This article throws light upon the ten basic inputs required for project evaluation. They are: 1. Initial Investment 2. Consumer Demand for the Product 3. Price of the Product or Service 4. Cost of the Product 5. The Life of the Project 6. Salvage Value 7. Transfer Restrictions 8. Tax Laws 9. Exchange Rate Variations 10. The Required Rate of Return.
A project’s initial investment is not only equal to the investment required to start the project but also the working capital required to run the operating cycle of the project. Working capital margin is needed until the revenue generated from the project is sufficient to cope with working capital requirement. The parent’s initial investment will also indicate the sourcing of funds.
A projection of consumer demand is very important for determining cash flows. It is very difficult to forecast the demand in a foreign country for the product which is either being introduced newly or will be competing with the existing domestic product. In the first case, the market has to be created for the product where as in the later; share for itself has to be carved out. However, there is a lot of uncertainty associated with such forecasts.
To forecast the price of the product, the firm needs to study the price of the competitive product. However, for a new product, the pricing is done on the basis of cost of production and the prospective customer segment of the population.
The cost of the product has two components:
(i) Variable cost, and
(ii) Fixed costs.
The forecasts on these two types of costs are also to be developed because the project usually conceived and prepared earlier than it actually is initiated and the projects have time lags. These costs may also be dependent on price of inputs whether procured indigenously or imported.
a. Variable Cost:
Variable costs forecasts can be developed by assessing prevailing comparative costs statistics for variable inputs such as labour energy and raw material. It is needed to forecast variable costs quite accurately.
b. Fixed Costs:
Fixed costs may be easier to predict as compared to the variable cost because normally it is not sensitive to the changes in demand for fixed factors.
In the case of some projects, the life of the project can be assigned, while in other cases it may not be possible. In the case of the definite life time of the project-capital budgeting decision making is easier. But one aspect of the MNC’s capital budgeting is that, MNCs does not have complete control over the life time of the project and it may be terminated any time due to political reasons, explained earlier.
The salvage value in the case of most of the projects is difficult to predict. Its value depends on several factors including the attitude of the host government, change in taste and fashions of society, technology upgradation, etc.
There may be restrictions on the transfer of earnings from subsidiary to the parent. The restriction may encourage the MNC to spend locally so that there is no huge transfer of funds. This makes the project viable for the subsidiary and unviable for the parent.
If the parent country does not tax the foreign earnings because it provides incentive to foreign earnings, the cash flows may increase. In capital budgeting, the tax effects must be accounted for.
The cash flows from international project may vary because of exchange rate variation. The exchange rate variations are difficult to forecast. The short run positions can be hedged but long run project cannot be hedged. Moreover, it is difficult to know the exact amount of cash flow to be hedged, over the time span of the project.
Once the relevant cash flows of the proposed project are estimated, these can be discounted at the required rate of return which differs from the MNC’s cost of capital because of additional risk involved in the launching of the new project at a foreign location.
You are the CFO of a UK Company. You are evaluating a project to be set up in the USA. Cash flow data and other information are as given in the table. The $/£ Spot rate is 1.5850. Pound is expected to appreciate by 6% every year. A UK based project need minimum return of 20%. Assess whether the project can be undertaken?
Approach 1: Host Currency or Foreign Currency Approach
Establish host currency cash flows:
UK is the home country and USA is the host country. The cash flows are already in dollars.
Identify host currency discount rate:
The Exchange rate is $ 1.585/GBP. For the American this is a direct quote. In that context pound is the commodity.
Using Inflation porting theory, [S × (1 + inflation rate)] the future spot rates are arrived at:
Year 1 – 1.6801
Year 2 – 1.7809
Year 3 – 1.8878
(1 + DIR/1 + FIR) = F/s
Here, DIR = Domestic Investment Rate; FIR = Foreign Interest Rate; F = Forward Rate; S = Spot Rate.
Since it is convenient to use direct quote, for the limited purpose of this formula we regard USD as DIR.
(1 + DIR/1 + 0.20) = 1.6801/1.585
Hence the expected return for US$ is 27.2%.
Discount $ cash flows at $ discount rate of 27.20%
Convert at spot rate to arrive at home currency, negative NPV: 64,88,000 @ 1.585 $/ GBP = 40,93,375 GBP
The NPV is negative and the project should be rejected.
Home Currency Approach
Compute host currency cash flows:
Convert to home currency based on future exchange rates:
Discount at host country discount rate:
The difference in the under the two methods is due to rounding off.
Project has negative NPV and hence should be rejected.
ROMA Ltd., in India is establishing a project in Centrica, a country in Central Africa. The idea was mooted by the CEO because of the prospects of a likely boom in demand in Centrica. Initial outlay is Rs.60 lakh. Annual cash flows (in Cen-$) would be 12 million, 6 million and 5.25 million in each of the three years respectively at the end of which the project would be wound up. Given the systematic risk involved, the CEO feels that 20% return in Cen-$ terms, on this project should be appropriate.
The local laws in Centrica permit foreign projects to remit to investor-parent a maximum of 10% of initial project cost each year. The remaining distributable surplus have to be held in Centrica in 5% Interest bearing deposits, to be brought back to India only at the end of project life. Current Rupee/Cen-$ spot rate is Re 0.40 = 1 Cen-$. (a) Should ROMA go ahead with the project? (b) Will the position change if there were no restrictions on repatriation?
With Repatriation Restrictions:
The initial cash flow of Rs.60 Lakh is converted into Cen-$ Rs.1,50,00,000 at the spot exchange rate is 0.40. The cash flows to the extent repatriable are computed and discounted at 20% to arrive at NPV.
The project has a negative NPV and should be rejected, if restrictions on repatriation applicable.
Without Repatriation Restrictions:
The entire cash flow is repatriable. Hence the whole of it is discounted at 20%
The project is viable if there are no restrictions on repatriation.
Let us continue with Centrica project of ROMA. The Rs.60 lakh (Centrica $ 15 million) would be funded 50% by equity and 50% by medium term rupee loan brought by the home country. The discount rate was reckoned at 20% assuming that the entire Rs.60 lakh (Centrica $15 million) would be funded by equity remitted by ROMA. The appropriate rate for debt is 12% in Cen $ terms. What would be the appropriate discount rate? What would be the relevant cash flow?
a. The appropriate rate is the weighted average rate: [0.5×20%] + [0.5 × 12%) = 16%
b. While discounting the cash flows should be before payment of interest.
Let us revert to ROMA Ltd. and modify the earlier assumption that the project is financed by remitting rupee funds at 0.40 = 1 Cen-$. ROMA now propose to finance this project as a Joint Venture, involving local partners who would be funding 50% of project cost as equity. The company’s dividend policy is to distribute the cash flows available as distributable in full. Can the project be undertaken?
With Repatriation Restrictions:
The project in Centrica turns out to be acceptable.
Only 50% of initial investment is taken since that is the investment made by the home country.
Consider the data relating to ROMA Ltd, as per Illustration 1 3.4 investing in Centrica. The following additional information is now available. The project beta is 1.25. The risk free return in Centrica is 5%. Market return is 1 7%. 50% of the money would be invested Cen-$ loans @12%. What is the expected return for ROMA Ltd investors? Is the project now viable for them?
The cost of equity with no leverage would be:
Ke = Rf + Beta (Rm – Rf) = 5% + 1.25 (1 7% – 5%) =20%
Since there is leverage, the cost of equity would undergo a change.
Project Beta is 1.25. Hence beta of equity of un-levered firm is 1.25.
Overall beta of levered firm will also be 1.25. The equity debt ratio is 1:1.
Assuming the beta of debt to be zero, the beta of equity can be ascertained as 2.5
Overall Beta = Equity Beta (E/V) = Debt Beta (D/V)
1.25 = Equity Beta (1/2) + 0.
Equity Beta = 2.5
Using CAPM Cost of equity is ascertained.
Ke = Rf + Beta (Rm – Rf); = 5% + 2.5 (1 7%-5%) =35%
The relevant cash flows and the consequential NPV is as follows:
The project is not viable.
Interest payable each year:
Loan borrowed in Cen$ = 50% of project cost = 75,00,000 Cen$
Interest @ 12% = 9,00,000 C$