Foreign capital budgeting analysis is the procedure for analyzing expected cash flows for a proposed direct foreign investment to determine if the potential investment is worth undertaking. In finance literature, foreign capital budgeting is also called foreign investment analysis. Capital budgeting analysis is concerned with direct (as distinct from portfolio) investments. Examples range from purchase of new equipment to replace existing equipment, to an investment in an entirely new business venture in a country where, typically, manufacturing or assembly has not previously been done. The technique is also useful for decisions to disinvest, that is, liquidate or simply walk away from an existing foreign investment. The overall foreign capital budgeting decision has two components: the quantitative analysis of available data (“capital budgeting” proper) and the decision to invest abroad as part of the firm’s strategic plans. Investments of sufficient size as to be important are usually conceived initially because they fit into a firm’s strategic plan. The quantitative analysis which follows is usually done to determine if implementation of the strategic plan is financially feasible or desirable.
This post deals with the quantitative aspects of foreign capital budgeting. It treats, first, the general methodology of capital budgeting, second, the international complexities of that procedure, and third, the implications of international accounting for conclusions reached by that methodology. For convenience, the United States will be regarded as “home” at this post. However, the principles discussed have relevance for any home company investing in a foreign land.
General Methodology For Capital Budgeting
Capital budgeting is essentially concerned with three types of data: (1) cash outflows (i.e., project costs) and (2) project cash inflows, both of which are measured over a period of time, and (3) the marginal cost of capital. This section will follow the typical procedure of using annual time periods, but an analysis could be based on cash flows for quarters, months, or even days.
Project Cash Outflows (Costs)
Project cash outflows refers to the cash cost paid out to start the project. Usually the outflow for an investment occurs at the time when the investment is made, which is to say in “year 0” if the project is to be analyzed in annual time periods. However, other time squences are possible; for example, the cash outlay could occur over several years, as when a very large hydroelectric plant is being constructed.
Cash outflows include:
- Cash paid for all new assets purchased.
- Cash paid to prepare a new site. These outlays might be for such costs as grading, building access roads, or installing utilities.
- Cash paid to dispose of, remove, or destroy old equipment or other assets, or, alternatively, net cash received from the sale of old assets. Cash disbursed or received, net of any tax effect, is the relevant flow.
- Cash cost of additional storage and/or transportation facilities needed because of the new investment. If the new venture necessitates additional warehousing space or additional transportation equipment (e.g., a new fleet of trucks), these additional costs must be included as part of the required supporting investment for the project.
- Cash payment for any additional engineering or design work to be incurred if a decision is made to invest. Care must be taken not to include “sunk costs” which reflect cash outflows already incurred in the process of preparing for the investment decision. The relevant cash outflows are those incurred from the decision day forward and only if the project is undertaken.
- The cash opportunity cost of any existing equipment or space allocated to the project. If a post of a factory is currently idle but would be used for the new project, the relevant cost is the alternate cash flow that post might generate. (Could it be subleased to another firm?) If no alternative use exists for the post (i.e., it will otherwise sit idle), it has no cash opportunity cost. An accounting allocation of overhead to departments or divisions on the basis of floor space occupied is not a relevant cost, because it does not involve cash flow.
- Investment in additional working capital necessitated by the new project, such as larger cash balances, more inventory, or expanded receivables. These items might be negative (i.e., a cash recovery) if a replacement project enables the firm to operate with less cash, inventory, or receivables.
- Outlays in future years needed to supplement the original investment. Examples are periodic major overhauls of key assets and costs incurred at the end of the project to close it. Examples of the latter are the cost of disposing of nuclear waste or restoring an open pit mining site to a natural state by regrading and replanting.
The essence of determining what cash outflows are relevant to the investment decision is to look only at those future cash outflows that will take place because of the investment decision, and to ignore both earlier cash outflows undertaken for analytical purposes (sunk costs) and accounting overhead charges which do not represent additional new cash outflows.
Project Cash Inflows
The relevant cash inflows for any project are those that will be received by the firm in each future year from the investment. This set of cash flows must be identified by specific year.
Each annual cash inflow differs from net income for that same period for two general reasons:
- The cash inflows are calculated ignoring noncash expenses, such as depreciation of assets, or amortization of earlier costs, such as research and development (R&D) or prior-service pension costs.
- The calculation is usually made on the hypothetical assumption that the entire venture is financed with equity (stockholder) funds and that taxes are thus based upon such an “all-equity” assumption. Consequently, the income tax calculation is a hypothetical amount, unless the firm is, in fact, financed without any debt. (The tax shelter consequences of interest payments are incorporated into the cost-of-capital calculation).
A simplified view of a single year’s cash flow calculations is illustrated below.
The project cash flow of $596 can be calculated from the income statement (above left) by either a top-down or a bottom-up approach:
Cash flow = EBIT – (TAX RATE) (EBIT) + DEPRECIATION + AMORTIZATION
= 600 – (0.34) (600) + 150 + 50
Cash flow = NET INCOME + DEPRECIATION + AMORTIZATION + (1 – TAX RATE) (INTEREST)
= 264 + 150 + 50 + (0.66) (200)
The top-down or bottom-up simplification is important, because, in practice, one or the other is often applied to pro forma income statements for a project as the fastest way to estimate likely cash flows. Hence, the person doing the calculations is often an unconscious slave to the accounting methods used in the pro forma analysis, and, when those methods differ from home country methods, errors are made.
The all-equity method just illustrated is justified for domestic capital budgeting because the tax shelter created by interest expense is incorporated into the cost-ofcapital calculation. However when this all-equity method is used for an international project, the project analyst must be aware that only actual foreign taxes paid can be used as a credit against U.S. taxes levied on grossed up dividends received from the foreign subsidiary. The hypothetical tax used for the cash flow calculation is not a valid base for credit against U.S. taxes.
Cost of Capital
Cost of capital is the discount rate used to equate present and future cash flows. This discount rate is more properly called the “weighted-average cost of capital” [WACC]. It is found by combining the cost of the firm’s equity with the cost of its debt in proportion to the relative weight of each in the firm’s optimal long-term financial structure. More specifically:
The essence of this calculation is that the firm determines a mix of debt and equity for its capital structure such that the resulting weighted average of the costs of equity and debt are minimized. With interest costs adjusted for the fact that interest is deducted before calculating income taxes, the resultant wighted-average cost of capital [WAAC] indicates the minimum rate of earnings on any project necessary if the value of the firm is to be maintained. The WACC thus becomes an acceptable “hurdle” rate, usable as a cutoff criteria for evaluating new projects.
Combining Cash Outflows, Cash Inflows, and the Cost of Capital
Traditionally, cash outflows, cash inflows, and the weighted-average cost of capital are combined in one of two ways to determine the feasibility of an investment proposal. The two approaches are: “net present value (NPV)” and “internal rate of return (IRR)“. The interaction of cash outflows, cash inflows, and the cost of capital is shown below:
The operating rule for the net present value (NPV) approach is: If present value (cash inflows discounted at the cost of capital) is greater than project cost (cash outflows discounted at the cost of capital), make the investment because net present value is positive.
The operating rule for the internal rate of return (IRR) approach is: If the internal rate of return (the discount rate which equates cash inflows and cash outflows) is greater than the firm’s weighted-average cost of capital, make the investment.
Under most conditions, NPV and IRR lead to the same decision. However, different decisions may result under certain circumstances, such as when projects of substantially different lifetimes are compared or when cash flows fluctuate sharply from year to year. If NPV and IRR give different decisions, NPV is preferable on theoretical grounds.
Capital Budgeting And Its International Complexities
Capital budgeting for a foreign project uses the one-country framework just described, but with certain adjustments to reflect thegreater complexities in an international situation. Many of the adjustments arise because of the fact that two separate sovereign nations are involved and the operating cash flows in the host country are in a different currency than those desired by the parent company.
Project versus Parent Cash Flows
Project (e.g., host country) cash flows must be distinguished from parent (e.g., home country) cash flows. Project cash flows generally follow the domestic, or one-country model, described earlier. However, parent cash flows reflect all cash flow consequences for the parent company.
Parent Cash Flows Tied to Financing
Because of the above, parent cash flows depend, in part, on financing. Unlike the domestic situation, financing cannot be kept separate from operating cash flows. In fact, “clever” financing is often the key to making an otherwise unattractive foreign investment proposal attractive to the parent firm. Cash may flow back to the parent because the venture is structured from a financial point of view to provide such flows. Fund flows back to the parent on international projects arise from any of the following, which must be incorporated into the original investment agreement:
- License fees.
- Interest on parent-supplied debt.
- Principal repayment of parent-supplied debt.
- Liquidating dividends.
- Transfer prices paid on goods supplied by the parent.
- Transfer prices paid on goods sent to the parent.
- Overhead charges.
- Recovery of assets at project end (i.e., terminal value).
Note: depreciation is not a cash flow to the parent.
Foreign Exchange Forecasts Needed
An explicit forecast is needed for future exchange rates. Future cash flows in a foreign currency have value to the parent only in terms of the exchange rates existing at the time funds are repatriated, or valued if they are not repatriated. Hence, an exchange rate forecast is necessary. In addition, the investment decision must consider the possibility, if not the probability, of unanticipated deviations between actual ending exchange rates and the original forecast.
Long-Range Inflation Must Be Considered
Over the extended period of years anticipated by most investments, inflation will have three effects on the value of the operation:
- inflation will influence the amount of local currency cash flows, both in terms of the amount of local money received for sales and paid for expenses and in terms of the impact local inflation will have on future foreign competition;
- inflation will influence the future foreign exchange rates used to measure the parent company’s value of local currency cash flows; and
- inflation will influence the real cost of financing choices between domestic and foreign sources of capital.
Subsidized Financing Must Be Explicitly Treated
Subsidized financing available from the host government must be explicitly treated. If a host country provides subsidized financing at a rate below market rates, the value of that subsidy must be considered. If the lower rate is built into a cost-of-capital calculation, the firm is making an implicit assumption that the subsidy will continue forever. It is preferable to build subsidized interest rates into the analysis by adding the present value of the subsidy rather than by changing the cost of capital.
Political Risk Must Be Considered
The host government may change its attitude towards foreign influence or control over some segments of the local economy. This may be through sudden revolution, or it may result from a gradual evolution in the political objectives of the host goverment. Political risk is also important in determining the terminal value, because politics may impose a specific ending date which negates use of an infinite horizon for valuation purposes. If a specific ending date is mandated, the value received on that date may be extremely difficult to anticipate. In the context of premiums for political risk, diversification among countries may create a portfolio effect such that no single country need bear the higher return that would otherwise be imposed if that country were the only location of a foreign investment.
Accounting Implications For The Capital Budgeting Methodology
The key concept in this section is that accounting principles and policies that are used in a particular country are likely also to be used in developing pro-forma financial statements for a particular project. These pro-forma financial statements, in turn, are likely to be the database from which financial executives estimate future cash flows as they try to determine whether or not the proposed project has a positive or a negative net present value. If financial executives are not aware of how the foreign accounting system differs from the home system, they may base their analysis on faulty cash flow data.
Accounting differences can be grouped by type. Specifically, we can think of (1) asset costs which become expenses as they are allocated to specific time periods, (2) operating costs of the current time period which do not flow through in the calculation of current income, (3) changes in the recorded amount of debt not matched by cash payments, and (4) basic differences in underlying accounting principles and methods. Some of these differences are relevant only when estimating cash flows for a physical investment, such as a new machine or a building. Others are relevant only when investing in an entire foreign corporation, in which case past and pro forma financial statements may be the base for estimating future cash flows.
Accounting differences, by type, are discussed in the following paragraphs.
Asset Cost Allocation to Income Periods
Fixed Asset Depreciation. Variations between historical cost depreciation and some types of replacement cost depreciation lead to different net income calculations. The difference in depreciation method may influence income tax payments and consequently cash flow after taxes.
Inventory Costing. Variations between historical costing and replacement costing and also between first in, first out (FIFO) and last in, first out (LIFO) as alternative methods of historical costing, have an influence on reported income, on taxes on that reported income, and on income allocation between time periods. The first two of these influence measures of cash flow, and the third influences the timing of total cash flow, with a possible consequence for any valuation method based on discounting.
Amortization of Purchased Goodwill. In some countries, purchased goodwill is amortized, reducing net income and possibly income taxes. However, goodwill amortization is not a cash cost. In other countries, purchased goodwill cannot be amortized. In either case, cash flow must be adjusted to account for the amortization or nonamortization of goodwill, or any similar cost. Such amortization, it will be noted, is a noncash expense similar to depreciation.
Asset Revaluation. In some high-inflation countries, such as Argentina, Brazil, and Israel, fixed assets are revalued upward to bring accounts closer to reality. The related expenses, such as depreciation, are also restated. Care must be taken not to let such revaluations influence estimates of cash flow.
Nonallocation of Current Operating Costs
Charges of Expenses to Reserves. In many countries, arbitrary reserves are created, against which certain expenses are charged. Examples are reserves for bad debts and reserves for pensions or other unfunded retirement obligations. In some cases a nonspecific “reserve for contingencies” is created against very vague future uncertainties. The intent is often to manipulate income (called “income smoothing”) by arbitrarily subtracting from good years and adding to bad years. The creation of such reserves reduces reported net income without reducing cash flow, and the charging of expenses to the reserves usually involves a cash outflow not recorded in the current year.
Deferred Taxes Shown as a Liability. Treatment varies among countries between reported incomes taxes for accounting purposes and actual income taxes paid. The difference usually arises when additional expenses (such as extra depreciation or a credit for taxes paid) are allowed by the government as a “tax incentive” but are not recognized as current income by the accounting process. In any case, a bottom-up calculation which approximates cash flow from the sum of net income and noncash expenses must include as additional cash flow any increase in the deferred tax liability, because actual payments are less than the accrued expense. The capital-budgeting process must recognize the possibility of different treatment of actual and accrued taxes in various countries.
Flow Through of Translation Gains. Translation gains which flow through income statements or which are taken directly to a cumulative translation reserve must be subtracted because they do not reflect cash flows. In the United States, under Statement of Financial Accounting Standards (SFAS) No. 8, which was issued in 1975, translation gains or losses were recognized in current quarterly income. This rule was replaced by SFAS No. 52 in 1981, under which translation gains and losses are charged to a reserve account and not passed through the income statement. Each country has its own approach, not only as to how to measure such gains and losses but also where to record the gains and losses. An analyst evaluating a foreign project from past financial records must be sure that measures of cash flow exclude that impact of translation gains and losses.
Severance Pay If the Foreign Affiliate Is Closed. In many countries, local social laws require severance pay of up to several years’ annual earnings for workers who are released. Thus, if a firm decides to close a foreign operation, it may face a large cash outflow related to severance benefits to workers who lose their jobs. Such severance payments represent a large cash outflow in the last year of a project and must be considered carefully, not only when a decision to stop operations is made but also
when an operation that has some risk of economic failure is started.
Debt Changes Not Matched by Cash Payments
Foreign Exchange Translation Gains or Losses on Long-Term Debt. If a project is financed with foreign currency debt, the book amount of that debt will change as foreign exchange rates change. The resulting charge or gain may show as a decrease or an increase in current income, depending upon the translation rules in effect. However, restatement of the book amount of debt has no cash flow implications until the year in which the debt is repaid.
Noncapitalization of Financial Leases. Some countries in the world, such as the United States, require that financial leases be capitalized as debt on the balance sheet. In other countries, financial leases are not capitalized. A change in accounting procedure, under which both assets and debts are increased by the present value of a financial lease, will change the apparent cash outflow (amount of assets required) without any real change being needed. Amortization of a financial lease obligation may also vary from a strict measurement of the cash needed for lease payments. An awareness of such variations is essential.
Other Accounting Difference Aspect
Changes in Accounting Principles and Methods Without Prior Year Change. Many countries switch from one accounting principle to another, say, from one type of depreciation assumption to another, without adjusting financial statements for the prior year. Under these conditions, measures of both income and cash flow from one year to another are not meaningful. Because depreciation is a noncash expense which is often added back to obtain cash flow, as in the bottom-up example given earlier, and because income taxes paid depend in part on the depreciation approach used, a change in depreciation method in future years may have cash flow implications. If the change is made to augment (“dress up”) reported income, the cash flow implication may be negative because of the tax impact.
Treatment of Unconsolidated Subsidiaries. Unconsolidated subsidiaries are recorded differently in different countries. In some countries, unconsolidated subsidiaries are carried at original historical cost (rather than at equity, as in the United States). Hence, earnings of the foreign subsidiary are reported only when received as dividends, rather than when earned. Retained earnings in the subsidiaries, and thus subsidiary cash flow less cash dividends, are concealed. This has two consequences: (1) some cash flow from a consolidated perspective is kept secret, and (2) variations in dividend payments from nonconsolidated subsidiaries can be used to conceal variations in earnings and/or cash flow in the parent entity. In periods when the parent entity itself has abnormally low earnings, dividends from subsidiaries may be used to bolster reported earnings.
The 2001–2002 scandal at Enron Corporation in the United States was a separate type of misstatement. Nonconsolidated subsidiaries were written up, creating a nonrealized increase in earnings that was used to justify pumped-up stock prices.
Blocked Funds. If cash flow in the host country is blocked so that it is not available for dividends and consequently for reinvestment elsewhere in the world system, the value of that cash flow in a capital budgeting context can be questioned. Although no treatment can necessarily be considered “correct,” often blocked cash is valued as if it were reinvested in the local economy at a nominal risk-free rate and then repatriated at a much later date. If repatriation of blocked cash flows is not expected, those funds should have no value in the capital budgeting analysis.
International investment analysis is based on analysis of expected future cash flows from a foreign direct investment. The database for estimating future cash flows is often current and recent past financial statements. In addition, future cash flows depend on local accounting and tax treatment of profits and expenses. The essential difference between domestic and international investment analysis is that estimates of future cash flows are in different currencies and depend on local accounting methods. Those methods often differ from one country to another. This post has described the investment analysis, or capital budgeting process, for both a home country and an international project, and it has explained how different accounting procedures will influence the cash flow estimate.