Project Appraisal International Investment

International Capital Budgeting •

Foreign investments generally involve higher risk which arises from factors like change in currency rate, discriminatory treatment of a foreign company, and threat of expropriation. Risk stemming from fluctuations in exchange rate looms constantly on the horizon of foreign investment. In addition, a foreign investment is subject to discriminatory treatment and selective control in various forms motivated mainly by political considerations. Finally, the threat of expropriation without adequate compensation may exist, particularly in countries where radical nationalistic sentiments are strong. • In view of higher risk associated with foreign investment, a a firm contemplating foreign investment would naturally expect a higher rate of return. Put differently, the discount rate applicable to foreign investment is higher than that applicable to domestic investment.

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A higher – than normal required rate of return on multinational investments is often viewed unfavorably by the critics of multinational companies. They hurl accusations of ‘profiteering’ even when the multinational company may simply be following the reasonable financial practice of asking for a rate of return commensurate with the risks characterizing the project. Can there be situations where the demand for higher returns by a multinational company can be unreasonable? Yes, when the multinational company invests in several different economies and enjoys the benefit of risk reduction arising from portfolio diversification. In such a case, it may be possible to reduce the overall risk of the firm’s portfolio of investments even while accepting a project which individually is highly risky. Of course, this depends on the existence of low or negative correlations between the project under consideration and the other projects within the firm’s portfolio of investments.

How to calculate the NPV of an overseas investment proposal: Example: India Pharma Limited, an India - based multinational is considering a project to build a plant in the U.S. The project will entail an initial outlay of $ 100 million and is expected to generate the following cash flows over its four years life. Year Cash flow (in million) 1 $ 30 2 $ 40 3 $ 50 4 $ 60 The current spot exchange rate is Rs. 45 per US dollar, the risk- free rate in India is 11% and the risk-free in the US is 6%. India Pharma’ required rupee rate on a project of this kind is 15%. Should the Company undertake this project?

How is the NPV of such a project calculated? There are two basic ways of calculation: Home Currency Approach

Foreign Currency Approach

*Convert all the dollar cash *Calculate the NPV in dollars flows into rupees ( use (use the dollar discount rate) forecasted exchange rates) *Calculate the NPV in rupees *Convert the dollar NPV into (using the rupee discount rate) rupees (use the spot exchange rate) Home Currency Approach We shall find out the forecasted exchange based on the information by using the following formula: t

Ste = So 1 + rh 1 + rf Where Ste = expected spot exchange rate at time t

So = current spot exchange rate rh = nominal risk free rate in home currency rf = nominal risk free interest rate in foreign currency In our example, So = Rs. 45, rh = 11%, rf = 6%. Hence the forecasted spot exchange rate are as follows: Year 1 2 3 4

forecasted spot exchange rate Rs. 45 ( 1.11/ 1.O6)¹ = Rs. 47.12 Rs. 45 ( 1.11/ 1.O6)² = Rs. 49.35 Rs. 45 ( 1.11/ 1.O6)³ = Rs. 51.67 Rs. 45 ( 1.11/ 1.O6)4 = Rs. 54.11

Using these forecasted rates along with the current spot rate of Rs. 45, we can convert the dollar cash flows into rupees.

Year 0 1 2 3 4

(1) Cash flow in dollar (million) 100 30 40 50 60

(2) Expected exchange rate Rs. 45.00 47.12 49.35 51.67 54.11

(3) Cash flow in rupees (million) (1) x (2) - Rs. 4500 1413.6 1974.0 2583.5 3246.6

Given a rupee discount rate of 15%, the NPV in rupee is: NPV = -4500 + 1413.6 + 1974.0 + 2583.5 + 3246.6 ( 1.15) ( 1.15)² ( 1.15)³ ( 1.15)4 = Rs. 1776.8 million

Foreign Currency Approach To apply the foreign currency approach we have to come up with a risk adjusted dollar discount rate corresponding to the risk adjusted rupee discount rate of 15 %. To do this, we have to first find the risk premium implicit in 15 %:

(1+Risk free rupee rate) (1+Risk free premium) = (1+Risk adjusted rupee rate) ( 1 +0.11) (1+Risk free premium) = ( 1. + 0.15) Hence (1+Risk free premium) = 1.15/1.11 = 1.036 Applying the above risk premium to the risk free dollar rate of 6%, we find that the risk adjusted dollar rate is: (1+ Risk adjusted dollar rate) = (1.06) (1.036) = 1.0982 Given the dollar cash flows, the NPV in dollars works out to: NPV = -100 +

30 + 40 + 50 + 60 (1.0982) (1.0982)² (1.0982) ³ (1.0982)4 = $ 39.484 million Since the spot exchange rate is Rs. 45 per dollar, the NPV of the project is: NPV = 39.484 x Rs. 45 = Rs. 1776.8 million Note: Unremitted Cash Flows There may be substantial differences between the cash flows generated by a foreign project and the amount that can be remitted to the parent firm because many governments put restrictions on remittances. Funds that cannot be currently remitted are referred to as blocked funds.

Example for practice: BIL is evaluating an overseas investment proposal. It is planning to build a plant in U.K. The project will entail an initial outlay of £ 50 million and is expected to generate the following cash flows over its four year life. Year Cash flow ( in million) 1 £ 20 2 £ 30 3 £ 20 4 £ 10 The current spot exchange rate is Rs. 70 per British Pound (£), the risk free rate in India is 10% and risk free rate in U.K. is 6%. BIL’s required rupee return on a project of this kind is 20%. What is the NPV of the project? Use the home currency approach. (Ans. Rs. 576.1 million)