capital budgeting for international products
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8/8/2019 Capital Budgeting for International Products
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8/8/2019 Capital Budgeting for International Products
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Capital budgeting (or investment appraisal) is
the planning process used to determine
whether a firm's long term investments suchas new machinery, replacement machinery,
new plants, new products, and research
development projects are worth pursuing. Itis budget for major capital, or investment,expenditures.
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As soon as a company reaches to a decision
to invest abroad, the firm evaluate projects
and selects one or more of them that rankshigh from the viewpoint of adding to the
corporate wealth.
The process is known as InternationalCapital Budgeting
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The method of evaluation of investment
proposals are grouped in two methods:-
Discounting Non-Discounting
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Non-discounting methods are simple.
One such method involves the average rate of return
earned by the project. It represents the mean profit on account of
investment prior to interest and tax payment.
The mean is compared with required rate of return.
A project is acceptable if the mean profit is higherthan the required rate of return.
Other discounting method is known as pay-back period.
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It is based on the accounting income and not
on the cash flow.
It considers profit before tax, rather thanpost-tax profit.
It ignores time value.
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Discounting methods take normally four
forms:-
1. Net present value (NPV) method2. Profitability index (PI) method3. Internal rate of return (IRR) method4. TheAdjusted PresentValue (APV)Approach
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NPV is the residue after deducting the initial
investment from the present value of future
cash flows relating to a project. PositiveNPVmeans additions to the corporate
wealth therefore accept the project; if notreject the project.
The equation is:-
NPV =
Iok
CF NPV
n
t
n
t ¼
½
»¬
-
«
! §!1 1
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PI is the ratio between the present value of
the future cash flows and the initial
investment. It shows the relative gains and would be
expressed as the following equation :-
¼½
»¬-
« n
t
n
t
1
1/(
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IRR is the discount rate equating the present
value of future cash flows and the initial
investment. For accepting a project, IRR > hurdle rate
(required rate of return).
Expressed as an equation:
0)(
(!
¼¼½
»
¬¬-
«
! §
!
Io IRR
CF PI
t
t
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Adjusted Present Value
If incentives exist to finance with debt - tax shields orinterest subsidies -Adjusted PresentValue (APV) shouldbe used.
If tax treatments are symmetric, and if uncoveredinterest parity is expected to hold, tax shields will have
identical value whether debt is raised in host or homecountry.
Low capital gains taxes, high deductibility of interestpayments, negative failure of UIP, and subsidized
interest rates will all favor financing in depreciatingcurrencies.
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Parent cash flows are different from projectcash flows.
All cash flows from the foreign projects mustbe covered into the currency of the parent
firm. Profits remitted to the parent are subject to 2
jurisdictions the parent country and thehost country. The possibility of foreign exchange risk and
its effect on the parents cash flows.
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If the host country provides concessionary
financing arrangements or/and benefits, the
profitability of the foreign project may go up. Initial investment in the host country may
benefit from the partial or total release of blocked funds.
The host country may impose restrictions onthe distribution of cash flows generated from
foreign projects.
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The foreign exchange risk
Remittance restrictions
The tax issue Project v/s parent cash flows
Cash flows v/sDiscount rate adjustment
Financing arrangement
Blocked funds
Inflation
Uncertain salvage value
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The above discussion was limited to the
numerator of theNPV- rule equation.
The denominator of the equation ,which isknown as the discount rate or hurdle rate
which is based on the risk- adjusted cost of capital ,is also very significant for the
computation of cash flow.
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Average cost of capital :- it represents the
weighted average of the cost of equity and
cost of debt.
Cost of Debt :- interest is the cost of debt
adjusted for taxes because interest is tax-deductibleand debited in the income statement before tax iscalculated.
k = k d(1-t)w d+k e*w e
k d= Interest/principal*(1-t)
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Cost of Equity :- Dividend is the cost of equity shares.
The price of equity share is equal the present value of theexpected dividend resulting the risk-adjusted rate requiredby the investors.
Cost of Retained Earnings :- funds for
investment normally comes from theretained earnings. The after-tax cost of
retained earnings is calculated.
k e=D/Po
ks= ke*(1-t)
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Real options is a different way of thinkingabout investment values.
At its core, it is a cross between decision-treeanalysis and pure option-based valuation.
Real option valuation also allows us to
analyze a number of managerial decisionsthat in practice characterize many majorcapital investment projects
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Real options start when there is expected a
change in cash flow from that originally
anticipated.
They are concerning (related to) :-postponement/abandonment/expansion/
contraction of the operation.
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Investment timing option (postponement)
Evaluate additional information
Abandonment option Reduce downside risk
Growth options(expansion)
Research programs, expand a small plant, orstrategic acquisition
Shutdown options
Temporarily
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Rodriguez and Carter (1984) group thesefactors asNon-Financial factors influencing
capital budgeting decision are :-
1. Behavioural characteristics of theorganisation.
2. Business strategy
These factors influence the final decision abouttaking up of the project.
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Varsha Chaurasiya 07
Anas Choudhary 10
AvaniGandhi 16 RashmiGupta 19
Nilofar Rayani 42
SalmanShah 45
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