It is well known that during a period of inflation, the project cost is bound to escalate on allheads viz. labours, raw material, cost of fixed assets, building materials, remunerations of technician and managerial personnel etc. Besides, such conditions erode the purchasingpower of the consumers and are likely to affect the pattern of demand. Thus, not only thecosts of production but also the projected statements of profitability, cash flows etc., will getseriously affected. Financial institutions may revise their lending rates of interest during suchinflationary times. IN these circumstances, project appraisal has to be done generally keepingin view the following guidelines which are adopted normally by governmental agencie s, banksand financial institutions.(a) It is always advisable to make provisions for cost escalation for all heads keeping in mindthe rate of inflation, likely delay in completion of project etc.(b) The various sources of finance should be scrutinized carefully with response to possiblerevision in the rates of interest by lenders which will affect the cost of borrowing, thecollateral securities offered, margins required etc.(c) Adjustments are to be made in the profitability and cash flow projections to take care of the inflationary pressure affecting future projections.(d) It is also advisable to critically examine the financial viability of the project at the revisedrates and reasons the economic justification of the project. The appropriate measu re for this is the economic rate of return for the project which will equate the present cost of capital expenditure to net cash flows over the project life. The rate of return should beacceptable which also accommodates the rate of inflation.(e) In an inflationary situation, projects having early pay back periods should be preferredbecause projects with a longer pay back periods may tend to be risky.Because inflation can have major effect on business, it is critically important and must berecognized.
The most effective way to deal with inflation is to build into each cash flowelement, using the best available information about how each element will be affected, sinceone cannot estimate future rates of inflation, errors are bound to be made. There fore, inflationadds to uncertainty, riskness and complexity to capital budgeting. Fortunately, computers andspread sheet models are available to help inflation analysis. Thus, in practice, the mechanicsof inflation adjustments are not difficult.
What are the issues that need to be considered by an Indian investor and incorporated withinthe Net Present Value (NPV) model for the evaluation of foreign investment proposals?
(8 marks) (November, 2000)
The issues that need to be considered by an Indian investor and incorporated within the NetPresent Value (NPV) model for the evaluation of foreign investment proposals are thefollowing:(1)
Taxes on income associated with foreign projects
: The host country levies taxes (ratesdiffer from country to country) on the income earned in that country by the Multi NationalCompany (MNC). Major variations that occur regarding taxation of MNC
s are as follows:(i) Many countries rely heavily on indirect taxes such as excise duty, value added taxand turnover taxes etc.(ii) Definition of taxable income differs from country to country and also someallowances e.g. rates allowed for depreciation.