Acceptance Criteria For Foreign Investments

By Harsh Vardhan Gupta

MBA 3rd Sem

Rollno 10

A multi national firm, in simple terms, means a company with substantial operations carried on outside its own national borders. These activities may be trading or manufacturing.

Whatever the activities, the important fact is that the firm must make decision about project returns which have a sizeable impact on the company. So, the financial manager has to take great care in measuring returns in the form of cash flows and also in developing the acceptance criteria for accepting or rejecting the project in any country.

Broadly the process can be divided into three parts:

1. Need for investment in foreign projects

2. Determination of expected cash flows3. Acceptance criteria for these projects

Need for investment in foreign projects The need for investment can be

broadly classified into two groups:

a) To increase the return or reduce the total risk of a company

b) On the basis of market characteristics

To increase the return or reduce the total risk of the company1. Comparative advantage: It states that in terms of total

output for the society, each productive is more effective if used in those tasks for which its relative advantage over other alternatives is greatest.In international corporate operations, the theory of comparative advantage can be related to:

a) Labour skills or unit costs:- the wage rates paid in many countries are much lower than what is paid in developed countries. So, this could be a reason for the companies to invest in such countries if the goods to be produced are labour intensive.

b) Transportation expenses:- the firms may favour establishment of several plants around the world to overcome high transportation costs. The selection of site here will try to minimize transportation costs to customers and to lower total unit costs. Countries selected would minimize average miles per unit delivered.

c) Capital markets:- limitations on capital export & import can produce rate differentials among different countries’ capital markets. For eg: when the local government commits public policy towards encouragement of a particular enterprise, then special tax concessions may offer attractive financing incentives for the MNC.

2. Operational constraints3. Taxation: If lower corporate taxes are available in

some area, then it attracts the management to invest there in order to maximize shareholder’s returns; either the absolute rate of taxes may be low or the definition of taxable income may be advantageous.

4. Financial diversification: Financial diversification or spreading the firm’s risk throughout a wider range than any one nation will permit, is also an economic motivation for good investment.

B) Market Characteristics1. Return on investment2. Market dominance :- Market dominance is related to profitability. A cross

sectional regression analysis based on 106 companies was presented by Gale in which he evaluated the impact of market share, firm size and concentration as some variables for rate of return .He founded that the positive relationship between market share and profitability were greater for

High concentration industries Moderate growth industries than the rapid growth industries Relatively large firms than the small firms large firms in high concentration industries with relatively moderate growth than

any firm. His conclusion is consistent with the strategy of a firm seeking access to particular markets in the expectation of greater long run profitability from obtaining a dominant market share.

3. Product life cycle :- it suggests that the corporation will be forced to seek untapped markets because of increasingly broad penetration of a market and company’s incremental investment.it is a dynamic oligopoly theory in which declining margins in one land induce the firm to go abroad.

4. Monopolistic advantage5. Oligopolistic market structure

Some of the difficulties that are

encountered in multinational settings 1. Joint products : If the proposed investment in another

country is either a form of vertical integration or horizontal integration, then it becomes difficult to measure the revenues independently bcoz when joint effects exist, the firm evaluates the project by aggregating total demand for the project.

2. Economies of scale : when there are substantial production economies of scale; individual small projects should be charged for the add. costs involved in the diseconomies of not using a centralized manufacturing policy.

3. Supervisory fees and Royalties: parents often require supervisory fees and royalties from their subsidiaries as means of remitting funds from foreign projects. In evaluating the cash flow of the project and cash flow to the parent there lies a difference. For the project, the relevant cash flow is the after-tax cost of what a real payment for the supervision on patent use would be worth in an arm’s length transaction. For the parent evaluating the cash flow to itself from the project, the supervisory and royalty inflows after subtracting any incremental costs simply constitute one more cash return.

4. Value of equipment contribution : when manufacturing is involved in a project, the contribution of used equipment from the parent can be a central item.

5. Tie- in Sales6. Inflation and currency fluctuations7. Taxation of income8. Remission of funds

For analyzing a particular project, the manager needs to consider the return that should be demanded for that project.

First, there are traditional corporate finance percepts on the cost of capital as the relevant hurdle rate.

But we must also assess what adjustment, if any, must be made to take into account the fact that the project is located in a foreign land.

The nature of the adjustments depends on the type of capital market we envisage.

The minimum rate of return that the project must yield is the cost of funds used to finance it.- its cost of capital.

The combination of the sources of funds used to finance the firm is called the capital structure of the firm. The optimum capital structure for a firm is that one which minimizes the total cost of funds for that firm.

To find the optimum capital structure, we have to know the risks of the firm and the returns it expects to generate.

The risks of a firm fall into two categories:1. The risks derived from the investment projects

themselves – the business risk. and2. the risks derived from how the firm is

financed – the financial risk.

Cost of Capital – The Basic Theory

The cost of capital as the required rate of return There are two factors that need special

attention:1. Long term capital structure :-

2. Business risk specific to the project:- the firm’s cost of capital is related to the return and risks of all its investments and it is the weighted avg of cost of capitals of all its projects. So, while evaluating a specific project, the cost of capital of the firm should be approximated to match that project.

Cost of capital for a foreign project1. The case of efficient markets:- in

efficient markets, the cost of capital chosen to discount the return from a project with a given risk is intrinsically the same whether the project is located in home or abroad. However, the cost of capital figure should correspond to the cost of capital in the currency used to measure the returns from the project. thus if both have the same risk, then the investor would demand the same return.

2. The case of inefficient markets:- the financial markets of most countries are better described as inefficient than efficient. the reasons responsible for this inefficiency are :-

an investment may be extraordinary large or the returns may be so far in the future that the lack of information on which returns can be estimated is a serious problem to pricing.

Investors in other nation may not know about the project . So, the returns to someone present in the economy may be extraordinary large as others are not bidding for the project.

there may be barriers to capital movement outside the country as per nations policy and also inside the country in an effort to protect their own infant industry or to avoid foreign domination

Segmented capital markets disequilibrium in the markets Special financing arrangements unique to many projects depending upon

their location.

There are two factors that may account for the different cost of capital for a foreign project than for a domestic project with the same total risk

A) Country differences in capital structuresB) Effects of consolidated financial statements

Cost of equity as a hurdle rate An alternative to the concept of the average cost of

capital is the concept of return to equity, one of the components of the total cost of capital. This approach can be particularly useful when special financing arrangements are attached to the specific project. However, in order for this approach to lead to correct conclusions, we must specify the financing sources throughout the entire life of the project. an example of a situation in which management usually concentrates its analysis on the return to equity is the shipping industry. Here, the yard that manufactures the ship supplies a substantial amount of the total funds reqd, secured only by the ship. The return to the equity holders is a function of the ship’s cost, revenues and operating expenses and the timing of particular financing scheme offered by a given shipyard.

Holding the cost, revenue and operating cost constant, it is obvious that the shorter loan option will have a lower return to equity in normal settings. Essentially, the cheaper debt financing will be paid off sooner,meaning that the ship will be financed increasingly by larger portfolio of equity over its life. Without debt on which to lever the return to equity in later years, the return to equity will be lower than otherwise would be the case.

Cash flows to parent v/s cash flows to projectAt the most basic level, the ultimate risk and

return considerations should be for the parent company’s stockholders. but the points which complicate this view are:-

1.The investors in the parent are increasingly from a world wide family so they may want a worldwide purchasing power return which isa difficult preposition.

2. Many companies in the true multinational tradition accept role as worldwide investors. So, it hardly matters then, whether the funds are remitted to the parent company or kept in the host country.

In most cases the firm will verify that the project return and the parent return are both agreeable. but there are other financial consideration also, beyond the return of the project and the return to the parent, like liquidity, reported earnings and alternative uses of cash which the firm has to take care of.

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