Multinational Capital Budgeting Process

Multinational Capital Budgeting

 Capital Budgeting

•

 Capital Budgeting may be defined as the decision

making process by which firms evaluate the purchase

of major fixed assets including premises, machinery

and equipment.

•

Capital budgeting is the process of identifying,

evaluating, and implementing a firm’s investment

opportunities

Multinational capital budgeting

•

like traditional domestic capital budgeting, focuses

on the cash inflows and outflows associated with

prospective long-term (foreign) investment

projects. 

Multinational capital budgeting

 has the

same theoretical framework as domestic capital

budgeting

Multinational capital budgeting

•

Multinational corporations (MNCs) evaluate international

projects by using multinational capital budgeting, which

compares the benefits and costs of these projects.

Multinational capital budgeting involves determining the

project’s net present value by estimating the present value of

the project’s  future cash flows and subtracting the initial

outlay required for the projects. Some special  circumstances

of international projects that affect the future cash flow or the

discount rate used to discount cash flow make multinational

capital budgeting more complex

Multinational capital budgeting

•

Analysis involves estimating annual cash flows

and salvage value to be received by the

parent, and then computing the net present

value (NPV) of the project.

•

Capital budgeting is necessary for all longterm

projects that deserve consideration.

Why Multinational capital budgeting

•

Many international projects are irreversible and cannot be

easily sold to other corporations  at a reasonable price

•

Proper use of multinational capital budgeting can identify

the international projects worthy  of implementation.

•

It affects the profitability of a firm.

•

It effect over a long time spans and inevitably affects the

company’s future cost structure.

•

Capital investment decision once made, are not easily

reversible without much financial loss of firm

•

It involves cost and the majority of the firms have scarce

capital sources.

Factors to Consider in Multinational Capital Budgeting

•

Exchange rate fluctuations

. Different scenarios should

be considered together with their probability of

occurrence.

•

Inflation

. Although price/cost forecasting implicitly

considers inflation, inflation can be quite volatile from

year to year for some countries.

•

Ž

Financing arrangement

. Financing costs are usually

captured by the discount rate. However, many foreign

projects are partially financed by foreign subsidiaries.

•

Blocked funds

. Some countries may require that the

earnings be reinvested locally for a certain period of

time before they can be remitted to the parent.

Factors to Consider in Multinational Capital Budgeting

•

Uncertain salvage value

. The salvage value typically

has a significant impact on the project’s NPV, and the

MNC may want to compute the break-even salvage

value.

•

Impact of project on prevailing cash flows

. The new

investment may compete with the existing business

for the same customers.

•

Host government incentives

. These should also be

considered in the analysis.

Input for Multinational Capital Budgeting

1.      Initial investment

2.      Consumer demand

3.      Product price

4.      Variable cost

5.      Fixed cost

6.      Project lifetime

7.      Salvage (liquidation) value

8.      Fund-transfer restrictions

9.      Tax laws

10.  Exchange rates

11.  Required rate of return

Multinational capital budgeting

•

Capital budgeting for multinational firms uses the

same framework as domestic capital budgeting.

However, multinational firms engaged in evaluating

foreign projects face a number of complexities, many

of which are not there in the domestic capital

budgeting process.

Foreign Complexities

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. The various factors are:

1.

Parents cash flows are different from project cash flows.

2.

All cash flows from the foreign projects must be converted

into the currency of the parent firm.

3.

Profits remitted to the parent are subject to two taxing

jurisdictions – the parent country and the host country.

Foreign Complexities

4.

Anticipate the differences in the rates of

national inflation as they can result in changes in

competitive position and thus in cash flows over

a period of time.

5.

The possibility of foreign exchange risk and its

effect on the parent’s cash flows.

6.

If the host country provides some concessionary

financing arrangements and/or other benefits,

the profitability of the foreign project may go

up.

Foreign Complexities

7. Initial investment in the host country may benefit from a partial or

total release of blocked funds.

8. The host country may impose various restrictions on the distribution

of cash flows generated from foreign projects.

9. Political risk must be evaluated thoroughly as changes in political

events can drastically reduce the availability of expected cash flows.

10. It is more difficult to estimate the terminal value in multinational

capital budgeting because potential buyers in the host or parent

company may have widely different views on the value to them of

acquiring the project.

Problems and Issues in Foreign Investment

Analysis

Foreign Exchange Risk

•

Multinational firms investing abroad are exposed to foreign exchange risk

– the risk that the currency will appreciate or depreciate over a period of

time. Understanding of foreign exchange risk is important in the

evaluation of cash flows generated by the project over its life cycle. To

incorporate the foreign exchange risk in the cash flow estimates of the

project, first an estimate is made of the inflation rate in the host country

during the life span of the project. The cash flows, in terms of local

currency, are then adjusted upwards for the inflation factor. Then the cash

flow are converted into the parent’s currency at the spot exchange rate

multiplied by an expected depreciation or appreciation rate calculated on

the basis of purchasing power parity. In certain specific situations, the

conversion can also be made on the basis of some exchange rate accepted

by the management.

Remittance Restrictions

•

Where there are restrictions on the repatriation of

income, substantial differences exist between project

cash flows and cash flows received by the parent firm.

Only those flows that are remittable to the parent are

relevant from the MNC’s perspective.

•

Many countries impose a variety of restrictions on

transfer of profits, depreciation and other fees accruing

to the parent company. Project cash flows consist of

profits and depreciation charges whereas parent’s cash

flows consist of the amounts that can be legally

transferred by the affiliate.

Remittance Restrictions

•

In cases where the remittances are legally limited, the restrictions

can be circumvented to some extent by using techniques like

internal transfer prices, overhead payments, and so on. To obtain a

conservative estimate of the contribution by the project, the

financial manager can include only the income which is remittable

via legal and open channels.

•

If this value is positive no more additions are made. If it is negative,

we can add income that is remittable via other methods (not

necessarily legal). Another adjustment in multinational capital

budgeting is the problem of Blocked Funds. Accounting for blocked

funds in the capital budgeting process depends on the opportunity

cost of blocked funds.

Tax Issue

•

Both in domestic and multinational capital budgeting, only

after-tax cash flows are relevant for project evaluation.

However, in multinational capital budgeting, the tax issue is

complicated by the existence of two taxing jurisdictions,

plus a number of other factors.

•

The other factors include the form of remittance to the

parent—dividends management fees, royalties, etc., tax

withholding provision in the host country, existence of tax

treaties, etc. In addition, tax laws in many host countries

discriminate between transfer of realised profits as against

local reinvestment of these profits.

•

The ability of the multinational firm to reduce its overall tax

burden through the transfer pricing mechanism should also

be considered.

Tax Issue

•

To calculate the actual after-tax cash flows accruing

to the parent the higher of the home or host country

tax rate can be used.

•

This will represent a conservative scenario in the

sense that if the project proves acceptable under this

alternative then it will necessarily be acceptable

under the more favourable tax scenario.

•

If not, other tax saving may be incorporated in the

calculation to determine whether or not the project

crosses the hurdle rate.

Project versus Parent Cash Flows

•

Substantial differences can exist between the project

and parent cash flows because of tax regulations and

exchange controls. Also, expenses such as

management fees and royalties are returns to the

parent company. In the light of substantial differences

that can exist between parent and project cash flows,

the important question is on what basis should the

project be evaluated. Should the project be evaluated

on the basis of

1. Its own cash flows?

2. Cash flows accruing to the parent company?

3. Both?

Project versus Parent Cash Flows

•

Evaluating a project on the basis of its own cash

flows serves some useful purposes. The project must

be able to compete successfully with other domestic

firms and also earn a rate of return in excess of its

locally based competitors. If not, the management

and the shareholders of the parent company would

be better off investing in the equity/government

bonds of local firms.

Project versus Parent Cash Flows

•

However, such a comparison is many times not

possible because most foreign projects replace

imports and generally do not compete with existing

local firms. Yet, evaluating projects on the basis of

local cash flows has the advantage of avoiding

currency conversion and hence eliminating problems

involved with fluctuating/forecasting exchange rates

changes for the life of the project.

Project versus Parent Cash Flows

•

A strong theoretically valid criterion in financial management is to

evaluate the foreign project from the viewpoint of the parent

company. Cash flows which are actually remitted to the parent are

the ultimate yardstick for company performance and form the basis

for distribution of dividends to the shareholders, repayment of

interest and debt to lenders and other purposes.

•

This helps in determining the financial viability of the project from

the viewpoint of the MNC as a whole. The cash flows that are

remitted to the parent consist of both operating cash flows and

financial cash flows like fees and royalties, interest on loans given

by the parent.

•

However, the theory of capital budgeting postulates that an

investment should be evaluated only on the basis of net after-tax

operating cash flows generated by the project. Since these flows

are usually lumped together, care should be taken that financial

cash flows are not mixed with operating cash flows.

Project versus Parent Cash Flows

•

Stonehill and Nathanson have suggested a three-stage financial

analysis of foreign projects. In the first stage, project cash flows are

computed and analysed from the viewpoint of the subsidiary or the

affiliate as if it were a separate entity.

•

The second stage involves evaluation of the profit on the basis of

forecasts of cash flows which will be transferable to the parent

company.

•

In the third and last stage, the analysis from the viewpoint of the

parent company is widened to include indirect benefits or costs

from the company as a whole, which are attributable to the foreign

project in question.

•

Various surveys conducted over a period of time

show that MNCs evaluate foreign projects from

both the parent’s and the project’s viewpoints.

Surveys conducted by Stonehill and Nathanson

(1968), Baker and Beandsley (1973), Oblak and

Helm (1980), Bavishi (1981), Stanley and Block

(1983) reveal that firms calculate and evaluate

rates of returns by using cash flows to and from

the parent as well as to and from foreign project

alone.

•

Thus, most firms generally evaluate foreign projects

from both parent and project viewpoints. Evaluating

and analysing cash flows from both viewpoints reveals

important aspects about the project’s competitiveness

and its contribution to the company as a whole. The

project viewpoint provides a closer approximation of

the effect on consolidated earnings per share, which all

surveys mention is of major concern to practising

managers. The parent’s viewpoint gives results closer

to the traditional meaning of net present value in

capital budgeting.

Techniques of Capital Budgeting

Techniques of Capital Budgeting

•

The process of evaluating specific long-term

investment decisions is known as the capital budgeting

or capital expenditure decision. This decision is one of

the critical decisions faced by the finance managers

and is crucial to the success of a company. Companies

devote significant time and effort in planning capital

budgeting decisions because a company that makes a

mistake in its capital budgeting process has to live with

that mistake for a long time. Two popularly used

discounted cash flow techniques of capital budgeting

are the Net Present Value (NPV) and Internal Rate of

Return (IRR).

Net Present Value

•

The NPV method explicitly recognizes the time value of

money. Companies use the NPV method when they

have to decide whether to continue with the existing

equipment or buy new equipment that would increase

production efficiency. The NPV method is important

because it expresses in absolute terms the benefit of

the project to the shareholders. NPV is the most

popular method and is defined as the present value of

future cash flows discounted at an appropriate rate

minus the initial net cash outlay for the projects. The

discount rate used here is known as the cost of capital.

The decision criteria

Net Present Value

•

To implement the NPV method you need:

1. To calculate the present value of the expected

cash inflows and outflows discounted at the

project’s cost-of-capital rate.

2. To subtract the present value of the cash inflows

from the present value of the initial net cash

outflows to calculate the NPV of the project.

3. If the NPV of a project is positive, accept the

project; if not reject the project.

Net Present Value

•

The accept-reject criterion can be specified as:

•

NPV > 0—– > Finance manager accepts the

investments

•

NPV < 0—– > Finance manager rejects the

investments

•

NPV = 0—– >Finance manager is indifferent

toward acceptance or rejection of the project

Internal Rate of Return

•

The IRR method is a discounted cash-flow

technique. Similar to the NPV method, it takes

into account the magnitude and timing of cash

flows. IRR is defined as the discount rate that

equates the present value of expected future

cash inflows with the present value of the

project’s initial cash outflows. Various empirical

surveys have shown that companies prefer the

IRR method because it is a relative measure of

the projects worth.

•

In the IRR method, you calculate the discount

rate to make the NPV of the project zero. This

means that in the IRR method, you equalize the

net cash proceeds over a project’s life with the

initial investment outlay. The IRR for a project is

then compared with the hurdle rate, which is the

company’s market-determined required rate of

return. If the IRR exceeds the cost-of-capital rate

the project is accepted, otherwise it is rejected.

The IRR calculation is generally a trial-and-error

exercise because the rate is unknown.

•

The accept-reject for the IRR criterion can be

specified as:

•

If IRR > k Accept the project

•

If IRR < k Reject the project

•

If IRR = k Indifferent between acceptance and

rejection of the proposal.

Adjustment for Risk: Cash Flows versus

Discount Rate Adjustment

•

Another important dimension in multinational capital budgeting is

whether to adjust cash

•

flows or the discount rate to account for the additional risk that arises

from the foreign location

•

of the project.

•

Traditionally, MNCs have adjusted the discount rate by moving it upwards

for riskier projects

•

to reflect the political and foreign exchange uncertainties. A significant

number of firms that use

•

the DCF technique in domestic projects also assign different hurdle rates

for different projects,

•

depending on their risk categories. Adjusting the discount rate is quite a

popular method with

•

MNCs mainly because of its simplicity and the rule that the required rate

of return of a project

•

should be in accordance with the degree of risk which it is exposed to.

•

Adjusting the discount rate for political risk thus

penalises early cash flows too heavily while

•

not penalising distant cash flows enough. As far

as the foreign exchange risk is concerned,

•

adjusting the discount rate to offset the exchange

risk is an oversimplification. This is so because

•

only adverse exchange rate movements are

expected whereas it is entirely possible for a MNC

•

to many times gain from favourable overall

currency movements during the life of the

project.

•

The other alternative is to adjust cash flows rather than the

discount rate in treating risk. The

•

annual cash flows are discounted using the applicable rate for that

type of project either at the

•

host country or at the parent country. Probability and certainty

equivalent techniques like

•

decision tree analysis are used in economic and financial

forecasting. Cash flows generated by

•

the project and remitted to the parent during each time period are

adjusted for political risk,

•

exchange rate and other uncertainties by converting them into

certainty equivalent. The method

•

of adjusting the cash flows rather than the discount rate is generally

the more popular method

•

and is usually recommended by finance

managers. There is generally more

information on the

•

specific impact of a given risk on a project’s

cash flows than on its discount rate.

Financing Arrangement

•

In some cases, the governments of countries are willing to provide loans at

subsidized rates so

•

as to stimulate investment in specific sectors. The value of a project will then be

determined by

•

the manner in which it is financed. For example, many times, international

agencies in order to

•

promote cross border trade finance at below market rates. In the case of

subsidized financing, it

•

is important to determine, if the subsidized financing is separable or not from the

project. When

•

the subsidized financing is inseparable from the project, the value of the loan

should be added

•

to that of the project in making the investment decision. When subsidized

financing is separable

•

from the project, the additional value from the subsidized financing should not be

allocated to

•

the project.

Blocked Funds

•

Blocked Funds are cash flows generate by a foreign

project that cannot be immediately transferred

•

to the parent, usually because of exchange controls

imposed by the government of the country

•

in which the funds are held. Some countries require

that the earnings generated by the subsidiary

•

be reinvested locally for at least a certain period of

time before they can be remitted to the

•

parent. Blocked funds cause a discrepancy between the

project value from the parent’s and local

•

perspective. Also, this can possibly affect the

accept/reject decision for a project.

Inflation

•

The impact of inflation on the parent’s and

subsidiary’s cash flows can be quite volatile from

•

year to year for some countries. It may cause the

currency to weaken and hence influence a

•

project’s cash flows. Also, inaccurate inflation

forecast by a country, can lead to inaccurate cash

•

flow forecasts. Thus, MNCs cannot afford to

ignore the impact of inflation on the cash flows.

Uncertain Salvage Value

•

The salvage value of a project has an important

impact on the NPV of the project. When the

•

salvage value is uncertain, the cash flows will not

be accurate and the MNC may need to

•

calculate various possible outcomes for the

salvage value and estimate the NPV based on

each

•

possible outcome. The feasibility of the project

may then depend upon the present value of the

•

salvage value.

Questions

•

What are blocked finds? Elucidate with examples.

•

Examine the impact of exchange rate movements

on cash flows to the parent/to the subsidiary.

•

Describe the various methods of capital

budgeting that are normally adopted by MNCs.

•

What additional factors deserve consideration in

multinational capital budgeting that are not

normally relevant for a purely domestic project?

•

Why should capital budgeting for subsidiary

projects be assessed from the parent company’s

perspective? Give reasons.

FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

•

Once a firm has compiled a list of prospective investments, it

uses capital budgeting techniques, to select from among them

that combination of projects that maximizes the firm‘s value

to shareholders. The theoretical framework involved in

evaluation of domestic projects is the same as for foreign

projects and various considerations influencing choice of a

project within the country are the, same as those for projects

overseas. However, there are a host of factors which are

unique to foreign investments that make cross-border

investment decisions complicated.

FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

•

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.

FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

•

As stated earlier, the above evaluation process

becomes complicated because of the factors peculiar

to international operations. Some of the factors

unique to capital budgeting for MNCs are:

FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

1. Conversion of cash flows from foreign projects into

the currency of the parent firm;

2. Restrictions on full remittance of cash flows from

foreign projects;

3. Exchange Rate fluctuations;

4. Application of different tax rates in the country of the

project and in the parent's country;

5. Involvement of royalties and management fees;

FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

6. Amenities and concessions granted by host country;

7. Benefits of international diversification to the

shareholders of parent firm;

8. Lost exports;

9. Difficulty in estimating terminal value of foreign

projects;

10. Differing rates of national inflation;

11. Knock-on effects of overseas investment projects on

other operations elsewhere;

12. Political risk involved in foreign investment.

Fixed Exchange Rate

•

In a fixed exchange rate system, the government of a

country can peg its currency to the currency of another

country. It is normally done in a case where the other

currency accounts for a sizeable trade with that

country. The currency of Bhutan is, for example,

pegged to Indian rupee.

•

A currency can be pegged to a basket of currencies.

Indian rupee was, for example, pegged to a basket of

five currencies prior to 1993. The reason is that the

appreciation and depreciation of currencies in the

basket make the weighted average comparatively

stable.

Fixed Exchange Rate

•

A few currencies were pegged to SDRs when the latter was more stable.

But now no currency is pegged to SDRs.

•

Sometimes pegging is a legislative commitment that 'is often known as the

currency board arrangement. The currency board pegs the domestic

currency to another nation‘s currency and buys and sells foreign currency

reserves in order to maintain the parity value. Again, it is a fact that the

exchange rate is fixed in case of pegging, yet it fluctuates within a narrow

margin of +/- 1.0 per cent around the central rate. On the contrary, in

some countries, the fluctuation band is wider and the arrangement is

known as pegged exchange rates within horizontal bands.

Fixed Exchange Rates

•

Fixed exchange rates are “fixed” by the government and not

determined by market forces, and only small deviations from

this fixed value is possible. With fixed exchange rates, foreign

central banks buy and sell their currencies at a fixed price. A

fixed exchange rate is generally seen as being transparent and

a simple anchor for monetary policy. An example of this

system was used under the Gold Standard where each

country committed itself to convert freely its currency into

gold at a fixed price. The value of each foreign currency was

defined in terms of gold and the exchange rate was fixed

according to the gold value of currencies that had to be

exchanged.

Fixed Exchange Rates: Pros & Cons

•

Proponents in favor of fixed exchange rates show that it

ensures stability in the exchange rate that stimulates

foreign trade, contributes to the coordination of macro

policies of countries, and is more conducive to the

expansion of world trade because it prevents risk and

uncertainty in transactions involving speculation in foreign

exchange markets. Some drawbacks of fixed exchange rates

include the fear of devaluation, where a central bank may

use its reserves to maintain the foreign exchange rate, and

when reserves are exhausted that compels the government

to devalue its domestic currency. Additionally, the benefits

of free markets are deprived since everything is fixed and

there is the possibility of under/over valuation.

Floating Exchange Rate

•

Floating exchange rate is determined by the market forces of

supply and demand. A particular currency is subject to

fluctuations depending upon the changes in the demand and

supply positions. Suppose the exchange rate between Indian

rupee and the US dollar is determined by the demand for, and

supply of, US dollar in the foreign exchange market. If dollar

experiences greater demand, the value of dollar vis-a-vis

Indian rupee will appreciate; or in other words, Indian rupee

will depreciate vis-a-vis US dollar. On the other hand, if supply

of US dollar increases, the reverse will be the case.

Floating Exchange Rate

•

Floating rate system may be either independent or it may be

managed. Theoretically speaking, there is no intervention by

the central bank of a country in case of the independent

floating. On the contrary, it does occur in a managed floating

rate system. But the experiences show that intervention is a

common phenomenon irrespective of the system being

independent or managed. It is because of this fact that the

IMF gives a clarification. If the purpose of intervention is to

moderate the exchange rate and to check undue fluctuation,

it will be an independent floating. But if the central bank

intervenes to establish a level for the exchange rate, this will

be a case of managed floating.

Flexible Exchange Rates

Flexible exchange rates are determined by forces of demand

and supply of the foreign exchange market and the value of

currency can float freely in tandem with the change in

demand and supply of foreign exchange. With flexible

exchange rates, the nation’s central bank allows the exchange

rate to be commensurate with the supply and demand of the

foreign currency. Flexible exchange rates have the advantage

that they allow a country to pursue an independent monetary

policy, rather than have its own monetary policy set by an

anchor currency country.

Fixed Rates versus Flexible Rates

Fixed Rates versus Flexible Rates

•

After delineating the features of the fixed and the

floating exchange rate regimes, it would be

worthwhile to pinpoint which one of the two is more

suitable. The advocates of the floating rate argue

that:

Fixed Rates versus Flexible Rates

•

The exchange rate changes automatically with the

changes in the macro-economic fundamentals. As a

result, there does not appear any gap in the real and

the nominal exchange rates. The economy remains

free from any ill effects of the emergence of such a

gap.

Fixed Rates versus Flexible Rates

•

The floating rate regime possesses insulation

properties meaning that the currency of a country is

not influenced by the changes in the macro-

economic fundamentals in the other country. In

other words, currency shocks emanating in one

country does not permeate to other countries.

Flexible Exchange Rates: Pros & Cons

•

Proponents of floating exchange rates argue that

is generally agreed and accepted that major

currencies (dollar, euro and yen) float against one

another. These currencies represent economies

that account for nearly half of global all economic

activity and virtually all global trade is

denominated in one of these three currencies.

Flexible exchange rates also allow a country to

have its own monetary policy, free from the

constraints set by another country.

Flexible Exchange Rates: Pros & Cons

•

Flexible exchange rates are more resilient in troubled times

and can distribute the burden of adjustment between the

external sector and the domestic economy more seamlessly.

Some drawbacks of flexible exchange rates are the creation of

potentially unstable conditions where instability and

uncertainty may exist. Another drawback is that flexible

exchange rates can cause extreme fluctuations in

imports/exports and undermine the economic stability of a

nation. Flexible exchange rates also expose itself to

inflationary risk due to the exchange depreciation on the

nation’s price level.