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International Financial Management

Topic-International Capital Budgeting
Submitted To :- Mr. Mujeebur Rehman

Submitted By:Nisha Bilochi IBM specialisation- BBA


International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation. Some of the techniques (i.e., calculation of net present value) are the same as traditional finance. Financial analysts may find that foreign projects are more complex to analyze than domestic projects for a number of reasons. There is the need to distinguish between parent cash flow and projects cash flow. Multinationals will have the opportunity to evaluate the cash flow associated with projects from two approaches. They may look at the net impact of the project on their consolidated cash flow or they may treat the cash flow on a stand alone or unconsolidated basis. The theoretical perspective asserts that the project should be evaluated from the parent companys viewpoint since dividends and repayment of debt are handled by the parent company. This action supports the notion that the evaluation is actually on the contributions that the project can make to the multinationals bottom line. There will also be a need to recognize money reimbursed to the parent company when there are differences in the tax system.

The way in which the cash flows are returned to the parent company will have an effect on the project. Cash flow can be returned in the following ways: Dividends it can only be returned in this form if the project has a positive income. Some countries may impose limits on the amounts of funds that subsidiaries can pay to their foreign parent company in this form. Intrafirm debt interest on debt is tax deductible and it helps to reduce foreign tax liability. Intrafirm sales this form is the operating cost of the project and it helps lower the foreign tax liability. Royalties and license fees this form covers the expenses of the project and lowers the tax liability. Transfer pricing this form refers to the internally established prices where different units of a single enterprise buy goods and services from each other.

Among the other factors that analysts must consider are differences in the inflation rate between countries, given that they will affect the cash flow over time. Also, they must analyze the use of

subsidized loans from the host country since the practice may complicate the capital structure and discounted rate. The host country may target specific subsidiaries in order to attract specific types of investment (i.e., technology). Subsidized loans can be given in the form of tax relief and preferential financing, and the practice will increase the net present value of the project. Some of the advantages of this practice include (1) adding the subsidiary to project cash inflows and discount, (2) discounting the subsidiary at some other rate, risk free, and (3) lowering the risk adjusted discount rate for the project in order to show the lower cost of debt. Other steps may include determining if political risk will reduce the value of the investment, assessing different perspectives when establishing the terminal value of the project, reviewing whether or not the parent company had problems transferring cash flows due to the funds being blocked, making sure that there is no confusion as to how the discount rate is going to be applied to the project, and, finally, adjusting the project cash flow to account for potential risks.

Significance of capital budgeting

The success and failure of business mainly depends on how the available resources are being utilized. Main tool of financial management All types of capital budgeting decisions are exposed to risk and uncertainty. They are irreversible in nature. Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investments. Capital budgeting offers effective control on cost of capital expenditure projects. It helps the management to avoid over investment and under investments.

The Major Capital Budgeting Methods

A variety of measures have evolved over time to analyze capital budgeting requests.The better methods use time value of money concepts. Older methods, like the payback period, have the deficiency of not using time value techniques and will eventually fall by the wayside and be replaced in companies by the newer, superior methods of evaluation. Very Important:A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large enough to repay the company for three things: (1) the cost of the asset, (2) the cost of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors made when estimating cash flows that will occur in the distant future. Let's take a look at the most popular techniques for analyzing a capital budgeting proposal. 1. Payback Period Alright, let's get this out of the way up front: the Payback Period isn't a very good method. After all, it doesn't use the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is still used by a large number of companies, so we'll include it in our list of popular methods. What is the payback period? By definition, it is the length of time that it takes to recover your investment. For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years.Companies that use this method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less will be accepted.(At a payback period of 3 years in the example above, that project would be rejected.) The payback period method is decreasing in use every year and doesn't deserve extensive coverage here.

2. Net Present Value Using a minimum rate of return known as the hurdle rate the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC) NPV = PVB - PVC By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return. Here are our decision rules:

If the NPV is: Positive Zero Negative

Benefits vs. Costs Benefits > Costs Benefits = Costs Benefits < Costs

Should we expect to earn at least our minimum rate of return? Yes, more than Exactly equal to No, less than

Accept the investment? Accept Indifferent Reject

Remember that we said above that the purpose of the capital budgeting analysis is to see if the project's benefits are large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. Therefore, if the NPV is: positive, the benefits are more than large enough to repay the company for (1) the asset's cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates. zero, the benefits are barely enough to cover all three but you are at break even - no profit and no

loss, and therefore you would be indifferent about accepting the project. negative, the benefits are not large enough to cover all three, and therefore the project should be rejected. 3. Internal Rate of Return The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment.Technically, it is the discount rate that causes the present value of the benefits to equal the present value of the costs.According to surveys of businesses, the IRR method is actually the most commonly used method for evaluating capital budgeting proposals.This is probably because the IRR is a very easy number to understand because it can be compared easily to the expected return on other types of investments (savings accounts, bonds, etc.). If the internal rate of return is greater than the project's minimum rate of return, we would tend to accept the project. The calculation of the IRR, however, cannot be determined using a formula; it must be determined using a trial-and-error technique.This process is explained in the following link. The Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is determined using a trial-and-error process. We generally start by conducting a test using the hurdle rate.This will tell us whether the project is expected to earn more than or less than the hurdle rate. Note:PVB and PVC are defined in the glossary above. Test Results PVB > PVC Interpretation of Results The project is expected to earn more than the percentage rate used for the test The project is expected to earn less than the percentage rate used for the test Next percentage to be tested? A higher rate


A lower rate

It isn't necessary to test in increments of one percent (e.g., 10%, 11%, 12%, etc.). Once you have conducted the test using the hurdle rate, compare the PVB and PVC.If the two numbers are relatively close to one another, the IRR is relatively close to the hurdle rate.If the PVB is a long distance away from the PVC, you will need to choose a percentage rate that is far away from the

hurdle rate for your second test. We continue the testing until we find a range of values for the IRR.In other words, we need to know that the IRR is greater than some percentage number and less than some percentage number (e.g., greater than 10% and less than 15%).In the interest of accuracy, keep this range to 5% or less, e.g., greater than 12% and less than 13% (i.e., a 1% difference) is ideal, greater than 10% and less than 15% (a 5% difference) is O.K., greater than 10% and less than 20% (a 10% difference) is not acceptable for the range. We then set up a proportion and interpolate to find the IRR. Calculation of the IRR Assume that we are evaluating a project that has a cost of $100,000.Using the hurdle rate, we obtain a PVB of $103,000.Comparing the PVB of $103,000 to the PVC of $100,000, this tells us that the project is expected to earn a rate higher than 10%.So we choose a higher rate for our second test.Since the gap between $103,000 and $100,000 is small (in relative terms), we shouldn't have to go far. Let's choose 15% for our second test. Using this as our discount rate, we obtain a PVB of $98,000. Since the PVB is now less than the PVC, the IRR is less than 15%.We now have our range: the IRR is between 10% and 15%. We are searching for the discount rate that will cause the PVB to equal the PVC. Here is what we know so far:

Percentage Tested 10% IRR 15%

PVB $103,000 $100,000 $98,000.00

In the table above, notice that we place the smaller percentage number on the top of the column (to simplify the arithmetic later). On the middle row, the IRR is the discount rate that will give us a PVB exactly equal to the PVC of $100,000.

Let's call the distance between 10% and the IRR (above) a distance of x. The ratio of this distance (i.e., between the top two numbers) to the distance between the outside two numbers (i.e., 10% and 15%) should be the same for both columns. In other words, we can set up a proportion using this: the ratio of the difference between the top two numbers and the outside two numbers is the same for both columns. That is:

x is to 5% as $3,000 is to $5,000.

x / 5% x x x

= = = =

$3,000 / $5,000 $3,000 / $5,000 * 5% 0.60 * 5% 3.0%

If x is 3.0%, then the IRR is 3% away from 10% and is larger than 10% (since we know that the IRR is between 10% and 15%); therefore, the IRR must be 13.0%. Which Method Is Better:the NPV or the IRR? Ignoring the payback period, let's ask the question: Which method is better - the NPV or the IRR? Answer: The NPV is better than the IRR. It is superior to the IRR method for at least two reasons: 1. Reinvestment of Cash Flows:The NPV method assumes that the project's cash inflows are reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to earn the IRR.Of the two, the NPV's assumption is more realistic in most situations since the IRR can be very high on some projects. 2. Multiple Solutions for the IRR:It is possible for the IRR to have more than one solution.If the cash flows experience a sign change (e.g., positive cash flow in one year, negative in the next), the IRR method will have more than one solution.In other words, there will be more than one percentage number that will cause the PVB to equal the PVC.

When this occurs, we simply don't use the IRR method to evaluate the project, since no one value of the IRR is theoretically superior to the others.The NPV method does not have this problem. Is there any way that we can improve the performance of the IRR? Fortunately, yes. Let's take a look at how we can do this, with another technique called the modified internal rate of return.

4. Modified Internal Rate of Return The Modified Internal Rate of Return (MIRR) is an attempt to overcome the above two deficiencies in the IRR method. The person conducting the analysis can choose whatever rate he or she wants for investing the cash inflows for the remainder of the project's life. For example, if the analyst chooses to use the hurdle rate for reinvestment purposes, the MIRR technique calculates the present value of the cash outflows (i.e., the PVC), the future value of the cash inflows (to the end of the project's life), and then solves for the discount rate that will equate the PVC and the future value of the benefits. In this way, the two problems mentioned previously are overcome: the cash inflows are assumed to be reinvested at a reasonable rate chosen by the analyst, and there is only one solution to the technique. Calculation of the MIRR Assume that we are evaluating a project that has a cost of $30,000, after-tax cash inflows of $10,000 per year for four years, and a hurdle rate of 10%. Since the cash inflows are assumed to be received at the end of each year, the cash inflows would be reinvested as shown below.Notice that the 1st year's cash inflow is assumed to be reinvested for 3 years, so we multiply it times the future value factor for 10% and year 3 (i.e., 1.331).The 2nd year's cash inflow is assumed to be reinvested for 2 years, so we multiply it time the future value factor for 10% and year 2 (i.e., 1.210).Year 3's cash inflow is invested for 1 year and year 4's cash inflow is received at the end of the 4th year, so it is not available for reinvestment since it coincides with the end of the project's life.

Year 1 2 3 4 Total Now, the only question remaining is:

Years Reinvested 3 2 1 0

Cash Inflow $10,000 $10,000 $10,000 $10,000

Future Value Factor (at 10%) 1.331 1.210 1.100 1.000

Future Value $13,310 $12,100 $11,000 $10,000 $46,410

If I invest $30,000 in an account today and receive the equivalent of $46,410 in four years, what rate would be earned on the investment?We can find the MIRR in one of two ways: The trial-and-error technique that was used earlier to find the IRR.Using any discount rate, like 10%, take the present value of the $46,410 received four years from now. (This is $31,699.)Since the present value of the benefits ($31,699) is larger than the present value of the cost ($30,000), we need to use a higher discount rate, like 12%.At 12%, the present value is $29,494. Since the PVB is now less than the PVC, the MIRR is less than 12%.We now have our range: the MIRR is between 10% and 12%. We are searching for the discount rate that will cause the PVB to equal the PVC.Here is what we know so far: Percentage Tested PVB 10% $31,699 MIRR $30,000 12% $29,494 On the middle row, the MIRR is the discount rate that will give us a PVB equal to the PVC of $30,000. Let's call the distance between 10% and the MIRR (above) a distance of x. The ratio of this distance to the distance between the outside two numbers (i.e., 10% and 12%) should be the same for both columns. In other words, x / 2% x = x = x = =

$1,699 / $2,205 $1,699 / $2,205 * 2% 0.7705 * 2% 1.54%

If x is 1.54%, then the MIRR is 1.54% away from 10% and is larger than 10% (since we know that the MIRR is between 10% and 12%); therefore, the MIRR must be 11.54%. As an easier alternate method, we can solve for the geometric mean return. Divide the future value of the cash inflows by the present value of the cash outflows (i.e., $46,410/$30,000) to get a value of 1.547. Notice that this is the value that $1.00 would grow to in 4 years if you invested money to earn the hurdle rate of 10%. Set the result to the 1/n power (where n = 4 years). If you have a y-to-the-x key on your calculator, simply enter 1.547 as the y-value and 0.25 (i.e., 1/4) as the x-value, and solve. The result is 1.1153. Subtract 1.0 from the answer and place the answer (0.1153) in percentage form. The answer is the MIRR of 11.53%. Removing Potential Biases When Evaluating Mutually Exclusive Proposals Unfortunately, some potential biases creep into our standard methods of analyzing capital budgeting projects. In other words, some of the methods have a tendency to make some projects look better than others, e.g., small vs. large projects, short-lived vs. long-lived projects. Let's look at these in more detail. Scale Effect - If we are considering mutually exclusive proposals and the assets (e.g., machines) cost different amounts, there is a potential bias in favor of accepting the more expensive asset, simply because of the larger size of the price tag. For example, we may consider investing in either: Asset A, which cost $100,000 and has an NPV of $3,000, or Asset B, which cost $300,000 and has an NPV of $3,100. If we make our decision based solely on the NPV's dollar amount, we would choose asset B since it has the higher NPV. However, per dollar invested, asset A obviously has the higher return. If the cost of the two assets differ by a considerable amount, we should use the profitability index instead of the NPV to make our decision. The profitability index, by definition, is the ratio of the present value of the benefits (PVB) to the present value of the cost (PVC). This simple benefits-to-costs ratio will remove the scale effect's bias. We obviously prefer to invest in the asset that has the higher value for the profitability index. Unequal Lives - If we are comparing mutually exclusive proposals and the assets (e.g., machines) have different lives, there is a bias in favor of accepting the longer-lived asset. For example,

assume that you are evaluating two machines but will only purchase one of them because they compete for the same job (i.e., they are mutually exclusive). Assume that one of the machines has an expected life of 3 years and the other has an expected lifetime of 5 years before it wears out. Everything else being the same, the 5-year machine will have the higher Net Present Value. (It has to do with the amount of interest earned on the reinvestment of the cash inflows over a longer period of time.)

Risk Management Techniques How accurate will our estimates of cash flows be? After all, these are estimates of cash flows, not guarantees. There is a certainty that our cash flow estimates will be wrong to some degree. After all, we are making certain assumptions (about future prices of raw materials, labor costs, operating schedules, etc.) to come up with these estimates of future savings and benefits. Some of these assumptions will prove to be faulty. Our goal is to avoid what we might call a Type II error - in this case, accepting a project that will lose money. (As opposed to a Type I error of not accepting a project that will eventually prove to be profitable.) Most people would consider the Type II error the more serious of the two since it leads to an actual, realized loss (as opposed to an opportunity loss). Fortunately, there are several procedures available for assessing this risk and managing it.

Incremental Cash Flow Overview Incremental cash flow analysis is the increase or decrease in cash flows that are specifically attributable to a management action. For example, if a management team is reviewing a proposal to improve the capacity of a machine, the entire cash flow resulting from the use of that machine is not the point upon which the decision must be made, but rather the incremental cost of improving the machine, and the incremental revenue that results from having additional capacity. Incremental Cash Flow Example For example, assume that a machine produces 1,000 cans per hour, and an upgrade to the machinery will result in an increase in the theoretical capacity to 1,500 cans per hour, for an incremental

change of 500 cans per hour. The cost of the upgrade is $100,000, and the profit from each can is $.04. Since the machine runs 8 hours a day for five days per week, the increase in capacity will result in an added cash inflow of $41,600, which is calculated as follows: (500 cans per hour) x $.04 = $20 per hour incremental cash inflow = ($20 per hour of cash inflow) x (40 hours per week) x (52 weeks per year) = $41,600 This incremental investment translates into a payback of 2.4 years, which is a reasonable return period for most investments. However, from an incremental perspective, why not run the machine a bit longer each day to obtain the same production that the machine would yield with the enhanced equipment? If the machine operator is paid $10 per hour and the same person stays late to work an extra 4 hours per day to run the machine, the added overtime cost per year will be only $15,600 (4 hours per day x 260 days x $15/hour), which is far less expensive than the equipment option. In addition, there may be no incremental need for the added capacity, since we do not know that the machine must be run at full capacity at all times. By using overtime instead of a fixed investment, we can scale back the use of the machine on a day-to-day basis to exactly match production to sales. This example shows that you must review the specific cash flows that will change as a result of a specific management decision to see if it will result in a positive incremental change in cash flows. Incremental Cash Flows Total project vs. incremental cash flows Shareholders are interested in how many additional dollars they will receive in the future for the dollars they lay out today Distinction between the projects total cash flows and the incremental cash flow from the project Incremental cash flow: compare worldwide corporate cash flows without investment (base case) with post-investment corporate cash flows Need to assess what will happen if we dont make investment Project total cash flow and incremental cash flows may deviate due to: Cannibalization: A new investment (product) takes sales away from the existing products

A foreign production plants production substitutes parent company export Incremental cash flow: If investment replace other existing cash flows (that otherwise would

have existed) these cash flows (the replaced) need to be subtracted from the investments total cash flow to obtain the incremental cash flow of the investment Sales creation Opposite of cannibalization investment leads to increasing cash flows at other production sites (than otherwise), due to Incremental cash flow = investments total cash flows + sales creation cash flows

e.g. a stronger local position of the firm

Other Cash Flow Issues Opportunity cost Project/investment cost must include the true economic cost of any resource required for the What the resource would be worth in use or on the market otherwise the opportunity cost Transfer prices the price at which goods and service are traded internally Prices used in the capital budgeting process should be valued at market prices project regardless if the firm already owns it.

Fees and Royalties Firms charges of legal counsel, power, heat ,rent, R&D, headquarter staff, management costs Should only be included in capital budgeting process if the investment leads to additional usually in form of fees and royalties expenditures Intangible benefits Better quality, faster distribution times and higher customer satisfaction and so on Learning experience Broader knowledge base

Higher competitive skills Should be attribute as positive benefits to an investment Usually hard to estimate (the value of the intangible benefits) Can be stated separate in the investment analysis

Case Study Capital Budgeting

The case involves an international company investing in a (fictitious) developing country. It also deals with the capital budgeting decision, method of financing and the problem of determining a discount rate for international investment decisions. Background Zenobia is a developing country situated on the coast of Africa. Its government, now democratically elected, has produced a programme of economic reforms aimed at promoting investment in the country and reducing its dependence on foreign aid. A major feature of this programme is the privatisation of companies and corporations which are currently 100% owned by the government, e.g. hotels, breweries and coffee production. For the time being, the government is not considering privatising services such as post, railways or the provision of basic telecommunications (this is mainly the fixed-line, voice telephony service). It does, however, wish to attract private capital to provide new services such as cellular (mobile) telephones and data communication. Global Telecommunications Inc (GTI) is a company registered in the USA but with global business interests. Its shares are not listed on a stock exchange, but industry sources estimate that it could command a market capitalisation of around US$200m. It has established itself as a specialist in the provision of mobile telephone (cellular) services. It is currently negotiating with the government of Zenobia (GoZ) for a licence to provide such services in the country and has already

spent US$O.5m in surveys and miscellaneous expenses. If GTI were successful in the negotiations, it would be the company's first experience of working in a developing country. Forecast cash flows Based on a recent World Bank report, GTI estimates that there is a market for between 10,000 and 15,000 customers in a rectangular geographical area bounded by the capital city and three other main towns. The proposed cellular service will operate in this relatively prosperous `urban rectangle' but the poorer, rural areas outside the rectangle will not be covered. The market for 10,000 lines is, apart from potential disasters, virtually guaranteed. GTI estimates that the initial investment for this number of lines will be US$25m. The company has asked the GoZ for a five-year exclusivity period (a period when no other company will be allowed to enter the market to compete). Net operating cash flows, based on a network of 10,000 lines, are forecast to be: Year: 1 2 3 4 5 3.5 4.8 5.6 6.8 7.2

Net operating cash flows (US$m):

In year 6, competitors are likely to enter the market and cash flows are expected to fall to around US$6m per annum. For the purposes of evaluation, GTI assumes this annual net cash flow will be maintained indefinitely from year 6 onwards on a network of 10,000 lines. The figures are, of course, an extreme simplification of what would be a complex appraisal. Cash flows would arise in both local currency and US$ (the `home' currency in this case). Forecasting the cash flows would be extremely difficult in the circumstances. However, forecasting cash flows in any currency is fraught with difficulty and the procedure has not been covered in detail here as it is not the main purpose of the article.

Discount rate There is some dispute about the discount rate to be used for the evaluation of this project. The company's cost of capital is 15% per annum constant, and this is the rate which is being suggested. However, the managing director thinks this is a particularly risky project. Although all calculations and negotiations with the GoZ are in US$, much of the cash inflow will be in local currency. The technical director says that, as the project increases international diversification, it actually reduces the company's risk, so a lower rate should be used. The finance director notes that the cash flows for each year are highly correlated with those of the previous and subsequent years and this also will affect risk. Method of financing GTI is at present all equity financed. The company has sufficient cash flows from other projects to enable it to finance the Zenobia deal internally. However, the IFC is prepared to offer 10% fixed interest rates on loans of up to US$20m for investments of this nature. Capital is repaid at the end of the loan period, which must be a minimum of five years. Interest is paid annually. No early repayment of the loan is permitted without severe financial penalties. If GTI were to raise a similar amount of debt in the capital markets, it would currently be obliged to pay 12.5% interest. GTI will be eligible for tax relief at 40% on loan interest payments. Case discussion As noted earlier, two methods exist to calculate the net present value of international investment decisions. In the investment decision in a developing country, neither of these methods is ideal. Forecasting foreign exchange rates is extremely difficult in countries where exchange rates are highly volatile. It is also difficult to estimate the cost of capital in a developing country. It is assumed that the company uses the first method noted above for evaluating investments of this type (i.e. it has converted all currency cash flows from the project into US$ and will discount them at a US$-denominated discount rate to generate a US$ NPV). The choice of this method is common in such circumstances. Implicit in the calculations is a suggestion that charges for telecommunication services will be increased in local currency terms to allow for inflation and

devaluation. Technically this is quite acceptable, but there is a political risk that the government may not wish to see big increases in telecommunication charges. However, what is being offered here is a cellular service, where the market is likely to be with expatriates, diplomats and wealthy local businessmen. Tariffs are therefore unlikely to be subject to the same amount of political pressure. The volatility of exchange rates adds to project risk. Thus a project in a country whose currency has been highly volatile against the US dollar would carry more risk than a similar project in a country whose currency is pegged to the dollar. Expropriation risk, which can never be ignored in developing countries, is difficult to diversify and even more difficult to assess, and companies tend to stay out of countries where such risk is high. However, as with all high-risk projects, the rewards should be high enough to compensate. The technical director is in principle correct in that international diversification will reduce overall risk. However, for a US company to diversify internationally in, for example, Western Europe, is a very different proposition from diversifying into a developing country with a very short history of political and economic reforms. Inter-temporal correlations (the correlation of one year's cash flows with the previous year's) affect the standard deviations of the net present value and internal rate of return and hence the project's stand-alone risk. Generally, projects having cash flows with zero inter-temporal correlations have lower standalone risk than projects with high correlations. This is because low correlation means that a lessthan-expected cash flow in one year can be offset by greater-than-expected cash flow in the next. Very few projects have zero inter-temporal correlations, and most of them are dependent to some extent on what has happened in a previous year. In theory, projects should be evaluated using a specific risk-adjusted discount rate which reflects the risk of that project. In order to determine a discount rate for a project we should use a `proxy' company's beta and include this in the capital asset pricing model. In practice this is almost impossible to do, particularly in a developing country. Even if we assume that: (i) the government of Zenobia has agreed to allow GTI to increase prices in line with depreciation of the local currency; (ii) it can be trusted not to prevent expropriation of profits and dividends; and (iii) GTI accepts there will be no political interference in its operations, three

risks remain. Risk 1: Demand is at the level forecast by the World Bank. Risk 2: Installation of the network does not meet geographical problems which were not foreseen. Risk 3: Civil disturbances. The board of directors of GTI can only take a view on this type of risk, and it is almost impossible to quantify a discount rate using any formal model such as CAPM. GTI is currently all equity financed and therefore has substantial debt capacity. Even though it is a service company, it will own a number of assets for the provision of telecommunications services. It will also own the right to future income generation on networks which it has installed, within the terms of its licences and agreements. On the face of it, GTI would be sensible to take the IFC offer of a loan fixed at 10%, as this would release internally generated cash flows to earn money in other areas, which should earn a return of the 15% cost of capital in projects of lower risk than that in Zenobia. The disadvantages could be as follows: The interest rate is fixed. If interest rates are expected to fall GTI could be locked to a high-interest loan for between five and ten years. The capital is not repaid until the end of the loan period therefore interest is payable on the full amount each year of the loan. The maximum amount of the loan of US$20m will not be sufficient to fund the project. The company will therefore have to provide a further US$5m from internally generated funds at the beginning of the project. The main advantages and disadvantages of taking out a loan of this type may be in the small print. It is possible that the IFC will offer some inbuilt insurance that if Zenobia was subject to civil disturbance, the loan becomes non-repayable. A disadvantage might be that taking out this loan for Zenobia could preclude GTI's borrowing money from the IFC for other projects in the future which may turn out

to be less risky and more profitable.

Project cash flows 0 Initial investment Terminal value (6m/0.2) Discount factor (at 20%) 1 Discounted cash flows Cumulative DCFs -25.0 -25.0 0.83 2.9 0.69 3.3 1 2 -25.0 3.5 4.8

Net operating cash flows

-22.1 -18.8

3 Initial investment

Net operating cash flows 5.6 Terminal value (6m/0.2) Discounted cash flows Cumulative DCFs 3.2 -15.5


7.2 30.0[*] 0.40 14.9 2.7

Discount factor (at 20%) 0.58 0.48 3.3 -12.2

[*] The terminal value is calculated as a perpetuity, i.e. we assume year 5's cash flows will continue indefinitely and the discount rate of 20% also remains constant

This proposal suggests that the project is just about viable using a discount rate for 20%, the internal rate of return being around 23.5%. The undiscounted payback period is just under five years. It is not possible to work out the discounted payback period without doing calculations on cash flows beyond year 6. This has not been provided at this stage. However, if this proposal is unacceptable to the GoZ it can only be used as a benchmark against which alternative options may be compared. The key to the acceptability of the project is GTI's attitude to risk. Telecommunications is a high-technology industry and accustomed to certain levels of risk, but developing a new network in a developing country, and in a country in which the company has no previous knowledge, is compounding the risk factors. As

noted earlier, the main risks may be summarised as follows: Currency risk. Unless GTI has built into its licence a Tight to increase tariffs when the Zenobia currency depreciates. Political risk. That the government will honour its agreement in the licence and will allow the company to remit profits and dividends as promised.

SUMMARY As companies take a more global perspective to their trading activities, investing overseas and the financing of such operations will be given greater consideration. The ability to raise capital, and the cost of that capital, will remain important but is is also important to be aware of the risks involved. In this article we have identified the main types of foreign exchange risk, which may have an impact on the method of financing overseas operations. When appraising overseas projects, two equivalent approaches may be used. The project's currency cash flows can be converted into sterling and appraised using a sterling discount rate. Alternatively, the cash flows in the overseas currency can be discounted at a discount rate appropriate to that currency. The NPV so produced can then be converted into a sterling NPV by converting at the spot rate of exchange. A case study was used to provide a real world situation around which a discussion of risk, discount rate to be used and financing of risky overseas investments could be focused. (*) The theory of interest rate parity says that interest rates are determined in the market by supply and demand (although note political interference). There is a relationship between foreign exchange and money markets. Other things being equal the currency with the higher interest rate will sell at a discount in the forward market against the currency with the lower interest rate.


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