Opening Case 18:External Factors Affecting Foreign
Pr oject Analysis
Foreign-exchange rates, interest rates, and inflation are three external factors that
affect multinational companies (MNCs) and their markets. Changes in these three
factors stem from several sources, such as economic conditions, government policies,
monetary systems, and political risks. Each factor is a significant external variable that
affects areas such as policy decisions, strategic planning, profit planning, and budget
control. To minimize the possible negative impact of these factors, MNCs must
establish and implement policies and practices that recognize and respond to their
influences.
These three factors – exchange rates, interest rates, and inflation – affect sales
budgets, expense budgets, capital budgeting, and cash budgets. However, they are
particularly useful when evaluating international capital budgeting alternatives.
Foreign-exchange rates have the most significant effect on the capital budgeting
process. A foreign investment project will be affected by exchange rate fluctuations
during the life of the project, but these fluctuations are difficult to forecast. There are
methods of hedging against exchange rate risks, but most hedging techniques are
used to cover short-term positions.
The cost of capital is used as a cutoff point to accept or reject a proposed project.
Because the cost of capital is the weighted average cost of debt and equity, interest
rates play a key role in a capital expenditure analysis. Most components of project
cash flows – revenues, variable costs, and fixed costs – are likely to rise in line with
inflation, but local price controls may not permit internal price adjustments. A capital
expenditure analysis requires price projections for the entire life of the project. In some
The basic principles of analysis are the same for foreign and domestic investment projects.
Howeve r, a foreign investment decision results from a complex process, which differs, in many
aspects, from the domestic investment decision.
Relevant cash flows are the dividends and royalties that would be repatriated by each sub-
sidiary to a parent firm. Because these net cash flows must be converted into the currency of a
parent company, they are subject to future exchange rate changes. Moreover, foreign investment
projects are subject to political risks such as exchange controls and discrimination. Normally, the
cost of capital for a foreign project is higher than that for a similar domestic project. Certainly,
this higher risk comes from two major sources, political risk and exchange risk.
This chapter is composed of four major sections. The first section describes the entire process
of planning capital expenditures in foreign countries beyond 1 year. The second section exam-
ines how international diversification can reduce the overall riskiness of a company. The third
section compares capital budgeting theory with capital budgeting practice. The fourth section
covers political risk analysis.
18.1 The Foreign Investment Decision-Making Process
The foreign investment decision-making process involves the entire process of planning capital
expenditures in foreign countries beyond 1 year. The 1-year time frame is arbitrary, but a 1-year
boundary is rather widely accepted. There are many steps and elements in this process. Each
element is a subsystem of the capital budgeting system. Thus, the foreign investment decision-
making process may be viewed as an integral unit of many elements that are interrelated. Here
we assume that the entire foreign investment decision-making process consists of 11 phases: (1)
the decision to search for foreign investment, (2) an assessment of the political climate in the
host country, (3) an examination of the company’s overall strategy, (4) cash flow analysis, (5) the
required rate of return, (6) economic evaluation, (7) selection, (8) risk analysis, (9) implemen-
tation, (10) expenditure control, and (11) post-audit.
1 The search for foreign investment
The availability of good investment opportunities sets the foundation for a successful investment
program. Hence, a system should be established to stimulate ideas for capital expenditures
abroad and to identify good investment opportunities. Moreover, good investment opportuni-
countries, the inflation rate may exceed 100 percent during a 3-year period, a con-
dition known as hyperinflation. These and other factors related to inflation make the
capital budgeting process extremely difficult.
Source:Paul V. Mannino and Ken Milani, “Budgeting for an International Business,” Management
Accounting , Feb. 1992, pp. 36–41.
ties come from hard thinking, careful planning, and, frequently, large outlays for research and
development.
The first phase in the foreign investment decision-making process is an analysis of the forces
that lead some company officials to focus on the possibilities of foreign investment. If a company
recognizes foreign investment as a legitimate program, its search for foreign investment oppor-
tunities will start. The economic and political forces in the host countries are largely responsible
for the expansion of foreign investment. Many companies also desire foreign investment to seek
new markets, raw materials, and production efficiency. Chapter 2 described these and other
motives for foreign investment in detail.
It is not easy to pinpoint one motive for a decision to invest abroad in any particular case or
to find out exactly who initiated a foreign project. The decision to search for foreign investment
comes at the end of a series of events, and it is a combination of several motivating forces and
activities of different persons. Typically, the decision to look abroad depends on the interaction
of many forces. Considerations such as profit opportunities, tax policy, and diversification strate-
gies are economic variables that may affect a decision to look overseas. In addition, environmental
forces, organizational factors, and a drive by some high-ranking officials inside a company could
be major forces leading a company to look abroad.
2 The political climate
Political risks may exist for the domestic investment. Price controls may be established or lifted,
some regulated industries may be deregulated, or quotas and tariffs on cheap imported compo-
nents may be imposed. Certainly, there are more political risks in foreign investment. For one
thing, at least two national governments become involved in a foreign investment project – that
of the home country of the parent company and that of the host country of the subsidiary. The
goals of the two countries may differ; laws may change; rights to repatriate capital may be mod-
ified; and, in an extreme situation, assets may be seized by a host government without adequate
compensation.
One major concern of MNCs is the possibility that the political climate of a host country
may deteriorate. The multinational financial manager must analyze the political environment of
the proposed host country and determine whether the economic environment would be recep-
tive to the proposed project. In general, projects designed to reduce the country’s need for imports
and thus save foreign exchange are given the highest priority by the host government.
Political actions, such as exchange controls and discrimination, adversely affect company oper-
ations. Thus, the analyst should emphasize such factors as the host government’s attitudes toward
foreign investment, the desire of the host country for national rather than foreign control, and
its political stability. The analyst should also determine whether adequate and prompt compen-
sation is guaranteed if a host country nationalizes alien assets in the public interest.
3 The company’s overall strategy
If the initial screening of the political climate is favorable, the MNCs can move on to the next
stage of the decision-making process. The analyst then assesses the usefulness of each alternative
within the company’s overall strategy to determine how foreign operations may perpetuate current
strengths or offset weaknesses. This approach allows a company to reduce alternatives to a man-
ageable number. At this stage, the company must check whether the project conflicts with
company goals, policies, and resources. The analyst must also evaluate whether the company has
the experience to handle the project and how the project could be integrated into existing pro-
jects.
The company’s overall strategy consists of objectives, policies, and resources. In capital expen-
diture analysis, there are objectives to be attained and policies designed to achieve these objec-
tives. If a particular set of policies is not consistent with the stated objectives, either the policies
or the objectives should be revised. The company must also have resources necessary to carry out
its policies. If resources are not available, they must be acquired, or the policies and/or the objec-
tives must be revised.
THE COMPANY GOAL The primary goal of the MNC is to maximize its stock price. The market
price of the firm’s stock reflects the market’s evaluation of its prospective earnings stream over
time and the riskiness of this stream. Thus, the company must attempt to accept projects whose
profits are higher and whose risks are lower.
COMPANY POLICY If the company has carefully established policies to achieve its goal, it can
ov ercome the threat of competitors and use its oligopolistic advantages. The company should
systematically evaluate individual entry strategies in foreign markets, continuously audit the effec-
tiveness of current entry modes, and use appropriate evaluation criteria.
COMPANY RESOURCES Resources are assets that enable the company to carry out its objectives
and policies; they include marketing skills, management time and expertise, capital resources,
technological capabilities, and strong brand names.
.4 Cash flow analysis
The fourth stage of the screening process involves a standard cash flow analysis. The after-tax
cash outflows and inflows directly associated with each project must be estimated to evaluate
capital investment alternatives. An MNC must forecast its expected expenditures for the pro-
posed project. Ordinarily, it obtains these forecasts from data of similar ventures. A company
may also make forecasts by such techniques as the percent-of-sale method or a linear regression
analysis. An important difference in the application of cash flow analysis for foreign investment
is that a company must make two sets of cash flow analyses, one for the project itself and one
for the parent company.
THE DEMAND FORECAST The first step in analyzing cash flows for any investment proposal is
a forecast of demand. These estimates of usage are highly correlated with historical demand, pop-
ulation, income, alternative sources of products, competition, the feasibility of serving nearby
markets, and general economic conditions.
There are a number of reasons for emphasizing market size in the investment decision-making
process. First, the expected market size can be used as an indication of profit possibilities for the
proposed investment project. Second, small markets tend to have high uncertainty. If a market
is small, the MNC has little or no leeway in case of an erroneous estimate. Third, small markets
are not worth the effort. Because management is one of scarce resources in a company, the pro-
posed project should be large enough to support management time on project analysis.
DUTIES AND TAXES Because foreign investment cuts across national boundaries, a unique set
of tax laws and import duties may be applicable. An MNC must review the tax structure of the
host country. In this analysis, the evaluator would include the definition of a taxable entity, statu-
tory tax rates, tax treaties, treatment of dual taxation, and tax incentive programs. The MNC
should also know whether the host government imposes customs duties on imported production
equipment and materials not obtainable from local sources.
FOREIGN -EXCHANGE RATES AND RESTRICTIONS Another important feature of foreign invest-
ment analysis is that project inflows available to the investor are subject to foreign-exchange rates
and restrictions. When the host country has a stable exchange rate, no problems are presented.
Howeve r, if the exchange rate is expected to change or allowed to float, cash flow analysis becomes
more complicated, because the analyst must forecast the exchange rate that may be applicable to
convert cash flows into hard currencies.
It is equally important to recognize that many host governments have various exchange control
regulations. Under these regulations, permission may be required to buy foreign exchange
with local currency for payment of loan interest, management fees, royalties, and most other
billings for services provided by foreign suppliers. Processing applications for permission to
purchase foreign exchange may take a long time. Moreover, the granting of permission to buy
foreign exchange does not guarantee that a related foreign exchange will be available in time,
because commercial banks can allocate only such amounts as are made available by a central
bank.
Many factors affect the blockage of funds to nonresidents. They include an expected short-
age of foreign exchange, a long-run deficiency of the foreign exchange, and certain types of
domestic political pressures. If all funds are blocked in perpetuity, the value of a project is zero
to the parent company. However, in actuality funds are likely to be only partially blocked, because
MNCs have many ways to remove blocked funds. These methods include transfer price adjust-
ments, loan repayments, royalty adjustments, and fee adjustments. Furthermore, most host coun-
tries limit the amount of fund transfers to nonresidents or block the transfer of funds only on a
temporary basis. Nevertheless, MNCs must analyze the effect of blocked funds on project return.
It is critical that an analyst determines the amount of blocked funds, their reinvestment return,
and ways in which funds can be transferred under the host country’s law.
PROJECT VERSUS PARENT CASH FLOWS To determine after-tax profits from a proposed project,
the MNC must develop a demand forecast, forecast its expected expenditures, and review the
tax structure of the host country. The estimated sales, less estimated expenses, plus noncash
outlays such as depreciation, gives the cash inflows from operations.
Typically, an MNC desires to maximize the utility of project cash flows on a worldwide basis.
The MNC must value only those cash flows that can be repatriated, because only these funds
can be used for investment in new ventures, for payment of dividends and debt obligations, and
for reinvestment in other subsidiaries. Project cash flows would have little value if they could not
be used for these alternatives.
Pr oject cash flows and parent cash flows can be substantially different due to tax regulations
and exchange controls. Moreover, some project expenses, such as management fees and royalties,
are returns to the parent company. In general, incremental cash flows to the parent company are
worldwide parent cash flows after investment minus worldwide parent cash flows before invest-
ment. These differences raise the question of which cash flows should be used as the relevant
cash flows in project evaluation. Because the value of a project is determined by the net present
value of future cash flows to an investor, a foreign investment analyst should use cash flows
available for repatriation as the relevant cash flows. Hence, the MNC must analyze the impact
of taxation, exchange controls, and other operational restrictions on cash flows to the parent
company.
CAPITAL BUDGETING AND TRANSFER PRICING Cash flow analysis of a foreign investment
project involves many unique environmental variables. They include (1) different tax systems,
(2) foreign-exchange risk, (3) project versus parent cash flows, (4) restrictions on remittance of
funds, and (5) political, financial, and business risks. In these five environmental variables, a
transfer pricing policy is an integral part of each of the following three issues: First, MNCs should
know the amount of funds they can withdraw from their foreign investment. Transfer price
adjustments, dividends, royalties, and management fees are the only techniques to withdraw
funds where there are restrictions on fund flow movements. Second, transfer pricing policies are
regarded as one of the best ways to reduce a variety of taxes, such as income taxes, tariffs, and
other taxes. Third, transfer pricing policies are one of the better means of minimizing foreign-
exchange losses from currency fluctuations, because they enable MNCs to shift funds from one
country to another. However, it is important to understand that use of market-based transfer
prices may lead to the better investment decision, because transfer price adjustments may sig-
nificantly distort the profitability of a foreign project.
5 The cost of capital
The cost of capital is the minimum rate of return that a project must yield in order to be accepted
by a company. This minimum rate of return is sometimes called the discount rate or the required
rate of return. The cost of capital is an extremely important financial concept. It acts as a major
link between the firm’s foreign investment decision and the wealth of the owners as determined
by investors in the global marketplace. It is in effect the “magic number” used to decide whether
a proposed foreign investment will increase or decrease the firm’s stock price. Clearly, only those
projects expected to increase stock price would be accepted. Because it plays a key role in inter-
national capital expenditure analysis, chapter 19 discusses the cost of capital for foreign invest-
ment projects in detail.
6 Economic evaluation
Once cash flows and the required rate of return have been determined, the company begins the
formal process of evaluating investment projects. Many techniques have been developed for eval-
uating projects under conditions of certainty. They range from simple rules of thumb to sophis-
ticated mathematical programming methods. The four most commonly used methods for an
economic evaluation of individual projects are payback, average rate of return, internal rate of
return, and net present value.
The literature on capital expenditure analysis favors the net-present-value and internal-rate-
of-return methods, which are sometimes called the discounted cash flow approaches. The two
discounted cash flow approaches provide a more sophisticated basis for ranking and selecting
investment projects, because the payback and average-rate-of return methods have various limi-
tations. These two methods clearly recognize that money has a time value and that money in the
near future is more valuable than money in the distant future. They also use the cash flows of a
project over its entire life span. Analysts can avoid difficult problems underlying the measure-
ment of income by using cash flows, thus eliminating such irrelevant influences as depreciation
methods and inventory valuation.
The net present value of a project is the present value of its expected cash inflows minus the
present value of its expected cash outflows. The internal rate of return is the discount rate that
equates the present value of the net cash flows to the present value of the net cash investment,
or the rate that provides a zero net present value. The decision rule tells us to (1) accept a project
if its net present value is positive and (2) accept a project if its internal rate of return is greater
than a firm’s cost of capital.
The net-present-value and internal-rate-of-return methods lead to the same decision in many
situations. These two rules lead to the same decision if the following conditions hold:
1Investment proposals under consideration are mutually independent and they are free of
capital rationing constraints.
2 All projects are equally risky, so that the acceptance or rejection of any project does not affect
the cost of capital.
3A meaningful cost of capital exists to the extent that a company has access to capital at that
cost.
4A unique internal rate of return exists; every project has just one internal rate of return.
In the absence of these assumptions, the two discounted cash flow approaches may lead to dif-
ferent decisions, thus making the capital budgeting decision much more complex.
When the net-present-value and internal-rate-of-return methods produce different answers,
net present value is better for a number of reasons:
1 The net present value is easier to compute than the internal rate of return.
2If the primary goal of a firm is to maximize the value of the firm, the net-present-value
method leads to the correct decision, while the internal-rate-of-return method may lead to
an incorrect decision.
3A single project may have more than one internal rate of return under certain conditions,
whereas the same project has just one net present value at a particular discount rate.
4Once computed, the internal rate of return remains constant over the entire life of the project.
This assumption about static conditions is hardly realistic during a period of rising interest
rates and inflation. Uneven discount rates present no problems when the net-present-value
method is used.
5In the net-present-value method, the implied reinvestment rate approximates the opportu-
nity cost for reinvestment. However, with the internal-rate-of-return method, the implied
reinvestment assumption does not approximate the opportunity cost for reinvestment at all.
Although the net-present-value method is theoretically superior, the internal-rate-of-return
method has certain advantages. First, internal rate of return is easier to visualize and interpret,
because it is identical with the yield to the maturity of bonds or other securities. Second, we do
not need to specify a required rate of return in the computation. In other words, it does not
require the prior computation of the cost of capital. Third, business executives are more
comfortable with internal rate of return, because it is directly comparable to the firm’s cost of
capital.
7 Selection
Each of the capital budgeting techniques described in the previous section measures the rate of
return on a uniform basis for all projects under consideration. A project or a set of projects will
be chosen at this stage if the following three assumptions hold: first, the company has a definite
cutoff point that all projects must meet; second, all cash outflows and inflows from each project
are known with absolute certainty; and, third, the company’s investment programs are not con-
strained by any lack of funds. The final selection of projects depends on three kinds of capital
budgeting decisions: the accept–reject decision, the mutually exclusive choice decision, and the
capital rationing decision.
The selected project must successfully pass the accept–reject decision. If projects under con-
sideration are mutually independent and not subject to capital rationing constraints, the company
must accept all projects whose expected rate of return exceeds its hurdle rate in order to maxi-
mize stockholder wealth. The hurdle rate may be based on the cost of capital, the opportunity
cost, or some other arbitrary standard. However, it is important to recognize the possibility that
(1) certain projects may compete with each other and (2) available projects may exceed available
funds. Mutual exclusiveness and capital rationing constraints are two cases in which otherwise
profitable projects are rejected. Investment proposals are said to be mutually exclusive if the accep-
tance of one project means the rejection of all the other projects. Capital rationing refers to an
upper ceiling on the size of capital expenditures during a given period of time.
8 Risk analysis
Up to this point, we have assumed that the dollar cash flows will certainly occur. In reality, all
foreign investment projects are subject to various risks – business and financial risks, inflation
and currency risks, and political risks. A change in some of these risks may have a decisive impact
on the financial consequences of a particular project. Furthermore, the risks vary widely from
country to country.
Only a few of the financial variables are normally known with a fair degree of accuracy in
advance. Investors are basically risk averters. If investors do not know in advance exactly which
future events will occur, they will have to determine the risk–return trade-off in order to choose
attractive projects.
Many MNCs use the risk-adjusted discount rate and the certainty equivalent approach to
adjust for project estimates. The risk-adjusted discount rate is a rate that consists of the risk-
less rate of return plus a risk premium. Assume that the cost of capital for a firm is 10 percent
when the riskless rate of return is 7 percent. This 3 percent difference between the cost of capital
and the riskless rate of return reflects the degree of risk for the company. The company may
increase its discount rate by 2 percent to a total of 12 percent for a mildly risky project, by 5
percent to a total of 15 percent for a more risky project, and so on. Hence, the risk-adjusted dis-
count rate accounts for the time value of money and the relative risk of the project in terms of
a risk premium.
The certainty equivalent approach is a method used to adjust for project risk in the numer-
ator of the net-present-value formula. In other words, while the risk-adjusted discount rate adjusts
for risk in the denominator of the net-present-value formula, the certainty equivalent approach
adjusts for risk in the numerator of the same equation.
When an analyst uses the certainty equivalent approach, the annual cash flows are multiplied
by a certainty equivalent coefficient, which is a certain cash flow divided by an uncertain cash
flow. If the analyst is indifferent between a certain $140 and an uncertain $200, its coefficient
is 0.70 ($140/$200). The coefficient assumes a value of between 0 and 1. It varies inversely with
risk. If a firm perceives greater risk, it uses a lower coefficient that would deflate the dollar return
value. Once all the risky cash flows are adjusted downward to reflect uncertainty through the use
of the coefficient, the analyst then discounts these certain cash flows at the risk-free rate of inter-
est to determine the certain net present value.
9 Implementation, control, and post-audits
The last three steps of the capital budgeting system consist of implementation, expenditure
control, and post-audits.
IMPLEMENTATION Authorization to expend funds for the accepted projects may be obtained
by submission of individual capital expenditure requests in accordance with formal proce-
dures set forth by the budget director. These procedures typically cover the use of standard
forms, the channels for submission and review, and the authority requirements and limits for
approval.
CONTROL There is a specific phase of the capital budgeting process during which the practi-
cal cost control of a foreign project becomes important. This is the time between the approval
of the project and its completion. The expenditure control of a foreign project in process is
designed to increase the probability that it is completed within the established guidelines. This
phase is particularly important for foreign investment projects, because operations are typically
supervised from a distance.
POST -AUDIT Because multinational capital budgeting decisions are made on the basis of
assumptions in foreign countries, estimates and actual results may differ. Thus, when a foreign
project is completed, the firm should perform a post-audit on the entire project to determine its
success or failure. The results of post-audits enable the firm to compare the actual performance
of a foreign project with established standards. If the capital budgeting process used by an MNC
has been successful, the system is likely to be reinforced. If the system has been unsatisfactory, it
is likely to be revised or replaced for future foreign projects.
Pr oject Analysis
Foreign-exchange rates, interest rates, and inflation are three external factors that
affect multinational companies (MNCs) and their markets. Changes in these three
factors stem from several sources, such as economic conditions, government policies,
monetary systems, and political risks. Each factor is a significant external variable that
affects areas such as policy decisions, strategic planning, profit planning, and budget
control. To minimize the possible negative impact of these factors, MNCs must
establish and implement policies and practices that recognize and respond to their
influences.
These three factors – exchange rates, interest rates, and inflation – affect sales
budgets, expense budgets, capital budgeting, and cash budgets. However, they are
particularly useful when evaluating international capital budgeting alternatives.
Foreign-exchange rates have the most significant effect on the capital budgeting
process. A foreign investment project will be affected by exchange rate fluctuations
during the life of the project, but these fluctuations are difficult to forecast. There are
methods of hedging against exchange rate risks, but most hedging techniques are
used to cover short-term positions.
The cost of capital is used as a cutoff point to accept or reject a proposed project.
Because the cost of capital is the weighted average cost of debt and equity, interest
rates play a key role in a capital expenditure analysis. Most components of project
cash flows – revenues, variable costs, and fixed costs – are likely to rise in line with
inflation, but local price controls may not permit internal price adjustments. A capital
expenditure analysis requires price projections for the entire life of the project. In some
The basic principles of analysis are the same for foreign and domestic investment projects.
Howeve r, a foreign investment decision results from a complex process, which differs, in many
aspects, from the domestic investment decision.
Relevant cash flows are the dividends and royalties that would be repatriated by each sub-
sidiary to a parent firm. Because these net cash flows must be converted into the currency of a
parent company, they are subject to future exchange rate changes. Moreover, foreign investment
projects are subject to political risks such as exchange controls and discrimination. Normally, the
cost of capital for a foreign project is higher than that for a similar domestic project. Certainly,
this higher risk comes from two major sources, political risk and exchange risk.
This chapter is composed of four major sections. The first section describes the entire process
of planning capital expenditures in foreign countries beyond 1 year. The second section exam-
ines how international diversification can reduce the overall riskiness of a company. The third
section compares capital budgeting theory with capital budgeting practice. The fourth section
covers political risk analysis.
18.1 The Foreign Investment Decision-Making Process
The foreign investment decision-making process involves the entire process of planning capital
expenditures in foreign countries beyond 1 year. The 1-year time frame is arbitrary, but a 1-year
boundary is rather widely accepted. There are many steps and elements in this process. Each
element is a subsystem of the capital budgeting system. Thus, the foreign investment decision-
making process may be viewed as an integral unit of many elements that are interrelated. Here
we assume that the entire foreign investment decision-making process consists of 11 phases: (1)
the decision to search for foreign investment, (2) an assessment of the political climate in the
host country, (3) an examination of the company’s overall strategy, (4) cash flow analysis, (5) the
required rate of return, (6) economic evaluation, (7) selection, (8) risk analysis, (9) implemen-
tation, (10) expenditure control, and (11) post-audit.
1 The search for foreign investment
The availability of good investment opportunities sets the foundation for a successful investment
program. Hence, a system should be established to stimulate ideas for capital expenditures
abroad and to identify good investment opportunities. Moreover, good investment opportuni-
countries, the inflation rate may exceed 100 percent during a 3-year period, a con-
dition known as hyperinflation. These and other factors related to inflation make the
capital budgeting process extremely difficult.
Source:Paul V. Mannino and Ken Milani, “Budgeting for an International Business,” Management
Accounting , Feb. 1992, pp. 36–41.
ties come from hard thinking, careful planning, and, frequently, large outlays for research and
development.
The first phase in the foreign investment decision-making process is an analysis of the forces
that lead some company officials to focus on the possibilities of foreign investment. If a company
recognizes foreign investment as a legitimate program, its search for foreign investment oppor-
tunities will start. The economic and political forces in the host countries are largely responsible
for the expansion of foreign investment. Many companies also desire foreign investment to seek
new markets, raw materials, and production efficiency. Chapter 2 described these and other
motives for foreign investment in detail.
It is not easy to pinpoint one motive for a decision to invest abroad in any particular case or
to find out exactly who initiated a foreign project. The decision to search for foreign investment
comes at the end of a series of events, and it is a combination of several motivating forces and
activities of different persons. Typically, the decision to look abroad depends on the interaction
of many forces. Considerations such as profit opportunities, tax policy, and diversification strate-
gies are economic variables that may affect a decision to look overseas. In addition, environmental
forces, organizational factors, and a drive by some high-ranking officials inside a company could
be major forces leading a company to look abroad.
2 The political climate
Political risks may exist for the domestic investment. Price controls may be established or lifted,
some regulated industries may be deregulated, or quotas and tariffs on cheap imported compo-
nents may be imposed. Certainly, there are more political risks in foreign investment. For one
thing, at least two national governments become involved in a foreign investment project – that
of the home country of the parent company and that of the host country of the subsidiary. The
goals of the two countries may differ; laws may change; rights to repatriate capital may be mod-
ified; and, in an extreme situation, assets may be seized by a host government without adequate
compensation.
One major concern of MNCs is the possibility that the political climate of a host country
may deteriorate. The multinational financial manager must analyze the political environment of
the proposed host country and determine whether the economic environment would be recep-
tive to the proposed project. In general, projects designed to reduce the country’s need for imports
and thus save foreign exchange are given the highest priority by the host government.
Political actions, such as exchange controls and discrimination, adversely affect company oper-
ations. Thus, the analyst should emphasize such factors as the host government’s attitudes toward
foreign investment, the desire of the host country for national rather than foreign control, and
its political stability. The analyst should also determine whether adequate and prompt compen-
sation is guaranteed if a host country nationalizes alien assets in the public interest.
3 The company’s overall strategy
If the initial screening of the political climate is favorable, the MNCs can move on to the next
stage of the decision-making process. The analyst then assesses the usefulness of each alternative
within the company’s overall strategy to determine how foreign operations may perpetuate current
strengths or offset weaknesses. This approach allows a company to reduce alternatives to a man-
ageable number. At this stage, the company must check whether the project conflicts with
company goals, policies, and resources. The analyst must also evaluate whether the company has
the experience to handle the project and how the project could be integrated into existing pro-
jects.
The company’s overall strategy consists of objectives, policies, and resources. In capital expen-
diture analysis, there are objectives to be attained and policies designed to achieve these objec-
tives. If a particular set of policies is not consistent with the stated objectives, either the policies
or the objectives should be revised. The company must also have resources necessary to carry out
its policies. If resources are not available, they must be acquired, or the policies and/or the objec-
tives must be revised.
THE COMPANY GOAL The primary goal of the MNC is to maximize its stock price. The market
price of the firm’s stock reflects the market’s evaluation of its prospective earnings stream over
time and the riskiness of this stream. Thus, the company must attempt to accept projects whose
profits are higher and whose risks are lower.
COMPANY POLICY If the company has carefully established policies to achieve its goal, it can
ov ercome the threat of competitors and use its oligopolistic advantages. The company should
systematically evaluate individual entry strategies in foreign markets, continuously audit the effec-
tiveness of current entry modes, and use appropriate evaluation criteria.
COMPANY RESOURCES Resources are assets that enable the company to carry out its objectives
and policies; they include marketing skills, management time and expertise, capital resources,
technological capabilities, and strong brand names.
.4 Cash flow analysis
The fourth stage of the screening process involves a standard cash flow analysis. The after-tax
cash outflows and inflows directly associated with each project must be estimated to evaluate
capital investment alternatives. An MNC must forecast its expected expenditures for the pro-
posed project. Ordinarily, it obtains these forecasts from data of similar ventures. A company
may also make forecasts by such techniques as the percent-of-sale method or a linear regression
analysis. An important difference in the application of cash flow analysis for foreign investment
is that a company must make two sets of cash flow analyses, one for the project itself and one
for the parent company.
THE DEMAND FORECAST The first step in analyzing cash flows for any investment proposal is
a forecast of demand. These estimates of usage are highly correlated with historical demand, pop-
ulation, income, alternative sources of products, competition, the feasibility of serving nearby
markets, and general economic conditions.
There are a number of reasons for emphasizing market size in the investment decision-making
process. First, the expected market size can be used as an indication of profit possibilities for the
proposed investment project. Second, small markets tend to have high uncertainty. If a market
is small, the MNC has little or no leeway in case of an erroneous estimate. Third, small markets
are not worth the effort. Because management is one of scarce resources in a company, the pro-
posed project should be large enough to support management time on project analysis.
DUTIES AND TAXES Because foreign investment cuts across national boundaries, a unique set
of tax laws and import duties may be applicable. An MNC must review the tax structure of the
host country. In this analysis, the evaluator would include the definition of a taxable entity, statu-
tory tax rates, tax treaties, treatment of dual taxation, and tax incentive programs. The MNC
should also know whether the host government imposes customs duties on imported production
equipment and materials not obtainable from local sources.
FOREIGN -EXCHANGE RATES AND RESTRICTIONS Another important feature of foreign invest-
ment analysis is that project inflows available to the investor are subject to foreign-exchange rates
and restrictions. When the host country has a stable exchange rate, no problems are presented.
Howeve r, if the exchange rate is expected to change or allowed to float, cash flow analysis becomes
more complicated, because the analyst must forecast the exchange rate that may be applicable to
convert cash flows into hard currencies.
It is equally important to recognize that many host governments have various exchange control
regulations. Under these regulations, permission may be required to buy foreign exchange
with local currency for payment of loan interest, management fees, royalties, and most other
billings for services provided by foreign suppliers. Processing applications for permission to
purchase foreign exchange may take a long time. Moreover, the granting of permission to buy
foreign exchange does not guarantee that a related foreign exchange will be available in time,
because commercial banks can allocate only such amounts as are made available by a central
bank.
Many factors affect the blockage of funds to nonresidents. They include an expected short-
age of foreign exchange, a long-run deficiency of the foreign exchange, and certain types of
domestic political pressures. If all funds are blocked in perpetuity, the value of a project is zero
to the parent company. However, in actuality funds are likely to be only partially blocked, because
MNCs have many ways to remove blocked funds. These methods include transfer price adjust-
ments, loan repayments, royalty adjustments, and fee adjustments. Furthermore, most host coun-
tries limit the amount of fund transfers to nonresidents or block the transfer of funds only on a
temporary basis. Nevertheless, MNCs must analyze the effect of blocked funds on project return.
It is critical that an analyst determines the amount of blocked funds, their reinvestment return,
and ways in which funds can be transferred under the host country’s law.
PROJECT VERSUS PARENT CASH FLOWS To determine after-tax profits from a proposed project,
the MNC must develop a demand forecast, forecast its expected expenditures, and review the
tax structure of the host country. The estimated sales, less estimated expenses, plus noncash
outlays such as depreciation, gives the cash inflows from operations.
Typically, an MNC desires to maximize the utility of project cash flows on a worldwide basis.
The MNC must value only those cash flows that can be repatriated, because only these funds
can be used for investment in new ventures, for payment of dividends and debt obligations, and
for reinvestment in other subsidiaries. Project cash flows would have little value if they could not
be used for these alternatives.
Pr oject cash flows and parent cash flows can be substantially different due to tax regulations
and exchange controls. Moreover, some project expenses, such as management fees and royalties,
are returns to the parent company. In general, incremental cash flows to the parent company are
worldwide parent cash flows after investment minus worldwide parent cash flows before invest-
ment. These differences raise the question of which cash flows should be used as the relevant
cash flows in project evaluation. Because the value of a project is determined by the net present
value of future cash flows to an investor, a foreign investment analyst should use cash flows
available for repatriation as the relevant cash flows. Hence, the MNC must analyze the impact
of taxation, exchange controls, and other operational restrictions on cash flows to the parent
company.
CAPITAL BUDGETING AND TRANSFER PRICING Cash flow analysis of a foreign investment
project involves many unique environmental variables. They include (1) different tax systems,
(2) foreign-exchange risk, (3) project versus parent cash flows, (4) restrictions on remittance of
funds, and (5) political, financial, and business risks. In these five environmental variables, a
transfer pricing policy is an integral part of each of the following three issues: First, MNCs should
know the amount of funds they can withdraw from their foreign investment. Transfer price
adjustments, dividends, royalties, and management fees are the only techniques to withdraw
funds where there are restrictions on fund flow movements. Second, transfer pricing policies are
regarded as one of the best ways to reduce a variety of taxes, such as income taxes, tariffs, and
other taxes. Third, transfer pricing policies are one of the better means of minimizing foreign-
exchange losses from currency fluctuations, because they enable MNCs to shift funds from one
country to another. However, it is important to understand that use of market-based transfer
prices may lead to the better investment decision, because transfer price adjustments may sig-
nificantly distort the profitability of a foreign project.
5 The cost of capital
The cost of capital is the minimum rate of return that a project must yield in order to be accepted
by a company. This minimum rate of return is sometimes called the discount rate or the required
rate of return. The cost of capital is an extremely important financial concept. It acts as a major
link between the firm’s foreign investment decision and the wealth of the owners as determined
by investors in the global marketplace. It is in effect the “magic number” used to decide whether
a proposed foreign investment will increase or decrease the firm’s stock price. Clearly, only those
projects expected to increase stock price would be accepted. Because it plays a key role in inter-
national capital expenditure analysis, chapter 19 discusses the cost of capital for foreign invest-
ment projects in detail.
6 Economic evaluation
Once cash flows and the required rate of return have been determined, the company begins the
formal process of evaluating investment projects. Many techniques have been developed for eval-
uating projects under conditions of certainty. They range from simple rules of thumb to sophis-
ticated mathematical programming methods. The four most commonly used methods for an
economic evaluation of individual projects are payback, average rate of return, internal rate of
return, and net present value.
The literature on capital expenditure analysis favors the net-present-value and internal-rate-
of-return methods, which are sometimes called the discounted cash flow approaches. The two
discounted cash flow approaches provide a more sophisticated basis for ranking and selecting
investment projects, because the payback and average-rate-of return methods have various limi-
tations. These two methods clearly recognize that money has a time value and that money in the
near future is more valuable than money in the distant future. They also use the cash flows of a
project over its entire life span. Analysts can avoid difficult problems underlying the measure-
ment of income by using cash flows, thus eliminating such irrelevant influences as depreciation
methods and inventory valuation.
The net present value of a project is the present value of its expected cash inflows minus the
present value of its expected cash outflows. The internal rate of return is the discount rate that
equates the present value of the net cash flows to the present value of the net cash investment,
or the rate that provides a zero net present value. The decision rule tells us to (1) accept a project
if its net present value is positive and (2) accept a project if its internal rate of return is greater
than a firm’s cost of capital.
The net-present-value and internal-rate-of-return methods lead to the same decision in many
situations. These two rules lead to the same decision if the following conditions hold:
1Investment proposals under consideration are mutually independent and they are free of
capital rationing constraints.
2 All projects are equally risky, so that the acceptance or rejection of any project does not affect
the cost of capital.
3A meaningful cost of capital exists to the extent that a company has access to capital at that
cost.
4A unique internal rate of return exists; every project has just one internal rate of return.
In the absence of these assumptions, the two discounted cash flow approaches may lead to dif-
ferent decisions, thus making the capital budgeting decision much more complex.
When the net-present-value and internal-rate-of-return methods produce different answers,
net present value is better for a number of reasons:
1 The net present value is easier to compute than the internal rate of return.
2If the primary goal of a firm is to maximize the value of the firm, the net-present-value
method leads to the correct decision, while the internal-rate-of-return method may lead to
an incorrect decision.
3A single project may have more than one internal rate of return under certain conditions,
whereas the same project has just one net present value at a particular discount rate.
4Once computed, the internal rate of return remains constant over the entire life of the project.
This assumption about static conditions is hardly realistic during a period of rising interest
rates and inflation. Uneven discount rates present no problems when the net-present-value
method is used.
5In the net-present-value method, the implied reinvestment rate approximates the opportu-
nity cost for reinvestment. However, with the internal-rate-of-return method, the implied
reinvestment assumption does not approximate the opportunity cost for reinvestment at all.
Although the net-present-value method is theoretically superior, the internal-rate-of-return
method has certain advantages. First, internal rate of return is easier to visualize and interpret,
because it is identical with the yield to the maturity of bonds or other securities. Second, we do
not need to specify a required rate of return in the computation. In other words, it does not
require the prior computation of the cost of capital. Third, business executives are more
comfortable with internal rate of return, because it is directly comparable to the firm’s cost of
capital.
7 Selection
Each of the capital budgeting techniques described in the previous section measures the rate of
return on a uniform basis for all projects under consideration. A project or a set of projects will
be chosen at this stage if the following three assumptions hold: first, the company has a definite
cutoff point that all projects must meet; second, all cash outflows and inflows from each project
are known with absolute certainty; and, third, the company’s investment programs are not con-
strained by any lack of funds. The final selection of projects depends on three kinds of capital
budgeting decisions: the accept–reject decision, the mutually exclusive choice decision, and the
capital rationing decision.
The selected project must successfully pass the accept–reject decision. If projects under con-
sideration are mutually independent and not subject to capital rationing constraints, the company
must accept all projects whose expected rate of return exceeds its hurdle rate in order to maxi-
mize stockholder wealth. The hurdle rate may be based on the cost of capital, the opportunity
cost, or some other arbitrary standard. However, it is important to recognize the possibility that
(1) certain projects may compete with each other and (2) available projects may exceed available
funds. Mutual exclusiveness and capital rationing constraints are two cases in which otherwise
profitable projects are rejected. Investment proposals are said to be mutually exclusive if the accep-
tance of one project means the rejection of all the other projects. Capital rationing refers to an
upper ceiling on the size of capital expenditures during a given period of time.
8 Risk analysis
Up to this point, we have assumed that the dollar cash flows will certainly occur. In reality, all
foreign investment projects are subject to various risks – business and financial risks, inflation
and currency risks, and political risks. A change in some of these risks may have a decisive impact
on the financial consequences of a particular project. Furthermore, the risks vary widely from
country to country.
Only a few of the financial variables are normally known with a fair degree of accuracy in
advance. Investors are basically risk averters. If investors do not know in advance exactly which
future events will occur, they will have to determine the risk–return trade-off in order to choose
attractive projects.
Many MNCs use the risk-adjusted discount rate and the certainty equivalent approach to
adjust for project estimates. The risk-adjusted discount rate is a rate that consists of the risk-
less rate of return plus a risk premium. Assume that the cost of capital for a firm is 10 percent
when the riskless rate of return is 7 percent. This 3 percent difference between the cost of capital
and the riskless rate of return reflects the degree of risk for the company. The company may
increase its discount rate by 2 percent to a total of 12 percent for a mildly risky project, by 5
percent to a total of 15 percent for a more risky project, and so on. Hence, the risk-adjusted dis-
count rate accounts for the time value of money and the relative risk of the project in terms of
a risk premium.
The certainty equivalent approach is a method used to adjust for project risk in the numer-
ator of the net-present-value formula. In other words, while the risk-adjusted discount rate adjusts
for risk in the denominator of the net-present-value formula, the certainty equivalent approach
adjusts for risk in the numerator of the same equation.
When an analyst uses the certainty equivalent approach, the annual cash flows are multiplied
by a certainty equivalent coefficient, which is a certain cash flow divided by an uncertain cash
flow. If the analyst is indifferent between a certain $140 and an uncertain $200, its coefficient
is 0.70 ($140/$200). The coefficient assumes a value of between 0 and 1. It varies inversely with
risk. If a firm perceives greater risk, it uses a lower coefficient that would deflate the dollar return
value. Once all the risky cash flows are adjusted downward to reflect uncertainty through the use
of the coefficient, the analyst then discounts these certain cash flows at the risk-free rate of inter-
est to determine the certain net present value.
9 Implementation, control, and post-audits
The last three steps of the capital budgeting system consist of implementation, expenditure
control, and post-audits.
IMPLEMENTATION Authorization to expend funds for the accepted projects may be obtained
by submission of individual capital expenditure requests in accordance with formal proce-
dures set forth by the budget director. These procedures typically cover the use of standard
forms, the channels for submission and review, and the authority requirements and limits for
approval.
CONTROL There is a specific phase of the capital budgeting process during which the practi-
cal cost control of a foreign project becomes important. This is the time between the approval
of the project and its completion. The expenditure control of a foreign project in process is
designed to increase the probability that it is completed within the established guidelines. This
phase is particularly important for foreign investment projects, because operations are typically
supervised from a distance.
POST -AUDIT Because multinational capital budgeting decisions are made on the basis of
assumptions in foreign countries, estimates and actual results may differ. Thus, when a foreign
project is completed, the firm should perform a post-audit on the entire project to determine its
success or failure. The results of post-audits enable the firm to compare the actual performance
of a foreign project with established standards. If the capital budgeting process used by an MNC
has been successful, the system is likely to be reinforced. If the system has been unsatisfactory, it
is likely to be revised or replaced for future foreign projects.
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