Capital Budgeting and Foreign Direct Investment Decision

Part I:

Foreign direct investment (FDI) plays an important role in stimulating economic growth of a country. FDI is defined as long-term investment by a foreign direct investor in an enterprise resident in an economy other than that in which the foreign direct investor is based. Kentucky Fried Chicken (KFC) is considering expanding in the African market. However, one should not ignore the fact that the African market is a risky market. Read the following story:

KFC to Move into Africa

After spending two decades introducing fried chicken and pizza to Chinese consumers, Yum! Brands Inc. now sees Africa as its next international jewel. Yum envisions 1,200 KFC restaurants in Africa by 2014, twice its current number. By 2014, the Louisville, Ky., restaurant-holding company expects to double its number of KFC outlets in Africa to 1,200. In the next four years, it aims to more than double its revenue on the continent to $2 billion. Africa wasnt even on our radar screen 10 years ago, but now we see it exploding with opportunity, says David Novak, Yum!s Chairman and Chief Executive Officer.

The improved political stability of various African governments, the regions vast population and a growing middle class in Africa -- where chicken is a dietary staple -- led Yum! to set its sights on the continent. The first KFC in South Africa opened in 1971 and Yum!, whose brands also include Pizza Hut, Taco Bell, Long John Silvers, and A&W Restaurants, is now branching out into Nigeria, Namibia, Mozambique, Ghana, Zambia, and other African countries. American restaurant companies and retailers have been moving into emerging markets as growth in the U.S. and other developed countries has slowed, and Africa is increasingly being added to the list. Wal-Mart Stores Inc. recently offered to buy 51% of South African retail giant Massmart Holdings Ltd. Africa is attractive for Western brands because its resource-rich countries are adding infrastructure while increasingly urbanized areas are creating opportunities for retail development.

Approximately 40% of Africans live in urban areas now and the number of households with discretionary income is projected to increase by 50% to 128 million over the next decade, according to a recent study by the McKinsey Global Institute.

People are now focusing on the emerging world, with a bit of a gold rush going on, says Graham Allan, CEO, Yum! Restaurants International. A lot of companies, especially Chinese ones, have invested in Africa, Mr. Allan adds. We share the general view that Africa over the next 10 to 20 years will have massive potential.

Of the roughly one billion people in Africa, KFC estimates it currently reaches 180 million. When McDonalds Corp. arrived in South Africa in the mid-1990s, KFC worried about the impact the burger giant would have on its business. So KFC began opening new restaurants and remodeling existing ones to make them more modern. By the early 2000s, KFC had about 300 restaurants in South Africa, quickly outpacing McDonalds, which has fewer than 200 restaurants in Africa. With more than 600 KFCs in South Africa now, the chicken chain has a 44% share of that countrys $1.8 billion fast-food market, followed by South African chain Nandos, with 6%, and McDonalds and the local Chicken Licken, each with a 5% share. A McDonalds spokeswoman declined to comment on the companys expansion plans in Africa. The menus at African KFCs are similar to those in more developed markets, albeit with more chicken drumsticks and wings, and fewer boneless items such as sandwiches and nuggets.

Africans are wary of processed food, says Keith Warren, General Manager of Yum!s Africa business. They want chicken on the bone. The chain seeks to appeal to wealthier Africans as well as to people living at an income level just above that of subsistence farming. Meals consisting of a chicken sandwich, fries and a drink can cost as much as the equivalent of $7, while two pieces of fried chicken and fries cost $3. The company also sells chicken sandwiches for $1 and four chicken wings for $1.20.

The KFC brand is highly aspirational in Africa. People will save up to buy the $3 meal, even if only once every three months, Mr. Warren says. KFC sells chicken more cheaply in South Africa than most parts of the world because local labour costs are lower and chicken suppliers dont charge as much, partly because South Africa is a major producer of corn to feed the birds. Although Africa is rebounding from the recent economic and food crises, its a slow march. The continents gross domestic product is projected to grow 4.6% next year, below the average growth rate of 6.1% in 2007, according to the World Bank. When Africas GDP growth slowed to 1.7% in 2009, seven million to 10 million Africans fell into poverty. Still, the low cost of doing business in Africa, coupled with a growing population, is expected to yield high returns for Yum! The company, along with franchisees, plans to invest about $500 million in the expansion and the company expects to more than double its operating profit in Africa to $120 million by 2014. Yum!, in total, posted $10.8 billion in sales in 2009 and almost $1.6 billion in operating profit.

The expansion will present plenty of challenges. In some countries, KFC imports its chicken from South Africa and Brazil. But there is still a lot of protectionism in Africa, Mr. Warren says. In Nigeria and East Africa, imports of chicken are banned, he adds. In those places, KFC has been working with local suppliers to ensure the quality and safety of their chicken meets the companys specifications. Sometimes the company finds itself hamstrung by bureaucracy. At my store in Angola, we were ready to start construction six months ago, but an official had a piece of paper he was tardy in handing over. We just started construction three weeks ago, Mr. Warren says.

Source:

Jargon, J. (2010, December 8). KFC savors potential in Africa -- Yum Brands unit plans to double number of outlets on continent, where middle class is growing. Wall Street Journal, New York, B. 1.

Part II:

Suppose you have been provided the following data on the proposed KFC project in Africa:

Initial cost/outflow: R12,000,000 (South African Rand Code: ZAR; Symbol: R)

Note: The company has R12,000,000 on the bank account in Africa to recover the initial cost.

Current exchange rate: 1USD = 8 ZAR; 1 ZAR = .125 USD

The company has provided the following cash flow figures to you:

Year	Cash Flow (In South African Rand Symbol: R)
0	-R12,000,000
1	3,350,000
2	3,899,000
3	1,122,000
4	4,200,000

The above cash flow is based on the current food items that KFC sells and the company will sell the restaurant after four years for approximately R10,000,000 (expected salvage value). It is also expected that the African government will impose 10% withholding tax on the transfer of cash to the USA. KFC will transfer the above cash to the USA each year.

The discount rate is 17% to the above project.

To complete the Module 4 Case Assignment, read the information in the background material, look for more information, and then write a 5- to 6-page report for your professor and the financial managers of KFC by answering the following questions:

How big is the risk for KFC to enter the African market? What can go wrong?

What would be your major concerns if you were the Chief Financial Officer of KFC and you were asked to find financing in the African market?

What is the project's net present value? To answer question 3, you need to calculate cash flow to parent company (KFC) and then, calculate net present value (NPV) of the project. Step 1: Calculate Cash Flow to Parent Company R = African Rand

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
						(Salvage Value)
Initial Cost (R)	(12,000,000)
Cash Flow (R)		3,350,000
Withholding Tax (10%)		0.10
Withholding Tax (R)		335,000
Cash Flow after tax (R)		3,015,000
Exchange Rate	0.125	0.125
Cash Flow to KFC	(1,500,000)	376,875

Initial Cost in U.S. Dollars = Initial Cost in Rand (R) x Exchange Rate (e.g., .125) = R12,000,000 x .125 = $1,500,000 Withholding Tax = Cash Flow x Withholding tax bracket (e.g., 10%) = 3,350,000 x .10 = R335,000 Cash Flow after tax in Rand (R) = Cash Flow Withholding Tax = 3,350,000 335,000 = R3,015,000 Cash Flow to Parent Company (KFC) = Cash Flow After Tax x Exchange Rate = 3,015,000 x .125 = $375,875 Step 2: Calculate NPV (In U.S. Dollars) You may use the following steps to calculate NPV:

Calculate present value (PV) of cash inflow (CF) PV of CF = CF₁ / (1+r)¹ + CF₂ / (1+r)² + CF₃ / (1+r)³ + CF₄ / (1+r)⁴ + CF₅ / (1+r)⁵ r = Discount rate (17%) If you do not know how to use a calculator to calculate present value, use Table 1 (Present value of $1 to be received after t years) of the following source:

Calculate NPV

NPV = Total PV of CF Initial Cost or -Initial Cost + Total PV of CF

Based on your analysis and findings, what would you recommend to KFC? Should KFC move into the African market? Are there any advantages of moving into African market for KFC?