International Financial Management

P G Apte

1
 Introduction
• What accounts for the phenomenal success
achieved by MNCs
– MNCs enjoy ownership-specific advantages because of
their proprietary access to assets such as brand names,
patents, technologies and copyrights which their local
competitors cannot reproduce
– MNCs may enjoy location-specific advantages such as
exclusive access to sources of critical raw materials,
access to cheap skilled labour or ability to reduce tax
burden by locating in tax havens

2
 Introduction
• Why can’t the local reproduce or nullify the ownership-
specific or location-specific advantages of MNCs?
• Many activities are internalized within a firm and carried out
within the framework of internal contractual arrangements rather
than by means of contracts with independent external agents.
• Through vertical integration, exclusive supply contracts,
patents and copyrights MNCs attempt to protect their proprietary
technologies or access to cheap, high-quality inputs.
• The sheer scale of their operations and ability to centralize
many tasks allow them to achieve scale economies which their
smaller local competitors cannot avail of
• MNCs can minimize tax burden by means of transfer pricing
and location in tax havens 3
 Introduction
• There are many forms of multinational presence –
exports, licensing, technology sharing, branch
operation, joint ventures, wholly owned
subsidiaries
• Since foreign direct investment is the most
important avenue for achieving multinational
presence, it is important to understand how MNCs
might be evaluating such investment proposals

4
 Introduction
Objectives of the Chapter
• Develop a framework for appraising foreign
investment projects
• Review the NPV procedure used to appraise a
project
• Adjusted Present Value approach
• Valuation of cross-border 100% subsidiaries
• Joint ventures

5
 Review of the NPV Approach
• The well known Net Present Value (NPV) formula widely
used in evaluating domestic investment projects

t =T
CFt
NPV = - C0 + ∑ t
t =1 (1 + k w )

C0: Initial capital cost; CFt : Periodic cash flows

kw : Weighted average cost of capital defined by
kw = α ke + (1-α)(1 - τ)kd

Where ke is cost of equity capital, kd cost of debt capital, α the

proportion of equity in project funding and τc the tax rate 6
 Review of the NPV Approach
There are two implicit assumptions.
(3) The project being appraised has the same business risk as the
portfolio of the firm's current activities
(4) The debt:equity proportion in financing the project is same as
the firm's existing debt:equity ratio.
An alternative formula for cost of capital allows for differences
in the debt:equity ratio :
kw = ke(1-τα) where ke is the "all equity" required rate of
return reflecting the project's business risk.
If the project's business risk differs from the existing portfolio
of projects, one must estimate the project's beta and the required
"all equity" return from some version of CAPM 7
THE ADJUSTED PRESENT VALUE (APV) FRAMEWORK
(1) (1) In the first step, evaluate the project as if it is financed
entirely by equity. The rate of discount is the required rate of
return on equity corresponding to the risk class of the project.
(2) In the second step, add the present values of any cashflows
arising out of special financing features of the project such as
external financing, special subsidies if any and so forth. The rate
of discount used to find these present values should reflect the risk
associated with each of the cash flows.
(3) Tax benefits of debt:
Additional borrowing capacity : ∆B = TDE×GPV
Tax savings : (RD × τ)∆B = (RD × τ)(TDE × GPV)
RD : Pre-tax Cost of Debt τ : Tax Rate
Discount using RD
8
The APV Approach
Add PV of any other cash flows on account of subsidies,
concessional finance etc.
Two assumptions:
(4) Firm will be able to utilize the interest tax shield fully in
every year. If not, carrying it forward involves loss of time
value
(5) The benefit of tax shield is fully appropriated by the firm I.e.
by the shareholders
In general, the calculation of the interest tax shield as
presented here probably represents an overestimate of the
true benefit from added borrowing capacity.

9
Cross-Border Projects
The main added complications which distinguish a foreign project
from a domestic project can be summarised as follows :
 Exchange Risk and Capital Market Segmentation
 Political or "Country" Risk
 International Taxation
 Blocked Funds
In addition, like in domestic projects, we must be careful to take
account of any interactions between the new project and some
existing activities of the firm - e.g. local production will usually
mean loss of export sales.

10
The APV Approach for Cross-Border Projects
1. First treat the project as a branch operation of the parent
company. All the cash flows generated by the project belong by
definition to the parent since the project has no distinct identity.
This allows us to focus on the pure economics of the project.
2. Next, consider the project as a fully equity financed, wholly
owned subsidiary of the parent, incorporated under the host
country laws, having a distinct legal identity. Now we focus on the
various financial arrangements between the parent and the
subsidiary and consider what means are available to the parent to
increase the cashflow transfers between the subsidiary and the
parent and minimise the overall tax burden.
3. Finally, as in the case of a domestic project, incorporate the
effects of external financing such as the interest tax shield.
11
 Valuing Foreign Currency Cashflows
First consider the problem of valuing risk-free cash flows in
foreign currency. There are three possible methods :
(1) Find the present value of the cashflows in terms of
foreign currency and translate at today's spot rate. Thus if FCFt is
the cashflow at time t and rF is the risk-free foreign currency
discount rate, the home currency PV is
[FCFt/(1+rF)t]S0

((2) Translate each cashflow FCFt at the forward rate F0,t and
(2)
discount at the home currency risk-free discount rate. The PV is
given by
(F0,t)(FCFt)/(1+rH)t
12
Valuing Foreign Currency Cashflows
(3) Translate at the expected spot rate E0(St) and discount at a
home currency discount rate that reflects exchange risk
[E0 E0 (St)](FCFt)/(1+rH)t

All the three methods would yield identical results if the home and
host country capital and money markets are free and integrated
When the markets are segmented (1) and (2) cannot be used. It
may happen that a project which is financially viable when
evaluated from the local point of view is not acceptable from the
parent point of view or vice versa – a project may not be viable
from the local point of view but appears acceptable from the
parent point of view.

13
Valuing Risky Cashflows
____________________________________________________
After-Tax Cashflow(Z$ Million)
Boom Recession
(prob.=0.6) (prob.=0.40)
13.8 10.5
____________________________________________________
Cashflow Translated to Rupees(Million)
Z$/Rs. 7.5 103.5 78.75
(prob.=0.5) (prob.=0.1) (prob.=0.3)
Z$/Rs. 5.5 75.9 57.75
(prob.=0.5) (prob.=0.5) (prob.=0.1)
____________________________________________________
14
Valuing Risky Cashflows
Once again, with integrated capital markets and validity of parity
conditions, we can discount the expected foreign currency
cashflow, Zimbabwe dollars [0.6×13.8+0.4×10.5] million, using
a discount rate which equals the rate of return required by
Zimbabwean investors from similar projects and translate into
rupees at the current spot rate. In obtaining this discount rate we
must employ the international CAPM which takes account of the
covariance of the project with the world market portfolio and the
Rs/Z$ exchange rate.
If host and home country capital markets are segmented this
procedure cannot be employed. The expected value in home
currency, of a risky foreign currency cashflow at a future date is
given by
Et(CFHT) = Et(CFFT)×Et(ST) + cov[CFFT,ST] 15
Valuing Risky Cashflows
In the example given above the expected value is
(103.5×0.1)+(75.9×0.5)+(78.75×0.3)+(57.75×0.1)
= Rs.77.7 million
To estimate this, we need forcasts of future spot rate and an
estimate of the covariance between the spot rate and the foreign
currency cashflow. This has to be discounted at a rate equal to
the rate of return required by home currency investors on
similar projects. This must be estimated with a single-country
CAPM augmented by exchange risk.
Degree of capital market integration is the crucial issue.
Integration is far from complete. This raises difficult issues.

16
Difficulties in incorporating exchange rate risk and
choice of discount rates
• Reliabale exchange rate forecasts are notoriously difficult to
obtain.
• Linking the performance of the project with the exchange rate is
no less difficult. If the project is intended to serve not only the
host country market but also third-country markets, the issues are
still more complex since the performance of the project now
depends upon several exchange rates and not just the home
country-host country exchange rate.
• The appropriate risk premium to be added for exchange risk is
far from easy to estimate in practice.
• The international CAPM is hard to operationalize.
17
 International taxation introduces further complications.
• Treatment of dividend income by home country government
• Withholding taxes,
• Treatment (by host and home country tax authorities) of other
forms of transfers such as interest, royalties etc. between the
subsidiary and the parent.
• Existence or otherwise of double taxation avoidance agreements
and their scope.
• The possibility of using transfer prices which are different from
arms-length prices.
• These are all highly complex issues best left to the specialists in
this area.
     18
In practice, firms use their all-equity required rate of return and
add a risk premium which is supposed to reflect not only
exchange risk but also other risks such as political or country
risk and in some cases also the fact that the firm may be totally
unfamiliar with the host country and may have to incur
additional costs. This is a rather arbitrary procedure.

Some risks should be accounted for by adjusting cash flows

Some risks are insurable – deduct premium payments from cash
flows
Exchange risks are to some extent diversifiable.
An arbitrary risk premium may err on the conservative side and
result in the parent firm foregoing potentially high NPV projects.
19
THE PRACTICE OF CROSS-BORDER DIRECT
INVESTMENT APPRAISAL

20