Purchasing Power Parity
MBA (Finance specialisation) & MBA Banking and Finance (Trimester)Term VIModule : International Financial ManagementUnit III: Financial Management of Multinational firmLesson 3.2 (Capital Budgeting and Cash management of MNC )
Capital Budgeting decisions of MNC IntroductionCapital budgeting technique provides the mechanism to identify opportunities and evaluate their economic viability. This is why MNCs evaluate international projects by using capital budgeting techniques. Proper use of capital budgeting techniques can help the firm in identifying the international projects worthy of implementation from those that are not. Capital Budgeting decisions of MNC Capital budgeting for multinational firms uses the same framework as domestic capital budgeting. Multinational capital budgeting encounters a number of variables and factors that are unique for a foreign project and are considerably more complex than their domestic counterparts.
Capital Budgeting decisions of MNC ProcessThe basic steps involved in evaluation of a project are: 1. Determine net investment outlay; 2. Estimate net cash flows to be derived from the project over time, including an estimate of salvage value; 3. Identify the appropriate discount rate for determining the present value of the expected cash flows; 4. Apply NPV or IRR techniques to determine the acceptability or priority ranking of potential projects. Capital Budgeting decisions of MNC Difference between Domestic and MNC capital budgeting decisionsIn case of MNC, the above evaluation process becomes complicated because of the factors peculiar to international operations which are given below:Overseas investment projects usually involve one or more foreign currencies, multiple tax rates and tax systems and foreign political risk. Overseas investment projects involve special problems, such as capital flow restrictions that do not allow the cash flows of projects to be remitted to the parent company. MNCs also face complexities because overseas investment projects have substantial knock-on-effects on other operations elsewhere within the group. For example, a foreign engineering company contemplating to setup a plant in Mexico may find that the proposed investment is likely to affect the operations of other units within the multinational group. Capital Budgeting decisions of MNC Difference between Domestic and MNC capital budgeting decisionsValuing an investment project in the local currency of the host country often provides different values from valuation in the parent's domestic country because the international parity conditions do not always hold.
Difficulty in estimating terminal value of foreign projects
Different rates of national inflation
Complexities of Budgeting for a Foreign ProjectSeveral factors make budgeting for a foreign project more complexParent cash flows must be distinguished from projectParent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing this changes the meaning of NPVAdditional cash flows from new investment may in part or in whole take away from another subsidiary; thus as a stand alone a project may provide cash flows but overall may add no value to the entire organizationParent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints
77Complexities of Budgeting for a Foreign ProjectNon-financial payments can generate cash flows to parent in the form of licensing fees, royalty payments, etc. relevant for parents perspectiveManagers must anticipate differing rates of national inflation which can affect cash flowsUse of segmented national capital markets may create opportunity for financial gains or additional costsUse of host government subsidies complicates capital structure and parents ability to determine appropriate WACCManagers must evaluate political riskTerminal value is more difficult to estimate because potential purchasers have widely divergent views
88Issues in Foreign Investment AnalysisParent Vs. Project Cash Flows The first specific issue that arises in respect of the overseas project is as to which cash flows should be considered for evaluating the project, the cash flows available to the project, or cash flows accruing to the parent company or both. Evaluation of an overseas project on the basis of project's own cash flows provides insight into its competitive status vis-a- vis domestic or regional firms. The project is expected to earn a risk-adjusted rate of return higher than that on its local competitors. Otherwise the MNC should invest money in the equity of local firms. This approach has the advantage of avoiding currency conversions, thus eliminating the margin of error involved in forecasting exchange rates over the life cycle of the project. Such approach is appreciated by local manager, local joint venture partners and host governments. Issues in Foreign Investment AnalysisParent Vs. Project Cash FlowsIt must be noted that in international capital budgeting a significant difference usually exists between the cash flows of a project and the amount that is remittable to the parent. The reasons are tax regulations and exchange controls. Further, project expenses such as management fees and royalties are earnings to the parent company. Furthermore, the incremental revenue available to the parent MNC from the project may vary from total project revenues particularly when the project involves substituting local production for parent company exports or if transfer price adjustments shift profits elsewhere in the system.
Issues in Foreign Investment AnalysisTax Holidays More often than not, governments of developing countries offer tax holidays to encourage foreign direct investment in their economies. Other tax holidays in the form of a reduced tax rate for a period of time on corporate income from a project are negotiable knowing how much the tax holiday is worth when the firm negotiates the environment of the project with the host government. A tax holiday in the project's early years is not worth much. In fact, if the project expected to suffer losses in the first few years which can be carried forward, the tax holiday robs the firm of a valuable tax-loss carry forward. In such a scenario, an MNC would prefer to be subjected to a high tax rate during the early loss-making (and tax-credit creating) years of a project. The management should, therefore, compute project value both with and without the tax holiday to uncover such type of situations.Issues in Foreign Investment AnalysisLost Exports Another issue relating to direct foreign investment decision is the issue of lost exports arising out of engaging in a project abroad. Profits from lost exports represent a reduction from the cash flows generated by foreign project for each year of its duration. This downward adjustment in cash flows may be total, partial or nil depending upon whether the project will replace projected exports or none of them. Issues in Foreign Investment AnalysisMultinationals Exchange Control Exchange control restricting the repatriation of earnings to the parent country is another reason that causes discrepancy between the project value, from the parent's perspective and from the local perspective. When an MNC is contemplating investment in a country having exchange control, the present value calculation from the parent's point of view will be based on the following facts:
The pattern of financing investment by MNC-debt or equity or both. In case of investment to be funded via debt, cash generated by the project is returned to the home country to the extent of debt repayment and interest.
Remittances of net cash flows expected to be generated by the foreign projects.
Issues in Foreign Investment AnalysisSubsidized Financing In order to attract foreign investments in key sectors, the governments of developing economies generally provide support in the form of subsidy. Likewise, international agencies entrusted with the responsibility of promoting cross-border trade sometimes offer financing at below-market rates. The value of the subsidized loan should be added to that of the project while making the investment decision if the subsidized financing is inseparable from the project. But if subsidized financing is separable from a project, the additional value from the subsidized financing should not be allocated to the project. In such a case, the manager's decision is that so long as the subsidized loan is unconditional, it should be accepted. If the MNC can use the proceeds of subsidized financing at a higher rate in a comparable risk investment, it will lead to positive NPV to the firm. Issues in Foreign Investment AnalysisInternational Diversification Benefits Dispersal of investment in a number of countries is likely to produce diversification benefits to the parent company's shareholders. However, it would be difficult to quantify such benefits as can be allocated to a particular project. Generally, such non-quantifiable variables are ignored in capital budgeting decision. However, in case of a marginal project or a project which is not acceptable on its merits, this factor may be taken care of. Sometimes, a marginal project may be found worthwhile when its beneficial diversification effect on the overall pattern of cash flow generation by the MNC is taken into consideration. Risk Analysis in International Capital Budgeting DecisionsMNCs have to face a host of additional risks while investing in foreign countries. These risks may be political and economic.
Political risk is the possibility that political events in a host country or political relationships with a host country will affect the value of corporate assets in the host country. The most extreme form of political risk is the risk of expropriation in which a host government seizes local assets of an MNC.
Besides, MNCs' foreign investments are subject to risk arising out of exchange rate fluctuations and inflation. While a firm knows that the exchange rate will typically change overtime, it does not know whether the foreign currency will strengthen or weaken in the future and how the cash flows will be affected .Risk Analysis in International Capital Budgeting DecisionsThree main methods used for incorporating additional political and economic risks in foreign investment analysis are: shortening the minimum pay-back period; raising the required IRR; and For example, if there is likelihood of embargo on remittances, a normal required rate of 12% might be raised to 16% or a 4-year payback period might be shortened to 3years.
iii) adjusting cash flows to reflect the specific impact of a given riskRisk Analysis in International Capital Budgeting DecisionsThere are two techniques employed to adjust the annual cash flows, keeping into consideration the risk factor for each year.
In the first method, adjustment for uncertainty involves reducing each year's cash flows by an amount equivalent to risk or an insurance premium, even if such arrangement is not actually made by the management. For example, if an MNC insures with an insurance company to hedge risk due to occurrence of a political event, the premium paid by the firm will be deducted from cash flows.
In the second method, probability and certainty equivalent techniques can be employed to adjust political risk, The MNC, generally, employs a statistical technique called the "Decision Tree" analysis to estimate the probability of expropriation. With the help of these techniques the MNC finds an NPV for the foreign project based on cash flows adjusted for the probability of expropriation for the particular year. Cash Management in MNCObjectivesCash Management in an MNC is primarily aimed at minimizing the overall cash requirements of the firm as a whole without adversely affecting the smooth functioning of the company and each affiliate, minimizing the currency exposure risk, minimizing political risk, minimizing the transaction costs and taking full advantage of the economies of scale and also to avail of the benefit of superior knowledge of market forces. Cash Management in MNCObjectivesCash Management in an MNC is primarily aimed at minimizing the overall cash requirements of the firm as a whole without adversely affecting the smooth functioning of the company and each affiliate, minimizing the currency exposure risk, minimizing political risk, minimizing the transaction costs and taking full advantage of the economies of scale and also to avail of the benefit of superior knowledge of market forces. Cash Management in MNCProblem/Difficulties Minimization of the political risk involves conversion of all receipts in foreign currencies in the currency of the home country. This may, however, go against the interest of the affiliates who need minimum working capital to be kept in the local currencies to meet their operational requirements.
Minimization of transaction costs involved in currency conversions calls for holding cash balances in the currency in which they are received. In another respect too, primary objectives are in contradiction to each other. A subsidiary, for example, may need to carry minimum cash balances in anticipation of future payments due to the time required to channelize funds to such a country. Holding of such balances in excess of immediate requirements may impact the objective to benefit from economies of scale in earning the highest possible rate of return from investing these resources. Cash Management in MNCProblem/Difficulties
Another major problem which an MNC faces in managing cash is with respect to estimation of cash flows emanating out of operations of its affiliates. This problem arises because of foreign exchange fluctuations.
Similar problem arises in estimating cash inflows stemming out of future sales because actual volume of sales to overseas buyers depends on foreign exchange fluctuations. The sales volume of exports is also susceptible to business cycles of the importing countries.
Uncertainty arises with regard to cash collections from receivables because it is the quality of credit standards that will decide the value of goods sold to be received back in cash. Loose credit standards may cause a slow. down in cash inflows from sales which could offset the benefits of augmented sales.
Cash management in an MNC is further complicated by the absence of effective tools to expedite transfers and by the great variations in the practices of financial institutions.
Cash Management in MNCSteps involved in Cash ManagementCash Flow Analysis: Subsidiary Perspective Prudent working capital management calls for estimating cash outflows and inflows periodically to ascertain excess or deficient cash for a period of time. Once estimates of cash outflows and inflows are made, the subsidiary will be in a position to know there is cash surplus or deficit for a particular period. If cash deficiency is expected, short-term financing is necessary. In case of excess cash, it must decide how the surplus cash will be used. Centralized Cash Management Centralization does not mean the pooling of overall liquid resources, although some degree of pooling would take place, but rather the centralization of reports, information and most importantly, the decision-making process as to cash mobilization, movement and investment outlets. The system enable the MNCs to make fuller utilization of the idle cash and maximize earnings without risking liquidity throughout the system and use multilateral netting system. Cash Management in MNCSteps involved in Cash ManagementAccelerating Cash Inflows Cash inflows can be prompted through quick deposit of customer's cheques, establishing collection centers, lock-box method and other devices.
Minimizing currency conversion costs Cash flow can also be optimized through Netting. Netting involves offsetting receivables against payables of the various entities so that only the net amounts are eventually transferred among affiliates. An MNC can also utilize multilateral netting with outside firms and agencies. This technique optimizes cash flow by reducing the administrative and transaction costs arising out of currency conversion. Cash Management in MNCSteps involved in Cash ManagementManaging Inter-subsidiary Cash Transfers Through techniques of leading and lagging, cash flows can be managed to the advantage of a subsidiary, If A purchases supplies from B and pays for its supplies earlier than necessary. This technique is called leading. Alternatively, if B sells supplies to A, it could provide financing by allowing A to lag its payments. The leading or lagging strategy can help in improving efficiency of cash utilization and thereby reducing debt. Diversifying Cash across Currencies: In order to avoid the possibility of incurring substantial losses arising out of depreciation of a foreign currency, an MNC prefers to diversify its investible funds among various foreign currencies.
Cash Management in MNCSteps involved in Cash ManagementManaging Inter-subsidiary Cash Transfers Through techniques of leading and lagging, cash flows can be managed to the advantage of a subsidiary, If A purchases supplies from B and pays for its supplies earlier than necessary. This technique is called leading. Alternatively, if B sells supplies to A, it could provide financing by allowing A to lag its payments. The leading or lagging strategy can help in improving efficiency of cash utilization and thereby reducing debt. Diversifying Cash across Currencies: In order to avoid the possibility of incurring substantial losses arising out of depreciation of a foreign currency, an MNC prefers to diversify its investible funds among various foreign currencies.
