capital budgeting for international projects

8/3/2019 Capital Budgeting for International Projects

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Firms decide what investment projects they should

undertake on the projects expected cash flowdiscounted by the cost of capital (return required bythe owners of the firm).

if a project has a positive net present value, the firm

should undertake it because it increases the firmsoverall value.

If a project has negative net present value, the firmshould not undertake it because it decreases the firms

overall value. The activity of allocating the firms financial capital to

investment projects is called Capital Budgeting, atechnique which ensures that equity capital is directedtowards the projects in which it is the most productive.


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It differs in two fundamental ways: First, Costs & Revenues are incurred in a foreign

currency, although the firm is ultimately concernedwith home-currency-equivalent cash flows.

Second, there are two relevant discount rates, adomestic rate & a foreign rate. In other words, the

project has a cost of capital in each country (orcurrency), where the cost of capital is the sum of therisk-free nominal interest rate & a risk premium thatreflects the project's riskiness.


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The 1st method of evaluating foreign projectsdiscounts local currency cash flows at theforeign cost of capital & then converts the NetPresent Value into home currency units at theprevailing spot exchange rate.

PV= E0 [CF1] S0(1 + COC*)t

Where PVis present value

E0[CFt] is the expected cash flow denominatedin the local currency

COC* is the cost of capital in the local currency

S0 is the current exchange rate

n

t = 0


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The 2nd method of evaluating foreign projectsconverts all local currency cash flows into thehome currency, then discounts the cash flowsat the domestic cost of capital.

PV= E0 [CF1St]

(1 + COC)t

Where PVis present value

E0[CFt] is the expected cash flow denominated

in the local currency St is the exchange rate in period t

COC is the cost of capital in the home currency

n

t = 0


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Note that centralization & decentralization hererefer to the method of analyzing a project, ratherthan to the location of decision-making, but that

there is a parallel between the two. If the headquarters office undertakes the

analysis, there will be a tendency to convertlocal currency cash flows into the home

currency, then discount at the domestic cost ofcapital; hence, the term "centralization" isappropriate.

If the subsidiaries undertake the capital

budgeting analysis, there will be a tendency todiscount local currency cash flows at the localcost of capital and then convert to homecurrency units for reporting to the parent; hence,

the term "decentralized" is appropriate.


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Example - Consider a simple 3 year project thata U.S. MNC named Victor Inc, is contemplatingin Switzerland.

The company decides to calculate theprojects present value using both themethods, assuming that the project is

completely financed with equity, which hasthe cost of capital as 17% in US Dollar &26.36% in SFr.

YEAR SFr CASH FLOWS

0 -20 mn

1 10 mn

2 12 mn

3 15 mn


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Now lets estimate the cash flows associatedwith the project using Centralized Method. Thefollowing is the estimated Cash Flow for Swiss

Project.

YEAR (Figures in SFr) 0 1 2 3

REVENUES 50,000,000 55,000,000 60,000,000

EXPENSES 38,205,128 40,128,205 40,512,820

DEPRECIATION 6,666,667 6,666,667 6,666,666

TAXABLE INCOME 5,128,205 8,205,128 12,820,514

INCOME TAX @ 35% 1,794,872 2,871,795 4,487,180

AFTER TAX INCOME 3,333,333 5,333,333 8,333,334

DEPRECIATION 6,666,667 6,666,667 6,666,666

AFTER TAX CASH FLOWS(INCOME +DEPRECIATION)

-20,000,000 10,000,000 12,000,000 15,000,000


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For implementing the centralized method ofCapital Budgeting, the firm convert cashflow into the home currency using of theforecasted exchange rate.

The firm determines that the risk free rate ofreturn in US is 10% IT Bills) & in Swiss it is 18.8%

Now based on the interest rate parity theorywe need to calculate the forecasted $/SFrexchange rate.

YEAR EXPECTED EXCHANGE RATE0 0.80

1 0.80 [1.10/1.188]

2 0.80 [1.10/1.188]2

3 0.80 [1.10/1.188]

3

$/SFr0.80

0.7407

0.6859

0.6351


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Now lets convert the cash flows into homecurrency.

Once we have the Cash Flowsdenominated in Us Dollar, we need to findthe present value of these cash flows

PV = -16,000,000 + 7,407,407 + 8,230,453 + 9,525,987

(1+0.17) + (1 + 0.17)2 + (1 + 0.17)3

PV = $ 2,291,320

YEAR EXPECTED EXCHANGE RATE0 SFr20,000,000 (0.80)

1 SFr 10,000,000 (0.7407)

2 SFr 12,000,000 (0.6859)

3 SFr 0.80 15,000,000 (0.6351)

U.S. Dollar-16,000,000

7,407,407

8,230,453

9,525,987


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Parent vs. Project Cash Flow which cash flow shouldbe considered for evaluating the project. Cash flowavailable to the project, cash flows accruing to theparent company or both.

Cash flow available to the project provides insights into itscompetitive status vis--vis domestic or regional firms. Theproject should earn higher return than its local competitorsotherwise it makes sense to takeover a local business entity.This approach eliminates the need of foreign exchange

forecast. However , the parent company is generally keen to evaluate

a foreign project from the viewpoint of net cash flow availableto it because it decides the level of earning per share &dividends distributed to the shareholders.


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in capital budgeting only after tax cash

flow are relevant, for both domestic or internationalprojects. The tax issue for multinational capital

budgeting purpose is complicated by the existence ofhost country & hoe country taxes as well as a numberof other factors. Thus, earning on foreign projects firstof all fall in the host country tax net. Then ondistribution, it is subjected to withholding tax & finally,in the home country the earnings are further taxed.

involves assessment of factors that

will affect countrys ability & willingness to service its

external obligations. A variety of political, economic &psycho social considerations are relevant. Manyrating system have been evolved which attempt toprecisely define, measure & weight these factors to

arrive at a single indicator of a countryscreditworthiness


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can be broadly

grouped into three categories.

The first of these pertains to the resource base of the

country. This category includes natural resources likeland, mineral deposits, human resources includingquality & depth of managerial & technical skills,strength of the entrepreneurial spirit & trainability of

the labor force & financial resources which pertains tosaving rate of the economy.

The second set of factor refers to macroeconomicperformance & the quality of economic

management. High & steady growth, high per capitaincome, high rate of capital formation, etc. Alsoinvestors prefer political & legal systems that provideincentive to enterprises with minimum of governemnt

regulation and fiscal & monetary conservatism.


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The third set of factors refers to the external position ofthe country. There are various parameters used toassess the countrys ability to generate sufficient

foreign exchange to service its liabilities. Some of themost important factors are listed below:

State of the current account. Choric deficits are regarded as adanger signal

Export potential & diversified export base are desirable

Existing Debt/GDP ratio & the debt service ratio which is definedas the ratio of debt service payments on existing liabilities to theexport earnings. A value in excess of 25% is a cause for concern.

The countrys access to IMF for meeting temporary Balance ofPayment difficulties.

Apart from the above parameters, investors are alsosensitive to political dimensions. Their main concern isthe possibility of political events occurring which willbring a governemnt to power that may not be friendlyto them or may not respect their interest.


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In order to attract foreigninvestment in key strategies the governments ofdeveloping economics generally provide support at

subsidized rate. In case of subsidized financing, the MNCraises finances at a rate lower than market rate. Thevalue of the subsidized loan should be added to that ofthe project while making the investment decisions.

another peculiar issue that needs tobe addressed, while evaluating overseas projects isknock on effects on other operations of the MNC. Forinstance, an international IT firm, contemplating to setup a plant in Germany, may find that the proposed

project will affect the operations of its other units, interms of sales of other units within Europe or in terms ofabsorption of output from the South American mineowned by it. Under such situations, the firm should

emulated thee project by aggregating all incrementalcash flows accruing.


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Net Investment Outlay

Estimating Streams of Cash Benefits Estimating Operating Cash Outflows

Salvage Value

Lifespan of the Project Restrictions on Transfer of Funds

Tax Laws

Exchange Rates Required rate of Return


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NPV Approach: often used for appraisinginvestment projects.

NPV = - C0+ CFt

(1+kw)t

C0 = Initial Investment

CFt

= Net Cash Flow @ the end of period t(1+kw)

t = Discount rate, where kw is theweighted average cost of capital

defined by kw = ke+(1- )(1- )kd

t = T

t = 1


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For using the NPV approach we need toassume two assumptions:

The project being appraised has the same business risk

as the portfolio of the firms current activities. Debt Equity proportion used in financing the project is

same as the firms existing debt equity ratio.

Adjusted Present Value Approach (APV)

First Step evaluate the project as if it is financedentirely by equity. The rate of discount is the requiredrate of return on equity corresponding to the risk classof the project.

Second StepAdd the present value of any cash flowarising out of special financing feature such as ExternalFinancing, Subsidies, etc. The rate of discount used tofind these present values should reflect the risk

associated with each of the cash flows.


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For instance A domestic project requires an initialinvestment of Rs. 70 mn of which Rs. 40 mn is in plant& machinery, Rs. 20 mn in land & the rest in working

capital. The project life is 5 years. The net salvage ofplant & machinery at the end of 5 years is expectedto be Rs. 10 mn & land is expected to appreciate isvalue by 50%. Use SLM depreciation of fixed assetsincluding land (20% for land & 15% for plant &machinery). The firm estimates that the requiredrate of return on an all equity financed project is22%. The project cash flow statement is:

The NPV of the above cash flows at a rate ofdiscount of 22% is Rs. 24.66 mn. The gross present

value (GPV) is Rs. 94.66 mn.

YEAR 0 1 2 3 4 5

(70) 22 23.20 31 31 81


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Year 0 1 2 3 4 5

Cash Flow -70 22 23.2 31 31 81DCF 18.03 15.59 17.07 13.99 29.97

Cost of Equity 22% GPV 94.66INITIAL COST -70.00

NPV 24.66


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Suppose the firm estimates that based on theGPV, it can raise fresh debt of Rs. 30 mn. Since theinterest payments on debt are tax deductible, the

present value of tax saving must be attributed tothe project. In general, the additional borrowingcapacity ( B) is given by B = TDE x GPV

TDE = Target Debt Equity ratio. If the pre tax cost of

debt is Rd & the tax rate is , the tax saving ineach year equals:

(Rd x ) B = (Rd x ) (TDE x GPV)

Suppose Rd is 15%. Then 30 mn of addedborrowing capacity, the annual tax saving is(0.15 x 0.40)(30) = Rs. 1.8 mn, if we assume atax rate of 40% & bullet repayment of loan at

the end of 5 years.


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ADDITIONAL BORROWING

TAX SHIELD 1 2 3 4 5

(Rd x ) B 1.8 1.8 1.8 1.8 1.8

(0.15 X 0.40)(30) Present Value 6.03

The present value at 15% discount rate is Rs.6.03 mn.

Further, suppose that the project would belocated in a backward area & thegovernment provides a cash subsidy of Rs.5mn. The firm will have to raise equity at an

issue cost of Rs. 2mn. The APV of the project istherefore:24.66 + 6.03 + 5.00 -2.00 = 33.69


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Options Approach To Project Appraisal: The discountcash flow approaches suffer from a seriousdrawback. They ignore the various operational

flexibilities built into many projects & assume that alloperating decisions are made once for all at thestart of the project. In many situations the projectsponsors have the freedom to alter various features

of the project in the light of development in input &output markets, competitive pressures & changes ingovernment policies. Among these flexibilities are:

The start of the project may be delayed till more

information about variable such as demand, costs,exchange rates, etc. is obtained. For e.g. starting aforeign plant may be postponed till the foreigncurrency stabilizes. Development of an oil field maybe delayed till oil prices harden.


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The project may be abandoned if demand or priceforecasts turn out to be over optimistic or operatingcosts shoot up. It may even temporarily closed down

& re-started again when market conditions improve.For e.g. copper mine can be closed down whencopper prices are low & operations re-started whenprices rise. Some exist & entry costs may be involved.

The operational scale of the project may beexpanded or contracted depending upon whetherdemand turns out be to more or less than initiallyenvisioned.

The input & output mix may change or a differenttechnology may be employed.

capital budgeting for international projects

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