INTERNATIONAL FINANCE

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(AcFn 721)
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 CHAPTER FOUR

INTERNATIONAL
CORPORATE FINANCE
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 CONTENTS:

4.1 Foreign Direct Investment (FDI)

4.2 International Capital Budgeting
4.3 International Cash Management

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 4.1
Foreign Direct
Investment
(FDI)
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4.1 Foreign Direct Investment
Foreign direct investment (FDI) happens when a
firm invests directly in facilities in a foreign
country.
A firm that engages in FDI becomes a
multinational enterprise (MNE)
Factors which influence FDI are related to
factors that stimulate trade across national
borders

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Forms of FDI
Purchase of existing assets
◦ Quick entry, local market know-how, local
financing may be possible, eliminate competitor
New investment

◦ No local entity exists or is available for sale,

local financial incentives may encourage, no
inherited problems, long lead time to
generation of sales or other desired outcome
Participation in an international joint-venture

◦ Shared ownership with local &/or other non-

local partner

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Alternative Modes of Market Entry
1. Direct Investment
1. FDI = 100% ownership
2. FDI < 100% ownership, Joint Venture
2. Strategic Alliances (non-equity)
3. Franchising
4. Licensing
5. Exports

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Political Economy of FDI
Radical View
◦ “Imperialist” extraction of host country wealth
◦ Implication: Always bad for the host country
Free Market
◦ Different countries have different comparative
advantages; best to allow countries to engage
activities for which they do so most efficiently
◦ Implication: Always good when countries are
specializing in activities for which they have a
comparative advantage
Pragmatic Nationalism
◦ Belief that FDI has costs & benefits, & whether to
engage in FDI depends on whether the benefits
exceed the cost
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Government Policy and FDI
Home country
◦ Outward FDI encouragement
 Risk reduction policies (financing, insurance, tax
incentives)
◦ Outward FDI restrictions
 National security, BOP
Host country
◦ Inward FDI encouragement
 Investment incentives
 Job creation incentives
◦ Inward FDI restrictions
 Ownership extent restrictions (national security; local
nationals can safeguard host country’s interests)
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Host Country Effects of FDI
Benefits
◦ Resource -transfer
◦ Employment
◦ Balance-of-payment (BOP)
 Import substitution
 Source of export increase
Costs
◦ Adverse effects on the BOP
 Capital inflow followed by capital outflow + profits
 Production input importation
◦ Threat to national sovereignty and autonomy
 Loss of economic independence

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Home Country Effects of FDI
Benefits
◦ BOP current account positively affected by
inward flow of foreign earnings
◦ Positive employment effect from increased
exports of raw materials/assemblies to the
overseas subsidiary
◦ Repatriation of skills and know-how
Costs
◦ BOP trade position is negatively affected (lower
finished goods exports)
◦ Loss of employment to overseas market
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 4.2
International Capital
Budgeting

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International Capital Budgeting

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Capital Budgeting Process
Capital Budgeting involves the following steps:
1. Strategic planning
2. Searching viable investment opportunities
3. Initial screening of projects
4. Forecasting net cash flow
5. Quantitative financial appraisal
6. Other qualitative appraisal
7. Accept /reject decision
8. Implementation
9. Monitoring and control
10. Post implementation audit
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Capital Budgeting Techniques
1.Traditional Capital Budgeting Techniques
1. Simple Payback Period (PBP)
2. Premium Payback Period Method(PPBP)
3. Accounting Rate of Return (ARR)
2. Discounted Cash Flow Techniques
1. Discounted Payback Period (DPBP)
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Profitability Index (PI)
5. Modified Internal Rate of Return (MIRR)
3. Other Sophisticated Techniques
1. Real Option (RO)
2. Game Theory (GT)
3. Economic Value Added (EVA)
4. Linear Programming (LP)
5. Other Management Science Techniques
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Risk Analysis in Capital Budgeting
1. Sensitivity analysis
2. Scenario analysis
3. Certainty equivalent factor
4. Adjusting the discount rate
5. Simulation technique
6. Probability analysis
7. Decision tree analysis
8. Shorten the payback period
9. Beta analysis

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Factors Complicating International Capital
Budgeting
Several factors make capital budgeting for a
foreign project more complex
 Parent subsidiary relationship
 Differing tax regulation
 Political & legal differences
 Investment policy of host country
 Difference in inflation rate
 Foreign currency risk & control
 Host country subsidy
 Transfer pricing
 Licensing & royalty fees
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Issues in Foreign Investment Analysis
Should cash flows be measured from the
viewpoint of the project or that of the parent?
◦ Most firms evaluate foreign projects from both
parent and project viewpoints
◦ The parent’s viewpoint gives results closer to
traditional NPV capital budgeting analysis

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Incremental Project Cash Flows
Estimating a project’s true profitability requires
various adjustments to the project cash flows under
parent company's point of view:
◦ Adjust for the effects of transfer pricing, fees &
royalties.
◦ Adjust for global costs/benefits that are not reflected
in the project’s financial statements.
 Cannibalization
 Sales creation
 Additional taxes
 Diversification of production facilities & markets

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Tax Factors
Only after-tax cash flows are relevant in the
project analysis.
Actual taxes paid are a function of:
◦ Time & form of remittance
◦ Domestic & foreign income tax rates
◦ Tax treaties between the two countries
◦ Foreign tax credits
Computing the tax liabilities of foreign
investments assumes that:
◦ The maximum amount of funds are available for
remittance each year.
◦ The tax rate applied is the higher of the home or host
country rate.
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Political and Economic Risk Analysis
There are three main methods for incorporating
additional political & economic risks into a
foreign investment analysis:
◦ Shortening the payback period
◦ Raising the required rate of return of the
investment
◦ Adjusting the future cash flows to reflect the
specific impact of political and economic risk.

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Political and Economic Risk Analysis…
Should the additional economic & political risks
that are uniquely foreign be reflected in cash flow or
discount rate adjustments?
The preferred method of incorporating political risk
is to adjust the cash flows of the project to reflect
the impact of a particular political event on the
present value of the project to the parent company.
The biggest political risks include:
 Expropriation
 Nationalization
 Blocking funds

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Exchange Rate Changes and Inflation
The analysis should also consider the appreciation
or depreciation of the foreign currency.
Estimate expected cash flows in the foreign
currency.
Two approaches to calculate NPV in terms of
home currency
◦ Approach A: Convert nominal foreign currency
cash flows into nominal home currency terms &
Discount those nominal cash flows at the nominal
domestic required rate of return.
◦ Approach B: Calculate NPV in foreign currency
using nominal foreign currency discount rate &
Convert the resulting foreign currency NPV into the
home currency using the current spot rate.
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Example:
• A US MNC is contemplating making a foreign
capital expenditure in South Africa.
• The initial cost of the project is ZAR 10,000.
• The annual cash flow over the five years
economic life of the project in ZAR are estimated
to be: 3,000; 4,000; 5,000; 6,000 & 7,000.
• The parent’s cost of capital in dollar is 10%.
• Long run inflation is forecasted to be 3% per
annum in USA & 7% per annum in South Africa.
• The current spot foreign exchange rate is
ZAR3.75/USD.
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Example:
Required:
Determine the NPV of the project in USD.
a) Converting all cash flow from ZAR to USD
at PPP forecasted exchange rate & then
calculating NPV at the dollar cost of capital
b) Calculate the NPV in ZAR using ZAR
equivalent cost of capital according to fisher
effect & converting to USD using current
spot rate
c) Are the two dollar NPVs equal or different?

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Real Option Analysis
DCF analysis cannot capture the value of the
strategic options, yet real option analysis allows
this valuation.
Real option analysis includes the valuation of the
project with future choices such as:
 The option to defer (Timing Option)
 The option to abandon
 The option to alter capacity (Growth Option)
 The option to switch

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Real Option Analysis…
Real option analysis treats cash flows in terms of
future value in a positive sense whereas DCF
treats future cash flows negatively (on a
discounted basis).
The valuation of real options & the variables’
volatilities is similar to equity option.
Anexpanded NPV rule consists of the traditional
DCF analysis plus the value of an option.

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 4.3
International Cash
Management

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International Cash Management
MNCs seek to optimize cash holding, minimize
financing & transaction cost, avoid foreign
exchange loss & balance cash management
needs against the impact of tax liability.
Parent company management requires individual
units to sacrifice their profit aspiration for the
benefit of the MNC as a whole.
MNCs must continually monitor changing
conditions.

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International Cash Management
Goals of an International Cash Manager includes
 Quick/efficient cash control
 Optimal usage
Centralized system should be used since it:
 Creates efficient liquidity levels
 Enhance profitability
 Help for quicker headquarter decision
 Better volume of currency quotes
 Greater cash management expertise
 Less political risk

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Collection/Disbursement of Funds
Accelerated cash collection Methods:
 Collect cash as early as possible
 Use cable/telephone remittances
 Use mobilization centers
 Use lock boxes
 Use Electronic fund transfers
Methods to Expedite Cash Payments
 Delay cash payment as much as possible
 Use cable/telephone remittances
 Establish accounts in client’s bank
 Negotiate with banks for payment
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Optimum Cash Balance
A firm should hold optimum cash balance
The optimal size of the firm’s cash balances
depend upon
 The cost of keeping “too much” cash on hand.

i.e. the opportunity costs of holding cash

 The cost of not keeping enough cash on hand.
i.e.the trading costs associated with having too little
cash
 Use Baumol’s or Miller–Orr Model to estimate
the amount of optimum cash balance.

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The Size of Cash Balances

Costs in dollars of holding cash

Trading costs increase when the
firm must sell securities to meet
cash needs.

Total cost of holding

cash
Opportunity
Costs
The investment income
foregone when holding
cash.
Trading
costs
C* Size of cash balance
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Payment Netting
Itis offsetting payments of affiliate receivables/
payables so that net amounts only are transferred the
parent company.
Payment netting will be made under two steps

◦ First bilateral netting

◦ Second multilateral netting
This will be done by Creating Netting Center

◦ A netting center should be set up in a location with

minimal exchange controls
◦ It should coordinate inter-affiliate payment flows
◦ Center’s value is a direct function of transfer volume

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Example: ABC is a U.K. multinational firm that
manufactures Golden watch which it sales throughout
America, Africa & Asia. In addition to the parent company
in UK, ABC has three affiliates in U.S., Kenya & India.
The table below shows one month inter-affiliate cash
receipt & disbursement among them.
Disbursements ( In Million Pound)
Receipts UK Kenya USA India Total
UK - 60 70 120 250
Kenya 40 - 20 80 140
USA 20 50 - 60 130
India 80 60 40 - 180
Total 140 170 130 260 700

Calculate net amount paid to the parent company in UK

after making bilateral and multilateral netting
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Blocked Funds
A form of political risk is the risk that the foreign
government may impose exchange restrictions on its
own currency.
Several methods exist for moving blocked funds:
 Transfer pricing
 Unbundling services
 Parallel or back-to-back loans
 Use local airlines when parent officials are
moving
 Transferring payroll of host country employee to
subsidiary
 Using local consultant
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CHAPTER FOUR

ENDS!
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