INTERNATI0NAL PROJECT

APPRAISAL
FOREIGN CAPITAL BUDGETING
DECISIONS
• The capital budgeting decisions have a
significant bearing for MNCs on efficiency
and competing position in an industry
• Incorrect investment decisions have
inherent threats of endangering the
survival even of large sized enterprises
• The above is more true for MNCs setting
up their subsidiaries abroad
 GENERAL PROBLEMS
• Foreign investment decisions are troubled with a variety
of problems that are not generally encountered by
domestic firms
• Some of these problems are
• Exchange rate risks
• Expropriation risk
– Confiscation of private owned assets by government
• Foreign tax regulations
• Multiple tiers of taxation
• Political risk
• Basic business risk of foreign and domestic projects
 BENEFITS OF INTERNATIONAL
INVESTMENTS

• In spite of these risks, there has been an

increased tendency towards foreign investment
or expansion of business into foreign territory
• Some of the main reasons are:
– Comparative cost advantage
– Taxation is another vital economic/financial incentive
– Financial diversification – spreading the firm’s risk
over a wider range of markets
 CAPITAL BUDGETING
DECISIONS
• Capital budgeting decisions relating to project
investment abroad require data pertaining to
their
– incremental investment outlays
– Operating costs and
– Benefits
• Which can be wholly and exclusively identified
with proposed investment
• It is very important to draw a distinction
between total and incremental cash flows
• The cost, benefits and revenue to be relevant
must be incremental in nature
• Care should be taken to include the true
economic cost (i.e. opportunity cost) of any
resource required for the project
• Eg. Rent foregone due to the use of office
space (proposed for the new project) is the
relevant cost
• Any costs/overheads are additional on
account of the project, they form part of the
relevant cost data
• The guideline is: but for the investment
proposal under consideration, these costs and
benefits would not have taken place
• Both costs and benefits should be measured on
a cash flow basis and not on the basis on the
accounting profit
• The reasons underlying the superiority of cash
flow approach are
• It avoids the ambiguities of the accounting
profit concept
• It takes into account the time value of money
• Is appropriate for investment decision analysis
since it helps in finding out whether future
economic inflows are sufficiently large to
warrant the initial investment
• The expected/projected incremental cash flows
after taxes arising out of an investment decision
constitute the relevant data for its evaluation
 EVALUATING A PROJECT
• Like domestic capital budgeting decisions,
the objective of foreign capital budgeting
decisions by MNCs is maximisation of the
wealth of its shareholders
• The technique of NPV is considered most
appropriate
• It is consistent with the objective of
financial decision to maximise
shareholders’ wealth
 NET PRESENT VALUE
• NPV is defined as
– the summation of future cash inflows after taxes
(CFAT) likely to accrue in future years
– discounted by appropriate cost of capital (k)
– minus the summation of net cash outflows required
to undertake such an investment,
– usually in the beginning of the project
• The decision criterion for a project under
evaluation by the NPV technique is to accept the
project if NPV is positive and reject if it is
negative
 CASH FLOW DETERMINATION
• Like domestic capital budgeting decisions,
foreign investment decisions require to be
evaluated on the basis of their
– cash flow requirements and
– cash flow generating capacity in the future
years
AT THE LEVEL OF SUBSIDIARY
• Assuming that the subsidiary is an
independent company and calculations
are to be performed in the local currency
where the subsidiary is located, it is
similar to domestic investment decisions
 CASH OUTFLOWS
• Cost of plant and equipment
• Shipping charges, custom duties
• Installation cost of plant and equipment
• Training cost of personnel
• Less capital subsidy from government, if any
• Less tax benefits due to investment allowance, if
applicable
• Less sale proceeds from the existing plant and
equipment
 CASH INFLOWS AFTER TAXES
• Sales revenue
• Less cash operating costs
• less management fees charged by parent
• Less royalties for patents, licences, brands etc., charged by parent
• Less depreciation
• Less amortisation of technology transfer
• Earnings before tax
• Less taxes
• Earning after taxes
• Add depreciation
• Add amortization
• CFAT
• Add salvage value of the plant
• Add recovery of working capital
 AT THE LEVEL OF PARENT
• The cash flows should evaluated from the
perspective of parent
• The analysis should be based on the cash flows
expected to be remitted to the parent and not of
CFAT generated by the project
• The difference in the above two arises primarily
due to tax regulations, exchange controls,
inflation and currency fluctuations
• Fee is also charged for technology transfer,
management fees and royalties from the
subsidiary unit, since they constitute returns to
the parent MNC
 CASH INFLOWS TO THE
PARENT
• Dividends received
• Interest received
• Management fees
• Royalties for patents, licenses, brands, etc.
• Terminal cash flows – repayment of loan, repatriation of
sale proceeds of plant, release of working capita,
accumulated sums not paid due to exchange control
restrictions
• Increase in cash profits (after tax) due to increased
export sales of other products at parent MNC
• (less decrease in cash profits (after taxes) due to decrease
in export sales)
• Gains due to transfer price adjustments
• Evaluation of cash flows from the
perspective of the parent firm should
consider factors such as
– taxes,
– restrictions on repatriation of income,
– exchange rate risk,
– country risk (political & economic), etc.
 EFFECT OF TAXES
• Since cash flows after taxes are relevant, it
is important to determine the
– Timing and
– Magnitude of taxes
• To be paid on
– Profits earned and
– Cash received
• Through foreign subsidiaries
 STAGES OF TAXATION OF
INCOME FROM FOREIGN
INVESTMENTS
• The local government of the country where a subsidiary is located taxes
profits
– As per the tax law of the country, the company pays corporate tax
• Local governments may impose withholding taxes on that part of profits
which is remitted in the form of dividends to the parent company
• To avoid double taxation, some governments allow tax credits for foreign
income taxes and for withholding taxes
• Legislation often requires that a part of the profits be retained, therefore
profit available for the parent company will be
– = P(1-t) (1-r)

P= profits of the subsidiary before taxes

t = corporate tax rate applicable to the subsidiary
r = retention rate
 REPATRIATION OF FUNDS
• Some countries have restrictions on repatriation
of income
• Only remittable cash flows are relevant from the
parent company’s perspective
• Restriction on movement of funds of the
subsidiary’s profits may cause severe adverse
impact on the profitability/ acceptability of
foreign direct investment
• Therefore the financial analyst should consider
the effect of funds blocked
• Firms use various means to remove blocked
funds, at least partially
• These measures include
– Transfer price adjustments on inter-corporate sales
– Loan repayments
– Fee and royalty adjustments
• If the parent intends to continue expanding a
profitable local operation,
– then a repatriation restriction is irrelevant to the
evaluation of the project as
– expansion of operations would require funds to be
ploughed back in the project instead of
– remitting to the parent company
 EXCHANGE RATE RISK
• Exchange rate risk is another significant
variable
• This risk is more pronounced for
undertaking investments in under
developed countries
• As a result, repatriable cash flows
(converted into the currency of the parent)
diminish on account of devaluation of
local currency
• The factors that should be incorporated
in calculation of NPV, for a foreign
capital budgeting decisions
– Partial repatriation
– Withholding taxes
– Change in the exchange rate, etc.
 EFFECT OF INFLATION
• Exchange rate changes are normally
preceded by relatively higher to lower
local rates of inflation than in the home
country
• Inflation and exchange risks are referred
to as the opposite sides of the same coin
• Effects of inflation vary from firm to firm
 POLITICAL AND ECONOMIC
RISK
• Confirming to the principles of capital
budgeting evaluation techniques in financial
management, political and economic risks can be
minimised by:
– Keeping a lower/shorter payback period
– Raising the required rate of return (cost of capital
used as discount rate)
• This is referred to as risk adjusted discount rate (RAD)
approach
– Adjusting cash flows to incorporate all available
information about the impact of a specific risk on
future returns from the investment
• A shorter payback period is not viewed
as a good approach
– Since the payback method does not take
into account CFAT accruing from the
project in all the years, and
– Disregards time value of money
• RAD approach is not considered sound
– Since choice of risk premium is arbitrary
– Using highly discounted rate penalises the
future cash flows
• Due to the serious limitations, of the
two approaches, the recommended
approach is to
– Adjust the cash flows of the project to
• fully incorporate all available information
about the effect of a specific risk on
• future returns from the proposed
investment
– Greater flexibility is available in
adjustments of cash flows than in
adjustments of discount rate
• Foreign capital budgeting decisions are strategic
decisions
• Since they normally involve large volume of funds,
wrong decisions may result in great losses/liquidation
of the company
• Cash flow approach is more scientific as a decision
criterion
• Approach based on incremental analysis is considered
useful
• Evaluation of a project’s capital budgeting decision
use
– Incremental cash outflows
– Projected/ expected incremental cash inflows after taxes
(CFAT)
– Cost of capital (ideally weighted average cost of long-term
sources of finance)