NPTEL

International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Module - 39
International Capital Budgeting

Developed by: Dr. A .K .Misra

Assistant Professor, Finance
Vinod Gupta School of Management
Indian Institute of Technology
Kharagpur, India
Email: arunmisra@vgsom.iitkgp.ernet.in

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

International Capital Budgeting

Learning Objectives:
The present session discusses about international capital budgeting. It outlines the differences
between domestic capital and international capital budgeting.

Highlights & Motivation:

In this session, the following details about management of transaction exposure are discussed.

Net present Value and its drawbacks

Adjusted Net Present Value

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

1. Introduction
Capital budgeting evaluates the investment decisions related to assets. The "capital" in capital
budgeting refers to the investment of resources in assets, while the budgeting refers to the
analysis and assessment of cash inflows and outflows related to the proposed capital investment
over a specified period of time. Objectives of capital budgeting is to (1) determine whether or
not a proposed capital investment will be a profitable one over the specified time period, and, (2)
to select between investment alternatives. Capital budgeting at the international level
addresses the issues related to (1) exchange rate fluctuations capital market segmentation,
(2) international financing arrangement of capital and related to cost of capital, (3)
international taxation, (4) country risk or political risk etc.
Present Session discussed about the evaluation international project and Foreign Direct
Investment Proposals.

2. Capital Budgeting: Net Present Value Approach

The investment decisions of a firm are generally known as the capital budgeting, or
capital expenditure decisions.
Investment Decisions: Expansion, Acquisition, modernisation and replacement
Investments lead to Exchange of current funds for future benefits.
The funds are invested in long-term assets so as to create cash inflows over a long period.
The future benefits will occur to the firm over a series of years.

Three steps are involved in the evaluation of an investment proposal:

Estimation of cash flows
Estimation of the required rate of return (the opportunity cost of capital)
Application of a decision rule for making the choice
Any investment should increase shareholders value. It should recognise the fact that bigger cash
flows are preferable to smaller ones and early cash flows are preferable to later ones. It should
help to choose among mutually exclusive projects that project which maximises the
shareholders wealth.
Cash flows of the investment project should be forecasted based on realistic assumptions.
Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the projects opportunity cost of capital.
Present value of cash flows should be calculated using the opportunity cost of capital as
the discount rate.
The project should be accepted if Net Present Value is positive (i.e., NPV > 0).

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Net present value should be found out by subtracting present value of cash outflows from present
value of cash inflows.
C1
C3
Cn
C2
NPV =
+
+
+"+
C0
2
3
(1 + k )
(1 + k ) n
(1 + k ) (1 + k )
n
Ct
NPV =
C0
k )t
(1
+
t =1

Acceptance Rule:

NPV: +: Accepted,
NPV: - : Rejected
NPV: 0: May be accepted or rejected

Higher NPV consider for mutually exclusive projects. NPV is most acceptable investment rule
for the following reasons:
Time value of money is recognised by discount rate
Measure of true profitability
Shareholders value maximised
The discount rate used in NPV is the opportunity cost or the WACC.
Kw = Ke +Kd(1-)(1-t)
In the above case it is assumed that
Business risk of the project is same as the firms current business risk
Debt-Equity ratio remains the same throughout the project period.
Since the above two assumptions are not true, the discount rate is not valid and hence the process
of evaluation is not correct. Hence, in place of NPV, an Adjusted NPV is used with following
corrections;
Project evaluation is carried out with Cost of Equity of the firm
Present value of any cash flows such as subsidies, external financing etc., would be
factored using special discount rates.

Example
Wipro is planning to start a wholly own subsidiary in Bangladesh to produce and sale Computer.
It is planning to invest BDT 60,000,000. The plant would be operational within one year and it
would have production capacity of 200,000 units per year and it would continue for 5 year as the
company kept a vision for this. The company is expected to sell computer in Bangladesh at a
price of BDT 22,000 per unit. Operating cost per unit is BDT 18,000 and Wipro is expecting an
opportunity cost of 18% from the new investment. The company has fixed depreciation 20% at
straight-line method. The project further also provides following information

The Company has accumulated balance BDT 2,000,000 in a local bank because of export
to Bangladesh. Its withdrawal would attract a tax of 55%.
Wipro domestic location would provide the Chips for the computer which cost BDT
4000 per piece which has variable cost of production BDT 2600.

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Bangladesh government permits 2% of sales as royalty payment it is tax deductible. This

income in India considered as technology export and hence in place of 35% tax it
would attract 20% tax.
Carry out the appraisal for the project.

Answer
Net Present Value estimation
Revenue: Per unit price * Number of Unit sell
Operating cost: Per unit operating cost * Number of unit produce
Profit before tax : Revenue Operating cost Depreciation
Profit after tax : Profit before tax (1- 55%)
Cash inflow : Profit after tax + Depreciation
Discounted Cash inflow: Each year CF is discounted by opportunity cost (18%)
Net Present Value : Discounted Cash Flow Initial Investment
Year >

200000

200000

200000

200000

200000

3600000000

3600000000

3600000000

3600000000

3600000000

4400000000

4400000000

4400000000

4400000000

4400000000

12000000

12000000

12000000

12000000

12000000

Profit before tax

Profit After Tax
(40%)

788000000

788000000

788000000

788000000

788000000

472800000

472800000

472800000

472800000

472800000

Cash Flow
Discounted Cash
Flow

484800000

484800000

484800000

484800000

484800000

410847458

348175812

295064247

250054447

211910548

Plant Investment

0
60000000

Units sell
Operating cost
( BDT 18,000
per Unit)
Revenue ( BDT
22,000 Per Unit)
Depreciation
(20%)

Total DCF
Total Outflow
NPV

1516052511
60000000
1456052511

Adjustment
Blocked Funds
Accumulated Funds: BDT 2,000,000
Withdrawal tax : 55%
Amount to be credited to NPV : BDT 2,000,000(1-55%): BDT 900000

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

Spare parts
Wipro domestic location would provide the Chips for the computer : BDT 4000 per piece
Variable cost of production: BDT 2600
Cost difference per unit : BDT 1400
Total cost difference per year for 2000000 unit: BDT 280000000
Risk cost of discount: 6% (Assumption)
NPV increased: BDT 1179461860
Royalty Payment
Bangladesh government permits 2% of sales as royalty payment it is tax deductible. This income
in India considered as technology export and hence in place of 35% tax it would attract 20%
tax. Total tax savings each year would be 55% in Bangladesh and 15% in India.
Adjustment
Blocked Funds
Opportunity cost of using
NPV increased
Spare parts
Chip domestic price
Variable cost
Cost difference per unit
Cost difference 2000000
units per year
Risk cost
NPV
NPV increased
Royalty Payment
2% of Sales
Tax (55% corporate tax)
in Bangladesh
Transfer to India as
Royalty
Tax in India (35%)
Tax actually paid (20%)
Tax savings
Risk cost
NPV
NPV Increased
Total NPV for
international project

2000000
55%
900000
4000
2600
1400
280000000
6%

Yr 1
264150943

Yr 2
249199003

Yr 3
235093399

Yr 4
221786226

Yr 5
209232288

88000000

88000000

88000000

88000000

88000000

48400000

48400000

48400000

48400000

48400000

39600000
30800000
17600000
61600000
Yr 1
58113208

39600000
30800000
17600000
61600000
Yr 2
54823781

39600000
30800000
17600000
61600000
Yr 3
51720548

39600000
30800000
17600000
61600000
Yr 4
48792970

39600000
30800000
17600000
61600000
Yr 5
46031103

1179461860

6%
259481609
2895895980

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NPTEL
International Finance
Vinod Gupta School of Management, IIT. Kharagpur.

References

International Finance, Thomas J.OBrien, Oxford Higher Education, 2edition

International Financial Management, P.G.Apte, McGraw-Hill, 5edition

Model Questions
1. Write in details the shortcomings of NPV method while evaluating capital budgeting for
international project.
2. What are the adjustments needed in NPV for making it suitable for evaluation of
Year

international

After Cash Flow (Euro)

-1550

450

675

825

budgeting decisions.

capital

3. Inflation in US is 6.50% and that of Euro-zone is 3.75%. The current spot rate is
Euro 1= US$1.26. Expected opportunity cost for the MNC in dollar term is 12%.
Evaluate the project if the after tax cash flows are in the following pattern:

Answer for 3
CF in
Year Euro
CF $
DCF $
0
-1550
-1953
-1953
1
450
582
520
2
675
896
714
3
825
1124
800
NPV

81

St($/) = {(1 + $) /(1 + )}t *1.26

CFt = St($/) *CFt in Euro

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