International Capital Budgeting

Introduction:
Assets fall in two categories

Short term or Current Asset Long term or fixed assets

Working Capital
capital Mgt Budgeting
 What is Capital Budgeting?

 The system of Capital Budgeting is employed to

evaluate expenditure decisions which involve
current outlays but are likely to produce benefits
over a period of time longer than one year.
These benefits may be in the form of increased
revenue or reduction in costs.
 Capital expenditure Mgt therefore includes
addition,disposition,modification and
replacement of Fixed Assets
 Basic features of Capital budgeting are:

 Potentially large anticipated benefits

 Relatively high degree of risk
 A relatively long period of time between
initial outlay and anticipated return
Importance of Capital Budgeting Decisions

 Determines the future destiny of the company

 The firms costs,BEP,sales and profits will be
determined by the firms selection of assets
 Capital investment decisions once made not
easily reversible without much loss to the firm
 The Capital investment involves costs and
majority of the firms have scarce capital
resources
 Multinational capital Budgeting

 The technique of Capital Budgeting is

similar between domestic and a
multinational firm. The only difference is
some additional complexities appear in
case of a multinational firm.
 Capital Budgeting in MNC encounters a
number of variables and factors that are
unique for a foreign project.
 Complexities are:
 Parent cash flows are different from project cash flows.
 Profits remitted are subject to two tax jurisdictions-
parent co &host Co.
 National inflation and its effect on the cash flows over a
period of time
 Possibility of foreign exchange risk and its effect on the
parents cash flows.
 Profitability may be enhanced by concessionary financial
arrangements and other benefits provided by host co.
 Foreign investment may produce diversification benefits
to the shareholders of the parent co.
 Complexities are:
 The host co may impose various restrictions on the
distribution of cash flows generated from foreign project.
 Political risk must be evaluated thoroughly as changes in
political events can drastically reduce the availability of
expected cash flows.
 Terminal value in MNCCB is more difficult to estimate
than domestic projects. Such value to the parent co may
differ from the valuation put on the facilities by potential
buyer in the host co.
Problems and issues in International/Foreign
Investment analysis
 Parent Vs Project Cash flows
 Exchange rate change and inflation risk.
 Tax treatment
 Political and economic risk
 Blocked funds
 Amenities and concessions granted by host companies
 Project Vs Parent Cash Flows

 Substantial differences can exist between the project and parent

cash flows.
 The cash flow accruing to the parent may not be represented
entirely by the cash flow accruing to the parent co.
 Project expenses like management fees ,royalties are returns to the
parent co i.e. the outflow of the subsidiary is treated as the inflow
for the parent co.
Important question is : On what basis should the project be evaluated?
1.On its own cash outflows ?
2.Cash flows accruing to the parent co?
3.Both?
 On its own cash outflows ?Its usefulness

 By doing this we can access/compare the capability of

the project whether it is able to earn a higher return
than its locally based competitors
 By evaluating the project on the basis of local cash flows
the currency conversion problem is eliminated and also
the problem involved with fluctuating/forecasting
exchange rates is eliminated for the life time of the
project.
 Cash flows accruing to the parent co? Its
usefulness

 A strong theoretically valid criterion in Financial Mgt is to

evaluate the foreign project in the view point of the
parent co.
 Cash flows which are actually remitted to the parent co
are ultimate yard stick for dividends to shareholders
,repayment of Int & Debt to lenders and other purposes.
 It helps to determine the financial viability of the project
from the point of view of the MNC as a whole
 Exchange rate Change and Inflation

To incorporate the foreign exchange risk in the cash flow estimate of the
project:
1.Estimate the inflation rate in the host country during the life term of the
project.

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

factor.

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

4.The above is multiplied by an expected appreciation or depreciation rate

calculated on the basis of purchasing power parity.

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

 Where there are restrictions on remittances of income to

the Parent co, substantial differences exist between
project cash inflows and cash inflows received by the
parent co.
 Only those cash flows which are remittable to the parent
are relevant from the MNC’s perspective.
 Many countries impose variety of restrictions on transfer
of profits,depriciation and other fees accruing to the
parent co.
 Project cash flows consists of profits and depreciation
charges whereas parent cash flows consists of amounts to
be legally transferred to it.
 Tax Issue
 Both in domestic as well as Multinational Capital budgeting only after tax
cash flows are relevant for project evaluation.

 However the MNCB is complicated by the existence of two tax

jurisdictions ,plus number of other factors.

 The other factors include the form of remittance to the parent-

dividends,fees,royalties etc.

 In addition tax laws in many host countries discriminate between transfer of

realized profits as against local re-investment of these profits.

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

 To calculate the after tax cash flows accruing to the parent co. the higher of
the home or host co tax rate should be used
 Political and economic risk

 While calculating the cash flows of the project the political and
economic risks of the overseas operation must be taken into
account.
 One method is use a higher discount rate for foreign projects and
another to require shorter pay back period.
 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 less threatening
than the initial years. In such a case uniformly higher discount
distorts the meaning of projects PV.
 The capital risk may be justified as long it is a systematic risk of a
proposed investment. To the extent the risks dealt are unsystematic
there is no theoretical justification to adjust the project costs to
reflect them.
 An alternative approach is use certainty equivalent method where
risk adjusted cash flows are discounted at risk free rate for which no
satisfactory procedure is yet to be developed.
 Blocked funds
 In many cases ,the host govt imposes
restrictions on the outflow of the funds
from the country. Such funds are known
as blocked funds.
 Suppose if the host govt says that the net
revenue transferred to the parent after the
completion of the project and not every
year ,this provision will certainly influence
the cash flow.
 Amenities and concessions granted by the host
country

 The foreign investments carry some sort of

assistance from the host govt. This may be in
the form of low cost of land, income tax holidays
for stated no. of years, exemption from or
reduction of custom duties on imported parts,
raw materials ,concesstional loans etc.
 Most of these benefits require no special interest
in the capital budgeting exercise, because they
are and should be reflected in capital costs.
 Project Evaluation Criteria
Methods of Project Evaluation

Non discounting Discounting

method Method

Avg Accounting Pay Back Net PV IRR

rate of return PI
Period method Method
Method
 Avg Accounting rate of return
 It represents the mean/average profits on account of the
investment prior to interest and tax payments.

 The mean/average profit is compared with the with the

hurdle rate or required rate of return.

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

project is accepted.
 Shortcomings of ARR method

 Based on accounting income and not cash flow.

 It considerers profit before tax rather than post tax

profit.

 It ignores time value of money

 Problem 1
Find the accounting rate of return based on the following
data:
Year Gross Depreciation Net Profit Investment
profit

1 $2000 5332 -3332 13,334

2 6000 5332 668 8000

3 10000 5332 4668 2666

Average 668 8000

ARR 668/8000=8.35%
 Pay back period method

 Payback period is the no. of years required

to recover the initial investment.
 If the investment is not recovered within
the payback period ,the project should not
be accepted.
 Thus this method stresses on the early
recovery of funds ,but fails to consider
time value of money.
 Pay back period method
 One technique is to compare the actual pay back with a
predetermined payback,ie pay back set by the Mgt terms
of max period during which the initial investment should
be recovered .Actual Pay back period <predetermined
PBP –Accept the Project.
 Alternatively the payback can be used as a ranking
method .when mutually exclusive projects are under
consideration, they can be ranked as per the length of
the pay back period.
 The project having the shortest payback is ranked I and
the project with the longest PBP is ranked the lowest.
 PBP=Initial Investment
Constant Annual Cash flow
 Problem -2
 Considering the target payback period as two years
the cash flows of two proposals are as follows:
Project A Project B

Initial Investment -2000 -2000

Net cash benefits Yr1 1200 1200
2 800 400
3 - 300
4 - 800
Proposal A will be accepted as initial investment is
recovered in 2yrs i.e. the target pay back period.
 Net Present Value rule:

 In this case, projects are accepted where

present value of net cash inflow during the
life span of the asset is greater than initial
investment.The difference adds to the
corporate wealth.
 Equation NPV =n CF t _ I 0
n
(1+k)

t=1
 Net Present Value rule:
 CFt =Expected after tax cash folw from t1 to tn, including
operational and terminal cash flow
 I 0 = Initial investment
 K= Risk adjusted discount rate
 N= Life span of the project
 CFt is incremental cash inflows after taxes and incusive of
depriciation.
 It is assumed CFAT is received after the end of every year.
 CFAT shout take into account salvage value.
 Working capital released at the end of the project life is included in
the CFAT
 Problem 3
 A project involves initial cash investment of$500000.The net
cash inflow in the first,second and third year is respectively
$3,000,000, $35000000,$2000000.At the end of the third year
scrap value indicated at $1000000. The risk adjusted discount
rate -10%.Calculate NPV.
 t1 +t2 +t3 –I 0 = 3000000 + 35000000 + 2000000+1000000 ----5000000

(1.10 )1 (1.10)2 (1.10)3

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

accepted
 Profitability Index
 Yet another time adjusted capital budgeting
technique is the PI.It is similar to NPV approach.
 PI measures the present value per rupee
invested, while NPV is based on the difference
between PV of cash inflows and PV of cash
outflows.
 PI can be defined as the ratio which is obtained
by dividing the PV of future cash inflows by PV
of cash outlays.
 Mathematically PI= PV of cash inflows
PV of cash outflows
 Profitability Index
 PI>1 accept the project
 PI<1 reject the project
 PI=1 point of indifference
For Sum 3
PI = 7873778/5000000=1.57 so accept the
project
 Internal rate of return
 IRR is that discount rate (r) which equates the
aggregate PV of Net cash inflows (CFAT) with the
aggregate PV of cash outflows of a project.
 In other words ,it is that rate which gives the project
NPV of zero.
Where r is the IRR of the project
Accept /reject criterion
Project will be accepted if IRR is
n greater than the required rate of
CFt ---I0
return/cut off rate /hurdle rate

t=1 (1+r)n If the IRR and the required rate of

return are equal, the firm is
indifferent as to accept or reject the
project
 Adjusted Present value approach

 A discounted cash flow technique that can be adapted to

the unique aspect of evaluating foreign projects is
adjusted Present value approach.
 The APV method begins with the assumption that the
projects cash flows can be decomposed into their
constituent parts.
 The APV format allows different components of the
project cash flows to be discounted seperately,thus it
allows the required flexibility to be accomidated in the
analysis of a foreign project.
 Adjusted Present value approach
 The APV approach uses different discount rates for
different segments of the total cash flows depending on
the degree of certainty attached to each cash flow.
 APV framework enables the capital budgeting analyst to
test the profitability of the foreign project after
accounting for all the complexities.
 If the project proves to be acceptable in this scenario no
further evaluation based on cash flows is necessary.But
if it fails to meet the acceptance criteria ,then an
additional evaluation is done taking into account other
complexities.
 Adjusted Present value approach

 For eg.the analysis may be conducted on the

basis of contractual cash flows which are
remittable to the parent co. under the existing
foreign exchange regulations of the host co. If
the project does not pass the hurdle rate
another cash flow component, such as cash flow
the MNC can unblock through transfer pricing
mechanism, will be added to ascertain whether
or not it could nudge the project towards
profitability.
 Adjusted Present value approach
 As foreign projects face a number of complexities not
encountered in domestic capital budgeting, for eg.issue
of remittence,foreign exchange regiulation,restriction on
transfer of cash flows, blocked funds etc.
 The APV model is a value addictively approach to capital
budgeting,ie each cash flow as a source of value is
considered individually.
 In APV approach each cash flow is discounted at the rate
of discount with the risk inherent in the cash flow.
 Adjusted Present value approach
 In the equation form APV approach can