TOPIC TWO

INTERNATIONAL CAPITAL BUDGETING

Introduction
The fundamental goal of the financial manager is shareholder wealth maximization. Shareholder
wealth is created when the firm makes an investment that will return more in a present value sense
than the investment costs. Perhaps the most important decisions that confront the financial
manager are which capital projects to select. Capital budgeting decisions determine the
competitive position of the firm in the product marketplace and the firm’s long-run survival. The
generally accepted methodology in modern finance is to use the net present value (NPV)
discounted cash flow model. Past studies have shown that a firm that could source funds
internationally rather than just domestically could feasibly have a lower cost of capital than a
domestic firm because of its greater opportunities to raise funds. A lower cost of capital means
that more capital projects will have a positive net present value to the multinational firm.
MULTINATIONAL CAPITAL BUDGETTING

What is Capital Budgeting?

Refers to the allocation of scares resources or making investment in fixed assets e.g. real estates,
development expenditures etc.
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the
best returns on investment.
An organization is often faced with the challenges of selecting between two projects/investments
or the buy vs replace decision. Ideally, an organization would like to invest in all profitable
projects but due to the limitation on the availability of capital an organization has to choose
between different projects/investments.
Capital budgeting for a foreign project uses the same theoretical framework as domestic capital
budgeting i.e. using the various capital budgeting techniques like NPV, IRR, PI, Payback period
etc.
International capital budgeting
Involves substantial spending in capital projects foreign countries, rather than in the home country
by the MNC.
However, capital budgeting analysis for a foreign project is more complex than the domestic case
for various reasons:

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Capital Budgeting Process
The process of capital budgeting is as follows:

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1. Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment opportunity can
be anything from a new business line to product expansion to purchasing a new asset. For
example, a company finds two new products that they can add to their product line.

2. Evaluating investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its options
for investment. That is to say, once it is decided that new product/products should be added to the
product line, the next step would be deciding on how to acquire these products. There might be
multiple ways of acquiring them. Some of these products could be:

 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchased from the market

3. Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an organization
needs to decide the most profitable investment and select it. While selecting a particular project an
organization may have to use the technique of capital rationing to rank the projects as per returns
and select the best option available.
In our example, the company here has to decide what is more profitable for them. Manufacturing
or purchasing one or both of the products or scrapping the idea of acquiring both.

4. Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the project it needs
to identify the sources of funds and allocate it accordingly.
The sources of these funds could be reserves, investments, loans or any other available channel.

5. Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially, the
organization had selected a particular investment for a predicted return. So now, they will
compare the investments expected performance to the actual performance.
In our example, when the screening for the most profitable investment happened, an expected
return would have been worked out. Once the investment is made, the products are released in the
market, the profits earned from its sales should be compared to the set expected returns. This will
help in the performance review.

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various techniques available
based on the comparison of cash inflows and outflows

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These techniques are:

1. Payback period method

In this technique, the entity calculates the time period required to earn the initial investment of the
project or investment. The project or investment with the shortest duration is opted for.

2. Net Present value

The net present value is calculated by taking the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. The investment with a
positive NPV will be considered. In case there are multiple projects, the project with a higher NPV
is more likely to be selected.

3. Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or average
investment to derive at the most profitable investment.

4. Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV becomes zero. The
project with higher IRR is usually selected.

5. Profitability Index
Profitability Index is the ratio of the present value of future cash flows of the project to the initial
investment required for the project.
Each technique comes with inherent advantages and disadvantages. An organization needs to use
the best-suited technique to assist it in budgeting. It can also select different techniques and
compare the results to derive at the best profitable projects.

Conclusion
Capital budgeting is a predominant function of management. Right decisions taken can lead the
business to great heights. However, a single wrong decision can inch the business closer to shut
down due to the number of funds involved and the tenure of these projects.
The main objective of the firm is to maximize profit either by way of increased revenue or by cost
reduction. Broadly, there are two types of capital budgeting decisions which expand revenue or
reduce cost.
Importance of Capital Budgeting decisions
The following are the objectives of capital budgeting;
1. Involves commitment of large amount of funds in the firm
2. Are irreversible (projects) at substantial loss
3. They influence the firm growth in the long run (future)

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 4. In case of a risk, the loss is high to the firm
5. Among the most difficult decisions to make
6. To know whether the fixed (capital) assets will gives more return or high profits.
7. To decide whether a specified project is to be selected or not.
8. To find out the amount of finance required for the capital expenditure.
9. To assess the various sources of finance for capital expenditure.
10. To evaluate the merits of each proposal and to decide which project is best.
THE INTERNATIONAL COMPLICATIONS IN CAPITAL BUDGETTING
1. Parent cash flows must be distinguished from project cash flows.
2. Parent cash flows often depend on the form of financing. Thus cash flows cannot be clearly
separated from the financing decisions, as is done in domestic capital budgeting.
3. Remittance of funds to the parent must be explicitly recognized because of differing tax
systems, legal and political constraints on the movement of funds, local business norms and
differences in how financial markets and institutions function.
4. Cash flows from affiliate to parent can be generated by an array of non-financial payments
such as payment of license fees and payments for imports from the parent.
5. Differing rates of national inflation must be anticipated because of their importance in
causing changes in competitive position and thus in cash flows over a period of time.
6. The possibility of unanticipated foreign exchange rate changes must be remembered because
of the possible direct effects on the competitive position of the foreign affiliate.
7. Use of segmented national capital market my create an opportunity for financial gains or
may lead to additional financial costs.
8. Use of the host government subsidized loans complicates both capital structure and the
ability to determine appropriate WACC for discounting purposes.
9. Political risk must be evaluated because political events can drastically reduce the value or
availability of expected cash flows.
10. Terminal value is more difficult to estimate because potential purchases from the host,
parent, third countries or the private or public sector may have widely divergent perspectives
on the value to them of acquiring the project.
All foreign complexities must be quantified as modifications to either expected cash flows or the
discount rate.

INPUT TO THE CAPITAL BUDGETING DECISION

Regardless of the long term project to be considered an MNC will normally require forecasts of
the following economic and financial characteristics related to the project.

 Initial investment
 Consumer demand
 Price
 Variable cost
 Fixed cost
 Project lifetime
 Fund transfer restriction

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  Tax laws
 Social costs
 Required rate of returns
 Exchange rates

FACTORS TO CONSIDER IN MULTINATIONAL CAPITAL BUDGETING.

1. Exchange rate fluctuations
2. Inflation
3. Financing arrangements
4. Blocked funds
5. Remittance provisions
6. Uncertain salvage value
7. Impact of the project on prevailing cash flows
8. Government incentives
9. Social costs
10. Threat of expropriation – projects of a foreign company forcibly being taken over
by the host government.

ADJUSTING PROJECT ASSESSMENT FOR RISK

If an MNC is unsure of the projected demand, price per unit etc. it needs to incorporate an
adjustment for risk. There are 5 common methods used for adjusting the evaluation for risk.

Methods used for adjusting the evaluation for risk

a) Risk adjusted discount rate
b) Certainty equivalent approach.
c) Payback period
d) Sensitivity analysis – use of WHAT IF Scenarios.
e) Simulation- generating probability distribution for NPV based on a range of possible values
for one or more variables.

MNC CHARACTERISTICS THAT AFFECT THE COST OF CAPITAL

An MNC should use a discount rate in capital budgeting that reflect its cost of capital adjusted for
the proposed projects risk.

There are various factors related to a MNC that may affect its cost of capital, including:
 Size of the firm
 Access to international capital markets
 International diversification
 Tax concessions
 Exchange rate risk
 Country risk

POLITICAL RISK ANALYSIS

POLITICAL RISK – is the exposure to a change in the value of an investment or cash position
resulting from government actions – the change in value could be positive or negative.

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Forms of Political Risk
 Changes in tax regulations.
 Exchange controls
 Stipulations about local production
 Expropriations
 Commercial discrimination against foreign controlled businesses
 Restrictions on access to local borrowings
 Environmental protection laws

STEPS OF POLITICAL RISK ASSESSMENT

1. Recognition of the existence of political risk and its likely consequences that is, measuring
political risk.
2. Development of policies to cope with political risk that is, managing political risk.
3. Development of tactics to maximize compensation should expropriation occur –
developing post expropriation policies.

REASONS FOR ANALYSIS OF COUNTRY/ POLITICAL RISK

1. Non-bank MNCs analyze political risk as a screening device to avoid countries with
excessive country risk.
2. It can be used to monitor countries where the MNC is currently engaged in international
business and consider divestment if necessary.
3. To assess particular forms of risk for a proposed capital budgeting project considered for a
foreign country.

POLITICAL RISK / COUNTRY RISK ANALYSIS

MEASUREMENT OF POLITICAL RISK

There are 2 ways used to measure political risk;

1. Country specific route/ micro approach

2. Firm specific route / macro approach – should include assessment of both political risks
and financial risks.

POLITICAL RISK FACTORS INCLUDE;

a) The host country taking over a subsidiary, the most extreme form of political risk.
b) Expropriation – with or without compensation.
c) Purchase home made products philosophy to an export.
d) Attitude of host government towards the MNC
e) Attitude of people in the host country towards the MNC
f) Blockage of fund transfers
g) Probability of war

FINANCIAL RISK FACTORS INCLUDE;

 Current and potential state of the country’s economy – particularly demand for the
products.
 Financial distress in a country can encourage a government to implement policies that
could limit the MNCs market penetrate there.

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The state of economy depend on many factors which an MNC should look out for:
a) Interest rates
b) Exchange rates
c) Inflation
The financial factors of a macro- assessment model should include;
 GNP Growth
 Inflation trends
 Government budget levels
 Interest rates
 Unemployment
 The country’s reliance on export income
 The balance of trade
 Foreign exchange controls

MICRO – ASSESSMENT OF COUNTRY RISK

a) Review the MNCs relationship with the host government
b) Review the relationship between the people’s attitude toward the MNC
c) Review the financial variables for example, sensitivity of the firm’s business to real GNP
growth, inflation trends, interest rates etc.

In summary, the overall assessment of country risk consists of 4 parts:

 Macro political risk
 Macro financial risk
 Micro political risk
 Micro financial risk

Techniques to assess Country risk

Once a firm identifies all the macro and micro factors that deserve consideration in the country
risk assessment, it may wish to implement a system for evaluating these factors and determining a
country risk rating.
The various techniques available to achieve this objective include:

a) Checklist approach
b) Delphi techniques
c) Quantitative analysis
d) Inspection visits
e) Combination of techniques

a) CHECKLIST APPROACH
It involves judgment of the political and financial factors (both macro and micro) that contribute
to a firm’s assessment of country risk such as real GNP growth which can be measured from
available data while others such as probability of entering into a war must be subjectively
measured.
The factors should then be converted to some numerical (indices) form in which they can be
assessed for a particular country.
Those factors thought to have a greater influence on country risk should be assigned greater
weights.

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The rating method developed by HANER (1979) is worth mentioning. Hanner rates on a scale of
0- 7, a number of factors which cause internal political distress.

Factors causing internal political distress

a) Fractionalization by language, ethnic or religious groups and power of resulting factions
b) Fractionalization of the political spectrum and power of resulting factions
c) Restrictive measures required to retain power
d) Xenophobia, nationalism, inclination to compromise
e) Social conditions, including extremes in population density and wealth distribution.
f) Organization and strength of a radical left government
g) Ratings from external factors, including;
 Dependence on or importance to a hostile major powers.
 Negative influence of regional political forces, possibilities of border wars and disruptions
arising from such sources of conflict.
Finally, additional ratings relating to estimated symptoms of problems are computed and
aggregated and include;
 Societal conflict
 Political instability

Scores are aggregated and updated regularly as the world political environment changes countries
are then rated as to:
 Minimal risk ( 0 to 19 rating points)
 Acceptance risk (20 to 34 rating points)
 High risk (35 to 44) rating points
 Prohibitive risk( > 45) rating points

b) DELPHI TECHNIQUE
Involves collection of independent opinions on country risk without group discussion by the
assessors who provided these opinions. The assessors here may be employees of the firm
conducting the assessment or outside consultants.
The MNC can oversee these country risk scores in some manner and even assess the degree of
disagreement by measuring dispersions of opinions.
c) QUANTITATIVE ANALYSIS
Attempts to identify the characteristic that influence the level of country risk.
They include;
 Discriminant analysis, a statistical tool.
 Regression analysis, measures sensitivity of one variable to other variables.

d) INSPECTION VISITS
Involves travelling to country and meeting with government officials, firm executives and
consumers.

e) COMBINATION OF TECHNIQUES
Could use one or more of the above techniques since each technique has is strengths and
weaknesses.

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MANAGEMENT OF COUNTRY RISK

In capital budgeting for a foreign project, a higher discount rate should be used for the countries
with low risk ratings (high risk countries)
Even after a project is accepted and implemented, country risk must continue to be monitored.
Political risk may be controlled at the pre- investment stage or in the course of operations or both.

APPROACHES TO MINIMIZING POLITICAL RISK IN THE PRE – INVESTMENT PERIOD.

 Avoidance
 Insurance against expropriation
 Negotiating the environment
 Structuring the environment ; structuring operating and financial policies e.g. strategy of
keeping the foreign company dependent on group companies for markets or supplies.

REDUCING EXPOSURE TO HOST GOVERNMENT TAKE OVERS

The most popular techniques for reducing exposure to a takeover include;
 Short term profit maximization – ensures recovery of cash flows quickly, minimum
replacement of worn out equipment and machinery at the subsidiary.
 Unique supplies – subsidiary can bring supplies from its HRs or sister subsidiary that
cannot be duplicated locally.
 Hire local labor
 Borrowing local funds
 Insurance, to cover the risk of expropriates
 Planned divestment; selling off assets to local investors or to the government in stages over
time.
 Joint ventures, ventures with the host government.
 Technological secrets; keep secrets on technology from the locals unless it is a friendly
takeover with adequate compensation.
 Use of power; Subsidiary Company threaten the host government with the local labor revolt
or that the subsidiary will support an opposition party.

POST EXPROPRIATION POLICIES

When the host government decides to expropriate the assets of an MNC subsidiary, the only
alternative for the subsidiary company is to enter into mutual concessions so that the firm might
continue operations. These concessions include:
1. Hire national (local) managers.
2. Raise transfer prices charged from the locally based firm to other parts of the group.
3. Accept local partners
4. Change expatriate management
5. Invest more capital
6. Contribute to political campaigns
7. Release the host government from concessions agreements
8. Support government programs
9. Suspend payment of dividends
10. Surrender majority control
11. Remove all home country personnel.
12. Reorganize to give greater benefit to the local company.

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Incremental Cash Flows
The most important as well as the most difficult part of an investment analysis is to calculate the
cash flows associated with the project: the cost of funding the project; the cash inflows during the
life of the project; and the terminal, or ending, value of the project. Shareholders are interested in
how many additional dollars they will receive in the future for the dollars they lay out today.
Hence, what matters is not the project’s total cash flow per period, but the incremental cash flows
generated by the project.
Causes of differences between Incremental cash flow total cash flow.

1. Cannibalization.
When Honda introduced its Acura line of cars, some customers switched their purchases from the
Honda Accord to the new models. This example illustrates the phenomenon known as
cannibalization, a new product taking sales away from the firm’s existing products.
Cannibalization also occurs when a firm builds a plant overseas and winds up substituting foreign
production for parent company exports. To the extent that sales of a new product or plant just
replace other corporate sales, the new project’s estimated profits must be reduced by the earnings
on the lost sales.
2. Sales Creation.
Black & Decker, the U.S. power tool company, significantly expanded its exports to Europe after
investing in European production facilities that gave it a strong local market position in several
product lines. Similarly, GM’s auto plants in Britain use parts made by its U.S. plants, parts that
would not otherwise be sold if GM’s British plants disappeared. In both cases, an investment either
created or was expected to create additional sales for existing products. Thus, sales creation is the
opposite of cannibalization.
3. Opportunity Cost.
Suppose IBM decides to build a new office building in Sao Paulo on some land it bought 10 years
ago. IBM must include the cost of the land in calculating the value of undertaking the project.
Also, this cost must be based on the current market value of the land, not the price it paid 10 years
ago. This example demonstrates a more general rule. Project costs must include the true economic
cost of any resource required for the project, regardless of whether the firm already owns the
resource or has to go out and acquire it. This true cost is the opportunity cost, the maximum amount
of cash the asset could generate for the firm should it be sold or put to some other productive use.
4. Transfer Pricing.
By raising the price at which a proposed Ford plant in Dearborn,
Michigan, will sell engines to its English subsidiary, Ford can increase the apparent profitability
of the new plant but at the expense of its English affiliate. Similarly, if Matsushita lowers the price
at which its Panasonic division buys microprocessors from its microelectronics division, the
latter’s new semiconductor plant will show a decline in profitability. These examples demonstrate
that the transfer prices at which goods and services are traded internally can significantly distort
the profitability of a proposed investment. Whenever possible, the prices used to evaluate project
inputs or outputs should be market prices. If no market exists for the product, then the firm must
evaluate the project based on the cost savings or additional profits to the corporation of going
ahead with the project.

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 5. Fees and Royalties.
Often companies will charge projects for various items such as legal counsel, power, lighting, heat,
rent, research and development, headquarters staff, management costs, and the like. These charges
appear in the form of fees and royalties. They are costs to the project, but they are a benefit from
the standpoint of the parent firm. From an economic standpoint, the project should be charged only
for the additional expenditures that are attributable to the project; those overhead expenses that are
unaffected by the project should not be included in estimates of project cash flows.
6. Getting the Base Case Right.
In general, a project’s incremental cash flows can be found only by subtracting worldwide
corporate cash flows without the investment—the base case—from post investment corporate cash
flows. To come up with a realistic base case, and thus a reasonable estimate of incremental cash
flows, managers must ask the key question, ‘What will happen if we don’t make this investment?’’
Failure to heed this question led General Motors during the 1970s to slight investment in small
cars despite the Japanese challenge; small cars looked less profitable than GM’s then-current mix
of cars. As a result, Toyota, Nissan, and other Japanese automakers were able to expand and
eventually threaten GM’s base business.
7. Accounting for Intangible Benefits.
Related to the choice of an incorrect base case is the problem of incorporating intangible benefits
in the capital-budgeting process. Intangibles such as better quality, faster time to market, quicker
and less error-prone order processing, and higher customer satisfaction can have tangible impacts
on corporate cash flows, even if they cannot be measured precisely. Similarly, many investments
provide intangible benefits in the form of valuable learning experiences and a broader knowledge
base. For example, investing in foreign markets can sharpen competitive skills: It exposes
companies to tough foreign competition; it enables them to size up new products being developed
overseas and figure out how to compete with them before these products show up in the home
market; and it can aid in tracking emerging technologies to transfer back home. Adopting practices,
products, and technologies discovered overseas can improve a company’s competitive position
worldwide.

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