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International Capital Budgeting

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Capital Budgeting

The process of appraising a capitalexpenditure decision of a company.

Involves arriving at the Costs andBenefits related to the decision

Involves using various discountingand non-discounting techniques toevaluate the financial viability of thedecision

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International Capital Budgeting

A Capital Expenditure decisionassumes the status of internationalcapital budgeting when the parentcompany

Would like to operate in a foreigncountry

Plans for an FDI Plans for a cross border merger

Expands like an MNC

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Foreign Direct Investment

Is a real investment outside the home country,

acquiring lasting interest and

control over the enterprise incorporated.

Modes of Investment Wholly owned Subsidiary

Acquiring a significant %age shares Merger and Acquisition

Joint Venture

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Motives

The motives broadly are Revenue related New Markets, Fight Trade

barriers, Exploit monopoly

Cost related Use low cost factor inputs,economies of scale, use foreign technology, fightexchange rate volatility

Knowledge related Tap & Exploit R&Dexpertise

Resource related Exploit Natural & MineralResources

Diversification related Sheer Diversification forrisk Management

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Theories on FDI

International Product Life Cycle Theory 1960s

International Capital Arbitrage Theory 1960s

Ownership Advantages 1976

Internalisation Theory 1976

O-L-I Theory 1993, 1998.

Ownership Advantage to generate superiorprofits due to low cost or higher pricing, thanthe costs of doing business abroad

Locational Advantage in terms of cost of inputs,fighting trade barriers and transportation costs

Internalisation Advantage to protect brand,formula, quality, and increased return, insteadof licensing and franchising.

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How is it different?

Due to the international dimension thefollowing factors are unique forInternational Capital Expenditure Decision

Exchange Rate Fluctuation Political Risk

Differences in Inflation

Wider opportunities to finance the investment

Differing Tax regimes

Differing regulatory environments

Contribution of the proposed investment to theoverall firms risk

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How are these effectsreckoned?

The effect of these factors are capturedwhile projecting the cashflows andcalculating the discounting rate.

When the risk perception is higher, aconservative estimate of the cashflow istaken.

When the risk perception is higher, the

discount rate is adjusted upwards withhigher risk premia in the cost of equity.

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From whose point of view is theappraisal undertaken?

Any international investment of a companyis to be treated as an equity investment.

Hence the shareholder of the parent

company are the ultimate beneficiaries ofthe investment, so the evaluation has to beundertaken from the parents shareholderspoints of view.

The project can also be evaluated from thehost country perspective, treating it as astand alone project.

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What is the Currency of Evaluation?

Since the investment is being made by aparent company the currency of evaluationhas to be that of the parent.

Two approaches to convert the cashflows Discount all the cashflows in foreign currency

and convert the present values at spot rate.

Convert the yearly cashflows using the

respective expected exchange rate. In general PPP is assumed and used to

predict future exchange rates.

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Unique cash flows of anInternational Capital Expenditure

Blocked Funds (IN)

Lost Sales (OUT)

Subsidised Loans of Host countries (IN)

Depreciation Tax Shields (IN)

Royalty or Consultancy Payments (IN)

Transfer Pricing related cashflows (IN)

Tax Shields on Increased Debt Capacity(IN) Annual Operating Cashflows adjusted to

inflation (IN/OUT)

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What is the technique to be usedfor Appraisal?

The traditional NPV technique inadequate since

It bundles all the cashflows with differing associatedrisk.

It applies only one discount rate for all the cashflows

Hence a refined technique used called THE ADJUSTEDPRESENT VALUE (APV)

It segregates all the cashflows with unique associatedrisk.

It applies only varying discount rates for different

cashflowsHOWEVER THE BASIC CONCEPT THAT PRESENT VALUES

OF CASH INFLOWS HAVE TO BE GREATER THAN THEINITIAL INVESTMENT ALWAYS REMAINS

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How do you arrive at the annualoperating cashflows?

The rules are similar to that of atypical domestic capital expendituredecision.

Since the project is evaluated fromthe parent countrys equityshareholders, the Post Corporate Tax

Post Repatriation Tax cashflows haveto be calculated.

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Which Countrys depreciation Ratesto be used?

Since the depreciation is claimed atthe subsidiary level, the depreciationrate of the subsidiary country (hostcountry) has to be applied.

The Depreciation Tax shield has tocalculated based on the higher of host

and home country tax rates.

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Which Countrys Corporate Tax rateto be applied?

Simply the higher of the twocountries tax rate to be applied when there is a double taxation

avoidance treaty between thenations.

In case there is no double taxavoidance treaty, which is a rareoccurrence, both the taxes have to beconsidered.

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Which countrys inflation rate hasto be considered?

Naturally the host country (subsidiarycountrys) inflation, since theoperations take place there.

Parent country inflation is embeded inthe discounting rate applicable forcalculating the APV

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What should be the discount ratefor APV

The discount rate applicable depends onthe cashflows to be discounted and the rateapplicable should be relevant to thecurrency. Operating cashflows all equity discounting rate

adjusted for all risks.

Depreciation and Debt tax shields Riskless rateof the home country

Transfer Pricing cashflows Higher than the allequity rate

Subsidised Loans The cost of debt without thesubsidy

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Calculating the all Equity Cost ofEquity