FIN 336 Module 5 International Capital Budgeting Assignment Example

Capital Budgeting for a Brazilian Plant in Reais and Dollars

[Student Name]

Southern New Hampshire University

FIN 336: Multinational Corporate Finance

Module Five Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Capital Budgeting for a Brazilian Plant in Reais and Dollars

Introduction

A composite Sioux Falls, South Dakota, maker of grain bins and dryers wants a value for the factory it has sketched outside Rondonópolis, where it would roll bin panels and put dryers together for cooperatives in the region. Project One judged Brazil's risks manageable and suggested adding two or three percentage points to the discount rate for them. This paper forecasts the plant's cash flows in Brazilian reais (BRL), values them in reais and in U.S. dollars, explains why both methods agree and tests how the result changes when key assumptions fail. All exchange rates are in reais per dollar.

Investment and Assumptions

The plant requires R$160 million for land, buildings and equipment and R$20 million of working capital, a total of R$180 million, or about $33.0 million at a starting rate of 5.45. Equipment is depreciated straight-line at 10 percent a year, a common Brazilian rate for machinery. The plant pays Brazil's combined corporate income tax and social contribution rate of 34 percent.

Key assumptions

Revenue rises as the plant replaces exports and reaches cooperatives the firm could not serve from South Dakota. The 18 percent margin is below the margin on U.S. sales because local steel and labor costs rise with Brazilian inflation and the plant will run below capacity at first.

Free Cash Flow

Each year's free cash flow equals operating profit after tax, plus depreciation, minus maintenance spending and added working capital. In year 1, operating profit before depreciation is R$27.0 million; after R$16 million of depreciation and 34 percent tax, after-tax operating profit is R$7.3 million. Adding back depreciation and subtracting R$6 million of spending and working capital leaves R$17.3 million.

Free cash flow in reais (millions)

The Discount Rate

The firm's dollar cost of capital for its U.S. business is 9 percent. Following Project One, the plant adds a 2.5 point country risk premium, giving 11.5 percent in dollars. Godfrey and Espinosa (1996) proposed a practical version of this approach, adding a sovereign spread to the home-market cost of equity, and a survey of Swedish firms found that raising the discount rate is the most common way managers account for political risk abroad (Holmén & Pramborg, 2009). Because the risk is in the rate, the cash flows above are expected values, not cut further for country risk. To discount reais, the dollar rate is converted through the inflation differential: 1.115 x 1.045 / 1.025 = 1.137, or 13.7 percent.

Method One: Discount in Reais

Beyond year 5, cash flow is assumed to grow only with Brazilian inflation, so the year-5 continuing value is 28.8 x 1.045 divided by the spread of 0.137 over 0.045, which is 0.092, or R$327.6 million. Discounting years 1 to 5 and the terminal value at 13.7 percent gives a present value of R$249.3 million. Subtracting the R$180 million investment leaves a net present value of R$69.3 million, which is about $12.7 million at today's rate.

Method Two: Convert, Then Discount in Dollars

Relative purchasing power parity implies the real will lose about 2 percent a year against the dollar, so forecast rates are 5.56 in year 1, rising to 6.00 in year 5. Converting each year's cash flow at those rates and discounting at 11.5 percent gives:

Dollar valuation (millions)

The present value is $45.8 million against an investment of $33.0 million, a net present value of $12.7 million. The two methods match because the exchange rate forecast and the real discount rate both rest on the same inflation differential. If they disagreed, one of the inputs would be inconsistent.

Parent Perspective

The parent's view counts only cash that can come home. Brazil does not currently block profit remittances, but conversion costs, financial transaction taxes and any future withholding on dividends would reduce what reaches Sioux Falls. This analysis assumes the plant reinvests most of its cash during its first five years, so the parent's claim is concentrated in the terminal value. That makes the plant's value more sensitive to the long-run exchange rate than the yearly figures suggest.

Sensitivity

Net present value under four tests

A real that falls faster than parity does not change the value in reais but cuts the dollar value by about 30 percent, which is the economic exposure Project One described. Lower sales, a thinner margin or a higher risk premium each cut value by half or more, but none turns it negative alone. The weakest point is the terminal value: it supplies about 69 percent of present value, and the five forecast years alone return only R$114 million of the R$180 million invested. Graham and Harvey (2001) found that many firms apply a single company-wide discount rate to every project; doing so here, at 9 percent, would overstate the plant's value, which is why the project-specific premium matters.

Recommendation

The plant has a positive net present value under the base case and under each single adverse test, so the valuation supports going ahead. Because most of its value lies beyond year 5, the firm should accept only if it is committed to Brazil for the long term, and it should reduce the risk of the early years by financing part of the plant in reais and securing state tax incentives. The next modules address that financing choice and the final recommendation.

References

Godfrey, S., & Espinosa, R. (1996). A practical approach to calculating costs of equity for investments in emerging markets. Journal of Applied Corporate Finance, 9(3), 80-90. https://doi.org/10.1111/j.1745-6622.1996.tb00300.x

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Holmén, M., & Pramborg, B. (2009). Capital budgeting and political risk: Empirical evidence. Journal of International Financial Management & Accounting, 20(2), 105-134. https://doi.org/10.1111/j.1467-646X.2009.01028.x