International Project Appraisal

By: Somya Agrawal

Sonam Agrawal

Laxmi Nandwani

Introduction• The fundamental goal of the finance

manager is to maximize shareholder’s wealth.

• This can be done if the firm selects those projects that maximize the company’s value.

• The selection process involves a detailed analysis of every project on every aspect.

• International projects involve more factors to be analyzed as compared to the domestic projects.

Issues to be analyzed for International Project Appraisal

Foreign Exchange

Remittance Taxation

Project v/s parent cash

flow

Adjustment for risk

Financing arrangements

Blocked funds Inflation Uncertain

salvage value

Foreign Exchange Risk• Risk that the currency will appreciate or

depreciate over a period of time.• It help in understanding the cash flows

generated by the project over its life cycle.• To made the estimates, the manager should

– Estimate the inflation rate in host country– The cash flows in terms of local currency– Adjust the cash flows for inflation– Convert the cash flows into parent country currency

according to the expected depreciation or appreciation rate calculated on the basis of PPP.

Remittance Restrictions• Many countries impose a variety of restriction on

transfer of profits, depreciation and other fees accruing to the parent company.

• Normally the project cash flow includes profits and depreciation but parent’s CF consist of the amount that can be legally transformed.

• There are some techniques to curtail the restrictions like transfer pricing, overhead payment, etc.

• To obtain a conservative estimate of the contribution by the project the financial manager can include only the income which is remittable by law in the host country.

Tax Issues• For a project evaluation only cash flows after

tax are relevant.• In international projects, there exists two taxing

jurisdiction.• There exists the differences in dividend

management fees, royalties, etc., • To calculate the actual after tax cash flow, the

higher tax rate are used.• This shows a conservative scenario that if the

project is acceptable under this condition then it will be necessarily acceptable under more favorable tax scenario.

Project Versus Parent Cash Flows

• Substantial differences can exist between the project and parent cash flows because of tax regulations and exchange control.

• Also, expenses such as management fees and royalties are returns to the parent company.

• Project Evaluation should be done on the basis of:– Its own cash flows?– Cash flows accruing to the parent company?– Both?

Basis of its own cash flows• The project must be able to compete

successfully with other domestic firms & also earn a rate of return in excess of its locally based competitors.

• If not, then it is better for parent company to invest in the equity/ government bonds of local firms.

Contd..

• Evaluating projects on the basis of local cash flows has the advantage of avoiding currency conversion & hence eliminating problems involved with fluctuating/ forecasting exchange rates changes for the life of the projects.

From the viewpoint of parent company

• Cash flows which are actually remitted to the parent are the ultimate yardstick for company performance.

• This helps in determining the financial viability of the project from the viewpoint of the MNC as a whole.

• Cash flows include both operating & financial like fees, royalties and interest on loans given by parent company.

Financial Analysis of Foreign Projects

• Project cash flows are computed & analyzed from subsidiary viewpoint & & consider it as separate entity.

First Stage• It involves evaluation of the

profit on the basis of forecasts of cash flows which will be transferable to the parent company.

Second Stage

• From viewpoint of parent- Include indirect benefits or costs from the company as a whole, which are attributable to the foreign project in question.

Third Stage

Financing Arrangements

• The value of the project will be determined by the manner in which it is financed.

• For example: many times, international agencies in order to promote cross border trade finance at below market rates.

• In case of subsidized financing, determine whether subsidized financing is separable or not from the project.

Contd..

• When the subsidized financing is inseparable then the value of loan should be added to that of the project in making investment decision.

• But, if it is separable, then there is no need to allocate the value of loan in the project.

Blocked Funds

• Blocked funds are the cash flows generate by a foreign project that cannot be immediately transferred to the parent, usually because of exchange controls imposed by the govt. of the country in which the funds are held.

Contd..• Some countries require that the earnings

generated by the subsidiary be reinvested locally for at least a certain period of time before they can be remitted to the parent company.

• Blocked funds cause a discrepancy b/w the project value from parent’s and local perspective.

• Also, this can possibly affect the accept/ reject decision for a project.

INFLATION The impact of inflation on the parent’s &

subsidiary’s cash flow can be quite volatile from year to year some countries. It may cause currency to weaken & hence influence a project’s cash flow

Inaccurate inflation forecast by a country, can lead to inaccurate cash flow forecast. Thus MNCs cannot afford to ignore the impact of inflation in the cash flow

Uncertain salvage value• The salvage value of a project has an important

impact on the NPV of the project. When the salvage value is uncertain, the cash flow will not be accurate & the MNC may need to calculate various possible outcome for the salvage value & estimate the NPV based on each possible outcome. The feasibility of the project may then depend upon the present value of the salvage value.

Adjustment for riskCash flow v/s Discount rate adjustment:• Another important dimension in multinational

capital budgeting is whether to adjust cash flow or the discount rate to account for the additional risk arises from the foreign location of the project.

• Traditionally, MNCs have adjusted the discount rate by moving it upwards for riskier projects to reflect the political and foreign exchanged uncertainties

• Adjusting the discount rate is quite a popular method with MNCs mainly because of its simplicity and the rule that the required rate of return of a project should be in accordance with the degree of risk which it is exposed to.

• However, combining all risk into a single discount rate has several drawbacks.

• The annual cash flow are discounted using the applicable rate for that type of project either at the host country or at the parent country. Probability and certainty equivalent techniques like decision tree analysis are used in economic and financial forecasting. Cash flows generated by the project and remitted to the parent during each time period are adjusted for political risk, exchange rate and other uncertainties by converting them into certainty equivalent. The method of adjusting the cash flows rather than discount rate is generally the more popular method and is usually recommended by finance managers. There is generally more information on the specific impact of a given risk on a projects’ cash flow than on its discount rate.

THANK - YOU