Analysing proposed international investment in non current assets

1. International Capital
Budgeting Decisions

2. Introduction
• Foreign Capital Budgeting is the procedure for
analysing the expected cash flows for a proposed
foreign direct investment to determine if the
potential foreign investment is worth undertaking
• Capital budgeting analysis is concerned with direct
direct (as distinct from portfolio) investments
• e.g. Replacement of obsolete equipment,
investment in a completely new business

3. Introduction
• Foreign Capital budgeting decisions has two
components:
1. The decision to invest abroad as part of the firm’s
strategic plans
• The investments have to be of sufficient size
2. The quantitative analysis of available data (capital
budgeting proper)
• Determine financial feasibility of plan

4. Introduction
• We are interested in the quantitative aspects of
international capital budgeting
1. General methodology of capital budgeting
2. The international complexity of that procedure
3. Implications of international accounting for
conclusions reached by the capital budgeting
technique

5. Methodology for Capital Budgeting
• Capital budgeting is concerned with three types of
data
1. Cash outflows (project costs)
2. Project cash inflows (measured over a period of
time)
3. The Cost of capital
• We will use annual time periods, but analysis
could be done using Quarters, months or even
days

6. Project Cash Outflows (Costs)
• Project Cash outflows refers to the cash cost paid
out to start the project
• Usually the outflow for an investment occurs at the
time when the investment is made, normally “year
0” if the proposed project is analysed in annual time
time periods
• However other time sequences are possible
• For large projects cash outlays could occur over
several years

7. Project Cash Outflows (Costs)
Cash outflows include
1. Cash paid to prepare a new site
• These outlays might be for such costs as grading,
building access roads, installing utilities etc.
2. Cash paid to dispose of, remove, or destroy old
equipment or other assets or cash received from
the sale of old assets
• Tax effects have to be considered

8. Project Cash Outflows (Costs)
Cash outflows include
3. Cash cost of additional storage and/or
transportation facilities needed because of the new
new investment
• Additional warehousing space
• Additional transportation equipment (lorries)
These are costs required to support investment for
the project

9. Project Cash Outflows (Costs)
Cash outflows include
4. Cash payment for any additional engineering or
design work to be incurred if a decision is made to
invest
Care must be taken not to include “sunk costs”
• Sunk costs are the cash outflows already incurred in
the process of preparing for the investment
decision, and cannot be recovered whether the
project is undertaken or not

10. Project Cash Outflows (Costs)
Cash outflows include
5. Cash opportunity cost of any existing equipment or
or space allocated to the project
• If a land plot of a factory is currently idle but
would be used for a new project, the relevant
cost is the alternate cash flow that the plot might
might generate (e.g. subleasing)
• If no alternative use exists for the plot, then it
has no cash opportunity cost

11. Project Cash Outflows (Costs)
Cash outflows include
6. Investment in initial/additional working capital
necessitated by the new project
• These items might be negative (i.e. cash
recovery) if a replacement project enables the
firm to operate with less cash, inventory, or
receivables
7. Outlays in future years needed to supplement
original investment

12. Project Cash Outflows (Costs)
The essence of determining what cash outflows are
relevant to the investment decision is
* To look only at those future cash outflows that will take
place because of the investment decision, and
* To ignore both
 Earlier cash outflows incurred for analytical purposes (sunk
costs) and
 Accounting overhead charges which do not represent
additional new cash outflows

13. Project Cash Inflows
• The relevant cash inflows for any project are those
that will be received by the firm in each future year
of the investment
• This set of cash flows must be identified by specific
year

14. Project Cash Inflows
• Each annual cash inflow differs from net income for
that same period for two reasons
1. The cash inflows are calculated ignoring non-
cash expenses, such as depreciation
2. The calculation assumes that the entire project is
is funded by equity (shareholders funds) and
taxes are based on an all-equity assumption
• So tax calculation is hypothetical

15. Project Cash Inflows
Projected Income Statement with New Investment
TShs
New sales 2,000,000
Cost of Goods Sold (1,000,000)
Administrative expenses (200,000)
Amortization of prior service pension costs (50,000)
Depreciation (150,000)
Total Expenses (1,400,000)
Earnings before interest and taxes 600,000
Interest expenses (200,000)
Pretax earnings 400,000
(136,000)
Income taxes (34%)
Net Income 264,000
Cash Flow Calculation
TSHs
Net Income 264,000
Plus Depreciation 150,000
Plus amortization 50,000
Plus (1-T)(interest) 132,000
Net Cash Flow 596,000

16. Cost of Capital
• Cost of Capital is the discount rate used to discount
the future cash flows into the present value
• The aim is to put into consideration the time value
of money
• The discount rate is more properly called the
“weighted average cost of capital” (WACC)

17. Cost of Capital

18. Cost of Capital
• The WACC indicates the minimum rate of earnings
on any project necessary if the value of the firm is
to be maintained
• The WACC becomes an acceptable rate usable as a
a cutoff criteria for evaluating new projects

19. Combining Outflows, inflows, WACC
• Traditionally, cash outflows, cash inflows and the
WACC are combined in one of two ways to
determine the feasibility of the investment project
1. The Net Present Value (NPV) approach
• If NPV>0 make the investment
2. The Internal Rate of Return approach
• If the IRR is greater than the firm’s WACC make
make the investment

20. Combining Outflows, inflows, WACC

21. Combining Outflows, inflows, WACC
• Under most conditions, NPV and IRR lead to the
same decision
• However, different decisions may result under certain
certain circumstances, such as
• When projects of substantially different lifetimes
are compared or
• When cash flows fluctuate form year to year
• If NPV and IRR give different decisions NPV is
preferable on theoretical grounds

22. International Complexity
• Capital budgeting for foreign project uses the
one country framework just described, but
with certain adjustments to reflect the greater
complexities in an international situation
• Many adjustments arise because of the fact
that two separate sovereign nations are
involved and the operating cash flows in the
host country are in a different currency than
those desired by the parent company

23. International Complexity
Project versus parent cash flows
• Project (e.g. host country) cash flows must be
distinguished from parent (e.g. home country) cash
cash flows.
• Project cash flows generally follow the domestic, or
or one country model
• Parent cash flows reflect all cash flow
consequences for the parent company

24. International Complexity
Foreign Exchange Forecasts Needed
• An explicit forecast is needed for future exchange
rates
• Future cash flows in a foreign currency have value to
to the parent only in terms of the exchange rates
existing at the time funds are repatriated, or valued if
if they are not repatriated
• Hence an exchange rate forecast is necessary
• Probability of deviations must be considered

25. International Complexity
Long-range inflation must be considered
• Over the extended period of years, inflation will have
have three effects on the value of the operation:
1. It will influence the amount of local currency cash
flows, both in terms of the amount of local currency
received for sales and paid for expenses and in
terms of the impact local inflation will have on
future competition
2. It will affect the future forex exchange rates

26. International Complexity
3. It will influence the real cost of financing choices
between domestic and foreign sources of capital

27. International Complexity
Subsidized Financing must be explicitly treated
• If a host country provides subsidized financing at a
rate below market rates, the value of the subsidy
must be considered.
• If the lower rate is built into a cost of capital
calculation, the firm is making an implicit
assumption that the subsidy will continue forever
• So add the PV of the subsidy leave the WACC

28. International Complexity
Political Risk must be Considered
• The host government may change its attitude
towards foreign influence or control over some
segments of the local economy
• Through a revolution
• Through a gradual evolution in the political
objectives of the government
• Political risk may be important in determining the
terminal value

29. International Complexity
Accounting Implications for Capital Budgeting
• Accounting principles and policies that are used in a
particular country are likely also to be used in capital
budgeting
• If financial executives are not aware of how the
foreign accounting system differs form the home
system they may base their analysis in a wrong cash
flow data

30. International Complexity
Transfer Pricing
• Transfer prices are internal prices (that are different
from market prices) on goods which are moving from
from one subsidiary to another within the MNE
• It arises due to the tendency of MNEs to price
products exchanged between subsidiaries at prices
which are not aligned with the market prices to
minimize the tax the MNE pays

31. International Complexity
Transfer Pricing
• Transfer prices have distorting and misleading effects
effects on capital budgeting decisions
• The value of the cash flows and that of the project
is likely to be distorted
• So the data will be incorrect
• Adjustments have to be made:
1. To use market prices and
2. To add back royalties cash inflows

32. Capital Budget
A US based multinational company is considering the
establishment of a two year project in Japan with a US$ 8 million
initial investment.
The company’s cost of capital is 12%. The required rate of return
on this project is 18%. The project with no salvage value after
two years is expected to generate net cash flows of ¥12,000,000
in year 1 and ¥30,000,000 in year 2.
Assume no taxes and a stable exchange rate of US$0.60/¥.
Required:
What is the net present value of the project in dollar terms