International Project Appraisal (International Capital Budgeting)

Capital Budgeting Techniques

NPV = summation of PV of Cash-Inflows – Cash outflows
NPV – Positive
Negative

Differences bw Domestic and International Capital Budgeting

- Political risk of operating
- Uncertainties w.r.t culture, norms
- Working conditions, labour laws – productivity, minimum wages
- Productivity = output/input = No of units * SP /MC + IL + CE
- Availability of technical manpower (Skilled Labor), expertise
- Greater hurdles by the government agencies
- Different legal, taxation, regulation (labor unions)
- MNC export – related procedure, EXIM policy, remittances that MNC
- Availability loan concessions, tax breaks,
- Exchange rate determination

Projection of Cash Flows

EBDIT
Free Cash Flow = EBIT(1-T) + Depreciation -Capital Expenditure – Increase in Working
Capital
FCF = EBIT (1-T) + D – CAPEX – Change in WC

Discounting Rate - Home currency, Foreign Currency

CF/ (1+ rh) CF/(1+rf)
F/S = (1+rh)/(1+rf)

10 Mn -loan-14%, Cash – 15%, rf + risk premium = 7% + 13%= 20%

Interest rate – real and nominal rate (Inflation rate)

Capital Budgeting Proposal

1. Initial capital outlay (Initial Investment or Cash outflow)
2. Projection Cashflows for the estimated life of the project
3. Estimation of salvage value or terminal value
4. Arrive a suitable discounting factor – Cash Inflows(Future)
5. Arrive at the NPV
Net Present Value
1. Flow of Equity (FTE) – discounting factor – Cost of Equity ke
2. Weighted Average Cost of Capital (WACC) - WACC – Equity +
Debt – Ke & Kd , We and Wd [WACC= Ke*We + kd*Wd(1-T)]

Method Cashflows Discount rate

WACC Method Cashflow for all WACC
investors
PBIT(1-T) + D + Non-
cash Expenses -
Capital Expenditure -
increase in WC
Flow of Equity Cashflows to equity Cost of Equity
(FTE) or Equity investors
Residual PAT
Method + Depreciation
+ Non-Cash expense
- Capital Expenditure
– Repayment of Debt
– Increase in WC

3. Adjusted Present Value (APV)

Review of Net Present Value Framework

a) Under Flow to Equity (FTE) approach the cash flows accruing to equity holders are
discounted at cost of equity to get the present value of cash inflows. To arrive at NPV
we subtract the initial outlay contributed by equity holders
b) Under WACC approach cashflows accruing to equity as well as debt holders are
discounted at weighted average cost of capital to get present value of the cash
inflows of the project. To arrive at the NPV we subtract the total cost of project.
Illustration
Assume a project costs Rs 450 million that generates earnings before depreciation, interest
and Taxes (EBDIT) of Rs 120 million
Cashflow Rs millions
Earnings before Depreciation, Interest, and Taxes (EBDIT) 120
Depreciation, d 20
Earnings before Interest and Taxes (EBIT) 100
Interest I (8% of 250) 20
Earnings before Taxes 80
Taxes T @ 40% 32
Profit after Taxes 48

Solution:
Cash Flow to Equity Holders = PAT + Depreciation = 60 + 20 = Rs 80 Million
Cash Flow to Equity Holders = EBIT(1-T) + Depreciation = 100 *(1-0.4) + 20 = Rs 80 Million
Cash Flow to equity Holders = EBDIT(1-T) + d*T = 120*(1-0.4) + 20 * 0.4 = Rs 80 Million
Present value of cash flow to Equity holders
= Cash flow to Equity Holders/ Cost of Equity = 80 mn/ 0.16 = 500 Mn
PV of the Cash Inflows = Value of the Firm is Rs 500 mn
Cash outflow = Rs 450
NPV = Rs 500 – 450 = 50 Mn

Scenario: Debt is introduced 50 % of Debt at 8% , D/E = 1

VL = VU + T*D = 500 + 0.4 * 250 = 600
Ke = Ko+ (Ko-Kd) (1-T) D/E = 16 + (16-8) *(1-0.4)*1= 20.8%

PV of Cash flow to equity holders = (48 + 20) /0.208 = 326.92 Million

Initial investment through equity = cost of the project – debt

financing = 450 – 326.9 = 123.08
NPV = 326.9 – 123.08 = Rs 203.84 + Tax Shield (0.4 * 326.9) =
334.608

WACC = Ke * We + Kd *(1-T)*Wd = 20.8 *0.5 + 8*0.6*0.5 = 12.8

PV of Cashflows = 80 /0.128 = Rs 625 Mn

NPV = 625 – 450 = Rs 175 Mn
ABC limited is evaluating a project costing Rs 800 lakh, which is expected to give earnings
before interest and Tax of Rs 200 lakh, per annum. Assume no depreciation or any other
non-cash expense and the firm faces a tax rate of 40%
a. Using WACC of 12%, Find the NPV of the project
b. Assuming that the project is funded through perpetual debt of Rs 400 lakh, (50% of
the original cost) at 10%, re-compute the NPV of the project using Flow of Equity
method.
Solution:
a.
WACC
Earnings Before Interest and Tax 200
Taxes @40% 80
Earnings after tax 120

PV of the Cash Inflows = 120/ 0.12 = 1,000

NPV = PV of the Cash Inflows – Cash outflows = 1000 – 800 = Rs 200 lakh

b. Using Flow to Equity Approach

Value of the Firm = 400 + 400 + addition of NPV = 800 + 200 = Rs 1,000 lakh

WACCn = Ke * 0.6 (600/1000)+ 10* 0.6 * 0.4 (400/1000) = 12

Ke = 12 – 2.4 = 9.6/0.6 = 16%

EBIT 200
Int on Debt(10% of 400) 40
EBT 160
Tax (40%) 64
EAT 96

PV of Cash flow of Equity = 96/ 0.16 = 600 Mn

NPV = 600 – 400 = 200 lakhs
 1. Ran Pharma an Indian based MNC, is evaluating an overseas investment proposal.
Ran pharma’s exports of pharmaceuticals product have increased to such an extent
that it is considering a project to build a plant in US. The project will entail an initial
outlay of $ 100 Mn and is expected to generate the following cashflows for four
years
Year Cash Flows (in $ Million)
1 30
2 40
3 50
4 60
The current exchange rate is Rs 75 per US$, the risk free rate in India is 11% and the
risk free rate in US is 6%. Ran Pharma’s requires rupee return on the project of this
kind is 15%. Should Ran Pharma undertake the project.
Solution:
Home Currency Approach (India)

F/S = (1+ rh)/(1+rf)

F / 75 = (1+0.11)/(1+0.06)
F1= 1.11*75 /1.06 = 78.5
F2 = (1.11/1.06)^2* 75 = 82.24
F3 = (1.11/1.06)^3* 75 = 86.121
F4 = (1.11/1.06)^4* 75 = 90.184

Year Cash FR Expected PV @ 15% PV of Cash Flows

Flows Cash in Rs
(in $
Million)
1 30 78.5 2355 0.869 2046.495
2 40 82.24 3289 0.756 2486.484
3 50 86.121 4306 0.657 2829.042
4 60 90.184 5410 0.571 3089.11

PV of Cash Inflow = 10,451.12

Cash outlay = 100 $ * 75 = 7500
NPV = 10,451.12 – 7500 = 2,951.1

Foreign Currency Approach

Step 1
Find risk premium in 15%
(1 + Risk Free rupee rate )(1+Risk Premium) = (1+ Risk Adjusted Rupee rate )
( 1+ 0.11) (1+ Risk Premium) = (1+ 0.15)
(1 + Risk Premium) = 1.15 /1.11 = 1.036
Risk Premium = 1.036 -1 = 0.036 = 3.6%
 Step 2
Using the Risk premium calculated calculate the Risk Free Dollar rate
(1 + Risk Free dollar rate)(1+Risk Premium) = (1+ Risk Adjusted Dollar rate )
(1+ 0.06) (1+0.036) = (1+ Risk Adjusted Dollar rate)
Risk Adjusted Dollar rate = 1.098 -1 = 0.0982 0r 9.82%

Year
Cash PV @ PV of Cash Flows
Flows 9.82%
(in $
Million)
1 30 0.910 27.3
2 40 0.829 33.16
3 50 0.755 37.75
4 60 0.688 41.28
PV of Cash Inflows =$ 139.49 Mn
Cash outlay = $100 Mn
NPV = 39.49 Mn * 75 = 2961.75

Gullit Inc is considering a new plant in Netherlands, which will cost 26 million guilders.
Incremental cashflows are expected to be 3 million guilders per year for the first three
years, 4 million guilders the next three, 5 million guilders in year 7 through 9 and 6 million
guilders in years 10 through 19, after which the project will terminate with no residual
value. The present exchange rate is 1.90 Guilders per $. The required rate of return on
repatriated dollars is 16%
a. If the exchange rate stays at 1.90, what is the project NPV
b. If the guilder appreciates to1.84 for years 1-3, to 1.78 for years 4-6, to 1.72 for
years 7-9 and to 1.65 for years 10-19, what happens to NPV

Solution:
Cash Flows (in Millions)
Year 0 1-3 4-6 7-9 10-19
Cashflow in -26.0 3.0 4.0 5.0 6.0
Guilders
G/$ 1.90 1.90 1.90 1.90 1.90
Cashflows in $ -13.68 1.58 2.11 2.63 3.16
PV -13.68 2.242 1.438 0.922 1.27

t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
1/(1.16) 0.741 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 .19 0.168 0.145 0.125 0.108 0.093 0.080 0.069 0.060
=0.86 5

NPV @ 16 % = -13.68 + (1.58*2.242 + 2.11 * 1.438 + 2.63 * 0.922 + 3.16 * 1.27 )

= -13.68 + ( 3.542 + 3.034 + 2.424 + 4.013) = -13.68 + 13.014 = -0.665
 Cash Flows (in Millions)
Year 0 1-3 4-6 7-9 10-19
Cashflow in -26.0 3.0 4.0 5.0 6.0
Guilders
G/$ 1.0 1.84 1.78 1.72 1.65
Cashflows in $ -13.68 1.630 2.25 2.91 3.64
PV -13.68 2.242 1.438 0.922 1.27

t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
1/(1.16) 0.741 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 .19 0.168 0.145 0.125 0.108 0.093 0.080 0.069 0.060
=0.86 5

NPV @ 16 % = -13.68 + (1.84*2.242 + 1.78 * 1.438 + 1.72* 0.922 + 1.65 * 1.27)

= -13.68 + ( 4.125 + 2.559 + 1.585+2.095)= -13.68 + 10.364 = -3.316

Worldwide Inc is proposing to construct a new plant in Europe. The two prime candidates
are Germany & Switzerland. The forecasted cashflows from the proposed plants are as
follows
Details C0 C1 C2 C3 C4 C5 C6 IRR (%)
Germany -60 10 15 15 20 20 20 18.8
(millions
Euro)
Switzerland -120 20 30 30 35 35 35 12.8
(Million SFr)
The spot rate for euro is $1.3/Euro. The spot rate for SFr is Sfr 1.5 /$. US interest rate is 5%
& Swiss interest rate is 4% & Euro countries interest rate is 6%. The finance manager has
suggested that, if the cash flows were stated in dollars, a returning excess of 10% would
be acceptable. Should the company go ahead with either project?

Solution
Details C0 C1 C2 C3 C4 C5 C6 IRR(%)
Germany -60 10 15 15 20 20 20 18.8
(millions
Euro)
Forward 1.2877 1.2754 1.2632 1.2511 1.2392 1.2274
Rate
Cashflows in 12.877 19.131 18.948 25.022 24.784 24.548
$
PV 1/ 0.8264 0.7513 0.6830 0.6209 0.5644
(1.10)
0.909
NPV -60 11.705 15.809 14.235 17.09 15.388 13.854
Switzerland -120 20 30 30 35 35 35 12.8
(Million SFr)
FR 1.514 1.528 1.542 1.557 1.572 1.587
Cash flows in -120 13.21 19.633 19.455 22.479 22.264 22.054
SFr
PV 1/ 0.8264 0.7513 0.6830 0.6209 0.5644
(1.10)
0.909
NPV -120 12.007 16.224 14.616 15.347 13.823 12.447
F 1= (1+rh)/(1+rf) * S = (1+0.05)/(1+0.06) * 1.3 = 1.2877
F 2 = 1.05/1.06 *1.2877 = 1.2754
NPV for Germany = -60 + 88.099 = $ 28.08
NPV for Switzerland = -$ 120 + 84.464 = $ - 35.53
IRR > Acceptable Return (10%)

Adjusted Present value (APV): Business Risk and Financial Risk – FTE and WACC
1. Differences in cashflows – remittances, payment of dividend, transfer pricing laws
2. Differences in capital structure – debt -equity
3. Political risk – inflation rate,
4. Differences in Risk
5. Financing – Debt rate
APV = Present value of investment outlay + Present value of Operating Cash inflows +
Present value of Interest tax Shield + Present value of interest subsidies
APV there are two category cash flow – Real Cashflows (Revenue) , Additional ( value of
Interest tax shield , subsidized financing

Step. 1: Calculate NPV for un-leveraged Project (NPV)

Step 2: calculate the NPV for the financing side (NPVF)
Step 3: Add step and Step 2.
APV = NPV + NPVF
 a. To determine the NPV of the project
All figure are in Million FF
Particulars Year 1 Year 2 Year 3
Total Revenue 24 32.5 42
Less: Fixed Cost 5 5 5
Less: VC 1 1.5 2.4
Less: Depreciation 6 6 6
EBIT 12 20 28.6
Less: Interest paid 1 1 1
@10%
EAT 11 19 27.6
Add: Depreciation 6 6 6
Net Cashflow 17 25 33.6
Salvage Value 42.0
Total Cash Flow 17 25 75.6
Less Withholding 1.7 2.5 7.56
Tax @10%
Net Remittance 15.3 22.5 68.04
PV @15% 0.869 0.7561 0.6575
PV in FF 13.2957 17.0122 44.7363
Forward Rate 0.22 0.25 0.28
PV($) 2.9250 4.2530 12.5261

NPV = PV of the Cash Inflows – PV of the Cash outflow = (2.9250+4.2530 + 12.5261) -12
= $ 7.7041 Mn
b.

Net Cashflow 18 26 34.6

Salvage Value 42.0
Return of working 10.0
Capital
Total Cash Flow 18 26 86.6
Less Withholding 1.8 2.6 8.66
Tax @10%
Net Remittance 16.2 23.4 77.94
PV @15% 0.869 0.7561 0.6575
PV in FF 14.0778 17.6927 51.2455
Forward Rate 0.22 0.25 0.28
PV($) 3.0971 4.4231 14.3487

NPV = PV of the Cash Inflows – PV of the Cash outflow = (3.0971+4.4231+14.3487) -12

= $ 9.8628 Mn
c.
d.
1 2 3
Net Remittance before Interest 16.2 23.4 77.94

Net Remittance 16.2 23.4 77.94

Net remittance after 17.496 25.27 77.94
reinvested
PV @15% 0.869 0.7561 0.6575
PV in FF 15.204 19.1066 51.2455
Forward Rate 0.22 0.25 0.28
PV($) 3.3448 4.7766 14.3487

NPV = (3.3448 + 4.7766+14.3487) – 12 = $10.47

e.

Net Cashflow 17
Salvage Value
Total Cash Flow 17
Less Withholding 1.7
Tax @10%
Net Remittance 15.3
PV @15% 0.869
PV in FF 13.2957
Forward Rate 0.22
PV($) 2.9250
Salvage 30
Total remittance 32.9250
PV($) 28.612
Outflow 12
NPV 16.612
Adjusted Present Value Method

An Indian firm DVS Limited (DVS) is a leading manufacturer of two-wheeler automobiles in

India. Besides having a dominant position in the local markets of India DVS is also very active
in export markets. In view of high population density and congested roads, DVS believes
that Bangladesh would constitute a major market for two-wheeler in times to come.
Presently they are exporting motorcycles to Bangladesh. In the current year, they expect to
export 5,000 vehicles there. This market is growing at about 5% per annum due to import
regulations prevailing in Bangladesh. Dealers are constantly asking for faster deliveries.
According to them current level of exports to Bangladesh indicates an acceptance of the
product.
With strong similarities in the consumer preferences in India and Bangladesh, DVS believes
that are very well placed to capture a better market share by expanding their presence. The
current regulation in Bangladesh for importing vehicles is containing the market growth to a
modest level of 5%. With proximity in India and opportunities available they need to with in
the scope and graduate from mere exporter so a producer by establishing a manufacturing
facility in Bangladesh. Besides overcoming the import regulations, this would help in
expanding market and improving profit margin.

Project Details and Features

A strategic team of DVS has drawn up a detailed plan to set up a project to produce
motorcycles in Bangladesh. The select data is given as follows:
At Today’s Value In Bangladesh Taka (BDT)
Capital cost of the project 1,000,000,000
At Year 1 Value In Bangladesh Taka (BDT)
Expected price per Vehicle 40,000
Cost of production per vehicle 32,000
Cash flow per vehicle 8,000
During the first year of its operation DVS targets to produce 20,000 vehicles. The market for
motorcycles in Bangladesh is growing at handsome rate of 12% per annum and width
accepted product already in the market DVS too would grow at the same rate. Ramping up
of the capacity and production there of would post much constraint.
The current exchange rate is BDT 1.40 per Indian rupee (INR). The inflation rate in India and
Bangladesh are 8% and 11% respectively. Though there exist currency controls in
Bangladesh the future exchange rate are expected to follow inflation rates. Accordingly, the
prices, cost of production, and cashflows can be increased in accordance with the inflation
rates in Bangladesh.
The marginal rate of taxation in Bangladesh is same as that of India. The marginal tax rate is
35% in both the countries. Double taxation Avoidance Treaty between the two nations
permits credit for tax paid in one country to another. The rates of depreciation permit
Straight Line method (SLM). The planned horizon for the project is eight years and salvage
value is negligible. Based on SLM, depreciation of BDT 12,50,00,000 ca be claimed.
DVS intends to fund the project in Bangladesh by internal accruals except for availing the
concessional loan that Bangladesh government is offering. The headquarters of DVS in India
believes that the total cost of BDT 1,000 million 25% is readily available by way of debt but
does not want to avail such loans. It perhaps would utilize such borrowing capacity in
Bangladesh for expansion of the same project or some other project in future.
At present DVS has funds of BDT 70 million locked up in Bangladesh on account of
motorcycles supplied which it tends not to remit and instead use it towards meeting capital
expenditure of the proposed project. It is required to pay only 20% tax on these funds if
retained in Bangladesh. If repatriated, then the sum would be subject to usual tax rate of
35%.
The concessional loan of BDT 100 million is available at concessional rate of 8% against
normal commercial rate of 14% that would be applicable to DVS if it were to mobilize such
loan from the market. The loan is repayable in eight annual equal instalments.
Other important features of the project include royalty payment of 1% of sales. The project
in Bangladesh would require the engine is Rs 5,000. It provides 10% cash profit to DVS.
These profits generated from exports are subjected to reduced rate of tax of 10% against
usual 35%. These profits generated from exports are subject to reduced rate of tax of 10%
against usual 35%.
We are required to find the desirability of implementation of the project in Bangladesh.

A UK multinational wants to evaluate the present value of a loan denominated in Australian

dollars. It prefers to evaluate the Australian dollar debt using the typical decentralized
technique in which the Australian dollar cashflows are discounted and then converted to US
$ at the prevailing spot rate. The spot exchange rate is currently 1 pound/2.15A$. The firm
is considering four0year debt in the amount of A$ 12,50,000 at an interest rate of 2%. The
loan structure provides for payment of interest and repayment of all principal in one lump
sum four years from now. The corporation tax rate is 34%, and the firm will be able to
realize all benefits of the tax-related debt shield. The cost of borrowing fort fin US dollars is
12.5%.
The risk-free rate interest rate in the UK is 10% and te risk free parity rate in Australia is 20.5
pent. If the firm decides to use uncovered interest parity to form expectations of future spot
exchange rates, calculate the fur year-ahead forecast.
a. W the present value of the Australian dollar financing using the decentralized
technique
b. IF the firm decides to used a centralized technique, in which the Australian dollar
cashflow are converted to U.K pounds and subsequently discounted at he U.K pound
cost of debt. If the firm uses uncovered interest rate parity in the risk-free deposit
markets to forecast future exchange rates, what is the present value of the loan
calculated to be?