Unit 2: INTERNATIONAL FINANCIAL DECISIONS

International Capital Budgeting – Influence of Inflation on Capital Budgeting Decisions;

Evaluation of Foreign Projects: Home Currency Approach and Foreign Currency Approach,
International Financing Decisions – Source of Finance – ADRs, GDRs, ECBs, FCCBs,
Masala Bonds; International Working Capital Management – Netting, Leads and Lags.

International capital budgeting is the process of evaluation of investments and projects and
productive assets in foreign countries focusing on cash inflow and outflow. It is the process
of identifying, evaluating, and implementing a firm’s investment opportunities. Factors like
Exchange rate fluctuations, inflation, political uncertainty, difference in tax laws are to be
considered.

Objectives of International Capital Budgeting

 To assess the profitability of the project over a period of time.

 Select among investment objectives.
 To address international issues – E.g., Exchange rates, Taxation differences, political
risk etc.

Types of Investment in Foreign Countries

a. Foreign Direct Investment - a substantial investment in, or the outright acquisition

of, a company based in another country by purchasing 50% or more shares or
investing in the infrastructure to set up a company in another country other than
parent country.
 Green Field Investment - a company will build its own, brand new facilities
from the ground up.
 Brown Field Investment- when a company purchases or leases an existing
facility.

b. Foreign Indirect Investments or Foreign Portfolio Investments - (FPI) refers to

investing in the financial assets of a foreign country, such as stocks or bonds available
on an exchange.

Types of countries in Multinational Capital Budgeting

Home Country - refers to the country where the headquarters is located or the location of the
owner.

Host / Subsidiary Country - Host country refers to the foreign countries where the company
invests.
Factors to be considered in International Capital budgeting / Evaluation of Foreign
Projects

 Exchange rates – Exchange rates can appreciate or depreciate therefore, there are
two scenarios optimistic and pessimistic. It has an influence on cash flows.

 Tax laws: Different countries have different tax laws. India has Double Taxation
Avoidance Agreement (DTAA) with almost 88 countries as per Organization for
Economic Cooperation and Development (OECD) norms. Tax Heavens are the
countries that offer low tax liability for foreign investors. For India, Mauritius has
been such tax heaven.
 Restrictions on transfer of funds- Some countries may restrict transfer of earnings
to its home country. Host country may block funds before it is remitted to home
country.

 Political Uncertainty – Some country’s political parties are against FDIs. For
example Coca-Cola and KFC found it difficult to enter India initially as it was against
the promotion of self-production.

 Life Span of the projects – Political developments, customers taste and preferences,
climatic conditions, availability of resources etc. in the host country will have an
influence on the life span of the projects.

 Net investment outlay – Initial investment and working capital required to support
the projects future cash inflows and outflows are to be evaluated.

 Inflation – in some countries inflation rates cab go beyond 100% compared to

previous year. E.g., Increase in oil prices. Non consideration or inaccurate inflation
can affect cost and revenues.

Influence of Inflation on Capital Budgeting

Inflation refers to increase in general prices of goods and services in an economy leading to
decrease in purchasing power.

Types of inflation are-

 Creeping Inflation – Mild or moderate inflation where the price level increases at
mild rate i.e., less than 10%.
 Galloping inflation – Increase in price levels in double or triple digits i.e., 50%,
100%, 200% etc. E.g., Brazil, Argentina, Latin America etc.
 Hyper Inflation – it is a situation where the increase in price levels goes out of
control and monetary authorities are unable to impose a check or control.
 Stagflation – It is inflation coupled with recession.
  Deflation – Decrease on the price levels of goods and services where inflation rates
fall below 0%.

Inflation drives up the cost of raw materials, labour and machinery making the projects
unfeasible.

In some developing countries the inflation rates can exceed 100% per year making the
projects unfeasible and the investors would seek higher real rate of return to compensate the
inflation which would make the projects expensive.

Capital budgeting decisions would be unrealistic if the impact of inflation is not considered.
In order to reflect the true picture cash flows should be adjusted in order to accommodate
inflation.

Two types of cash flows are considered for capital budgeting-

 Nominal Cash flows – Amount the company is expected to receive in future and
expenses expected to pay without the adjustment made for inflation. Here, actual
inflow and outflow of money is considered.
 Real Cash flows – Inflow and outflow of cash with adjustment made for inflation.
Here, purchasing power of money is given importance and this is the apt mode to
calculate cash flows for multinational capital budgeting.

Multinational Capital budgeting should consider real cash flows rather than nominal cash
flows as it helps the business to see the future and figure out profitability of a long term
investment.

Effect of inflation on capital budgeting

 Input cost: Inflation increases the input cost of materials the string in the overall cost
of sale.
 Borrowing cost: With inflation the government is going to increase the rate of
interest on loan which drives the borrowing cost.
 Cost of labour: Cost of labour will have a cascading effect with increase in input
cost.
 Discount rate: Discount rate will be on a higher rate so that the income has to match
with the growing inflation.
 Inventory accounting: Inventory accounting becomes a challenge with huge
fluctuation due to increase in prices.
 Depreciation: Depreciation charged will have less impact on adjusting the cost
required to re purchase the asset after its life.
 Decline purchasing power: It declines the purchasing power of the customers
leading to Slow Down of economy.
 Affects production policy: With all about points it is going to affect the production
policy and targets that are set by the company.
There are several aspects of inflation that an analyst must consider when evaluating a capital
project:

 Inflation and the Depreciation Tax Shied: if inflation is higher than expected at the
time of the investment decision, then the value of the depreciation tax shield is
lowered and true net present value of the project is lowered.
 Inflation and Debt Payments: When inflation is lower than expected, this increases
the firm’s debt costs and lowers the net present value of the project.
 Inflation, Revenues, and Expenses: When a firm is not able to pass the costs of
inflation to product inputs on to customers in the form of higher prices, the net present
value of the project will be lower.

Inflation will lower the interest rates and the weighted average cost of capital (WACC) of a
company. Most companies use WACC as a discount rate for NPV appraisals. Thus, inflation
will indirectly increase the NPV amount keeping all other factors constant.

Techniques of capital budgeting under inflation –

 Discounted Cash Flow Analysis (DCF)

 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Adjusted Present Value Approach (APV)

NPV is the most popular method. There are two approaches under NPV method-

 Home Currency Approach and

 Foreign Currency Approach

Home Currency Approach

Under home currency approach, Net Present Value (NPV) of a foreign project is determined
by-

Step-1: Converting the foreign-currency cash flows of the project to the domestic currency
based on the expected forward exchange rates, and

Step-2: Discounting the cash flows based on the domestic currency cost of capital.

Foreign Currency Approach

Step - 1: Calculating NPV based on foreign country cost of capital and

Step – 2: Converting the foreign currency NPV to local currency at the spot exchange rate.

Problems on the above topic are covered in notes.

International Financing Decisions

The issue of optimal capital structure and finding the optimal mix of funding instruments is
one of the key strategic decisions for an MNC. The actual selection and implementation of
the selected funding program involves several consideration and satisfaction of regulatory
requirements, choosing the right timing and price marketing cost of the shares, bonds or debt
instrument issue.

Factors to be considered before raising International Financing are-

 Proportion of Debt and Equity Mix adopted by the firm.

 Decision on acquisition and usage of funds as per the requirement of the firm.
 Availability of incentives and subsidies.
 Prevailing interest and inflation rates.
 Development of Capital Market, liquidity and efficient price discovery mechanism.
 Related costs or raising investments like agent’s fees, registration charges, up-front
fees etc.
 Political, legal and socio-economic factors.

Sources of finance for raising long term funds

 International Equity Instrument

o American Depositary Receipts (ADRs)
o Global Depositary Receipts (GDRs)
 International Debt Instrument
o Euro Convertible Bonds
o Foreign Currency Convertible Bonds
o Masala Bonds

International Equity Instrument-

International equity markets are an important platform for global finance. They ensure the
participation of a wide variety of participants and also offer global economies to prosper. To
understand the importance of international equity markets, market valuations and turnovers
are important tools.

American Depositary Receipts (ADR)

ADRs are negotiable certificates issued by US banks representing shares of a foreign

company traded in American Stock Exchanges.

 These certificates trade on American stock exchanges.

 American depositary receipts were introduced in 1927.
 ADRs and their dividends are priced in U.S. dollars.
 ADRs represent an easy, liquid way for U.S. investors to own foreign stocks.
Types of ADRs

Types of American Depositary Receipts

American depositary receipts come in two basic categories:

Sponsored ADR - A bank issues a sponsored ADR on behalf of the foreign company. The
bank and the business enter into a legal arrangement. The foreign company usually pays the
costs of issuing an ADR and retains control over it, while the bank handles the transactions
with investors. Sponsored ADRs are categorized by what degree the foreign company
complies with Securities and Exchange Commission (SEC) regulations and American
accounting procedures.

Unsponsored ADR- A bank also issues an unsponsored ADR. However, this certificate has
no direct involvement, participation, or even permission from the foreign company.
Theoretically, there could be several unsponsored ADRs for the same foreign company,
issued by different U.S. banks. These different offerings may also offer varying dividends.

Levels of ADRs

ADRs are additionally categorized into three levels, depending on the extent to which
the foreign company has accessed the U.S. markets.

Level I: This is the most basic type of ADR where foreign companies either don't qualify or
don't want to have their ADR listed on an exchange. This type of ADR can be used to
establish a trading presence but not to raise capital. Level I ADRs found only on the over-the-
counter market have the loosest requirements from the Securities and Exchange Commission
(SEC) and they are typically highly speculative. While they are riskier for investors than
other types of ADRs, they are an easy and inexpensive way for a foreign company to gauge
the level of U.S. investor interest in its securities.

Level II: Level II ADRs can be used to establish a trading presence on a stock exchange, and
they can’t be used to raise capital. Level II ADRs have slightly more requirements from the
SEC than do Level I ADRs, but they get higher visibility and trading volume.

Level III: Level III ADRs are the most prestigious. With these, an issuer floats a public
offering of ADRs on a U.S. exchange. They can be used to establish a substantial trading
presence in the U.S. financial markets and raise capital for the foreign issuer. Issuers are
subject to full reporting with the SEC.
American Depository Receipts (ADRs) issue mechanism

• Company issues: Indian company issues the shares to be raised in foreign currency.

• Ordinary shares: Ordinary equity shares are issued.

• Kept with custodian/depository banks: It is kept with the depository banks of the
foreign country which breaks down the overall value into receipts.

• Against which Receipts are issued: Receipts are issued like any other shares in the
foreign Stock Exchange.

• Foreign Investors: Foreign investors purchase these receipts and enjoy the rights like
any other equity shareholders.

Example: Volkswagen, a German company trades on New York Stock Exchange. The
investor in America can easily invest into the German company, through the stock
exchange. Volkswagen is listed on the American stock exchange after complying the
required laws.

Advantages of ADR Disadvantages of ADR

 Easy to track and trade  Could face double taxation
 Available through U.S. brokers  Limited selection of companies
 Denominated in dollars  Unsponsored ADRs may not be SEC-
 Offer portfolio diversification compliant
 Investor's may incur currency conversion
fees

Global Depositary Receipts (GDR)

Global Depository Receipt (GDR) is an instrument in which a company located in a domestic

country issues one or more of its shares or convertibles bonds outside the domestic country.

Global Depository Receipt Mechanism

 The domestic company enters into an agreement with the overseas depository bank to
issue GDR.
 The overseas depository bank then enters into a custodian agreement with the
domestic custodian of such a company.
 The domestic custodian holds the equity shares of the company.
 On the instruction of the domestic custodian, the overseas depository bank issues
shares to foreign investors.
 The whole process is carried out under strict guidelines.
 GDRs are usually denominated in Euros or U.S. dollars.
Global Depository Receipt Example

A company based in the USA willing to get its stock listed on the German stock exchange can do so
with the help of the GDR. The US-based company shall enter into an agreement with the German
depository bank, which shall issue shares to residents based in Germany after getting instructions
from the domestic custodian of the company. The shares are issued after compliance with the law in
both countries.

Advantages and disadvantages of GDR

Advantages Disadvantages
 GDR provides access to foreign capital  Violating any regulation can lead to
markets. serious consequences for the company.
 Shares can be traded in more than one  Dividends are paid in the domestic
currency. country’s currency which is subject to
 GDR increases the shareholders’ base of volatility in the forex market.
the company.  GDR is one of the expensive sources of
 GDR saves the taxes of an investor. finance.

Difference between ADRs and GDRs

Basis ADR GDR

Issued in America All over the world
Currency of issue Dollars Euros and Dollars or any freely
convertible currency.
Regulatory authority Securities Exchange Stock Market regulatory of respective
Commission country of issue.
Listed in American Stock Exchanges Non- US stock Exchanges like
Luxembourg Stock Exchange, London
Stock Exchange.
Negotiation Only in USA All over the world.

Euro-Convertible Bonds (ECB)

Euro-Convertible Bonds (ECBs): A convertible bond is a debt instrument which gives the holders
of the bond an option to convert the bond into a predetermined number of equity shares of the
company. Usually, the price of the equity shares at the time of conversion will have a premium
element. The bonds carry a fixed rate of interest. If the issuer company desires, the issue of such
bonds may carry two options viz.

(i) Call Options: where the terms of issue of the bonds contain a provision for call
option, the issuer company has the option of calling (buying) the bonds for
redemption before the date of maturity of the bonds.

(ii) Put options - A provision of put option gives the holder of the bonds a right to put
his bonds back to the issuer company at a pre-determined price and date.
External Commercial Borrowing (ECB)

An external commercial borrowing (ECB) is an instrument used in India to facilitate Indian

companies to raise money outside the country in foreign currency. The government of India permits
Indian corporates to raise money via ECB for expansion of existing capacity as well as for fresh
investments.

ECB refers to commercial loans, which can be in the form of bank loans, bonds, securitized
instruments, buyers’ credit, and suppliers’ credit availed from non-resident lenders with a minimum
average maturity of 3 years.

Routes for ECB

ECB can be availed by either automatic route or by approval route.

Automatic Route- Under the automatic route, the government has permitted some eligibility norms
with respect to industry, amounts, end-use, etc. If a company passes all the prescribed norms, it can
raise money without any prior approval.

Permission/Approval Route- For specific pre-specified sectors, the borrowers have to take explicit
permission from the government/The Reserve bank of India (RBI) before borrowing through ECB.
RBI has issued formal guidelines and circulars specifying these borrowing rules.

Benefits of ECBs

 The cost of funds is usually cheaper from external sources if borrowed from economies with a
lower interest rate.
 Availability of a larger market can help companies satisfy larger requirements from global
players better than what can be achieved domestically..
 The borrower can diversify the investor base.
 It provides access to international markets for the borrowers and gives good exposure to
opportunities globally.
 The economy also enjoys benefits, as the government can direct inflows into the sector and
has the potential to grow.
 Avenues of lower-cost funds can improve the profitability of the companies and can aid
economic growth.

Disadvantages of ECBs

 Availability of funds at a cheaper rate may bring in a lax attitude on the company’s side,
resulting in excessive borrowing.
 Higher debt on the company’s balance sheet is usually viewed negatively by the rating
agencies, resulting in a possible downgrade by rating agencies which eventually might
increase the cost of debt.
 Since the borrowing is foreign currency-denominated, the repayment of the principal and the
interest needs to be made in foreign currency, exposing the company to exchange rate risk.
Foreign Currency Convertible Bonds (FCCBs)

The money being raised by the company through issue issuing bonds in the form of a foreign
currency. A convertible bond is a mix between a debt and equity instrument. It acts like a bond by
making regular coupon and principal payments, but these bonds also give the bondholder the option to
convert the bond into stock after a fixed period of time.

Advantages of FCCBs

 Flexibility to convert the bond into equity: The convertible bond gives the investor the
flexibility to convert the bond into equity at a price or redeem the bond at the end of a
specified period.
 Delayed dilution of equity: Companies prefer bonds as it leads to delayed dilution of equity
and allows company to obtain tax benefit.
 FCCBs are easily marketable: Investors enjoys option of conversion into equity if resulting
to capital appreciation. Further investor is assured of a minimum fixed interest earnings.

Disadvantages of FCCBs

 Exchange risk: Exchange risk is more in FCCBs as interest on bonds would be payable in
foreign currency.
 Creation of more debt and a forex outgo: FCCBs mean creation of more debt and a forex
outflow in terms of interest which is in foreign exchange.
 Interest rate is low: In the case of convertible bonds, the interest rate is low, say around 3–
4% but there is exchange risk on the interest payment as well as re-payment if the bonds are
not converted into equity shares.

Masala Bonds

 Masala Bonds are rupee-denominated bonds.

 It is a debt instrument issued by an Indian entity in foreign markets to raise money, in Indian
currency.

 Masala is an Indian word that means spices. The IFC used the term ‘Masala’ to evoke the
cuisine and culture of India. The first Masala Bonds were issued by World Bank in 2014 to
fund an infrastructure project in India.

 There are certain rules and regulations which have been set up by the Reserve Bank of India
(RBI) regarding Masala Bonds:

 Any corporate and Indian bank is eligible to issue Rupee denominated bonds overseas

 Money raised through these bonds cannot be invested in real-estate activities.

However, they can be used for the development of integrated township or affordable
housing projects

 Also, the money raised through Masala Bonds cannot be invested in capital markets.
  The minimum maturity period for bonds raised up to 50 million USD equivalent in INR per
financial year should be three years. The minimum original maturity period for bonds raised
above 50 million USD equivalents in INR per financial year should be five years.

 Investors from outside of India who are interested to invest in Indian assets are eligible to
invest in Masala bonds.

Advantages of Masala Bonds:

 It offers higher interest rates and thus benefits the investor.

 It helps in building up foreign investors’ confidence in the Indian economy.
 It helps strengthen the foreign investments in the country as it facilitates foreign investors’
confidence in Indian currency.
 The capital gains arising from rupee denomination are exempted from tax.
 If the rupee appreciates at the time of maturity, it benefits the investor.
 It aids borrowers to cut down their cost as they are issued outside India below 7% interest
rate.

Limitations of Masala Bond:

 RBI has been making periodical rate cuts in Masala Bonds which has made it a bit less
appealing to the investors.
 The money raised through these bonds cannot be used everywhere. There are fixed fields
where the money can be invested.

International Working Capital Management

The management of current assets and current liabilities constitutes working capital management. The
efficient allocation of funds among various current assets, the acquisition of short-term funds on
favourable terms and providing adequate funding and liquidity for the conduct of its global businesses
so as to enhance value to equity shareholders and also to firm are termed as International Working
Capital Management.

Multinational Cash Management –

Cash Management in an MNC is primarily aimed at minimizing the overall cash requirements of the
firm as a whole without adversely affecting the smooth functioning of the company and each affiliate,
minimizing the currency exposure risk, minimizing political risk, minimizing the transaction costs and
taking full advantage of the economies of scale as also to avail of the benefit of superior knowledge of
market forces.

Techniques of cash management in International context are-

 Netting
 Leads and Lags
Netting:

Netting refers to a method of risk reduction in financial contracts by connecting or aggregating

multiple financial obligations to arrive at the amount of net obligation. Netting is adopted to decrease
the settlement, credit, and other financial risks between two or more participants.

Advantages of Netting:

 By netting the amount owed by the party with each other, a single invoice can be created for
the company that has the balance outstanding. This method can also be adopted while
transferring funds between two subsidiaries.

 Netting helps in saving more time and money by reducing the number of transactions per
month that needs billing.

 It cuts down the transactions just to a single payment.

 It also limits the number of foreign exchange transactions as the number of fund flows
decreases for banks.

Types of Netting:

 Close-Out Netting: Close-out netting occurs after default. In other words, when a party fails
to make repayments, transactions between the parties are netted for a single amount payable
by only one party.
 Settlement Netting: Settlement netting consolidates the amount due among parties and
offsets the cash flows into a single payment. The party only exchanges the net difference in
the total amounts with the net owed obligation.
 Netting by Novation: Novation netting refers to the cancellation of offsetting swaps. It
replaces them with new obligations on calculating the net amount, where two companies have
obligations to each other on the settlement date.
 Multilateral Netting: Multilateral netting refers to a form of netting involving more than two
parties. A clearinghouse or central exchange often mediates in a multilateral netting event. It
can also happen inside a company with multiple subsidiaries.
 Bilateral Netting: It enables two counterparties in a financial contract to offset claims against
each other to determine a single net payment obligation that is due from one counterparty to
the other.

Leading and lagging:

 Leading means paying an obligation in advance of the due date when the payer anticipates
further depreciation in the currency.
 Lagging means delaying payment of an obligation beyond its due date when the payer
anticipates further appreciation in the currency.

It basically refers to credit terms and payment between associate companies within a group. In forex
market where exchange rates are constantly fluctuating, the leading and lagging tactics come handy to
take advantage of expected rise / fall in exchange rates.

The factors need to consider in leading and lagging:

1. Finance cost (settlement discount)

2. Goodwill