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18th April 2014 International capital budgeting

International capital budgeting
Nominal vs Real cash flows:
Cash flows can be either nominal or real, where real cash flows shows cash flows with constant purchasing
power, where effect of inflation is removed, the nominal cash flows adds inflation to real cash flows.
For example, if an investment promises you a return of 10 percent and the expected inflation rate is 5 percent,
the expected real return on your bond are, 1.10/1.05-1 or 4.76 percent, where as the nominal return is 10%.
Proof:
With inflation 1$ might have became 1.05 due to inflation after 1 year
The 1$ with return of 10% will be $1.10, so $1.10 is having two parts one adjusted for inflation of 1.05 and
other true return let us assume it is (1+r), so (1+r) x (1.05)=1.10, so 1+r=1.10/1.05 or r=1.10/1.05 - 1.
The relationship between real and nominal rates was originally provided by Fisher as (1+nominal or money
terms) = (1+real) x (1+inflation)
So to get nominal cash flows or current price levels from real cash flows we have to multiply the same with (1+
inflation) and to get real cash from nominal cash flow you have to divided the same with (1+inflation)
What discount rate we have to use?
It should be noted that if cash flows are real the real discount rate should be used and vice versa.
How to adjust for inflation?
If inflation is having effect on cash flows it should reflect not only on current year’s cash flows but also for future
years
for example net cash inflows
Year $
1 1,000
2 2,000
3 3,000
4 4,000
5 5,000

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 If the rate of inflation is likely to be 15% in year 1 and 10% in year 2 and 8% each of the following years
The nominal cash flows will be
Year $
1 1,000 x (1+0.15)
2 2,000 x 1.15 x (1+0.10)
3 3,000 x 1.15 x1.10 x (1+0.08)
4 4,000 x 1.15 x 1.10 x 1.08 x (1+0.08)
5 5,000 x 1.15 x 1.10 x 1.08 x1.08 x (1+0.08)

Or

Year $
1 1,000 x (1.15)
2 2,000 x 1.15 x (1.10)
3 3,000 x 1.15 x1.10 x (1.08)1
4 4,000 x 1.15 x 1.10 x (1.08)2
5 5,000 x 1.15 x 1.10 x (1.08)3

If the question says the rate of inflation is likely to be 15% in years 1 -3 and 10% each of the following years
Year $
1 1,000 x (1.15)1
2 2,000 x (1.15)2
3 3,000 x (1.15)3
4 4,000 x (1.15)3x (1.10)1
5 5,000 x (1.15)3x (1.10)2

How to remember this: just look at power the sum of power should be equal to years, see for fourth year 3
above 1.15 and 1 above 1.10 adds to 4 years.
How to get real cash flows?
Just do the opposite divide nominal cash flows with rate of inflation.
For example if nominal cash flows after one year is 11500 and rate of inflation is 15% what are real cash flows.
11500/(1+0.15) = 11500/1.15 =10000
Example: A German manufacturer normally discounts projects at 10%, let us assume inflation at 15%, how
ever the cash flows were given in real terms as follows calculate NPV.
Year Cash flows €
0 -50000
1 17500
2 25000
3 15000
Method 1. Convert real cash flows to nominal cash flows and discount it by using nominal discount rate of
10%.
Real Cash Adjusting for Nominal cashflows Discounted at 10% Nominal Present
Year flows inflation values €
0 -50000 -50000 -50000 -50000/(1.10)0 -50000
1 17500 17500x(1.15) 20125 20125/(1.10)1 18295.45
2 25000 25000 x(1.15)2 33062.5 33062.5/(1.10)2 27324.38
3 15000 15000 x(1.15)3 22813.13 22813.13/(1.10)3
17139.84
NPV= 12759.67
Method 2. Convert Nominal discount rate to Real discount rate and use the same to discount cash flows
1+nominal discount rate = (1+ real discount rate) x (1 + inflation)
1+0.10= (1+ real discount rate) x (1 + 0.15)
(1+ real discount rate) = 1.10/1.15 or 0.9565
Real Cash Discounting at real Nominal cashflows
Year flows discount rate €
0 -50000 -50000 -50000
1 17500 17500/(0.9565) 18295.45

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 2 25000 25000 /(0.9565)2 27324.38
3 15000 15000 /(0.9565)3 17139.84
NPV= 12759.67

See both methods are giving the same NPV value of €12759.67
What about depreciation and tax?
Tax is always calculated on nominal cash flows, so if nominal cash flows are given calculate tax on nominal
cash flows, but if real cash flows given convert them to nominal to calculate tax. As depreciation tax shield is
available based on tax, here also nominal cash flows are relevant.
What happens when project undertaken in foreign country?
If cash flows and discount rate is given in the currency of domestic currency then calculate NPV as usual.
But if cash flows are given in foreign currency, then discount them with appropriate discount rate, then convert
the foreign NPV into domestic NPV using spot rate of exchange.
Spot rate can be found by interest rate parity theory.
1+annual discount rate at foreign currency = forward rate foreign/domestic
1+annual discount rate at domestic currency spot rate foreign/ domestic
So if domestic currency is dollar (i.e., a USA company) investing in Europe whose foreign currency is (Euro)
1 + annual discount rate € = forward rate €/$
1+annual discount rate $ spot rate €/$
Example:
P an entity in Germany is considering investing in a new project in USA which will have a life of 4 years.
The initial investment is $ 15000, including working capital. The net after-tax cash flows which the project will
generate are $ 6000 per annum for years 1, 2 and 3 and $ 4500 in year 4. The terminal value of the project is
estimated at $ 5000 net of tax.
The current spot rate for $ against Euro is 1.7. It is expected that Euro to strengthen against the dollar by 5%
per annum over the next 4 years. The entity evaluates German projects of similar risk at 14%.
As it is German company the NPV should be in Euros, but the cash flows are in dollars. But the cashflows are
given in foreign currency of $, so we can calculate NPV in two ways.
Current spot rate is 1.7 dollar =1 Euros or 1 dollar = 1/1.7 Euros = 0.5882 Euros
It is expected that Euro will strengthen 5% per annum over next 4 years.
So if Euro strengthens against dollar we will get less Euro for every dollar
1 dollar against euro now becomes 1.05 dollar against euro in one year
1.7 dollar against euro becomes 1.70 x (1.05) =1.785 dollar against Euro in 1 year time
1.70 x (1.05)2 = 1.87425 dollar against Euro in two years time, 1.70 x (1.05)3 = 1.9680 dollar against Euro in
three years time , 1.70 x (1.05)4 = 2.066 dollar against Euro in four years time.
1 Euro now =1.7 dollars or 1 dollar = 1/1.7 Euros = 0.5882 Euros
1 Euro after 1 year =1.785 dollars or 1 dollar after 1 year is 1/1.785 = 0.560 Euro
You can use the above formula to get forward rate
1 + annual discount rate $ = forward rate $/€
1+annual discount rate € spot rate $/€
1.5/1 = forward rate/1.7
Forward rate = 1.7 x 1.5 after 1 year and so on
year Details cash flows in $ total in $ Value of Euro per dollar Euros discounted in Euros @ 14%
0 initial investment -15000 -15000 0.588 -8823.00 -8823.00
1 cash flows 6000 6000 0.560 3360.00 2947.37
2 cash flows 6000 6000 0.534 3201.28 2463.28
3 cash flows 6000 6000 0.508 3048.78 2057.84
4 cash flows 4500 9500 0.484 4598.26 2722.54
4 terminal value 5000 NPV = 1368.03

See the Answer carefully, the future cash flows are converted using future Euro values per doller then
discounted as usual using discount rate as Euro is the domestic currency then discount rate is also the rate
used for domestic projects.
There is another way of doing the problem.
You can use the above formula to get forward rate
1 + annual discount rate $ = forward rate $/€

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 1+annual discount rate € spot rate $/€
1 + annual discount rate $ = 1.05
1+0.14 1
1 + annual discount rate $ = 1.14 x 1.05 = 1.197 =19.7% is the discount rate to be used for cash flows in
dollars
year Details cashflows in $ total in $ discounted @ 19.7%
0 initial investment -15000 -15000 -15000.00
1 cash flows 6000 6000 5012.53
2 cash flows 6000 6000 4187.58
3 cash flows 6000 6000 3498.39
4 cash flows 4500 9500 4627.51
4 terminal value 5000 NPV in $ 2326.01
Spot rate is 1.7$ per Euro NPV in Euro 2326 / 1.7 =1368.24

Note: see the above solution if there is a foreign project there are two approaches and both involves three
steps.
1st approach: step one calculates forward rates of domestic currency against foreign currency
Use them to convert foreign net cash flows into domestic currency
Then use discount rate we use for domestic projects to discount the cash flows calculated above.
2nd approach: find out discounted rate in foreign currency using formula and find.
Discount cash flows in foreign currency and calculate NPV in foreign currency.

Then use spot rate to convert NPV in foreign currency to NPV in domestic currency.
Posted 18th April 2014 by C.V.D.Somayajulu

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