Capital Budgeting for Multinationals

Topics: Investment, Net present value, International economics Pages: 10 (3315 words) Published: June 8, 2012
Although the original decision to undertake an investment in a particular foreign country may be the outcome of combination of strategic, behavioural and economic considerations, choice of a specific project within a particular product-market posture calls for evaluation of its economic feasibility. For this purpose, capital budgeting exercise has to be done. A firm should deploy funds in a project if the marginal revenue obtained there from exceeds the marginal cost. For an MNC, capital budgeting involves economic analysis of the firm's direct investment opportunities. Whatever be the motive for Direct Foreign Investment (DFI), an MNC's very survival and sustainable competitive position depends on its ability to identify and choose the most profitable investment opportunity. Capital budgeting technique provides the mechanism to identify opportunities and evaluate their economic viability. This is why MNCs evaluate international projects by using capital budgeting techniques. Proper use of capital budgeting techniques can help the firm in identifying the international projects worthy of implementation from those that are not. 13.2 FUNDAMENTALS OF EVALUATING FOREIGN PROJECTS

Once a firm has compiled a list of prospective investments, it uses capital budgeting techniques to select from among them that combination of projects that maximizes the firm's value to shareholders. The theoretical framework involved in evaluation of domestic projects is the same as for foreign projects and various considerations influencing choice of a project within the country are the, same as those for projects overseas. However, there are a host of factors which are unique to foreign investments that make cross-border investment decisions complicated. The basic steps involved in evaluation of a project are:

1. Determine net investment outlay;
2. Estimate net cash flows to be derived from the project over time, including an estimate of salvage value; 3. Identify the appropriate discount rate for determining the present value of the expected cash flows; 4. Apply NPV or IRR techniques to determine the acceptability or priority ranking of potential projects.

As stated earlier, the above evaluation process becomes complicated because of the factors peculiar to international operations. Some of the factors unique to capital budgeting for MNCs are: 1. Conversion of cash flows from foreign projects into the currency of the parent firm; 2. Restrictions on full remittance of cash flows from foreign projects; 3. Exchange Rate fluctuations;

4. Application of different tax rates in the country of the project and in the parent's country; 5. Involvement of royalties and management fees;
6. Amenities and concessions granted by host country;
7. Benefits of international diversification to the shareholders of parent firm; 8. Lost exports;
9. Difficulty in estimating terminal value of foreign projects; 10. Differing rates of national inflation;
11. Knock-on effects of overseas investment projects on other operations elsewhere; 12. Political risk involved in foreign investment.

In view of the above, International finance manager encounters a number of complications in cross-border investment decisions. Overseas investment projects usually involve one or more foreign currencies, multiple tax rates and tax systems and foreign political risk. Overseas investment projects involve special problems, such as capital flow restrictions that do not allow the cash flows of projects to be remitted to the parent company. MNCs also face complexities because overseas investment projects have substantial knock-on-effects on other operations elsewhere within the group. For example, a foreign engineering company contemplating to setup a plant in Mexico may find that the proposed investment is likely to affect the operations of other units within the multinational group. This may occur partly...
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