Acceptance Criteria For Foreign Investments

Acceptance Criteria For
Foreign Investments
By Harsh Vardhan Gupta

MBA 3rd Sem
Rollno 10
 A multi national firm, in simple terms, means a company
with substantial operations carried on outside its own
national borders. These activities may be trading or
manufacturing.
 Whatever the activities, the important fact is that the firm

must make decision about project returns which have a
sizeable impact on the company. So, the financial
manager has to take great care in measuring returns in the
form of cash flows and also in developing the acceptance
criteria for accepting or rejecting the project in any
country.
 Broadly the process can be divided into three
parts:
1. Need for investment in foreign projects
2. Determination of expected cash flows
3. Acceptance criteria for these projects
Need for investment in foreign projects
 The need for investment can be broadly

classified into two groups:
a) To increase the return or reduce the total risk of

a company
b) On the basis of market characteristics
To increase the return or reduce the total
risk of the company
1. Comparative advantage: It states that in terms of total output for
the society, each productive is more effective if used in those
tasks for which its relative advantage over other alternatives is
greatest.
In international corporate operations, the theory of comparative
advantage can be related to:
a) Labour skills or unit costs:- the wage rates paid in many
countries are much lower than what is paid in developed
countries. So, this could be a reason for the companies to invest
in such countries if the goods to be produced are labour intensive.
b) Transportation expenses:- the firms may favour establishment of
several plants around the world to overcome high transportation
costs. The selection of site here will try to minimize
transportation costs to customers and to lower total unit costs.
Countries selected would minimize average miles per unit
delivered.
c) Capital markets:- limitations on capital export & import can produce
rate differentials among different countries’ capital markets. For eg:
when the local government commits public policy towards
encouragement of a particular enterprise, then special tax concessions
may offer attractive financing incentives for the MNC.
2. Operational constraints
3. Taxation:
If lower corporate taxes are available in some area,
then it attracts the management to invest there in
order to maximize shareholder’s returns; either the
absolute rate of taxes may be low or the definition of
taxable income may be advantageous.
4. Financial diversification:
Financial diversification or spreading the firm’s risk
throughout a wider range than any one nation will
permit, is also an economic motivation for good
investment.
B) Market Characteristics
1. Return on investment
2. Market dominance :- Market dominance is related to profitability. A cross sectional regression
analysis based on 106 companies was presented by Gale in which he evaluated the impact of
market share, firm size and concentration as some variables for rate of return .
He founded that the positive relationship between market share and profitability were greater for
 High concentration industries
 Moderate growth industries than the rapid growth industries
 Relatively large firms than the small firms
 large firms in high concentration industries with relatively moderate growth than any firm. His
conclusion is consistent with the strategy of a firm seeking access to particular markets in the
expectation of greater long run profitability from obtaining a dominant market share.
3. Product life cycle :- it suggests that the corporation will be forced to seek untapped markets
because of increasingly broad penetration of a market and company’s incremental investment.
it is a dynamic oligopoly theory in which declining margins in one land induce the firm to go
abroad.
4. Monopolistic advantage
5. Oligopolistic market structure
Some of the difficulties that are encountered in
multinational settings
1. Joint products : If the proposed investment in another country is either a
form of vertical integration or horizontal integration, then it becomes
difficult to measure the revenues independently bcoz when joint effects
exist, the firm evaluates the project by aggregating total demand for the
project.
2. Economies of scale : when there are substantial production economies of
scale; individual small projects should be charged for the add. costs
involved in the diseconomies of not using a centralized manufacturing
policy.
3. Supervisory fees and Royalties: parents often require supervisory fees and
royalties from their subsidiaries as means of remitting funds from foreign
projects. In evaluating the cash flow of the project and cash flow to the
parent there lies a difference. For the project, the relevant cash flow is the
after-tax cost of what a real payment for the supervision on patent use
would be worth in an arm’s length transaction. For the parent evaluating the
cash flow to itself from the project, the supervisory and royalty inflows
after subtracting any incremental costs simply constitute one more cash
return.
4. Value of equipment contribution : when manufacturing is
involved in a project, the contribution of used equipment
from the parent can be a central item.
5. Tie- in Sales
6. Inflation and currency fluctuations
7. Taxation of income
8. Remission of funds
 For analyzing a particular project, the manager needs to consider the
return that should be demanded for that project.
 First, there are traditional corporate finance percepts on the cost of
capital as the relevant hurdle rate.
But we must also assess what adjustment, if any, must be made to take
into account the fact that the project is located in a foreign land.
The nature of the adjustments depends on the type of capital market we
envisage.
Cost of Capital – The Basic Theory
The minimum rate of return that the project must yield is the
cost of funds used to finance it.- its cost of capital.
The combination of the sources of funds used to finance the firm
is called the capital structure of the firm. The optimum
capital structure for a firm is that one which minimizes the
total cost of funds for that firm.
To find the optimum capital structure, we have to know the risks
of the firm and the returns it expects to generate.
The risks of a firm fall into two categories:
1. The risks derived from the investment projects themselves –
the business risk. and
2. the risks derived from how the firm is financed – the
financial risk.
The cost of capital as the required rate of
return
 There are two factors that need special attention:
1. Long term capital structure :-
2. Business risk specific to the project:- the firm’s cost

of capital is related to the return and risks of all its
investments and it is the weighted avg of cost of
capitals of all its projects. So, while evaluating a
specific project, the cost of capital of the firm
should be approximated to match that project.
Cost of capital for a foreign project
1. The case of efficient markets:- in efficient

markets, the cost of capital chosen to discount the
return from a project with a given risk is
intrinsically the same whether the project is
located in home or abroad. However, the cost of
capital figure should correspond to the cost of
capital in the currency used to measure the returns
from the project. thus if both have the same risk,
then the investor would demand the same return.
2. The case of inefficient markets:- the financial markets of most countries are better
described as inefficient than efficient. the reasons responsible for this inefficiency are :-
 an investment may be extraordinary large or the returns may be so far in the future that
the lack of information on which returns can be estimated is a serious problem to pricing.
 Investors in other nation may not know about the project . So, the returns to someone
present in the economy may be extraordinary large as others are not bidding for the
project.
 there may be barriers to capital movement outside the country as per nations policy and
also inside the country in an effort to protect their own infant industry or to avoid foreign
domination
 Segmented capital markets disequilibrium in the markets
 Special financing arrangements unique to many projects depending upon their location.
There are two factors that may account for the different cost of capital for a foreign
project than for a domestic project with the same total risk
A) Country differences in capital structures

B) Effects of consolidated financial statements
Cost of equity as a hurdle rate
 An alternative to the concept of the average cost of capital is the
concept of return to equity, one of the components of the total
cost of capital. This approach can be particularly useful when
special financing arrangements are attached to the specific
project. However, in order for this approach to lead to correct
conclusions, we must specify the financing sources throughout
the entire life of the project. an example of a situation in which
management usually concentrates its analysis on the return to
equity is the shipping industry. Here, the yard that manufactures
the ship supplies a substantial amount of the total funds reqd,
secured only by the ship. The return to the equity holders is a
function of the ship’s cost, revenues and operating expenses and
the timing of particular financing scheme offered by a given
shipyard.
 Holding the cost, revenue and operating cost
constant, it is obvious that the shorter loan option
will have a lower return to equity in normal
settings. Essentially, the cheaper debt financing will
be paid off sooner,meaning that the ship will be
financed increasingly by larger portfolio of equity
over its life. Without debt on which to lever the
return to equity in later years, the return to equity
will be lower than otherwise would be the case.
Cash flows to parent v/s cash flows to
project
At the most basic level, the ultimate risk and return
considerations should be for the parent company’s
stockholders. but the points which complicate this view
are:-
1.The investors in the parent are increasingly from a world
wide family so they may want a worldwide purchasing
power return which isa difficult preposition.
2. Many companies in the true multinational tradition accept
role as worldwide investors. So, it hardly matters then,
whether the funds are remitted to the parent company or
kept in the host country.
In most cases the firm will verify that the project
return and the parent return are both agreeable.
but there are other financial consideration also,
beyond the return of the project and the return to
the parent, like liquidity, reported earnings and
alternative uses of cash which the firm has to take
care of.
 Thank you for your patience

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Acceptance Criteria For

By Harsh Vardhan Gupta

 Whatever the activities, the important fact is that the firm

 The need for investment can be broadly

a) To increase the return or reduce the total risk of

 Moderate growth industries than the rapid growth industries

 Relatively large firms than the small firms

2. Business risk specific to the project:- the firm’s cost

1. The case of efficient markets:- in efficient

A) Country differences in capital structures

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