Question

Brilliant Berhad, a Singaporean company is contemplating on opening new subsidiary in Manila. After thorough analysis, the management found out that the NPV from the perspective of Singaporean’s parent company is unfavourable compared to NPV from the perspective of subsidiary in Manila. Discuss the difference between performing the capital budgeting analysis from the parent firm’s perspective as opposed to the subsidiary’s perspective.

Answer 1

This is a case of NPV involving two countries and two companies - one being the parent company located in one country and other being the subsidiary company located in a different country.

NPV involving such two countries can be done using two approaches --- from parent and home country perspective and from subsidiary and foreign country perspective. These two approaches are explained as below:

Parent and home country perspective:

a. Estimate the cash-flows from the subsidiary in the foriegn currency --- the cash-flows will be after applicable taxes payable to the foreign country where the subsidiary is located

b. Convert the cash-flows using the appropriate exchange rate between the home currency and foreign currency

c. Discount the cash-flows converted to the home currency using the cost of capital required by the parent company and applicable in the home country

d. Aggregate of the discounted cash-flows is the NPV of the project (along with any home currency cash-flows).

Subsidiary and foreign country perspective:

a. Estimate the cash-flows from the subsidiary in the foreign currency --- the cash-flows will be after applicable taxes payable to the foreign country where the subsidiary is located

b. Discount the cash-flows using the implied cost of capital applicable for the subsidiary located in the foriegn country

c. Aggregate of thhome currency .e discounted cash-flows is the NPV in foreign currency

d. Convert the foreign currency NPV using the appropriate exchange rate between the home currency and foreign currency

e. Add any relevant home currency cash-flows to arrive at the project NPV.

Thus, the main difference lies in when the cash-flows are discounted and converted to home currency. From parent perspective, subsidiary earnings are first converted into home currency and then discounted using home country interest rates to arrive at NPV while from subsidiary perspective, subsidiary earnings are discounted using foreign country interest rates to arrive at the NPV and then converted to home currency.