Page 226 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 13: Cross-border Capital Budgeting

In the IRR method, you calculate the discount rate to make the NPV of the project zero. This Notes
means that in the IRR method, you equalize the net cash proceeds over a project’s life with the
initial investment outlay. The IRR for a project is then compared with the hurdle rate, which is
the company’s market-determined required rate of return.
If the IRR exceeds the cost-of-capital rate the project is accepted, otherwise it is rejected. The IRR
calculation is generally a trial-and-error exercise because the rate is unknown.
The accept-reject for the IRR criterion can be specified as:
If IRR > k Accept the project

If IRR < k Reject the project
If IRR = k Indifferent between acceptance and rejection of the proposal.

13.2.3 Adjusted Present Value Approach

A DCF technique that can be adapted to the unique aspect of evaluating foreign projects is the
Adjusted Present Value (APV) approach. The APV format allows different components of the
project’s cash flow to be discounted separately. This allows the required flexibility, to be
accommodated in the analysis of the foreign project. The APV approach uses different discount
rates for different segments of the total cash flows depending upon the degree of certainty
attached with each cash flow. In addition, the APV format helps the analyst to test the basic
viability of the foreign project before accounting for all the complexities. If the project is acceptable
in this scenario, no further evaluation based on accounting for other cash flows is done. If not,
then an additional evaluation is done taking into account the other complexities. As mentioned
earlier, foreign projects face a number of complexities not encountered in domestic capital
budgeting, for example, the issue of remittance, foreign exchange regulation, lost exports,
restriction on transfer of cash flows, blocked funds, etc.

!
Caution The APV model is a value additivity approach to capital budgeting, i.e., each cash
flow as a source of value is considered individually.

Also, in the APV approach each cash flow is discounted at a rate of discount consistent with the
risk inherent in that cash flow. Where
APV = Present value of investment outlay

+ Present value of operating cash flows
+Present value of interest tax shields
+Present value of interest subsidies

In equation form the APV approach can be written as:
n x n T n S
I + ∑ t + ∑ t + ∑ t
APV = 0 t t t
+
+
+
t1 (1 k*) t1 (1 i ) t1 (1 i )
=
=
=
d d
Where the term I = Present value of investment outlay
o
x t
(1 k*) t = Present value of operating cash flows
+
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