15.2 International Capital Budgeting

International capital budgeting is crucial for firms operating globally. It involves evaluating projects with cash flows in different currencies, considering exchange rates, political risks, and tax implications. This process helps companies make informed decisions about investing abroad.

Calculating international NPV requires forecasting exchange rates and converting foreign cash flows. Firms must also assess political and country risks, deal with blocked funds, and navigate tax differentials. Real options analysis can provide valuable insights for strategic decision-making in international projects.

Foreign Cash Flows and Exchange Rates

Calculating International Net Present Value

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• International NPV is the net present value of a project with cash flows in multiple currencies
  • Requires forecasting exchange rates and converting foreign cash flows to the domestic currency
  • Discount rate should reflect the risk of the project and the countries involved
• Foreign cash flows are cash inflows and outflows denominated in a foreign currency
  • Need to be converted to the domestic currency using forecasted exchange rates for each period
  • Conversion can significantly impact the NPV calculation (Euro, Yen)
• Exchange rate forecasting involves predicting future exchange rates between currencies
  • Techniques include using forward rates, purchasing power parity (PPP), or econometric models
  • Accuracy of forecasts decreases as the time horizon increases (1 year vs. 10 years)
  • Sensitivity analysis can help assess the impact of exchange rate fluctuations on the NPV

Adjusted Present Value for International Projects

• Adjusted present value (APV) is an alternative to the traditional NPV method
  • Separates the value of the project into its operating cash flows and financing side effects
  • Useful when the project's debt-to-equity ratio differs from the company's target capital structure
• APV involves discounting the operating cash flows at the unlevered cost of equity
  • Financing side effects (tax shields, subsidies) are then added to the unlevered value
  • Allows for more accurate valuation when financing terms vary across countries (interest rates, tax rates)

Risk Assessment

Political and Country Risk

• Political risk refers to the potential for government actions to adversely affect a project's cash flows
  • Examples include expropriation, currency controls, or changes in regulations (tariffs, quotas)
  • Higher political risk increases the required return on the project
• Country risk premium is an additional return required to compensate for the risk of investing in a specific country
  • Reflects factors such as political stability, economic conditions, and legal system
  • Can be estimated using sovereign bond yields or country risk ratings (Moody's, S&P)

Blocked Funds and Repatriation Risk

• Blocked funds occur when a government restricts the repatriation of profits or capital
  • May be due to foreign exchange shortages or political reasons
  • Increases the risk of the project and reduces its expected cash flows
• Strategies to mitigate blocked funds risk include reinvesting profits locally or using transfer pricing
  • Reinvestment can defer repatriation until conditions improve
  • Transfer pricing involves setting prices for goods or services between related entities to shift profits

Tax and Transfer Pricing

Tax Differentials and International Projects

• Tax differentials refer to differences in corporate tax rates across countries
  • Can create incentives to shift profits to lower-tax jurisdictions
  • Need to consider the tax implications of repatriating profits (withholding taxes, tax credits)
• Evaluating international projects requires incorporating the tax effects on cash flows
  • Statutory tax rates, tax holidays, and depreciation rules can vary by country
  • Tax planning strategies (debt financing, transfer pricing) can enhance the project's value

Transfer Pricing and Profit Shifting

• Transfer pricing involves setting prices for transactions between related entities in different countries
  • Can be used to shift profits to lower-tax jurisdictions and minimize overall tax liability
  • Subject to regulations and arm's length principle (prices should reflect market conditions)
• Optimal transfer pricing balances tax minimization with operational efficiency and compliance
  • Requires considering factors such as tax rates, tariffs, and exchange controls
  • Documentation and justification of transfer prices are crucial to avoid penalties

Strategic Considerations

Real Options in International Projects

• Real options are embedded in international projects and provide flexibility to adapt to changing conditions
  • Examples include the option to expand, delay, or abandon the project
  • More valuable in projects with high uncertainty and irreversible investments (natural resources, R&D)
• Evaluating real options requires considering the project's strategic value beyond its NPV
  • Option to expand into new markets or products can justify a negative NPV project
  • Option to delay can be valuable when facing political or regulatory uncertainty (permit approvals)
• Real options analysis involves identifying the key uncertainties and their impact on the project's value
  • Binomial trees or Monte Carlo simulation can be used to model the options and estimate their value
  • Incorporating real options can lead to better decision-making and risk management in international projects