CHAPTER 5

INTERNATIONAL CAPITAL BUDGETING

2.5.0 Introduction
Investment decision is one of the key decisions in financial management. Funds acquired from financing
decisions should be allocated in assets which generate returns greater than the cost of acquired funds. As
introduced in the earlier course, Investment appraisal entails techniques used to select investment projects
which attain the central objective of the firm in finance i.e. maximization of long-term shareholders wealth. The
earlier discussion was however focused on domestic perspective.

With the growing rate of globalization and internationalization of markets, both investors and financial advisors
need to be in a position of evaluating projects located in different countries. On the other hand, foreign
investment appraisal involves complexities such as forecasting future exchange rates, double taxation,
intercompany flows as well as remittance restrictions. The understanding of international investment appraisal
at this end is of great importance as it will enable professionals to be in the position of making informed foreign
investment decisions. This guide aims at exposing a student on evaluating potential international investment
decisions and assessing their financial and strategic consequences as well as adjusting present values.

2.5.1 International Investment Decision

Investment appraisal is a process of identifying, analysing and selecting investment projects whose returns
(cash flow) are expected to lengthen further than one year. Foreign investment appraisal is also called capital
budgeting. Objectives of capital budgeting are to determine whether a proposed capital investment will be a
profitable one over the specified time period and to select between investment alternatives.

Investment appraisal for international firm’s uses the same framework as the domestic capital budgeting.
Examples of a foreign investment decision range from purchase of new equipment to replace existing
equipment, to an investment in an entirely new business venture in a country where, typically, manufacturing
or assembly has not previously been done. The activities involved in international capital budgeting is similar
to those in domestic capital budgeting except the fact that foreign investment appraisal involves the following
complexities:
 Foreign Exchange Risks - cash flow from a foreign project are in foreign currency and therefore subject
to exchange risk from the parent’s point of view. Foreign exchange risk is that the currency will
depreciate or appreciate over the period of time.
 International financing arrangement of capital and related to cost of capital,
 Remittance restrictions- where there are restrictions on the repatriation of income, substantial
differences exist between projects cash flow and cash flows received by the parent firm. Only cash
flows that are remittable to the parent company are relevant from the firm’s perspective
 International Taxation -both in domestic and international capital budgeting, only after-tax cash flows
are relevant for project evaluation. However, in international capital budgeting tax issue is complicated
by existence of two taxing jurisdictions plus a number of other factors including form of remittance to
the parent firm, tax withholding provision in the host country
 Political or Country Risk - assets located abroad are subject to the risk of appropriation or
nationalization by the host government, also there are may be changes in applicable withholding taxes,
restrictions on remittances by the subsidiary to the parent
Due to these complexities, some difficulties in international capital budgeting arises. These difficulties
include:
 Parent cash flows are different form project cash flows.
 All cash flows from the foreign projects must be converted into the currency of the parent firm.
 Profits remitted to the parent are subject to two taxing jurisdictions i.e. the parent country and the
host country.
 Anticipate the differences in the rate of national inflation as they can result in changes in competitive
position and thus in cash flows over a period of time
 The possibility of foreign exchange risk and its effect on the parent’s cash flow.

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  If the host country provides some concessionary financing arrangements and/or other benefits, the
profitability of the foreign project may go up.
 Initial investment in the host country may benefit from a partial or total release of blocked funds.

 The host country may impose restrictions on the distribution of cash flows generated form the foreign
projects.
 Political risk must be evaluated thoroughly as changes in political events can drastically reduce the
availability of cash flows.
 It is more difficult to estimate the terminal value in the multinational capital budgeting because
potential buyers in the host or parent company may have widely different views on the value to them
of acquiring the project.
Some Explanations on Capital Budgeting and Its International Complexities
Capital budgeting for a foreign project uses the one-country framework just described, but with certain
adjustments to reflect the greater complexities in an international situation. Many of the adjustments arise
because of the fact that two separate sovereign nations are involved and the operating cash flows in the host
country are in a different currency than those desired by the parent company.
Project versus Parent Cash Flows

Project (e.g., host country) cash flows must be distinguished from parent (e.g., home country) cash flows.
Project cash flows generally follow the domestic or one-country model, described earlier. However, parent cash
flows reflect all cash flow consequences for the parent company.

Parent Cash Flows Tied to Financing

Because of the above, parent cash flows depend, in part, on financing. Unlike the domestic situation, financing
cannot be kept separate from operating cash flows. In fact, “clever” financing is often the key to making an
otherwise unattractive foreign investment proposal attractive to the parent firm. Cash may flow back to the
parent because the venture is structured from a financial point of view to provide such flows. Fund flows back
to the parent on international projects arise from any of the following, which must be incorporated into the
original investment agreement:

 Dividends.
 Royalties.
 License fees.
 Interest on parent-supplied debt.
 Principal repayment of parent-supplied debt.
 Liquidating dividends.
 Transfer prices paid on goods supplied by the parent.
 Transfer prices paid on goods sent to the parent.
 Overhead charges.
 Recovery of assets at project end (i.e., terminal value).
 Note: depreciation is not a cash flow to the parent.

Foreign Exchange Forecasts Needed

An explicit forecast is needed for future exchange rates. Future cash flows in a foreign currency have value to
the parent only in terms of the exchange rates existing at the time funds are repatriated, or valued if they are
not repatriated. Hence, an exchange rate forecast is necessary. In addition, the investment decision must
consider the possibility, if not the probability, of unanticipated deviations between actual ending exchange
rates and the original forecast.

Long-Range Inflation Must Be Considered

Over the extended period of years anticipated by most investments, inflation will have three effects on the
value of the operation:
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  inflation will influence the amount of local currency cash flows, both in terms of the amount of local
money received for sales and paid for expenses and in terms of the impact local inflation will have on
future foreign competition;
 inflation will influence the future foreign exchange rates used to measure the parent company’s value
of local currency cash flows; and
 Inflation will influence the real cost of financing choices between domestic and foreign sources of
capital.
 

Subsidized Financing Must Be Explicitly Treated

Subsidized financing available from the host government must be explicitly treated. If a host country provides
subsidized financing at a rate below market rates, the value of that subsidy must be considered. If the lower
rate is built into a cost-of-capital calculation, the firm is making an implicit assumption that the subsidy will
continue forever. It is preferable to build subsidized interest rates into the analysis by adding the present value
of the subsidy rather than by changing the cost of capital.

 Political Risk Must Be Considered

The host government may change its attitude towards foreign influence or control over some segments of the
local economy. This may be through sudden revolution, or it may result from a gradual evolution in the political
objectives of the host goverment. Political risk is also important in determining the terminal value, because
politics may impose a specific ending date which negates use of an infinite horizon for valuation purposes. If a
specific ending date is mandated, the value received on that date may be extremely difficult to anticipate. In
the context of premiums for political risk, diversification among countries may create a portfolio effect such
that no single country need bear the higher return that would otherwise be imposed if that country were the
only location of a foreign investment.

2.5.2 Alternative international investment appraisal techniques

In international capital budgeting two approaches are commonly applied:
1. Discounted cash flow analysis (DCF)
2. The adjusted present value approach

Approach 1: The Discounted Cash Flow Analysis

DCF technique involves the use of the time value of money principle to project evaluation. The two most widely
Used criteria of the DCF technique are the
 The net present value (NPV)
 The internal rate of return (IRR)

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The net present value (NPV)

In domestic capital budgeting there is no need of converting currencies since the project is within the home
country, but for international capital budgeting there is need of converting currencies from foreign to home
currency especially during repatriation of the profits at the end of the project.

The evaluation of the international capital budgeting projects should take this issue into consideration; two
techniques have been designed on how and when the currency should be converted. These techniques are:

 Centralized capital budgeting technique

 Decentralized capital budgeting technique

Centralized international capital budgeting technique (Home Currency Approach)

Under a centralized international capital budgeting, a project is evaluated from the domestic country point of
view. Domestic country in this context means the home country in which head office operates and
centralization takes place in that office. With a centralized approach, cash flows to be discounted should be
denominated in domestic currency i.e. there is a need to convert the currency prior discounting them. A simple
way is that the cash flow should follow the currency of the cost of capital. With centralized capital budgeting
technique, forecast the cash flows in foreign currency first, then convert these cash flows into domestic
currency using the relevant forward exchange rates and finally discount the cash flows in domestic currency
and the discount rate appropriate for domestic projects.

A strong theoretical argument exists in favour of analysing any foreign project from the view point of the
parent. Cash flows to the parent are ultimately the basis for dividends to stakeholders, reinvestment elsewhere
in the world, repayment of corporate-wide debt, and other purposes that affect the firm’s many interest
groups.

Example

If Exim bank has its head office in South Africa and all operations takes place in South Africa, South Africa will
then be a domestic country for capital budgeting purposes.
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Centralized international capital budgeting technique involves the following steps

1. Estimate the relevant cash flow of the project in local currency (foreign currency) terms
2. Forecast the exchange rate over the project life, parity relationship are used, specifically International
Fisher Effect. In this case home and foreign country will be determined by forecaster’s point of view, or
in other words use exchange rate quotation.
3. Convert the local currency denominated cash flow into domestic currency values using the forecast
exchange rate (relevant forward rates)
4. Decide on appropriate discount rate or required rate of return between domestic cost of capital and
domestic cost of the project, both calculated from the domestic country point of view.
The domestic cost of project can be calculated by using CAPM or any other relevant technique covered
under cost of capital especially when the project is perpetual.
5. Discount the cash flows to the present values using the selected discount rate
6. Calculate the NPV in domestic currency terms , then make decision if NPV is greater or equal to zero
accept the project otherwise reject

Note: Centralized means domestic appraisal so in discounting cash flows the domestic cost of capital or
domestic cost of project should be used. When both are given in the question the domestic cost of project
should be preferred.

Example

The Management of I Kid`s International Co., Tanzania based firm is reviewing the Company’s capital
investment options for the coming year and is considering investing in Malawi. The investment would involve a
current outlay of MKW 8,800,000,000 on capital equipment and MKW 2,000,000,000 on working capital. The
corporate tax rate in Tanzania is 30% and that of Malawi is 40%, no withholding tax for amount repatriated
from Malawi to Tanzania.

The project is expected to last for three years 20X6- 20X8; and all in investments including the working capital
requirements will be incurred and paid for in December, 20X5.

The revenues and cost for the projects are as provided in the table below [Figures in “000” Malawi kwacha].

Fixed costs include an annual charge of MKW 6,000,000,000 for depreciation. At the end of the year 3 the
working capital investment would be recovered and the net realizable value of the equipment MKW
9,000,000,000. Annual inflation rate in Tanzania is 6% while in the Malawi inflation is running at 7%. The
current spot rate is MKW20/TSHS. The company requires a 10% return on any foreign investment.

Required: Appraise and comment on the viability of the project using the NPV method.

Suggested Solution:

Given:

Initial costs: Capital equipment MKW 8,800,000,000

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Working capital requirement MKW 2,000,000,000

Spot rate: MKW 20/TSHS

TSHS Inflation rate = 6% = 0.06; MKW inflation rate= 7% = 0.07

Recall: The Purchasing Power Party (PPP)

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Decentralized international capital budgeting technique (Foreign Currency Approach)
Project is evaluated from the host country’s point of view and NPV initially is calculated in the currency of the
host country. Evaluation of a project from the local viewpoint serves some useful purposes, but it should be
subordinated to evaluation from parent’s viewpoint. Almost any project should at least be able to earn a cash
return equal to the yield available on the host government bond with similar maturity to the project, if a free
market exists for that bond. With decentralized capital budgeting technique, a project analyst should forecast
the cash flows in foreign (local) currency, discount these cash flows at the discount rate appropriate for the
foreign market to get an NPV in terms of foreign currency and convert the NPV in foreign currency into
domestic values at the spot exchange rate.

Decentralized international capital budgeting technique involves the following steps:

1. Estimate the relevant cash flows in local currency (foreign currency) terms
2. Decide on appropriate discount rate or required rate of return between foreign cost of capital and
foreign cost of projects both calculated from the foreign point of view.

The foreign cost of capital can be deduced from the domestic cost of capital as follows:

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In this case home and foreign country/currency will be determined by the investors point of view, this means
that the investor’s home will be home currency and the where he/she invest will be foreign country

3. Discount the cash flow using the selected discount rate

4. Calculate NPV in local currency terms
5. Convert the NPV to domestic currency value using the current spot exchange rate
6. Make decision if NPV is greater than zero or zero accept the project otherwise reject

Note:

 Decentralized means foreign appraisal so in discounting cash flows the foreign cost of capital or foreign
cost of project should be used
 When both are given in the question the foreign cost of project should be preferred
 Decentralized means, before discounting cash flow they should be in foreign currency, simple way is
that the cash flow should follow the currency of the cost of capital, since the cash flows are already in
foreign currency thus there is no need to convert cash flow

Recall: Nominal cash flows should be discounted by using nominal discount rate and real cash flows should be
discounted by real discount rate most MNCs tend to evaluate projects from both the parent and project view
point. The parent’s viewpoint gives results closer to the traditional meaning of net present value in capital
budgeting. Project valuation provides a closer approximation of the effect on consolidated earnings per share,
which is a major concern to practicing managers. However, the truth is the CFS from the two perspectives may
differ because the \net after tax cash flows to the subsidiary may differ substantially with that to the parent.

Example

A US firm is considering an investment in Tanzania, which will cost Tshs 200million and is expected to produce
an income of Tshs 30million in real terms in each of the next seven year. The firm estimate that the appropriate
cost of capital or the project in the US is 8%. Nominal interest rates are 9% in Tanzania and 7% in the US, the
spot exchange rate is Tshs 1354.50 per USD. At the end of the seventh year the US Firm expects to sell the
Tanzanian investment to a local firm for Tshs 50million.

Required

Evaluate and comment on the economic viability of the proposed project. Use Decentralized capital budgeting.

Suggested Solution

Computation of foreign (TZ) CoC:

The foreign cost of capital can be deduced from the domestic cost of capital as follows:

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NPV in USD = -TZS 28.35
TZS 1354.50/USD
=-USD 0.0209
Basing on monetary grounds alone, the project is not feasible because NPV is negative.

The internal rate of return (IRR)

Principle of IRR remains the same in international capital budgeting only that care should be taken in
computing NPV as explained in the preceding section. Recall that IRR is the rate that equates NPV to zero. This
study guide has therefore focused more on NPV.

Example:

Calculating the IRR involves a complex equation, and even the use of complex polynomial equations, requiring
a computer package for accurate results.

Approximate results can be obtained by using linear interpolation between two estimated discount rates. The
closer these rates are to the actual IRR, then the more accurate the answer will become.

Internal Rate of Return Example

The following is an example of a project investment appraisal. All values in £1000’s.

Note: The cost of capital for the proposed project is considered 7%

In order to calculate the IRR, we choose (any) two discounts factors, and calculate the NPV for each:

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Internal Rate of Return Calculation

Following this, we can represent these values graphically:

Internal Rate of Return Graph

We can then use this straight line (note how it approximates the actual result) to interpolate the IRR:

Internal Rate of Return Equation

Therefore, the IRR in this example is approximately 10.7%.

By Using Linear Extrapolation & Iteration

Another closely related linear estimation technique is extrapolation.
This involves the straight-line estimation of values outside the range of the sample data used to do the estimation with.

Example 2: Extrapolation
Using the following data to estimate net present value (NPV) at a yield of 7%, using extrapolation:
NPV of +$4m at a yield of 5%.

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NPV of -$4m at a yield of 6%.
Solution
Based on the sample data, for every 1% increase in the yield, the NPV moved by:
-$4m - $4m = -$8m

Extrapolating this trend to a yield of 7%, this is a further increase in the yield of 7 - 6 = 1%.
The NPV would be modeled to fall from -$4m to:
= -$4m - $8m
= -$12m.

Approach two: adjusted present value method (APV)

The APV format allows different components of the project’s cash flow to be discounted separately. This allows
the required flexibility, to be accommodated in the analysis of the foreign project. The method uses different
discount rates for different segments of the total cash flow depending upon the degree of certainty attached
with each cash flow. In addition, the APV format helps the analyst to test the basic viability of the foreign
project before accounting for all the complexities. The APV framework is a useful technique because
international projects frequently have cash flows not encountered in domestic projects; the APV technique
easily allows the analyst to add terms to the model that represents the special cash flows.
The APV model is a value additive approach to capital budgeting. The cash flows are logically discounted at
different rates, a function of their different risk. Operating cash flows are viewed as being more risky. They are
therefore discounted at the cost of equity. The adjusted present value of a project is given by:
APV = NPV + NPVF
Where:
NPV = the Net present value of the project to an Unlevered firm (Net present value of the-after tax operating
cash flows)
NPVF=the Net present value of the financing side effects.
There are four side effects of financing:
(i) The Tax subsidy to Debt
(ii) The costs of issuing New securities
(iii) The costs of financing Distress
(iv) Subsidy to Debt Financing
In other words, the adjusted present value is given as:

The impact of alternative project financing sources on international project economic viability.
In multinational investment projects, the type of financing package is often critical in making otherwise
unattractive projects attractive to the parent company. Thus, cash may flow back to the parent because the
project is structured to generate such flows via royalties, licensing fees, dividends, and so on. Unlike in
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domestic capital budgeting, operating cash flows cannot be kept separate from financing decisions.
Implications of source of financing on foreign investment appraisal
 If an MNC is financed from expensive sources, then a number of attractive investment decreases as it
becomes difficult to find an investment that brings returns greater than the cost of acquired funds.
 If a project has been financed through loan from domestic country, a lender (foreign country or
country of investment) should ideally be paid solely or almost exclusively out of the money generated
from foreign project. This brings about the issues of transfer price, income repatriation
 On the other hand, financing a foreign project though a foreign loan may bring about simplicity in
repayment of interests and administering the loan
 An MNC has an advantage of raising funds from both domestic and foreign capital markets.
Be it that funds are sourced domestically of from foreign sources, shareholders wealth has to be maximised.
Managers should therefore adopt the most convenient and cheaper option of raising funds. Raising funds
from expensive sources will cause WACC to increase and hence a decrease in the value of the firm.

The impact of political and foreign exchange risk on international investment decisions
Political Risk Must Be Considered. The host government may change its attitude towards foreign influence or
control over some segments of the local economy. This may be through sudden revolution, or it may result
from a gradual evolution in the political objectives of the host government. Political risk is also important in
determining the terminal value, because politics may impose a specific ending date which negates use of an
infinite horizon for valuation purposes. If a specific ending date is mandated, the value received on that date
may be extremely difficult to anticipate. In the context of premiums for political risk, diversification among
countries may create a portfolio effect such that no single country need bear the higher return that would
otherwise be imposed if that country were the only location of a foreign investment.

Political risk: This is another factor that can significantly impact the viability and profitability of foreign
projects. Whether it be through democratic elections or as a result of sudden developments such as
revolutions or military coups, changes in a country's government can affect the attitude in that country
towards foreign investors and investments. This can affect the future cash flows of a project in that country in
a variety of ways. Political developments may also affect the life and the terminal value of foreign
investments.
Political risks should be incorporated into foreign investment analysis by adjusting the expected cash flows of
a project, rather than its required rate of return. Establishing certainty equivalents of the expected cash flows
of that particular project can do this.

An important thing to notice is that there is an important source of risk (exchange rate risk) that isn’t
incorporated firm’s local cost of capital.

Worked Example for APV.

Amberle Co is a listed company with divisions which manufacture cars, motorbikes and cycles. Over the last few years,
Amberle Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new
investment of $150 million in facilities to produce electric cars, which it proposes to finance solely by debt finance.

Project information
Amberle Co’s finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time
horizon, together with the realisable value at the end of four years:
Year 1 2 3 4

$m $m $m $m

Post-tax operating cash flows 28·50 36·70 44·40 50·90

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Realisable value 45·00
Working capital of $6 million, not included in the estimates above and funded from retained earnings, will also be
required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working
capital will be released in full at the end of the project.

Predicted rates of inflation are as follows:

Year 1 2 3 4

8% 6% 5% 4%
The finance director has proposed the following finance package for the new investment:

$m

Bank loan, repayable in equal annual instalments over the project’s life, interest payable at 8% per year 70

Subsidised loan from a government loan scheme over the project’s life on which interest is payable at 80
3·1% per year

150

Issue costs of 3% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank
loan. Issue costs are not allowable for tax.

Financial information
Amberle Co pays tax at an annual rate of 30% on profits in the same year in which profits arise.
Amberle Co’s asset beta is currently estimated at 1·14. The current return on the market is estimated at 11%. The
current risk-free rate is 4% per year.
Amberle Co’s chairman has noted that all of the company’s debt, including the new debt, will be repayable within three
to five years. He is wondering whether Amberle Co needs to develop a longer term financing policy in broad terms and
how flexible this policy should be.

REQUIRED:
(a) Calculate the adjusted present value (APV) for the project and conclude whether the project should be accepted or
not.
(b) Discuss the factors which may determine the long-term finance policy which Amberle Co’s board may adopt and the
factors which may cause the policy to change.

Suggested Solution:
Adjusted Present Value (12.5 marks)

Year 0 1 2 3 4
$m $m $m $m $m
Post-tax operating cash flows 28·50 36·70 44·40 50·90
Investment (150·00)

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Realisable value 45·00
Working capital (W1) (6·00) (0·48) (0·39) (0·34) 7·21
––––––– –––––– –––––– –––––– –––––––
Cash flows (156·00) 28·02 36·31 44·06 103·11
Discount factor 12% (W2) 1·000 0·893 0·797 0·712 0·636
––––––– –––––– –––––– –––––– –––––––
Present value (156·00) 25·02 28·94 31·37 65·58
––––––– –––––– –––––– –––––– –––––––
Base case net present value (5·09)
Base case net present value is approximately ($5·09 million) and on this basis, the investment should be rejected.
Workings
1. Working capital
Year 0 1 2 3 4
$m $m $m $m $m
Working capital 6·00 6·48 6·87 7·21
Required/(released) 6·00 0·48 0·39 0·34 (7·21)
2. Discount rate
Using asset beta

All-equity financed discount rate = 4% + (11% – 4%) 1·14 = 12%

3. Issue costs
$80 million/0·97 = $82,474,227
Issue costs = 3% x $82,474,227 = $2,474,227
There will be no issue costs for the bank loan.

4. Tax shield on subsidised loan

Use PV of an annuity (PVA) years 1 to 4 at 8% (normal borrowing rate)
$80m x 0·031 x 30% x 3·312 = $2,464,128

Note to markers
Full credit should be given if tax shield is discounted at the government interest rate of 3·1% rather than thenormal
borrowing rate of 8%.

5. Tax shield on bank loan

Annual repayment = ($70m/PVA 8% Yr 1 – 4) = ($70m/3·312) = $21,135,266

Year 1 2 3 4
$000 $000 $000 $000
Opening balance 70,000 54,465 37,687 19,567
Interest at 8% 5,600 4,357 3,015 1,565
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Repayment (21,135) (21,135) (21,135) (21,135)
Closing balance 54,465 37,687 19,567 (3)
Year 1 2 3 4
$000 $000 $000 $000
Interest cost 5,600 4,357 3,015 1,565
Tax relief at 30% 1,680 1,307 905 470
Discount factor 8% 0·926 0·857 0·794 0·735
Present value 1,556 1,120 719 345
Net present value 3,740
6. Subsidy benefit

Benefit = $80m x (0·08 – 0·031) x 70% x 3·312 = $9,088,128

7. Financing side effects

$000
Issue costs (W3) (2,474)
2,464
Tax shield on subsidised loan (W4)
Tax shield on bank loan (W5) 3,740
Subsidy benefit (W6) 9,088
Total benefit of financing side effects
12,818

Financing the project in this way would add around $12·82 million to the value of the project.

The adjusted present value of the project is around $7·73 million and so the project should be accepted. Sensitivity
analysis should be undertaken on all the significant variables.

Further analysis may be needed, particularly of the assumptions which lie behind the post-tax cash flows, such as
sales and the tax rate. The realisable value of $45 million may be questionable.

On the other hand, the time horizon of four years seems low and analysis should be done of potential cash flows
beyond that time.

(b) Amberle Co’s board can use various principles to determine its long-term finance mix. The directors may aim to
follow consistent long-term policies, or they may have preferences which change as circumstances change.
Long-term policy factors
At present Amberle Co is using a mix of finance, raising the question of whether the directors are aiming for an
optimal level of gearing, or there is a level which they do not wish gearing to exceed.

If the board wishes to maintain gearing at an optimal level, this is likely to be determined by a balance of risks and
advantages. The main risks are not being able to maintain the required level of payment to finance providers,

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interest to debt providers or required level of dividend to shareholders.

Advantages may include lower costs of debt, tax relief on finance costs as shown in the APV calculation or, on the
other hand, not being legally required to pay dividends in a particular year.

Another issue is whether Amberle Co’s board has preferences about what source of finance should be used and in
what order. One example of this is following the pecking order of retained earnings, then debt, then equity.

The board may prefer this pecking order on the grounds that avoiding a new equity issue means that the
composition of shareholdings is unchanged, or because retained earnings and longer term debt are judged low risk,
or because the market will assume that an equity issue is being made because directors want to take advantage of
Amberle Co’s shares being over-priced.

Other specific sources of finance may have benefits which attract the directors or drawbacks which deter them.
This investment highlights the aspect of whether the board prefers to match sources of finance with specific
investments.

Matching arguably gives greater flexibility and avoids committing Amberle Co to a long-term interest burden.
However, to adopt this approach, the board will need assurance either that the investment will be able to meet
finance costs and ultimately repayment burdens, or these can be met from surpluses from other operations.

Changing long-term financing policy

As well as deciding what financing mix or sources of finance they desire to use, the directors will also need to
consider what factors would cause this decision to change.

A major change in the scope of the operations, with investment requirements being paramount, may cause a
change in financing policy. Here the $150 million investment has been financed entirely by medium-term debt.

Amberle Co may have chosen solely to use debt if it has made a recent equity issue and does not feel it can make
another one so soon afterwards.

In addition, if Amberle Co expands its manufacture of electric cars, it may decide to sell off its motorbike or cycles
divisions if they are performing less well. If part of the business is sold, the sale proceeds could help finance new
investment in the cars division.

The board may also be flexible at times and take advantage of whatever source of finance seems to be offering the
best terms for Amberle Co. Here the board is taking advantage of loan finance being available at a low cost, thanks
to the government loan scheme.

A change in the business or economic environment may also lead to the board rethinking how the company is
financed. An economic recession, leading to falling share prices, may mean that the results of a share issue are
uncertain.

On the other hand, an increase in economic or business risk may mean that lenders are less likely to lend at
acceptable rates or will impose greater restrictions. If the directors are risk-averse, they may not seek new finance
during a recession but instead rely on retained earnings to finance any expansion.

END OF INTERNATIONAL INVESTMENT ANALYSIS QUESTIONS.

Q1. Lake Manyara Ltd is a Company based in Tanzania and having its offices in Arusha. The firm is thinking of
establishing a branch in South Africa or Mbeya. The CEO of Lake Manyara company is well informed about difficulties
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when appraising domestic projects but he is unsure of difficulties involved in international capital budgeting. In this
light, you are required to explain the complexities to the CEO.

Q2. Multidrop Inc. is a Kenyan based company. The company is contemplating a foreign direct investment in Arusha,
Tanzania. The investment is estimated to cost a total of KES 400,000,000; Divided as for non-current assets KES
350,000,000 and working capital requirements of KES 50,000,000.

The project is expected to last for four years, and all initial investment costs will be incurred and paid for, in the year
2013. The investment is expected to produce the following after tax cash flows in real terms:

The firm estimates that the appropriate (nominal) cost of capital for the project is 8%. Annual interest rates are 9% in
Tanzania, 7% in Kenya. The spot exchange rate is TSHS.18.50/KES. And inflation in Tanzania is expected to average 10%
per year for the next four years.

At the end of the fourth year, the Multidrop Inc. expects to sell the Tanzanian investments to local firm for
TSHS.10,000,000,000. The corporate tax rate in Tanzania is 30% and 35% in Kenya. However, the Kenyan government
does not charge tax on the remittance from Tanzania, nor does Tanzania charge repatriation tax for transfers to Kenya.

Required:

Evaluate and comment on the economic viability of the proposed project.

Q3. Excurb Co. is a Japanese based manufacturer of TV sets. The firm is reviewing the Company’s capital investment
options for the coming year and is considering investing in Tanzania. The company wishes to set up a manufacturing
subsidiary in Tanzania. The Tanzanian subsidiary would undertake the construction of a new factory in Arusha. The
initial project cash investment is estimated at Japanese Yen 100,000,000. Of the total amount, Yen 50,000,000 will be
used to finance the acquisition of fixed assets and the remaining amount will be used to meet working capital needs.

The project duration is four years. The expected net operating income and depreciation expense over the four year
period is as given below:

End of Year 1 2 3 4

Net operating income (TSHS million) 300 500 200 300

Depreciation expense 50 50 50 50

Depreciation is a tax allowable expense. The sport exchange rate is TSHS10/¥ and an annual appreciation of 5% of the
Japanese Yen against the TSHS is predicted over the next four years. Corporate tax rates are 40% and 50% in Tanzania
and Japan respectively. Tanzania imposes a withholding tax of 10% on earnings remitted by subsidiaries of foreign
companies. The after-tax realizable value of the investment in four years’ time is expected to be approximately TSHS

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200 million.

Required:

Evaluate whether Excurb Co. should establish the Tanzanian Subsidiary if the company requires a 14% return on any
foreign investment.

Q4. Bromwich Inc, a US company, is considering undertaking a new project in the UK. This will require
initial capital expenditure of £1,250 million, with no scrap value envisaged at the end of the five-year
lifespan of the project. There will also be an initial working capital requirement of £500 million, which
will be recovered at the end of the project. The initial capital will therefore be £1,750 million. Pre-tax net
cash inflows of £800 million are expected to be generated each year from the project. Company tax will
be charged in the UK at a rate of 40%, with depreciation on a straight-line basis being an allowable
deduction for tax purposes. UK tax is paid at the end of the year following that in which the taxable
profits arise.

There is a double taxation agreement between the US and the UK, which means that no US tax will be
payable on the project profits.

The current £/$ spot rate is £0.625 = $1. Inflation rates are 3% in the US and 4.5% in the UK. A project of
similar risk recently undertaken by Bromwich Inc in the US had a required post-tax rate of return of
10%.

Required

Calculate the net present value of the project using each of the two alternative approaches.

Q5. Goody plc is considering whether to establish a subsidiary in the US, at a cost of $2,400,000. This
would be represented by non-current assets of $2,000,000 and working capital of $400,000. The
subsidiary would produce a product which would achieve annual sales of $1,600,000 and incur cash
expenditures of $1,000,000 a year.

The company has a planning horizon of four years, at the end of which it expects the realizable value of
the subsidiary's non-current assets to be $800,000.

It is the company's policy to remit the maximum funds possible to the parent company at the end of each
year.

Tax is payable at the rate of 35% in the US and is payable one year in arrears. A double taxation treaty
exists between the UK and the US and so no UK taxation is expected to arise.

Tax-allowable depreciation is at a rate of 25% on a straight-line basis on all non-current assets. The tax-
allowable depreciation can first be claimed one year after the investment.

Because of the fluctuations in the exchange rate between the US dollar and sterling, the company would
protect itself against the risk by raising a eurodollar loan to finance the investment. The company's cost
of capital for the project is 16%.

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Required;

Should a project be established?

Q6. Donegal plc manufactures Irish souvenirs. These souvenirs are exported in vast quantities to the US
to the extent that Donegal is considering setting up a manufacturing and commercial subsidiary there.
After undertaking research, it has been found that it would cost $6m, comprising $5m in non-current
assets and $1m in working capital. Annual sales of the souvenirs have been estimated as $4m and they
would cost $2.5m per annum to produce. Other costs are likely to be $300,000 per annum.

Tax rates are as follows:

Ireland 23% US 25%

Tax is payable in the year of occurrence in both countries. Assume there is no double tax relief.

Capital allowances at a rate of 20% reducing balance are available. Balancing allowances or balancing
charges should also be accounted for at the end of the project's life.

The maximum possible funds will be remitted to the home country (Ireland) at the end of each year. The
exchange rate is €0.71 = $1. It is assumed that this rate will remain constant over the project's life.

The project is being appraised on a five-year time span. The non-current assets will be sold for an
expected $2.5m at the end of the project's life. Donegal uses a cost of capital of 12% on all capital
investment projects.

Required

Calculate the NPV of the proposed project and recommend to the board of directors of Donegal whether
the US subsidiary should be set up.

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