CAIIB ABFM Module B Unit 4 : Capital Budgeting For International Project Investment Decisions

06/10/2023

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CAIIB Paper 3 ABFM Module B Unit 4 : Capital Budgeting For International Project Investment Decisions (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called “Capital Budgeting For International Project Investment Decisions”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module B (THE MANAGEMENT PROCESS) Unit 4 : Capital Budgeting For International Project Investment Decisions, Aspirants must go through this article to better understand the topic, Capital Budgeting For International Project Investment Decisions and practice using our Online Mock Test Series to strengthen their knowledge of Capital Budgeting For International Project Investment Decisions. Unit 4 : Capital Budgeting For International Project Investment Decisions

Foreign Investment Analysis

Special Considerations-Foreign & Home Currency Cash Flows
Adoption of a currency conversion rate, particularly for cross currency transactions, will need care and efforts.
If the project implementation time is long, the foreign currency valuation can pose problem because of the rate volatility.
Your imports and exports, borrowings and repayments, dividends and repatriation; all will be at rates fluctuating from time to time.
Elaborate workings and spread sheets, including for estimates, will be required.
One may have to keep updating or revising in case of major exchange rate fluctuation.
Moreover, the foreign investment cash flows, made in the relevant foreign currency, may need integration with Indian cash flows if the activities are integrated or the project cost benefits are shared both between the overseas outfit and local entity.
One has to make a choice about the currency, on the basis of which one is dominant from the project point of view.

Foreign Currency Discount Rates Computation

Converting local currency into a foreign currency is done at a prevailing rate which is called spot rate.
Even spot rate varies from one form or mode of the currency to another such as currency notes, travellers’ cheques, telegraphic transfer etc. However, if you want to contract for purchase at a future date, the rate called forward contract rate is to be adopted.
If you want to sell your local currency to buy say USD at a future date, there will be discount to the value of your currency because you will have to pay future premium.
Future contract rate needs to be adjusted by the interest rate and the time factor.
To calculate the forward rate, we have to multiply the spot rate by the ratio of interest rates and adjust for the time until expiration.
Thus, this aspect of currency rates is an important aspect while conducting the exercise of capital budgeting for foreign investments.

Capital Asset Pricing Model

The abbreviated term CAPM describes the relationship between the risk and the returns or specifically, between the systemic risk and expected returns.
The returns are always based on the risk and the time value of money.
For pricing of a particular security or investment product, one has to undertake quite a few analyses.
CAPM is one such method.
This is generally done for risky assets, so that the price paid is appropriated to generate expected returns.
Basically, one would like to find out risk free return over a time.
A beta is generated, which is a measure of volatility or the systemic risk compared to the market as a whole.
A security beta is calculated by dividing the product of the co-variance of the security’s returns and the market returns by the variance of the of the market returns over a specified period.
If it was possible to accurately forecast future cash flows, this type of derivative method would not be necessary. However, that not being the case, an investor would like to depend on such pricing method.

Calculation of CAPM

Cost of Equity (re) = Risk-Free Rate + Levered Beta x Market Risk Premium

Cost of Equity (re) = rf + βL x (rm – rf)

where: rf = risk-free rate

βL = levered beta

rm = expected return on the market

rm – rf = market risk premium

Risk-Free Rate (rf):

The expected rate of return on an investment in a security considered to have no inherent risks is referred to as the risk-free rate.
The actual risk-free rate that is used in CAPM shifts depending on the yields that are currently available for the selected security.

Market Risk Premium (rm – rf or mrp)

The difference between the expected return on an investment and the risk-free rate is known as the market risk premium.

Beta (β)

The S&P 500 index has traditionally been used as a stand-in for the market when calculating beta, which is a measure of the co-variance between the rate of return on a company’s stock and the return on the overall market (systematic risk).

Example: rf = 7% , βL = 1.20 Rm – rf = 6%, Calculate Cost of equity using CAPM method

Cost of Equity (re) = rf + βL x (rm – rf)

= 7% + 1.2 (6%) = 7% + 7.2%

= 14.2%

Example: Calculate cost of equity where risk free rate of return is 10%, the firm’s beta is equal to 1.75 & market return in 15%

Cost of Equity (re) = rf + βL x (rm – rf)

= 10% + 1.75 (15%-10%)

= 10% + 1.75*5

= 10% + 8.75% =18.75%

Arbitrage Pricing Theory

This is an alternative method to CAPM.
While CAPM takes into account security returns and market returns, this method or theory goes beyond it, thinking that market sometimes misprices securities.
APT, therefore, tries to take advantages of any or many arbitrage opportunities or derivatives in the market or the economy.
It uses the linear relationship between the asset’s expected return and a number of macroeconomic factors or variables that affect or capture the systemic risk.
GDP, Domestic Inflation Rate, Stock Indices, Gold Prices, risk free rate of interest are such factors.

ILLUSTRATION

For example, the following four factors have been identified as explaining a stock’s return and its sensitivity to each factor and the risk premium associated with each factor have been calculated: (RP means Risk Premium)

Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
Inflation rate: ß = 0.8, RP = 2%
Gold prices: ß = -0.7, RP = 5%
Sensex index return: ß = 1.3, RP = 9%
The risk-free rate is 3%

Using the APT formula, the expected return is calculated as:

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

Example: Let us take a look at an arbitrage pricing theory example. For this example, let’s consider our asset as a commodity stock called GOLD 123. The stock has two risk factors associated with it – inflation and the price of the U.S Dollar currency.

Rf (risk free rate) = 2%

Inflation – Risk premium = 2%, Beta = 0.2

U.S Dollar – Risk Premium =10%, Beta = 0.5

E(ri) = Rf + β1 *(factor 1) + β2 *(factor 2) + …+ βn *(factor n)

E(ri) = 0.02 + 0.2 * (0.02) + 0.5 * (0.10)

= 0.02 + 0.004 + 0.05

= 0.074, or 7.4%

In this arbitrage pricing theory example, the expected return of GOLD 123 is equivalent to 7.4%.

Issues Involved In Evaluation Of Overseas Projects

While the methods of evaluation of overseas projects are the same as for the domestic projects, the following issues are involved:

Calculation of Discount rate: Arriving at an appropriate discount rate is essential for applying the discounting methods of project evaluation. While the risk-free interest/discount rate is readily available in both India and the foreign country, we have to arrive at the relevant risk-adjusted discount rate.

The method applied for this will be clear from the following

(1 + ra) = (1 + rf) * (1 + rp)

Where,

ra = risk-adjusted discount rate,

rf = risk-free discount rate

rp = the risk premium

ILLUSTRATION: The following data is provided:

The risk-free discount rate in USA is 4%
The risk-free discount rate in India is 7%
The risk-adjusted discount rate, required by the company in India is 12% We have to calculate the risk-adjusted discount rate in USA, which will be acceptable to the company.

(1 + 0.12) = (1 + 0.07) * (1 + rp)

(1 + rp) = 1.12/ 1.07 = 1.0467

calculate the risk adjusted discount rate for US$, as under:

(1 + ra) = (1 + rf) * (1 + rp) or,

(1 + ra) = (1 + 0.04) * 1.0467 = 1.0888 = 8.88%

risk-adjusted discount rate, applicable for cash flows in US$

Here we have assumed that the risk premium, required by the company for the US project is same as acceptable to it for a similar Indian project.

However, in practice, it may require a higher risk premium in view of the additional risks involved like, trade barriers, currency fluctuations, stringent laws etc.

Approaches For Evaluation Of Overseas Project

There are, basically, two approaches for foreign project evaluation, viz. Home Currency Approach and Foreign Currency Approach.

Home Currency Approach

Under this approach, all the cash flows of the project are converted in to home currency (rupee) by applying the actual/estimated spot rate at the time of the cash flow.
These cash flows are then discounted using the domestic risk-adjusted discount rate.

This approach will be clear from the following

ILLUSTRATION: The following data is provided:

The cash flows of the project are as under (in US$, lakh):

Initial investment 100
First year net cash inflow 30
Second year net cash inflow 40
Third year net cash inflow 50
Fourth year net cash inflow 50

The risk-adjusted rupee discount rate, required by the company, which is envisaging project in USA, is 12%

The notional risk-free interest rate in USA is 4%

The notional risk-free interest rate in India is 7%

Current Spot rate of 1 US$ is Rs. 80

We have to calculate the PV of the cash inflows of the project which has a useful life of 4 years, using the Home Currency approach.

Solution:

1st calculate the estimated spot rate for 1 US$, as under:

S1 = 80 * (1 + 0.07)/ (1 + 0.04) or,

S1 = 80 * (1.07)/ (1.04) = 80 * 1.0288

= Rs. 82.310

For 2^nd Year,

S2 = 80 * (1.0288)² = 80 * 1.0585

= 84.6820

For Third Year

S3 = 80 * (1.0288)³ = 80 * 1.0889

= 87.1130

For Fourth Year

S4 = 80 * (1.0288)4 = 80 * 1.1203

= 89.6250

Foreign Currency Approach

Under this approach, the cash flows of the project remain in the foreign currency only and are not converted in to home currency (rupee).
These cash flows are then discounted, using the risk-adjusted discount rate of the foreign currency.
The present value of the discounted cash flow, thus arrived, is converted in to home currency by applying the Present Spot Rate.

This approach will be clear from the following

ILLUSTRATION: The following data is provided:

a.The cash flows of the project are as under (in US$, lakh):

Initial investment 100
First year net cash inflow 30
Second year net cash inflow 40
Third year net cash inflow 50
Fourth year net cash inflow 50

The risk-free discount rate in USA is 4%
The risk-free discount rate in India is 7%
The risk-adjusted discount rate, required by the company, in India, is 12%
Current Spot rate of 1 US$ is Rs. 80

We are required to calculate the PV of the cash inflows of the project, which has a useful life of 4 years, using the Foreign Currency approach.

(1 + ra) = (1 + rf) * (1 + rp)

(1 + 0.12) = (1 + 0.07) * (1 + rp)
(1 + rp) = 1.12/ 1.07 = 1.0467

calculate the risk adjusted discount rate for US$, as under:

(1 + ra) = (1 + rf) * (1 + rp) or,
(1 + ra) = (1 + 0.04) * 1.0467 = 1.0888 = 8.88%

Evaluation Methods

Evaluation methods using Home Currency Approach

Pay- back period method

Step 1.

Estimate the spot rate for each year of the project’s life by using the formula, St = S0 * [(1 + rh)/ (1 + rf )]t

Step 2.

Convert foreign currency cash inflows in to home currency inflows, by using the spot rates arrived at in step 1

Step 3.

Convert initial investment in foreign currency in to home currency by using actual present spot rate

Step 4.

Find out the period during which the cash inflows in home currency are equal to the initial investment in home currency. This is the pay-back period.

Payback period = 2 + 2144/4356 = 2.49 years

NPV method

Step 1.

Estimate the spot rate for each year of the project’s life by using the formula, St = S0 * [(1 + rh)/ (1 + rf)]t

Step 2.

Convert foreign currency cash inflows in to home currency inflows, by using the spot rates arrived at in step 1

Step 3.

Convert initial investment in foreign currency in to home currency by using actual present spot rate

Step 4.

Discount the cash inflows using the domestic risk-adjusted discount rate and find their PV.

Step 5. Calculate NPV by subtracting initial investment from the PV

Internal Rate of Return Method

Step 1.

Estimate the spot rate for each year of the project’s life by using the formula, St = S0 * [(1 + rh)/ (1 + rf)]t

Step 2.

Convert foreign currency cash inflows in to home currency inflows, by using the spot rates arrived at in step 1

Step 3.

Convert initial investment in foreign currency in to home currency by using actual present spot rate

Step 4.

By trial and error, find that discount rate which makes the PV of cash inflows equal to the initial investment

ILLUSTRATION:

IRR (r)of the project:

8000 = 2469/(1 + r) + 3387/(1 + r)² + 4356/(1 + r)³ + 4481/(1 + r)⁴

By trial and error, the rate is about 27%

Profitability Index Method

Step 1.

Estimate the spot rate for each year of the project’s life by using the formula, St = S0 * [(1 + rh)/ (1 + rf)]

Step 2.

Convert foreign currency cash inflows in to home currency inflows, by using the spot rates arrived at in step 1

Step 3.

Convert initial investment in foreign currency in to home currency by using actual present spot rate

Step 4.

Discount the cash inflows using the domestic risk-adjusted discount rate and find their PV.

Step 5.

Calculate PI by dividing PV by the initial investment

ILLUSTRATION:

So, PI = PV/ Initial investment = 10,852/ 8000 = 1.356

Evaluation methods using Foreign Currency Approach

Pay- back period method

Step 1.

Find out the period during which the cash inflows in foreign currency are equal to the initial investment in foreign currency. This is the pay-back period

So, the pay-back period is 2 + (30/ 50) =2.6 years or 2 years and 7.2 months

NPV method

Step 1.

First calculate the risk-adjusted discount rate for foreign currency, which will be acceptable to the company, by using the formula; (1 + ra) = (1 + rf) * (1 + rp)

Step 2.

Discount the cash inflows in foreign currency, using this risk-adjusted discount rate for foreign currency, to arrive at the present value of the cash inflows in foreign currency.

Step 3.

Convert the figure, arrived at Step 2 to home currency by multiplying it by the present spot rate.

Step 4.

Convert the initial investment to home currency by multiplying it by the present spot rate.

Step 5.

Calculate NPV by subtracting initial investment from the PV

ILLUSTRATION:

Internal Rate of Return Method

Step 1.

First calculate the risk-adjusted discount rate for foreign currency, which will be acceptable to the company, by using the formula; (1 + ra) = (1 + rf) * (1 + rp)

Step 2.

By trial and error, find out that rate of discount which makes PV of cash inflows in foreign currency, equal to initial investment in foreign currency. This is the IRR of the project.

Step 3.

If the rate calculated in step 2 is more than that in step 1, the proposal is acceptable.

For finding IRR (r), use the formula;

80 = 30/(1 + r) + 40/(1 + r)² + 50/(1 + r)³ + 50/(1 + r)⁴

By trial and error, the value of r can be found, which will be about 35%

Profitability Index Method

Step 1.

First calculate the risk-adjusted discount rate for foreign currency, which will be acceptable to the company, by using the formula; (1 + ra) = (1 + rf) * (1 + rp)

Step 2.

Discount the cash inflows in foreign currency, using this risk-adjusted discount rate for foreign currency, to arrive at the present value of the cash inflows in foreign currency.

Step 3.

Convert the figure, arrived at Step 2 to home currency by multiplying it by the present spot rate.

Step 4.

Convert the initial investment to home currency by multiplying it by the present spot rate

Step 5.

Divide the figure of step 3 by the figure of step 4 to arrive at the PI