Joint Venture Investment Appraisal Report - Assignment Example

Joint venture Investment Appraisal Report Introduction Multinational corporations (MNC) are businesses engaged in production or sale of goods or services in multiple countries. There are several advantages of a company being a multinational. Multinational firms are exposed to more risk than domestic firms. These risks include agency costs, environmental constraints, regulatory constraints and Ethical constraints. Therefore, an understanding of the foreign exchange markets, international financing, different regulatory environments and management of taxation is important to the MNC. This paper is an evaluation of a joint venture, its cost and benefit to IMF Plc. To determine if the Joint venture between IFM and EFM Plcs is beneficial IFM will use tools of capital budgeting. This will involve a thorough evaluation of the financial implications of the Joint Venture on IFM, the non-financial risks exposures of carrying out the joint venture with EFM. It will also involve understanding the risks exposure to the parent company, IFM, in relation to tax reporting and fund transfer. Wholly-owned MNC can circumvent financial constraints in cases of currency depreciations (Hebous & Weichenrieder, 2009) while Joint ventures may not have this benefit. According to Srivastava (2008), MNCs need to respond well to changes in the financial environment to cope with the problems and risks that arise from from their operations while capitalizing on the emerging markets. Multinational financial systems allow MNC’s to arbitrage tax systems, financial markets, and regulatory systems. Multinational financial systems allow multinational MNCs to shift funds internally and accounting profits. Investment Appraisal Methods Investment appraisal is a method of determining if an investment is worthy taking up. We will look at the appraisal methods that are available in brief (Götze, et al., 2008). Payback Method This method is used to determine the time that it will take to repay the initial capital cost (Brigham & Daves, 2007). Information about the returns of the investment is required to calculate the payback period. Payback does not keep in consideration the time value for money according to (Kinney & Raiborn, 2011). Payback does not consider cash flow that may be generated after the period considered for payback. For high capital investments that require longer periods of time to generate higher cash flow may not favour this method of evaluation. This method suits short term investments. Payback method is calculated by Where Period can be in moths, days or weeks, the period chosen must be equal to the periods of cash flow calculation. If you calculate cash flow in months calculate the period also in months. Account Rate of Return (ARR) This method compares the cost of an investment with the profit generated by the investment (Hansen & Mowen, 2007). This method simply is a ratio of Annual return or profit to initial cost of investment. Its simplicity offers several limitations as it requires a benchmark rate for comparison. An investor needs to know what percentage return is worthy investing in. There is no measure or initial method to determine what is the right investment return. It ignores time value of money just like Payback method. These two methods are called discount methods. Net Present Value (NPV) NPV calculates the net value of the investment while taking into consideration the changing value of cash. This method tries to calculate the amount need to be invested to attain certain annual revenue in a specified period of time. The value of money will be affected by interest rates payable on a certain investment. This method is good in comparing alternative investments. NPV assumes a constant capital gearing. This rarely happens as constant refinancing the project will be needed according to (Delaney, et al., 2008). This method cannot be used in environments where companies are facing capital rationing. Capital rationing is where there is a limitation to the amount that can be invested. In this situation it is important to use both profitability indexing and NPV to evaluate the viability of an investment. Where i = interest rate n= number of years NPV uses a process called discounting Cash flow. Using discounted cash flow method finance accountants can determine which investment over a longer period of time is more beneficial even though the first may yield higher returns in a shorter period of time. This method is appropriate in evaluating different investments with the same cost. Internal Rate of Return (IRR) This method allows the risks associated with an investment are assessed. IRR discounts future cash flow of a given investment to the point where the Net Value Present is equal to zero. This method gives a margin of safety in case of decline of rate of return. Brigham & Daves, (2009) argue that IRR’s biggest drawback is that it can give two different IRR rates for the same period cash flow if the inflows and outflows reverse during the investment. The method also assumes that the inflows will be reinvested during the period of investment. IRR allows finance accountants to compare performance of two investments with different initial capital demands. Profitability Indexing It allows comparision of cost and benefits of different projects. It is a ratio of Net Present value to Initial capital cost. Selection of an appraisal method When selecting an appraisal method the consideration of the consideration will be given to the need or type of investment, the degree of accuracy, measure of future cash flow and the ability to measure future interest. IFM’s Joint venture will require usage of different appraisal methods. In choosing a method of appraisal for a joint venture cash flow can be affected by foreign exchange, exchange controls, management fees, transfer prices adjustments or royalties paid. The appraisal method that IFM chooses will need to take into consideration on the revenue and cash flow generated from the subsidiary in Germany. Research from both American and United Kingdom shows that many companies prefer other methods over NPV despite the numerous deficiencies these methods have. To take into consideration additional risk from non-financial factors such as political risk and environmental risk companies choose from three methods i.e. Adjusting the Payback period to be as short as possible, adjusting the discount rate or adjusting the cash flow to reflect the new risks. Adjusting cash flow is the recommended method though. Preferred Appraisal Method The preferred method of appraisal for IFM Plc joint venture with EFM is Net Present Value. NPV takes care of changes in cash flow and interest rates. IFM’s capital gearing is 88% and has been stable for the last five years. The constant capital gearing favours the use of Net Present value as a method of appraisal. The second reason why we chose NPV as the method of appraisal is its ability to give comparative figures of two strategic options. While IFM is evaluating the joint venture and alternative investment venture that yields 12% profit is available. Hence, both investment options can be compared to determine viability. Finally, we choose this method because it only restriction is in cases of capital rationing. IFM is well capitalized. With no need for debt financing for the joint venture the availability of cash to invest is not in doubt. This method therefore, will not require calculations of the profitability index as the cost of the second investment option is not fully known. Investment Analysis We will use multinational capital budgeting methods to analysis the best option for IFM Plc; whether to enter a joint venture or invest the money in an alternative investment vehicle that yields 12% interest. Multinational capital budgeting will identify the capital put at risk, estimate the future cash flows, identify appropriate discount rates then apply investment appraisal method to determine the joint venture’s acceptability index. The determination of the viability of the joint venture only cash flow from the German subsidiary will be considered as using the cash flow from the parent company will not show the competitiveness of the German subsidiary in its market. Financial Assumptions Capital investment of in the JV The capital requirement for the JV is 2Million Euros paid in two years – year 0 and year 1. Financing Financing of the JV will be through 50% by IFM and 50% EFM. Calculations The interest rate parity for the investment is year 0 and year 1 is: Where Year Calculation Exchange rate in Euros Year 0 1*0.841 0.841 Year 1 1.01/1.02 * 0.841 0.8328 Year 2 (1.01/1.02)2 * 0.841 0.8246 Year 3 (1.01/1.02)3 * 0.841 0.8165 Year Cash Flow in Euro millions Expected exchange rate Cash Flow in £ millions 0 1.2 0.841 1.0092 1 2.240 0.8328 1.865472 2 2.576 0.8246 2.1241696 3 2.9624 0.8165 2.4187996 Year 0 cash flow is 60% of the value of IFM’s investment requirement (60% * 2 Million Euros) total of 1.2 Million Euros. Year 1 cash flow is 40% of the initial investment plus 0.9Million Euros plus 0.450Million pound (0.540 Euros). The total is 2.240 Million Euros Year 2 is 2.240 Million Euros plus 15% of 2.24 which is equal to 2.576 Million Euros Year 3 is 15% of 2.576 Million plus 2.576 million = 2.9624 Calculations Cost of equity Cost of Debt Calculation of weighted average cost of capital Where Re = cost of equity Rd = cost of debt E = firm’s equity D = firm’s Debt V= E+D D/V = Debt % E/V = Equity % Tc = Corporate Tax Projected cash Flows in Germany (Euro millions) Year 0 1 2 3 Net cash flow 1.2 2.24 2.576 2.9624 Taxation 0.348 0.6496 0.74704 Net cash flow after tax 1.2 1.892 1.9264 2.21536 Attributable to IFM 1.2 5.48 7.152 8.9248 Net present value = -1.2 + Recommendation to Senior Management Team Other factors that have been considered are The joint venture produces a positive Net Present Value then you could argue that Electrotact should not invest in the joint venture with Copeit. However it might be sensible to consider the following: are the projections regarding sales and costs conservative or optimistic ? would it be possible to negotiate a higher price for Electrotact’s share of the joint venture after three years ? is the company reliable and trustworthy ? should Electrotact have used its existing weighted average cost of capital to evaluate the joint venture ? (see part b) for further on this point) sensitivity or scenario analysis should be undertaken to measure the impact on the NPV of the different variables Part II To: Senior Management Team (SMT) From: Accountant Date: 18th April 2014 Subject: Strategic Re-Domiciling of Plc IFM in Monaco Operational Challenges Re-domiciling the company there are advantages that IFM will benefit from. Its highest revenues are generated from Monaco. This in effect will mean that the need to transfer funds to the head office in Paris, France will be eliminated. The cost of generated revenue transfer is high and though many time multinationals can get away with it through inter-company transfers it is still significant. Taxation Monaco is a low tax country. Domiciling IFM in Monaco will assist IFM in tax arbitrage as they can reduce the total cost of taxes paid by filling groups taxes in Monaco. Considerations of the joint Monaco is a low-tax nation. It also generates the highest revenue for IFM. Moving the company’s head office and centralized treasury to Monaco will see the company save on tax. Taxes differ from country to country with most common forms of taxes being company income tax, Capital Gain tax, and tax on retained earnings. With the benefit of the multinational financial system IFM’s decision to move to Monaco can be beneficial to the company by allowing tax arbitrage – moving retained earnings through intercompany transfer to the head quarter where it will attract less taxation. Key Operational challenges Moving operations from the head quarter will mean moving the centralized treasury from France too. This will have a major effect on the company’s remittances to and from other subsidiaries. The subsidiaries operate with one treasury and this poses risks. Inflation Inflation is a factor that the company has to consider when re-domiciling its operations. The inflation rate in Monaco is higher than that of France. This poses challenges to the company. The Working capital and the Spot rate are factors that are determined or influenced by inflation. The purchasing power parity being the key component in determining spot rate the movement of operations will definitely poses major challenges to the company. Operational Cost The operation cost may increase. The current operational cost of the business are relatively stable allowing the company to make a stable profit. Increasing operational cost of setting up in the Island will affect the business. Worldwide versus territory Taxation IFM needs to review its taxation mechanism. There are two ways that MNCs deal with taxes. Either they remit their taxes in the countries of origin or in the domiciled (host) country. Campbell, stated that worldwide taxes system is a situation where a company pays its taxes in it host country regardless of where the profits were generated (Campbell, 2004) Part III: Sources of Finance IFM can rais finance for the expansion into Asia through a number of methods. Financing of operations is a risky business as it may leave the company exposed with little liquidity. This means that IFM must consider more than one source of funding for the expansion without putting the current business ventures into strain. Funds for multinational corporations can be raised internally or from external sources. Internal source will include share capital, reinvestment of retained earnings or loan from parent company. External sources are: Commercial Banks This is a good source of finance for IFM as its books are good. Commercial Banks will provide the required finances for international expansion in foreign currency. Banks can offer short-term overdrafts to finance operations or they can be used to acquire long term financing for the business setup. Discounting of Trade Bills Discounting of trade bills is a short-term financing method that many corporate can enjoy. This method is widely used in Asia and Europe making it a perfect method for short-term finance for IFM. It can be used for both international and domestic finance needs. Companies holding bills get to cash them before they mature through a bank. The cashing of the bills is through a discount. Euro-currency Market – When the currency is deposited outside the country of origin.  It is termed as Eurocurrency.  For example, US $ deposited outside United States is termed as Euro-dollar.  These deposits are largely outside the control of national banking activities.  Thus, euro-currency market is another attractive source for borrowing foreign currency. Euro-bond Markets – Euro-bond have emerged as a significant source for capital investment. They are primarily sold within the Eurozone. Mainly they are sold in different countries from the countries where the company or business that is sourcing for funds is domiciled. They are denominated in currency other than that of the country in which they are being sold. It would be Bonds denominated in Yen and sold in US, Britain are known as euro-bonds. Development Banks – financing can be sort from development backs which operate in many countries. They fund large companies and large projects. The investment needs of IFM qualify them to get a long term loan from a development bank. Asian countries are likely to offer incentives to companies of the size of IFM so as to invest in the country. This incentive leads to countries / governments to fund proportion s of the initial capital needs for the company. International Agencies – another common source for finance in large companies is interntional agencies such as IMF, World bank, European Bank etc. International agencies have private wings that fund large developmental nees. IFC is a subsidiary of the world bank that fund private sector. These international agencies came into being for financing specific category of projects.  International Finance Corporation (IFC) and World Bank assist developing countries by financing projects in private and public sectors.  Also Regional Development Banks provide finance to various projects in certain countries for priority projects. References Brigham, E. & Daves, P., 2007. Fundamentals of financial management. 11th ed. s.l.:Thomson Higher Education. Brigham, E. & Daves, P., 2009. Intermediate Financial Management. 10th ed. s.l.:Cengage Learning. Campbell, H., 2004. When Good Law Goes Bad: Stanley Works’ Recent Dilemma and how the Internal Revenue Code Disadvantages U.S. Multinational Corporations Forcing Their Flight to Foreign Jurisdictions.. Syracuse Journal of International Law and Commerce, 31(95), pp. 95-120. Delaney, C., Rich, S. & Rose, J., 2008. Financing costs and NPV analysis in finance and real estate. Journal of Real Estate Portfolio Management, 14(1), pp. 35-40. Götze, U., Northcott, D. & Schuster, P., 2008. Investment Appraisal: Methods and Models. 1st ed. Berlin: Springer. Hansen, D. & Mowen, M., 2007. Managerial accounting. 8th ed. s.l.:Thomson South-Western. Hebous, S. & Weichenrieder, A. J., 2009. Debt Financing and Sharp Currency Depreciations: Wholly vs. Partially Owned Multinational Affiiates, s.l.: Unpublished. Kinney, M. & Raiborn, C., 2011. Cost Accounting – Foundations and Evolutions. 8th ed. Mason: South-Western Cengage Learning. Srivastava, R. M., 2008. Multinational Financial Management. 1st ed. New Delhi: Excel Books. Read More