Capital budgeting under financial system-1.pdf

MCOM –Semester IV
Module : – International Financial Management
Unit II: International capital Budgeting Decision

Backdrop
Financial Management: Management of Financial
Resources i.e. Procurement of Funds & Utilization of funds.
Objectives:
❖ Profit Maximization (maximizing profits by increasing sales
& minimizing costs )
❖ Wealth Maximization( maximizing the wealth of
shareholders or maximizing prices of shares)
“Wealth Maximization is superior criteria than Profit
Maximization” because there is ambiguity in the term
profit itself and profit maximization obj ignores time value
of money and risk.

Ctd……
Decision Areas of Financial Management:
❑Investment decisions
✓Long term Investment (Capital Budgeting)
✓Short term Investment(Working capital)
❑Financing decisions
✓Right mix of Debt & Equity to raise funds
❑Dividend Policy decisions
✓How much profit is to be retained and how
much to be distributed.

Capital budgeting
➢Planning for long term expenditure
➢Long term decision making involving huge
outlay of funds
➢Capital budgeting decisions usually of
irreversible nature.
➢Time gap between investment of funds &
future benefits.
➢High degree of risk.

Capital Budgeting by Domestic firms
• Traditional Methods
Name of method Formula Decision Rule
Average Rate of
return Method
(ARR)
ARR= (Avg Profit after
tax/ Avg
investment)*100
If ARR>Desired rate of
return, accepted
otherwise rejected.
Pay Back Method PBP= Initial Outlay/
Annuity
PBP under
proposal<Predetermined
PBP, accepted, otherwise
rejected.

Modern/ Discounted Cash flow techniques:
Name of
method
Formula Decision Rule
Net Present
Value
Method
(NPV)
NPV= P.V of all Cashinflows-
Cash outflow or cost
If NPV>0, accept
If NPV<0, reject
If NPV+0, indifferent
Internal rate
of return
Method(IRR)
IRR= Rate at which P.V of
cashinflow is equal to P.V of
cash outflow.
(IRR is the rate at which
NPV=0)
If IRR> Cost of
Capital, accept.
If IRR< Cost of
Capital, reject.
Profitability
Index (PI)
method
PI= P.V of cash inflows
P.V of cash Outflows
If PI>1, accept
If PI<1, reject

Capital Budgeting decisions of MNC
Introduction
Capital budgeting technique provides the
mechanism to identify opportunities and evaluate
their economic viability. This is why MNCs
evaluate international projects by using capital
budgeting techniques. Proper use of capital
budgeting techniques can help the firm in
identifying the international projects worthy of
implementation from those that are not.

❖Capital budgeting for multinational firms uses
the same framework as domestic capital
budgeting.
❖ Multinational capital budgeting encounters a
number of variables and factors that are unique
for a foreign project and are considerably more
complex than their domestic counterparts.

Process
The basic steps involved in evaluation of a project
are:
1. Determine net investment outlay;
2. Estimate net cash flows to be derived from the
project over time, including an estimate of salvage
value;
3. Identify the appropriate discount rate for
determining the present value of the expected cash
flows;
4. Apply NPV or IRR techniques to determine the
acceptability or priority ranking of potential projects.

Domestic Vs MNC Capital Budgeting
decisions
In case of MNC, the above evaluation process becomes
complicated because of the factors peculiar to international
operations which are given below:
➢Overseas investment projects usually involve one or more
foreign currencies, multiple tax rates and tax systems and
foreign political risk.
➢Overseas investment projects involve special problems,
such as capital flow restrictions that do not allow the cash
flows of projects to be remitted to the parent company.
➢Difficulty in estimating terminal value of foreign projects
➢Different rates of national inflation

Issues in Foreign Investment Analysis
• Parent Vs. Project Cash Flows
• Tax Holidays
• Lost Exports
• Multinationals Exchange Control
• Subsidized Financing
• International Diversification Benefits

Project versus Parent Valuation
12
Foreign Investment
US$ invested in overseas
Particular investment
Project Viewpoint
Capital Budget
(Local Currency)
Estimated cash flows
of project
Parent Viewpoint
Capital Budget
(U.S. dollars)
Cash flows remitted
to Parent (FC to US$)
END
Is the project investment
Justified (NPV > 0)?
Parent Firm (US)
START

Parent Vs. Project Cash Flows
The first specific issue that arises in respect of the overseas
project is as to which cash flows should be considered for
evaluating the project, the cash flows available to the
project, or cash flows accruing to the parent company or
both.
Evaluation of an overseas project on the basis of project's
own cash flows provides insight into its competitive status
vis-a- vis domestic or regional firms. The project is
expected to earn a risk-adjusted rate of return higher than
that on its local competitors. Otherwise the MNC should
invest money in the equity of local firms. This approach has
the advantage of avoiding currency conversions, thus
eliminating the margin of error involved in forecasting
exchange rates over the life cycle of the project. Such
approach is appreciated by local manager, local joint
venture partners and host governments.

Parent Vs. Project Cash Flows
It must be noted that in international capital
budgeting a significant difference usually exists
between the cash flows of a project and the amount
that is remittable to the parent. The reasons are tax
regulations and exchange controls. Further, project
expenses such as management fees and royalties are
earnings to the parent company. Furthermore, the
incremental revenue available to the parent MNC
from the project may vary from total project revenues
particularly when the project involves substituting
local production for parent company exports or if
transfer price adjustments shift profits elsewhere in
the system.

Tax Holidays
More often than not, governments of developing countries offer
tax holidays to encourage foreign direct investment in their
economies. Other tax holidays in the form of a reduced tax rate
for a period of time on corporate income from a project are
negotiable knowing how much the tax holiday is worth when the
firm negotiates the environment of the project with the host
government.

Lost Exports
Another issue relating to direct foreign investment
decision is the issue of lost exports arising out of
engaging in a project abroad. Profits from lost
exports represent a reduction from the cash flows
generated by foreign project for each year of its
duration. This downward adjustment in cash flows
may be total, partial or nil depending upon
whether the project will replace projected exports
or none of them.

Multinationals Exchange Control
Exchange control restricting the repatriation of earnings to the
parent country is another reason that causes discrepancy
between the project value, from the parent's perspective and
from the local perspective. When an MNC is contemplating
investment in a country having exchange control, the present
value calculation from the parent's point of view will be based
on the following facts:
➢The pattern of financing investment by MNC-debt or equity or
both. In case of investment to be funded via debt, cash
generated by the project is returned to the home country to the
extent of debt repayment and interest.
➢Remittances of net cash flows expected to be generated by the
foreign projects.

Subsidized Financing
In order to attract foreign investments in key
sectors, the governments of developing
economies generally provide support in the form
of subsidy. Likewise, international agencies
entrusted with the responsibility of promoting
cross-border trade sometimes offer financing at
below-market rates. The value of the subsidized
loan should be added to that of the project while
making the investment decision if the subsidized
financing is inseparable from the project.

International Diversification Benefits
Dispersal of investment in a number of countries is
likely to produce diversification benefits to the parent
company's shareholders. However, it would be
difficult to quantify such benefits as can be allocated
to a particular project.
Generally, such non-quantifiable variables are ignored
in capital budgeting decision. However, in case of a
marginal project or a project which is not acceptable
on its merits, this factor may be taken care of.
Sometimes, a marginal project may be found
worthwhile when its beneficial diversification effect
on the overall pattern of cash flow generation by the
MNC is taken into consideration.

Risk Analysis in International Capital Budgeting
Decisions
MNCs have to face a host of additional risks while investing in
foreign countries. These risks may be political and economic.
➢Political risk is the possibility that political events in a host
country or political relationships with a host country will
affect the value of corporate assets in the host country. The
most extreme form of political risk is the risk of expropriation
in which a host government seizes local assets of an MNC.
➢Besides, MNCs' foreign investments are subject to risk
arising out of exchange rate fluctuations and inflation. While a
firm knows that the exchange rate will typically change
overtime, it does not know whether the foreign currency will
strengthen or weaken in the future and how the cash flows
will be affected .

Methodology for risk analysis
Three main methods used for incorporating additional
political and economic risks in foreign investment analysis are:
i) shortening the minimum pay-back period;
ii) raising the required IRR; and
For example, if there is likelihood of embargo on
remittances, a normal required rate of 12% might be raised
to 16% or a 4-year payback period might be shortened to
3years.
iii) adjusting cash flows to reflect the specific impact of a
given risk

Questions
• What do you mean by Multinational Capital
Budgeting?
• What is subsidiary vs parent Perspective of
Capital Budgeting?
• Briefly discuss the factors affecting multinational
capital Budgeting. What is ANPV approach of a
project?
• Discuss the various risks involved in international
projects and describe the methods for assessing
those risks.

Two techniques employed to adjust the annual
cash flows
➢In the first method, adjustment for uncertainty involves reducing
each year's cash flows by an amount equivalent to risk or an
insurance premium, even if such arrangement is not actually made
by the management. For example, if an MNC insures with an
insurance company to hedge risk due to occurrence of a political
event, the premium paid by the firm will be deducted from cash
flows.
➢In the second method, probability and certainty equivalent
techniques can be employed to adjust political risk, The MNC,
generally, employs a statistical technique called the "Decision Tree"
analysis to estimate the probability of expropriation. With the help
of these techniques the MNC finds an NPV for the foreign project
based on cash flows adjusted for the probability of expropriation
for the particular year.

Practically on what basis MNCs take
their capital budgeting decisions
• Like domestic capital budgeting decisions, the
objective of foreign capital budgeting decisions
by MNCs is maximization of wealth of its
shareholders.
• The technique of NPV is considered most
appropriate as it is consistent with the objective
of maximization of wealth.
• However there are certain additional
complexities in foreign projects. Therefore we
need to adjust NPV method for those
complexities.

Adjusted NPV Technique
• Lessard (1979) developed APV technique.
• It covers up all the complexities in
computation of cash flows and discount rates.
• If all the complexities are incorporated in cash
flows and if risk-adjusted weighted average
cost of capital is taken as discount rate, then
APV approach is not different from NPV
approach.

Cash Outflow/ Initial investment
• If the entire cost of project is met by the parent
company, then CO= entire amount of initial
investment.
• If project is partly financed by subsidiary itself through
borrowings, then it is not part of CO.
• If subsidiary is investing money out of its retained
earnings, it is a part of CO. The reason is it is
opportunity cost, apparently no outflows from parent’s
side. But if these earnings had not been retained by
subsidiary, they must have been remitted to parent.
• The amount invested out of blocked funds are also
treated as cash outflow.

Blocked Funds
• Blocked funds are funds which do not flow to
parent company because sometimes
government imposes restriction on outflow of
funds from the country(in view of strained
BOP)
• If host government says that net revenue will
be transferred to parent only after
completion of project and not every year, this
provision will certainly influence the cash flow.

Problem
Q: A project of the subsidiary costs $15.5 million.
The parent company makes an initial investment
of $10 million, a sum of $2 million is invested out
of blocked funds, another sum of $2 million is
taken out of retained earnings and $1 million is
met by subsidiary out of local borrowing. At the
same time host government provides some
subsidised establishment for the project that
brings in a gain for $0.5 million. Calculate the
cash outflow from parent’s perspective.

• Thus in this case , the cash outflow recorded
for initial Investment from the parents
perspective will be:$10+2+2=$14.0 million.

• A project of the subsidiary costs $ 20 million. It is
financed through different modes of funds. The
parent company makes an initial investment
for$12 million. A sum of $2 million is drawn out
of blocked funds and another sum of $3 million
is taken out of retained earnings. The Subsidiary
borrows $2 million from the host country market.
The Remaining $1 million is in the form of free
land and building supplied by the host country
government. Find out the amount of initial
investment from the view point of the parent
unit.

Initial Investment from the parents View point
= $12+3+2=17 million
Calculate the operating cash flow on the basis of the
following data:
a) Sales in the domestic market=$ 10 million
b) Export = $ 4 million
c) Replacement of parent export=$ 2 million
d) Parents export of components to subsidiary =$ 3
million
e) Royalty payment by subsidiary =$.5 million
f) Dividend flow to the Parent = $ .5 million
Sol: $10 + 4 +3+.5+.5-2=$16 million

Find the Break Even salvage if:
a) Initial investement = $30 million
b) The net cash inflow during the first and
second year respt.=$20 million and $15
million
c) Discount Rate= 10%
Sol: (30-(20/1.10+15/1.21))*1.21=$0.70 million.

Problem of APV method
Q: A MNC has to set up a manufacturing plant in India
involving an initial outlay of Rs 50 million. The plant is
expected to have a useful life of 5 years with Rs10 million
salvage value. The MNC follows SLM of depreciation. To
support additional level of activity, investment would
require additional working capital of Rs5 million.
Since the cost of production is lower in country X, the
variable cost of production and sales would be lower,
i.e.Rs20 per unit. Additional fixed cost per annum are
estimated at Rs2 million. Further the forecasted selling
price is lower i.e. Rs70 per unit to sell 500000 units. The
MNC is subjected to 40% tax rate and its cost of capital is
15% p.a.

Ctd…..
It is forecasted that rupee will depreciate
/devalue in relation to US$@3% p.a. after the
first year, with an initial exchange rate of Rs.36/$.
The following assumption have been made that US
parent MNC has not been exporting to India and
full repatriation every year with no withholding
taxes and full tax credit being available in USA.

Answer
INITIAL OUTLAY
Cost of Plant = Rs. 50,000,000
Working Capital = Rs. 5,000,000
Total outlay = Rs. 55000,000
US$ (Equivalent)= Rs. 55000000 / 36*
= $1527778
*Initial exchange rate
Note- Initial outlay is in beginning (at zero point of
time), need not calculate present value.

Exchange Rate
Year Exchange Rate (Rs. Per $)
1 36
2 37.08 (36*103/100)
3 38.1924 (37.08*103/100)
4 39.338 (38.1924*103/100)
5 40.5183 (39.338*103/100)

Operating Cash flows (CFAT)
Sales Revenue (500000*70) = Rs. 35,000,000
Less: Variable costs (500000*20) (10,000,000)
Fixed costs (2000000)
Depreciation (50m -10m)/5 (8000000)
Earnings before taxes 15000000
Less: Taxes @40% (6000000)
Earnings after taxes (EAT) 9000000
Add: Depreciation 8000000
CFAT (cash flow after taxes) 17,000,000

Terminal CFAT
• CF in the 5th Year
• Release of Working Cap Rs.5,000,000
• Salvage Value of plant Rs.10,000,000
Rs. 15,000,000
+ Normal Cash Flows 17,000,000
Terminal Cash flows Rs.32,000,000

Year CFAT Rs/$ Equivalent$
1 17,000,000 36 4,72,222
2 17,000,000 37.08 4,58,468
3 17,000,000 38.1924 4,45,115
4 17,000,000 39.3382 4,32,150
5 32,000,000 40.5183 7,89,767

Calculation of NPV
Year CFAT ($) PVF@15% P.V($)
1 4,72,222 0.870 4,10,833
2 4,58,468 0.750 3,43,851
3 4,45,115 0.658 2,92,886
4 4,32,150 0.572 2,47,190
5 7,89,767 0.497 3,92,514
G.P.V 16,87274
(-) Outflows
NPV
15,27778
59,496

expected to have a useful life of 5 years with Rs. 15 million
require additional working capital of Rs. 8 million.
variable cost of production and sales would be lower, i.e.
Rs. 25 per unit. Additional fixed cost per annum are
estimated at Rs. 4 million. Further the forecasted selling
price is lower i.e. Rs. 75 per unit to sell 600000 units. The
12% p.a.

Ctd…..

Answer
INITIAL OUTLAY
Total outlay = Rs. 68000,000
US$ (Equivalent)= Rs. 68000000 / 40*
= $1700000

Exchange Rate
1 40
2 42 (40*105/100)
3 44.1 (42*105/100)
4 46.305 (44.1*105/100)
5 48.620 (46.305*105/100)

Sales Revenue (600000*75) = Rs. 45,000,000
Fixed costs (4,000,000)
Depreciation (60m -15m)/5 (9,000,000)
Earnings before taxes 17,000,000
Less: Taxes @40% (5,950,000)
Earnings after taxes (EAT) 11,050,000
Add: Depreciation 9,000,000

Terminal CFAT
Rs. 23,000,000

1 20,050,000 40 501,250
2 20,050,000 42 477,381
3 20,050,000 44.1 454,648
4 20,050,000 46.350 432,578
5 43,050,000 48.620 885,438

Calculation of NPV
Year CFAT ($) PVF@12% P.V($)
1 501,250 0.8929 447,566
2 477,381 0.7972 380,568
3 454,648 0.7118 323,618
4 432,578 0.6355 274,903
5 885,438 0.5674 502,397
G.P.V 1,929,052
(-) Outflows
NPV
1,700,000
229,052

expected to have a useful life of 10 years with Rs. 20 million
require additional working capital of Rs. 10 million.
variable cost of production and sales would be lower, i.e.
Rs. 30 per unit. Additional fixed cost per annum are
estimated at Rs. 5 million. Further the forecasted selling
price is lower i.e. Rs. 100 per unit to sell 800000 units. The
20% p.a.

Ctd…..

Answer
INITIAL OUTLAY
Total outlay = Rs. 90,000,000
US$ (Equivalent)= Rs. 90,000,000 / 50*
= $1800000

Exchange Rate
1 50
2 52 (50*104/100)
3 54.08 (52*104/100)
4 56.2432 (54.08*104/100)
5 58.4929 (56.2432*104/100)
6 60.8326 (58.4929*104/100)
7 63.2659(60.8326*104/100)
8 65.7965(63.2659*104/100)
9 68.4283(65.7965*104/100)
10 71.1654(68.4283*104/100)

Sales Revenue (800000*100) = Rs. 80,000,000
Fixed costs (5,000,000)
Depreciation (80m-20m)/10 (6,000,000)
Earnings before taxes 45,000,000
Less: Taxes @40% (20,250,000)
Earnings after taxes (EAT) 24,750,000
Add: Depreciation 6,000,000

Terminal CFAT
Rs. 30,000,000

1 30,750,000 50 615,000
2 30,750,000 52 591,346
3 30,750,000 54.08 568,602
4 30,750,000 56.2432 546,732
5 30,750,000 58.4929 525,704
6 30,750,000 60.8326 505,485
7 30,750,000 63.2659 486,043
8 30,750,000 65.7965 467,350
9 30,750,000 68.4283 449,375
10 60,750,000 71.1654 853,645

Calculation of NPV
Year CFAT ($)
PVF@160.8621%
P.V($)
1 615,000 0.8621 447,566
2 591,346 0.7432 380,568
3 568,602 0.6407 323,618
4 546,732 0.5523 274,903
5 525,704 0.4761 502,397
6 505,485 0.4104 207451
7 486,043 0.3538 171962
8 467,350 0.3050 142541
9 449,375 0.2630 118185
10 853,645 0.2267 193521
G.P.V 2,762,712
(-) Outflows
NPV
1,800,000
962,712

Case Study
• An India company is making appraisal of its project to be set up with its
subsidiary in the USA. The initial project cost amount To US $ 1,25,000 which, as
expected will add Rs. 30 lakh to the Indian company’s borrowing capacity over a
period of three years. A sum of Rs. 40 lakh of the initial investment is met by the
Indian parents and the remaining $ 25,000 is borrowed at 10% interest rate in the
USA. The project has a life of three years. The net operating cash inflows is
$50,000, $ 60,000 and $72,000 respectively in the first, second and third years.
The salvage value is expected to be $10,000. The spot exchange rate is Rs. 40.$ .
It is assume that PPP holds with no lag and that real prices remain constant in
both absolute and relative terms. Hence the sequence of exchange rate reflects
anticipation annual rate of inflation equating 8 percent in RS. and 5 percent in
dollar. Depreciation allowances amount to Rs. 15 lakh a year for three years. Tax
rate is 30 percent in India and 25 percent in the USA. Expected tax saving from
intra-firm transfer pricing is Rs. 50,000 a year in all the three years. Discount rate
for cash flows assuming all equity financing is 20 %. Discount rate for
depreciation/tax saving on interest deduction from contribution to borrowing
capacity is 12 percent. Discount rate related to loan repayment is 20 percent and
on tax saving on account of transfer pricing is 25 percent. Find the APV.

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