TERM PAPER

On

Capital budgeting for Foreign Investment in Local Market

Course Name: Financial Management

Course Code: ALD 2202

Prepared by:
Rafiquzzaman Biplob (17211002)
Greg Anindya Talukder (17211042)
Md Imran Hossain (17211036)
Rafsan Rahman Mitchel (17211026)
Saiful Mahmud Abir (17211038)
Md Atiqur Rahman (17211054)

Prepared for:
Debashis Saha
Adjunct Faculty
Faculty of Business Studies
Bangladesh University of Professionals

Date of Submission:
1st November, 2018

Bangladesh University of Professionals

Letter of Transmittal
25th October, 2018
Debashis Saha
Adjunct Faculty
Department of Bachelors in Business Studies
Bangladesh University of Professionals

Subject: Application for Accepting the Report

Dear Sir,

We like to state that the undersigned students of AIS-2 (B) batch have reported on “Capital
budgeting for foreign investment in local market” under the course: Financial Management.
In this report we, try to find out the techniques of capital budgeting for foreign investors to
invest in local markets.
We hope that this request will meet your approval.

Sincerely,

_____________ _____________ _____________

Rafiquzzaman Biplob Md Atiqur Rahman Greg Anindya Talukder

_____________ _______________ _____________

Saiful Mahmud Abir Rafsan Rahman Michael Md Imran Hossain

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 Acknowledgement
First of all, thank goes to almighty Allah who has created us and provided us with the
wisdom required for this study.

We are really thankful to our respected faculty Debashis Saha for his continuous guidance
henceforth. His guidance has been of extreme help to us.

We also like to thank those whose work inspired and helped us to conduct this study on this
particular topic and those who have helped us throughout the period.

Finally thanks to our friends for their continuous support and love inspired us all the time.

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Table of contents

Contents
Letter of Transmittal..............................................................................................................................1
Acknowledgement.................................................................................................................................2
Table of contents...................................................................................................................................3
Executive summary...............................................................................................................................4
Introduction...........................................................................................................................................5
Literature Review..............................................................................................................................5
The Foreign Investment Decision-Making Process................................................................................8
Foreign Direct Investment (FDI).............................................................................................................8
Fundamentals of Evaluating Foreign Projects........................................................................................8
Legal Protection:..................................................................................................................................16
Issues Related to Foreign Investments Analysis..................................................................................16
Categorizing subsidies...................................................................................................................19
Broad and narrow.....................................................................................................................19
Economic Effects of Subsidized Financing..................................................................................19
Tax Holidays......................................................................................................................................21
Tax Holidays in Bangladesh..........................................................................................................22
Lost Exports.......................................................................................................................................23
International Diversification Benefits..............................................................................................23
Factors to consider in Capital Budgeting.........................................................................................26
Inputs for Capital Budgeting............................................................................................................26
Capital Budgeting Case.....................................................................................................................29
RISK ANALYSIS IN INTERNATIONAL. INVESTMENT DECISION...............................................................33
Conclusion...........................................................................................................................................35
Questions............................................................................................................................................36

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 Executive summary

The term paper titled “Capital Budgeting for Foreign Investments in Local Market” is an
analytical study about the importance of capital budgeting and its various procedures
necessary for foreign investors to invest in local market. From this study, it can be clearly
understood that capital budgeting is indispensable for a foreign investor if he/she wants to
invest in the local market of a country. Because capital budgeting helps a foreign investor to
analyse the best project for a particular local market, given the available resources, by
determining the initial investment necessary, estimating net cash flows, identifying the
appropriate discount rate and applying NPV or IRR technique. Capital budgeting also
analyses the risk factors for foreign investments. It is a very vast field. Therefore, further
studies can be done on capital budgeting and how it can be applied properly to undertake
foreign investments in local market of other countries.

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 Introduction
Although the original decision to undertake an investment in a particular foreign country may
be the outcome of combination of strategic, behavioural and economic considerations, choice
of a specific project within a particular product-market posture calls for evaluation of its
economic feasibility. For this purpose, capital budgeting exercise has to be done. A firm
should deploy funds in a project if the marginal revenue obtained there from exceeds the
marginal cost. For foreign investors, capital budgeting involves economic analysis of the
firm's direct investment opportunities. Whatever be the motive for Direct Foreign Investment
(DFI), foreign investor very survival and sustainable competitive position depends on its
ability to identify and choose the most profitable investment opportunity. Capital budgeting
technique provides the mechanism to identify opportunities and evaluate their economic
viability. This is why foreign investors 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.

Literature Review
Capital budgeting Capital refers to an investment in goods or services that provide benefits
over a period of time after their acquisition. (Robert D. Reischauer, Brookings Institution,
(April 24, 1998). Capital Budgeting refers the techniques or process used to make good
decisions concerning investments in the long-term assets of the firm. In other words, funds or
capital raised by the firms are basically used to invest in assets or in any investment activities
that will enable the firm to generate revenues several years for future use. Therefore, firm has
to budget how does these funds are invested. Capital budgeting decisions is an important
aspect for firm’s future operations. This is because it has huge impact such as unnecessary
cost which will be more costly with respect to competition for the firm for several years if
decisions failed to plan carefully. In nutshell, the amount of capital available at any given
time for new projects is limited; management needs to use capital budgeting techniques to
determine which projects will yield the most return over an applicable period of time. Popular
methods of capital budgeting include net present value (NPV), internal rate of return (IRR),
discounted cash flow (DCF) and payback period. However each method has it own distinct
advantages and disadvantages when evaluating any projects.
The theory of the determinants of private investment, irrespective of whether it originates
domestically or from abroad, is relevant for an understanding of what drives FDI. This has
become increasingly true with the globalization of world markets, although there remain
additional factors which may inhibit or encourage FDI that would not affect domestic
investment.

Much of the research on the determinants of investment is based on the neoclassical theory of
optimal capital accumulation pioneered by Jorgenson (1963, 1971). In this framework, a
firm’s desired capital stock is determined by factor prices and technology, assuming profit
maximization, perfect competition and neoclassical production functions. This theory was a
deliberate alternative to views expressed initially by Keynes (1936) and Kalecki (1937) that
fixed capital investment

Much of the research on the determinants of investment is based on the neoclassical theory of
optimal capital accumulation pioneered by Jorgenson (1963, 1971). In this framework, a
firm’s desired capital stock is determined by factor prices and technology, assuming profit

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maximization, perfect competition and neoclassical production functions. This theory was a
deliberate alternative to views expressed initially by Keynes (1936) and Kalecki (1937) that
fixed capital investment

The development literature has long been concerned with investment, because of its
importance for the rate of growth of per capita output in the economy (Dornbusch and
Reynoso, 1989:204; Fei and Ranis, 1963:283; IMF, 1988). Although empirical models of the
determinants of investment in developing countries are in broad agreement with results
obtained for industrialized countries, there are additional factors which have been found to
constrain capital accumulation.

Most of these are related to the problem of uncertainty and/or risk, which acts as a
disincentive to private investment, because of the irreversible nature of most investment
expenditures (Pindyck, 1991).

Inflation reduces private investment by increasing risk, reducing average lending maturities,
distorting the informational content of relative prices, and indicating macroeconomic
instability (Dornbusch and Reynoso, 1989:206-208; Oshikoya, 1994:585,590). Empirical
studies show that the variability of inflation has a stronger negative effect on private
investment than does the level (Serven and Solimano, 1993:137).

Some researchers support the notion that FDI contributes to the productivity and growth of
local enterprises. Blomstrom and Sjoholm( 1998) are of the opinion that the productivity and
growth of local enterprises could be achieved through spillover effects/externalities from
FDI.

Empirical research shows that FDI affects the economy of a host country in a variety of ways.
Firstly, it provides the required capital and state -of -the- art technology that enhances
economic growth in the host country (Caves, 1996; Dunning, 1993; Blomstrom and Sjoholm,
1998; Smarzynska, 2002; Akinkugbe, 2005).

In addition, FDI can be expected to encourage economic growth of the host nation, given the
prevailing view that MNE’s can complement the local industry and stimulate growth and
welfare in the host nations (Grossman and Helpman, 1991; Barro and Sala-i-Martin, 1995).

Dunning’s (1981, 1988) ‘electric theory’ provides a flexible and popular framework where it
is argued that Foreign Direct Investment (FDI) is determined by three sets of advantages
which direct investment should have over the other institutional mechanisms available for a
firm in satisfying the needs of its customers at home and abroad. The first of the advantages
is the ownership specific one which includes the advantage that the firm has over its rivals in
terms of its brand name, patent or knowledge of technology and marketing. This allows firms
to compete with the other firms in the markets it serves regardless of the disadvantages of
being foreign. The second is the internationalization advantage that is why a ‘bundled’ FDI
approach is preferred to ‘unbundled’ product licensing, capital lending or technical assistance
(Wheeler and Mody, 1992).

Dar, Presley and Malik (2004) studied the causality and long-term relationship between
Foreign Direct Investment (FDI), economic growth and other socio-political determinants.
Although a considerable literature gives the evidence of relationship between FDI and
economic growth. Their paper considers economic growth, exchange rate and level of interest

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rates, unemployment, and political stability as determinants of the level of FDI inflows for
Pakistan over the period 1970-2002. Almost all variables are found to have the theoretically
expected signs with two-way causality relationship. The present study also estimates an error
correction model by ordinary least squares, based on integrating VAR (2).

Artige and Nicolini (2005) analyse the determinants of FDI (foreign direct investment)
inflows for a group of European regions. The originality of their approach lies in the use of
disaggregated regional data. First, they develop a qualitative description of their database and
discuss the importance of the macroeconomic determinants in attracting FDI. Then, they
provide an econometric exercise to identify the potential determinants of FDI. In spite of
choosing regions presenting economic similarities, they show that regional FDI inflows rely
on a combination of factors that differs from one region to another.

With regards to research on the determinants of FDI to Africa there appears to be a dearth of
literature. A Search on the Econlit database using ‘Foreign Direct Investment’ and ‘Africa’ as

This research extends the limited to empirical literature on the determinants of FDI to Africa
by examining the extent to which the economic, political, institutional characteristics of a
country, as well as the policy environment affect FDI flows.

Nunnekamp (2002) sought to assess whether determinants of FDI have changed with
globalization i.e whether traditional determinants are losing importance whilst nontraditional
ones are increasingly gaining importance. Two approaches were adopted, namely survey data
from European Round Table of Industrialists ( ERT 2000) and simple correlation for 28
developing countries.

The survey results were supplemented by World Bank Data on variables that are considered
important FDI determinants. Results show that traditional market related determinants still
dominate determinants of FDI distribution among the countries considered (Nunnekamp
2002:24). Nontraditional determinants such as cost factors, and trade openness, measured by
ratio of exports plus imports to GDP, have typically not become more important with
globalization. Of importance is the availability of skills which is peroxided by average years
of schooling, which has become a relevant pull factor of FDI in the process of globalization
(Nunnekamp 2002:35).

An analysis of a developing country by (Tsai 1991) focused on Taiwan by providing demand

size determinants of FDI using time series data. Tsai (1991:279) employed OLS method
using equations in logarithm form. Two equations were specified, i.e. first on the demand size
determinants and the second using variables as ratio of GDP to eliminate possible side of
influences. A dummy variable was used to assess the impact of government incentive polices
on FDI in different periods.

Tsai (1991:276) suggests that for Taiwan only labor cost, market size and government
incentive policies are important demand size determinants. Although FDI is seen to exploit
cheap labor in developing countries, the case of Taiwan seems to show that growth in FDI
with rising labor costs indicates the cheap labor may not be as important as expected.

It is generally believed that factors determine FDI inflow in developing countries could have
a different impact on SSA countries in particular. This is because developing countries

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outside Africa seem to attract huge FDI inflow while SSA attracts low levels of FDI as
discussed by Asiedu (2002).

The empirical results of Moolman et al (2006:3) indicate that market size, openness,
infrastructure and the nominal exchange rate are factors which South African policy makers
should focus on when seeking to attract FDI. The FDI output link does not take other factors
such as increased employment, improved skills and new management techniques into account
(Moolman et al 2006:29).

The Foreign Investment Decision-Making Process

The foreign investment decision-making process involves the entire process of planning
capital expenditures in foreign countries beyond 1 year. The 1-year time frame is arbitrary,
but a 1-year boundary is rather widely accepted. There are many steps and elements in this
process. Each element is a subsystem of the capital budgeting system. Thus, the foreign
investment decision-making process may be viewed as an integral unit of many elements that
are interrelated. Here we assume that the entire foreign investment decision-making process
consists of 11 phases: (1) the decision to search for foreign investment, (2) an assessment of
the political climate in the host country, (3) an examination of the company’s overall strategy,
(4) cash flow analysis, (5) the required rate of return, (6) economic evaluation, (7) selection,
(8) risk analysis, (9) implementation, (10) expenditure control, and (11) post-audit.

Foreign Direct Investment (FDI)

Foreign investment is a direct investment into production or business in a country by an
individual or company of another country, either by buying a company in the target country
or by expanding operations of an existing business in that country to gain some measure of
ownership control. Foreign direct investment is in contrast to portfolio investment which is a
passive investment in the securities of another country such as stocks and bonds. Foreign
direct investment (FDI) occurs when a firm invests directly in new facilities to produce
and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational
enterprise

Fundamentals of Evaluating Foreign Projects

Once a firm has compiled a list of prospective investments, it uses capital budgeting
techniques which have been explained .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

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projects overseas. However, there are a host of factors which are unique to foreign
investments that make cross-border investment decisions complicated.

The basic steps involved in evaluation of a project are:

Determine Net Investment Outlay:

1. Initial investment

Initial investment outlay is the amount required to start a business or project. It is also called
initial investment. It equals capital expenditures plus working capital requirement plus after-
tax proceeds from assets disposed off or available for use elsewhere. Capital budgeting
decisions involve careful estimation of the initial investment outlay and future cash flows of a
project. Correct estimation of these inputs helps in taking decisions that increase shareholders
wealth.

Formula: Initial Investment outlay = (Capital Expenditure + Increase in Working Capital -

Disposal Inflows)

2. Estimate Net Cash Flows:

Net cash flows have to derive from the project over time, including salvage value. It is refer
to the difference between a company’s cash inflows and outflows in a given period. In the
strictest sense, net cash flow refers to the challenge in a company’s cash balance as detailed
on its cash flow statement. Investors often hunt for companies that have high or improving
net cash flow but low share prices –the disparity often means the share price will soon
increase. Net cash flow is the fuel that helps companies expands, develop new products, buy
back stocks, pay dividends, or reduce debt.

3. Identify the Appropriate Discount Rate

For determining the present value of the expected cash flow appropriate discount rate is
needed. For example, to determine the present value of $ 1000 a year from now, one needs to
discount it by a particular interest rate. Assuming a discount rate of 10%, the present value
would be $909.09, according to the formula: 1000/(1+0.1). Many companies calculate their
weighted average cost of capital (WACC) and use it as their discount rate when budgeting for
a new project.

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4. Apply NPV or IRR Technique:

This technique is used to determine the acceptability or priority ranking of potential projects.
Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability
of potential investments. Internal rate of return is a discount rate that makes net present value
(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the
same formula as NPV does. IRR is effective when cash flow similar, time horizon is short,
rate of return is similar. But in longer period context NPV is better because of fluctuation of
interest rate.

The above evaluation process becomes complicated because of the factors peculiar to
International operations. Some of the factors unique to capital budgeting for foreign investors
are:

1. Conversion of cash flows from foreign projects into the currency of the parent firm:
Converting the foreign project cash flows to local currency based on expected forward
exchange rate and discounting them based on home country cost of capital. Foreign projects
must be evaluated from the perspective of the parent company. A project might make sense in
the foreign country when executed by a company based in that country but might not be
feasible after considering the foreign exchange risk, taxation and restriction of repatriation of
income back to the home country. Foreign currency cash flows should be projected based on
the foreign currency inflation rate.

2. Restriction on Full Remittance of Cash Flows from Foreign Projects:

Remittance restrictions occur where an overseas government places a limit on the funds that
can be repatriated back to holding company. This restriction may change the cash flows that
are received by the holding company.

3. Exchange Rate fluctuations:

Exchange rates float freely against one another, which means they are in constant fluctuation.
Currency valuations are determined by the flows of currency in and out of a country. A high
demand for a particular currency usually means that the value of that currency will increase.
Currency demand is driven by tourism, international trade, Speculation and the perception of
safety in terms of geo-political risk. For example, if a company in Bangladesh sells products
to a company in U.S. and the U.S. based company has to convert dollars into Bangladeshi

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taka. If the total currency flow led to a net demand for Bangladeshi taka, the currency would
increase in value. As banks around the world buy and sell currencies, the value of currencies
remain in fluctuation. Interest rate adjustments in different countries have the greatest effect
on the value of currencies, because investors typically gravitate toward safety with the
highest yields. If an investor can earn 8.5% interest on deposits in England, but can pay 1 %
interest for the use of money in Japan, then the investor would pay to borrow the Japanese
yen in order to buy the British pound.

4. Application of different tax rates in the country of the project and in the parent’s
country:

In capital budgeting, only after-tax flows are relevant. This is true for both domestic and
overseas projects. The tax issue for foreign capital budgeting purposes is complicated by
existence of host country and home country taxes as well as a number of factors. Tax rules
significantly affect capital flow from foreign direct investment (FDI). Home country taxes in
particular appear to significantly affect the behaviour of FDI. By identifying the incentives
associated with different tax parameters in the home and host countries. The home country
statutory tax rate is claimed to measure the incentive effect of potential home-country
surtaxes on new FDI. The home-country effective tax rate is shown to measure how taxes
affect the substitution of investment in one country for investment in another. The host
country’s effective tax rate should represent either the incentives for FDI in that country or
simply the amount of foreign tax payments that are creditable against the home tax liability
on the FDI.

5. Involvement of royalties and management fees:

A royalty fee is an on-going fee that the franchisee pays to the franchisor. This fee is usually
paid monthly or quarterly, and is typically calculated as a percentage of gross sales. While the
Initial Franchise Fee can be seen as the upfront cost to join as a “member” of the franchise
system, the royalty payments can be seen as the on-going “membership fees” required to
remain that membership. These payments are collected by the franchisor to fund the
franchisor entity’s actions, which include both corporate and franchise-related expenses. The
ongoing royalty payments are how the franchisor makes its money, which it uses to support
its franchisees and further build the business.

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Generally, all the support provided by the franchisor through its field consultants, marketing
plans, business strategies, etc., are funded through the Royalty Payments provided by the
franchisees. Additionally, all the administrative costs of running the franchisor’s headquarters
and staff are funded from the royalty payments. Lastly, the franchisor’s efforts to further
expand and develop the brand through recruiting and bringing in new franchisees to the
system is funded by royalties.

On the other hand, management fee is the cost of having your assets professionally managed.
The fee compensates professional money managers to select securities for a fund’s portfolio
and manage it based on the fund’s investment objective. Management fee structures vary
from fund to fund, but they are typically based on a percentage of assets under management
(AUM). For example, a mutual fund's management fee could be stated as 0.5% of assets
under management. Management fees can range from a low as 0.10% to more than 2% of
AUM. This disparity in the amount of fees charged is generally attributed to the investment
method used by the fund’s manager. The more actively managed a fund is, the higher the
management fees that are charged. For example, an aggressive stock fund that turns over its
portfolio several times a year in search of profit opportunities costs much more to manage
than a more passively managed fund, such as an index fund that more or less sits on a basket
of stocks without much trading. As a result evaluating foreign project become evaluation
process becomes complicated.

6. Difficulty in estimating terminal value of foreign projects;

The Terminal Value (TV) is the present value of all future cash flows, with the assumption of
perpetual stable growth in some cases. TV is used in various financial tools such as the
Gordon Growth Model, the discounted cash flow, and residual earnings computation.
However, it is mostly used in discounted cash flow analyses. In financial analysis, terminal
value includes the value of all future cash flows even when they are not considered in a
particular projection period. It captures values that are otherwise difficult to predict using the
regular financial model forecast period. There are two methods used to calculate terminal
value, which depends on the type of analysis to be done.

The terminal multiple method has a defined projection period. It also greatly considers
market-driven information, as compared to the perpetuity growth model.
The perpetuity growth model assumes that cash flow values grow at a constant rate ad
infinitum. Because of this assumption, the formula for a perpetuity with growth can be used.

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The perpetuity growth model is harder to accurately use, however, as predicting a rate of
perpetual growth and stability is not like the underlying economics.

7. Political risk involved in foreign investment:

Political risk is the risk an investment's returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a change in
government, legislative bodies, other foreign policy makers or military control. Political risk
is also known as "geopolitical risk," and becomes more of a factor as the time horizon of an
investment gets longer. The outcome of a political risk could drag down investment returns or
even go so far as to remove the ability to withdraw capital from an investment

Aside from business factors arising from the marketplace, businesses are also impacted by
political decisions. There are a variety of decisions governments make that can affect
individual businesses, industries and the overall economy. These include taxes, spending,
regulation, currency valuation, trade tariffs, labour laws such as the minimum wage, and
environmental regulations. The laws, even if just proposed, can have an impact. Regulations
can be set at all levels of government, including federal, state and local, as well as in other
countries.

8. Differing rates of national inflation:

This is the factors unique to capital budgeting. Inflation rate is always fluctuating. The
national inflation doesn’t remain same constant. As a result evaluating foreign project
become evaluation process becomes complicated.it has become very difficult to take decision
to foreign investors to take decision invest in local market

9. Amenities and concessions granted by host country:

Bangladesh offers generous opportunities for foreign investors to invest in local market. The
government's role is that of a facilitator which helps create an enabling environment for
expanding private investment, both domestic and foreign. The Board of Investment (BOI),
established by the government for accelerating foreign investment, provides institutional
support services to intending investors.

General Amenities are:

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Tax holiday

Tax holiday facilities will be available for 5 or 7 years depending on the location for foreign
investors. For industrial enterprises located in Dhaka and Chittagong Divisions (excluding
Hill Tract districts of Chittagong Division) the tax holiday facility is for 5 years while it is 7
years for locations in Khulna, Sylhet, Barisal, and Rajshahi, Divisions and the 3 Chittagong
hill districts. 
Tax holiday facilities are provided in accordance with existing laws. The period of tax
holiday will be calculated from the month of commencement of commercial production. Tax
holiday certificate will be issued by NBR (National Board of Revenue) for the total period
within 90 days of submission of application.

Tax exemption

Tax exemptions are allowed in the following cases: 

* Tax exemption on royalties, technical know-how fees received by any foreign collaborator, firm,
company and expert. 

* Exemption of income tax up to 3 years for foreign technicians employed in industries specified in
the relevant schedule of the income tax ordinance. 

* Tax exemption on income of the private sector power generation company for 15 years from the
date of commercial production. 

Accelerated depreciation

Industrial undertakings not enjoying tax holiday will enjoy accelerated depreciation
allowance. Such allowance is available at the rate of 100 per cent of the cost of the machinery
or plant if the industrial undertaking is set up in the areas falling within the cities of Dhaka,
Narayangonj, Chittagong and Khulna and areas within a radius of 10 miles from the
municipal limits of those cities. If the industrial undertaking is set up elsewhere in the
country, accelerated depreciation is allowed at the rate of 80 per cent in the first year and 20
per cent in the second year.
Concessionary duty on imported capital machinery

Import duty, at the rate of 5% ad valorem, is payable on capital machinery and spares
imported for initial installation or BMR/BMRE of the existing industries. The value of spare
parts should not, however, exceed 10% of the total C & F value of the machinery. For

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100% export oriented industries, no import duty is charged in case of capital machinery and
spares. However, import duty @ 5% is secured in the form of bank guarantee or an indemnity
bond will be returned after installation of the machinery. Value added Tax (Vat) is not
payable for imported capital machinery and spares.

Other Amenities

(a) For foreign direct investment, there is no limitation pertaining to foreign equity
participation, i.e. 100% foreign equity is allowed. Non-resident institutional or individual
investors can make portfolio investments in stock exchanges in Bangladesh. Foreign
investors or companies may obtain full working loans from local banks. The terms of such
loans will be determined on the basis of bank-client relationship.

(b) A foreign technician employed in foreign companies will  not be subjected to personal tax
up to 3 (three) years , and beyond that period his/ her personal income tax payment will be
governed by the existence or non-existence of agreement on avoidance of double taxation
with country of citizenship.

(c) Full repatriation of capital invested from foreign sources will be allowed. Similarly,
profits and dividend accruing to foreign investment may be transferred in full. If foreign
investors reinvest their reparable dividends and or retained earnings, those will be treated as
new investment. Foreigners employed in Bangladesh are entitled to remit up to 50 percent of
their salary and will enjoy facilities for full repatriation of their savings and retirement
benefits.

(d) Foreign entrepreneurs are, therefore, entitled to the same facilities as domestic
entrepreneurs with respect to tax holiday, payment of royalty, technical know-how fees etc.

(e) The process of issuing work permits to foreign experts on the recommendation of
investing foreign companies or joint ventures will operate without any hindrance or
restriction. Multiple entry visa" will be issued to prospective foreign investors for 3 years. In

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the case of experts," multiple entry visa" will be issued for the whole tenure of their
assignments.

(f) Special facilities and venture capital support will be provided to export-oriented
industries under "Thrust sectors”. Thrust Sectors include Agro-based industries, Artificial
flower-making, Computer software and information technology, Electronics, Frozen food,
Floriculture, Gift items, Infrastructure, Jute goods, Jewellery and diamond cutting and
polishing, leather, Oil and gas, Sericulture and silk industry, Stuffed toys, Textiles, Tourism.

Legal Protection:
The policy framework for foreign investment in Bangladesh is based on 'The Foreign Private
Investment (Promotion & Protection) Act. 1980 which ensures legal protection to foreign
investment in Bangladesh against nationalisation and expropriation. It also guarantees non-
discriminatory treatment between foreign and local investment, and repatriation of proceeds
from sales of shares and profit.

Issues Related to Foreign Investments Analysis and Their Implications in

capital budgeting decision

 Parent Vs. Project Cash Flows

The first specific issue that arises in respect of the foreign 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 a foreign project on the basis of project's own cash flows provides knowledge
to its competitive status in relation with 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
foreign investors 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.

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However, the foreign investors is generally keen to evaluate a foreign project from the
viewpoint of net cash flows available to it because on it depends the level of earnings per
share and dividends distributed to the stockholders. It is these funds that actually make it
possible to pay dividends to shareholders and make interest and principal payments to
lenders. Further, project evaluation from the investor viewpoint furnishes the basis for raising
funds from the market to finance overseas operations.

Now the question arises which one of the above would be useful for making international
investment decision. 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 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.

According to Corporate financial theory, the value of a project is determined by the present
value of future cash flows that are available to the investor. Thus, the parent should value
only those cash flows that are repatriated net of any transfer costs because only these
remaining funds can be used to pay interest at home and corporate dividends, for payment of
the firm's debt, and for re-investment.

Tax Issue

In capital budgeting, only after-tax cash flows are relevant. This is true both for domestic and
international projects. The tax issue for foreign investors in capital budgeting purposes is
complicated by the existence of host country and home country taxes as well as a number of
factors. Thus, earnings on foreign projects, first of all, fall in host country tax net. Then on
distribution, it is subjected to withholding tax and finally, in the home country the earnings
are further taxed. Recent analysis supports the view that the sensitivity of tax depends on the
host country and the mobility of business activities underlying the tax base. In particular,
where firms benefit from locating production in large markets to reduce the costs of trade,
such as transportation costs, a certain degree of inertia is predicted in the location choice of
firms. Host country benefits and some fixity of capital mean that profits may be taxed up to

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some point without discouraging investment. This view is consistent with the observation that
a number of large domestic output markets and strong inflows have relatively high corporate
tax rates. New explanatory models also suggest that the optimal tax rate on business falls as
trade costs fall and capital is more mobile. This view is consistent with the observation that a
number of countries impose a lower tax burden on more mobile business activities such as
shipping, film production or head-office activities.

Exchange Rate Changes

An exchange rate is the price of a nation’s currency in terms of another currency. Thus, an

exchange rate has two components, the domestic currency, and a foreign currency, and can be
quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign
currency is expressed in terms of the domestic currency. In an indirect quotation, the price of
a unit of domestic currency is expressed in terms of the foreign currency. Exchange rates are
quoted in values against the US dollar. However, exchange rates can also be quoted against
another nation's currency, which is known as a cross currency, or cross rate.

The foreign investors engaged in business with foreign countries in different ways. One point
to remember is that, independent of the type of foreign involvement, all international
businesses deal with exchange rates. Foreign investors have to buy or sell foreign currency as
part of their daily business. Therefore, these companies face foreign exchange risk every day.

A short definition of foreign exchange risk is the possibility of losing money when you buy
or sell currency because of unexpected changes in exchange rates.

Some international companies are export or import firms. These companies are engaged in
selling domestic goods abroad or buying foreign goods. Therefore, a Chinese company that
exports to Bangladesh is a multinational company. Exchange rates affect both types of firms.

Subsidized Financing

A subsidy or government incentive is a form of financial aid or support extended to an

economic sector (or institution, business, or individual) generally with the aim of promoting
economic and social policy. Although commonly extended from government, the term
subsidy can relate to any type of support – for example from NGOs or as implicit subsidies.
Subsidies come in various forms including: direct (cash grants, interest-free loans) and
indirect (tax breaks, insurance, low-interest loans, accelerated depreciation, rent rebates).

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Furthermore, they can be broad or narrow, legal or illegal, ethical or unethical. The most
common forms of subsidies are those to the producer or the consumer. Producer/production
subsidies ensure producers are better off by either supplying market price support, direct
support, or payments to factors of production. Consumer/consumption subsidies commonly
reduce the price of goods and services to the consumer. For example, in the US at one time it
was cheaper to buy gasoline than bottled water. Whether subsidies are positive or negative is
typically a normative judgment. As a form of economic intervention, subsidies are inherently
contrary to the market's demands. However, they can also be used as tools of political and
corporate cronyism. Government subsidies help an industry by paying for part of the cost of
the production of a good or service by offering tax credits or reimbursements or by paying for
part of the cost a consumer would pay to purchase a good or service. Governments seek to
implement subsidies to encourage production and consumption in specific industries. On the
supply side, government subsidies help an industry by allowing the producers to produce
more goods and services. This increases the overall supply of that good or service, increases
the quantity demanded for that good or service, and lowers the overall price of the good or
service. Since the government helps suppliers through tax credits or reimbursements, the
lower overall price of their goods and services is more than offset by the savings they receive.
On the consumer side, government subsidies can help potential consumers with the cost to of
a good or service, usually through tax credits. A great example of this is when consumers
who refit their houses with solar panels receive a tax credit to offset the high price of
purchasing the new solar panels. This helps the renewable energy industry by allowing more
consumers to purchase the products associated with that industry. Government subsidies can
help an industry on both the supplier side and the consumer side. To implement subsidies,
governments need to raise taxes or reallocate taxes from existing budgets. There is also an
argument that incentives in the form of subsidies actually reduce the incentives of firms to cut
costs. 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. But if subsidized financing is separable from a project, the additional value from the
subsidized financing should not be allocated to the project. In such a case, the manager's
decision is that so long as the subsidized loan is unconditional, it should be accepted. If the
foreign investors can use the proceeds of subsidized financing at a higher rate in a
comparable risk investment, it will lead to positive NPV to the firm.
Categorizing subsidies
Broad and narrow
These various subsidies can be divided into broad and narrow. Narrow subsidies are those
monetary transfers that are easily identifiable and have a clear intent. They are commonly
characterized by a monetary transfer between governments and institutions or businesses and
individuals. A classic example is a government payment to a farmer. Conversely broad
subsidies include both monetary and non-monetary subsidies and is often difficult to

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identify. A broad subsidy is less attributable and less transparent. Environmental externalities
are the most common type of broad subsidy.
Economic Effects of Subsidized Financing
Competitive equilibrium is a state of balance between buyers and suppliers, in which the
quantity demanded of a good is the quantity supplied at a specified price. When the quantity
demand exceeds the equilibrium quantity, price falls; conversely, a reduction in the supply of
a good beyond equilibrium quantity implies an increase in the price. The effect of a subsidy is
to shift the supply or demand curve to the right (i.e. increases the supply or demand) by the
amount of the subsidy. If a consumer is receiving the subsidy, a lower price of a good
resulting from the marginal subsidy on consumption increases demand, shifting the demand
curve to the right. If a supplier is receiving the subsidy, an increase in the price (revenue)
resulting from the marginal subsidy on production results increases supply, shifting the
supply curve to the right.

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Assuming the market is in a perfectly competitive equilibrium, a subsidy increases the supply
of the good beyond the equilibrium competitive quantity. The imbalance creates deadweight
loss. Deadweight loss from a subsidy is the amount by which the cost of the subsidy exceeds
the gains of the subsidy. The magnitude of the deadweight loss is dependent on the size of the
subsidy. This is considered a market failure, or inefficiency. Subsidies targeted at goods in
one country, by lowering the price of those goods, make them more competitive against
foreign goods, thereby reducing foreign competition. As a result, many developing countries
cannot engage in foreign trade, and receive lower prices for their products in the global
market. This is considered protectionism: a government policy to erect trade barriers in order
to protect domestic industries. The problem with protectionism arises when industries are
selected for nationalistic reasons (Infant-Industry), rather than to gain a comparative
advantage. The market distortion, and reduction in social welfare, is the logic behind the
World Bank policy for the removal of subsidies in developing countries. Subsidies create
spillover effects in other economic sectors and industries. A subsidized product sold in the
world market lowers the price of the good in other countries. Since subsidies result in lower
revenues for producers of foreign countries, they are a source of tension between the United
States, Europe and poorer developing countries. While subsidies may provide immediate
benefits to an industry, in the long-run they may prove to have unethical, negative effects.
Subsidies are intended to support public interest, however, they can violate ethical or legal
principles if they lead to higher consumer prices or discriminate against some producers to
benefit others. For example, domestic subsidies granted by individual US states may be
unconstitutional if they discriminate against out-of-state producers, violating the Privileges
and Immunities Clause or the Dormant Commerce Clause of the United States
Constitution. Depending on their nature, subsidies are discouraged by international trade
agreements such as the World Trade Organization (WTO). This trend, however, may change
in the future, as needs of sustainable development and environmental protection could
suggest different interpretations regarding energy and renewable energy subsidies.

Tax Holidays

A tax holiday is a temporary reduction or elimination of a tax. It is synonymous with tax

abatement, tax subsidy or tax reduction. Governments usually create tax holidays as
incentives for business investment. Tax holidays have been granted by governments at
national, sub-national, and local levels, and have included income, property, sales, VAT, and
other taxes. Some tax holidays are extra-statutory concessions, where governing bodies grant
a reduction in tax that is not necessarily authorized within the law. In developing countries,
governments sometimes reduce or eliminate corporate taxes for the purpose of
attracting foreign direct investment or stimulating growth in selected industries. A tax holiday
may be granted to particular activities, in particular to develop a given area of business, or to
particular taxpayers. Researchers found that on sales tax holidays, households increase the
quantities of clothing and shoes bought by over 49% and 45%, respectively, relative to what
they buy on average. More often than not, governments of developing countries offer tax

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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. A tax holiday in the project's early
years is not worth much. In fact, if the project expected to suffer losses in the first few years
which can be carried forward, the tax holiday robs the firm of a valuable tax-loss carry
forward. In such a scenario, a foreign investor would prefer to be subjected to a high tax rate
during the early loss-making (and tax-credit creating) years of a project. The management
should, therefore, compute project value both with and without the tax holiday to uncover
such type of situations. When a government body wants to encourage the purchase of certain
items or bolster participation in certain activities, it may issue a tax holiday, a temporary
period during which the tax rate applied to certain products or services is reduced or
removed. For instance, many local governments have a sales tax holiday the weekend before
school resumes in the fall to reduce the cost burden that parents carry when shopping for their
children’s school supplies or clothing. Sales tax holidays, like the back-to-school one
described, are a common type of tax holiday administered by state governments. A tax
holiday is also implemented for businesses to encourage economic activity and foster growth.
Used in the hopes of increasing the gross domestic product (GDP) in developing countries,
tax holidays are a way in which governments attract foreign investors or foreign companies
that establish base in the host country. Tax holidays are often put in place in particular
industries to help promote growth, develop, or diversify domestic industries. In some cases,
new businesses are given tax holidays which helps the business reduce some of its costs of
operation, while it focuses on increasing revenue and growing. This fiscal policy measure
may also serve as an incentive for more people to start businesses. Whether there is any
benefit to tax holidays is still a debate. On the one hand, even though the government loses
out on revenues that would have been generated from sales during the temporary tax-
break periods, tax holidays are said to increase tax revenue over the long term because they
help businesses stay in business or grow, creating more taxable revenue for the tax authority.
In addition, the lost revenue is also said to be offset by the increased purchases of consumers
looking to take advantage of the tax break. On the other hand, it is believed that the increased
sales during a tax holiday is preceded by reduced sales before the holiday; thus, the tax
holiday simply shifted sales that would have happened before or after the holiday to the
holiday dates. In effect, consumer don’t buy more, they simply shift the timing of purchases.
Also, since retailers do not pay sales tax out-of-pocket (the consumer is responsible for sales
tax), some retailers may unethically take advantage of tax holidays by increasing the prices of
the goods and reducing consumer savings.
Tax Holidays in Bangladesh
Finance Bill 2017 makes no changes to the current tax legislation providing tax holidays for:

 industries established in export processing zones (5 to 7 years, depending on location)

 investment in economic zones (10 years) and development of economic zones (12
years) 

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  industrial undertakings (5 to 10 years, depending on location) 

 physical infrastructure (10 years) 

 coal-based private power generation companies (15 years)

 Non-coal-based power generation companies (10 years). 

The tax holiday (until 2024) for companies engaged in “information technology enabled
services” also remains intact, although Finance Bill 2017 includes specifically defines these
services.

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.

International Diversification Benefits

International diversification is the attempt to reduce risk by investing in more than one
nation. By diversifying across nations whose economic cycles are not perfectly correlated,
investors can typically reduce the variability of their returns. Because portfolio investment
earnings are more likely to be tied to the broader macroeconomic indicators of a country,
such as overall market capitalization of an economy, they can be more sensitive to factors
such as: high national economic growth rates, exchange rate stability and general
macroeconomic stability. Some reasons to diversify are-
1. Not all types of investments perform well at the same time.
2. Different types of investments are affected differently by world events and changes in
economic factors such as interest rates, exchange rates and inflation rates.
3. Diversification enables a foreign investor to build a portfolio with generally less risk
than the combined risks of the individual securities. Having an international portfolio
can be used to reduce investment risk. If U.S. stocks underperform, gains in the
investor’s international portfolio can smooth out returns. For example, an investor’s
domestic portfolio may have declined by 10%, meanwhile, their international
portfolio could have advanced 20%, leaving the investor with a net investment return
of 10%. Risk can be reduced further by holding a selection of stocks from developed
and emerging markets in an international portfolio.
4. If the portfolio is not diversified, it may carry unnecessary risk.
5. Diversifies Currency Exposure: When investors buy stocks for their international
portfolios, they are also effectively buying the currencies in which the stocks
are quoted. For example, if an investor purchases a stock on the London Stock

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 Exchange, he is also buying the British pound. If the U.S. dollar falls, the investor's
international portfolio helps to neutralize currency fluctuations.
6. Market Cycle Timing: An investor with an international portfolio can take advantage
of the market cycles of different nations. For instance, an investor may believe U.S.
stocks and the U.S. dollar are overvalued and may look for investment opportunities
in developing countries, such as Latin America and China that are believed to benefit
from capital inflow and demand for commodities.
There are generally three types of markets to choose from when thinking about international
diversification:
Developed market – generally defined as a country with well-developed capital markets and
economy. Developed market countries may be less risky than countries in emerging or
frontier markets.
Emerging market – generally defined as a country that does not have as well-developed an
economy or capital markets when compared to a country in the developed market. Emerging
market countries may be riskier than developed market countries.
Frontier market – generally defined as a country that has signs of development, but cannot
be considered an emerging market. Frontier markets generally carry the highest investment
risk.
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 foreign investor is taken into consideration.
Example: 3 Sample Portfolios for Foreign Investors

Young Investors: Up to 35

Most financial advisors recommend that younger investors assume more risk in their
portfolios since they have a longer time horizon. While riskier investments — like equities —
may experience more short-term volatility, they tend to outperform less risky investments —
like bonds — over the long-term. Young investors that don’t plan on selling for several
decades are typically best off with riskier investment classes for these reasons. When it
comes to international investing, these risky investments include emerging
market and frontier market equities and bonds. The countries that fall into these categories
have faster growing economies than developed countries, but may experience more short-
term volatility from heightened political risk, currency risk, and other factors.
Young investors can benefit from these dynamics by increasing allocations to these asset
classes.

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An example young investor portfolio might include:

ETF Class Allocation

Vanguard Total Stock Market ETF (VTI) US Equities 40 Percent 
Vanguard FTSE Developed Markets ETF (VEA) International Equities 40 Percent
Vanguard FTSE Emerging Markets ETF (VWO) Emerging Market Equities 10 Percent
I Shares Emerging Market Bond ETF (EMB) Emerging Market Bonds 10 Percent

Middle Age Investors: 35-65

Middle age investors should focus on a balance between growth and income. While they still
have time to ride out volatility, the goal is starting to shift from capital gains to capital
preservation as retirement approaches. Bonds and other fixed income investments help
provide greater certainty, while blue-chip dividend and value stocks may be appropriate to
reduce risk and volatility in the equity portion of a portfolio.
In the context of international investing, middle age investors may want to consider reducing
exposure to emerging and frontier markets and increasing exposure to developed markets.
They may also want to consider building bond exposure as a way to diversify fixed income
risks away from the United States. These approaches typically result in lower portfolio
volatility and ongoing attractive income over time.
An example middle age investor portfolio might include:

ETF Class Allocation

Vanguard Total Stock Market ETF (VTI) US Equities 45 Percent
Vanguard FTSE Developed Markets ETF (VEA) International Equities 15 Percent
Vanguard US Total Bond ETF (BND) US Bonds 25 Percent
Vanguard Total International Bond ETF (BNDX) International Bonds 15 Percent

Retirement Investors: 65 and up

Retirement investors usually prioritize low-risk income investments given their short time
horizon. During this time, the investment objective switches from capital gains to capital
preservation since the goal are to ensure there’s enough income to meet retirement needs.
Bonds are the most popular way to achieve these goals since they rarely default and provide a
steady source of income over time.

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When investing internationally, retirement investors may want to consider some exposure to
foreign fixed income investments. Investors need U.S. dollars during their retirement —
unless living abroad — which means that currency conversions can become costly if foreign
currencies depreciate against the dollar.
An example middle age investor portfolio might include:

ETF Class Allocation

Vanguard US Total Bond Market ETF (BND) US Bonds 80 Percent 
Vanguard Total International Bond ETF (BNDX) International Bonds 20 Percent

There is no universally-accepted consensus on the amount of international diversification

that’s appropriate for a retirement portfolio. Some financial advisors may deem the figures in
these sample portfolios as over-exposed to international assets, while others see them as an
appropriate level of diversification. Investors should carefully assess their own situation and
comfort level with international investments before making any decisions.
Most investors are aware of the benefits of international diversification, but it can be difficult
to put the theory into practice. The good news is that international ETFs make it easier than
ever to build internationally-diversified portfolios.

Factors to consider in Capital Budgeting

• Exchange rate fluctuations

• Inflation
• Financing arrangement
• Blocked funds
• Uncertain salvage value
• Impact of project on prevailing cash flows
• Host government incentives
• Real options

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Inputs for Capital Budgeting
Regardless of the long-term project to be considered, a foreign investor will normally require
forecasts of the economic and financial characteristics related to the project. Each of these
characteristics is briefly described here:

1. Initial investment. The parent’s initial investment in a project may constitute the major
source of funds to support a particular project. Funds initially invested in a project may
include not only whatever is necessary to start the project but also additional funds, such as
working capital, to support the project over time. Such funds are needed to finance inventory,
wages, and other expenses until the project begins to generate revenue. Because cash inflows
will not always be sufficient to cover upcoming cash outflows, working capital is needed
throughout a project’s lifetime.

2. Price and consumer demand. The price at which the product could be sold can be
forecasted using competitive products in the markets as a comparison. A long-term capital
budgeting analysis requires projections for not only the upcoming period but the expected
lifetime of the project as well. The future prices will most likely be responsive to the future
inflation rate in the host country (where the project is to take place), but the future inflation
rate is not known. Thus, future inflation rates must be forecasted in order to develop
projections of the product price over time.
When projecting a cash flow schedule, an accurate forecast of consumer demand for a
product is quite valuable, but future demand is often difficult to forecast. For example, if the
project is a plant in Germany that produces automobiles, the foreign investor must forecast
what percentage of the auto market in Germany it can pull from prevailing auto producers.
Once a market share percentage is forecasted, projected demand can be computed. Demand
forecasts can sometimes be aided by historical data on the market share other foreign
investors in the industry pulled when they entered this market, but historical data are not
always an accurate indicator of the future. In addition, many projects reflect a first attempt, so
there are no predecessors to review as an indicator of the future.

3. Costs. Like the price estimate, variable-cost forecasts can be developed from assessing
prevailing comparative costs of the components (such as hourly labor costs and the cost of
materials). Such costs should normally move in tandem with the future inflation rate of the
host country. Even if the variable cost per unit can be accurately predicted, the projected total
variable cost (variable cost per unit times quantity produced) may be wrong if the demand is
inaccurately forecasted.
On a periodic basis, the fixed cost may be easier to predict than the variable cost since it
normally is not sensitive to changes in demand. It is, however, sensitive to any change in the
host country’s inflation rate from the time the forecast is made until the time the fixed costs
are incurred.

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4. Tax laws. The tax laws on earnings generated by a foreign subsidiary or remitted to the
foreign investor vary among countries. Under some circumstances, the foreign investor
receives tax deductions or credits for tax payments by a subsidiary to the host country.
Withholding taxes must also be considered if they are imposed on remitted funds by the host
government.
Because after-tax cash flows are necessary for an adequate capital budgeting analysis,
international tax effects must be determined on any proposed foreign projects.

5. Remitted funds. In some cases, a host government will prevent a subsidiary from sending
its earnings to the parent. This restriction may reflect an attempt to encourage additional local
spending or to avoid excessive sales of the local currency in exchange for some other
currency. Since the restrictions on fund transfers prevent cash from coming back to the
parent, projected net cash flows from the parent’s perspective will be affected. If the parent is
aware of these restrictions, it can incorporate them when projecting net cash flows.
Sometimes, however, the host government adjusts its restrictions over time; in that case, the
foreign investor can only forecast the future restrictions and incorporate these forecasts into
the analysis.

6. Exchange rates. Any international project will be affected by exchange rate fluctuations
during the life of the project, but these movements are often very difficult to forecast. There
are methods of hedging against them, though most hedging techniques are used to cover
short-term positions. While it is possible to hedge over longer periods (with long-term
forward contracts or currency swap arrangements), the foreign investor has no way of
knowing the amount of funds that it should hedge. This is because it is only guessing at its
future costs and revenue due to the project. Thus, the foreign investor may decide not to
hedge the projected foreign currency net cash flows.

7. Salvage (liquidation) value. The after-tax salvage value of most projects is difficult to
forecast. It will depend on several factors, including the success of the project and the attitude
of the host government toward the project. As an extreme possibility, the host government
could take over the project without adequately compensating the foreign investor.

Some projects have indefinite lifetimes that can be difficult to assess, while other projects
have designated specific lifetimes, at the end of which they will be liquidated. This makes the
capital budgeting analysis easier to apply. It should be recognized that the foreign investor
does not always have complete control over the lifetime decision. In some cases, political
events may force the firm to liquidate the project earlier than planned. The probability that
such events will occur varies among countries.

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8. Required rate of return. Once the relevant cash flows of a proposed project are
estimated, they can be discounted at the project’s required rate of return, which may differ
from the foreign investor’s cost of capital because of that particular project’s risk.

Capital Budgeting Case

Capital budgeting for the foreign investor is necessary for all long-term projects that deserve
consideration. The projects may range from a small expansion of a subsidiary division to the
creation of a new subsidiary. This section presents an example involving the possible
development of a new subsidiary. It begins with assumptions that simplify the capital
budgeting analysis. Then, additional considerations are introduced to emphasize the potential
complexity of such an analysis. This example illustrates one of many possible methods
available that would achieve the same result. Also, we should keep in mind that a real-world
problem may involve more extenuating circumstances than those shown here.

Spartan, Inc. is considering the development of a subsidiary in Singapore that would

manufacture and sell tennis rackets locally. Spartan’s management has asked various
departments to supply relevant information for a capital budgeting analysis. In addition, some
Spartan executives have met with government officials in Singapore to discuss the proposed
subsidiary. The project would end in 4 years. All relevant information follows.

Initial Investment: An estimated 20 million Singapore Dollar (S$), which include funds to
support working capital would be needed for the project. Given the existing spot rate of $.50
per Singapore dollar, the U.S. dollar amount of the parent’s initial investment is $10 million.

Price and demand: The estimated price and demand schedule during each of the next 4
years are shown here:

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 Year 1 Year 2 Year 3 Year 4

Price per S$ 350 S$ 350 S$ 360 S$ 380

racket

Demand in 60,000 units 60,000 units 100,000 units 100,000 units

Singapore

Costs: The variable costs (for materials, labor, etc.) per unit have been estimated and
consolidated as shown here:

Year 1 Year 2 Year 3 Year 4

Variable S$ 200 S$ 200 S$ 250 S$ 260

cost per
Racket

The expense of leasing extra office space is S$1 million per year. Other annual Overhead
expenses are expected to be S$1 million per year.
Depreciation: The Singapore government will allow Spartan’s subsidiary to depreciate the
cost of the plant and equipment at a maximum rate of S$ 2 million per year
Taxes: The Singapore government will impose a 20 percent tax rate on income. In addition it
will impose a 10 percent withholding tax on any funds remitted by the subsidiary to the
parent.
Remitted Funds: The Singapore government promises no restrictions on the cash flows to be
sent back to the parent firm.
Salvage Value: The Singapore government will pay the parent S$12 million to assume
ownership of the subsidiary at the end of 4 years.
Exchange Rate: Assume that the spot exchange rate of the U.S dollar against one
Singaporean Dollar is $0.50.
Required Rate of return: Spartan Inc. requires a 15 percent return on this project.

Analysis

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The capital budgeting analysis will be conducted from the parent’s perspective, based on the
assumption that the subsidiary is intended to generate cash flows that will ultimately be
passed on to the parent. Thus, the net present value (NPV) from the parent’s perspective is
based on a comparison of the present value of the cash flows received by the parent to the
initial outlay by the parent. As explained earlier, an international project’s NPV is dependent
on whether a parent or subsidiary perspective is used. Since the U.S. parent’s perspective is
used, the cash flows of concern are the dollars ultimately received by the parent as a result of
the project. The required rate of return is based on the cost of capital used by the parent to
make its investment, with an adjustment for the risk of the project. For the establishment of
the subsidiary to benefit Spartan’s parent, the present value of future cash flows (including
the salvage value) ultimately received by the parent should exceed the parent’s initial outlay.

The capital budgeting analysis to determine whether Spartan, Inc., should establish the
subsidiary is provided in Exhibit below. The first step is to incorporate demand and price
estimates in order to forecast total revenue (see lines 1 through 3). Then, the expenses are
summed up to forecast total expenses (see lines 4 through 9). Next, before-tax earnings are
computed (in line 10) by subtracting total expenses from total revenues. Host government
taxes (line 11) are then deducted from before-tax earnings to determine after-tax earnings for
the subsidiary (line 12).

Year 0 Year 1 Year 2 Year 3 Year 4

1. Demand 60,000 60,000 100,000 100,000

2. Price per unit S$350 S$350 S$360 S$380

3. Total Revenue S$21,000,000 S$21,000,000 S$36,000,000 S$38,000,000

= (1)*(2)

4. Variable Cost S$200 S$200 S$250 S$260

per unit

5. Total Variable S$12,000,000 S$12,000,000 S$25,000,000 S$26,000,000

cost = (1)*(4)

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 6. Annual lease S$1,000,000 S$1,000,000 S$1,000,000 S$1,000,000
expense

7. Other fixed S$1,000,000 S$1000,000 S$1000,000 S$1,000,000

annual expense

8.Noncash S$2,000,000 S$2,000,000 S$2,000,000 S$2,000,000

expense
(depreciation)
9.Total S$16,000,000 S$16,000,000 S$29,000,000 S$30,000,000
expense=(5)+(6)
+(7)+(8)
10.Before –tax S$5,000,000 S$5,000,000 S$7,000,000 S$8,000,000
earnings of
subsidiary=(3)-
(9)
11.Host govt. S$1,000,000 S$1,000,000 S$1,400,000 S$1,600,000
tax(20%)

12.After-tax S$4,000,000 S$4,000,000 S$5,600,000 S$6,400,000

earnings of
subsidiary
13.Net cash flow S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
to subsidiary =
(12)+(8)
14. S$ remitted S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
by
subsidiary(100%
) net cash flow
15.Withholding S$6,000,00 S$6,000,00 S$7,600,00 S$8,400,00
tax on remitted
funds (10%)
16.S$ remitted S$5,400,000 S$5,400,000 S$6,840,000 S$7,560,000
after
withholding tax
17.Salvage value S$12,000,000

18. Exchange $0.50 $0.50 $0.50 $0.50

rate of S$

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 19.Cash Flow to $2,700,000 $2,700,000 $3,420,000 $9,780,000
parent

20.PV of parent $2,347,826 $2,041,588 $2,248,706 $5,591,747

cash flow (15%
discount rate)
21.Initial $10,000,000
investment by
parent
22.Cumulative -$7,652,174 -$5,610,000 -$3,361,880 $2,229,867
NPV

The depreciation expense is added to the after-tax subsidiary earnings to compute the net cash
flow to the subsidiary (line 13). All of these funds are to be remitted by the subsidiary, so line
14 is the same as line 13. The subsidiary can afford to send all net cash flow to the parent
since the initial investment provided by the parent includes working capital. The funds
remitted to the parent are subject to a 10 percent withholding tax (line 15), so the actual
amount of funds to be sent after these taxes is shown in line 16. The salvage value of the
project is shown in line 17. The funds to be remitted must first be converted into dollars at the
exchange rate (line 18) existing at that time. The parent’s cash flow from the subsidiary is
shown in line 19. The periodic funds received from the subsidiary are not subject to U.S.
corporate taxes since it was assumed that the parent would receive credit for the taxes paid in
Singapore that would offset taxes owed to the U.S. government.

The net cash flow per period (line 19) is discounted at the required rate of return (15 percent
rate in this example) to derive the present value (PV) of each period’s net cash flow (line 20).
Finally, the cumulative NPV (line 22) is determined by consolidating the discounted cash
flows for each period and subtracting the initial investment (in line 21). For example, as of
the end of Year 2, the cumulative NPV was -$5,610,586. This was determined by
consolidating the $2,347,826 in Year 1, the $2,041,588 in Year 2, and subtracting the initial
investment of $10,000,000. The cumulative NPV in each period measures how much of the
initial outlay has been recovered up to that point by the receipt of discounted cash flows.
Thus, it can be used to estimate how many periods it will take to recover the initial outlay.
For some projects, the cumulative NPV remains negative in all periods, which suggests that
the discounted cash flows never exceed the initial outlay. That is, the initial outlay is never
fully recovered. The critical value in line 22 is the one for the last period because it reflects
the NPV of the project.

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In our example, the cumulative NPV as of the end of the last period is $2,229,867. Because
the NPV is positive, Spartan, Inc., may accept this project if the discount rate of 15 percent
has fully accounted for the project’s risk. If the analysis has not yet accounted for risk,
however, Spartan may decide to reject the project.

RISK ANALYSIS IN INTERNATIONAL. INVESTMENT DECISION

Foreign investors have to face a host of additional risks while investing in foreign countries.
As noted earlier, 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 a foreign investor.
11 Capital Budgeting for Multinationals Besides, FOREIGN Investors’ 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.
Further, there has been a tendency for rising variable cost per unit and product prices have
been going up overtime. However, inflation can be quite volatile from year to year in some
countries and can, therefore, strongly influence a project's net cash flows. Inaccurate inflation
forecasts could lead to inaccurate net cash flow forecasts. So FOREIGN INVESTOR while
contemplating to invest overseas must assess the consequences of various political risks for
the viability of political investment. 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 iii) adjusting cash flows to reflect the
specific impact of a given risk,
Adjusting the Discount Rate or Payback Period

The additional risk exposure to overseas investment is expressed usually in general terms
rather than in terms of their effect on specific project. This vague view of risk probably
explains the use of two unsystematic approaches to account for additional foreign investment
risks. One is to employ a higher discount rate for overseas business and the other one is to use
shorter period of payback. 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. However, these methods fail to assess precisely the actual impact of a
particular risk on cash flows. Comprehensive risk analysis calls for an evaluation of the
magnitude and timing of risks and their implications for the projected cash flows, there does
not seem to be any logic in using a uniformly higher discount rate to cash flows from the
proposed project to incorporate risk of likely embargo on remittances 4 years hence. Further,
the choice of a risk premium is arbitrary one. Further, these methods do not consider the
favourable currency movements. That is why alternative method of adjusting the annual cash
flows taking into consideration the impact of a specific risk on the future returns from an
investment is employed.
Adjusting the Annual Cash Flows

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 There are two techniques employed to adjust the annual cash flows, keeping into
consideration the risk factor for each year. 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
a foreign investor 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. However,
uncertainty absorption principle suffers from certain fundamental weaknesses. First, risk
insurance covers only a fixed proportion of the book value of the firm (in the case of
expropriation while the economic value of expropriated assets normally far exceeds the book
value). Secondly, there are number of political decisions such as import restrictions, higher
tariff rates on the imports and/or exports to neighbouring markets, as well as variety of
measures designed create problems which do impact the operation and profitability of the
subsidiary business, for which no insurance coverage is available. International Investment
12 Decisions and Working Capital Management In the second method, probability and
certainty equivalent techniques can be employed to adjust political risk, The FOREIGN
INVESTOR, generally, employs a statistical technique called the "Decision Tree" analysis to
estimate the probability of expropriation. With the help of these techniques the FOREIGN
INVESTOR finds an NPV for the foreign project based on cash flows adjusted for the
probability of expropriation for the particular year. The above techniques can be used for
adjusting foreign exchange rate risk. For instance, probability analysis can be employed to
estimate the exchange rate (of the host versus parent currency) for each time period. The firm
is required to construct several exchange rate scenarios over the project's life cycle. Projected
cash flows for each year would then be converted into home currency for each of these years.
Finally, cash flows for, each of these years would be converted to equivalent cash flows by
applying the assigned probability for each of the scenarios. However, this approach has
certain inbuilt weakness. For instance, this approach does not consider range of possible
outcome in which the management may also be interested. Furthermore, it is doubtful if
calculation of the expected values of alternative scenarios would be superior to the one based
on purchasing power parity assumption or any other forecasting technique.

Conclusion

Capital Budgeting for foreign investors presents many elements such as conversion of cash
flows from foreign projects into the currency of the parent country, restrictions of remittances
of cash flows, exchange rate fluctuations, different tax rates, different inflation rates, etc.,
which rarely exist in domestic capital budgeting. Evaluating an overseas project on the basis
of its own cash flows provides an insight about its competitive status vis-a-vis domestic or
regional firms. However, a foreign investor is more interested in net cash flows available to it
from its foreign project. A three-stage analysis has been recommended for overseas project
evaluation. Incremental cash 13 capital budgeting for foreign investors flows to the parent
company can be ascertained by subtracting worldwide parent-company cash flows without
investment from post investment parent company cash flows. While making these estimates,
adjustments for transfer pricing effects, fees and royalties, foreign tax credits usable
elsewhere, product and market diversification, etc. have to be made. Adjustments for tax,
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exchange control and risk factors have also to be made while deciding about the viability of
the foreign projects.

Questions
1. Capital Budgeting for foreign project is considerably more complex than that in domestic
case. Identify the factors and add complexity.

Answer:
Parent cash flows must be distinguished from project cash flows
Parent cash flows often depend on the form of financing
Additional cash flows generated by a new investment in one foreign subsidiary may be in
part or in whole taken away from another subsidiary
The parent must explicitly recognize remittance of funds because of differing tax systems,
legal and political constraints on the movement of funds, local business norms, and
differences in the way financial markets and institutions function
An array of nonfinancial payments can generate cash flows from subsidiaries to the parent
Managers must keep the possibility of unanticipated foreign exchange rate changes in mind
because of possible direct effects on cash flows as well as indirect effects on competitiveness

2. How different rate of inflation impact on foreign investor? How political risk involved in
foreign investment?

Answer:

Rate of inflation is a crucial factor in influencing the inflow of foreign investment. A high
rate of inflation signifies economic instability associated with inappropriate government
policies, especially the monetary fiscal policy mix. High rates of inflation distort the
economic activities, leading to lesser inflow of capital. A low and stable inflation rate acts as
a sign of internal economic stability. This is because it reduces uncertainty and boosts the
confidence of people and businesses for making investment decisions.

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Political risk is a type of risk faced by investors, corporations, and governments that political
decisions, events, or conditions will significantly affect the profitability of a business or the
expected value of a given economic action. This is a special type of risk, because only
companies that do business abroad are exposed to it, while those who operate exclusively in
own country are not affected. It might involve the government taking control of the company,
forcing renegotiation of contract terms, dictating the number of local supervisors or imposing
restrictions on the distribution of capital.

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