Many organizations charge their finance department with overseeing the financial stability of the organization. The chief financial officer (CFO) may lead a team of financial analysts in determining which projects deserve investment. This process is referred to as capital budgeting. It is an example of how an organization may conduct a cost-benefit analysis. There is a comparison between the cash inflows (benefits) and outflows (costs) in order to determine which is greater. Capital budgeting could be the result of purchasing assets that are new for the organization or disposing some of the current assets in order to be more efficient. The finance team will be charged with evaluating (1) which projects would be good investments, (2) which assets would add value to the current portfolio, and (3) how much is the organization willing to invest into each asset.
In order to answer the questions about the potential assets, there are a set of components to be considered in the capital budgeting process. The four components are initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value technique. Most of the literature discusses how the capital budgeting process operates in the traditional, domestic environment. However, as the world moves to a more global economic environment, consideration needs to be given to how multinational corporations will conduct the capital budgeting process when operating in countries outside their home base.
International Capital Budgeting
International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation. Some of the techniques (i.e., calculation of net present value) are the same as traditional finance. Financial analysts may find that foreign projects are more complex to analyze than domestic projects for a number of reasons. There is the need to distinguish between parent cash flow and projects cash flow. Multinationals will have the opportunity to evaluate the cash flow associated with projects from two approaches. They may look at the net impact of the project on their consolidated cash flow or they may treat the cash flow on a stand-alone or unconsolidated basis. The theoretical perspective asserts that the project should be evaluated from the parent company’s viewpoint since dividends and repayment of debt are handled by the parent company. This action supports the notion that the evaluation is actually on the contributions that the project can make to the multinational’s bottom line. There will also be a need to recognize money reimbursed to the parent company when there are differences in the tax system.
The way in which the cash flows are returned to the parent company will have an effect on the project. Cash flow can be returned in the following ways:
- Dividends—it can only be returned in this form if the project has a positive income. Some countries may impose limits on the amounts of funds that subsidiaries can pay to their foreign parent company in this form.
- Intrafirm debt—interest on debt is tax deductible and it helps to reduce foreign tax liability.
- Intrafirm sales—this form is the operating cost of the project and it helps lower the foreign tax liability.
- Royalties and license fees—this form covers the expenses of the project and lowers the tax liability.
- Transfer pricing—this form refers to the internally established prices where different units of a single enterprise buy goods and services from each other.
Among the other factors that analysts must consider are differences in the inflation rate between countries, given that they will affect the cash flow over time. Also, they must analyze the use of subsidized loans from the host country since the practice may complicate the capital structure and discounted rate. The host country may target specific subsidiaries in order to attract specific types of investment (i.e., technology).
Subsidized loans can be given in the form of tax relief and preferential financing, and the practice will increase the net present value of the project. Some of the advantages of this practice include (1) adding the subsidiary to project cash inflows and discount, (2) discounting the subsidiary at some other rate, risk free, and (3) lowering the risk-adjusted discount rate for the project in order to show the lower cost of debt.
Other steps may include determining if political risk will reduce the value of the investment, assessing different perspectives when establishing the terminal value of the project, reviewing whether or not the parent company had problems transferring cash flows due to the funds being blocked, making sure that there is no confusion as to how the discount rate is going to be applied to the project, and, finally, adjusting the project cash flow to account for potential risks.
- Shahid Ansari, The Capital Budgeting Process (McGraw-Hill/Irwin, 2000);
- Stanley Block, “Integrating Traditional Capital Budgeting Concepts Into an International Decision Making Environment,” Engineering Economist (Winter, 2000);
- Adrian Buckley, International Capital Budgeting (Prentice Hall, 1995);
- Neil Seitz and Mitch Elllison, Capital Budget and Long-Term Financing Decisions (South-Western College Pub., 2004).
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