Capital Budgeting for

UNIT 13 CAPITAL BUDGETING FOR Multinationals

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,

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International Investment
Decisions and Working there are a host of factors which are unique to foreign investments that make cross-
Capital Management border 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.

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
6 hold.
 Capital Budgeting for
13.3 ISSUES IN FOREIGN INVESTMENT ANALYSIS 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 joint 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 affiliate.

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
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International Investment
Decisions and Working worldwide parent company cash flows without the investment from post investment
Capital Management parent company cash flows. While making these estimates following adjustment have
to be made:

1. 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.
2. 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.

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
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proposal so long as the return is positive in parent terms 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 terms, will be converted back to home currency values at estimated
ongoing exchange rate of the terminal value date.

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International Investment
Decisions and Working Subsidized Financing
Capital Management
In order to attract foreign investments in key sectors, the governments of developing
economies generally provide support 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

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

terms rather than in terms of their effect on specific project. This vague view of risk
probably explains the use of two unsystematic approaches to account 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 premium 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 premium, 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 premium 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.

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International Investment
Decisions and Working In the second method, probability and certainty equivalent techniques can be
Capital Management 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.

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Identify cash inflows that an MNC must take into consideration while evaluating an
overseas project.

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Explain, in brief, three-stage analysis of overseas project evaluation.

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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
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flows to the parent company can be ascertained by subtracting worldwide parent- Capital Budgeting for
company cash flows without investment from post investment parent company cash Multinationals
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.

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
affiliate 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
accounted 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.
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