INTERNATIONAL CAPITAL

BUDGETING
Cross-Border Acquisitions
NPV Framework
• Golden rule of net present value (NPV) of capital
budgeting is represented as
N
CFn
NPV   (1  r ) n
 CF0
Where 1

CFn represents free cash flows for period n over the life of
the project on N years and r is the discount rate.
• And the rule of acceptance is
– Accept projects with positive NPV and reject those
with negative NPV.

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Cash Flows and Discount Rate
1. Whose cash flows: Subsidiary vs. Parent
2. Whose discount rate
SUBSIDIARY:
• Responsible for administering and managing the
project.
• What is good for subsidiary is also good for parent
PARENT
• Capital budgeting exercise is viewed from the
perspective of investor.
Parent being investor the cash flow should be
viewed from parent’s perspective.
Debatable if subsidiary is not wholly owned ??
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Cash Flow – Subsidiary Vs Parent?
• In case of international projects while it is the subsidiary
that generates the cash flows but ownership lies with the
parent.
• There are often several items that are included in the cost
of subsidiary reducing the cash flows but actually are
sources of cash inflows to the parent such as
– Royalty payments, technical or management fee etc. that are
the cash outflows for the subsidiary but are actually cash
inflows for the parent.
– Inputs provided by parent in the form of supplies are cash out
flows for the subsidiary but the profit adds to the parent.

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Domestic Vs International Projects
• The capital budgeting decision in another country involves
situations that are often absent in the domestic environment,
such as
– Political risk of operating in different country,
– Uncertainties with respect to culture, norms,
– Working conditions and labour laws and minimum wages,
– Level of protections based on nationalities of stakeholders,
– Availability of technical manpower and expertise,
– Red tape,
– Different legal and administrative environments,
– Commitments with respect to export, remittances, local
procurement,
– Availability of incentives like as taxes, loans, etc.
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Causes for Differential in Cash Flows
• Insist on local participation (FDI policy) to guide capital
structure.
• Higher rates of corporate taxes for MNC than domestic
companies.
• Ceilings on royalty and technical fee payments.
• Lock-in period for remittances.
• Additional taxes on remittances.
• Export obligations/commitments.
• Specify minimum level of local procurement.

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Parent’s Cash Flow From Subsidiary
Subsidiary’s Cash Flow
Less: Host country’s Taxes Less: Cannibalisation
Less: Retained by subsidiary Add: Sales creation
Remitable cash flow Add: Technical fees and royalty
payments (net of host’s taxes)
Less: Dividend withholding tax Add: Opportunity costs for non
cash based services/resources.
Remittance to parent Convert to parent’s currency
Parent’s cash flow in parent’s
currency

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When Debt is from Host Country
• When debt is availed in host nation, add equivalent
loan in parent’s nation to make NPVs comparable.
Debt in Host Equivalent debt in
Country Parent’s country
EBIT 200 200
Interest, 10% on 100 (4 years) 10 -
EBT 190 200
Tax, 30% 57 60
PAT 133 140

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 When Debt is from Host Country
Debt in Host Eq debt
PAT (Previous slide) 133 140
Less: Repayment 25 -
Remitted cash flow 108 140
Expected Ex Rate 0.5 0.5
Cash flow in Parent’s currency 54 70
Less: Parent’s interest on equivalent loan (at - 3
ex rate of 0.6 debt is 60 @ 5%)
Add: Tax shield, 33% - 1
Less: Principal repaid parent’s debt - 15
Cash flow in parent’s currency (discount at re) 54 53

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Cash Flow Differentials
• Differences in the cash flows of subsidiary and parent may
make projects abroad
– Positive NPV project from the perspective of
subsidiary, but negative NPV project for parent, and
– Negative NPV project at the level of subsidiary, but
positive NPV project at parent’s level.
• If subsidiary is a joint venture with local shareholder
(51:49), whose perspective must be considered?
• Conflicting opinions????
(Suzuki in Maruti, Airtel and Walmart, Hero Honda and
Honda, Royalties to Nestle, Suzuki, Unilever……)

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Discount Rate
If cash flow in foreign currency for period t is CFt, the projected
spot exchange rate is St, the discount rates in subsidiary’s
(country abroad) currency and parent’s (Home) currency are ra
and rh respectively, then the discounted value of the cash
flows would be

Discounting home Discounting foreign

currency cash flow at host currency cash flow at
country discount rate parent’s discount rate
CFt x St
Present Value 
(1  rh ) t

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 The Discount Rate
• Cash flows measured in foreign currency or in
home currency must lead to same NPV as long
as we use the appropriate discount rate i.e.
CFt CFt x St
x S0 
(1  ra ) t
(1  rh ) t
• For this to happen relative PPP must hold:
St (1  rh ) t

S 0 (1  ra ) t
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PROJECTING CASH FLOWS
Who Generates And Whom It Belongs To

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Operating Cash Flows - Parent
• Operating cash flows are generated by the subsidiary
and denominated in the currency of the host nation.
• Operating cash flows of the subsidiary is the starting
point for projecting the cash flows for the parent.
• These operating cash flows in the currency of the host
nation need to be converted into the parent’s currency.
• Therefore forecasting of exchange rate is essential.

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Projecting Operating Cash Flows
Item Basis of Projection
A Quantity Project in numbers
B Selling price Project at t = 0 and then increase by inflation
rate of the host nation
C Revenue (A X B) Would rise because of rising production/sales
and inflation rate of host nation incorporated in
D Variable Cost the price and all costs.
E Fixed Cost Project fixed cost and a rate of increase
modified by inflation rate
F Licence and Normally specified as % of sales and hence
Technical Fees automatically rise by increased sales and
inflation of the host nation.
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Projecting Operating Cash Flows
Item Basis of Projection
H Depreciation As per policy; Mostly SLM: No adjustment of
inflation.
I Interest Ignored; Would be incorporated in the discount rate
as is done in domestic capital budgeting exercise.
J EBIT
K Taxes Corporate tax rate and tax rules of host country.
L Changes in Working capital of first year in the initial outlay.
working capital Normally taken as % of sale. Only increase of working
capital to be deducted from profit.
M Net repatriable J – K – L + H
profit

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Operating Cash Flows

Item Basis of Projection

N Exchange rate Assuming Relative PPP holds project exchange rate
for each year, or use any alternate method.
O Cash flows MxN
from
Operation to
the parent
P Present Value Use all-equity discount rate of parent’s

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Treatment of Royalty and Supplies
• The royalty payments which are considered as
cost in the cash flows of the subsidiary are cash
inflows for the parent and must be valued
separately and added, net of host nation’s tax.
• In foreign project the proprietary items are
supplied by parent that are incorporated as cost
in the foreign project. The contribution derived
from supply of such items must be valued
separately and added to the NPV of the project.
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METHODS TO FIND NPV
What Is The Right Discount Rate

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Properties of Discount Rate
• The discount rate is a function of several factors
and would be different for
– different risk profiles,
– different capital structures,
– changing preferences and expectation of
equity and debt suppliers, and
– constraints of tax and remittances affecting
dividend decision.
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FTE and WACC Approaches to NPV

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Requirements for NPV Approach
For several reasons WACC or FTE approach are appropriate for
evaluating domestic projects because;
1. Market values of debt & equity are readily available.
2. Cost of equity incorporating the business risk and financial risk
and cost of debt are directly observable.
3. These projects often relate to expansions in the same line of
business letting existing cost of capital serve as appropriate
discount rate.
4. Expansion projects are small relatively and keeping capital
structure constant.
5. Since financial risk and the business risk are same the existing
cost of capital is best discount rate.
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NPV Approach & MNCs Projects
For several reasons WACC or FTE approach cannot be used for
international projects:
1. International projects do not have same business risk as they
operate in economic environments different than domestic.
2. International projects often have incentives and concessionary
loans that make the capital structure different.
3. International expansion projects are normally large compared to
the existing business warranting a change in capital structure
making WACC inappropriate as discount rate.
4. Since financial risk and business risk are different than existing
business and environment, existing WACC may NOT be the best
discount rate.
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Limitations of WACC/FTE
• WACC is conceptually easy to apply: But can be used only when
business risk and financial risk faced by the project is similar to
that of the existing operations.
• It is a difficult assumption to fulfill in the international scenario,
where business risk and financial risk become substantially
different.
• Business risk alters the required rate of return (cost of equity).
• Due to change in the capital structure (financial risk) the cost of
equity too changes because there exist a claim of debt suppliers
that is prior to the claims of the shareholders,

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Need to Use All-Equity Rate
• WACC and FTE approaches use single discount rate for all the
cash flows treating all operating cash flows bear the same risk.
• All cash flows do not carry the same risk (e.g. depreciation) and
therefore cannot have same discount rate.
• International projects have several funding options than local
and hence these funding option may
a) require different discount rate, and
b) force the MNC to alter the capital structure (financial risk)
because it has more financing options in the host country
than in the home country.
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ADJUSTED PRESENT VALUE (APV)
A Method Best Suited to MNCs Project Appraisal

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 Adjusted Present Value (APV) Method
• Adjusted Present Value (APV) approach attempts
to address the issues of changes in business risk
and financial risk complementing conventional
NPV approach and is imminently suitable for
evaluation of international capital budgeting
proposals.
• It is based on MM Proposition II.

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 Adjusted Present Value (APV) Method
• MM Position
VL = VU + Value of Tax Shield
= VU + T x Debt (for perennial debt)
– VL and VU are the values of the levered and
unlevered firm.
– VU needs to be found using all equity discount
rate
– Value of the tax shield for the debt to be found
using cost of debt.
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Advantage of APV Approach
• APV provides flexibility for the adjustment of
different means of financing to the NPV of all equity
cash flows e.g. project specific funding, including
subsidised loans that may be available to the MNC.
• Allows measurement of benefits of each financing
option.
• Allows use of different discount rates to different
kinds of cash flows appropriate to their risk.

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APV Example – Does Debt Add Value?
• A firm ABCL is up for sale. ABCL is a profitable debt free
company generating cash flows of Rs 5 million a year at
present that are expected to grow at 2%. The owner of
the firm wants Rs 30 million. The cost of equity for
ABCL is reckoned to be 20%.
– You are a professional and can generate Rs 2 million
only. A bank is prepared to lend the remaining Rs
28 million at 10% (Leveraged Buy Out) repayable in
10 equal annual installments.
– What is the worth of the firm?
– Would the worth change if a loan is taken?
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 Applying APV Method
• Under Adjusted Present Value (APV) approach:
– We find NPV assuming all-equity financing. With all-
equity financing only business risk is incorporated.
– Value each of the financing alternatives separately and
adjust the net present value accordingly.
– The value of debt is found using MM proposition that
value of levered firm is greater than the value of
unlevered firm by the amount of tax shield of debt.
• Each component of financing permits the use of separate
discount rate as befitting the cash flow.
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Obtain All-Equity Rate of Return
• WACC is conceptually easy to apply: But can be used
only when financial risk faced by the project is similar
to that of the parent. Difficult assumption to fulfill in
the international scenario.
• Use all equity approach to discount the operating
cash flows. o
e 
1  (1 T )D / E
where βe and β0 are all equity beta and observed beta
respectively, T is marginal tax rate, and D/E is the debt equity
ratio using market values.
• Can be used only when D/E ratio is constant. For
LBOs D/E changes substantially from year to year.
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NPV with All-Equity Discount Rate
• Find out NPV assuming no leverage (100% equity
financing)
NPV = 5 x 1.02/(0.20 - 0.02) - 30 = - 1.667 m
• With financing by debt the value will increase by
the amount of tax shield the debt provides.
Therefore present value adjusted for tax shield
of debt
APV = NPV (all equity) + PV of debt tax shield

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Value of Interest Tax Shield on Debt
Year O/S Interest Tax saved Repayment PV Of Tax Saved
10% 35% at 10%
1 28.000 2.800 0.980 2.800 0.891
2 25.200 2.520 0.882 2.800 0.729
3 22.400 2.240 0.784 2.800 0.589
4 19.600 1.960 0.686 2.800 0.469
5 16.800 1.680 0.588 2.800 0.365
6 14.000 1.400 0.490 2.800 0.277
7 11.200 1.120 0.392 2.800 0.201
8 8.400 0.840 0.294 2.800 0.137
9 5.600 0.560 0.196 2.800 0.083
10 2.800 0.280 0.098 2.800 0.038
PRESENT VALUE OF TAX SHIELD 3.778

APV = -1.667+3.778 = Rs 2.111 million

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Value of Subsidised Loan
• A loan of 125 million is available to IBM for setting up a
plant in Sikkim at interest of 8% with bullet repayment
after 10 years. What is the value of the loan if debt
otherwise is available at 15% and the tax rate is 40%.
• The value of the subsidised loan comes from a) interest
tax shield provided, and b) concessionary rate of
interest instead of commercial rate.
• The value can be found by discounting the cash flow of
the concessionary loan at commercial rate of interest.

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Value of Subsidised Loan
Interest on subsidised loan = 125 x 0.08 x 0.6 = 6.00
Interest saved = (0.15 – 0.08) x 125 = 8.75
Tax Saved = 0.4 x 0.08 x 125 = 4.00
10
6 125
NPV = 125  (1.15)n 1.15 10
= 63.99
1

Consists of two parts i) Interest subsidy and

ii) Tax shield
10
8.75
PV of Interest Subsidy = ∑ = 43.91
1 (1.15)n
10
4.0
PV of Tax Shield = ∑ n
= 20.07
1 (1.15)
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Obtaining Discount Rate
• These are discounted at all-equity capitalization rate.
Normally all-equity capitalization rate is available in
home country. This must be converted to an
equivalent all-equity capitalization rate in foreign
currency using inflation rates in the foreign and
home country.
• Depreciation tax shield must be discounted at cost of
debt. The known cost of debt in home currency again
must be converted to equivalent cost of debt in
foreign currency using inflations rates in two
currencies.
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Applying APV Method
Blocked Funds and Borrowing Capacity
• Concessionary loan if available may be valued at
commercial rate of interest.
• In case of blocked funds that are not remitted due to
higher rates of taxes payable the value must be
reckoned as the difference between the tax payable
and tax paid.
• Foreign project usually affects the borrowing
capacity in the home nation. If it enhances the debt
capacity of the parent the value of additional debt
must be added as benefit of the project, and valued
at market rate of debt.
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Determining Discount Rates
• Operating Cash flows = EBDIT to be discounted at cost of
equity assuming no debt.
• Tax shields on depreciation and interest are discounted at
cost of debt.
• Restricted funds released must be viewed before tax as
MNC saves taxes if funds are retained for funding the
project.
• All rates used for discounting: parent’s home land.
• ADJUSTING FOR RISK: All equity beta to be used for
arriving at appropriate discount rate.
Unlever beta of competing firm if project is not of the
same risk class to arrive at all-equity discount rate.
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