capital budgeting for international products

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.



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



The method of evaluation of investment

proposals are grouped in two methods:-

Discounting Non-Discounting



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.



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.



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



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



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/(



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



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.



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.



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.



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



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.



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)



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)



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



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.



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



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.



Varsha Chaurasiya 07

Anas Choudhary 10

AvaniGandhi 16 RashmiGupta 19

Nilofar Rayani 42

SalmanShah 45

capital budgeting for international products

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