Arun Nagyal Choudhary 11-MBA-10

 International

capital budgeting analysis differs from purely domestic analysis because:
• cash inflows and outflows occur in a foreign

currency, and • foreign investments potentially face significant political risks

What is a company’s motivation to invest capital abroad?
 

Fill product gaps in foreign markets where excess returns can be earned. To produce products in foreign markets more efficiently than domestically. To secure the necessary raw materials required for product production.

How does a firm make an international capital budgeting decision?
1. 2. 3. Estimate expected cash flows in the foreign currency. Compute their U.S.-dollar equivalents at the expected exchange rate. Determine the NPV of the project using the U.S. required rate of return, with the rate adjusted upward or downward for any risk premium effect associated with the foreign investment.

Only consider those cash flows that can be “repatriated” (returned) to the home-country parent. The exchange rate is the number of units of one currency that may be purchased with one unit of another currency. • For example, the current exchange rate might be 50 Rs for one U.S. dollar.

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International diversification and risk reduction Government taxation Foreign Taxation Political Risk

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term (foreign) investment projects Same theoretical framework as domestic capital budgeting The basic steps are: - Identify the initial capital invested - Estimate cash flows to be derived from the project over time, including an estimate of the terminal value of the investment - Identify the appropriate discount rate to use in valuation - Apply traditional capital budgeting decision criteria such as Net Present Value (NPV) and Internal Rate of Returns (IRR) - Alternative, Adjusted Present Value (APV).

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The decision to search for foreign investment An assessment of the political climate in the host country Examination of the overall strategy Cash Flow Analysis Required Rate of Return Economic Evaluation Selection Risk Analysis Implementation Expenditure Control Post Audit


> 0, Accept  NPV < 0, Reject  NPV = 0, May accept

• •

If IRR > Cost of capital, accept the project. If IRR < Cost of capital, reject the project.

• • •

If PI > 1, Accept If PI < 1, Reject If PI = 1, May accept

Once cash flows and cost of capital are known – process of evaluating investment projects. * * * * Pay back period ARR NPV IRR

Which is Good

* * *

Accept – Reject decision Mutually Exclusive Choice Capital Rationing

Adjusted Present Value : PV Technique – Discounts different cash flows at different rates – depending upon risk associated with each cash flow.

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Home country or host country whose Blocked Funds Loss due to lost exports Restrictions on Repatriation Taxation Effect on Borrowing capacity Concessional Loan Depreciation




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Firms must select combinations of investment projects that maximize the firms value to it’s shareholders 􀂉 Decision rule/criteria is needed: 􀂉 Net Present Value (NPV) 􀂉 Consistent with shareholder wealth maximization (focus on cash flows and opportunity cost of money invested – not accounting profits) 􀂉 Value additive: “The NPV of a set of independent project is simply the sum of NPVs of the individual projects

“present value of future cash flows discounted at the projects cost of capital minus the initial net cash outlay for the project”

Need to calculate:  Net cash flows (in- and out flows) from the project  Cost of funding the project  The terminal value of project  Need to decide on:  The lifetime of the project (horizon)  The discount rate (projects cost of capital)

Total project vs. incremental cash flows  􀂉 “Shareholders are interested in how many additional dollars they will receive in the future for the dollars they lay out today”  􀂉 Distinction between the projects total cash flows and the incremental cash flow from the project  Incremental cash flow: compare worldwide corporate cash flows without investment (base case) with post-investment corporate cash flows 􀂉 Need to assess what will happen if we don’t make investment

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Project total cash flow and incremental cash flows may deviate due to: 􀂉 Cannibalization: 􀂉 A new investment (product) takes sales away from the existing products 􀂉 A foreign production plant’s production substitutes parent company export 􀂉 Incremental cash flow: If investment replace other existing cash flows (that otherwise would have existed) these cash flows (the replaced) need to be subtracted from the investments total cash flow to obtain the incremental cash flow of the investment

 Sales

creation  􀂉 Opposite of cannibalization  􀂉 “investment leads to increasing cash flows at  other production sites (than otherwise), due to  e.g. a stronger local position of the firm”  􀂉 Incremental cash flow = investments total  cash flows + “sales creation cash flows

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