MCOM Semester IV Module : International Financial Management …commerce.du.ac.in/web/uploads/e - resources 2020 1st/M... · 2020-04-21 · MCOM –Semester IV ... each year's cash

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 decisions of MNC

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.

Capital Budgeting decisions of MNC 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


Q: A MNC has to set up a manufacturing plant in India involving an initial outlay of Rs 60 million. The plant is expected to have a useful life of 5 years with Rs. 15 million salvage value. The MNC follows SLM of depreciation. To support additional level of activity, investment would 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 MNC is subjected to 35% tax rate and its cost of capital is 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


Q: A MNC has to set up a manufacturing plant in India involving an initial outlay of Rs 80 million. The plant is expected to have a useful life of 10 years with Rs. 20 million salvage value. The MNC follows SLM of depreciation. To support additional level of activity, investment would 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 MNC is subjected to 45% tax rate and its cost of capital is 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 ($) [email protected]%

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.

Documents

MCOM Semester IV Module : International Financial Management …commerce.du.ac.in/web/uploads/e - resources 2020 1st/M... · 2020-04-21 · MCOM –Semester IV ... each year's cash