MANIPAL UNIVERSITY

International Financial Management

Topic-International Capital Budgeting

Submitted To :- Mr. Mujeebur Rehman

Submitted By:-

Nisha Bilochi
 WHAT IS INTERNATIONAL CAPITAL BUDGETING ?

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 company’s 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 multinational’s 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.

Basics of Capital Budgeting

Firms must select combinations of investment projects that maximize the firms value to it’s
shareholders
Decision rule/criteria is needed:
Net Present Value (NPV)
 Consistent with shareholder wealth maximization (focus on cash flows and
opportunity cost of money invested – not accounting profits)
 Value additive: “The NPV of a set of independent project is simply the sum of NPVs
of the individual projects
– Implication: each project can be considered on its own
Net Present Value
“present value of future cash flows discounted at the projects cost of capital minus the initial net
cash outlay for the project”
 Need to calculate:
 Net cash flows (in- and out flows) from the project
 Cost of funding the project
 The terminal value of project
Need to decide on:
 The lifetime of the project (horizon)
 The discount rate (projects cost of capital)

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:

Should we expect
to earn at least Accept the
If the NPV is: Benefits vs. Costs
our minimum rate investment?
of return?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than 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 Next percentage

Interpretation of Results
Results to be tested?
The project is expected to
earn more
PVB > PVC A higher rate
than the percentage rate
used for the test
The project is expected to
earn less
PVB < PVC A lower rate
than the percentage rate
used for the test
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 PVB

10% $103,000
IRR $100,000
15% $ 98,000
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% =
$3,000 / $5,000
$3,000 / $5,000 *
x =
5%
x = 0.60 * 5%
x = 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:

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.

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.

To see how the MIRR is calculated, click on the link below:

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.

Future
Years Cash Value Factor Future
Year Reinvested Inflow (at 10%) Value
1 3 $10,000 1.331 $13,310
2 2 $10,000 1.210 $12,100
3 1 $10,000 1.100 $11,000
4 0 $10,000 1.000 $10,000
Total $46,410
Now, the only question remaining is:

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% = $1,699 / $2,205
 x = $1,699 / $2,205 * 2%
x = 0.7705 * 2%
x = 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.

ncremental 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 don’t 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 plant’s 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 e.g. a stronger local position of the firm”
 Incremental cash flow = investments total cash flows + “sales creation cash flows

Other Cash Flow Issues

Opportunity cost
 Project/investment cost must include the true economic cost of any resource required
for the project regardless if the firm already owns it.
 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

Fees and Royalties

 Firms charges of legal counsel, power, heat ,rent, R&D, headquarter staff,
management costs usually in form of fees and royalties
 Should only be included in capital budgeting process if the investment leads to
additional 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

In the remaining sections of this article we use a case study to explore further the issues
raised in previous sections. 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

Net operating cash flows (US$m): 3.5 4.8 5.6 6.8 7.2
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 less-than-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 1 2

Initial investment -25.0

Net operating cash flows 3.5 4.8
Terminal value (6m/0.2)
Discount factor (at 20%) 1 0.83 0.69
Discounted cash flows -25.0 2.9 3.3
Cumulative DCFs -25.0 -22.1 -18.8
 3 4 5

Initial investment
Net operating cash flows 5.6 6.8 7.2
Terminal value (6m/0.2) 30.0[*]
Discount factor (at 20%) 0.58 0.48 0.40
Discounted cash flows 3.2 3.3 14.9
Cumulative DCFs -15.5 -12.2 2.7

[*] 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.