Introduction

Capital budgeting for multinational

firms uses the same framework as
domestic capital budgeting.
Cont...
International Capital Budgeting
consider the following;
Relevant cash flows; ie incremental
cash flows,
Opportunity cost,
Transfer pricing-market price;
Cont..
Cannibalization/The Side Effects
Sales lost due to the introduction of new product under
review.
Should be considered as cost when there is no
competition
However, when there is strong competitions from
rivals; should not be considered
Cont..
• The process of analyzing foreign direct investments is
more complicated than for purely domestic ones.
Measuring cash flows is more difficult as a result of:
– different tax laws,
– fluctuating exchange rates,
– the difficulty of forecasting macroeconomic conditions
in a foreign country,
– political risk, and
– cultural differences and communications problems.
Foreign Exchange Risk
Cash flows from a foreign project are in foreign
currency and therefore subject to exchange risk from
the parent’s point of view.
 Multinational firms investing abroad are exposed to foreign
exchange risk i.e. the risk that the currency will depreciate or
appreciate over a period of time.
 Understanding of foreign exchange risk is very important. In

the evaluation of cash flows generated by the project over its

life cycle.
Remittance Restrictions

 Where there are restrictions on the repatriation of

income, substantial differences exist between projects
cash flows and cash flows received by the parent firm.
Only those cash flows that are remittable to the
parent company are relevant from the firm’s
perspective.
Macro-economic Conditions
• The difficulty of forecasting macroeconomic conditions in
a foreign country,
 Changes in employment levels
 Gross Domestic project
 Prices-inflation
 Interest rates
Cultural Differences
Cultural differences and communications problems
Individualism vs. collectivism
International Taxation

• Both in domestic and international capital budgeting,

only after tax cash flows are relevant for project
evaluation.
• However in international capital budgeting, the tax
issue is complicated by the existence two taxing
jurisdictions, plus a number of other factors including
for of remittance to the parent firm, tax withholding
provision in the host country.
Political or Country Risk

Assets located abroad are subject to the risk of

appropriation or nationalization (without adequate
compensation) by the host country government.
Also there are may be changes in applicable
withholding taxes, restrictions on remittances by the
subsidiary to the parent, etc.
Incremental Cash Flows
Focus should be on incremental cash flows .
Methods of International Capital
Budgeting

In international capital budgeting two approaches are

commonly applied:
Discounted Cash Flow Analysis (DCF)
The Adjusted Present Value Approach
The Discounted Cash Flow
Analysis

DCF technique involves the use of the time value of

money principle to project evaluation. The two most
widely used criteria of the DCF technique are;
The Net Present Value and (NPV)
The Internal rate of return (IRR)

The NPV is the most popular method.

The Net Present Value and (NPV)

Under NPV we have;

Decentralized Capital Budgeting Technique
Centralized Capital Budgeting Technique
Method I: Decentralized Capital
Budgeting Technique

I. Forecast the cash flows in foreign currency

II. Discount these cash flows at the discount rate
appropriate for the foreign market; this gives an
NPV in terms of foreign currency.
III. Convert the NPV in foreign currency into domestic
values at the spot exchange rate.
Method II: Centralized Capital
Budgeting Technique

I. Forecast the cash flows in foreign currency

II. Convert these cash flows into domestic currency,
using the relevant forward exchange rates.
III. Discount the cash flows in domestic currency and
the discount rate appropriate for domestic projects
Class Example
A US firm is considering an investment in Tanzania,
which will cost TZS200 million and is expected to
produce cash inflows of TZS30 million in real terms in
each of the next 7 years. The firm estimates that the
appropriate cost of capital for the project is 8%. Annual
interest rates are 9% in Tanzania, 7% in the US, the spot
exchange rate is TZS 2,325.58 per US$, and inflation in
Tanzania is expected to average 6% per year. At the end
of the seventh year the US firm expects to sell the
Tanzanian investment to a local firm for TZS50 million.
 
Required:
You have been selected as the firm’s financial analyst
and you have been assigned the task of supervising
the international capital budgeting analysis. Evaluate
and comment on the economic viability of the
proposed project. (Use the NPV Method: i)
Centralized Capital Budgeting and ii) Decentralized
Capital Budgeting Techniques; given that Foreign
Cost of Capital = 9%) Ignore taxation.
Required Readings for the
Module

Bodie Z., Kane A. and Marcus A.(200) , Investments,

McGraw Hill,
Reilly F. and Brown K., Thomson (2003) Investment
Analysis and Portfolio Management (7e),
Dimitris Chorafas, (2003) ‘Alternative Investments
and the Mismanagement of Risk’
Shapiro, A (2006), Multinaltional Financial
Management, 8ed John Wiley & Sons
Pandey, I M (2010), Financial Management, 10 ed,
Vikas Publishing House.
Thank you for Listening