International Business Finance: Evaluating an Investment Proposal - Assignment Example

Finance Task Q 1(a) Determine whether the proposed investment in Gujistan satisfies the investment criteria set by PASE plc. Also discuss the limitations of the criteria in context of this project and then advise the company whether or not it should invest in the project. The Finance Directors of this company need to consider the above question in real earnest and should not jump into any conclusions before assessing the full facts of the case. The principal criteria that this proposed investments in Gujistan need to assume is in terms of the following: 1. Criteria : FDI should achieve Payback discounted period of 7 years 2. Criteria : The project should have a positive Net Present Value The Discounted Payback System (DPS) of evaluating capital investments are a shade better than the payback system since the former also considers the time value of investments. It is “An Investment decision rule in which Cash flows are discounted at an Interest rate and one determines how long it takes for the sum of the discounted cash flows to equal the initial investment.” (Investing glossary: Discounted payback period rule, 2010). Fundamentally speaking, the DPS considers the time frame within which the investment outlay is recompensed to the promoters through cash inflows. When comparing different investment options, the Finance Director would seek to choose such projects in which the discounted payback period is lower, since these would be more economically viable for the company, in terms of returns on investments. However, there are also a host of factors and variables that also need to be considered. In this Case Study of PASR Plc, the first thing that needs to be considered is the yearly outflows from the project. Computation of Cost of Capital: For the purpose of computing CoC, only PASE (parent investor company figures are considered) 1. Equity capital rate – 7.5% 2. Rate of inflation – 2.5% 3. Hurdle Rate - 5. 0% Total 15% Investments for this project: G$ 900m excluding documentation and working capital costs. It is necessary to conduct computation of Payback discount in order to decide whether this investment would be able to payback at the end of seven years. Computation of Payback discount (in millions) Year Cash Outflows (G$) Cash Inflows (G$) Discount Factor (15%) (G$) Total (G$) Cumulative 1. 1. (900) 30 .8696 + 26 (900) +26 2. 177 .7561 + 133 +159 3. 229 .6575 + 150 +309 4. 238 .5718 +136 +445 5. 264 .4972 +131 +576 6. 282 .4323 + 121 + 697 7. 309 .3759 +116 + 813 From the above chart it is evident that even after the 7th year, the discounted inflows have not been able to meet the primary cost of investments and at the end of the 7th year there is still an uncovered deficit of G$ 87 m ( 900- 813). Thus from the point of view of the Payment discount method, this project does not seem to be viable as it cannot meet the criteria of paying back investments within the first 7 years of the workings of the project. Project got rejected under Project discount method. It is now necessary to consider the second criteria, which is Net Present Value (NPV) method, in the event of a positive cash outflow, this project may be considered as a viable and feasible option. “The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.” (Net present value – NPV, 2010). (B) Under Net Present Value Method: Under this Method this project could be considered viable if the net present value is greater than 0, and is positive. Under this method, depreciation is not considered but the element of depreciation is taken in computation of Tax as shown in Appendix 2. Under Net Present Value Method(millions) Year Cash Outflows (G$) Cash Inflows (G$) Discount Factor (15%) (G$) Total (G$) Cumulative 1. 1. (900) 30 .8696 26 (900) 26 2. 200 .7561 151 177 3. 250 .6575 164 341 4. 258 .5718 148 489 5. 283 .4972 140 629 6. 300 .4323 130 759 7. 326 .3759 122 881 NPV -19 The NPV in this case is negative and thus this project cannot be rendered feasible. Thus, the investment proposal has failed on both counts of Payback discount and NPV and it is recommended that this project is not taken up by this company. Limitations of this project: Considering the limitations of this project it could be said that a capital intensive investment proposal of this nature needs to consider a long term perspective and not necessarily a seven year period, since the impact of depreciation, taxation and other impacts need to be considered. When the discounted factors of the inflows are considered it perhaps does not meet the criteria of acceptance of this project. Thus, since both NPV and Payback Discount have not been positively inclined, this project may not be considered. 1 b) Discuss the major risks which PASE plc will face if it decides to implement the project. Your answer should include a discussion of how the risks can be mitigated or managed by the company. Foreign direct investment plays a crucial, astonishing and critical role in the development of international business. Foreign direct investments (FDI) are self-motivating in nature for companies because their profits multiply in instances. The home country PASE plc is investing in the host country Gujistan for the purpose of construction of a power station. PASE plc is a UK based company which wants to invest in the central Asian country called Gujistan for a power station. While investing in a business, four topics of financial management should be analyzed by a company. The four topics which PASE plc should consider before making the investment decision is the financial performance of the company, the financial condition of PASE plc, the financial structure and the alterations which can be made in the capital structure of the company. The major risk in a FDI is that the investment process always has an element of uncertainty because it involves different governmental levels which are there in different countries. FDI is a very time consuming process. The major risk for PASE plc’s investment in the Gujisatn project is that of Political risk. Gujisatn has undergone tremendous political changes and has recently turned into a politically stable country so there is an apprehension about what will happen if once again Gujistan returns to its political instability. “Political risk arises because unexpected modifications of the legal and fiscal frameworks in the host country may change the economic outcome of a given investment in a drastic manner.” (Moosa 2002, p.50). Gujistan is an emerging market and there is a high level possibility of country risk in terms of location, trade barriers, political and economic factors. The market for power utility in Gujistan should be analyzed because if there is not a strong market for the investment then the investment will not be cost effective. So Market risk or demand risk is a risk factor for PASE plc. The total cost of the project is G$900 million and the company PASE plc will have to spend G$540 million in the first year itself with full financing of the project by the UK based company PASE plc. This investment by PASE plc is a highly expensive venture which also has a lengthy incubation period which implies that it will be an extended project so the results of the investment cannot be quickly found. The direct investment period is for 10 years. So the risk factor in terms of time is also high. Country risk in FDI should be investigated properly before investing and so PASE plc should study the country properly before investing. In the Economic risk factor there is monetary risk because there is high level of inflation in Gujistan when compared to UK. While the inflation rate in PASE plc’s country UK is 2.5% the current inflation rate in Gujistan was 15 percent in 2010 and it is expected to stabilize at 10 per cent only so there is high level of monetary risk for PASE plc. The treatment of tax on profits generated in Gujistan will have an effect on the net return of PASE plc’s investment in Gujisatn because there is a 5 % withholding tax by Gujistan on the profits while making remittance by PASE plc to UK. Tax policies in UK require PASE plc to pay cooperation tax of 30% which is considerably high which indicates a negative impact of the UK tax rate on the investment in Gujistan. The depreciation rate of 50% for plant and machinery is a high risk factor. Transfer risks exist in all foreign direct investments. Gujistan’s currency is pegged against US dollars and not directly to UK pounds and secondly there is a wide difference between the official spot rate and the unofficial spot rate. The Government of Gujistan has not yet decided on the forward exchange rate policy. The instability of the foreign exchange rate is also a risk factor. Since FDI changes the weighted cost of capital so there is a risk factor because it is the weighted cost of capital which shows the amount of returns that the company has to pay to the shareholders How the risks can be mitigated or managed by the company? PASE plc is investing in Gujistan for the construction of a power house. Gujisatn has the natural resources like natural oil and gas. FDI helps in the development of both the home as well as the host country. PASE plc faces some risks while making FDI in Gujistan like Political Risk, Economic Risk which includes monetary risk, fiscal risk and Exchange rate risk. Inflation levels in Gujistan could be controlled by adopting new monetary policies. Gujistan has agreed to waive the taxes on these profits for the first three years it can be asked to extend it to a term of 6 years so that the business is established. The problem of Double Taxation is also a risk factor. PASE plc can request the UK government for the signing of a Double Taxation Treaty by the two countries in order to eliminate the problem of double taxation so that FDI could be made more beneficial. The company PASE plc can force the Gujistan government to use a fixed depreciation rate from the beginning so that it is equalized every year and the company does not face financial pressure in the first year. The differences between the official spot rate and unofficial spot rate in the exchange rate should be nullified. The Company PASE plc can ask the Gujistan government to incorporate the option of a floating currency exchange rate with the fixation of an equilibrium rate and effort should be made to maintain it and revise the rate according to the economic profits. The company PASE plc should make arrangements for loans from other sources without disturbing the weighted cost of capital. Political risks can be eliminated to a certain extent if financing is done from the subsidiary country. The interest rates can be reduced if PASE plc decides to source finance from some other country rather than UK. PASE plc should compare and contrast the risks and the rewards associated with this investment decision in order to make a good investment decision. 1 c) Comment on the sources of capital employed by PASE plc in financing its Operations: Capital employed means the investment that PASE plc needs to operate the investment function. In order to finance its operations a company needs to make use of both its long term and short term finances. In financing an investment project, it is better to raise funds in UK with a combination of both debt and equity capital. For long term projects it is better that the company uses long term finance loans at fixed rates of interest. The definition of capital employed as many dimensions like capital employed can be considered as simply shareholders equity in which case the profits will be the net profit available to shareholders after deduction of tax and expenses. Capital employed can also be defined as shareholder’s equity plus the long term liabilities of the firm etc. In this case the net profit figure is the figure before the deduction of long term liability interest and the tax. “In order to test the solvency position of a business, it is usual to calculate the ratio of long term liabilities to capital employed. The ratio of long term liabilities to capital employed provides an indication of the extent to which the business has incurred obligations to pay back loan capital in the longer term.” (Robson 2000, p.104). The balance sheet of PASE plc shows that the company has 1,200 million shares of 50 pence each but the market price of each share is 350 pence. It also has debt capital in the form of 6.5% secured bank loan of £200 million, and 4.5% December 2030 Eurodollar bond of $3,740 million of $1000 each, both presently trading at parity. In financing the Gujistan project the directors of PASE plc does not want to change the capital structure ratio but then it plans to further raise its equity capital by issuing right shares to its existing shareholders at a price of 297.5 pence each. It also raises it debt capital by 10 year at an unsecured loan at 7.5% interest rate p.a from syndicated sterling bank. The change in weighted cost of capital will affect the return to shareholders. It is better that the company sPASE plc finances the Gujistan project through the debt financing mode instead of changing the equity capital by allotting right shares because it is a long duration project of 10 years and so debt financing is the better option. The net present value and the investment rate of return should be analyzed while making FDI decisions. Q.2 2 (a) The Spot Rates for Euro /GBP = 1 GBP = Euro 1.11 The Spot Rates for GBP/US$ = 1 GBP = US $ 1.49 Similarly, for 30 days forward trading: 1 GBP = Euro 0.877 1 GBP = 1.53 US $ The forward rate is often seen expressed as a discount or premium as compared to spot rate. “If the spot Pound buys more dollars than the forward, the forward pound could be said to be at a discount equal to the difference between the spot and forward rates.” (Reading 1960). In the event it is the forward that buys more, it could be said to be at a premium. Similarly if the spot pound buys more Euros than the forward, the forward pound could be said to be at a discount and it would be a premium if vice versa. Applied in this context, it is evidenced that the in the GBP/Euro nexus, the forward GBP is at a discount, whereas in the case of GBP/US$, it is seen that the forward pound is at a premium. The reason could be the volatility of markets and the recessionary trends in the currency market. 2 (b) It is seen that the pooling of cash balances is more lucrative rather than individual holdings since this could ensure greater degree of liquidity and ease of operations. This “avoids need for costly conversions and/or swaps.” (Baird 2007, p.13). c) Discuss the benefits and possible drawbacks to the parent company and to each subsidiary if a system of pooling were to be introduced as a general policy of the group. Cash pooling is a system of cash management system in which the credit and debit positions are combined into a single account. It is a system of cash management in which debit balance in an exchange are counter balanced against the credit balance of the other. The concept of cash pooling is based on the foundation of a Zero based concept in which credits are offset against debits. The system of cash pooling minimizes the interest rate expense and at the same time maximizes interest profits. The subsidiary company should make remittances to the parent company. Cash pooling is a system of cash management. The benefits of the cash pooling system to the whole group of parents and subsidiary companies are that the liquidity of the companies in a group is controlled through the system of cash pooling. The deliberation of cash management through the cash pooling system leads to an efficient and transparent cash management system. The benefits to a parent company are that the parent company has better commanding powers over the liquid assets of the subsidiary group of companies. The parent company also can use the funds flexibly by transferring funds from subsidiaries which are rich to the poor. The parent company also gets higher rate of return on investments through the method of cash pooling. The parent company also has the risk and may have to bear the liability in case if it does not supply adequate funds to the subsidiary for its operations. The subsidary companies benefit because cash floats in according to their requirement through the system of cash pooling. The benefit of the cash pooling system is that it reduces the need for external financing in subsidiary companies as it improves the net interest rate. The drawback for the subsidiary company is that it is totally dependent on the parent company for funds in the case of cash pooling. The benefits of the cash pooling system will be overshadowed if the cash management system does not take preventive steps in the case of liquidity. Reference List Baird, S., 2007. Designing a regional liquidity structure for Europe. [Online] Treasury Strategies, p.13. Available at: http://www.treasurystrategies.com/resources/presentations/EuroCashPoolingWC07.pdf [Accessed 11 April 2010]. Investing glossary: Discounted payback period rule, 2010. [Online] Trading-Glossary. Available at: http://www.trading-glossary.com/d0220.asp [Accessed 11 April 2010]. Moosa, I.A., 2002. Foreign direct investment: Theory, evidence and practice. [Online] Palgrave Macmillan, p.50. Available at: http://books.google.co.in/books?id=0VUafaE3pOIC&pg=PA50&dq=risks+in+home+country+in+FDI&hl=en&ei=fv2-S6a0JZLCrAffib25CQ&sa=X&oi=book_result&ct=result&resnum=8&ved=0CGEQ6AEwBw#v=onepage&q=risks%20in%20home%20country%20in%20FDI&f=false [Accessed 11 April 2010]. Net present value – NPV, 2010. [Online] Investopedia. Available at: http://www.investopedia.com/terms/n/npv.asp [Accessed 11 April 2010]. Reading, B., 1960. The forward pound 1951-59. [Online] Royal Economic Society. Available at: http://www.jstor.org/pss/2228730 [Accessed 11 April 2010]. Robson, A.P., 2000. Essential accounting for managers. [Online] Cengage Learning EMEA, p.104. Available at: http://books.google.co.in/books?id=zdHk05t8ULYC&pg=PA100&dq=definition+of+capital+employed&hl=en&ei=HQnAS-u0N8KvrAf7v4y0CQ&sa=X&oi=book_result&ct=result&resnum=8&ved=0CFgQ6AEwBw#v=onepage&q=definition%20of%20capital%20employed&f=false [Accessed 11 April 2010]. APPENDIX – 1 Value of Plant and Equipment for year 2010 G$ 900,000,000 Less 50% Depreciation written off during the year G$ 450,000,000 Written down value at beginning of 2011 G$ 450,000,000 Less : 5% Dep during 2011 22,500,000 Written down value at beginning of 2012 G$ 427,500,000 Less : 5% Dep during 2012 21,375,000 Written down value at beginning of 2013 G$406,125,000 Less: 5% Dep during 2013 20,306,250 Written down value at the beginning of 2014 G$385,818,750 Less5% Dep .during 2014 19,290,938 Written down value at the beginning of 2015 G$ 366,527,812 Less : 5% Dep. during 2015 18,326,390 Written down value at the beginning of 2016 G$348,201,422 Less: 5% Dep during 2016 17,410,071 Written down value at the beginning of 2017 G$330,791,351 APPENDIX – 2 narration 2010 2011 2012 2013 2014 2015 2016 Profits Less Dep.(5% wdv) 30 200 23 250 21 300 20 330 19 350 18 380 17 Less: Tax (15% from 4th year) . 30 nil 177 nil 229 nil 280 42 311 47 332 50 363 54 Net profits 30 177 229 238 264 282 309 Read More