international capital budgeting

International Capital International Capital BudgetingBudgeting

Introduction:Introduction:

Assets fall in two categoriesAssets fall in two categories

Short term or Current Asset Long term or fixed assets

Working capital Mgt

Capital Budgeting

What is Capital What is Capital Budgeting?Budgeting?

The system of Capital Budgeting is The system of Capital Budgeting is employed to evaluate expenditure employed to evaluate expenditure decisions which involve current outlays decisions which involve current outlays but are likely to produce benefits over a but are likely to produce benefits over a period of time longer than one year. These period of time longer than one year. These benefits may be in the form of increased benefits may be in the form of increased revenue or reduction in costs.revenue or reduction in costs.

Capital expenditure Mgt therefore includes Capital expenditure Mgt therefore includes addition,disposition,modification and addition,disposition,modification and replacement of Fixed Assetsreplacement of Fixed Assets

Basic features of Capital budgeting Basic features of Capital budgeting are:are:

Potentially large anticipated benefitsPotentially large anticipated benefits Relatively high degree of riskRelatively high degree of risk A relatively long period of time A relatively long period of time

between initial outlay and between initial outlay and anticipated returnanticipated return

Importance of Capital Budgeting Importance of Capital Budgeting DecisionsDecisions

Determines the future destiny of the Determines the future destiny of the companycompany

The firms costs,BEP,sales and profits will be The firms costs,BEP,sales and profits will be determined by the firms selection of assetsdetermined by the firms selection of assets

Capital investment decisions once made Capital investment decisions once made not easily reversible without much loss to not easily reversible without much loss to the firmthe firm

The Capital investment involves costs and The Capital investment involves costs and majority of the firms have scarce capital majority of the firms have scarce capital resources resources

Multinational capital BudgetingMultinational capital Budgeting

The technique of Capital Budgeting is The technique of Capital Budgeting is similar between domestic and a similar between domestic and a multinational firm. The only multinational firm. The only difference is some additional difference is some additional complexities appear in case of a complexities appear in case of a multinational firm.multinational firm.

Capital Budgeting in MNC encounters Capital Budgeting in MNC encounters a number of variables and factors a number of variables and factors that are unique for a foreign project.that are unique for a foreign project.

Complexities are:Complexities are:

Parent cash flows are different from project cash Parent cash flows are different from project cash flows.flows.

Profits remitted are subject to two tax jurisdictions-Profits remitted are subject to two tax jurisdictions-parent co &host Co.parent co &host Co.

National inflation and its effect on the cash flows National inflation and its effect on the cash flows over a period of timeover a period of time

Possibility of foreign exchange risk and its effect on Possibility of foreign exchange risk and its effect on the parents cash flows.the parents cash flows.

Profitability may be enhanced by concessionary Profitability may be enhanced by concessionary financial arrangements and other benefits provided financial arrangements and other benefits provided by host co.by host co.

Foreign investment may produce diversification Foreign investment may produce diversification benefits to the shareholders of the parent co.benefits to the shareholders of the parent co.

Complexities are:Complexities are:

The host co may impose various restrictions on The host co may impose various restrictions on the distribution of cash flows generated from the distribution of cash flows generated from foreign project.foreign project.

Political risk must be evaluated thoroughly as Political risk must be evaluated thoroughly as changes in political events can drastically reduce changes in political events can drastically reduce the availability of expected cash flows.the availability of expected cash flows.

Terminal value in MNCCB is more difficult to Terminal value in MNCCB is more difficult to estimate than domestic projects. Such value to estimate than domestic projects. Such value to the parent co may differ from the valuation put the parent co may differ from the valuation put on the facilities by potential buyer in the host co.on the facilities by potential buyer in the host co.

Problems and issues in Problems and issues in International/Foreign Investment International/Foreign Investment

analysisanalysis Parent Vs Project Cash flowsParent Vs Project Cash flows Exchange rate change and inflation risk.Exchange rate change and inflation risk. Tax treatmentTax treatment Political and economic riskPolitical and economic risk Blocked fundsBlocked funds Amenities and concessions granted by host Amenities and concessions granted by host

companiescompanies

Project Vs Parent Cash FlowsProject Vs Parent Cash Flows

Substantial differences can exist between the project and Substantial differences can exist between the project and parent cash flows.parent cash flows.

The cash flow accruing to the parent may not be The cash flow accruing to the parent may not be represented entirely by the cash flow accruing to the parent represented entirely by the cash flow accruing to the parent co.co.

Project expenses like management fees ,royalties are Project expenses like management fees ,royalties are returns to the parent co i.e. the outflow of the subsidiary is returns to the parent co i.e. the outflow of the subsidiary is treated as the inflow for the parent co.treated as the inflow for the parent co.

Important question is : Important question is : On what basis should the project be On what basis should the project be evaluated?evaluated?

1.On its own cash outflows ?1.On its own cash outflows ?

2.Cash flows accruing to the parent co?2.Cash flows accruing to the parent co?

3.Both?3.Both?

On its own cash outflows ?Its On its own cash outflows ?Its usefulnessusefulness

By doing this we can access/compare the By doing this we can access/compare the capability of the project whether it is able to earn capability of the project whether it is able to earn a higher return than its locally based competitorsa higher return than its locally based competitors

By evaluating the project on the basis of local By evaluating the project on the basis of local cash flows the currency conversion problem is cash flows the currency conversion problem is eliminated and also the problem involved with eliminated and also the problem involved with fluctuating/forecasting exchange rates is fluctuating/forecasting exchange rates is eliminated for the life time of the projecteliminated for the life time of the project..

Cash flows accruing to the parent co? Cash flows accruing to the parent co? Its usefulnessIts usefulness

A strong theoretically valid criterion in Financial A strong theoretically valid criterion in Financial Mgt is to evaluate the foreign project in the view Mgt is to evaluate the foreign project in the view point of the parent co.point of the parent co.

Cash flows which are actually remitted to the Cash flows which are actually remitted to the parent co are ultimate yard stick for dividends to parent co are ultimate yard stick for dividends to shareholders ,repayment of Int & Debt to lenders shareholders ,repayment of Int & Debt to lenders and other purposes.and other purposes.

It helps to determine the financial viability of the It helps to determine the financial viability of the project from the point of view of the MNC as a project from the point of view of the MNC as a wholewhole

Exchange rate Change and InflationExchange rate Change and Inflation

To incorporate the foreign exchange risk in the cash flow estimate of To incorporate the foreign exchange risk in the cash flow estimate of the project:the project:

1.Estimate the inflation rate in the host country during the life term 1.Estimate the inflation rate in the host country during the life term of the project.of the project.

2. Cash inflows in terms of local currency is adjusted upwards for 2. Cash inflows in terms of local currency is adjusted upwards for inflation factor.inflation factor.

3.The cash flows are converted into the parent company’s currency 3.The cash flows are converted into the parent company’s currency at spot exchange rate.at spot exchange rate.

4.The above is multiplied by an expected appreciation or 4.The above is multiplied by an expected appreciation or depreciation rate calculated on the basis of purchasing power depreciation rate calculated on the basis of purchasing power parity.parity.

In certain specific situations ,the conversion can also be made on the In certain specific situations ,the conversion can also be made on the basis of some exchange rate accepted by the managementbasis of some exchange rate accepted by the management

Remittance RestrictionsRemittance Restrictions

Where there are restrictions on remittances of Where there are restrictions on remittances of income to the Parent co, substantial differences income to the Parent co, substantial differences exist between project cash inflows and cash exist between project cash inflows and cash inflows received by the parent co.inflows received by the parent co.

Only those cash flows which are remittable to the Only those cash flows which are remittable to the parent are relevant from the MNC’s perspective.parent are relevant from the MNC’s perspective.

Many countries impose variety of restrictions on Many countries impose variety of restrictions on transfer of profits,depriciation and other fees transfer of profits,depriciation and other fees accruing to the parent co.accruing to the parent co.

Project cash flows consists of profits and Project cash flows consists of profits and depreciation charges whereas parent cash flows depreciation charges whereas parent cash flows consists of amounts to be legally transferred to it.consists of amounts to be legally transferred to it.

Tax IssueTax Issue Both in domestic as well as Multinational Capital budgeting only Both in domestic as well as Multinational Capital budgeting only

after tax cash flows are relevant for project evaluation.after tax cash flows are relevant for project evaluation.

However the MNCB is complicated by the existence of two tax However the MNCB is complicated by the existence of two tax jurisdictions ,plus number of other factors.jurisdictions ,plus number of other factors.

The other factors include the form of remittance to the parent-The other factors include the form of remittance to the parent-dividends,fees,royalties etc.dividends,fees,royalties etc.

In addition tax laws in many host countries discriminate between In addition tax laws in many host countries discriminate between transfer of realized profits as against local re-investment of these transfer of realized profits as against local re-investment of these profits.profits.

The ability of the MNC to reduce the over all tax burden through The ability of the MNC to reduce the over all tax burden through transfer pricing mechanism should be considered.transfer pricing mechanism should be considered.

To calculate the after tax cash flows accruing to the parent co. the To calculate the after tax cash flows accruing to the parent co. the higher of the home or host co tax rate should be usedhigher of the home or host co tax rate should be used

Political and economic riskPolitical and economic risk

While calculating the cash flows of the project the political While calculating the cash flows of the project the political and economic risks of the overseas operation must be taken and economic risks of the overseas operation must be taken into account.into account.

One method is use a higher discount rate for foreign projects One method is use a higher discount rate for foreign projects and another to require shorter pay back period.and another to require shorter pay back period.

Here we have to asses the magnitude of risk and the time Here we have to asses the magnitude of risk and the time pattern of the risk. For Eg:5 years from now is likely to be pattern of the risk. For Eg:5 years from now is likely to be less threatening than the initial years. In such a case less threatening than the initial years. In such a case uniformly higher discount distorts the meaning of projects uniformly higher discount distorts the meaning of projects PV. PV.

The capital risk may be justified as long it is a systematic risk The capital risk may be justified as long it is a systematic risk of a proposed investment. To the extent the risks dealt are of a proposed investment. To the extent the risks dealt are unsystematic there is no theoretical justification to adjust the unsystematic there is no theoretical justification to adjust the project costs to reflect them.project costs to reflect them.

An alternative approach is use certainty equivalent method An alternative approach is use certainty equivalent method where risk adjusted cash flows are discounted at risk free where risk adjusted cash flows are discounted at risk free rate for which no satisfactory procedure is yet to be rate for which no satisfactory procedure is yet to be developed.developed.

Blocked fundsBlocked funds

In many cases ,the host govt In many cases ,the host govt imposes restrictions on the outflow of imposes restrictions on the outflow of the funds from the country. Such the funds from the country. Such funds are known as blocked funds.funds are known as blocked funds.

Suppose if the host govt says that Suppose if the host govt says that the net revenue transferred to the the net revenue transferred to the parent after the completion of the parent after the completion of the project and not every year ,this project and not every year ,this provision will certainly influence the provision will certainly influence the cash flow.cash flow.

Amenities and concessions granted by the Amenities and concessions granted by the host countryhost country

The foreign investments carry some sort of The foreign investments carry some sort of assistance from the host govt. This may be assistance from the host govt. This may be in the form of low cost of land, income tax in the form of low cost of land, income tax holidays for stated no. of years, exemption holidays for stated no. of years, exemption from or reduction of custom duties on from or reduction of custom duties on imported parts, raw materials ,concesstional imported parts, raw materials ,concesstional loans etc.loans etc.

Most of these benefits require no special Most of these benefits require no special interest in the capital budgeting exercise, interest in the capital budgeting exercise, because they are and should be reflected in because they are and should be reflected in capital costs.capital costs.

Project Evaluation CriteriaProject Evaluation Criteria

Methods of Project EvaluationMethods of Project Evaluation

Non discounting method

Discounting Method

Avg Accounting rate of return

Pay Back Period

Net PV method

P I Method

IRR Method

Avg Accounting rate of return

It represents the mean/average profits on It represents the mean/average profits on account of the investment prior to interest and account of the investment prior to interest and tax payments.tax payments.

The mean/average profit is compared with the The mean/average profit is compared with the with the hurdle rate or required rate of return.with the hurdle rate or required rate of return.

If the mean profit is greater than the required If the mean profit is greater than the required

rate the project is acceptedrate the project is accepted..

Shortcomings of ARR methodShortcomings of ARR method

Based on accounting income and not cash flow.Based on accounting income and not cash flow.

It considerers profit before tax rather than post It considerers profit before tax rather than post tax profit.tax profit.

It ignores time value of moneyIt ignores time value of money

Problem 1Problem 1

Find the accounting rate of return based on the Find the accounting rate of return based on the following data:following data:

YearYear Gross Gross profitprofit

DepreciationDepreciation Net Net ProfitProfit

InvestmentInvestment

11 $2000$2000 53325332 -3332-3332 13,33413,334

22 60006000 53325332 668668 80008000

33 1000010000 53325332 46684668 26662666

AverageAverage 668668 80008000

ARRARR 668/8000=8.35%668/8000=8.35%

Pay back period methodPay back period method

Payback period is the no. of years Payback period is the no. of years required to recover the initial required to recover the initial investment.investment.

If the investment is not recovered If the investment is not recovered within the payback period ,the within the payback period ,the project should not be accepted.project should not be accepted.

Thus this method stresses on the Thus this method stresses on the early recovery of funds ,but fails to early recovery of funds ,but fails to consider time value of money.consider time value of money.

Pay back period methodPay back period method

One technique is to compare the actual pay back One technique is to compare the actual pay back with a predetermined payback,ie pay back set by with a predetermined payback,ie pay back set by the Mgt terms of max period during which the the Mgt terms of max period during which the initial investment should be recovered .Actual Pay initial investment should be recovered .Actual Pay back period <predetermined PBP –Accept the back period <predetermined PBP –Accept the Project.Project.

Alternatively the payback can be used as a Alternatively the payback can be used as a ranking method .when mutually exclusive ranking method .when mutually exclusive projects are under consideration, they can be projects are under consideration, they can be ranked as per the length of the pay back period. ranked as per the length of the pay back period.

The project having the shortest payback is ranked The project having the shortest payback is ranked I and the project with the longest PBP is ranked I and the project with the longest PBP is ranked the lowest.the lowest.

PBP=Initial InvestmentPBP=Initial InvestmentConstant Annual Cash flow

Problem -2Problem -2

Considering the target payback period as two Considering the target payback period as two years the cash flows of two proposals are as years the cash flows of two proposals are as follows: follows: Project AProject A Project BProject B

Initial Investment -2000 -2000Initial Investment -2000 -2000

Net cash benefits Yr1 1200 1200Net cash benefits Yr1 1200 1200

2 800 4002 800 400

3 - 3003 - 300

4 - 8004 - 800

Proposal A will be accepted as initial investment Proposal A will be accepted as initial investment is recovered in 2yrs i.e. the target pay back is recovered in 2yrs i.e. the target pay back period.period.

Net Present Value rule:Net Present Value rule:

In this case, projects are accepted In this case, projects are accepted where present value of net cash where present value of net cash inflow during the life span of the inflow during the life span of the asset is greater than initial asset is greater than initial investment.The difference adds to investment.The difference adds to the corporate wealth.the corporate wealth.

Equation NPV =nEquation NPV =nCF (1+k)

nt

t=1

_ I0

Net Present Value rule:Net Present Value rule:

CFt =Expected after tax cash folw from t1 to tn, including CFt =Expected after tax cash folw from t1 to tn, including operational and terminal cash flowoperational and terminal cash flow

I 0 = Initial investmentI 0 = Initial investment K= Risk adjusted discount rateK= Risk adjusted discount rate N= Life span of the projectN= Life span of the project CFt is incremental cash inflows after taxes and incusive of CFt is incremental cash inflows after taxes and incusive of

depriciation.depriciation. It is assumed CFAT is received after the end of every year.It is assumed CFAT is received after the end of every year. CFAT shout take into account salvage value.CFAT shout take into account salvage value. Working capital released at the end of the project life is Working capital released at the end of the project life is

included in the CFATincluded in the CFAT

Problem 3Problem 3

A project involves initial cash investment A project involves initial cash investment of$500000.The net cash inflow in the first,second and of$500000.The net cash inflow in the first,second and third year is respectively $3,000,000, third year is respectively $3,000,000, $35000000,$2000000.At the end of the third year scrap $35000000,$2000000.At the end of the third year scrap value indicated at $1000000. The risk adjusted discount value indicated at $1000000. The risk adjusted discount rate -10%.Calculate NPV.rate -10%.Calculate NPV.

t1 +t2 +t3 –I t1 +t2 +t3 –I 0 = 30000000 = 3000000 + + 35000000 35000000 + + 2000000+1000000 ----2000000+1000000 ----50000005000000 (1.10 )

1(1.10)2 (1.10)3

The NPV =$2873778 is positive hence the project should be accepted

Profitability IndexProfitability Index

Yet another time adjusted capital Yet another time adjusted capital budgeting technique is the PI.It is similar budgeting technique is the PI.It is similar to NPV approach.to NPV approach.

PI measures the present value per rupee PI measures the present value per rupee invested, while NPV is based on the invested, while NPV is based on the difference between PV of cash inflows and difference between PV of cash inflows and PV of cash outflows.PV of cash outflows.

PI can be defined as the ratio which is PI can be defined as the ratio which is obtained by dividing the PV of future cash obtained by dividing the PV of future cash inflows by PV of cash outlays.inflows by PV of cash outlays.

Mathematically PI= Mathematically PI= PVPV of cash inflowsof cash inflowsPV of cash outflows

Profitability IndexProfitability Index PI>1 accept the projectPI>1 accept the project PI<1 reject the projectPI<1 reject the project PI=1 point of indifferencePI=1 point of indifference

For Sum 3For Sum 3

PI = 7873778/5000000=1.57 so PI = 7873778/5000000=1.57 so accept the projectaccept the project

Internal rate of returnInternal rate of return

IRR is that discount rate (r) which equates the IRR is that discount rate (r) which equates the aggregate PV of Net cash inflows (CFAT) with the aggregate PV of Net cash inflows (CFAT) with the aggregate PV of cash outflows of a project.aggregate PV of cash outflows of a project.

In other words ,it is that rate which gives the In other words ,it is that rate which gives the

project NPV of zeroproject NPV of zero..

t=1

CFt

(1+r)n

---I0

Where r is the IRR of the project

Accept /reject criterion

Project will be accepted if IRR is greater than the required rate of return/cut off rate /hurdle rate

If the IRR and the required rate of return are equal, the firm is indifferent as to accept or reject the project

n

Adjusted Present value approachAdjusted Present value approach

A discounted cash flow technique that can be A discounted cash flow technique that can be adapted to the unique aspect of evaluating adapted to the unique aspect of evaluating foreign projects is adjusted Present value foreign projects is adjusted Present value approach.approach.

The APV method begins with the assumption that The APV method begins with the assumption that the projects cash flows can be decomposed into the projects cash flows can be decomposed into their constituent parts.their constituent parts.

The APV format allows different components of The APV format allows different components of the project cash flows to be discounted the project cash flows to be discounted seperately,thus it allows the required flexibility to seperately,thus it allows the required flexibility to be accomidated in the analysis of a foreign be accomidated in the analysis of a foreign project.project.


The APV approach uses different discount rates The APV approach uses different discount rates for different segments of the total cash flows for different segments of the total cash flows depending on the degree of certainty attached to depending on the degree of certainty attached to each cash flow.each cash flow.

APV framework enables the capital budgeting APV framework enables the capital budgeting analyst to test the profitability of the foreign analyst to test the profitability of the foreign project after accounting for all the complexities.project after accounting for all the complexities.

If the project proves to be acceptable in this If the project proves to be acceptable in this scenario no further evaluation based on cash scenario no further evaluation based on cash flows is necessary.But if it fails to meet the flows is necessary.But if it fails to meet the acceptance criteria ,then an additional evaluation acceptance criteria ,then an additional evaluation is done taking into account other complexities.is done taking into account other complexities.


For eg.the analysis may be conducted on For eg.the analysis may be conducted on the basis of contractual cash flows which the basis of contractual cash flows which are remittable to the parent co. under the are remittable to the parent co. under the existing foreign exchange regulations of the existing foreign exchange regulations of the host co. If the project does not pass the host co. If the project does not pass the hurdle rate another cash flow component, hurdle rate another cash flow component, such as cash flow the MNC can unblock such as cash flow the MNC can unblock through transfer pricing mechanism, will be through transfer pricing mechanism, will be added to ascertain whether or not it could added to ascertain whether or not it could nudge the project towards profitability.nudge the project towards profitability.


As foreign projects face a number of complexities As foreign projects face a number of complexities not encountered in domestic capital budgeting, not encountered in domestic capital budgeting, for eg.issue of remittence,foreign exchange for eg.issue of remittence,foreign exchange regiulation,restriction on transfer of cash flows, regiulation,restriction on transfer of cash flows, blocked funds etc.blocked funds etc.

The APV model is a value addictively approach to The APV model is a value addictively approach to capital budgeting,ie each cash flow as a source of capital budgeting,ie each cash flow as a source of value is considered individually.value is considered individually.

In APV approach each cash flow is discounted at In APV approach each cash flow is discounted at the rate of discount with the risk inherent in the the rate of discount with the risk inherent in the cash flow.cash flow.

Adjusted Present value Adjusted Present value approachapproach

In the equation form APV approach In the equation form APV approach cancan

international capital budgeting

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