Capital Budgeting for International Products

Capital Budgeting of International Products : 

Capital Budgeting of International Products

Capital Budgeting : 

Capital Budgeting Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

International Capital Budgeting : 

International Capital Budgeting As soon as a company reaches to a decision to invest abroad, the firm evaluate projects and selects one or more of them that ranks high from the viewpoint of adding to the corporate wealth. The process is known as International Capital Budgeting

Evaluation Criteria : 

Evaluation Criteria The method of evaluation of investment proposals are grouped in two methods:- Discounting Non-Discounting

Non Discounting Method : 

Non Discounting Method Non-discounting methods are simple. One such method involves the average rate of return earned by the project. It represents the mean profit on account of investment prior to interest and tax payment. The mean is compared with required rate of return. A project is acceptable if the mean profit is higher than the required rate of return. Other discounting method is known as pay-back period.

Shortcomings of Non Discounting Method : 

Shortcomings of Non Discounting Method It is based on the accounting income and not on the cash flow. It considers profit before tax, rather than post-tax profit. It ignores time value.

Discounting Method : 

Discounting Method Discounting methods take normally four forms:- Net present value (NPV) method Profitability index (PI) method Internal rate of return (IRR) method The Adjusted Present Value (APV) Approach

Net present value (NPV) method : 

Net present value (NPV) method NPV is the residue after deducting the initial investment from the present value of future cash flows relating to a project. Positive NPV means additions to the corporate wealth therefore accept the project; if not reject the project. The equation is:- NPV =

Profitability index (PI) method : 

Profitability index (PI) method PI is the ratio between the present value of the future cash flows and the initial investment. It shows the relative gains and would be expressed as the following equation :-

Internal rate of return (IRR) method : 

Internal rate of return (IRR) method IRR is the discount rate equating the present value of future cash flows and the initial investment. For accepting a project, IRR > hurdle rate (required rate of return). Expressed as an equation:

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Adjusted Present Value If incentives exist to finance with debt - tax shields or interest subsidies - Adjusted Present Value (APV) should be used. If tax treatments are symmetric, and if uncovered interest parity is expected to hold, tax shields will have identical value whether debt is raised in host or home country. Low capital gains taxes, high deductibility of interest payments, negative failure of UIP, and subsidized interest rates will all favor financing in depreciating currencies.

Cash Flow : 

Cash Flow Parent cash flows are different from project cash flows. All cash flows from the foreign projects must be covered into the currency of the parent firm. Profits remitted to the parent are subject to 2 jurisdictions  the parent country and the host country. The possibility of foreign exchange risk and its effect on the parent’s cash flows.

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If the host country provides concessionary financing arrangements or/and benefits, the profitability of the foreign project may go up. Initial investment in the host country may benefit from the partial or total release of blocked funds. The host country may impose restrictions on the distribution of cash flows generated from foreign projects.

Problems and Issues in international investment analysis. : 

Problems and Issues in international investment analysis. The foreign exchange risk Remittance restrictions The tax issue Project v/s parent cash flows Cash flows v/s Discount rate adjustment Financing arrangement Blocked funds Inflation Uncertain salvage value

Cost of Capital : 

Cost of Capital The above discussion was limited to the numerator of the NPV- rule equation. The denominator of the equation ,which is known as the discount rate or hurdle rate which is based on the risk- adjusted cost of capital ,is also very significant for the computation of cash flow.

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Average cost of capital :- it represents the weighted average of the cost of equity and cost of debt. Cost of Debt :- interest is the cost of debt adjusted for taxes because interest is tax-deductible and debited in the income statement before tax is calculated. k= kd(1-t)wd+ke*we kd= Interest/principal*(1-t)

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Cost of Equity :- Dividend is the cost of equity shares. The price of equity share is equal the present value of the expected dividend resulting the risk-adjusted rate required by the investors. Cost of Retained Earnings :- funds for investment normally comes from the retained earnings. The after-tax cost of retained earnings is calculated. ke= D/Po ks= ke*(1-t)

Real Options and Project Appraisal : 

Real Options and Project Appraisal Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects

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Real options start when there is expected a change in cash flow from that originally anticipated. They are concerning (related to) :- postponement/abandonment/expansion/ contraction of the operation.

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Investment timing option (postponement) Evaluate additional information Abandonment option Reduce downside risk Growth options(expansion) Research programs, expand a small plant, or strategic acquisition Shutdown options Temporarily

Non- Financial Factors in Capital Budgeting : 

Non- Financial Factors in Capital Budgeting Rodriguez and Carter (1984) group these factors as Non-Financial factors influencing capital budgeting decision are :- Behavioural characteristics of the organisation. Business strategy These factors influence the final decision about taking up of the project.

Group Members : 

Group Members Varsha Chaurasiya 07 Anas Choudhary 10 Avani Gandhi 16 Rashmi Gupta 19 Nilofar Rayani 42 Salman Shah 45

Thank You : 

Thank You