MODULE 3: INTERNATIONAL INVESTMENT AND

FINANCING DECISIONS

3.1 INTERNATIONAL CAPITAL BUDGETING - FOREIGN DIRECT INVESTMENT AND

CROSS BORDER ACQUISITIONS, INTERNATIONAL PORTFOLIO INVESTMENT.
INTERNATIONAL PROJECT APPRAISAL.

3.2 INTERNATIONAL FINANCING DECISIONS: FINANCIAL CHOICES FOR AN MNC,

CAPITAL AND MONEY MARKET INSTRUMENTS.
INTERNATIONAL CAPITAL BUDGETING - BASICS

 The fundamental goal of the financial manager is shareholder

wealth maximization.
 Shareholder wealth is created when the firm makes an
investment that will return more in a present value sense than
the investment costs.
 Capital budgeting is a process of investigation and analysis that
leads to a key financial decision for both purely domestic firms
and MNCs.
INTERNATIONAL CAPITAL BUDGETING

 More broadly, capital budgeting is defined as the process of analyzing

capital investment opportunities and deciding which, if any, to undertake.
 International capital budgeting is very complicated in MNC’s than
domestic companies as they are large and capital intensive.
 Capital budgeting decisions determine the competitive position of the
firm in the product marketplace and the firm’s long-run survival.
 The generally accepted methodology in modern finance is to use the net
present value (NPV) discounted cash flow model.
FACTORS CONSIDERED IN CAPITAL BUDGETING

Common factors:  Project lifetime

 Initial investment  Fund transfer restriction
 Consumer demand  Tax laws
 Price  Social costs
 Variable cost  Required rate of returns
 Fixed cost  Exchange rates
FACTORS CONSIDERED SPECIFICALLY IN INTERNATIONAL CAPITAL
BUDGETING

 1. Exchange rate fluctuations prevailing cash flows

 2. Inflation  8. Government incentives
 3. Financing arrangements  9. Social costs
 4. Blocked funds  10. Threat of expropriation –
 5. Remittance provisions projects of a foreign company
forcibly being taken over by the
 6. Uncertain salvage value host government.
 7. Impact of the project on
FACTORS CONSIDERED IN INTERNATIONAL CAPITAL BUDGETING

 While calculating the cash flows for international capital budgeting the
following accounts must be taken into accounts while calculating the
incremental cash flows.
Cannibalization
 Sometime the new projects causes the existing cash flows to
diminish because of the new projects ;
 these diminish cash flows are considered as the cash out flows for the
new projects and these cash out flows are deducted in the final analysis
;this is known as cannibalization.
 Fees and Royalties
 Some time you have to pay extra fee of license and other royalties
to domestic government these are considered as cash out flows.
 Opportunity Cost
 Sometimes the opportunity cost is also considered as the cash out
flows.
Transfer Pricing
 In the international transfer major portion of some product is
manufactured in some other subsidiary and the host country
little value to finished product.
 The parent country and the host country are involved in
transfer pricing.
 Exchange rate risk - is one of the additional considerations that
has to be taken into account.
 Exchange rate risk refers to the risk that arises due to fluctuations
in the exchange rate between foreign and domestic currency.
 To counteract this risk, at least partly, organization may use various
techniques.
 Particular cash flows can be hedged in the short-term. Further, an
organization can borrow in the foreign market in the foreign
currency to counteract long-term exchange rate risk.
 Political (country) risk is another consideration that must be
taken into account and refers to risks associated with doing
business in particular country.
 Political risks may include difficulties with transferring returns on
investment (repatriating profits) from the foreign country to
domestic due to foreign government’s actions or even
expropriation.
FOREIGN DIRECT INVESTMENT (FDI)

 Foreign direct investment (FDI) is an investment made by

a company or an individual in one country into business
interests located in another country.
 FDI is an important driver of economic growth.
FOREIGN DIRECT INVESTMENT (FDI)

 According to the IMF and OECD definitions, direct

investment reflects the aim of obtaining a lasting
interest by a resident entity of one economy (direct
investor) in an enterprise that is resident in another
economy (the direct investment enterprise).
 The “lasting interest” implies the existence of a long-term
relationship between the direct investor and the direct investment
enterprise and a significant degree of influence on the management
of the latter.
 Direct investment involves both:
 initial transaction establishing the relationship between the
investor and the enterprise and
 all subsequent capital transactions between them and among
affiliated enterprises , both incorporated and unincorporated.
FEATURES OF FDI
• Generally, FDI is when a foreign entity acquires ownership or
controlling stake in the shares of a company in one country, or
establishes businesses there.
• It is different from foreign portfolio investment where the foreign
entity merely buys equity shares of a company.
• In FDI, the foreign entity has a say in the day-to-day operations of
the company.
• FDI is not just the inflow of money, but also the inflow of
technology, knowledge, skills and expertise/know-how.
• It is a major source of non-debt financial resources for the
economic development of a country.
• FDI generally takes place in an economy which has the prospect of
growth and also a skilled workforce.
• FDI has developed radically as a major form of international
capital transfer since the last many years.
• The advantages of FDI are not evenly distributed. It depends on
the host country’s systems and infrastructure.
THE DETERMINANTS OF FDI
The determinants of FDI in host countries are:
 Policy framework
 Rules with respect to entry and operations/functioning
(mergers/acquisitions and competition)
 Political, economic and social stability
 Treatment standards of foreign affiliates
 International agreements
 Trade policy (tariff and non-tariff barriers)
 Privatisation policy
FDI IN INDIA

 The investment climate in India has improved tremendously since 1991

when the government opened up the economy and initiated the LPG
strategies.
 The improvement in this regard is commonly attributed to the easing of
FDI norms.
 Many sectors have opened up for foreign investment partially or wholly
since the economic liberalization of the country.
 Currently, India ranks in the list of the top 100 countries in ease of doing
business.
FDI STATISTICS IN INDIA

 According to the World Bank, India ranked 63rd in 2022 in ease

of doing business across the world among 190 countries,
improving its rank from 142 in 2014
 According to the Department for Promotion of Industry and
Internal Trade (DPIIT), India's FDI equity inflows reached
US$52.34 billion in 2022, marking an increase from the
US$51.34 billion recorded in 2021 but falling short of the
US$64.68 billion recorded in 2020
SECTORS WHERE FDI IS PROHIBITED
• Agricultural or Plantation Activities (although there are many exceptions
like horticulture, fisheries, tea plantations, Pisciculture, animal
husbandry, etc.)
• Atomic Energy Generation
• Lotteries (online, private, government, etc.)
• Investment in Chit Funds
• Any Gambling or Betting businesses
• Cigars, Cigarettes, or any related tobacco industry
• Housing and Real Estate (except townships, commercial projects, etc.)
BENEFITS OF FDI

FDI brings in many advantages to the country. Some of them are

discussed below.
 Brings in financial resources for economic development.
 Brings in new technologies, skills, knowledge, etc.
 Generates more employment opportunities for the people.
 Brings in a more competitive business environment in the country.
 Improves the quality of products and services in sectors.
DISADVANTAGES OF FDI

However, there are also some disadvantages associated with foreign direct
investment. Some of them are:
 It can affect domestic investment, and domestic companies adversely.
 Small companies in a country may not be able to withstand the onslaught
of MNCs in their sector. There is the risk of many domestic firms
shutting shop as a result of increased FDI.
 FDI may also adversely affect the exchange rates of a country.
CROSS BORDER ACQUISITIONS

 Cross-border mergers and acquisitions involve assets and

operations of firms belonging to two different countries.
 Acquisition refer to the purchasing of assets or stocks of part
or all of another firm (or other firms) that result in operational
control of the whole or part of the other firm.
 Mergers describe the case where two separate firms are
combined or amalgamated into a single business.
LEGAL TERMINOLOGY IN THE CROSS BORDER M&A’S

 It involves two countries according to the applicable legal terminology:-

 A.) The state where the origin of the companies that make an acquisition
(the acquiring company) in other countries: – “Home Country”.
 B.) A country where the target company is situated refers to as the
“Host Country”
BENEFITS OF CROSS BORDER MERGERS & ACQUISITIONS
 Expansion of markets
 Geographic and industrial diversification
 Technology transfer
 Avoiding entry barriers & Industry consolidation
 Tax planning and benefits
 Foreign exchange earnings & Accelerating growth
 Utilisation of material and labour at lower costs
 Increased customers base & Competitive advantage
TYPES OF CROSS BORDER MERGERS

 The most popular types of mergers are horizontal, vertical,

market extension or marketing/technology related concentric,
product extension, conglomerate, congeneric and reverse.
 Recently, the concept of inbound and outbound mergers was
also introduced in the Companies Act, 2013 as part of Section
234 of the Act.
FOREIGN PORTFOLIO INVESTMENT (FPI)

 Foreign portfolio investment (FPI) comprises securities and other

financial assets held by investors in a different country.
 It does not present the investor with direct ownership of a
company's assets and is relatively liquid based on the volatility of the
market.
 Along with foreign direct investment, FPI is a common way to invest
in an overseas economy.
 FDI and FPI are both known to be important sources of funding for
most economies.
FPI

 Portfolio investment involves the making and holding a hands-off—or

passive—investment of securities, performed with the expectation of
earning a return.
 In foreign portfolio investment (FPI), these securities can involve
stocks, American depositary receipts (ADRs), or global
depositary receipts of businesses headquartered outside the
investor's nation.
 Holding also encompasses bonds or other debt issued by these
companies or foreign governments, mutual funds, or exchange-traded
funds (ETFs) that invest in assets abroad or overseas.
BENEFITS OF FPI

• Portfolio diversification: FPI enables investors to diversify

their portfolios on the international stage.
• International Credit: FPI can give creditors a large crest
base as it provides access to credit in foreign nations.
• Benefits from the Exchange rates: If an investor has an
FPI in a foreign country with a stronger currency than their
own country, the difference in exchange rates between the
two countries can benefit the investor.
• Feasibility: Foreign Portfolio Investment option is feasible
with retail investors as the amount of money is much less
than that of the FDI and involves simpler legalities in
general.
• Returns: Foreign Portfolio Investments give quicker
returns as compared to that FDI. basically, the investor
can sell his or her portfolio investments as and when
he/she wants on the prevailing prices of that asset.
INTERNATIONAL PROJECT APPRAISAL

 International project appraisal also known by a variety

of names such as internal company analysis, profiling
the organization, capability or resource audit position
and strategic advantage analysis.
 It is the process of evaluating a company’s posture
relative to its business competition within and outside
the country, overall performance and its capability in
terms of strengths and weaknesses.
ISSUES IN INTERNATIONAL PROJECT APPRAISAL

 Appraisal of international projects involve quite a few more

complexities than domestic projects. The variables that are unique
to international project appraisal are as follows :
 a. Cash flows from foreign projects may be subject to various
restrictions that are imposed by the host country.
 b. Initial investment in the host country may benefit from a partial
or total release of blocked funds.
 c. Cash flows from foreign projects must be converted into the
currency of the parent firm.
 d. Cash flows generated from foreign projects may replace revenue
producing exports to the host country.
 e. Profits generated from projects undertaken in other countries are
subject to two taxing jurisdiction: the host country and the parent
country.
 f Profitability of foreign projects may be enhanced from concessionary
financing arrangements and other benefits provided by the host country.
 g. Foreign investment may contribute to the corporate overall strategy of
growth and gaining foothold in markets to prompt competitors.
INTERNATIONAL PROJECT APPRAISAL TECHNIQUES

 It may be mentioned that NPV technique of project appraisal is

as much applicable in cash of international project appraisal as it
is in case of domestic project appraisal.
 However, in view of the unique complexities as indicated above.
 Adjusted Present Value International Project Appraisal I (APV)
technique is found more suitable for appraising international
projects.
ADJUSTED PRESENT VALUE TECHNIQUE

 The Adjusted Present Value is essentially a method which allows

different components of' the project's cash flow to be discounted
separately,
 thus providing the needed flexibility to allow the various variables
and other features of the project to impact the outcome.
 This approach also makes possible the use of different discount
rates for different segments of the total cash flow
 depending on the degree of certainty of the eventual materialisation
of each segment.
INTERNATIONAL FINANCING DECISIONS

 Empirical research shows that MNC financing decisions are

affected by several factors besides cost of capital.
 MNC affiliates’ capital structure is designed to accommodate the
imperatives of tax planning, agency costs, host country political
risk, the level of creditor rights protection, regulatory restrictions
and capital market development in the host country.
 Additionally, as issuer requirements increase, there can also be a
be a shift in preference.
FACTORS AFFECTING FINANCING DECISIONS OF MNC’S

 1. Tax Planning Considerations

 2. Carry Forward of Losses
 3. Protection of Creditor Right
 4. Level of Development of Local Debt Markets
 5. Access to Inter-Affiliate Loans
 6. FDI Restrictions:
 7. Thin Capitalization Rules
 8. Trends in Currency Movements
 9. Exchange Rate Risk
 10. Agency Costs
1. TAX PLANNING CONSIDERATIONS:

 Corporate tax rates vary among countries. When an MNC chooses debt
as a financing source, it will prefer to raise it in a country where the tax
rates are higher.
 Why? Because interest on debt is a tax deductible expense, and
this reduces tax payable.
 Secondly, for a given pre-tax cost of debt, the post-tax cost of debt is
lower in the country with the higher tax rate.
 MNC affiliates in countries such as Japan and Italy, with high corporate
taxes are more highly geared than those in tax havens such as Bermuda
and Barbados.
2. CARRY FORWARD OF LOSSES

 The tax shield on debt reduces tax liability, and increases post tax
profitability.
 But this is an attraction only when the company has pre-tax profits.
 If it has pre-tax profits, any brought forward losses from the earlier
years can be set off against profits so that its tax liability is zero.
 In such a case, the tax deductibility of interest on debt becomes
irrelevant.
 So an MNC affiliate with carry forward losses may not select debt
financing.
3. PROTECTION OF CREDITOR RIGHTS

 In countries that do not have laws that protect creditors’ rights, or

where such laws exist but enforcement is poor, lenders face difficulties
when principal is not repaid.
 Since non-performing assets are likely to be high, lenders build this
into the cost of debt.
 So, interest rates on debt are likely to be higher, since default risk is
factored into the price of the loan.
 The differential between the cost of debt and cost of equity narrows
down, and borrowers are deterred from debt.
 The World Bank publishes a ‘strength of legal rights’ index (SLRI), on a
scale of 1 to 10. A rating of ‘1’ implies poorly designed and weak laws and
a rating of ’10’ implies well designed, strong laws.
4. LEVEL OF DEVELOPMENT OF LOCAL DEBT MARKETS

 An affiliate’s ability to raise debt in the host country depends on

the availability and willingness of investors (institutional and
retail) to subscribe to debt.
 Many emerging markets have underdeveloped debt markets that
run a poor second to equity markets, in terms of issue
volumes, investor interest, trading and liquidity, the
number of domestic institutional investors, and the
absence of credit rating of debt instruments.
 Even in India, more than 90% of corporate debt issues are
privately placed, and retail trading of debt instruments is virtually
non-existent.
5. ACCESS TO INTER-AFFILIATE LOANS

 An affiliate can choose between borrowing money from the capital

market (external borrowing), or from within the group—either the
parent MNC or other affiliates (internal borrowing).
 That is, it can substitute internal borrowing for external borrowing.
 It will choose internal borrowing (from the parent or from another
affiliate) when external borrowing is unavailable, inadequate or more
expensive.
 Since the parent MNC can structure the capital for the entire group of
affiliates, the parent may draw borrowing from affiliates in countries
with strong creditor rights, deep capital markets, and higher tax
regimes.
6. FDI RESTRICTIONS

 FDI ceilings vary between countries and within a country; they can vary
from sector to sector, as well as over time.
 Some countries impose rules specifying that a certain percentage (say
40%) of the project cost must be raised by an MNC affiliate from local
capital markets.
 FDI ceilings specify the maximum equity holding in local companies,
and also the type of debt that forms part of FDI.
 In a host country whose FDI ceiling excludes specific forms of long term
debt, the affiliate may choose such debt to overcome the FDI ceiling.
7. THIN CAPITALIZATION RULES

 Since interest is a tax-deductible expense, MNCs ask affiliates in

countries with high tax rates to lend to affiliates in low tax
locations.
 MNCs raise more debt in high tax countries so that these countries
stand to lose tax revenues.
 To protect themselves against these practices, many countries
impose restrictions on the capital structure choices of MNCs, so as
to limit the interest paid on excess leverage.
 The restrictions are called thin capitalization rules (or earning
stripping rules).
8. TRENDS IN CURRENCY MOVEMENTS

 Exchange rate fluctuations cause uncertainty in future cash

flows, and influence the effective cost of borrowing.
 Suppose the affiliate is located in a country whose currency
consistently depreciated against the US dollar in 2011 and this
trend is expected to continue.
 If the affiliate raises funds in 2012 by issuing three-year dollar
denominated bonds, it will need more of the local currency at
the time of repayment of principal, and for periodic interest
payments.
9. EXCHANGE RATE RISK

 If the affiliate’s revenues are denominated in host country

currency, it makes sense for the affiliate to raise funds
denominated in the same currency.
 Therefore, to avoid currency mismatches (and the
exchange rate risk inherent therein) wherever possible the
affiliate should consider raising funds in the same
currency in which it earns its revenues.
10. AGENCY COSTS

 These are the costs that arise when there is a separation of

ownership and control.
 In a corporate form of organization, the managers are agents the
owners (equity shareholders) and lenders are the principals.
 The principals incur agency costs in order to ensure that the agent
(management) acts in their interest.
 Lenders impose restrictions on management through ‘covenants’
that limit or prevent future borrowing by the company, and restrict
the dividend that the company pays its equity shareholders.