International Project Appraisal

International Project AppraisalBy: Somya Agrawal Sonam Agrawal Laxmi Nandwani IntroductionThe 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 AppraisalForeign Exchange RiskRisk 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 shouldEstimate the inflation rate in host countryThe cash flows in terms of local currencyAdjust the cash flows for inflationConvert the cash flows into parent country currency according to the expected depreciation or appreciation rate calculated on the basis of PPP.Remittance RestrictionsMany 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 IssuesFor 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 FlowsSubstantial 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 flowsThe 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 companyCash 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 ProjectsFinancing ArrangementsThe 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 FundsBlocked 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.INFLATIONThe 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 flowInaccurate 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 valueThe 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 riskCash 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 uncertaintiesAdjusting 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.THANK - YOU