International financial

managementpart II
Capital budgeting for multinationals
Application of the principles of domestic
capital budgeting to the varying international
environments-language, culture, policies, laws,
customs
Goal is to increase value to the parent share
holders

Investment is the art of finding out
assets that would have more value
in future than what they cost today.
Theory of value and rules
relating to return apply to
investment decisions




















Objective of investment is
growth with stability
Types
Based on location
Investments within the business or
outside.
Investments within business is
capital budgeting.
Investment Outside

in financial and real assets either
for
treasury operations or for
strategic control or acquisition
Investment within
Business needs long-term assets
or capital assets such as land,
building plant and machinery for
creating and maintaining facilities. For
utilizing the facilities so created and to
generate income, business requires
short-term assets or current assets
like cash, materials and receivables.

Planned investment in projects
within the organisation is
Capital budgeting
Purpose
For
Creating facilities for the production of
goods or for rendering services,
Maintaining and improving existing
facilities and for
Updating process
Better utilization of the existing facilities to
generate additional revenues.

Broad classification of projects

New projects
Expansions
Diversifications
Modernizations
Acquisitions
Research and development
Replacements and
Social projects.

Steps in capital budgeting
>Identification of project ideas
>Calculation of cash flows of each
proposal
>Evaluating cash flows of proposals
>Ranking the projects
>Choosing that alternative, which is best
(gives maximum benefit for same cost
or same benefit for minimum cost)
Calculation of cash flows
Initial investment = cash outflow (-) =
investment in fixed assets and working
capital
Period when project is completed and ready
for production is 0 year
Where gestation period is more than a year
investments before zero year (pre-zero
years) are indicated -1, -2, -3, etc.

Cash inflows-returns
Returns are profit after tax plus depreciation
added back less additional investment, if any
= free cash flow
Returns over useful life of projects indicated
as year 1, 2, 3,--- n

Terminal value
End of project salvage value (or
terminal value or scrap value),
calculated at 5% of fixed assets
and 100% of working capital


Evaluation techniques


Accounting rate of return.
Payback period method and
Present value method.
Accounting rate of return (ARR)
ARR = (Po+C1 +C2 + ---Cn) / n /Po
Illustration:
The cash flow on Walter Wears Ltd. project
is as in table next page

Years Rs. lakhs
0 year
1 year
2 year
3 year
4 year
5 year
6 year
7 year
-550.00
211.13
231.54
264.07
314.45
355.39
396.11
526.55
Accounting Rate of return for the project
would be
ARR = (Po+C1 +C2 + ---Cn) / n /Po,
= (- 550 + 211.13 +231.54 +264.07
+314.45+355.39+396.11+526.55)
/ 7/550
=38.84%.
Pay back period method

Pay back period = Po / AAR.
AAR is average annual return.
Illustration: Kavia Chemicals has invented
a formula at a cost of Rs.52.50 lakhs. The
formula is expected to give an annual return of
Rs.17.50 for 6 years . The pay back period of
the investment would be 52.50 / 17.50
= 3 years.
Present value method
n
Present value of project = i.e. C / 1+r +

t=1
C
2
/ (1 +r)
2
+ C
3
/ (1+r)
3
+ C
n
/ (1 + r)
n
.



Net Present Value(NPV) is

n
= i.e. Po +C / 1+r + C
2
/ (1 +r)
2
+

t=0
C
3
/ (1+r)
3
+ C
n
/ (1 + r)
n
CAPITAL RATIONING

Kavia Keltons Ltd. has a weighted average
cost of capital of 15%. The company has
identified three projects, of which it could
afford only two. Details of the projects are:
Rs. Lakhs.

Project A Project B Project C
Investment
Returns
1 year
2 year
3year
4year
-326.78

77.50
126.55
157.00
165.25
-412.80

196.86
174.80
158.25
127.69
-278.54

112.40
112.40
112.40
112.40
Project A- PV= Rs.360.79= NPV 34.01
Project B-PV = Rs.480.41 =NPV 67.61
Project C-PV = Rs.320.90 =NPV 42.36
All projects give + NPV
How to choose the two projects?
Profitability index (PI).
PI = PV / P
o


PI of the projects
Project A = Rs.360.79 / Rs.326.78
=1.104
Project B = Rs.480.41 / Rs.412.80
=1.164
Project C = Rs.320.90 / Rs.278.54
=1.152
IRR
IRR is the actual rate of return a project
gives during its effective life. It is that rate at
which the discounted cash flow would equal
investment.
It is the point where PV Investment = 0.
n
IRR = NPV= 0 = = 0

t=0
Defects of IRR
AS IRR HAS THE DEFECT OF SHOWING
MULTIPLE RATES OF RETURN,
EVALUATORS PREFER NPV AND PI TO
IRR AS RELIABLE TECHNIQUES IN
PROJECT EVALUATION
Defects
There could be more than one IRR
for a particular investment
IRR could be negative whereas NPV
would be positive
International capital budgeting
Application of the principles of domestic capital
budgeting, to projects across the Borders.
Hence all the stages of capital budgeting such as
>identification of projects
>calculation of cash flows
>evaluation of cash flows and
> selection of projects
would apply to international capital budgeting
also, but subject to additional risks due to
external environment
Investing country is parent /home country
and where to be invested is host /foreign
country
Decision as to invest in a particular country
or not depends upon the risk adjusted value
the investment would add to the parent investors.
Hence opportunity cost of investment and
discounted incremental cash flow, that is
repatriable funds, alone had to be taken into
consideration
International capital budgeting decisions
under two situations
1.Under situations when there are no barriers in
host country for repatriation of funds, i.e
>full convertibility,
>equilibrium rate of exchange,
>similar rate of taxation to that of parent country,
>no political risk.

Identifying project opportunities
1. Locational advantages -internalization of
specific advantages -ecological, demographic,
ethnical, governmental concessions
2. Imperfect market and product differentiation in
host country
3. Transfer cost saving
4. Product life cycle



Cash outflow
Investment in fixed assets and working capital.
Equipment to be used for foreign project should
be valued at the highest of
>replacement cost
>net realisable value
>PV of the asset during its residual life

Cash inflow
3 sets of cash flows need to be prepared
1. Project cash flow as such
2. Parents cash flow without the project
3. Incremental cash flow 2-1 incremental
cost (cannibalisation) +incremental
benefits( sales creation, transfer pricing
and fees, royalties etc)
Weighted average cost of capital
Risk adjusted rate of return
weighted average cost of capital of the
project adjusted to the risks (other than
cross border risks).
Or
A higher rate than parents cost of capital
Discounting
Adjusted present value (APV) which consists of
1.PV of operating cash flows of the project+
2. PV of tax shields+
3.PV of subsidies and other benefits
Instead,
Cash inflow= repatriable part of PAT
+Depreciation added back- risk premia +
incremental benefits.
Discounted by risk adjusted rate
2.When there are barriers for repatriation
due to
>Political risk
>Exchange controls
>Differential taxation
>exchange rate fluctuations,
Then only the repatriable cash flow has to
be taken as cash inflow

Political risk
>political instability of host country
>level of violence in host country
>armed insurrections in host country
>conflict with other countries
>fiscal irresponsibility in host country
>controlled exchange in host country
Political risks
BusinessEnvironment Research Institute
S.A.(BERI) is the US based private source
for comprehensive ratings, analyses, and
forecasts for over 140 countries.
Its latest report is for 2005
POLITICAL RISKS MINIFESTED IN
1. Exchange controls
2. Expropriation
Exchange control (in host country)
>forbidding/controlling earnings to be held by
nationals
>national holding foreign currency assets
controlled
>demand for foreign currency restricted and
controlled
>repatriation controlled
= blocked remittance
How to overcome
>transfer pricing under invoice exports from
host and over invoice supplies to host
>charge fees, royalties, franchises with
governmental consent
>leading and lagging- recover from host fast
but delay payments to host
>avail more loans from host country for the
project than subscribing to equity by
parent
>counter trade-barter, counter purchase and
buy back
>use blocked currency to buy capital goods
for use by other units
>avail services in blocked currency
>carry out R&D in blocked country
>conduct conferences, conventions etc in
blocked country

Expropriation
Expropriation is the act of removing
ownership / control from the owner of an
item of property
It is confiscation of the foreign asset for the
compensation of a pittance payment.
If known in advance, avoid such investmets
Or insure or eneter into undersatnding with
the government
After investment- prevention / avoidance
>Agreeing to hire host country personnel
>Accepting local partners
>surrendering majority control to locals
>supporting government programmes
>contributing to political campaign


If expropriation not preventable, find out
probability of political risk
PR = PV of project cash flows /PV of cash
flows to be foregone

Exchange exposures
Exposures are degrees to which parent
companys finances are affected by exchange
rate changes in the host country between two
reporting periods.
At the end of a financial period. parent company
(home country) consolidates its financials by
incorporates the data of its overseas operations
(host country) -balance sheet and profit and loss
account- into its books.
Exposures Depend up on
functional currency
Functional currency is the accounting unit in
foreign (host ) units operations. Reporting
currency is the currency into which the host
units accounts are to be translated.
If functional currency is home (parent)
currency, both the functional and reporting
currencies are same and needs no translation.
When functional currency is home
/foreign currency
When host (foreign) operation is a branch,
functional currency is home currency. FC&RC
are same
In subsidiaries and affiliates, it is the host/local
currency is functional currency, except
When there is heavy inflation in local country.
Then functional currency will be parent currency
If functional currency is host currency
(foreign), then the transactions are
exposed to foreign exchange rate
fluctuations

At what rate of exchange the data has to be
incorporated
Different rates of converting foreign currency
>at historic rate, rate prevailing at the time of
transaction
>at current rate-rate prevailing as on the
date of the final reports
>at average rate- the rate on the opening
date and that on closing dateadded and
divided by 2


Types of exposures
1.. Accounting Exposures
< Translation
< Transaction
2. Economic Exposures

Translation exposure
Translation exposure is the exchange rate
risk while incorporating the statements in to the
parent companys books.
All items are not exposed equally. Items are
categorised into exposed assets and liabilities and
non-exposed assets and liabilities and revenues
and costs .

Modes of valuing translation
exposure
>Current / Non- current method
>Monetary / Non monetary method
>Temporal method
>Current rate method
Categorisation and treatment of exposed
and non-exposed items are treated
differently under different modes of
translation

1.Current / non Current
Under this method assets and liabilities are
categorised into current and non-current.
Al current assets and current liabilities (exposed )
are translated at current exchange rate.
All non-current assets and non-current liabilities
(not exposed) at historic rate
Income statement translated at average exchange
rate


Rule :
1. Translate C.A. and C.L. at current rate as
at the time of the report
2. Non CA/CL at historic rate as prevailed on
the date of transaction
3. Items in P&L a/c translated at average rate
of exchange except those related to non-c/a
2. Monetary / Non Monetary
Claims by or to the business (CA Inventory, C.L.
LT Liabilities) are monetary. Others (physical
assets, including inventory) and investments
non-monetary.
Monetary claims(exposed) translated at current
rate
Non- monetary (not exposed) at historic rate
P&L (except arising out of non-monetary items) at
average rate.
Costs/benefits arising out of non-monetary items at
historic rate
3. Temporal
Same as monetary method , except
The treatment of inventory.
If inventory valued at market price, it is
translated at current rate. Otherwise, historic
rate
4. Current Rate
Everything in balance sheet and profit and
loss account translated at current rate
One variant of the method is to treat net
fixed assets at historic rate and the rest at
current rate
US adopted as per FASB 8 (Based on temporal
method) since 1976
Before that, US companies created a
reserve to which all unrealised exposure
losses and gains were transferred.
FASB 8, disallowed the creation of reserve.
Losses and gains were to be accounted in the
parents account.
OPPOSITION TO THE STANDARD

1981,US introduced FASB 52
Translation of assets and liabilities at current
exchange rate and the income statement at
at weighted average rate
Losses and gains of translation to be
accumulated in transaction adjustment
account under equity

Management of translation exposures
Transaction exposures
TE is the possibility of future exchange
gains or losses on transactions already
entered into and denominated in host
Currency.
Receivables or payables

Management of transaction exposures-hedging,
money market hedging, pricing strategy, risk
sharing,
1.Hedging- forward, future, options
bid/ call fore receivables; ask or put for
payables
2.Money market hedging-Indian receivableRs.10
m to be received in 3 months; spot rate
$=Rs.40.75; rate of interest India 15% and US
10%.Rs.10m =
Management of accounting
exposures

>Hedging through derivatives
>Money market hedging
>Risk shifting (Export in hard imports in soft)
>Risk sharing
>Pricing (after adjusting for hedging loss/gain)
>Netting (swaps)