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MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit III: Financial Management of Multinational firm
Lesson 3.2
(Capital Budgeting and Cash management of MNC )

Capital Budgeting decisions of MNC
Introduction
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.
Capital Budgeting decisions of MNC
Capital budgeting for multinational firms uses the same
framework as domestic capital budgeting.
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.

Capital Budgeting decisions of MNC
Process
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.
Capital Budgeting decisions of MNC

Difference between Domestic and MNC capital budgeting decisions
In case of MNC, the above evaluation process becomes complicated
because of the factors peculiar to international operations which are
given below:
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.
Capital Budgeting decisions of MNC

Difference between Domestic and MNC capital budgeting
decisions
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.

Difficulty in estimating terminal value of foreign projects

Different rates of national inflation

Complexities of Budgeting for a
Foreign Project
Several factors make budgeting for a foreign project
more complex
Parent cash flows must be distinguished from project
Parent cash flows often depend on the form of financing,
thus cannot clearly separate cash flows from financing
this changes the meaning of NPV
Additional cash flows from new investment may in part or
in whole take away from another subsidiary; thus as a
stand alone a project may provide cash flows but overall
may add no value to the entire organization
Parent must recognize remittances from foreign
investment because of differing tax systems, legal and
political constraints

7
Complexities of Budgeting for a
Foreign Project
Non-financial payments can generate cash flows to parent
in the form of licensing fees, royalty payments, etc.
relevant for parents perspective
Managers must anticipate differing rates of national
inflation which can affect cash flows
Use of segmented national capital markets may create
opportunity for financial gains or additional costs
Use of host government subsidies complicates capital
structure and parents ability to determine appropriate
WACC
Managers must evaluate political risk
Terminal value is more difficult to estimate because
potential purchasers have widely divergent views

8
Issues in Foreign Investment Analysis

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.
Issues in Foreign Investment Analysis

Parent Vs. Project Cash Flows
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.

Issues in Foreign Investment Analysis
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.
Issues in Foreign Investment Analysis
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.
Issues in Foreign Investment Analysis
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.

Remittances of net cash flows expected to be generated by the foreign
projects.


Issues in Foreign Investment Analysis
Subsidized Financing
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.
Issues in Foreign Investment Analysis
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.
Risk Analysis in International Capital
Budgeting Decisions
MNCs have to face a host of additional risks while investing in
foreign countries. 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 political risk is the risk of expropriation in which
a host government seizes local assets of an MNC.

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 .
Risk Analysis in International Capital
Budgeting Decisions
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
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.

iii) adjusting cash flows to reflect the specific impact of a
given risk
Risk Analysis in International Capital
Budgeting Decisions
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.

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.
Cash Management in MNC
Objectives
Cash Management in an MNC is primarily aimed
at minimizing the overall cash requirements of the
firm as a whole without adversely affecting the
smooth functioning of the company and each
affiliate, minimizing the currency exposure risk,
minimizing political risk, minimizing the
transaction costs and taking full advantage of the
economies of scale and also to avail of the benefit
of superior knowledge of market forces.
Cash Management in MNC
Objectives
Cash Management in an MNC is primarily aimed
at minimizing the overall cash requirements of the
firm as a whole without adversely affecting the
smooth functioning of the company and each
affiliate, minimizing the currency exposure risk,
minimizing political risk, minimizing the
transaction costs and taking full advantage of the
economies of scale and also to avail of the benefit
of superior knowledge of market forces.
Cash Management in MNC
Problem/Difficulties
Minimization of the political risk involves conversion of all receipts in
foreign currencies in the currency of the home country. This may,
however, go against the interest of the affiliates who need minimum
working capital to be kept in the local currencies to meet their
operational requirements.

Minimization of transaction costs involved in currency conversions calls
for holding cash balances in the currency in which they are received. In
another respect too, primary objectives are in contradiction to each
other. A subsidiary, for example, may need to carry minimum cash
balances in anticipation of future payments due to the time required to
channelize funds to such a country. Holding of such balances in excess of
immediate requirements may impact the objective to benefit from
economies of scale in earning the highest possible rate of return from
investing these resources.
Cash Management in MNC
Problem/Difficulties

Another major problem which an MNC faces in managing cash is with respect
to estimation of cash flows emanating out of operations of its affiliates. This
problem arises because of foreign exchange fluctuations.

Similar problem arises in estimating cash inflows stemming out of future sales
because actual volume of sales to overseas buyers depends on foreign exchange
fluctuations. The sales volume of exports is also susceptible to business cycles of
the importing countries.

Uncertainty arises with regard to cash collections from receivables because it
is the quality of credit standards that will decide the value of goods sold to be
received back in cash. Loose credit standards may cause a slow. down in cash
inflows from sales which could offset the benefits of augmented sales.

Cash management in an MNC is further complicated by the absence of
effective tools to expedite transfers and by the great variations in the practices
of financial institutions.

Cash Management in MNC
Steps involved in Cash Management
Cash Flow Analysis: Subsidiary Perspective
Prudent working capital management calls for estimating cash outflows and
inflows periodically to ascertain excess or deficient cash for a period of time.
Once estimates of cash outflows and inflows are made, the subsidiary will be in a
position to know there is cash surplus or deficit for a particular period. If cash
deficiency is expected, short-term financing is necessary. In case of excess cash,
it must decide how the surplus cash will be used.
Centralized Cash Management
Centralization does not mean the pooling of overall liquid resources, although
some degree of pooling would take place, but rather the centralization of
reports, information and most importantly, the decision-making process as to
cash mobilization, movement and investment outlets.
The system enable the MNCs to make fuller utilization of the idle cash and
maximize earnings without risking liquidity throughout the system and use
multilateral netting system.
Cash Management in MNC
Steps involved in Cash Management
Accelerating Cash Inflows
Cash inflows can be prompted through quick deposit of customer's
cheques, establishing collection centers, lock-box method and
other devices.

Minimizing currency conversion costs
Cash flow can also be optimized through Netting. Netting involves
offsetting receivables against payables of the various entities so
that only the net amounts are eventually transferred among
affiliates. An MNC can also utilize multilateral netting with outside
firms and agencies. This technique optimizes cash flow by reducing
the administrative and transaction costs arising out of currency
conversion.
Cash Management in MNC
Steps involved in Cash Management
Managing Inter-subsidiary Cash Transfers
Through techniques of leading and lagging, cash flows can be
managed to the advantage of a subsidiary, If A purchases supplies
from B and pays for its supplies earlier than necessary. This
technique is called leading. Alternatively, if B sells supplies to A, it
could provide financing by allowing A to lag its payments. The
leading or lagging strategy can help in improving efficiency of cash
utilization and thereby reducing debt.
Diversifying Cash across Currencies:
In order to avoid the possibility of incurring substantial losses
arising out of depreciation of a foreign currency, an MNC prefers to
diversify its investible funds among various foreign currencies.

Cash Management in MNC
Steps involved in Cash Management
Managing Inter-subsidiary Cash Transfers
Through techniques of leading and lagging, cash flows can be
managed to the advantage of a subsidiary, If A purchases supplies
from B and pays for its supplies earlier than necessary. This
technique is called leading. Alternatively, if B sells supplies to A, it
could provide financing by allowing A to lag its payments. The
leading or lagging strategy can help in improving efficiency of cash
utilization and thereby reducing debt.
Diversifying Cash across Currencies:
In order to avoid the possibility of incurring substantial losses
arising out of depreciation of a foreign currency, an MNC prefers to
diversify its investible funds among various foreign currencies.