Capital Budgeting in a Trade War (#377)
/The topic of this episode is based on current events in the United States, and it is how to do capital budgeting during a trade war.
Trade War Issues
Let’s define the issues. When a tariff is imposed, the importer of the goods pays the tariff amount to the government, which means that it’s up to the importer to decide whether to absorb the cost of the tariff or to pass it along to the customer through a price hike, or a combination of the two. Given the massive amounts of the tariffs being imposed, it’s extremely likely that a large part of the tariff cost is going to be passed along to the customer. That’s the first issue.
The second issue is the duration and amount of the tariff. Usually, the tariff amount is low, and the probability of it changing is also low. In fact, tariffs usually only change when a new trade deal is approved by the government, which is pretty infrequent. And when a new trade deal goes through, tariffs generally go down, not up. But in this case, the tariff amount is high, and the volatility of the changes is also high, which makes for an extremely uncertain environment.
The third issue is how long the tariffs are likely to last. In this case, there’s a high probability that the tariffs will be eliminated or at least reduced at the end of the current administration, so we’re looking at a duration of somewhat less than four years. And keep in mind that this is a trade war, so other countries are imposing similar tariff amounts on goods being imported from the United States.
Capital Budgeting in a Trade War
Given these issues, how do you make a capital budgeting decision that makes any sense? The first consideration is that you’re looking at making an investment in what is now a high-cost, protected market. This means that the United States is the worst possible place to invest in large facilities from which you plan to export goods to other countries – and especially because it’s very likely that other countries are going to slap tariffs on any goods that you ship to them from the United States.
Instead, any investment should result in just enough capacity to meet local demand within the United States for the duration of the current administration. If there’s a large step cost in that facility that you’ll have to pay for to increase your capacity level, then the wise choice is to not incur the step cost, and instead keep the capacity level lower, so that you’re not investing too much. If that means that you lose some sales, then so be it.
Another consideration is that, if you’re producing goods within the United States, the cost of some of your inputs will probably increase, because some of them are coming in from outside the country, and tariffs will be getting charged on them. Since you’re the customer for these supplies, that means that your costs are going to go up. And when that’s the case, you’ll probably have to increase prices to your customers, which means that demand will decline. And that gets back to the need to keep your investment in new capacity as low as possible.
Your next consideration is how to spread the risk of loss, in case tariffs are later dropped, and cheaper competing goods start coming in from outside the country. There are a couple of options. First, consider outsourcing your manufacturing to someone who’s already constructed facilities within the country. Sure, the per-unit cost will probably be higher, but on the other hand, you’re not investing in new facilities. Another option is to enter into a joint venture deal with some other company, so that you can split the risk with them.
Another option is to pause all investments in the country until the current administration is out of office. After all, you can always invest in other parts of the world. The United States is responsible for about 15% of global trade, which of course means that 85% is everywhere else. So, a pretty safe option is to work on other capital investments elsewhere, and just avoid the uncertainty.
A lesser option is to sell off your investments in the country and get out entirely. This is an unlikely option, since a reasonable assumption is that the tariffs will go down or be eliminated in four years, and business gets back to normal. However, if the next administration decides to continue with the tariffs, then you’ll need to explore whether your business can realistically generate any profits within the country, and then maybe consider selling out.
Yet another possibility is to apply a really high discount rate to your net present value calculations for any proposed new investment, based on the extremely high risk level in the current environment. If you can come up with a wildly profitable investment that still generates a positive net present value, then have at it. This sort of investment would be quite rare – something that can start generating positive cash flow almost immediately, with a large return, so that the payback period is really short. The downside is that I have no idea how you’d even come up with a reasonably valid discount rate; it would probably be a wild-ass guess.
Here's another option. Spend the next few years investigating suppliers within the United States to see if they can reduce their prices and increase their quality levels to match what you’re already getting from your suppliers elsewhere in the world. I’m assuming that this might be a substantial effort, since you’d already be using adjacent suppliers if it made sense to do so. This sort of investment is relatively low, and it could take a couple of years to bring the new suppliers up to your standards. But by the time the trade war is over, you may have shorter supply lines, which reduces your transportation expenses, and which protects you in case there’s another trade war at some point in the future.
And one other possibility. You could treat this time as a good period for experimentation, and just invest in pilot projects to see if some new business ideas might be profitable. These investments would be small, so losing your investment would not be a big deal. And if any of the pilots work out, then you’d be well positioned to make larger investments after the trade war is over.