Multinational Business Finance

This article will focus on capital budgeting as it applies to multinational corporations. Capital budgeting could be the result of purchasing assets that are new for the organization or getting rid of some of the current assets in order to be more efficient. Capital budgeting for the multinational corporation presents many problems that are rarely found in domestic capital budgeting. There will be a review of recommendations that could assist financial analysts with conducting a cost benefit analysis and reviewing cash flow from the perspective of the parent corporation and its subsidiaries.

Keywords Capital Budgeting; Capital Costs; Chief Financial Officer; Discounted Cash Flow Analysis; Expropriation; International Capital Budgeting; Net Present Value Technique; Rates of Return; Risk Adjusted Discount Rate; Transfer Pricing

International Business > Multinational Business Finance

Overview

Many organizations charge the finance department with overseeing the financial stability of the organization. The chief financial officer (CFO) may lead a team of financial analysts in determining which projects deserve investment. To do this, an organization undertakes capital budgeting; a process that frequently involves conducting a cost-benefit analysis. A cost-benefit analysis comprises a comparison between the cash inflows (benefits) and outflows (costs) in order to determine which is greater. Capital budgeting could result in the purchasing of assets that are new for the organization or the removal of some of the current assets in order to be more efficient. The finance team is charged with evaluating which projects would be good investments, which assets would add value to the current portfolio, and how much the organization willing to invest into each asset.

In order to answer the questions about potential assets, there are a set of components to be considered in the capital budgeting process. The four components are initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value (NPV) technique. Most of the literature discusses how the capital budgeting process operates in the traditional, domestic environment. However, as the world moves to a more global economic environment, consideration needs to be made as to how multinational corporations will conduct the capital budgeting process when operating in countries outside of their home base.

International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation. Some of the techniques (i.e. calculation of net present value) are the same as traditional finance. However, "capital budgeting for a multinational is complicated because of the complexity of cash flows and financing options available to the multinational corporation" (Booth, 1982, p. 113). Capital budgeting for the multinational corporation presents many problems that are rarely found in domestic capital budgeting (Shapiro, 1978; Ang & Lai, 1989).

Financial analysts may find that the analysis of foreign projects is more complex than domestic projects due to the need to:

• Distinguish between parent cash flow and projects cash flow Multinationals will have the opportunity to evaluate the cash flow associated with projects from two approaches. They may look at the net impact of the project on their consolidated cash flow or they may treat the cash flow on a stand alone or unconsolidated basis. The theoretical perspective asserts that the project should be evaluated from the parent company's viewpoint since dividends and repayment of debt is handled by the parent company. This action supports the notion that the evaluation is actually based on the contributions that the project can make to the multinational's bottom line.

Some organizations may want to evaluate the project from the subsidiary's (local) point of view. However, the parent company's viewpoint should supersede the subsidiary's point of view. Multinational corporations tend to compare their projects with the subsidiary's projects in order to determine where their investments should go. The rule of thumb is to only invest in those projects that can earn a risk-adjusted return greater than the local competitors performing the same type of project. If the earnings are not greater than the local competitors, the multinational corporation can invest in the host country's bonds since they will pay the risk free rate adjusted for inflation.

Although the theoretical approach is a sound process, many multinationals tend to evaluate their projects from both the parent and project point of view because of the combined advantages. When looking from the parent company's viewpoint, one could obtain results that are closer to the traditional net present value technique. However, the project's point of view allows one to obtain a closer approximation of the effect on consolidated earnings per share. The way the project is analyzed is dependent on the type of technique utilized to report the consolidated net earnings per share.

• Recognize money reimbursed to parent company when there are differences in the tax system The way in which the cash flows are returned to the parent company has an effect on the project. Cash flow can be returned in the following ways:
• Dividends — It can only be returned in this form if the project has a positive income. Some countries may impose limits on the amounts of funds that subsidiaries can pay to their foreign parent company in this form.
• Intrafirm Debt — Interest on debt is tax deductible and it helps to reduce foreign tax liability.
• Intrafirm Sales — This form is the operating cost of the project and it helps lower the foreign tax liability.
• Royalties and License Fees — This form covers the expenses of the project and lowers the tax liability.
• Transfer Pricing — This form refers to the internally established prices where different units of a single enterprise buy goods and services from each other.

• Anticipate the differences in the inflation rate between countries given that it will affect the cash flow over time

• Analyze the use of subsidized loans from the host country since the practice may complicate the capital structure and discounted rate The host country may target specific subsidiaries in order to attract specific types of investment (i.e. technology). Subsidized loans can be given in the form of tax relief and preferential financing, and the practice will increase the net present value of the project. Some of the advantages of this practice include adding the subsidiary to project cash inflows and discount, discounting the subsidiary at some other rate, risk free, and lowering the risk adjusted discount rate for the project in order to show the lower cost of debt.
• Determine if the political risk will reduce the value of the investment Expropriation is the ultimate level of political risk, and the effects of it depends on when the expropriation takes place, the amount of money the host government will pay for the expropriation, how much debt is still outstanding, the tax consequences of expropriation and the future cash flow.
• Assess the different perspectives when assessing the terminal value of the project Estimating the salvage value or terminal value depends on the value of the project if retained, the value of the project if purchased by outside investors and the value of the project if it were liquidated. The corporation would use the assessment that yields the highest value.
• Review whether or not the parent company had problems transferring cash flows due to the funds being blocked An example would be when a host country limits the amounts of dividends that can be paid. If this were to occur, the multinational corporation would have to reexamine its reinvestment return and other methods in which funds could be transferred out of the country. The blocked funds can be used to repay bank debt in the host country and allow the organization to have open lines of credit to other countries.

• Make sure that there is no confusion as to how the discount rate is going to be applied to the project

• Adjust the project cash flow to account for potential risks One must assume that every project has some level of risk. The risk is usually seen as part of the cost of capital. International projects tend to have more risk than domestic projects. Therefore, it is advantageous to review the risk based on the parent's and project's perspective. Each perspective has a different way of adjusting risk. For example, the parent company may propose to treat all foreign risk as a single problem by increasing the discount rate applicable to the foreign projects or incorporate all foreign risk in adjustments to forecasted cash flows of the project. The first option is usually not recommended because it may penalize the cash flows that are not really affected by any sort of risk and it may ignore events that are favorable to the organization. The four components are initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value (NPV) technique.

Application

Given the complexities experienced by most multinational corporations when evaluating foreign investments, researchers in the field have indicated a need for a better way to evaluate the investments. One proposal was to establish operational foreign investment criteria that are consistent with the behavioral theory of the corporation. Stonehill and Nathanson (1968) conducted a survey to see what methods were utilized by organizations when making multinational financing investments. The researchers used Fortune's list and selected 219 American firms and 100 foreign firms. The results of their research revealed that most foreign and domestic investment alternatives use the same capital budgeting procedures, there was a difference in the way that organizations viewed foreign income, over 64 percent of the organizations did not vary cost or capital for foreign investments, nearly all of the organizations indicated that they made allowances for risk, and nearly all of the organizations consolidated majority owned foreign subsidiaries with domestic divisions.

Oblak and Helm (1980) conducted a similar study to see if there had been any significant changes since the study conducted by Stonehill and Nathanson. Their survey was sent to 226 Fortune 500 organizations which operated wholly owned subsidiaries in 12 or more foreign countries. There was a 26% response rate and the capital budgets of the respondent firms ranged from $10 million to $2 billion annually with a median of $200 million. The results of the survey indicated that multinational corporations conducted more detailed analyses of their foreign projects. Compared to the results found by Stonehill and Nathanson in 1966, Oblak and Helm reported that a higher percentage of multinational corporations used discounted cash flow methods and adjusted for risk in foreign project evaluations. However, the corporations had not made a significant change in the way in which they measured the returns from foreign projects or determined the appropriate discount rate.

Viewpoint

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• "Capital budgeting is a financial analysis tool that applies quantitative analysis to support strong management decisions" (Bearing Point, n.d.). Capital budgeting seeks to provide a simple way for the finance department to see the "big picture" of the benefits, costs and risks a corporation planning to make short term and/or long term investments may experience. Unfortunately, many of the leading methods for capital budgeting resulted in problems; especially when an organization is using a standardized template. Examples of potential problems include:
• The benefits, costs, and risks associated with an investment tend to be different based on the type of industry (i.e. technology versus agricultural).
• A corporation may highlight the end results of the return on investment model and the assumptions that support the results versus a balanced analysis of benefits, costs, and risks.

If an organization does not account for the above-mentioned scenarios, there is a possibility of skewed results, which would make the data unusable. This type of error could keep a project from being approved. Therefore, it is critical for financial analysts to have a more effective and efficient technique to use. Bearing Point (n.d.) identified several leading practices that organizations are using in order to avoid reporting faulty information. The theme in all of the techniques is that capital budgeting is not the only factor considered. Other quantifiable factors are utilized in order to see the big picture.

• Consider the nature of the request — The type of benefit obtained by the investment will determine the nature of the request. Therefore, it may be beneficial to classify the benefit types into categories such as strategic, quantifiable and intangible.
• All benefits are not created equal — Benefits should be classified correctly in order to properly analyze. There are two types of benefits — hard and soft. Hard benefits affect the profit and loss statement directly, but soft benefits do not have the same effect.
• Quantify risk — Make sure that the risks are properly evaluated. In most cases, risks are neglected. Also, it would be a good idea to build a risk factor into whatever model is utilized.
• Be realistic about benefit periods — Make sure that the expectations are realistic. In the past, corporations have created unrealistic goals for the benefits period by anticipating benefits to come too early and reusing models that reflect the depreciation period for the capital asset.

Conclusion

Capital budgeting could be the result of purchasing assets that are new for the organization or getting rid of some of the current assets in order to be more efficient. The finance team will be charged with evaluating which projects would be good investments, which assets would add value to the current portfolio, and how much the organization is willing to invest into each asset. International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation.

International capital budgeting can be a very complex process as the financial analysts carefully conduct a cost benefit analysis comparing cash inflow and outflow. Stonehill and Nathanson (1968) recognized that there could be potential problems when applying the "pure" capital budgeting theory to a multinational corporation, and made the following recommendations when performing the techniques:

• Incremental cash inflow from the viewpoint of the parent corporation should include dividends, know-how payments, interest and loan repayments, export profits, any intangible gains, and the "cash out" value of the subsidiary at a time horizon that allows capital budgeting to reflect the value of reinvested earnings. Cash outflow should include both equity and loan capital provided to the subsidiary.
• Incremental cash inflow from the viewpoint of a foreign subsidiary should include net earnings after local taxes but before depreciation interest and "know how" payments. Cash outflow should be the original investment in assets.
• The parent corporation should discount the cash flows by its normal weighted average cost of capital under an "optimal" capital structure.
• The foreign subsidiary should discount its cash flow by its own weighted average cost of capital under an "optimal" capital structure. The optimal capital structure may be different than other local firms because of the financial backing of the parent corporation (p. 52).

Terms & Concepts

Capital Budgeting: Method for choosing which long-term projects to invest in by comparing the costs with the rates of return.

Capital Costs: The costs assumed when the decision is made to invest in one project over others; is equal to the possible rate of return on the projects which were not invested in.

Chief Financial Officer: Executive position responsible for a company’s financial planning and recordkeeping.

Discounted Cash Flow Analysis: Analytical tool which measures valuation; follows the capitalization approach to value.

Expropriation: The action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty.

International Capital Budgeting: When projects are located in host countries other than the home country of the multinational corporation.

Net Present Value (NPV) Technique: Method for determining the value of an investment; accounts for the initial costs of the investment along with the present value of the expected cash flows.

Rates of Return: Comparison of the money gained or lost on an investment with the amount of money invested.

Risk Adjusted Discount Rate: Sum of an investment’s risk premium (the risk characteristics of the investment) along with the risk-free rate (generally the return on short-term U.S. Treasury securities).

Transfer Pricing: The price of the sharing of goods between different parts of the same company; allows for the individual calculation of each division’s profit and loss.

Bibliography

Ang, J., & Lai, T. (1989). A simple rule for multinational capital budgeting. Global Finance Journal, 1, 71-76. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6338721&site=ehost-live

Bearing Point (n.d.). Improve your capital budget techniques. Retrieved July 9, 2007, from http://office.microsoft.com/en-us/help/HA011553851033.aspx

Booth, L. (1982). Capital budgeting frameworks for the multinational corporation. Journal of International Business Studies, 13, 113-123. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4667759&site=ehost-live

Guillén, M. F., & García-Canal, E. (2009). The American model of the multinational firm and the "new" multinationals from emerging economies. Academy of Management Perspectives, 23, 23-35. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=39985538&site=ehost-live

Lutz, S. (2012). Determination of market values and risk premia of multi-national enterprises and its application to transfer-pricing. International Business Research, 5, 1-7. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84380674&site=ehost-live

Maria, M. (2009). Operational risk in international business: Taxonomy and assessment methods. Annals of the University Of Oradea, Economic Science Series, 18, 195-201. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=48497630&site=ehost-live

Oblak, D., & Helm Jr., R. (1980). Survey and analysis of capital budgeting methods used by multinationals. Financial Management (1972), 9, 37-41. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5031602&site=ehost-live

Shapiro, A. (1978). Capital budgeting for the multinational corporation. Financial Management (1972), 7, 7-16. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5029365&site=ehost-live

Stonehill, A., & Nathanson, L. (1968). Capital budgeting and the multinational corporation. California Management Review, 10, 39-54. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5045314&site=ehost-live

Suggested Reading

Dotan, A., & Ovadia, A. (1986). A capital-budgeting decision-The case of a multinational corporation operating in high-inflation countries. Journal of Business Research, 14, 403-410.

Edmunds, J., & Ellis, D. (1999). A stock market-driven reformulation of multinational capital budgeting. European Management Journal, 17, 310-316.

Stanley, M. (1993). Multinational capital budgeting, emerging markets and managerial agency: A proposal for an ethically constrained capital budgeting model. Business & Professional Ethics Journal, 12, 87.