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CPA REVIEWS PROGRAMME
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Module F
P17: INTERNATIONAL FINANCE
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INTERNATIONAL CAPITAL BUDGETING
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I: THE BASICS OF CAPITAL BUDGETING
1. WHAT IS CAPITAL BUDGETING?
Capital budgeting may be defined as the process of identifying, analyzing, and selecting
investment projects whose returns (cash flows) are expected to extend beyond one year.
Capital budgeting involves the following:
Generating investment project proposals consistent with the firm’s
strategic objectives
Estimating aftertax incremental operating cash flows for the investment
projects
Evaluating Project incremental cash flows
Selecting Projects based on valuemaximizing acceptance criterion
Reevaluating implemented projects continually and performing post
audits for completed projects.
2. GENERATING INVESTMENT PROJECT PROPOSALS
Investment project proposals can stem from a variety of sources. For the purpose of
analysis, projects may be classified into one of the following categories:
(i) New Products or Expansion of Existing Project
(ii) Replacement of equipment or buildings
(iii) Research and Development
(iv) Exploration
(v) Safety and/or environmental projects
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For a new product, the proposal usually originates in the marketing department. A
proposal to replace a piece of equipment with a more sophisticated model, however,
usually arises from the production area of the firm.
3. ESTIMATING AFTERTAX INCREMENTAL OPERATING CASH FLOWS
One of the most important tasks in capital budgeting is estimating future cash flows for
a project. In evaluating a capital budget project we are concerned only with those cash
flows that results directly from the project. These cash flows, called incremental cash
flows, represents changes in the firm’s total cash flows that occur as a direct result of
accepting or rejecting the project.
Basic Characteristics of the Relevant Project Flows
Incremental (not total) flows
Cash (not accounting income) flows. Since cash, not accounting income is central to
all decisions of the firm, we express the benefit we expect to receive from a projection
terms of cash flows rather than income flows.
Operating (not financing) flows. For each investment we used to provide information
on operating as opposed to financing cash flows. Financing flows such as interest
payments, principal payments, and cash dividends are excluded from our cash flow
analysis.
Basic Principles that must be adhered to in estimating the after tax incremental
operating cash follows:
Ignore Sunk Costs:
Include Opportunity Costs:
Opportunity cost may be defined as what is lost by not taking the nextbest investment
alternative. For instance if we allocate plant space to a project and this space can be
used for something else, its opportunity cost must be included in the project’s evaluation.
Include project driven changes in working capital net of spontaneous changes in current
liabilities
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Consider effects of inflation
Calculating the Incremental Cash Flows
It is helpful to place project cash flows into three categories based on timing:
(i) Initial Cash outflow (= the initial net cash investment)
(ii) Interim Incremental net Cash Flows (= those net cash flows occurring
after the initial cash investment but not including the final period’s cash
flows).
(iii) Terminal Year Incremental Net Cash Flow (This period’s cash flows
is singled out for special attention because a particular set of cash flows
often occurs at project termination)
Basic Format For Determining Initial Cash Outflow
Cost of New Asset(s)
Add: Capitalized Expenditure (for example, installation costs)
Add/(Less): Increased (decreased) level of net working Capital
Less: net proceeds from sale of “old asset(s)” if the investment is a replacement decision.
Add/(Less): Taxes (tax savings) due to the sale of “old asset(s)” if the investment is a
replacement decision
Note: Asset cost plus capitalization expenditures form the basis upon which tax depreciation is
computed.
Basic Format For Determining Interim Incremental Net Cash Flow
Net increase (decrease) in operating revenue less (plus) any net increase (decrease) in
operating expenses excluding depreciation.
Less (Add): Net increase (decrease) in tax depreciation charges
Net change in income before taxes
Less (Add): Net Increase (decrease) in taxes
Net Change in Income after Taxes
Add (Less): Net Increase (decrease) in tax depreciation changes
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Incremental net Cash Flow for the Period
Basic Format for Determining Terminal year Incremental NCF
Net Increase (decrease in operating revenue less (plus) any net increase (decrease) in
operating expenses, excluding depreciation.
(+) Net increase (decrease) in tax depreciation charges
= Net change in Income before Taxes
(+) Net increase (decrease) in Taxes
Net change in Income after Taxes
+() Net increase (decrease) in tax depreciation changes
= Incremental cash flow for the terminal year before project windup
considerations
+ Final salvage value of “new” asset(s)
(+) Taxes (tax savings) due to sale or disposal of “new” asset(s)
+() Decrease(increased) level of net working capital
= Terminal year incremental net cash flow
A mathematical definition of Cash Flow
Net Cash Flow may be defined as:
AfterTax net Cash flow = Net Income After Taxes + Depreciation
= (Revenues – Expenses including Depr) (1T) + Depreciation
= Net Operating Income (1T) + Depreciation
Where T = Corporate tax rate applicable to the firm
Another equivalent formulation of after tax net cash flow can be obtained by considering
operating income that does not reflect non cash expense.
After Tax Net Cash Flow = (Operating Income) (1–T) + T Depreciation
4. PROJECT EVALUATION AND SELECTION
Several techniques are available for project evaluation and selection. Among the many
capital budgeting techniques used the following are common:
(i) The Accounting Rate of Return (ARR)
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(ii) The Payback Period (PBP)
(iii) Net present Value (NPV)
(iv) Internal Rate of Return (IRR)
(v) Profitability Index (PI)
The Accounting Rate of Return of (ARR)
Definition: The ARR is the average rate of return found by dividing the average
profit by the average investment.
ARR = Average Profits/Average Investment
Acceptance Criterion:
If the ARR is greater than a minimum acceptable rate the project is accepted, if not it is
rejected.
Merits:
1. Uses accounting data with which executives are familiar
2. Easy to understand and calculate
Demerits
1. Ignores the time value of money
2. Does not use cash flows
3. Gives more weight to future receipts
4. No objective way to determine the minimum acceptable rate of return
The Payback period Method (PBP)
Definition:
The payback period method is a simple additive method for assessing the worth of a
project. The payback period of an investment project tells us the number of years
required to recover the initial cash investment.
Acceptance Criterion:
If the payback period calculated is less than some maximum acceptable payback period,
the proposal is accepted, if not, it is rejected.
Merits:
1. It does give a rough idea of the liquidity of a project
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2. It is easy to understand, apply, and inexpensive to use
3. It is used as a ………… measure of project risk
4. It considers cash flows.
Demerits:
1. It ignores the time value of more
2. Ignores cash flows occurring after the payback period
3. The maximum acceptable payback period, which serves as the cutoff standard, is
purely subjective choice.
The Discounted Payback Method
The discounted payback period is the number of years for which cash inflows are
required to:
(i) recover the amount of investment; and also
(ii) earn the required rate of return on the investment during the period
In this method, each year’s cash inflow is discounted at the required rate of return, and
these present values are accumulated by year until their sum equals the amount
invested.
The Net Present Value (NPV) Method
Definition
The NPV method discounts all cash flows to the present using a predetermined
minimum acceptable rate of return as the discount are
NPV = The present value of an investment project’s net cash flows minus the project’s
initial cash outflow.
NPV = CF1, /(1+K)1 + CF2/(1+K)2 +……..CFn/(1+k)n 160
Where: k = the required rate of return
CF1, CF, ….CFn = Net Cash Flows
ICO = initial Cash Outflow
Acceptance Criterion
1. Consider all cash flows
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2. Recognizes the time value of money
3. Consistent with wealth maximization principle
Demerits:
1. Requires estimation of cash flows which is a tedious task
2. Requires the computation of opportunity cost of capital which poses practical
difficulties
3. Sensitive to discount rates
The Internal Rate of Return (IRR)
Definition:
The IRR is defined as the discount rate that equates the present value of the further net
cash flows from an investment project with the project’s initial cash outflow. It is the
discount rate which forces the NPV to equal zero.
ICO = CF1/(1+IRR))1 + CF2/(1+IRR)2 +……..CF1/(1+IRR)n
Finding the Internal Rate of Return:
The following methods are used to find the IRR
- Trial – and error procedure using present value tables.
- Using computer programs and programmed calculators
Acceptance Criterion
The acceptance criterion generally employed with the internal rate of return method is
to compare the IRR to a required rate of return, known as the cutoff, or hurdle rate. If
the internal rate of return exceeds the required rate, the project is accepted, it not, the
project is rejected.
Merits:
1. Considers all cash flows
2. Recognizes time value of money
Demerits:
1. Requires estimates of cash flows which is a sections task
2. At times fails to indicate correct choice between mutually exclusive project
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3. At times yields multiple rates
The Profitability Index Method (PI)
Definition:
The PI is the ratio of the present value of future net cash flows to the initial outflow. It is
also known as the benefit – Cost ratio.
PI {CF1/(1+K)1 + CF2/(1+k)2 +……….+ CFn/(1+k)n}/ICO
Acceptance Criterion:
As long as the profitability index is 1.00 or greater, the investment proposal is accepted.
Merits:
1. Considers all cash flows
2. Recognises the time value of money
3. It is a relative measure of profitability (for comparison)
4. Generally consistent with the wealth maximization principle.
Demerits:
Some as those of the IRR method (1 and 2)
NOTE:
The Payback period (PBP) and the ARR – Method are sometime referred to as the Non
discounted cash flow capital budgeting techniques. The NPV, IRR, and PI are referred to
as Discounted Cash Flow Methods.
II: CAPITAL BUDGETING FOR MULTINATIONAL FIRMS
Capital budgeting for multinational firms uses the same framework as domestic capital
budgeting. However multinational firms engaged in evaluating foreign projects face a
number of complexities, many of which are not there in the domestic capital budgeting
process. The process of analyzing foreign direct investments is more complicated than
for purely domestic ones. Measuring cash flows is more difficult as a result of:
1) different tax laws,
2) fluctuating exchange rates,
3) the difficulty of forecasting macroeconomic conditions in a foreign country,
4) political risk, and
5) cultural differences and communications problems.
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Also, the process of measuring the appropriate cost of capital is complicated by the
problem of measuring systematic risk for real investments in a global context.
There are also a number of issues and problems which needs to be considered when
analyzing foreign investments.
2.1 Foreign Complexities
Multinational capital budgeting encounters a number of variables and factors that are
unique for a foreign project and are considerably more complex than their domestic
counterparts. The various factors are:
Parent cash flows are different form project cash flows.
All cash flows from the foreign projects must be converted into the currency of
the parent firm.
Profits remitted to the parent are subject tow two taxing jurisdiction i.e the
parent country and the host country.
Anticipate the differences in the rate of national inflation as they can result in
changes in competitive position and thus in cash flows over a period of time
The possibility of foreign exchange risk and its effect on the parent’s cash flow.
If the host country provides some concessionary financing arrangements and/or
other benefits, the profitability of the foreign project may go up.
Initial investment in the host country may benefit from a partial or total release
of blocked funds.
The host country may impose restrictions on the distribution of cash flows
generated form the foreign projects.
Political risk must be evaluated thoroughly as changes in political events can
drastically reduce the availability of cash flows.
It is more difficult to estimate the terminal value in the multinational capital
budgeting because potential buyers in the host or parent company may have
widely different views on the value to them of acquiring the project.
2.2 Problems and Issues in Foreign Investment Analysis
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The main added complications which distinguish a foreign project from domestic project
can be summarized as follows:
2.2.1 Foreign Exchange Risk
Cash flows from a foreign project are in foreign currency and therefore subject to
exchange risk from the parent’s point of view. Multinational firms investing abroad are
exposed to foreign exchange risk i.e. the risk that the currency will depreciate or
appreciate over a period of time. Understanding of foreign exchange risk is very
important. In the evaluation of cash flows generated by the project over its life cycle.
2.2.2 Remittance Restrictions
Where there are restrictions on the repatriation of income, substantial differences exist
between projects cash flows and cash flows received by the parent firm. Only those cash
flows that are remittable to the parent company are relevant from the firm’s perspective.
2.2.3. International Taxation
Both in domestic and international capital budgeting, only after tax cash flows are
relevant for project evaluation. However in international capital budgeting, the tax issue
is complicated by the existence two taxing jurisdictions, plus a number of other factors
including for of remittance to the parent firm, tax withholding provision in the host
country.
2.2.4 Political or Country Risk
Assets located abroad are subject to the risk of appropriation or nationalization (without
adequate compensation) by the host country government. Also there are may be changes
in applicable withholding taxes, restrictions on remittances by the subsidiary to the
parent, etc.
2.3 Methods of International Capital Budgeting
In international capital budgeting two approaches are commonly applied:
1. Discounted Cash Flow Analysis (DCF)
2. The Adjusted Present Value Approach
2.3.1 The Discounted Cash Flow Analysis
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DCF technique involves the use of the time value of money principle to project
evaluation. The two most widely used criteria of the DCF technique are the
The Net Present Value and (NPV)
The Internal rate of return (IRR)
The NPV is the most popular method.
Method I: Decentralized Capital Budgeting Technique
1. Forecast the cash flows in foreign (local) currency
2. Discount these cash flows at the discount rate appropriate for the foreign market; this
gives
an NPV in terms of foreign currency.
3. Convert the NPV in foreign currency into domestic values at the spot exchange rate.
Method II: Centralized Capital Budgeting Technique
1. Forecast the cash flows in foreign currency
2. Convert these cash flows into domestic currency, using the relevant forward
exchange rates.
3. Discount the cash flows in domestic currency and the discount rate appropriate
for domestic projects
2.3.2 The Adjusted Present Value Method (APV)
The APV format allows different components of the project’s cash flow to be discounted
separately. This allows the required flexibility, to be accommodated in the analysis of
the foreign project. The method uses different discount rates for different segments of
the total cash flow depending upon the degree of certainty attached with each cash flow.
In addition the APV format helps the analyst to test the basi viability of the foreign
project before accounting for all the complexities.
The APV model is a value additive approach to capital budgeting. The cashflows are
logically discounted at different rates, a function of their different risk. Operating cash
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flows are viewd as being more risky. They are therefore discounted at the cost of equity.
The adjusted present value of a project is given by:
APV = ∑OCFt/(1+k*)t + ∑kdDTc/(1+kd)t Initial Cash Investment
Where:
OCFt = The After Tax Operating Cash Flows in period t
k*= The required rate of return in the absense of leverage (all equity financing)
D = Value of debt Financing sustainable by the project
kd = Cost of Debt Financing
© ABDUL 2007