International Capital Budgeting

Introduction
Whenever a foreign direct investment is proposed in a multinational corporation, the proposal is evaluated by means of capital budgeting analysis.

Parent

Subsidiary

As we know that the feasibility of the project may change if the perspective changes. This is because the net after tax cash inflows will change from the subsidiary to parent. The after tax cash inflows are changes due to the following reasons

Existence of Tax differentials : Host country impose low tax rate on earnings generated by subsidiary and the funds are allowed to be remitted, then the project may be feasible from both the point of view. But if tax rates are high on fund remittance, then the project may be feasible from subsidiarys point and may not be viable from parents point of view.
High Fees: When parent charge high fee from the subsidiary, the net income of the subsidiary decreases and therefore the project may be viable from parents point and may not be viable from subsidiary point of view. Remittance Restrictions: When there are restrictions on remittance or only a %of the total profit a subsidiary is allowed to remit then in that case the project may be feasible from subsidiary point but it may not be attractive from parents point of view. Exchange Rate Variation: When earning are remitted to the parent, they may be normally converted from subsidiarys local currency to parents. therefore, the amt. remitted to the parent may decline due to exchange rate movement in favor of parents currency

Project Evaluation -Basic Inputs

The MNCs need to forecasts on the following economic & Financial variables related to the projects: Initial Investment Demand Price of the products Cost of the product Variable cost Fixed Cost The life of the project Salvage Value Transfer Restrictions Tax Laws Exchange Rate Variation The required Rate of Return

Complexities
Multinational corporations financial decisions are influenced by three types of economic environments : Host countrys economic environment Parent countrys economic environment International economic environment The influence of these three environment make the decision making difficult and complex. The main complexities are discussed below : Regulatory Environment : The difference exist between the parents cash flow and the projects cash flow because of tax laws and other regulatory environment. For parent, the cash flow to the parent relevant because the shareholder expect higher rate of return. Therefore , it is necessary to make a distinction between parents cash flow from that of the project.

Type of Financing : Parents cash flow depend on the form of financing that parent adopts to finance the project. Thus the parents cash flow can not be separated from the financing decisions Difficulty in recognizing the exact remittances : Remittance to the parent must be explicitly recognized. Because of difference tax laws, and political systems, differences in functioning of Financial markets, the cash flow to parent tend to vary. These aspects are also required to be considered while determining parents cash flows. Anticipating Inflation Rate: Differing rate of inflation must also be anticipated for forecasting the real return and exchange rate forecast. Inflation also changes the competitive position of the launched product/services. If the cash flow are in different currencies, the expected inflation rate are required to be forecasted for evaluating a project.

Segmented Capital Market: Since the project is being implemented in different country, therefore the capital markets are segmented by space. Use of segmented capital markets may provide an opportunity or may involve higher cost. Subsidized Loan and cost of capital : Use of subsidized loans complicate both the capital structure and the ability to calculate weighted average cost of capital for discounting purpose.

Evaluation of political risk: For each project political risk may be evaluated. This is because the cash flow can be severely effected by the changes in political environment. The changes in the government would change in the political philosophy thereby leading to new environment. Extreme form of risk is the risk of expropriation . In this case the projects and the parents cash flow tend to change drastically because in this case the funds are blocked in the country of the project.

Adjusted risk- Parents point of view

Everything remaining equal, the firms would like to invest in currencies which are stable over time, healthy economies and minimal political risk. In the real world, countries are different in most of economic aspects. Therefore, the risk of location are different and therefore location have different viability of investments. The risk can be incorporated in the project evaluation in three ways: By shorting the payback period By raising the required rate of return By adjusting cash flows to reflect the specific impact of a given risk.

The Exchange Rate variation, Inflation and the Expected Cash Flows
The present value of cash flows depends on the value of the currency in which the cash flows are occurring. The present value of future cash flows from a foreign project can be calculated using a two stage procedure: Convert nominal foreign currency cash flow into nominal home currency terms Discount those nominal cash flows at nominal domestic required rate of return

Incremental Cash Flows and Factors Affecting Cash Flows

Shareholders wealth maximization is the primary objective. Shareholders are interested in how many additional dollars they will receive in the future for the dollars invested today. Hence, incremental, not total cash flow, is what matters.

Differences Between Incremental and Total Cash Flows Effects of sales from the (new) investment on existing divisions: Cannibalization: New product taking away sales from the firm's existing products, e.g., substituting foreign production for parent company exports. Sales Creation: New investment creates additional sales for existing products. The benefits of additional sales (or lost sales) and associated incremental (decreased) cash flows should be attributed to the project.

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Transfer Pricing: Prices at which goods and services are traded internally can significantly distort the profitability of a proposed investment. Opportunity Costs: Project costs must include the true economic cost of any resource required for the project - already owned or just acquired. Sunk Costs: Cash outlay already incurred, and which cannot be recovered regardless of whether project is accepted or rejected, e.g., site analysis, feasibility studies, etc. Exclude sunk costs from cost considerations. Fees and Royalties: These are costs to the project but are benefits to the parent, e.g., legal counsel, power, lighting, heat, rent, R&D, H.Q. cost, and management costs, etc.

A project should be charged only for additional expenditures that are attributable to the project.
In general, incremental cash flows associated with an investment can be found by subtracting worldwide corporate cash flows without the new investment from "with" the new investment cash flows.

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NPV versus APV Strategy

NPV Strategy Include the financing values, e.g., the tax advantages of debt, financial distress costs, by adjusting the discount rate. That is, use the WACC as the discount rate. APV Strategy Separate the financing values, e.g., the tax advantages of debt, financial distress costs, into different calculations. Value Additivity Model

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Key Idea about APV

Separate Valuation of A) Operating Cash Flows for Unlevered Firm B) Other Value Components Tax Advantages of Debt Financial Distress Subsidies Hedges Costs of Issuing Securities These are adjustments to the NPV to account for other value changes. Financing Tax Advantages of Debt and Depreciation (+) Financial Distress (-) Hedges (+ hopefully ) Other Subsidies (+) Real Options (+)

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The APV Calculation

APV = NPV + PV(Tax Advantage) PV(Financial Distress) + PV(Real Options) +

A B

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Adjusted Present Value

If we apply NPV method, the above aspects can not be adjusted easily. APV method is applied because in this method every item of cash flow is treated separately. IN APV method, various difficulties and risk faced can be treated separately. The equation giving APV of an international project is : APV= -So.Ko +So.AFo+ (Se ( CFt-Le)(1-)/(1+Dre)t) + ((DAt. ) / (1+DRt)) + ((rgBCo+)/(1+DRb)t) + So(Clo-(LRt/(1+DRc)t) + (Tdet/(1+DRd)t) +((Rfet/(1+DRf)t) Where : So = Spot exchange rate at zero period Ste = Expected spot rate at time t Ko= Capital cost of the project in foreign currency unit AFo = Restricted fund activated by the project CFte= Expected remittable cash flow in foreign currency units Le= Profit from lost sale in foreign currency.

 = The higher of domestic & foreign rate T= life time of the project DAt= Depreciation allowance in foreign currency BCo= contribution of the project to borrowing capacity in domestic currency CLo= Face value of concessionary loan in foreign currency LRt =Loan repayment on concessionary loan in foreign currency TDt = Expected tax savings from deferral, inter subsidiary transfer pricing Rfet =Expected illegal repatriation of income DRe = Discounted rate of cash flow DRd = Discounted rate of tax savings on interest deduction from contribution to borrowing capacity DRe = Discounted rate of saving via concessionary interest rate DRd =Discounted rate for saving via inter-subsidiary transfer pricing DRf = Discounted rate for illegal repatriation and rg = market borrowing rate at home.

Practice question: Project 1 500000 150000 250000 100000 250000 150000 Project 2 300000 75000 150000 150000 50000 50000

Initial Investment Cash InFlow: Year 1 Year 2 Year 3 Year 4 Year 5 Calculate the following: 1. Payback Period 2. NPV @ 10 % 3. PI 4. IRR

Defining Political Risks

Firm-specific are those risks that affect the MNE at the project or corporate level (governance risk due to the goal conflict between an MNE and its host government being the main political firm-specific political risk in chapter; business risk and FX risk are also in this category) Country-specific are those risks that also affect the MNE at the project or corporate level but originate at the country level (e.g. transfer risk, war risk, nepotism & corruption) Global-specific are those risks that affect the MNE at the project or corporate level but originate at the global level (e.g. terrorism, anti-globalization, poverty)

Classification of Political Risks

Assessing Political Risk

How can multinational firms anticipate government regulations that, from the firms perspective, are discriminatory or wealth depriving? At the macro level, firms attempt to assess a host countrys political stability and attitude toward foreign investors At the micro level, firms analyze whether their firm-specific activities are likely to conflict with host-country goals as evidenced by existing regulations The most difficult task is to anticipate changes in host-country goal priorities Predicting Firm-Specific Risk (Micro-Risk) The need for firm-specific analyses of political risk has led to a demand for tailor-made studies undertaken in-house by professional political risk analysts In-house political risk analysts relate the macro risk attributes of specific countries to the particular characteristics and vulnerabilities of their client firms Certainly, even the best possible analysis will not reflect unforeseen changes in the political or economic situation

Assessing Political Risk

Predicting Country-Specific Risk (Macro-Risk) Macro political risk analysis is still an emerging field of study These studies usually include an analysis of the historical stability of the country in question, evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in cultural and religious activities It is important to remember, especially in the analysis of political trends, that the past will certainly not be an accurate predictor of the future Predicting Global-Specific Risk Predicting this type of risk is even more difficult than the other two types of political risk The attacks of September 11th, 2001 are an important example of theses difficulties However, the military buildup in Afghanistan was not as difficult to predict As we now live in a world with an expectation of future terrorist attacks, we may begin to see country-specific terrorism or other risk indices being developed

Firm-Specific Risks
Governance Risk This is the ability to exercise effective control over and MNEs operations within a countrys legal and political environment For an MNE, however, governance is a subject similar in structure to consolidated profitability it must be addressed for the individual business unit and subsidiary as well as for the MNE as a whole Negotiating investment agreements An investment agreement spells out the rights and responsibilities of both the foreign firm and the host government The presence of MNEs is as often sought by development-seeking host governments as a particular foreign location sought by an MNE

Firm-Specific Risks
An investment agreement should spell out policies on financial and managerial issues; including the following; Basis on which fund flows such as dividends, royalty fees and loan repayments may be remitted Basis for setting transfer prices The right to export to third-country markets Obligations to build, or fund social and economic overhead projects such as schools and hospitals Methods of taxation, including rate, type and means by which rate is determined Access to host country capital markets Permission for 100% foreign ownership versus required local partner Price controls, if any, applicable to sales in host countrys markets Requirements for local sourcing versus importation of materials Permission to use expatriate managerial and technical personnel Provision for arbitration of disputes Provisions for planned divestment, indicating how the going concern will be valued (build-to-own or build-to-transfer)

Country-Specific Risks
These risks affect all firms, both domestic and foreign operating within the host country Most typical risks are
Transfer risk Cultural differences Host country protectionism

Country-Specific Risks
Transfer risk are the limitations on the MNEs ability to transfer funds into and out of a host country without restrictions MNEs can react to potential transfer risk at three stages
Prior to making the investment, a firm can analyze the effect of blocked funds During operations a firm can attempt to move funds through a variety of repositioning techniques Funds that cannot be moved must be reinvested in the local country to avoid deterioration in real value

Management Strategies for Country-Specific Risks

Global-Specific Risks
Global-specific risks faced by MNEs have come to the forefront in recent years:
Terrorism and War Crisis Planning Cross-Border Supply Chain Integration Supply Chain Interruptions (Inventory Management, Sourcing, Transportation) Antiglobalization Movement Environmental Concerns Poverty Cyberattacks

Management Strategies for GlobalSpecific Risks

Capital Structure
Capital Structure is that part of financial management, which represent longterm sources. It is the mix of long-term source of funds, such as equity shares, reserve and surplus, debentures, long-term debts from outside sources and preference share capital. Capital Structure = Long-term debt+ Preferred Stock+ Net Worth OR Capital Structure = Total Assets- Current Liabilities

Optimum Capital Structure

Optimum Capital Structure is that capital structure at that level of debt-equity proportion where the market value per share is maximum and the cost of capital is minimum.

Features of an appropriate Capital Structure

Profitability : Appropriate capital structure is one , which is most advantageous. It should generate maximum returns without adding additional cost. Solvency: The use of excessive debt threatens the solvency of the firm. Debt should be used till the point where debt does not have any significant risk, Otherwise use of debt should be avoided. Flexibility: Flexible capital structure should allow existing capital structure to change according to the changing condition without increasing cost. Conservation: Capital structure should be determined within the debt capacity of a firm. The debt capacity of a firm depends on its ability to generate future cash inflows. Control: Construction of capital structure should not involve the risk of loss of control on the firm

Determinants of Capital Structure

Tax Benefit of Debts Flexibility Control Industry Leverage Ratios Seasonal Variations Degree of Competition Industry Life Cycle Agency Cost Company Characteristics Timing of Public Issue Requirement of Investors Period of Finance Purpose of Finance Legal Requirement

Cost of Capital & Multinational Financial Environment

Cost of Equity for a firm is the min rate of return necessary to induce investors to buy or hold the forms stock. The required rate of return equals a basic yield covering the time value of money plus a risk premium. Rr = Rf+RP Where Rr = required rate of return Rf = risk free rate of return RP = Risk premium One of the approach is to determine the project specific required rate of return on equity, based on modern capital market theory Ri = Rf + ( Rm Rf ) Where : Ri = Equilibrium expected return from asset I Rf = Rate of return on risk free assets Rm = Expected return on market portfolio consisting all risky assets = Cov ( Ri, Rm ) / Var (Rm)

According to the dividend valuation the price of equity is given by : Po = Div 1 / ( Ke-g) Where : Ke = Companys cost of equity capital Div 1 = Expected dividend in year 1 Po = Current stock price g = Expected average annual growth rate of dividend Or Ke = ( Div 1 / Po )+g Weighted cost of capital Kw = W1. Ke + W2 . Kd + W3 . Kp

The weighted cost of capital when the capital , is obtained in the form of debt & equity , is given by : Kw = ( 1-L) . Ke + L (1-t ) . Kd Example : Suppose a company is financing a project with 50% common stock, 30% debt and 20% preferred Share stock, the after tax cost of capital are 20%, 10% and 15% respectively. The weighted cost of capital is : Kw = 0.50 x 0.20 + 0.30 x 0.10 + 0.20 x 0.15 = 16%

Cost of various sources of funds Suppose a project of a subsidiary requires I* investment in term of parents currency and suppose that P amount has been provided by the parent, Re has been provided from the retained earnings of the subsidiary and Df is the debt mobilized from foreign source so that I* = P+ Re + Df To know the cost of capital, we have to know the cost of all three components of capital and by adding these three cost we got the cost of capital. Cost of Parents company fund : K*o = Ko + ( 1 L ) . ( Ke1 Ke ) Where : Ko = Marginal cost of capital Ke1 = cost of equity based on the new perception of riskiness ( Ke1 Ke ) = Marginal change in the cost of equity

Cost of retained earning : Ks + Ke x ( 1- t) Cost of foreign debt to a foreign affiliate : rfd = fj ( 1-t ) ( 1-d) d Where : rfd = cost of foreign debt rj = foreign interest rate t = tax rate d = expected depreciation of foreign currency

Example : Suppose a foreign affiliate borrows dollars at rj = 9% and the $ is expected to appreciate by 7% , in this case the cost of debt without tax Rfd = .09 x ( 1+.07) + 0.07 = 16.63%

If tax rate is 5% then

Rfd = .09 x ( 1+.07) ( 1-.05) +.07 = 16.148%

Cost of capital when risk perception do not change Kw = Ko a. ( Ke Ks ) b. ( rd ( 1-t) rf ) Where: a = E / ( E+D) b = D / ( E+D) Cost of capital when taking up of a foreign project changes and risk perception of investors;

Kw = Ko +( 1- L ). ( Ke1-Ke) a . ( Ke1-Ks )- b. ( Kd ( 1-t)- Kf )

Question: An Indian company is making appraisal of its project to be setup with its subsidiary in the USA. The initial project cost amount to $125000 which, as expected, will add Rs. 30 lakh to indian companys borrowing capacity over a period of three years. A sum of Rs. 40 lakh of the initial investment is met by the indian parent and remaining $ 25000 is borrowed at 10% interest rate in the USA. The project has a life of three years. The net operating cash inflow is $50000, $60000 & $72000 the salvage value is expected to be $ 10000 The spot rate is Rs 40/$ . It is assumed that PPP holds with no lag and that real prices remain constant in both absolute & relative terms. Hence the sequence of exchange rate reflects anticipated annual rates of inflation equating 8% in Rs and 5% in $. Depreciation allowance amount to Rs 15 lakh per year for three year. Tax rate is 30% in india & 25% in USA. Expected tax saving from intra firm transfer pricing is Rs. 50000/ yr for all three years. Discount rate for cash flow assuming all equity financing is 20% . Discount rate for depreciation/tax saving on interest deduction from contribution to borrowing capacity is 12%. Discount rate relating to loan repayment is20% and on tax saving on account of transfer pricing is 25% . FIND THE APV

Spot exchange rate = 40/$ Year 1 = Rs. 40 x( 1.08/1.05) = Rs. 41.14/$ Year 2 = Rs. 41.14 x (1.08/1.05) = Rs. 42.32/$ Year 3 = Rs. 42.32 x ( 1.08/1.05) = Rs. 43.53/$ Operating Cash Flow ( Including salvage value) : Year 1 = 50000 x 41.14 = 2057000/1.20 = Rs. 1714167 Year 2 = 60000 X 42.32 = 2539000/1.202 = Rs. 1763333 Year 3 = 82000 x 43.53 = 3569460/1.203 = Rs. 2065660 Depreciation allowance x tax @ .30 Year 1 = 1500000x0.30 = 450000/1.12 =401785 Year 2 = 1500000x0.30 = 450000/1.122 =358737 Year 3 = 1500000x 0.30= 450000/1.123 =320307 Borrowing Capacity : Year 1 = 1000000x.10x.3 = 30000/1.12 = 26786 Year 2 = 1000000x.10x.30=30000/1.122 = 23916 Year 3 = 1000000x.10x.30= 30000/1.123 = 21354

Tax Saving on account of transfer pricing : Year 1 = Rs. 50000x.30 =15000/1.25 = 12000 Year 2 = Rs. 50000x.30=15000/1.252 =9600 Year 3= Rs. 50000x.30 = 15000/1.253 = 7680 Loan Repayment ( Interest+ amortization ) Year 1 =

Question : Suppose new foreign investment of $100 mn is required by a subsidiary of a U.S parent. The capital structure which seemed feasible is : $ 20 mn will be subscribed by the parent, $30mn will be subscribed through the retained earning and remaining $50mn will be mobilized through issue new debt by subsidiary. Parents cost of equity is 15% and after tax cost of debt is 5%. The optimal debt ratio is 40% However , the project has higher risk than firms typical investment requiring 18% ( Ke1) rate of return on the new parent equity and 6% on new parent debt. The incremental tax rate is 9%. Nominal local currency rate of interest is 20% with an average devaluation of 5% and the foreign tax rate 30% calculate the weighted cost of capital