Overseas projects in general, and global projects in particular throw up unique issues in coordination, management and control, arising from behavioural, cultural, regulatory, and political differences. There is the added problem of teams working in different time zones and the project’s ‘public visibility’ especially if it was given the green signal by the host country’s government in the face of public opposition. International project management incorporates all these aspects.
Lessard (1979) identified some unique features of an overseas investment proposal that do not crop up in a domestic capital budgeting proposal:
i. The project may displace exports.
ii. The cash flows may be denominated in foreign currency.
iii. Some expenses and revenue streams require estimation (based on forecasts) while others are known in advance, so their riskiness varies.
iv. The host country may offer concessionary loans.
v. There may be repatriation restrictions, and
vi. There may be inter-affiliate transactions.
Home country – The country of the parent company.
Host company – The country where the project is to be located.
1. Degrees of Risk in Cash Flows:
The computation of cash flows after tax (CFAT) involves an estimation of projected revenues over the life of the overseas project, and the annual depreciation and interest expenses. Since the financing decision (debt or equity) and the depreciation method are determined by the company, depreciation and interest expense per annum are known at the beginning of the project itself, as are the depreciation shield and the interest shield.
Therefore, they are not risky components. Projected revenues over the life of the overseas project are difficult to predict. They will vary based on the prices of inputs, prices of competing products and changes in demand and supply. So, projected revenues are risky when compared to the depreciation shield and the interest shield.
2. Impact on Other Subsidiaries:
The proposed overseas project might affect t other subsidiaries in the region. The interdependent nature of the MNC very careful calculation of the ‘incremental’ nature of cash flows to the entire group rather than to one subsidiary alone. When calculating the incremental revenues, reduction in sales revenues due to the commissioning of the project must be taken into account.
3. Restrictions on Repatriation of Profits:
The host country may not permit the remittance of all revenues earned from the project. Suppose only 60% of the earnings are allowed to be repatriated, then the question arises as to whether the entire amount should be considered while evaluating the proposal or just the remittable earnings.
4. Estimation of Future Exchange Rates:
The project is evaluated from the parent MNC’s point of view. If the initial cash outlay and subsequent after-tax cash flows of the overseas proposal are denominated in foreign currency, they have to be expressed in the parent MNC’s home currency before the evaluation technique can be applied. Since cash inflows are generated over a number of years, exchange rate forecasting is required to estimate the exchange rate at the end of each year of the project’s life. The accuracy of the forecasts of future exchange rates is critical to the evaluation of an overseas proposal.
Future exchange rates can be estimated by using forecasting models, or by using the purchasing power parity (PPP) theory. As long as exchange rates are fairly stable, the PPP theory offers a reasonable approximation of exchange rates.
5. Selection of the Tax Rate:
The corporate tax rate in the parent company’s home country is unlikely to be the same as the tax rate in the host country. The choice of the tax rate will affect the size of the after-tax cash flows. If the corporate tax rate in the home country is 33% and that in the host country is 25%, which tax rate ought to be used in determining the after tax cash flows?
6. Incentives Offered by the Government in the Host Country:
Very often countries compete to attract FDI. One of the inducements by host countries is the offer of financing at a rate well below market rates, through concessional or subsidized financing. This must be incorporated into the evaluation process.
7. Appropriate Discount Rate:
The discount rate is the weighted average cost of capital (WACC) that is used to determine the present value under DCF methods of evaluation. The cost of equity (ke) for the parent MNC’s domestic capital budgeting proposal is calculated is based upon beta – the measure of systematic risk in the Capital Asset Pricing Model (CAPM) —using the price series of equity on a stock exchange in the parent MNC’s home country.
Systematic risk in the home country may not be identical to that in proposed host countries. Though theory suggests that an international beta should be used for calculating the cost of equity in an overseas capital budgeting proposal, empirical evidence indicates that the ‘domestic’ beta value is almost identical to an international beta value.
The discount rate should be uniform for all overseas projects being evaluated irrespective of the financing decision, and the proportions of debt and equity. But the WACC will vary depending upon where the funding for the project is raised (since component costs of capital vary across countries) and the proportion of debt and equity (since debt is cheaper than equity).
Therefore, aspects of the financing decision, such as where the project cost is being raised (the host country or the home country), the capital structure (project cost being raised solely through debt for tax planning reasons, solely through equity, or some combination), and the differing costs of debt in the host country and the home country, should be ignored.
What should the interest rate used to calculate interest payable be? The market cost of borrowing in the home country or the market cost of borrowing in the foreign country? Interest payable must be calculated irrespective of whether the project is financed by using only debt or only equity or a combination of both. The reason is that the parent company takes a comprehensive view of the increase in borrowing capacity for the group as a whole.
Even if the overseas project is financed entirely through equity, the extra borrowing capacity can be used by the MNC in another country, because the borrowing capacity of the entire group of companies will rise as a result of accepting the project. Recall that the cash flows of concern in a capital budgeting decision are incremental cash flows—that is incremental benefits and costs. The incremental or ‘extra’ borrowing capacity will be available to the MNC for use elsewhere in the world if the debt financing is not used in the present overseas project.
9. Transfer Pricing:
Pricing of inter-affiliate purchases and sales is used to move funds from affiliates in high-tax countries to those in low-tax countries, so as to generate tax savings. Movement of earnings from the project through transfer pricing must be incorporated into the evaluation process.
10. Additional Remittances:
The project may be located in a country that has strict remittance and repatriation restrictions. If there is scope for repatriation of project cash flows through other channels, they must be accommodated into the evaluation process.
11. Activated Funds:
These are funds that have accumulated in the foreign country where the project will be located, and can be used in the project. Suppose existing repatriation restrictions have resulted in funds earned by the MNC’s affiliate remaining in the local country, these funds can be used to meet a part of the project cost.