IFM Unit 4

Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance
Chapter 4
International Capital Budgeting

Introduction
• Capital budgeting may be defined as the firm’s formal
process for the acquisition and investment of capital.
• It involves firm’s decision to invest its current funds
for addition, disposition, modification and
replacement of fixed assets.
International Financial Management 2

Capital budgeting process

Project Project Project Project
generation evaluation selection implementation

Capital Budgeting Techniques

Traditional method
A) payback period method
B) accounting rate of return method
Discounted cash flow method

A) present value method
B) Internal rate of return method
C) Profitability index method…..

Pay back period method

• The term pay back is defined as the length of time,
required for the stream of cash proceeds produced by
an investment equal to the original cash outlay required
by the investment.
pay back period = initial investment (cash outlay)
annual cash inflow
Accounting/Average rate of return method (ARR)

• The accounting/average rate of return is founded by dividing the average
income after tax by the average investment
ARR = average income x100
average investment
Average investment
= original investment – scrap value (if any)
2
Discounted cash flow method

• Net Present Value Method : The NPV method
is one of the discounted cash flow (DCF)
technique which recognize the time value of
money.

Profitability Index (PI)

• PI = PV of cash inflow
initial cash outlay
Accept or Reject Criteria
PI>1 = accept
PI<1 = reject
Investment/Internal Rate of Return

• IRR is that rate at which the sum of discounted cash inflow (DCF) equal the same of discounted cash
outflow.
• It is the rate at which the net present value of the investment is Zero.
• Factor = original investment
cash inflow per year
IRR = A+ C – O x (B-A)
C- D
A = discount factor of low trial
B= discount factor of higher trial
C= PV of cash inflow in low trial
D = present value of cash inflow in the higher trial
O = original or initial outlay

Review of Domestic Capital Budgeting

1. Identify the SIZE and TIMING of all relevant cash flows on a time line.
2. Identify the RISKINESS of the cash flows to determine the appropriate discount rate.
3. Find NPV by discounting the cash flows at the appropriate discount rate.
4. Compare the value of competing cash flow streams at the same point in time.

International capital budgeting

Factors to Consider
• Exchange rate fluctuations. different scenarios should be considered together with their probability of occurrence.
• Inflation. inflation can be quite volatile from year to year for some countries.
• Financing arrangement. financing costs are usually captured by the discount rate. However, many foreign projects
are partially financed by foreign subsidiaries.
• Blocked funds. some countries may require that the earnings be reinvested locally for a certain period of time
before they can be remitted to the parent.
• Uncertain salvage value. The salvage value typically has a significant impact on the project’s NPV, and the MNC
may want to compute the break-even salvage value.
• Impact of project on prevailing cash flows. The new investment may compete with the existing business for the
same customers.
• Host government incentives. These should also be considered in the analysis.

International Capital Budgeting

• You have two equally valid approaches:
– Change the foreign cash flows into dollars at the exchange rates expected to prevail. Find the
$NPV using the dollar cost of capital.
– Find the foreign currency NPV using the foreign currency cost of capital. Translate that into
dollars at the spot exchange rate.
• If you watch your rounding, you will get exactly the same answer either way.

Capital Budgeting from the Parent Firm’s Perspective
One recipe for international decision makers:
1. Estimate future cash flows in foreign currency.
2. Convert to the home currency at the predicted exchange rate.

Use PPP, IRP criteria for the predictions.
3. Calculate NPV using the home currency cost of capital.

Example
A U.S. MNC is considering a European opportunity. The size and timing of the after-tax cash flows
are:
–€600 €200 €500 €300
0 1 2 3
The inflation rate in the euro zone is € = 3%, the inflation rate in dollars is p$
= 6%, and the business risk of the investment would lead an unlevered U.S.-
based firm to demand a return of Kud = i$ = 15%.

–€600 €200 €500 €300
0 1 2 3
The current exchange rate is S0($/€) = $1.25
€
Is this a good investment from the perspective of the
U.S. shareholders?
To address that question, let’s convert all of the cash flows to dollars and
then find the NPV at i$ = 15%.
–$750
–€600 €200 €500 €300
0 1 2 3
CF0 = (€600)× S0($/€) =(€600)×$1.25
€ = $750
Finding the dollar value of the initial
S ($/€) = $1.25
cash flow is easy; convert at the spot 0 €
rate: International Financial Management 16
–$750 $257.28
–€600 €200 €500 €300
0 1 2 3
The exchange rate expected to prevail in the first year, S1($/€),
can be found with PPP:
1 + $ 1.06 $1.25
S1($/€) = 1 +   S0($/€) =  = $1.2864/€
€ 1.03 €
CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28
–$750 $257.28 $661.94

–€600 €200 €500 €300
0 1 2 3
1.06 1.06 $1.25

CF=2    €500 = $661.94
1.03 1.03 €

–$750 $257.28 $661.94 $408.73

–€600 €200 €500 €300
0 1 2 3
1.06 1.06 1.06 $1.25
CF=3     €300 = $408.73
1.03 1.03 1.03 €

–$750 $257.28 $661.94 $408.73
0 1 2 3
Find the NPV using the cash flow menu of your financial
CF0 = –$750 calculator and and interest rate i$ = 15%:
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 International Financial Management
NPV = $242.99 20
Capital Budgeting from the Parent Firm’s Perspective:

Alternative
Another recipe for international decision makers:

1. Estimate future cash flows in foreign currency.
2. Estimate the foreign currency discount rate.
3. Calculate the foreign currency NPV using the foreign cost of capital.
4. Translate the foreign currency NPV into dollars using the spot exchange rate
– €600 €200 €500 €300
0 1 2 3
Let’s find i€ and use that on the euro
€ = 3% cash flows to find the NPV in euros.
i$ = 15% Then translate the NPV into dollars
at the spot rate.
p$ = 6% $1.25
The current exchangeInternational
rate is S 0 ($/€) =
Financial Management € 22
• Before we find i€ let’s use our intuition.
• Since the euro-zone inflation rate is 3% lower than the

dollar inflation rate, our euro denominated discount rate
should be lower than our dollar denominated discount
rate.
Recall that the Fisher Effect holds that

(1 + e) × (1 + $) = (1 + i$)
real inflation nominal

rate rate rate
So for example the real rate in the U.S. must be 8.49%
(1 + i$) 1.15
(1 + e) = e= – 1 = 0.0849
(1 + $) International Financial Management 1.06 24
If Fisher Effect holds here and abroad then

(1 + i$) (1 + i€)
(1 + e$) = and (1 + e€) =
(1 + $) (1 + €)
If the real rates are the same in dollars and euros (e€ = e$)
we have a very useful parity condition:
(1 + i$) (1 + i€)
=
(1 + $)
International Financial Management
(1 + €) 25
If we have any three of these variables, we can find the

fourth:
(1 + i$) (1 + i€)
= In our example, we want to find i€
(1 + $) (1 + €)
(1 + i$) × (1 + €)
(1 + i€) = (1 + $)
(1.15) × (1.03)
i€ = –1
(1.06)
i€ = 0.1175
– €600 €200 €500 €300

0 1 2 3
Find the NPV using the cash flow menu and i€ = 11.75%:
CF0 = –€600 I = 11.75
CF1 = €200 NPV = €194.39
CF2 = €500
CF3 = €300 €194.39 × $1.25
€
= $242.99
€200 + €500 2 + €300 3 = €194.39

NPV = –€600 + 1.1175 (1.1175) (1.1175)
€194.39 × $1.25
€
= $242.99
–$750 $257.28 $661.94 $408.73
0 1 2 3
$257.28 $661.94 $408.73
NPV = –$750 + + 2 + 3 = $242.99
1.15 International(1.15)
Financial Management
(1.15) 28
Computing IRR
Recall that a project’s Internal Rate of Return (IRR) is the discount rate that gives a
project a zero NPV.
€200 €500 €300
NPV = –€600 + + 2 + 3 = €0
1+IRR€ (1+IRR€) (1+IRR€)
IRR€ = 28.48%
$257.28 $661.94 $408.73
NPV = –$750 + + 2+ 3 = $0
1+IRR$ (1+IRR$) (1+IRR$)
IRR$ = 32.23%International Financial Management 29
Computing IRR
€200 €500 €300

NPV = –€600 + + 2 + 3 = €0
1+IRR€ (1+IRR€) (1+IRR€)
CF0 = –€600 IRR€ = 28.48%
CF1 = €200
CF2 = €500
CF3 = €300
Computing IRR
$257.28 $661.94 $408.73

NPV = –$750 + + 2+ 3 = $0
1+IRR$ (1+IRR$) (1+IRR$)
CF0 = –$750
CF1 = $257.28 IRR$ = 32.23%
CF2 = $661.94 24.85% may Check
CF3 = $408.73

Converting from IRR$ to IRR€

• Use the same IRP and PPP conditions that we used to convert from
one discount rate to another.
1+IRR$ 1+IRR€ In our example, it was easy to find IRR€
=
(1 + $) (1 + €) Finding IRR$ without converting all cash
flows into dollars is straightforward:
(1+IRR€)(1 + $) (1.2848)(1.06)
(1+IRR$) = i€ = –1
(1 + €) (1.03)
 = 3%, p = 6%International Financial Management IRR$ = 32.23% 32
€ $
Risk and Uncertainty in Capital Budgeting

• Risk exist because of the inability of the decision maker to make
perfect forecasts.
• Forecasts cannot be made with certainty since future events on
which they depend are uncertain.
• Hence we have to take decision in capital budgeting after
adjusting these risk or uncertainty.
Risk Adjustment in the Capital Budgeting Process
• Clearly risk and return are correlated.

• Political risk may exist along with business risk,
necessitating an adjustment in the discount rate.

Sensitivity Analysis
• In sensitivity analysis, different estimates are used for expected
inflation rates, cost and pricing estimates, and other inputs to give
the manager a more complete picture of the planned capital
investment.
• Lends itself to computer simulation.
Thank you

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Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

International Capital Budgeting

International Financial Management 2

Capital budgeting process

International Financial Management 3

Capital Budgeting Techniques

Discounted cash flow method

International Financial Management 4

Pay back period method

Accounting/Average rate of return method (ARR)

Discounted cash flow method

International Financial Management 7

Profitability Index (PI)

Investment/Internal Rate of Return

International Financial Management 9

Review of Domestic Capital Budgeting

International Financial Management 10

International capital budgeting

International Financial Management 11

International Capital Budgeting

International Financial Management 12

Capital Budgeting from the Parent Firm’s Perspective

One recipe for international decision makers:

1. Estimate future cash flows in foreign currency.

2. Convert to the home currency at the predicted exchange rate.

3. Calculate NPV using the home currency cost of capital.

–€600 €200 €500 €300

International Financial Management 14

–€600 €200 €500 €300

–$750 $257.28 $661.94

1.06 1.06 $1.25

International Financial Management 18

–$750 $257.28 $661.94 $408.73

International Financial Management 19

–$750 $257.28 $661.94 $408.73

Capital Budgeting from the Parent Firm’s Perspective:

Another recipe for international decision makers:

– €600 €200 €500 €300

• Before we find i€ let’s use our intuition.

• Since the euro-zone inflation rate is 3% lower than the

Recall that the Fisher Effect holds that

real inflation nominal

If Fisher Effect holds here and abroad then

If we have any three of these variables, we can find the

– €600 €200 €500 €300

€200 + €500 2 + €300 3 = €194.39

–$750 $257.28 $661.94 $408.73

€200 €500 €300

$257.28 $661.94 $408.73

International Financial Management 31

Converting from IRR$ to IRR€

Risk and Uncertainty in Capital Budgeting

Risk Adjustment in the Capital Budgeting Process

• Clearly risk and return are correlated.

International Financial Management 34

International Financial Management 36

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