Multinational Capital Budgeting 136e4w

UNIT 13

CAPITAL BUDGETING FOR MULTINATIONALS

Capital Budgeting for Multinationals

Objectives After going through this unit, you should be able to: •

appreciate the capital budgeting techniques in evaluating overseas projects;

•

understand the fundamentals of evaluating foreign projects;

•

analyse important issues pertaining to cross-border investments and their

•

implications in capital budgeting decisions; and

•

explain various methods of incorporating risk in international investment decision.

Structure 13.1

Introduction

13.2

Fundamentals of Evaluating Foreign Projects

13.3

Issues in Foreign Investment Analysis

13.4

Risk Analysis in International Investment Decision

13.5

Summary

13.6

Self-Assessment Questions

13.7

Further Readings

13.1 INTRODUCTION Although the original decision to undertake an investment in a particular foreign country may be the outcome of combination of strategic, behavioural and economic considerations, choice of a specific project within a particular product-market posture calls for evaluation of its economic feasibility. For this purpose, capital budgeting exercise has to be done. A firm should deploy funds in a project if the marginal revenue obtained there from exceeds the marginal cost. For an MNC, capital budgeting involves economic analysis of the firm's direct investment opportunities. Whatever be the motive for Direct Foreign Investment (DFI), an MNC's very survival and sustainable competitive position depends on its ability to identify and choose the most profitable investment opportunity. Capital budgeting technique provides the mechanism to identify opportunities and evaluate their economic viability. This is why MNCs evaluate international projects by using capital budgeting techniques. Proper use of capital budgeting techniques can help the firm in identifying the international projects worthy of implementation from those that are not.

13.2 FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS Once a firm has compiled a list of prospective investments, it uses capital budgeting techniques which have been explained earlier to you in the course MS-4, to select from among them that combination of projects that maximizes the firm's value to shareholders. The theoretical framework involved in evaluation of domestic projects is the same as for foreign projects and various considerations influencing choice of a project within the country are the, same as those for projects overseas. However,

5

International Investment Decisions and Working Capital Management

there are a host of factors which are unique to foreign investments that make crossborder investment decisions complicated. The basic steps involved in evaluation of a project are: 1.

Determine net investment outlay;

2.

Estimate net cash flows to be derived from the project over time, including an estimate of salvage value;

3.

Identify the appropriate discount rate for determining the present value of the expected cash flows;

4.

Apply NPV or IRR techniques to determine the acceptability or priority ranking of potential projects.

As stated earlier, the above evaluation process becomes complicated because of the factors peculiar to international operations. Some of the factors unique to capital budgeting for MNCs are: 1.

Conversion of cash flows from foreign projects into the currency of the parent firm;

2.

Restrictions on full remittance of cash flows from foreign projects;

3.

Exchange Rate fluctuations;

4.

Application of different tax rates in the country of the project and in the parent's country;

5.

Involvement of royalties and management fees;

6.

Amenities and concessions granted by host country;

7.

Benefits of international diversification to the shareholders of parent firm;

8.

Lost exports;

9.

Difficulty in estimating terminal value of foreign projects;

10. Differing rates of national inflation; 11. Knock-on effects of overseas investment projects on other operations elsewhere; 12. Political risk involved in foreign investment. In view of the above, International finance manager encounters a number of complications in cross-border investment decisions. Overseas investment projects usually involve one or more foreign currencies, multiple tax rates and tax systems and foreign political risk. Overseas investment projects involve special problems, such as capital flow restrictions that do not allow the cash flows of projects to be remitted to the parent company. MNCs also face complexities because overseas investment projects have substantial knock-on-effects on other operations elsewhere within the group. For example, a foreign engineering company contemplating to setup a plant in Mexico may find that the proposed investment is likely to affect the operations of other units within the multinational group. This may occur partly through the new project's effect on sales of other parts of the group and partly through vertical integration. In case of knock-on-effects, the firm should consider all incremental cash flows accruing while appraising the project.

6

To make matters even more complicated, valuing an investment project in the local currency of the host country often provides different values from valuation in the parent's domestic country because the international parity conditions do not always hold.

13.3 ISSUES IN FOREIGN INVESTMENT ANALYSIS

Capital Budgeting for Multinationals

We shall now discuss important issues pertaining to cross-border investments and their implications in capital budgeting decision. •

Parent Vs. Project Cash Flows

The first specific issue that arises in respect of the overseas project is as to which cash flows should be considered for evaluating the project, the cash flows available to the project, or cash flows accruing to the parent company or both. Evaluation of an overseas project on the basis of project's own cash flows provides insight into its competitive status vis-a- vis domestic or regional firms. The project is expected to earn a risk-adjusted rate of return higher than that on its local competitors. Otherwise the MNC should invest money in the equity of local firms. This approach has the advantage of avoiding currency conversions, thus eliminating the margin of error involved in forecasting exchange rates over the life cycle of the project. Such approach is appreciated by local manager, local t venture partners and host governments. However, the parent MNC is generally keen to evaluate a foreign project from the viewpoint of net cash flows available to it because on it depends the level of earnings per share and dividends distributed to the stockholders. It is these funds that actually make it possible to pay dividends to shareholders and make interest and principal payments to lenders. Further, project evaluation from the parent's viewpoint furnishes the basis for raising funds from the market to finance overseas operations. Now the question arises which one of the above would be useful for making international investment decision. It must be noted that in international capital budgeting a significant difference usually exists between the cash flows of a project and the amount that is remittable to the parent. The reasons are tax regulations and exchange controls. Further, project expenses such as management fees and royalties are earnings to the parent company. Furthermore, the incremental revenue available to the parent MNC from the project may vary from total project revenues particularly when the project involves substituting local production for parent company exports or if transfer price adjustments shift profits elsewhere in the system. According to Corporate financial theory, the value of a project is determined by the present value of future cash flows that are available to the investor. Thus, the parent multinational should value only those cash flows that are repatriated net of any transfer costs because only these remaining funds can be used to pay interest at home and corporate dividends, for payment of the firm's debt, and for re-investment. A three-stage analysis has been recommended for overseas project evaluation. In the first stage project cash flows might be computed from the overseas subsidiary's standpoint, exactly as if the subsidiary were a separate national corporation. Focus in the second stage shifts to the parent. Here the analysis requires specific forecasts concerning the amounts and timing of distributable cash. Expenses will be incurred in the process of transfer. It should be, noted here that flows which are relevant from the standpoint of the multinational in the third and final stage, the MNC must consider the indirect benefits and costs that this investment confers on the rest of the system, such as an increase or decrease in export sales by another . According to several surveys, MNCs tend to evaluate overseas projects from both the parent and projects' viewpoints. Undoubtedly, the MNC must estimate a project's true profitability which involves determining the marginal revenue and marginal cost associated with the project. Incremental cash flows to the parent can be ascertained only by subtracting

7

International Investment Decisions and Working Capital Management

worldwide parent company cash flows without the investment from post investment parent company cash flows. While making these estimates following adjustment have to be made: 1.

2.

•

Adjustment for the effects of Transfer pricing and fees and royalties by •

Using market costs/prices for goods, services and capital transformed internally;

•

Adding back fees and royalties to project cash flows;

•

Removing the fixed portions of such costs as corporate overhead.

Adjustment for global costs/benefits that are not reflected in the project's financial statements. These costs/benefits include: •

Reduction of sales of other units;

•

Creation of incremental sales of other units;

•

Additional taxes owed when repatriating profits;

•

Foreign tax credits usable elsewhere;

•

Diversification of production facilities;

•

Market diversification;

•

Provision of a key link in a global service network;

•

Knowledge of competitors, technology, markets and products.

Tax Issue

In capital budgeting, only after-tax cash flows are relevant. This is true both for domestic and overseas projects. The tax issue for multinational capital budgeting purposes is complicated by the existence of host country and home country taxes as well as a number of factors. Thus, earnings on foreign projects, first of all, fall in host country tax net. Then on distribution, it is subjected to witholding tax and finally, in the home country the earnings are further taxed. Assume that an MNC with a proposed project in one overseas territory expects to earn pre-tax the foreign currency equal to $2 million with an overseas tax rate of 15 percent, a witholding tax of 10 percent and a home corporate tax rate of 33 percent, after tax net cash inflows will be, as given in Table 13.1.

8

In case the parent firm decides to re-invest the entire post-foreign tax earnings of $1700,000 in the host country, it is not required to pay witholding tax nor home tax. In case the firm decides to pay out the earnings to an intermediate holding company, which are then onward re-routed for reinvestment elsewhere in the worldwide operations of the multinational, the amount available for reinvestment would be $1530,000 (the amount left after payment of foreign and witholding taxes but before payment of home country tax). Thus, the management will accept the project

proposal so long as the return is positive in parent under the harshest tax scenario.

Capital Budgeting for Multinationals

Multinationals Exchange Control Exchange control restricting the repatriation of earnings to the parent country is another reason that causes discrepancy between the project value, from the parent's perspective and from the local perspective. When an MNC is contemplating investment in a country having exchange control, the present value calculation from the parent's point of view will be based on the following facts: •

The pattern of financing investment by MNC-debt or equity or both. In case of investment to be funded via debt, cash generated by the project is returned to the home country to the extent of debt repayment and interest. However, this will not be possible in case of equity funded investment.

•

Remittances of net cash flows expected to be generated by the foreign projects. Not all remittances under exchange restrictions are permissible. Hence, forecasts of the proportion of the cash flows that can be remitted to the parent company will have to be made.

•

Remittances expected back to the parent company by way of debt service and management fees and royalties. Of course, these are subject to ceilings by exchange control regulations.

•

Allowances for parent contribution of equipment as part of its input.

•

Any real operating option effects.

•

In case, cash earnings expected to be generated by the foreign project are permanently blocked with no way to get back the money to the parent, the value of such blocked funds must be zero. But in real life this does not happen because countertrade and similar other techniques prevent ways of blocking. Further, there is usually some expectation of existing controls being relaxed or removed together. A profitability factor may be applied to model such expectations.

•

An allowance for any terminal value. This terminal value, calculated in overseas currency , will be converted back to home currency values at estimated ongoing exchange rate of the terminal value date.

9

International Investment Decisions and Working Capital Management

Subsidized Financing In order to attract foreign investments in key sectors, the governments of developing economies generally provide in the form of subsidy. Likewise, international agencies entrusted with the responsibility of promoting cross-border trade sometimes offer financing at below-market rates. The value of the subsidized loan should be added to that of the project while making the investment decision if the subsidized financing is inseparable from the project. But if subsidized financing is separable from a project, the additional value from the subsidized financing should not be allocated to the project. In such a case, the manager's decision is that so long as the subsidized loan is unconditional, it should be accepted. If the MNC can use the proceeds of subsidized financing at a higher rate in a comparable risk investment, it will lead to positive NPV to the firm. Tax Holidays More often than not, governments of developing countries offer tax holidays to encourage foreign direct investment in their economies. Other tax holidays in the form of a reduced tax rate for a period of time on corporate income from a project are negotiable knowing how much the tax holiday is worth when the firm negotiates the environment of the project with the host government. A tax holiday in the project's early years is not worth much. In fact, if the project expected to suffer losses in the first few years which can be carried forward, the tax holiday robs the firm of a valuable tax-loss carry forward. In such a scenario, an MNC would prefer to be subjected to a high tax rate during the early loss-making (and tax-credit creating) years of a project. The management should, therefore, compute project value both with and without the tax holiday to uncover such type of situations. Lost Exports Another issue relating to direct foreign investment decision is the issue of lost exports arising out of engaging in a project abroad. Profits from lost exports represent a reduction from the cash flows generated by foreign project for each year of its duration. This downward adjustment in cash flows may be total, partial or nil depending upon whether the project will replace projected exports or none of them. International Diversification Benefits Dispersal of investment in a number of countries is likely to produce diversification benefits to the parent company's shareholders. However, it would be difficult to quantify such benefits as can be allocated to a particular project. Generally, such non-quantifiable variables are ignored in capital budgeting decision. However, in case of a marginal project or a project which is not acceptable on its merits, this factor may be taken care of. Sometimes, a marginal project may be found worthwhile when its beneficial diversification effect on the overall pattern of cash flow generation by the MNC is taken into consideration.

13 4 RISK ANALYSIS IN INTERNATIONAL. INVESTMENT DECISION MNCs have to face a host of additional risks while investing in foreign countries. As noted earlier, these risks may be political and economic. Political risk is the possibility that political events in a host country or political relationships with a host country will affect the value of corporate assets in the host country. The most extreme form of

10

political risk is the risk of expropriation in which a host government seizes local assets of an MNC.

Capital Budgeting for Multinationals

Besides, MNCs' foreign investments are subject to risk arising out of exchange rate fluctuations and inflation. While a firm knows that the exchange rate will typically change overtime, it does not know whether the foreign currency will strengthen or weaken in the future and how the cash flows Will be affected. Further, there has been a tendency for rising variable cost per unit and product prices have been going up overtime. However, inflation can be quite volatile from year to year in some countries and can, therefore, strongly influence a project's net cash flows. Inaccurate inflation forecasts could lead to inaccurate net cash flow forecasts. So MNC while contemplating to invest overseas must assess the consequences of various political risks for the viability of political investment. Three main methods used for incorporating additional political and economic risks in foreign investment analysis are: i) shortening the minimum pay-back period; ii) raising the required IRR; and iii) adjusting cash flows to reflect the specific impact of a given risk, Adjusting the Discount Rate or Payback Period The additional risk exposure to overseas investment is expressed usually in general rather than in of their effect on specific project. This vague view of risk probably explains the use of two unsystematic approaches to for additional foreign investment risks. One is to employ a higher discount rate for overseas business and the other one is to use shorter period of payback. For example, if there is likelihood of embargo on remittances, a normal required rate of 12% might be raised to 16% or a 4-year payback period might be shortened to 3years. However, these methods fail to assess precisely the actual impact of a particular risk on cash flows. Comprehensive risk analysis calls for an evaluation of the magnitude and timing of risks and their implications for the projected cash flows, There does not seem to be any logic in using a uniformly higher discount rate to cash flows from the proposed project to incorporate risk of likely embargo on remittances 4 years hence. Further, the choice of a risk is arbitrary one. Further, these methods do not consider the favourable currency movements. That is why alternative method of adjusting the annual cash flows taking into consideration the impact of a specific risk on the future returns from an investment is employed. Adjusting the Annual Cash Flows There are two techniques employed to adjust the annual cash flows, keeping into consideration the risk factor for each year. In the first method, adjustment for uncertainty involves reducing each year's cash flows by an amount equivalent to risk or an insurance , even if such arrangement is not actually made by the management. For example, if an MNC insures with an insurance company to hedge risk due to occurrence of a political event, the paid by the firm will be deducted from cash flows. However, uncertainty absorption principle suffers from certain fundamental weaknesses. First, risk insurance covers only a fixed proportion of the book value of the firm (in the case of expropriation while the economic value of expropriated assets normally far exceeds the book value). Secondly, there are number of political decisions such as import restrictions, higher tariff rates on the imports and/or exports to neighbouring markets, as well as variety of measures designed create problems which do impact the operation and profitability of the subsidiary business, for which no insurance coverage is available.

11

International Investment Decisions and Working Capital Management

In the second method, probability and certainty equivalent techniques can be employed to adjust political risk, The MNC, generally, employs a statistical technique called the "Decision Tree" analysis to estimate the probability of expropriation. With the help of these techniques the MNC finds an NPV for the foreign project based on cash flows adjusted for the probability of expropriation for the particular year. The above techniques can be used for adjusting foreign exchange rate risk. For instance, probability analysis can be employed to estimate the exchange rate (of the host versus parent currency) for each time period. The firm is required to construct several exchange rate scenarios over the project's life cycle. Projected cash flows for each year would then be converted into home currency for each of these years. Finally, cash flows for, each of these years would be converted to equivalent cash flows by applying the assigned probability for each of the scenarios. However, this approach has certain inbuilt weakness. For instance, this approach does not consider range of possible outcome in which the management may also be interested. Furthermore, it is doubtful if calculation of the expected values of alternative scenarios would be superior to the one based on purchasing power parity assumption or any other forecasting technique. Activity I Putting yourself in the position of an MNC finance manager, list out the major steps that you would take to evaluate the financial feasibility of an overseas project. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Identify cash inflows that an MNC must take into consideration while evaluating an overseas project. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Explain, in brief, three-stage analysis of overseas project evaluation. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... .........................................................................................................................................

13.5 SUMMARY Capital Budgeting for MNCs presents many elements such as conversion of cash flows from foreign projects into the currency of the parent country, restrictions of remittances of cash flows, exchange rate fluctuations, different tax rates, different inflation rates, etc., which rarely exist in domestic capital budgeting. Evaluating an overseas project on the basis of its own cash flows provides an insight about its competitive status vis-a-vis domestic or regional firms. However, an MNC is more interested in net cash flows available to it from its foreign project. A three-stage analysis has been recommended for overseas project evaluation. Incremental cash

12

flows to the parent company can be ascertained by subtracting worldwide parentcompany cash flows without investment from post investment parent company cash flows. While making these estimates, adjustments for transfer pricing effects, fees and royalties, foreign tax credits usable elsewhere, product and market diversification, etc. have to be made. Adjustments for tax, exchange control and risk factors have also to be made while deciding about the viability of the foreign projects.

Capital Budgeting for Multinationals

13.6 SELF-ASSESSMENT QUESTIONS 1.

In what respects does international capital budgeting differ from domestic capital budgeting?

2.

Capital Budgeting for foreign project is considerably more complex than that in domestic case. Identify the factors that add complexity.

3.

Why should a foreign project be evaluated both from a project and parent viewpoint?

4.

Why is it important to separately identify the value of any side effects that accompany foreign investment project?

5.

What are the various specific issues that deserve consideration in multinational capital budgeting that are not normally relevant for a purely domestic project?

6.

How can exchange control factor be incorporated in international capital budgeting decision?

7.

What are the two approaches used to incorporate the exchange rate and political risks in the multinational capital budgeting exercise?

8.

Discuss the utility of adjusted rate of return method in incorporating political and economic risks.

9.

How can you adjust the risk of blockage of transfer of dividends from an to the parent company while evaluating foreign investment projects?

10. How should subsidized financing be treated in international capital budgeting decision? 11. How should an MNC factor host-country inflation into its evaluation of an investment proposal? 12. Explain how the financing decision can influence the sensitivity of NPV to exchange rate forecasts. 13. Project A has an NPV estimated to be $2 million. This estimate has not ed for risk, but with such a large NPV, it is reported that the project should be accepted since even a risk-adjusted NPV would likely to be positive. What would be your decision regarding acceptance or rejection of the project?

13.7 FURTHER READINGS 1.

Adrian Buckley,(l 996),Multinational Finance,3rd Ed. Prentice Hall, USA..

2.

Alan C. Shapiro,(2003), "Multinational Financial Management",John Wiley & Sons Inc. Singapore.

3.

.A.Stonehill and L.Nathanson, "Capital Budgeting and the Multinational Corporation", California Management Review, Summer, 1968, pp.39-54.

4.

4, V.B.Barishi, "Capital Budgeting Practices at Multinationals", reprinted in International Finance, Concepts and Issues, Richmond V.A.; Robert F.;Dame IC, 1983, pp.520-527.

13