NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Module - 39 International Capital Budgeting

Developed by: Dr. A .K .Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India Email: [email protected]

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

International Capital Budgeting

Learning Objectives: The present session discusses about international capital budgeting. It outlines the differences between domestic capital and international capital budgeting.

Highlights & Motivation: In this session, the following details about management of transaction exposure are discussed. •

Net present Value and its drawbacks

•

Adjusted Net Present Value

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

1. Introduction Capital budgeting evaluates the investment decisions related to assets. The "capital" in capital budgeting refers to the investment of resources in assets, while the budgeting refers to the analysis and assessment of cash inflows and outflows related to the proposed capital investment over a specified period of time. Objectives of capital budgeting is to (1) determine whether or not a proposed capital investment will be a profitable one over the specified time period, and, (2) to select between investment alternatives. Capital budgeting at the international level addresses the issues related to (1) exchange rate fluctuations capital market segmentation, (2) international financing arrangement of capital and related to cost of capital, (3) international taxation, (4) country risk or political risk etc. Present Session discussed about the evaluation international project and Foreign Direct Investment Proposals.

2. Capital Budgeting: Net Present Value Approach • • • • •

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. Investment Decisions: Expansion, Acquisition, modernisation and replacement Investments lead to Exchange of current funds for future benefits. The funds are invested in long-term assets so as to create cash inflows over a long period. The future benefits will occur to the firm over a series of years.

Three steps are involved in the evaluation of an investment proposal: • Estimation of cash flows • Estimation of the required rate of return (the opportunity cost of capital) • Application of a decision rule for making the choice Any investment should increase shareholders value. It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project which maximises the shareholders’ wealth. • Cash flows of the investment project should be forecasted based on realistic assumptions. • Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of capital. • Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. • The project should be accepted if Net Present Value is positive (i.e., NPV > 0).

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. ⎡ C1 C3 Cn ⎤ C2 NPV = ⎢ + + +"+ − C0 2 3 (1 + k ) (1 + k ) n ⎥⎦ ⎣ (1 + k ) (1 + k ) n Ct NPV = ∑ − C0 k )t (1 + t =1

Acceptance Rule:

NPV: +: Accepted, NPV: - : Rejected NPV: 0: May be accepted or rejected

Higher NPV consider for mutually exclusive projects. NPV is most acceptable investment rule for the following reasons: • Time value of money is recognised by discount rate • Measure of true profitability • Shareholders’ value maximised The discount rate used in NPV is the opportunity cost or the WACC. Kw = αKe +Kd(1-α)(1-t) In the above case it is assumed that • Business risk of the project is same as the firm’s current business risk • Debt-Equity ratio remains the same throughout the project period. Since the above two assumptions are not true, the discount rate is not valid and hence the process of evaluation is not correct. Hence, in place of NPV, an Adjusted NPV is used with following corrections; • Project evaluation is carried out with Cost of Equity of the firm • Present value of any cash flows such as subsidies, external financing etc., would be factored using special discount rates.

Example Wipro is planning to start a wholly own subsidiary in Bangladesh to produce and sale Computer. It is planning to invest BDT 60,000,000. The plant would be operational within one year and it would have production capacity of 200,000 units per year and it would continue for 5 year as the company kept a vision for this. The company is expected to sell computer in Bangladesh at a price of BDT 22,000 per unit. Operating cost per unit is BDT 18,000 and Wipro is expecting an opportunity cost of 18% from the new investment. The company has fixed depreciation 20% at straight-line method. The project further also provides following information • •

The Company has accumulated balance BDT 2,000,000 in a local bank because of export to Bangladesh. Its withdrawal would attract a tax of 55%. Wipro domestic location would provide the Chips for the computer which cost BDT 4000 per piece which has variable cost of production BDT 2600.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

•

Bangladesh government permits 2% of sales as royalty payment it is tax deductible. This income in India considered as “technology export” and hence in place of 35% tax it would attract 20% tax. Carry out the appraisal for the project.

Answer Net Present Value estimation Revenue: Per unit price * Number of Unit sell Operating cost: Per unit operating cost * Number of unit produce Profit before tax : Revenue – Operating cost – Depreciation Profit after tax : Profit before tax (1- 55%) Cash inflow : Profit after tax + Depreciation Discounted Cash inflow: Each year CF is discounted by opportunity cost (18%) Net Present Value : Discounted Cash Flow – Initial Investment Year >

1

2

3

4

5

200000

200000

200000

200000

200000

3600000000

3600000000

3600000000

3600000000

3600000000

4400000000

4400000000

4400000000

4400000000

4400000000

12000000

12000000

12000000

12000000

12000000

Profit before tax Profit After Tax (40%)

788000000

788000000

788000000

788000000

788000000

472800000

472800000

472800000

472800000

472800000

Cash Flow Discounted Cash Flow

484800000

484800000

484800000

484800000

484800000

410847458

348175812

295064247

250054447

211910548

Plant Investment

0 60000000

Units sell Operating cost ( BDT 18,000 per Unit) Revenue ( BDT 22,000 Per Unit) Depreciation (20%)

Total DCF Total Outflow NPV

1516052511 60000000 1456052511

Adjustment Blocked Funds Accumulated Funds: BDT 2,000,000 Withdrawal tax : 55% Amount to be credited to NPV : BDT 2,000,000(1-55%): BDT 900000

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Spare parts Wipro domestic location would provide the Chips for the computer : BDT 4000 per piece Variable cost of production: BDT 2600 Cost difference per unit : BDT 1400 Total cost difference per year for 2000000 unit: BDT 280000000 Risk cost of discount: 6% (Assumption) NPV increased: BDT 1179461860 Royalty Payment Bangladesh government permits 2% of sales as royalty payment it is tax deductible. This income in India considered as “technology export” and hence in place of 35% tax it would attract 20% tax. Total tax savings each year would be 55% in Bangladesh and 15% in India. Adjustment Blocked Funds Opportunity cost of using NPV increased Spare parts Chip domestic price Variable cost Cost difference per unit Cost difference 2000000 units per year Risk cost NPV NPV increased Royalty Payment 2% of Sales Tax (55% corporate tax) in Bangladesh Transfer to India as Royalty Tax in India (35%) Tax actually paid (20%) Tax savings Risk cost NPV NPV Increased Total NPV for international project

2000000 55% 900000 4000 2600 1400 280000000 6%

Yr 1 264150943

Yr 2 249199003

Yr 3 235093399

Yr 4 221786226

Yr 5 209232288

88000000

88000000

88000000

88000000

88000000

48400000

48400000

48400000

48400000

48400000

39600000 30800000 17600000 61600000 Yr 1 58113208

39600000 30800000 17600000 61600000 Yr 2 54823781

39600000 30800000 17600000 61600000 Yr 3 51720548

39600000 30800000 17600000 61600000 Yr 4 48792970

39600000 30800000 17600000 61600000 Yr 5 46031103

1179461860

6% 259481609 2895895980

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

References •

International Finance, Thomas J.O’Brien, Oxford Higher Education, 2edition

•

International Financial Management, P.G.Apte, McGraw-Hill, 5edition

Model Questions 1. Write in details the shortcomings of NPV method while evaluating capital budgeting for international project. 2. What are the adjustments needed in NPV for making it suitable for evaluation of Year

0

1

2

3

international

After Cash Flow (Euro)

-1550

450

675

825

budgeting decisions.

capital

3. Inflation in US is 6.50% and that of Euro-zone is 3.75%. The current spot rate is Euro 1= US$1.26. Expected opportunity cost for the MNC in dollar term is 12%. Evaluate the project if the after tax cash flows are in the following pattern:

Answer for 3 CF in Year Euro CF $ DCF $ 0 -1550 -1953 -1953 1 450 582 520 2 675 896 714 3 825 1124 800 NPV

81

St($/€) = {(1 + π$) /(1 + π€)}t *1.26 CFt = St($/€) *CFt in Euro

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