treated as cash inflows to the parent because they
reduce its outstanding consolidated debt burden and increase the value of its equity by an equivalent amount. Assuming
that the parent would repay these loans regardless, then having IDC-U.K. borrow and repay funds is equivalent to
IDC-U.S. borrowing the money, investing it in IDC- U.K., and then using IDC-U.K.'s higher cash flows (since it no
longer has British loans to service) to repay IDC-U.S.'s debts.

10. Under what circumstances should IDC-U.S. earnings on lost export sales to the United Kingdom and the rest of
the Common Market countries be treated as a cost of the project?

ANSWER . IDC-U.S. earnings on lost export sales to the U.K. and other EEC countries should be treated as a cost of
the project if IDC-U.S. had sufficient excess capacity to have continued selling in the EEC in the absence of the
IDC-U.K. project.

11. Under what circumstances should these lost export earnings be ignored when evaluating the project?

ANSWER . The lost export earnings should be ignored when evaluating the project if the sales would have been lost
anyway because (1) IDC- U.S. no longer had sufficient capacity to service both the U.S. market and the European
market or (2) import restrictions would have kept out exports otherwise.

12. How sensitive is the value of the project to the threat of currency controls and expropriation? How can the
financing be structured to make the project less sensitive to these political risks?

ANSWER . Figures in Exhibit 17.6 reveal that the value of IDC's English project is quite sensitive to the potential
political risks of currency controls and expropriation. The project NPV does not turn positive until well after its fifth
year of operation (assuming there are no lost sales). Should expropriation occur or exchange controls be imposed at
some point during the first five years, the project is unlikely to ever be economically viable. In the face of these risks,
the project is viable only if compensation is sufficiently great in the event of expropriation, or if unremitted funds can
earn a return reflecting their opportunity cost to IDC-U.S., with eventual repatriation, in the event of exchange controls.
The project can be made less sensitive to political risks by using pound financing. Pound cash flows from the project
can be used to service these debts. By borrowing from British banks, IDC will also have fewer assets at risk in the event
of expropriation. In addition, the impact of potential currency controls can be minimized by setting high initial transfer
prices on the sale of components to IDC-U.K. by other units, by setting fees and royalties at a high initial level, and,
to the extent possible, by investing parent funds as debt rather than equity.

13. What options does investment in the new British diesel plant provide to IDC-U.S.? How can these options be
accounted for in the traditional capital budgeting analysis?
234 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH
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ANSWER . Here are some of the option that IDC-U.S. will realize by investing in the British diesel plant: The plant's
output can be raised or lowered depending on current and expected future demand conditions, currency movements
and other relative cost changes; the plant can be expanded or shut down, temporarily or permanently, again depending
on future cost and market conditions (e.g., the success or failure of Europe 1992). Moreover, IDC has an enhanced
market position in the EEC that can be used to expand its product offerings in the future, depending on demand
conditions as well as the output of IDC's R&D efforts.

14. Should the cost of capital for the IDC-U.K. project be higher, lower, or the same as the cost of capital for a similar
project to manufacture and sell diesel engines in the United States? Explain.

ANSWER . There is no obviously correct answer to this question. However, three points that are relevant here. First,
one of the major messages of modern financial theory is that the required return on a project depends on the riskiness
of the project itself. Thus, the required return on the project should equal the required return on a similar investment
undertaken in the United States only if the risks are the same. Second, the relevant risk that is priced and enters the cost
of capital is the systematic risk of the project, not the project's total risk. Third, returns on the U.S. plant are strongly
affected by variations in the U.S. economy--a major element of systematic risk. By contrast, returns on IDC-U.S.'s
British venture are primarily affected by the state of the European economy, which is less related to factors that
systematically affect returns on a well-diversified U.S. or world portfolio. The net result of these three points is that
the cost of capital for IDC-U.K. is most likely to be less than the cost of capital for a similar project in the United
States.

15. Early results on the Lexus, Toyota's upscale car, showed it was taking the most business from customers changing
from either BMW (15%), Mercedes (14%), Toyota (14%), General Motors' Cadillac (12%), and Ford's Lincoln
(6%). With what in the auto business is considered a high percentage of sales coming from its own customers, how
badly is Toyota hurting itself with the Lexus?

ANSWER . Toyota appears to be hurting itself with Lexus. But, in fact, Lexus is doing exactly what Toyota intended:
retaining customers, since Toyota determined that many of its customers who switched to Lexus were ready to "trade
up" to a luxury car. Now Toyota's customers are trading up to a Lexus instead of a BMW or Mercedes. The key point
is that the cannibalization is more apparent than real: If Toyota had not built the Lexus, it would have lost these
customers anyway, but to another company.

16. Comment on the following statement that appeared in The Economist (August 20, 1988, p. 60): Those oil producers
that have snapped up overseas refineries--Kuwait, Venezuela, Libya and, most recently, Saudi Arabia--can feed
the flabbiest of them with dollar-a-barrel crude and make a profit.... The majority of OPEC's existing overseas
refineries would be scrapped without its own cheap oil to feed them. Both Western European refineries fed by
Libyan oil (in West Germany and Italy) and Kuwait's two overseas refineries (in Holland and Denmark) would
almost certainly be idle without it.

ANSWER . The statement that OPEC can make a profit from these refineries is incorrect, assuming the author is
referring to true economic profit. On an integrated basis, profits on the refinery are more than offset by losses on sales
of the crude oil at subsidized prices. In fact, the oil producers are cross-subsidizing their refineries. They would be
better off without the refineries and selling their oil on the open market. As noted in the chapter, investments should
be evaluated taking into account the true opportunity costs of all the assets used.

17. Some economists have stated that too many companies are not calculating the cost of not investing in new
technology, world-class manufacturing facilities, or market position overseas. What are some of these costs? How
do these costs relate to the notion of growth options discussed in the chapter?

ANSWER . The company that gets to market first often goes on to dominate it. Those companies that don't invest early
may quickly be out of the business altogether. They may also lose out on other opportunities that were not foreseen at
CHAPTER 17: CAPITAL BUDGETING FOR THE MULTINATIONAL CORPORATION 235

the time of the investment decision, but that developed later. For example, a company that forgoes investment in a novel
technology passes up the chance to explore its technical possibilities, market opportunities, development costs, and
competitors' strategies. In other words, initial expenditures on product and process technologies and market position
should be viewed as investments in information and in the creation of options to utilize that information in ways that
may not have been envisioned originally. For example, Merck, the pharmaceutical firm, decided to invest in an
automated packaging and distribution plan, even though the labor savings didn't justify the investment, in order to
explore the potential benefits of plant automation. Results from the pilot project have clarified these benefits to the
point that Merck is now expanding automation to its diverse manufacturing operations. Thus, firms that forgo
investments in are passing up the chance to create and act on options. And the fact that a company passes up the chance
to invest in options does not mean that its competitors will. For example, an auto maker may give up on ceramic
engines, because technically they seem infeasible. But a rival who makes prosaic ceramic parts with the aim of one day
using the knowledge to build a ceramic engine--as the Japanese are doing--can quickly change the competitive balance.
Similarly, although liquid crystal displays (LCDs) are a U.S. invention (they were developed by RCA, which
abandoned them as uneconomic), Japanese companies used them to make watches and small TVs; now they lead in
LCD flat-panel computer screens. The ability to make these displays are a major reason Toshiba and other Japanese
firms have won a large share of the laptop computer market. Moreover, the advanced display screens used in laptops
not only are important as computer screens but also promise to open up huge markets in all types of display technology
from cockpit, medical instrument, automotive, and home appliance displays to large flat-panel screens for HDTV.

18. In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian
state-owned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on
the price GE paid).

a. What might account for GE's decision to spend so much money to acquire such a dilapidated, inefficient
manufacturer?

ANSWER. Eastern Europe has the potential to be both a large market for Western goods and a low-cost manufacturing
platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize
its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years experience in
"they pretend to pay us and we pretend to work" can produce at the level and quality necessary to be competitive with
their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern
European market. It also is learning what it takes to install modern Western management methods in a former
communist country and to use Hungary as a low-cost backdoor to Western Europe. The latter is especially critical to
GE as part of its strategy to expand its weak global presence.

GE's presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically
it has dominated the U.S. market. Then came a highly successful raid on GE's U.S. fortress by Philips, which is the
world's largest light bulb producer. GE decided to fight back by storming Philip's European base. But GE was unable
to acquire a controlling interest in any Western European firm and building a new plant would have cost at least $300
million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already
exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low
Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European
market; (b) introducing new technologies and higher-priced products to Tungsram; and (c) a low-cost export platform.

b. A Hungarian light bulb worker earns about $170 a month in Hungary, compared with about $1,700 a month in the
United States. Do these figures indicate that Tungsram will be a low-cost producer?

ANSWER . No. You must also know how productive these workers are. What matters is what you are getting relative
to what you are paying for. In fact, GE estimates that the productivity of Hungarian workers is one-seventh that of its
workers in the U.S. Since GE is paying only one-tenth the wages but getting one-seventh the productivity, these figures
taken together indicate that Tungsram should produce a light bulb 30% cheaper than GE's U.S. plants (1/10:1/7 = .70).
In response, Philips recently took over Poland's leading lamp producer and another Western European competitor,
Siemens' Osram unit, has acquired an East German producer.
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SUGGESTED SOLUTIONS TO CHAPTER 17 PROBLEMS

1. Suppose a firm projects a $5 million perpetuity from an investment of $20 million in Spain. If the required return
on this investment is 20%, how large does the probability of expropriation in year 4 have to be before the
investment has a negative NPV? Assume that all cash inflows occur at the end of each year and that the
expropriation, if it occurs, will occur prior to the year-4 cash inflow or not at all. There is no compensation in the
event of expropriation.

ANSWER . This problem can be solved by breaking the cash flow stream into two components--one component if
expropriation takes place and the other if no expropriation takes. The expected value of these streams is found by
multiplying the first component by the probability that expropriation will take place and the other component by the
probability that expropriation will not take place. Note that the cash flow streams are identical prior to year 4. All
numbers are in millions of dollars.

Year 0 1 2 3 4 5+

Cash flow with $20 $5 $5 $5 0 0

expropriation
20
Cash flow if no 5 5 5 5 5
expropriation

If the probability of expropriation in year 4 is p, then the expected cash flows associated with this investment are:

Year 0 1 2 3 4 5+

-$20 $5 $5 $5 $5(1 - p) $5(1 - p)

The net present value of these cash flows, discounted at a 20% required return, is

-20 + 5/1.2 + 5/(1.2)2 + 5/(1.2) 3 + 5(1 - p)/(1.2)4 + ... + 5(1 - p)/(1.2) t + ...

= -20 + 5/.2 - (5p/.2)/(1.2)3

= -20 + 25 - 14.68p

Setting this quantity equal to 0 yields a solution of p = 34.1%. This means that the probability of expropriation has to
be 34.1% before the investment no longer has a positive NPV.

Note. The summation of the terms in the NPV equation uses the fact that the sum of an infinite annuity (a perpetuity)
is a/r, where a is the annuity and r is the discount rate. Recognize also that the expected cash flow can be split into two
annuities--one beginning in year 1 and equal to 5 per annum and the other beginning in year 4 and equal to -5p per
annum.
CHAPTER 19: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 237

2. Suppose a firm has just made an investment in France that will generate $2 million annually in depreciation,
converted at today's spot rate. Projected annual rates of inflation in France and in the United States are 7% and 4%,
respectively. If the real exchange rate is expected to remain constant and the French tax rate is 50%, what is the
expected real value (in terms of today's dollars) of the depreciation charge in year 5, assuming that the tax write-off
is taken at the end of the year?

ANSWER . If the real exchange rate is expected to remain constant, then the real dollar value of the French franc is
expected to decline at the same rate as the real franc value, namely the 7% French inflation rate. Hence, the real dollar
value of the depreciation tax write-off will decline at the rate of 7% per annum. If the French tax rate is 50%, then a
depreciation charge of $2 million is worth $1 million in today's dollars. If the real dollar value of this write- off is
declining at the rate of 7% annually, then its real value in year 5, given that the write-off is taken at the end of the year,
is $1,000,000/(1.07) 5 = $712,986.

3. Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California, manufacturer of disk-drive
controllers, is trying to decide whether to switch to offshore production. Given Xebec's well- developed
engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking
full advantage of both low-wage labor and a grab bag of tax holidays, low-interest loans, and other government
largess. Most of his competitors seemed to be doing it. the faster he followed suit, the better off Xebec would be
according to the conventional discounted cash-flow analysis, which shows that switching production offshore is
clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of
certain intangible strategic benefits associated with domestic production.

a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the fact that its customers
are all U.S. firms and that manufacturing technology--particularly automation skills --is key to survival in this
business.

ANSWER . Short-run benefits include better quality control, better communication with customers, and the ability to
adapt quickly to changing markets. Longer term, a domestic manufacturing facility would give Xebec a laboratory in
which to apply the latest thinking about automated production. By working with the production process on a daily basis,
Xebec would have a better sense of the technology's wider potential, of possible applications that it would otherwise
not think about. For example, running a highly automated manufacturing operation next door to the engineering group
would enable Xebec to provide production-related input in the early stages of product design--something that offshore
production managers can rarely do. And with successfully automated production, Xebec's new disk drives could be
offered with a price and quality level to match those of potential competitors from Japan or anywhere else. By contrast,
contracting to have its products built for it by a potential competitor in a country like Taiwan or Japan might cost Xebec
both market share and its technological edge.

The video recorder is a classic example of how production know-how can yield important technical advances. Sony,
along with Matsushita Electric and its partner, Japan Victor Corp. (JVC), redesigned a professional-use product from
the United States that cost $20,000 or more and turned it into a $1,500 home product with a relatively small market.
Japanese designers then worked closely with Japanese factories to make every component smaller and less expensive.
Cooperation between Matsushita's design teams and employees on the shop floor eliminated more than three-quarters
of the product's cost while dramatically improving its quality. In the process, the company turned a niche product into
the mass-market success story of the 1980s.

b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing
(which are intangible costs of offshore production) into the factory location decision?

ANSWER . The intangible strategic benefits of domestic manufacturing can be factored into the factory location
decision by using the option pricing framework. By investing in domestic manufacturing, Xebec creates for itself a
series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and
benefit from expanding into new products or markets or new process technologies. Whether Xebec will exercise these
growth options depends on what happens in the future, which is unknowable today.
238 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH
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The value of these growth options depends on several factors:

1. The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before
responding to changes in the marketplace (since automation enables it to respond so quickly once it decides to).
The investment in automation also provides Xebec with a set of long-lasting skills.

2. The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in
automation is likely to be especially valuable since it so risky.

3. The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options.

4. The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared
with others. Learning about the automation process is clearly a proprietary skill and so more valuable than
investing in a new piece of equipment that everyone has access to.

Valuing an investment in automation which embodies discretionary follow-up projects requires an expanded net present
value rule that considers the attendant options. More specifically, the value of an option to undertake a follow-up
project equals the expected NPV from investing in the project using the conventional discounted cash flow analysis
plus the value of the discretion associated with undertaking the project.

c. How would the possibility of radical shifts in manufacturing technology affect the production location decision?

ANSWER . The possibility of radical shifts in manufacturing technology would increase the benefits from investing
in factory automation in the U.S. The phrase "radical shifts" implies that the project is high risk, which increases the
option component of value.

For example, companies that in the mid -1970s made the transition from electro-mechanical manually operated machine
tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities--much
higher performance at much lower cost--of the microprocessors and microcontrollers that became available in the early
1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and
comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when
they became available. Companies that had deferred investment in the emerging electronic technology were not able
to participate in the great technological advances in microelectronics; they had not acquired an option in this new
process technology.

d. Xebec is considering producing more-sophisticated drives that require substantial customization. How does this
possibility affect its production decision?

ANSWER . The more customization is required, the more important it is to work closely with the customer. To meet
the exacting needs of customers, there must be close personal contract between Xebec's engineering and production
staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and
with severe language and cultural barriers. It is also difficult to coordinate the efforts of the marketing, engineering,
design, and manufacturing people when they are spread around the globe. The need for coordination increases the value
of domestic production facilities.

e. 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:
CHAPTER 19: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 239

Interest PV Factor Present

Year Principal Savings (@ 14%) Value

1 $10,000,000 $900,000 .8772 $789,480

2 8,000,000 720,000 .7695 554,040
3 6,000,000 540,000 .6750 364,500
4 4,000,000 360,000 .5921 213,156
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.

f. Projected before-tax income from the Taiwan plant is $1 million annually, beginning at the end of the first year.
Taiwan's corporate tax rate is 25%, and there is a 20% dividend withholding tax. However, Taiwan will exempt
the plant's income from corporate tax (but not withholding tax) for the first five years. If Xebec plans to remit all
income as dividends back to the United States, how much is the tax holiday worth?

ANSWER . Very little. Assuming that Xebec doesn't have any excess foreign tax credits (FTCs), it will owe the
difference between the 20% withholding tax on dividends and the 34% rate levied by the IRS on its Taiwanese income.
Xebec's after-tax income from Taiwan, with and without the tax holiday, will be:

Taiwan

No Tax Holiday Tax Holiday

PBT $1,000,000 PBT $1,000,000

PAT (tax @ 25%) 750,000 PAT (no tax) 1,000,000
Dividend 750,000 Dividend 1,000,000
Withholding tax (@ 20%) 150,000 Withholding tax (@ 20%) 200,000

Net Dividend to Xebec $600,000 Net Dividend to Xebec $800,000

United States

U.S. tax owed (@ 34%) $340,000 U.S. tax owed (@ 34%) $340,000
Direct FTC 150,000 Direct FTC 200,000
Indirect FTC 250,000 Indirect FTC 0

Net U.S. tax owed ($60,000) Net U.S. tax owed $140,000
PAT to Xebec $600,000 PAT to Xebec $660,000

Assuming that Xebec has no use for excess foreign tax credits, the calculations show that the value of the tax holiday
to it is only about $60,000 annually.

g. An alternative sourcing option is to shut down all domestic production and contract to have Xebec's products built
for it by a foreign supplier in a country such as Japan. What are some of the potential advantages and
disadvantages of foreign contracting vis -á-vis manufacturing in a wholly owned foreign subsidiary?

ANSWER . See the answer to part a.

240 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH
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SUGGESTED ANSWERS TO
INTERNATIONAL MACHINE CORPORATION
1. Should IMC make this investment?

2. What is IMC's required rate of return for this project?

3. What factors and assumptions are critical to your project analysis?

ANSWER. Subsidiary peso operating cash flows are calculated in Exhibit 1. The 32% annual increase in sales revenue
and variable costs results from the combination of a 10% increase in unit sales and a 20% rate of Mexican inflation (1.1
x 1.2 = 1.32). The 10% annual increase in the dollar costs of imported items is equivalent to a 20% increase in the peso
cost of the items because a constant real exchange rate is assumed (i.e., the peso value of the dollar is assumed to grow
at an annual rate of 1.2/1.1 - 1), which when combined with the 10% U.S. inflation rate yields an annual peso cost
increase of 20% ([1.2/1.1] x 1.1 - 1 = .2).

Based on the information provided in section B, net working capital requirements are 30% of sales. These requirements,
as well as the net additions to working capital, are shown in Exhibit 2.

Net cash flows for the subsidiary are calculated in Exhibit 3. The calculations are performed in terms of both pesos and
dollars. Working capital is assumed to be funded out of retained earnings and depreciation-generated cash flow. This
assumption is valid save for the first year. Discounting the dollar cash flows at 15% yields a positive NPV of about
$15.1 million. The internal rate of return equals 30.45%.

From IMC's standpoint, however, returns on this investment look very different. First, IMC has only a 60% equity stake
in the venture. Second, its dividend receipts don't begin until the fourth year of operation, and even then the payout rate
is only 70%. Third, it does not receive the depreciation-generated cash flows until year 10 as part of the terminal value.
Fourth, licensing fees are revenue to IMC while being costs to the subsidiary. Other differences include the added U.S.
taxes on foreign earnings, the lost profit on lost export sales, and the different way in which terminal value is calculated.

Returns to IMC are calculated in Exhibit 4. The net present value of these returns, discounted at 15%, equals $7.7
million. The internal rate of return equals 27.49%.

The required discount rate is a separate issue. The information provided in the case is insufficient to permit an estimate
of the project's cost of capital. Historical debt costs are irrelevant. So is the cost of equity capital for the firm as a whole
unless the project's risk characteristics are similar to those of the parent's other operations. Moreover, if inflation has
accelerated in recent years, investors will require a higher nominal return than in the past. With an anticipated inflation
rate of 10% and a historical real return on equities of approximately 8% (based on University of Chicago data), the
required nominal return should be somewhere in the neighborhood of 18-20%. Given the approximately 27% internal
rate of return, this investment would seem to make the grade.
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244INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

SUGGESTED ANSWERS TO EURO DISNEYLAND

1. These questions relate to the $800 million (FF 4.8 billion at FF 6 - $1) in French government-subsidized loans.

a. What is the value to Disney of the French government's loan subsidies?

ANSWER . According to the case, the FF 4.8 billion in government loans carry an interest rate of 7.85%. The loans
have a ten-year amortization schedule, with interest only for the first five years and repayment over the next five years
at the rate of FF 960 million each year. The annual interest savings on these loans for the first six years, given that the
market rate is 9.25% while the loan rate is only 7.85%, equals FF 4,800,000,000(.0925 - .0785), or FF 67,200,000
(since loan repayments don't begin until the end of 1997, EDL pays interest on the full FF 4.8 billion for six years). As
the loan is repaid, the value of the interest subsidy falls. In general, the interest subsidy on a loan with a remaining
balance of B is B(.0925 - .0785) or .014*B. For example, in year seven, the loan balance falls to FF 3,840,000,000 and
the interest savings decline to FF 3,840,000(.0925 - .0785), or FF 53,760,000. The annual interest subsidy is computed
in the table below. The present value of the year-by-year interest subsidy, discounted at the 9.25% before-tax cost of
debt, is shown in the final column. Summing the present values of these interest subsidies leads to a present value for
the interest subsidy overall equal to FF 365,694,336.

Loan Balance at Value of Interest PV Interest PV of Interest

Year End of Year Subsidy Factor at 9.25% Subsidy
(1) (2) = .014 x (1) (3) (4) = (2) x (3)

1 FF 4,800,000,000 FF 67,200,000 0.9153 FF 61,508,160

2 FF 4,800,000,000 FF 67,200,000 0.8378 FF 56,300,160
3 FF 4,800,000,000 FF 67,200,000 0.7669 FF 51,535,680
4 FF 4,800,000,000 FF 67,200,000 0.7020 FF 47,174,400
5 FF 4,800,000,000 FF 67,200,000 0.6425 FF 43,176,000
6 FF 4,800,000,000 FF 67,200,000 0.5881 FF 39,520,320
7 FF 3,840,000,000 FF 53,760,000 0.5383 FF 28,939,008
8 FF 2,880,000,000 FF 40,320,000 0.4928 FF 19,869,696
9 FF 1,920,000,000 FF 26,880,000 0.4510 FF 12,122,880
10 FF 960,000,000 FF 13,440,000 0.4128 FF 5,548,032
_____________
Total FF 365,694,336

Converted into dollars at the current exchange rate of FF 6 = $1, this amount has a present value of $60,949,056. This
is the figure that would go into the adjusted present value calculation shown in Equation 17.4 in the text.

b. What exchange risk is this project subject to from the standpoint of Disney? How can financing be used to mitigate
this exchange risk?

ANSWER . Clearly, changes in the franc:dollar and DM:dollar exchange rate will affect Disney's dollar cash flow from
EDL. When the dollar appreciates, the dollar value of EDL's operating cash flow will drop. Presumably Disney will
already be charging the profit-maximizing franc price and there is little reason to change this price because of franc
depreciation. The result is lower dollar revenues and profits. Similarly, if the DM falls against the dollar, EDL will
generate fewer dollars from German tourists. The reason in both instance for the lack of pricing flexibility is that EDL
is not facing much competition from foreign imports. (However, this situation could change if a company like Universal
EURO DISNEYLAND 245

Studios decides to set up a park in Europe.) Its only competition is either Disneyland in California or Disney World
in Florida and these are rather expensive to arbitrage. That being said, it is true that when the franc devalues against
the dollar, more Americans are likely to visit Europe and Euro Disneyland and more Europeans are likely to stay home
and visit Euro Disneyland too. When the dollar depreciates against the franc and other European currencies, more
Europeans will visit Disneyland and Disney World. This provides some diversification.

An appropriate financial response to Disney's exchange risk is to accept the French government's offer of franc
financing. Disney might also want to consider financing part of the rest of its project with Deutsche marks. A rough
estimate of the recommended percentages of DM and franc financing can be developed as follows:

Let XF = forecast percentage of French tourists

XG = forecast percentage of German tourists
CF = franc operating costs as a percentage of total sales

Assuming that virtually all costs will be denominated in French francs, then a fraction of the project's initial cost equal
to XF - CF should be financed in FF, another fraction equal to XG should be financed in DM, and the remainder in
dollars. So, for example, if XF = 60%, X G = 40%, and C F = 45%, then Disney should finance 15% of the project in
francs (about $375 million), 40% in Deutsche marks (about $1 billion), and 45% (about $1.125 billion) in dollars. Franc
costs are subtracted because sourcing costs in France hedges some of the exchange risk on the French revenue side.
This analysis implicitly assumes that tourists from other countries are not a significant fraction of the total. If they are,
then one could finance the remainder of the project with other foreign currencies in proportion to the tourists coming
from those countries.

c. Suppose it turns out that having $800 million in francs financing actually adds to Disney's economic exposure.
How could this affect Disney's willingness to accept the full amount of financing offered by the French
government?

ANSWER . Even if borrowing $800 million in French francs actually adds to Disney's economic exposure, as in the
example above, Disney should accept the full amount of franc financing. The reason is that the French government is
subsidizing its $800 million loan to Disney (that's what financing at very favorable terms means). Disney can always
swap the excess francs for dollars (or any other currency). Because of interest rate parity (a swap is the equivalent of
a forward contract hedge), a lower interest rate in francs translates into a lower interest rate in any other currency. In
other words, a good deal should never be passed up.

2. Based on purchasing power parity, project the dollar:franc exchange rate from 1989 through 1996.

ANSWER . Given an exchange rate at the end of 1989 equal to FF 6 = $1, or FF 1 = $0.16667, and annual French and
U.S. inflation projected at 5% and 4%, respectively, the PPP exchange rate in t years will equal

1.04 t
e($/FF1 )t = 0.16667( )
1.05

Based on this formula, the dollar:franc PPP exchange rate for years 1989 through 1996 will be:

1989 1990 1991 1992 1993 1994 1995 1996

0.16667 0.16508 0.16351 0.16195 0.16041 0.15888 0.15737 0.15587

3. What is the range of projected dollar net income for Euro Disney for the years 1992-1996?
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ANSWER . The only variation for which we have figures arises from attendance. According to the case, attendance
in 1992 can vary between 11 million and 16 million visitor days. Given 1992 attendance, future attendance is expected
to grow by 3% annually. Exhibits 1 and 2 show yearly net income based on the two extremes: (1) 1992 attendance is
11 million visitor days, or (2) 1992 attendance is 16 million visitor days. Individual expenditures on admission fees,
food and beverages, merchandise, and parking and other items are each projected to rise at the 5% expected rate of
French inflation. Interest expense in 1992 is projected at FF 376,800,000 for the government loans (.0785 x FF 4.8
billion) and FF 65,550,000 for the working capital loan (.095 x $115,000,000/6). The latter figure is expected to grow
at the rate of sales increase. The promotional fee is expected to begin at $35 million, converted into French francs at
the 1992 exchange rate, and then this French franc figure is expected to grow at the 5% rate of French inflation.

4. Suppose the terminal value at the end of 1996 is estimated at seven times net income for 1996. Using a 15% cost
of capital what is the range of net present values of Euro Disneyland as a standalone project?

ANSWER . Exhibits 1 and 2 show all work associated with calculating the range of project NPVs. The analysis is
performed assuming that the 15% cost of capital applies to the $1.5 billion equity portion of the investment in Euro
Disneyland. Hence, it analyzes only the cash flows to the $1.5 billion equity investment. As can be seen, although the
project is expected to be profitable from the start, the NPVs–even under the high attendance scenario–are negative,
ranging from -$710 million to -$990 million. The negative NPVs stem from the vast amounts of capital necessary to
invest in the project. In other words, the projected cash flow is insufficient to generate a return high enough to equal
the cost of capital. The benefits of the low-interest French government loans are already reflected in the projected cash
flows to equity. EDL’s interest expenses reflect the 7.85% interest expense on the FF 4.8 billion government agency
loan (FF 376.8 million annually) plus the 9.5% rate charged on EDL’s working capital loan. This loan, which begins
at the franc equivalent of $115 million (or FF 690 million at the current rate of FF 6/$), is expected to grow at the rate
of sales revenue. Hence, the interest expense on EDL’s working capital loan is expected to grow at this same rate.

It should be noted that this NPV takes into account the $350 million investment that Disney has already made. On a
going-forward basis, this past investment is a sunk cost and is irrelevant to the future investment decision. Valued on
a going-forward basis, therefore, the NPV for the project is still negative but less so than before.

5. Using the same 15% cost of capital, what is the range of net present values of Walt Disney's investment in Euro
Disney?

ANSWER . According to Exhibit 3, the NPV of Euro Disneyland to Walt Disney, based on its $500 million estimated
investment in the project, will range between -$37.4 million and $11.8 million. It is assumed that the present value of
Disney's royalties from 1997 on will equal royalties from 1996 growing at a rate of 5% annually (French inflation) and
discounted at 15% (i.e., a 10x multiplier, using the dividend growth formula). Note that Disney is assumed not to owe
further U.S. tax on its profit remittances and royalties as the French tax rate of 55% far exceeds the U.S. corporate tax
rate at that time of 34%. In fact, given the disparity in tax rates, Disney will wind up with excess foreign tax credits
from the project. The calculations in Exhibit 3 assume that Disney cannot use these excess FTCs. As in the answer to
question 4, this analysis incorporates the $350 million that Disney has already invested in the project. From an
economic standpoint, these past expenditures are a sunk cost and are irrelevant to the decision of whether to invest
further in the project. Ignoring the $350 million already sunk in the project yields a highly positive NPV. The NPV is
likely to be even more positive because, as mentioned above, the analysis presented in Exhibit 3 assumes that Disney
pays a 55% tax rate on its income and cannot use the excess foreign tax credits it thereby generates on its U.S. profit
remittances. To the extent that Disney owes U.S. tax on other foreign source income, it can use these excess FTCs to
offset the U.S. tax it would otherwise owe on the other foreign source income. The net effect of being able to use these
excess FTCs would be to lower the effective tax rate on Disney’s EDL income and increase the project’s NPV.

6. Should Walt Disney go ahead with this project? What other factors might you consider in estimating the value of
Euro Disneyland to Walt Disney?
EURO DISNEYLAND 247

ANSWER . Although Euro Disneyland looks marginal at best from the standpoint of conventional net present value
analysis (as presented in Exhibit 3, but without the additional considerations presented in the answer to question 5),
the EDL project provides Walt Disney with substantial profitable growth options. Disney's options include the right
to purchase land at well below market value, the possibility of earning substantial additional profits if the OCF turns
out to be a lot higher than currently expected, and the ability to add new projects to EDL (such as the proposed new
movie studio theme park. Disney also will strengthen its European film production, a valuable option given the cultural
nationalism being exhibited in Europe (especially in France). These options add value to EDL for Disney but are
excluded from the NPV analysis in Exhibit 3. Taking these additional elements into account, Disney appears to have
an investment with a relatively small downside and the possibility of a high upside.

Moreover, if we consider Disney’s investment of $350 million in planning the park to be a sunk cost–as it is–then the
project will have a significantly positive NPV. That is, although Disney might not have invested the initial $350 million
in the project given the figures in Exhibit 3, once those costs had already been incurred, it made sense for Disney to
finish the project. The NPV will be even more positive if Disney is able to use some of the excess foreign tax credits
it will generate from EDL–the project pays taxes at a rate of 55% in contrast to a U.S. corporate tax rate of 34% (at that
time)–to offset U.S. taxes it owes on other foreign-source income. At the extreme, if Disney could fully utilize the
excess FTCs generated by EDL, it will drive its tax rate on EDL income all the way down to the 34% U.S. corporate
rate then in existence. As shown in Exhibit 4, the net effect of analyzing the project taking into account a $150 million
incremental investment and a 34% corporate tax rate is a highly positive net present value project.

As it turns out, Euro Disneyland has been unprofitable so far for both Disney and the shareholders of Euro Disneyland.
According to Disney's chairman, Michael Eisner, although visitor days have held up, the visitors have spent much less
per capita than was projected. In November 1993, Disney took a $350 million write-off for the company's investment
in Euro Disneyland. In a Wall Street Journal story (November 12, 1993, A5), Eisner was quoted as saying that Euro
Disneyland's problems stemmed from its initial high cost. "Everything costs 50% more in France." According to the
story, he also blamed the current European recession and the fact that Disney built too many hotels that have high fixed
costs and are unoccupied during the winter months (not that bad weather during winter comes as a total surprise). The
depressed real estate market put on hold development of the vast tracts of land around the park that the French
government granted to the company at such a low price. In 1994, creditor banks rescued Euro Disney from losses by
agreeing to restructure its debt. As part of this deal, Disney agreed to a five-year moratorium on receiving royalties and
management fees from the park. EDL is now showing accounting profits but it remains unprofitable on an economic
basis, taking into account the cost of the capital invested in it.
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