PRESENTED BY

DHANYA K P

CUANCOM008

M.COM 4TH SEM

SEMINAR PRESENTATION

INTERNATIONAL CAPITAL BUDGETING: CONCEPT, PROBLEMS ASSOCIATED, EVALUATION OF A PROJECT, FACTORS AFFECTING, RISK EVALUATION, IMPACT ON VALUE AND LONG TERM ASSET LIABILITY MANAGEMENT.

INTERNATIONAL CAPITAL BUDGETING

• The evaluation of the long-term investment project is known as capital budgeting

• The technique of capital budgeting is almost similar between a domestic company and international company. The only difference is that some additional complexities appear in the case of international capital budgeting.

• These complexities influence the computation of the cash flow and the rate of return.

EVALUATION CRITERIA

• Discounting and Non discounting criteria

• Non discounting methods:

Average accounting rate of return

Pay back period

AVERAGE ACCOUNTING RATE OF RETURN

• It represents the mean profit on account of investment prior to interest and tax payment. The mean profit is compared with the hurdle rate or required rate of return earned by the project. A project is acceptable if the mean profit is higher than the hurdle rate,

PAY-BACK PERIOD

• The other non discounting method is known as the pay-back period, that is the number of years required to recover the initial investment. If the investment is not recovered within the pay-back period, the project should not be accepted.

• Discounting methods:

Net Present Value (NPV) method

Profitability Index (PI) method

Internal rate of return(IRR) Method

1. NET PRESENT VALUE

• NPV is the residue after deducting the initial investment from the PV of future cash flows relating to a project. Positive NPV means additions to the corporate wealth. In this case, projects are accepted where the present value of net cash inflow during the life span of the project is greater than the initial investment.

2. PROFITABILITY INDEX

• Profitability index is the ratio between the present value of future cash flows and the initial investment. This shows the relationship between net cash flows and initial investment.

3. INTERNAL RATE OF RETURN

Internal rate of return is the discount rate equating the present value of future cash flows and the initial investment. For accepting a project, IRR> hurdle rate.

The project shall be acceptable if IRR is greater than the required rate of rate of return.

PROFITABILITY INDEX VERSUS NET PRESENT VALUE

• The same amount of cash inflow may yield different results under the two methods. It is possible that PI may be higher in case of lower NPV and so the decision would be different in case of these two different methods.

• NPV represents an absolute value, it should be relied upon even if the PI is higher.

RANKING OF PROPOSALS

• If there are two or more mutually exclusive proposals, they need to be ranked in order of preference.

• Under the NPV rule, first preference is given to a proposal with the highest NPV but judged by the IRR method and initial outlay differs, the decision could be erroneous. In such cases, the incremental approach is considered.

RISK ADJUSTMENT IN THE CAPITAL BUDJETING ANALYSIS

1. Risk adjusted discount method: This approach requires adjusting the discount rate upward or downward for increases or decreases, respectively, in the systematic risk of the project relative to the firm as a whole .

2. Certainty equivalent method:This approach extracts the risk premium from the expected cash flow to convert them in to equivalent riskless cash flows, which are then discounted at the risk free rate of interest. This is accomplished by multiplying the risky cash flow by a certainty equivalent factor that is unity or less. The more risky the cash flow, the smaller is the certainty-equivalent factor.

COMPUTATION OF THE CASH FLOW

• The taking up of a new project demands a part of a firms current wealth, but in return, brings in funds and adds to the firms stock wealth in future.

• Cash outflow occurs on account of capital expenditure, other expenses (excluding depreciation), and the payment of taxes.

• Cash inflow includes revenue on account of additional sale or cash from eventually selling of an asset which is known as salvage value.

• Cash flows are grouped under three heads:

1. initial investment during the period,t0.

2. Operating cash flow during the period t1 to tn.

3. Terminal cash flow or the salvage value that emerges at the end of the period, tn.

PARENT UNITS PERSPECTIVE AND THE CASH FLOW• The value of the project is determined by the Net

Present Value of the future cash flow available to the investor. Since the parent company that is taken in to account in context of international capital budgeting.

• The cash flow is broadly compartmentalized into three heads:

1. initial investment

2. operating cash flow

3. terminal cash flow

1. INITIAL INVESTMENT

• If the entire project cost is met by the parent company, the entire amount of initial investment is treated as the cash out flow. In some cases, the project is partly financed by the subsidiary itself through local borrowing but such borrowings of the subsidiary itself through local borrowings of the subsidiary do not from a part of the initial cash outflow.

2. OPERATING CASH FLOW

• Besides the initial investment, the operating cash flow too needs some adjustment. As a normal practice, the revenue generated through the sale of a subsidiary’s product in the local market as well as in other countries, is known as the operating cash flow from the parents perspective but it is subject to downward adjustment by the lost income on sales previously realized through the parent company’s export of these markets.

3. TERMINAL CASH FLOW• Besides adjustments in the initial

investment and in the operating cash flow, some adjustments have to be made for the salvage value that influences the terminal cash flow. If there is provision in the foreign collaboration agreement for reversion of the project to the government after a certain period of time on the payment of a specific amount, that specific amount is treated as the terminal cash flow.

FACTORS AFFECTING INTERNATIONAL CAPITAL BUDGETING

• Project Risk Project risk approximates the chance that the project will not be as profitable as expected due to errors from the company or from the project's initial evaluation. Project risk is increased when a company invests in a business that is not in its area of expertise. This increases the chance that management will not be able to properly value the project's cash flows and that the company will make errors while running the business.

• Market RiskMarket risk measures the part of a project's risk from macroeconomic factors such as inflation and interest rates. Market risk is increased during a weak economy. A poor economy can decrease demand for a product, potentially turning a project unprofitable. Banks may be more reluctant to lend in a weak economy, raising the cost of capital for the project. High inflation can also be a problem at it weakens the long-term real return of the project. These factors increase the market risk of a project and contribute higher total risk.

• International RiskIf a company's capital budget project will involve another country, it will be exposed to international risk. This entails political and exchange-rate risk of the project. If a project is based in a country with an unstable political structure, civil or political unrest could cause the entire investment to be lost. If currency rates move in an unfavorable direction, the company could face higher relative costs and lower relative gains. Domestic projects are completely devoid of this type of risk.

ASSET LIABILITY MANAGEMENT

• Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating).

• ALM involves Planning, directing and Controlling the flow , mix, cost and yield of the consolidated funds of bank

• Assesses various asset mixes, funding combinations, price volume relations and their implications on Liquidity, Income and Capital ratio

• Planning procedure which accounts for all assets and liabilities of a bank by rate, amount and maturity

OVERALL OBJECTIVE.. • The central theme of (ALM) is the

management of a bank’s entire balance sheet on continuous basis with a view to ensure a proper balance between funds mobilisation and their deployment with respect to their maturity profiles, cost and yield as well as risk exposure so as to improve profitability, ensure adequate liquidity, manage risks and ensure long term viability

• The immediate focus of ALM is interest-rate risk and return as measured by a bank’s net interest margin.

• ALM is a systematic approach that attempts to provide a degree of protection to the risk arising out of asset/liability mismatch.

• NIM (Net Interest Margin) = (Interest income – Interest expense) / Earning assets A bank’s NIM, in turn, is a function of the interest-rate sensitivity, volume, and mix of its earning assets and liabilities. That is, NIM = f (Rate, Volume, Mix)

SCOPE OF THE ALM

• The exact roles and perimeter around ALM can vary significantly from one bank (or other financial institutions) to another depending on the business model adopted and can encompass a broad area of risks.

• The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet (as they require coordination between assets and liabilities).

• But ALM also now seeks to broaden assignments such as foreign exchange risk and capital management.

THE SCOPE OF THE ALM FUNCTION TO A LARGER EXTENT COVERS THE FOLLOWING PROCESSES

• Liquidity risk: the current and prospective risk arising when the bank is unable to meet its obligations as they come due without adversely affecting the bank's financial conditions. From an ALM perspective, the focus is on the funding liquidity risk of the bank, meaning its ability to meet its current and future cash-flow obligations and collateral needs, both expected and unexpected. This mission thus includes the bank liquidity's benchmark price in the market.

• Interest rate risk: The risk of losses resulting from movements in interest rates and their impact on future cash-flows.

• Currency risk management: The risk of losses resulting from movements in exchanges rates. To the extent that cash-flow assets and liabilities are denominated in different currencies.

• Funding and capital management: As all the mechanism to ensure the maintenance of adequate capital on a continuous basis. It is a dynamic and ongoing process considering both short- and longer-term capital needs and is coordinated with a bank's overall strategy and planning cycles (usually a prospective time-horizon of 2 years).

• Profit planning and growth.

• ALM deals with aspects related to credit risk as this function is also to manage the impact of the entire credit portfolio (including cash, investments, and loans) on the balance sheet. The credit risk, specifically in the loan portfolio, is handled by a separate risk management function and represents one of the main data contributors to the ALM team.

CONCLUSION

• The technique of capital budgeting is almost similar between a domestic company and an international company. The only difference is that some additional complexities appear in the case of international capital budgeting. These complexities influence the computation of the cash flow and the required rate of return.

• Risk management is the heart of bank financial management and ALM is one of the most important risk-management functions in a bank.

REFERENCES

• V. SHARAN, International Financial Management, Prentice-Hall of India pvt ltd, New Delhi .

• M Y KHAN, FINANCIAL SERVICES, Tata M C Graw Hill, New Delhi, 2004.

THANK YOU