Capital Budgeting

The term budgeting refers to forecasting of

future and the term capital asset refers to fixed
assets. Thus the term capital budgeting refers
to forecasting of future investment to be made
in capital assets.
Capital budgeting is a process which involves
study of various alternatives, its impact on the
organisation and selection of best alternative
which satisfies the constraints.
 Tools or Methods of Capital Budgeting

Methods which do not consider time
value of money
• Pay Back Period
• Pay Back Period Reciprocal
• Post Pay Back Period
• Accounting Rate of Return
Methods which considers time value of
money
• Net Present Value
• Internal Rate of Return
• Benefit Cost Ratio
• Discounted Payback Period
• Modified NPV
• Modified IRR
 International Financial Market
Many firms in India, however, raise finances in
foreign markets, export goods and services,
import goods and services, and even invest
abroad. The international involvement of
Indian firms is increasing and this trend is
expected to continue as India forges stronger
linkages with the world economy.
The basic principles of financial management are
the same whether a firm is a domestic firm or an
international firm- a firm that has a significant
foreign operation is called an international firm
or a multinational firm.
Multinational firms, however, operate in more than
one country and their operations involves
multiple foreign currencies. There operations are
influenced by politics and laws of the countries
where they operate. Thus, they face higher
degree of risk as compared to domestic firms.
 Factors peculiar to Multinational Firms
• Currency denominations
• Diverse tax
• Legal systems
• Varying accounting standards
• Language differences
• Disparate culture and values
• Barriers to trade and financial flows
• Political risk
• Inflation rates
• Interest rates
Foreign Exchange Market
1. The foreign exchange market is the market where the
currency of one country is exchanged for the currency
of another country. Most currency transactions are
channelled through the world-wide interbank market.
Interbank market is the wholesale market in which
major banks trade with each other.
Forex market is a worldwide market of an informal network
of telephone, telex, satellite and computer
communications between the dealers, arbitrageurs
traders and speculators.
2. A foreign exchange rate is the price of one currency
quoted in terms of another currency.
 When the rate is quoted per unit of the domestic currency, it
is referred to as direct quote. Thus, the US$ and INR
exchange rate would be written as US$ 0.02538/INR.
 When the rate is quoted as units of domestic currency per
unit of the foreign currency, it is referred to as indirect
quote.
3. A cross rate is an exchange rate between the
currencies of two countries that are not quoted
against each other, but are quoted against one
common currency.
4. The spot exchange rate is the rate at which a
currency can be bought or sold for immediate
delivery which is within two business days after the
day of the trade.
5. Bid-ask spread is the difference between the bid and
ask rates of a currency.
6. The forward exchange rate is the rate that is
currently paid for the delivery of a currency at some
future date.
The forward rate may be at a premium or at a discount.
For a direct quote, the annualised forward discount or
premium can be calculated as follows:
 Spot rate – Forward rate  360
Forward premium (discount)    
 Spot rate  Days
Companies go global for various reasons:
1. Trade barriers
2. Intangible assets
3. Vertical integration
4. Diversification
5. Product life cycle
6. Imperfect labour market
7. Share holders diversification
 Multinational Capital Budgeting
Foreign capital budgeting decisions are beset
with a variety of problems that are rarely
encountered by domestic/local firms.
The reason is that international firms have to
deal with issues related to, among others,
exchange rate risks, expropriation risk, blocked
funds, foreign tax regulations, political risk and
differences between basic business risks of
foreign and domestic projects.
 Multinational Working Capital Management
The goals of working capital management in an
MNC are the same as those of a domestic firm,
that is, to manage the firm’s current assets and
liabilities in such a way that a satisfactory level
of working capital is maintained. The discussion
of the working capital management in this
section with reference to:
• Cash management
• Credit management
• Inventory management
Cash Management
Cash management one of the key areas of
working capital management. Its basic
objective is to meet the payment schedule,
that is, to have sufficient cash to meet the cash
disbursement needs of the firm.
In the normal course of business, firms are to
make cash payment on a continuous and
regular basis to suppliers of goods, employees,
bankers and so on.
Like domestic firms, multinational companies
can employ the following key cash
management strategies to minimise the
operating cash balance requirement:
1. Speedy collection of accounts receivable.
2. Stretching accounts payable.
3. Shift cash as fast as possible from those parts
of the business/foreign subsidiaries where it
is not needed to those parts/places where it
is needed.
Credit Management
Multinational firms located in different countries
compete for the same global export markets. Being
so, it is imperative that they offer attractive/liberal
credit terms to potential customers while the
favorable credit terms are desirable to enhance
sales and hence profits.
MNCs should ensure that the risk/cost of default is
lower than the incremental profits expected from
such liberal credit terms because granting credit is
more risky in the international context.
Inventory Management
The task of inventory management in the case of multinational
firms is more complex than that of domestic firms, particularly
when foreign subsidiaries encounter the following situations:
1. When a foreign subsidiary is located in a country having a high
rate of inflation, it may be profitable, to accumulated more
stocks than otherwise needed.
2. When the foreign subsidiary is located far from the market
supplying the goods, the consideration will have to be given to
potential delays in getting the goods from central storage
locations to user locations, all around the world.
3. Finally, the MNC and its subsidiaries are to deal with, adverse
exchange rate fluctuations, tariffs, non-tariff barriers, and
other similar problems, generally when they are located in less
developed nations.