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The system of Capital Budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year.
These benefits may be in the form of increased revenue or reduction in costs. Capital expenditure Mgt therefore includes addition,disposition,modification and replacement of Fixed AssetsBasic features Case study on international capital budgeting Capital budgeting are: Potentiallylarge anticipated benefits Relatively high degree of risk A relatively long period of time between initial outlay and anticipated returnImportance of Capital Budgeting Decisions Determines the future destiny of the company The firms costs,BEP,sales and profits will be determined by the firms selection of assets Capital investment decisions once made not easily reversible without much loss to the firm The Capital investment involves costs and majority of the firms have scarce capital resourcesMultinational capital Budgeting Thetechnique of Capital Budgeting is similar between domestic and a multinational firm.
The only difference is some additional complexities appear in case of a multinational firm. Capital Budgeting in MNC encounters a number of variables and factors that are unique for a foreign project.
Parent cash flows are different from project cash flows. National inflation and its effect on the cash flows over a period of time Possibility of foreign exchange risk and its effect on the parents cash flows.
Profitability may be enhanced by concessionary financial arrangements and other benefits provided by host co. Foreign investment may produce diversification benefits to the shareholders of the parent co. The host co may impose various restrictions on the distribution of cash flows generated from foreign project.
Political risk must be evaluated thoroughly as changes in political events can drastically reduce the availability of expected cash flows. Such value to the parent co may differ from the valuation put on the facilities by potential buyer in the host co.
Tax treatment Political and economic risk Blocked funds Amenities and concessions granted by host companiesProject Vs Parent Cash FlowsSubstantial differences can exist between the project and parent cash flows.
The cash flow accruing to the parent may not be represented entirely by the cash flow accruing to the parent co. Project expenses like management fees ,royalties are returns to the parent co i.
On what basis should the project be evaluated? On its own cash outflows?
Cash flows accruing to the parent co? Its usefulnessA strong theoretically valid criterion in Financial Mgt is to evaluate the foreign project in the view point of the parent co. It helps to determine the financial viability of the project from the point of view of the MNC as a wholeExchange rate Change and InflationTo incorporate the foreign exchange risk in the cash flow estimate of the project: Estimate the inflation rate in the host country during the life term of the project.
Cash inflows in terms of local currency is adjusted upwards for inflation factor. The cash flows are converted into the parent company s currency at spot exchange rate.
The above is multiplied by an expected appreciation or depreciation rate calculated on the basis of purchasing power parity. In certain specific situations ,the conversion can also be made on the basis of some exchange rate accepted by the managementRemittance RestrictionsWhere there are restrictions on remittances of income to the Parent co, substantial differences exist between project cash inflows and cash inflows received by the parent co.
Only those cash flows which are remittable to the parent are relevant from the MNC s perspective. Many countries impose variety of restrictions on transfer of profits,depriciation and other fees accruing to the parent co.
Project cash flows consists of profits and depreciation charges whereas parent cash flows consists of amounts to be legally transferred to it. Tax IssueBoth in domestic as well as Multinational Capital budgeting only after tax cash flows are relevant for project evaluation.
However the MNCB is complicated by the existence of two tax jurisdictions ,plus number of other factors. The other factors include the form of remittance to the parentparentdividends,fees,royalties etc.
In addition tax laws in many host countries discriminate between transfer of realized profits as against local re-investment of these profits.
To calculate the after tax cash flows accruing to the parent co. One method is use a higher discount rate for foreign projects and another to require shorter pay back period. Here we have to asses the magnitude of risk and the time pattern of the risk.
In such a case uniformly higher discount distorts the meaning of projects PV. The capital risk may be justified as long it is a systematic risk of a proposed investment. To the extent the risks dealt are unsystematic there is no theoretical justification to adjust the project costs to reflect them.
An alternative approach is use certainty equivalent method where risk adjusted cash flows are discounted at risk free rate for which no satisfactory procedure is yet to be developed.
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Blocked funds Inmany cases ,the host govt imposes restrictions on the outflow of the funds from the country.Question International Capital Budgeting "We better get started on this report", said Jack to his assistant Bruno as he straightened his seatback and fired up.
Capital budgeting is the process of making long-run planning decisions for investments in projects. In much of accounting, income is calculated on a period-by-period basis.
In this methodology case study, conjoint analysis is used to determine the importance of factors that influence international capital budgeting decisions by multinational corporations. Chapter Multinational Cost of Capital and Capital Structure 2 1 N L 47 markets, the MNC’s access to the international capital markets may allow it cur, so the capital budgeting process should incorporate such risk.
Capital Budgeting and Investment Decisions: The case of valuating a new investment in a company. Evangelos Ergen, [email protected] this study intends not only to present a proposal but, in extent, to support this process with academic arguments and views.
Keywords: capital budgeting, investment, cash flows, risk, financial techniques. CHAPTER 18 INTERNATIONAL CAPITAL BUDGETING SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Why is capital budgeting analysis so important to the firm?