international financial management-part ii

International financial management—part II

Capital budgeting for multinationalsApplication of the principles of domestic capital budgeting to the varying international environments-language, culture, policies, laws,customs Goal is to increase value to the parent share holders

Investment is the art of finding out assets that would have more valuein future than what they cost today.Theory of value and rules relating to return apply to investment decisions

Objective of investment is growth with stability

TypesBased on locationInvestments within the business oroutside. Investments within business is capital budgeting.

Investment Outside

in financial and real assets eitherfor treasury operations or for strategic control or acquisition

Investment within

Business needs long-term assets or capital assets such as land, building plant and machinery for creating and maintaining facilities. For utilizing the facilities so created and to generate income, business requires short-term assets or current assetslike cash, materials and receivables.

Planned investment in projects within the organisation isCapital budgeting

Purpose

For Creating facilities for the production of

goods or for rendering services, Maintaining and improving existing

facilities and for Updating processBetter utilization of the existing facilities to

generate additional revenues.

Broad classification of projects

• New projects• Expansions• Diversifications• Modernizations• Acquisitions• Research and development• Replacements and • Social projects.

Steps in capital budgeting

>Identification of project ideas >Calculation of cash flows of each

proposal>Evaluating cash flows of proposals >Ranking the projects >Choosing that alternative, which is best

(gives maximum benefit for same cost or same benefit for minimum cost)

Calculation of cash flowsInitial investment = cash outflow (-) = investment in fixed assets and working capitalPeriod when project is completed and readyfor production is 0 year Where gestation period is more than a yearinvestments before zero year (pre-zero years) are indicated -1, -2, -3, etc.

Cash inflows-returns

Returns are profit after tax plus depreciationadded back less additional investment, if any = free cash flow Returns over useful life of projects indicatedas year 1, 2, 3,--- n

Terminal value

End of project salvage value (or terminal value or scrap value), calculated at 5% of fixed assetsand 100% of working capital

Evaluation techniques

• Accounting rate of return.• Payback period method and • Present value method.

Accounting rate of return (ARR)

ARR = (Po+C1 +C2 + ---Cn) / n /Po Illustration:The cash flow on Walter Wears Ltd. project

is as in table next page

Years Rs. lakhs

0 year 1 year2 year3 year4 year5 year6 year7 year

-550.00211.13231.54264.07314.45355.39396.11

526.55

Accounting Rate of return for the project would be

ARR = (Po+C1 +C2 + ---Cn) / n /Po, = (- 550 + 211.13 +231.54 +264.07 +314.45+355.39+396.11+526.55) / 7/550 =38.84%.

Pay back period method

Pay back period = Po / AAR.AAR is average annual return.Illustration: Kavia Chemicals has inventeda formula at a cost of Rs.52.50 lakhs. The formula is expected to give an annual return ofRs.17.50 for 6 years . The pay back period of the investment would be 52.50 / 17.50 = 3 years.

Present value method

n

Present value of project = i.e. C / 1+r + t=1

C2 / (1 +r)2 + C3 / (1+r)3 + Cn / (1 + r)n.

Net Present Value(NPV) is

n

= i.e. Po +C / 1+r + C2 / (1 +r)2 +

t=0

C3 / (1+r)3 + Cn / (1 + r)n

CAPITAL RATIONING

Kavia Keltons Ltd. has a weighted average cost of capital of 15%. The company has identified three projects, of which it could afford only two. Details of the projects are:

Rs. Lakhs. Project A Project B Project C

InvestmentReturns1 year2 year3year4year

-326.78

77.50126.55157.00165.25

-412.80

196.86174.80158.25127.69

-278.54

112.40112.40112.40112.40

Project A- PV= Rs.360.79= NPV 34.01Project B-PV = Rs.480.41 =NPV 67.61Project C-PV = Rs.320.90 =NPV 42.36All projects give + NPVHow to choose the two projects?Profitability index (PI).PI = PV / Po

PI of the projects

Project A = Rs.360.79 / Rs.326.78 =1.104Project B = Rs.480.41 / Rs.412.80 =1.164Project C = Rs.320.90 / Rs.278.54 =1.152

IRRIRR is the actual rate of return a projectgives during its effective life. It is that rate at which the discounted cash flow would equal investment. It is the point where PV – Investment = 0. n

IRR = NPV= 0 = = 0 t=0

Defects of IRR

AS IRR HAS THE DEFECT OF SHOWINGMULTIPLE RATES OF RETURN, EVALUATORS PREFER NPV AND PI TO IRR AS RELIABLE TECHNIQUES IN PROJECT EVALUATION

Defects There could be more than one IRR for a particular investment IRR could be negative whereas NPV

would be positive

International capital budgeting

Application of the principles of domestic capital budgeting, to projects across the Borders.Hence all the stages of capital budgeting such as

>identification of projects >calculation of cash flows >evaluation of cash flows and > selection of projects would apply to international capital budgeting also, but subject to additional risks due to external environment

Investing country is parent /home country and where to be invested is host /foreign country

Decision as to invest in a particular country or not depends upon the risk adjusted valuethe investment would add to the parent investors.Hence opportunity cost of investment and discounted incremental cash flow, that is repatriable funds, alone had to be taken into consideration

International capital budgeting decisions under two situations

1.Under situations when there are no barriers in host country for repatriation of funds, i.e>full convertibility, >equilibrium rate of exchange, >similar rate of taxation to that of parent country, >no political risk.

Identifying project opportunities

1. Locational advantages -internalization of specific advantages -ecological, demographic, ethnical, governmental concessions

2. Imperfect market and product differentiation in host country

3. Transfer cost saving 4. Product life cycle

Cash outflow

Investment in fixed assets and working capital.Equipment to be used for foreign project should be valued at the highest of >replacement cost>net realisable value>PV of the asset during its residual life

Cash inflow

3 sets of cash flows need to be prepared1. Project cash flow as such2. Parents cash flow without the project3. Incremental cash flow– 2-1 – incremental

cost (cannibalisation) +incremental benefits( sales creation, transfer pricing and fees, royalties etc)

Weighted average cost of capital

Risk adjusted rate of returnweighted average cost of capital of the project adjusted to the risks (other than cross border risks).Or A higher rate than parent’s cost of capital

Discounting

Adjusted present value (APV) which consists of 1.PV of operating cash flows of the project+2. PV of tax shields+3.PV of subsidies and other benefitsInstead,Cash inflow= repatriable part of PAT +Depreciation added back- risk premia + incremental benefits. Discounted by risk adjusted rate

2.When there are barriers for repatriation due to

>Political risk>Exchange controls>Differential taxation>exchange rate fluctuations, Then only the repatriable cash flow has to

be taken as cash inflow

Political risk

>political instability of host country>level of violence in host country>armed insurrections in host country>conflict with other countries>fiscal irresponsibility in host country>controlled exchange in host country

Political risks

BusinessEnvironment Research Institute S.A.(BERI) is the US based private source for comprehensive ratings, analyses, and forecasts for over 140 countries.Its latest report is for 2005

POLITICAL RISKS MINIFESTED IN

1. Exchange controls 2. ExpropriationExchange control (in host country)>forbidding/controlling earnings to be held by

nationals>national holding foreign currency assets

controlled>demand for foreign currency restricted and

controlled>repatriation controlled= blocked remittance

How to overcome>transfer pricing –under invoice exports from

host and over invoice supplies to host>charge fees, royalties, franchises with

governmental consent>leading and lagging- recover from host fast

but delay payments to host>avail more loans from host country for the

project than subscribing to equity by parent

>counter trade-barter, counter purchase and buy back

>use blocked currency to buy capital goods for use by other units

>avail services in blocked currency>carry out R&D in blocked country>conduct conferences, conventions etc in

blocked country

ExpropriationExpropriation is the act of removing ownership / control from the owner of an item of property It is confiscation of the foreign asset for the compensation of a pittance payment. If known in advance, avoid such investmetsOr insure or eneter into undersatnding with the government

After investment- prevention / avoidance

>Agreeing to hire host country personnel>Accepting local partners>surrendering majority control to locals>supporting government programmes>contributing to political campaign

If expropriation not preventable, find out probability of political risk

PR = PV of project cash flows /PV of cash flows to be foregone

Exchange exposuresExposures are degrees to which parent company’s finances are affected by exchange rate changes in the host country between two reporting periods.At the end of a financial period. parent company (home country) consolidates its financials by incorporates the data of its overseas operations (host country) -balance sheet and profit and loss account- into its books.

Exposures Depend up on functional currency

Functional currency is the accounting unit inforeign (host ) unit’s operations. Reporting currency is the currency into which the host unit’s accounts are to be translated.If functional currency is home (parent) currency, both the functional and reporting currencies are same and needs no translation.

When functional currency is home /foreign currency

When host (foreign) operation is a branch, functional currency is home currency. FC&RC are same

In subsidiaries and affiliates, it is the host/local currency is functional currency, except

When there is heavy inflation in local country. Then functional currency will be parent currency

If functional currency is host currency (foreign), then the transactions are exposed to foreign exchange rate fluctuations

At what rate of exchange the data has to be incorporated

Different rates of converting foreign currency >at historic rate, rate prevailing at the time of

transaction>at current rate-rate prevailing as on the

date of the final reports>at average rate- the rate on the opening

date and that on closing dateadded and divided by 2

Types of exposures1.. Accounting Exposures

< Translation< Transaction

2.Economic Exposures

Translation exposure

Translation exposure is the exchange rate risk while incorporating the statements in to the parent company’s books.All items are not exposed equally. Items are categorised into exposed assets and liabilities and non-exposed assets and liabilities and revenues and costs .

Modes of valuing translation exposure

>Current / Non- current method>Monetary / Non – monetary method>Temporal method>Current rate methodCategorisation and treatment of exposed and non-exposed items are treated differently under different modes of translation

1.Current / non – CurrentUnder this method assets and liabilities are categorised into current and non-current.

Al current assets and current liabilities (exposed ) are translated at current exchange rate.All non-current assets and non-current liabilities (not exposed) at historic rateIncome statement translated at average exchange rate

Rule :1. Translate C.A. and C.L. at current rate as at the time of the report2. Non – CA/CL at historic rate as prevailed on the date of transaction3. Items in P&L a/c translated at average rate of exchange except those related to non-c/a

2. Monetary / Non – MonetaryClaims by or to the business (CA – Inventory, C.L. LT Liabilities) are monetary. Others (physical assets, including inventory) and investments non-monetary. Monetary claims(exposed) translated at current rateNon- monetary (not exposed) at historic rateP&L (except arising out of non-monetary items) at average rate.Costs/benefits arising out of non-monetary items at historic rate

3. Temporal

Same as monetary method , except The treatment of inventory. If inventory valued at market price, it is translated at current rate. Otherwise, historicrate

4. Current Rate

Everything in balance sheet and profit and loss account translated at current rate One variant of the method is to treat net fixed assets at historic rate and the rest at current rate

US adopted as per FASB 8 (Based on temporal method) since 1976

Before that, US companies created a reserve to which all unrealised exposure losses and gains were transferred.FASB 8, disallowed the creation of reserve. Losses and gains were to be accounted in the

parents account.OPPOSITION TO THE STANDARD

1981,US introduced FASB 52Translation of assets and liabilities at current exchange rate and the income statement at at weighted average rateLosses and gains of translation to be accumulated in “transaction adjustment account” under equity

Management of translation exposures

Transaction exposures

TE is the possibility of future exchange gains or losses on transactions already entered into and denominated in host Currency. Receivables or payables

Management of transaction exposures-hedging, money market hedging, pricing strategy, risk

sharing,

1.Hedging- forward, future, options bid/ call – fore receivables; ask or put for

payables2.Money market hedging-Indian receivableRs.10

m to be received in 3 months; spot rate $=Rs.40.75; rate of interest India 15% and US 10%.Rs.10m =

Management of accounting exposures

>Hedging through derivatives>Money market hedging>Risk shifting (Export in hard imports in soft)>Risk sharing>Pricing (after adjusting for hedging loss/gain)>Netting (swaps)