INTERNATIONAL

CAPITAL BUDGETING
• Capital budgeting is the planning process used
to determine whether an organisation’s long
term investments such as new machinery,
replacement of machinery, establishment of
new plant, introducing of new product and
research development projects are worth
pursuing.
• It is a budget for major capital or investment
expenditures purposes.
• The decisions to invest abroad takes a concrete
share when a future project is evaluated in order
to ascertain whether the implementation of the
project is going to add to the value of the investing
company.
• The evaluation of the long-term investment project
is known as capital budgeting. The technique of
capital budgeting is almost similar between a
domestic company and an international company.
• In this case we will have two companies, they are
Parent company and subsidiary company.
• Project is considered by the parent company as an
investment opportunity abroad. Therefore we will
consider capital budgeting in parent’s company
perspective.
• For evaluation of the project, the cash flows are
required to be estimated irrespective of the term of
project, the MNCs need the forecasts on following
economic and financial variables related the project.
1. Initial investment 6. Salvage value

2. Consumer Demand for the 7. Transfer Restrictions

Product
3. Price of the Product/service 8. Tax Laws

4. Cost of the Product 9. Exchange Rate Variations

5. Life of the Project

• 1. Initial investment: A project’s initial investment is
not only equal to the investment required to start
the project but also the working capital required to
meet the variable cost and to run the project.
• Working capital needed until the revenue
generated from the project is sufficient to cope
with working capital requirement.

• 2. Consumer Demand for the Product: Projections

of consumer demand is very important for
determining cash flows. It is very difficult to
forecast the demand in a foreign country for the
product which is either being introduced newly or
will competing with the existing product.
• In the first case, the market has to be created for
the product where as in the later; share for itself
has to be fixed out. However, there is a lot of
uncertainty associated with such forecasts.

• 3. Price of the Product/service: Forecasting the

price of the product which already has the
competitive product may be looked as the basis
of forecasting. However, for a new product, the
pricing is done on the basis of cost of production
and the segment of the population for which the
goods has been produced. Experimenting with
such prices can finally reach a suitable price
forecast.
• 4. Cost of the Product: The cost of the product has
two components:
• A) Fixed costs B) Variable costs
• Fixed costs may be easier to predict as compared to
the variable cost because normally it is not sensitive
to the changes in demand for fixed factors.

• 5. Life of the Project: in the case of some projects, the

life of the project can be assigned, while in other
cases it may not be possible. In the case of the
definite life time of the project, capital budgeting
decision making is easier. But in the case of MNCs
capital budgeting, MNCs does not have complete
control over the life time of the project and it may be
terminated any time due to political reasons.
• 6. Salvage value: The salvage value in the case of
most projects is difficult to predict. Its value
depends on several factors including the attitude
of the host government.

• 7. Transfer Restrictions: There may be

restrictions on the transfer of earnings from
subsidiary to the parent. The restrictions may
encourage the MNC to spend locally so that
there is no huge transfer of funds. This make the
project viable for the subsidiary and unviable for
the parent.
• 8. Tax Laws: If the parent country does not tax
the foreign earnings because it provides
incentive to foreign earnings, the cash flows
may increase.
• 9. Exchange Rate Variations: The cash flows
from international project may vary because
of exchange rate variation. The exchange rate
variations are difficult to forecast.
 METHODS OF CAPITAL BUDGETING

Adjusted Present Value

Discounted cash flows Approach

1. Net Present Value

2. Internal Rate of Return (IRR)

04/19/2022 VIJAY 11
 NET PRESENT VALUE METHOD
• It is one of the discounted cash flow methods. This
method is considered to be one of the best methods
of evaluating the capital investment proposals.
Under this method the cash inflows and outflows
associated with each project are first calculated.
• The cash inflows and out flows are then converted
to the present values using a discounting factor. The
rate of return is considered as the cut-off rate and is
generally determined on the basis of the cost of
capital adjusted for risk element. The CFAT is
considered to calculate the NPV.
 CASH FLOW AFTER TAX CALCULATION
Sales XXX
(-) Variable Cost XXX
CONTRIBUTION xxx
(-) Fixed Cost XXX
EARNING BEFORE DEP, & TAX(EBDT) xxx
(-) Depreciation XXX
EARNING BEFORE TAX(EBT) xxx
(-) Taxes XXX
EARNING AFTER TAX(EAT) xxx
(+) Depreciation XXX
CFAT
04/19/2022 VIJAY
x xx 13
• NPV is the difference between the present
value of cash inflows and present value of
cash outflows. The NPV is calculated in TWO
methods.
• A) Conventional Cash Flows System
• B) Non-conventional Cash Flows System
• In case of conventional cash flows:
NPV = { A1/(1 + k )1+ A2/ (1 + k )2…An/ (1 + r )n } - Co
Where :
A1, A2,…. An = The CFATs at different time periods
k = Discounting Factor
n= Time period
Co = Initial investment or cash outflow.
• In case of non-conventional cash flows:
NPV = { A1/(1 + k )1+ A2/ (1 + k )2…An/ (1 + k )n } –
{Co + C1/(1 + k )1+ C2/ (1 + k )2…Cn/ (1 + k )n }
Where :
A1, A2,…. An = The CFATs at different time periods
k = Discounting Factor
n= Time period
Co = Initial investment or cash outflow.
C1…Cn = Cash outflows at different time periods.
 DECISION RULE:
• Accept or reject rule of the project decided
based on the NPV.

• ACCEPT : NPV > ZERO

• REJECT : NPV < ZERO

• In case of a number of projects or more

than one project, select the project with
greatest NPV .
04/19/2022 VIJAY 17
• An American MNC is considering to set up a
manufacturing plant in India, which involves an
investment outlay of Rs. 50 Million. An additional
working capital requirements amout to Rs.5
Million.
• The CFATs are expected to the Rs.17 Million for 5
Years. The 5th year is expected to generate an
additional cash flow of Rs.15 Million an account
of sale of plant and release of working capital.
• The Present exchange rate is Rs. 36 per $. The
exchange rates for the relevant 5 years period of
the project as follows:
Y
E
EXCHANGE
RATE
Assume that US MNC has not been
A
R
(Rs./$0) exporting the product to India. The
required rate of return on
1 36.00
repatriated (SEND BACK) $ is 15%.
2 37.08 Can you advise the MNC regarding
3 38.1924 the financial viability of the
4 39.3382 project.
5 40.5183
• Step 1: calculation of incremental cash outflows:
• Cost of Plant Rs.50,000,000
• Add: working capital Rs. 5,000,000
• Total Initial Investment Rs.55,000,000
• Cash outflow in terms of $ = 55,000,000
36
$ = 15,27,778
Converting the Rupees into dollers
Year CFAT (IN Rs.) Exchange Rate $
(1) (2) (3) (2 /3 = 4)
1 17,000,000 36 4,72,222
2 17,000,000 37.08 4,58,468
3 17,000,000 38.1924 4,45,115
4 17,000,000 39.3382 4,32,150
5 32,000,000 40.5183 7,89,767
(17 + 15)
Year CFAT (IN Rs.) Present Value Total PV$
(1) (2) Factor @ 15% (2 X 3 = 4)
(3)
1 4,72,222 0.870 4,10,833
2 4,58,468 0.756
3 4,45,115 0.658
4 4,32,150 0.572
5 7,89,767 0.497

Total Present Value ?

Particulars $
Total Gross Present Value
LESS: CASH OUT FLOWS 15,27,778
NET PRESENT VALUE ?
RECOMMENDATION:

In this case the NPV is Positive, therefore as per the NPV rules it is worth accepting the
project.

ACCEPT : NPV > ZERO

REJECT : NPV < ZERO
 COST OF PREFERENCE SHARES
• The cost of preference shares is based on the ratio of
preferred dividend and the net proceeds received from
the issue of preference shares.
Kp = Dp
Po (1-f)
• Dp = constant annual preference Dividend
• Po = Expected sale price of preference shares
• F= Flotation cost as % of sale price of preference
share.
• An American based multinational corporate
firm has a subsidiary in India. The subsidiary is
planning to issue 17% preference shares (non-
participating) of Rs.100/- each at par.
Flotation costs of the expected sale price is
estimated at 5%. Determine the cost of
preference shares.
• Dp= Rs.17 ; Po = 100 ; f = 5%
Kp = 17
100 (1- 0.05)
= 17/95
= 0.1789 X 100
= 17.89%
 Cost of Equity capital
• Because of few reasons, the required rate of
return of equity-holder is higher than that of
debt holders and preference. Therefore, higher
costs are associated with equity funds.
• Conceptually, the cost of equity capital for a
firm is the minimum rate of return necessary
to induce investors to buy or hold the firm’s
stock. It is the required rate of return of equity
investors.
Cost of equity capital models
Dividend valuation model (Gordon-Shapiro)

Capital Asset Pricing Model (CAPM)

 Dividend valuation model
• It is based on a hypothesis that the market price of a
share at any point of time is the sum of the present
values of future dividend.

Ke = D1 + g
Po

• P0 = the share price at the time zero (or now)

• D1 = dividend at the end of the period 1;
• g = the rate of growth of dividend
• The current market price of share of a
company is Rs.200. it is expected to pay
dividend of Rs.15 at the end of the current
year. Further the estimated growth rate of
dividend is 5%. Determine the cost of equity.

Ke = 15 + 0.05
200
= 0.075 + 0.05 = 0.125 or 12.5%
 Capital Asset Pricing Model Approach

• According to the CAPM , the cost of equity

capital is a function of riskless rate of return,
market rate of return and the beta (ß) parameter.
• Ke = Rf + ß (Rm – Rf)
• Rf = Rate of return on risk free asset/investment.
• Rm= Expected rate of return on the market
portfolio consisting of the risky assets.
• ß = is a measure of coefficient of systematic risk.
• The American multinational equity shares
have ß of 1.2 while the riskless rate of return is
5% and the market rate of return is 10%. The
cost of equity capital of the American
multinational is ?
• Ke = Rf + ß (Rm – Rf)
• Ke = 0.05 + 1.2 (0.10 – 0.05)
= 0.11 or 11%
 Cost of retained earnings
• Retained earnings have implicit costs. In
operational terms, there is an opportunity
cost of retention.
• It is equivalent to the possible income which
could have been earned by equity
shareholders themselves, if profits had been
distributed among them instead of being
retained by corporate firms.
• The cost of retained earnings is calculated as
follows:

• Kr = Ke (1-t) (1 – c)
t = incremental taxes owed on earnings
repatriated (SEND BACK) to the parent
company.
c= costs of transfer.
• Suppose a French subsidiary operating in Africa
has cost of equity of 15%, it is estimated that
repatriation will cause incremental taxes in Africa
and France to the tune of 20%; further, transfer
costs in remittance are likely to be 1%. Determine
the cost of retained earnings.
• Kr = Ke (1-t) (1 – c)
• Kr = 0.15 (1 – 0.20) (1 – 0.01) = 0.1188 or
• 11.88%
 WEIGHTED AVERAGE COST OF CAPITAL
• Computation of weighted average cost of
capital or overall cost of capital is now an easy
one. It is the weighted arithmetic mean of the
costs of individual long-term sources of
finance.
• Ko = (Ke X We) + (Kp X Wp) + (Kd X Wd) + (Kr X Wr)
• These weights may be based on book value or
market value. Theoretically, market value weights are
considered superior as the costs of specific sources
of finance are computed using the prevailing market
price.
• However, in practice, there are practical
difficulties in computing market value (Ex:-
retained earnings). Besides, market values are
likely to fluctuate widely. No such problem is
faced with book value weights.
• Ex:- Assume that capital structure of a
multinational group is optimal. It uses book
value weights for the purpose of determining
the overall cost of capital. The abstract of
liability side of its consolidated balance sheet
along with specific after-tax cost is as follows:
 WIGHTED AVERAGE COST OF CAPITAL (WACC)
An weighted average cost of each of the source of funds
employed by the firm is called WACC. Steps to compute WACC as follows

STEP:1
.Determination of the source of funds
STEP : 5.
to be Raised & their individual share in the
Add individual source Weight cost
total Capitalization of the firm
To get COST OF CAPITAL.

STEP:2.
Computation of cost of specific
Source of funds

STEP :4.
STEP 3.
Multiply the cost of each source
Assignment of weights to By the related weights to get Weighted cost

Specific source of funds

Tuesday, April 19, 20 38
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 A firm has the following capital structure
as per the latest statement :
Source of funds Rs. After tax cost %
Debt 30,00,000 4.00
Preference shares 10,00,000 8.50
Equity shares 20,00,000 11.50
Retained earnings 40,00,000 10.00
TOTAL 100,00,000

 Based on the book value compute the

cost of capital (WACC)

Tuesday, April 19, 20 39

22
 Calculation of Overall cost of capital (Ko)

Source of finance Weights Specific cost Weighted cost

1 2 3 4 = (2X3)
Debt 0.30 0.04 0.012
Preference shares 0.10 0.08 0.008
Equity shares 0.20 0.11 0.022
Retained earnings 0.40 0.10 0.040
TOTAL 1.00 0.082

Cost of weights
Ex:- Debt weight = Debt capital / Total capital
30,00,000/100,00,000 = 0.30

Ko = Total Weighted cost X 100

= 0.082 X 100 = 8.2%

Tuesday, April 19, 20 40

22
Particulars Amount Specific cost
($ millions) (%)
Equity Share Capital 30 15
Retained Earnings 10 12
Preference Share Capital 15 13
Debt (D1) 20 08
Debt (D2) 25 06
TOTAL 100

Determine the WACC of the

Multinational group.
 Calculation of Overall cost of capital (Ko)
Particulars Amount Specific cost (%) Total cost
($ millions) ($ millions)
Equity Share Capital 30 15 4.50
Retained Earnings 10 12 1.20
Preference Share 15 13 1.95
Capital
Debt (D1) 20 08 1.60
Debt (D2) 25 06 1.50
TOTAL 100 10.75

Ko = total cost/total amount X 100

10.75 / 100 X 100 = 10.75.