Page 221 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes If the blocked funds can be utilised in a foreign investment, the project cost to the investor may
be below the local project construction cost. Also, if the opportunity cost of the blocked funds is
zero the entire amount released for the project should be considered as a reduction in the initial
investment.

Tax Issue

Both in domestic and multinational capital budgeting, only after-tax cash flows are relevant for
project evaluation. However, in multinational capital budgeting, the tax issue is complicated by
the existence of two taxing jurisdictions, plus a number of other factors. The other factors include
the form of remittance to the parent—dividends management fees, royalties, etc., tax withholding
provision in the host country, existence of tax treaties, etc. In addition, tax laws in many host
countries discriminate between transfer of realised profits as against local reinvestment of these
profits. The ability of the multinational firm to reduce its overall tax burden through the transfer
pricing mechanism should also be considered.
To calculate the actual after-tax cash flows accruing to the parent the higher of the home or host
country tax rate can be used. This will represent a conservative scenario in the sense that if the
project proves acceptable under this alternative then it will necessarily be acceptable under the
more favourable tax scenario. If not, other tax saving may be incorporated in the calculation to
determine whether or not the project crosses the hurdle rate.

Project versus Parent Cash Flows

Substantial differences can exist between the project and parent cash flows because of tax
regulations and exchange controls. Also, expenses such as management fees and royalties are
returns to the parent company. In the light of substantial differences that can exist between
parent and project cash flows, the important question is on what basis should the project be
evaluated. Should the project be evaluated on the basis of
1. Its own cash flows?
2. Cash flows accruing to the parent company?

3. Both?
Evaluating a project on the basis of its own cash flows serves some useful purposes. The project
must be able to compete successfully with other domestic firms and also earn a rate of return in
excess of its locally based competitors. If not, the management and the shareholders of the
parent company would be better off investing in the equity/government bonds of local firms.

However, such a comparison is many times not possible because most foreign projects replace
imports and generally do not compete with existing local firms. Yet, evaluating projects on the
basis of local cash flows has the advantage of avoiding currency conversion and hence eliminating
problems involved with fluctuating/forecasting exchange rates changes for the life of the project.
A strong theoretically valid criterion in financial management is to evaluate the foreign project
from the viewpoint of the parent company. Cash flows which are actually remitted to the parent
are the ultimate yardstick for company performance and form the basis for distribution of
dividends to the shareholders, repayment of interest and debt to lenders and other purposes.
This helps in determining the financial viability of the project from the viewpoint of the MNC
as a whole. The cash flows that are remitted to the parent consist of both operating cash flows
and financial cash flows like fees and royalties, interest on loans given by the parent. However,
the theory of capital budgeting postulates that an investment should be evaluated only on the
basis of net after-tax operating cash flows generated by the project. Since these flows are usually
lumped together, care should be taken that financial cash flows are not mixed with operating
cash flows.

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