International

Project Appraisal

By: Somya Agrawal

Sonam Agrawal
Laxmi Nandwani

Introduction
The fundamental goal of the finance
manager is to maximize shareholders
wealth.
This can be done if the firm selects those
projects that maximize the companys value.
The selection process involves a detailed
analysis of every project on every aspect.
International projects involve more factors
to be analyzed as compared to the domestic
projects.

Issues to be analyzed for International Project

Appraisal

Foreign Exchange Risk

Risk that the currency will appreciate or
depreciate over a period of time.
It help in understanding the cash flows
generated by the project over its life cycle.
To made the estimates, the manager should

Estimate the inflation rate in host country

The cash flows in terms of local currency
Adjust the cash flows for inflation
Convert the cash flows into parent country currency
according to the expected depreciation or
appreciation rate calculated on the basis of PPP.

Remittance Restrictions
Many countries impose a variety of restriction on
transfer of profits, depreciation and other fees
accruing to the parent company.
Normally the project cash flow includes profits and
depreciation but parents CF consist of the amount
that can be legally transformed.
There are some techniques to curtail the restrictions
like transfer pricing, overhead payment, etc.
To obtain a conservative estimate of the
contribution by the project the financial manager
can include only the income which is remittable by
law in the host country.

Tax Issues
For a project evaluation only cash flows after
tax are relevant.
In international projects, there exists two taxing
jurisdiction.
There exists the differences in dividend
management fees, royalties, etc.,
To calculate the actual after tax cash flow, the
higher tax rate are used.
This shows a conservative scenario that if the
project is acceptable under this condition then
it will be necessarily acceptable under more
favorable tax scenario.

Project Versus Parent Cash Flows

Substantial differences can exist between
the project and parent cash flows because
of tax regulations and exchange control.
Also, expenses such as management fees
and royalties are returns to the parent
company.
Project Evaluation should be done on the
basis of:
Its own cash flows?
Cash flows accruing to the parent company?
Both?

Basis of its own cash flows

The project must be able to compete
successfully with other domestic firms &
also earn a rate of return in excess of its
locally based competitors.
If not, then it is better for parent company
to invest in the equity/ government bonds of
local firms.

Contd..
Evaluating projects on the basis of local cash
flows has the advantage of avoiding
currency conversion & hence eliminating
problems
involved
with
fluctuating/
forecasting exchange rates changes for the
life of the projects.

From the viewpoint of parent company

Cash flows which are actually remitted to
the parent are the ultimate yardstick for
company performance.
This helps in determining the financial
viability of the project from the viewpoint of
the MNC as a whole.
Cash flows include both operating &
financial like fees, royalties and interest on
loans given by parent company.

Financial Analysis of Foreign Projects

Financing Arrangements
The value of the project will be determined
by the manner in which it is financed.
For example: many times, international
agencies in order to promote cross border
trade finance at below market rates.
In case of subsidized financing, determine
whether subsidized financing is separable or
not from the project.

Contd..
When the subsidized financing is
inseparable then the value of loan should
be added to that of the project in making
investment decision.
But, if it is separable, then there is no need
to allocate the value of loan in the project.

Blocked Funds
Blocked funds are the cash flows generate by
a foreign project that cannot be immediately
transferred to the parent, usually because of
exchange controls imposed by the govt. of the
country in which the funds are held.

Contd..
Some countries require that the earnings
generated by the subsidiary be reinvested
locally for at least a certain period of time
before they can be remitted to the parent
company.
Blocked funds cause a discrepancy b/w the
project value from parents and local
perspective.
Also, this can possibly affect the accept/ reject
decision for a project.

INFLATION
The impact of inflation on the parents &
subsidiarys cash flow can be quite volatile
from year to year some countries. It may
cause currency to weaken & hence influence
a projects cash flow
Inaccurate inflation forecast by a country,
can lead to inaccurate cash flow forecast.
Thus MNCs cannot afford to ignore the
impact of inflation in the cash flow

Uncertain salvage value

The salvage value of a project has an important
impact on the NPV of the project. When the salvage
value is uncertain, the cash flow will not be accurate
& the MNC may need to calculate various possible
outcome for the salvage value & estimate the NPV
based on each possible outcome. The feasibility of
the project may then depend upon the present value
of the salvage value.

Adjustment for risk

Cash flow v/s Discount rate adjustment:
Another important dimension in multinational
capital budgeting is whether to adjust cash flow or
the discount rate to account for the additional risk
arises from the foreign location of the project.
Traditionally, MNCs have adjusted the discount
rate by moving it upwards for riskier projects to
reflect the political and foreign exchanged
uncertainties

 Adjusting the discount rate is quite a popular

method with MNCs mainly because of its
simplicity and the rule that the required rate of
return of a project should be in accordance with
the degree of risk which it is exposed to.
However, combining all risk into a single discount
rate has several drawbacks.

 The annual cash flow are discounted using the applicable

rate for that type of project either at the host country or at
the parent country. Probability and certainty equivalent
techniques like decision tree analysis are used in economic
and financial forecasting. Cash flows generated by the
project and remitted to the parent during each time period
are adjusted for political risk, exchange rate and other
uncertainties by converting them into certainty equivalent.
The method of adjusting the cash flows rather than
discount rate is generally the more popular method and is
usually recommended by finance managers. There is
generally more information on the specific impact of a
given risk on a projects cash flow than on its discount rate.

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