Nature of international capital budgeting decision

Shareholder wealth is created when the firm makes an investment that will return more in a present value sense than the investment costs. Perhaps the most important decisions that confront the financial manager are which capital projects to select. By their very nature, capital projects denote investment in capital assets that make up the productive capacity of the firm. These investments, which are typically expensive relative to the firm’s overall value, will determine how efficiently the firm will produce the product it intends to sell, and thus will also determine how profitable the firm will be. In total, these decisions determine the competitive position of the firm in the product marketplace and the firm’s long-run survival.

Difficulties and importance of international capital budgeting decisions .Multinational capital budgeting decisions are relatively more complex than domestic investment decisions because the international firms have to deal with issues related to, among others, exchange rate risks, expropriation risk, blocked funds, foreign tax regulations, political risk and differences between basic business risks of foreign and domestic projects. However, in spite of the complex problems of investing abroad, there is an increasing trend to set-up subsidiaries by MNCs and to have direct foreign investment by international firms in other countries. The major motivating factors for undertaking these investments are as follows: (1) Comparative cost advantage is a major factor in favour of foreign investments; (2) Taxation is another vital economic/financial incentive to make such investments; (3) Financial diversification, in terms of spreading the firm’s risk over a wider range than just one nation, constitutes yet another economic motivation for multinational firms.

Foreign capital budgeting projects/decisions are more difficult to evaluate than domestic capital budgeting projects. For operational purposes, there is a need to develop a conceptual framework that enables the set of factors mentioned above to be measured/reduced to a common denominator so that the various foreign investment projects under consideration can be evaluated on a uniform basis.

Capital structure of MNC versus domestic firm

There is no consensus on its issue because some characteristics of MNC may favour a debt intensive capital structure while other characteristics may favour an equity intensive capital structure. The arguments are as follows:

A debt intensive capital structure would favour a firm that has stable net cash inflows since it could readily make the interest payments on debt with these cash inflows. Since the MNCs are often well diversified geographically, the diversification reduces risk, therefore, the impact of any single event on net cash flow is tolerable. Consequently, an MNC will be able to handle a greater debt burden as a percentage of capital than a purely domestic firm.

The other characteristics of an MNC that might cause its cash flow to be more volatile than a purely domestic firm are:

(a) The earnings of subsidiary company earnings are subject to host government tax rules that could change over time;

(b) Host government could force the local subsidiaries to maintain all earnings within the country. This is the case of blocked funds which destabilizes the net cash flows from the subsidiary to the parent. In the absence of cash flow, it may not be able to make its periodic interest payments to creditors. In this case, MNCs should maintain an equity intensive capital structure. However, a well diversified MNC would not face this kind of problem;

(c) The MNCs are affected by exchange rate variations, their net cash flows may be more unstable;

(d) If an MNC is well diversified among countries, then the subsidiary earnings are in a variety of currencies.

MNCs that generate more stable net cash flows can maintain a leveraged capital structure. While adapting to the local capital structure following advantages and disadvantages should be borne in mind:

The main advantages are as follows:

1. A localized financial structure reduces the criticism of foreign affiliate that had been operating with too high a debt ratio.

2. A localized financial structure helps in evaluating the returns on investments, relative to local competitors in the same industry.

3. In economies where interest rates are relatively high because of scarcity of capital, the penalty paid for borrowing local funds reminds the management that unless the returns on the assets, i.e. negative leverage they are probably misallocating the scarce resources.

The disadvantages of localized capital structures are:

1. A subsidiary might be having the comparative advantage only in sourcing of capital from the parent. Therefore once it starts adopting the local capital structure, it looses the comparative advantage.

2. If the financial structure of each subsidiary company is localized, the consolidation of the balance sheet of all the subsidiaries may not conform to any particular financial structure.

3. This feature could increase perceived financial risk.

4. This may push the consolidated debt ratio out of discretionary range of acceptable debt ratios in the flat area of the cost of capital.

5. A multinational firm will not be able to replace the high cost debt of an affiliate with low cost debt if the markets are segmented and the Fisher effect does not operate.

6. The debt ratio of a foreign affiliate, in reality, is cosmetic. The lenders look towards parent rather than the subsidiary for amortisation of loans.

Optimal capital structure

When companies mobilize funds, they are mainly concerned with the marginal cost of funds. The companies should always try to expand keeping in view their optimal capital structure. However, as their capital budget expands in absolute terms, their marginal cost of capital (MCC) will eventually increase. This means that companies can tap the capital market for only some limited amount in the short run before their MCC rise, even though the same optimum capital structure is maintained.

A variety of factors affect a company’s cost of capital: its size, access to capital markets, diversification, tax concessions, exchange rate risk, and political risk. The first four factors favour the multinational company, where as the last two factors favour the purely domestic company. Figure 14.3 shows multinational companies usually enjoy a lower cost of capital than purely domestic companies for a number of reasons. Firstly the multinational companies usually enjoy a lower cost of capital than purely domestic companies for a number of reasons. Firstly the multinational companies may borrow money at lower rates of interest because they are bigger, (2) they may raise funds in a number of capital markets, (3) the MNCs are more diversified than purely domestic companies, and (iv) the MNCs are able to lower their overall taxes because they can use tax heavens. The MNCs are less riskier than purely domestic companies and because these not only diversify in domestic investment projects but across countries also. The lower overall risk of multinational companies tends to reduce their overall taxes because they can use tax heavens. The MNCs are less riskier than purely domestic companies and because these not only diversify in domestic investment projects but across countries also. The lower loverall risk of multinational companies tends to reduce their overall cost of capital.

Fig. 14.3. Optimum capital structure

Figure 14.3. shows that the optimum capital budget (B) of a typical multinational company is higher than the capital budget (A) of a purely domestic company. The multinational corporations can tap foreign capital markets, when the domestic markets are saturated and their risk is lower than that of purely domestic companies. International capital availability and lower risk permit multinational companies to lower their cost of capital and maintain a constant MCC for a broad range of their capital budget. They have more investment opportunities than purely domestic companies. These two factors give multinational company higher optimum capital structure than the optimum structure of domestic companies.

Date: 2014-12-28; view: 2738