International investment and financing decisions

Advanced Financial Management (AFM) · ACCA · 5 min read

Welcome to International Investment Appraisal!

Hello future finance leaders! Today, we are taking your Net Present Value (NPV) skills on a trip around the world. In the basic AFM syllabus, you learned how to value projects in your home country. Now, we are looking at what happens when a company decides to set up a factory or office abroad.

Don't worry if this seems tricky at first—it’s essentially the same NPV you already know, just with a few "travel hurdles" like different currencies, foreign taxes, and political risks. Think of it like planning a vacation: you need to worry about the exchange rate and local laws, but the goal (having a good time/making a profit) remains the same!

1. The Two-Stage Approach to International NPV

When a parent company (let's say in the UK) invests in a project (let's say in the USA), there is a standard process we follow to see if it's worth it. We call this the Foreign to Domestic method. It is the most common method tested in AFM.

Step-by-Step Process:

1. Local Cash Flows: Calculate the project's cash flows in the foreign currency (e.g., USD $ \$ $).
\n2. Foreign Tax: Deduct any tax paid to the foreign government.
\n3. Remittances: Determine how much of that money can actually be sent back home (some governments might block funds).
\n4. Conversion: Convert those foreign cash flows into the home currency (e.g., GBP $ \unicode{x00A3} $) using forecasted exchange rates.
\n5. Domestic Tax: Calculate any extra tax owed in the home country (Double Taxation).
\n6. Discount: Discount the final home-currency cash flows using the parent company's required rate of return.\n

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Quick Review Box: Remember, we always discount the final home-currency cash flows using the Home Country's discount rate. Never use the foreign rate on home-currency cash flows!

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2. Forecasting Exchange Rates: Purchasing Power Parity (PPP)

In international exams, you are rarely given all the future exchange rates. You usually have to calculate them yourself using Purchasing Power Parity (PPP).

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The Core Idea: Inflation eats away the value of money. If a country has high inflation, its currency will likely weaken (become worth less) compared to a country with low inflation.

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The Formula:
\n$ S_1 = S_0 \times \frac{1 + i_f}{1 + i_d} $

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Where:
\n- $ S_1 $ = The future (Expected) Spot Rate
\n- $ S_0 $ = The Current Spot Rate
\n- $ i_f $ = Inflation rate in the foreign country
\n- $ i_d $ = Inflation rate in the domestic (home) country

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Analogy: Imagine a loaf of bread costs 1 unit in both countries today. If Country A's prices double (high inflation) and Country B's prices stay the same, you’ll need twice as much of Country A's money to buy that same bread. The exchange rate must adjust to reflect this!

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Common Mistake to Avoid: Always double-check which inflation rate is on top. A simple trick: if you are calculating "Foreign Currency per $ \$1 $ Home Currency," the Foreign inflation goes on top.

3. Taxation: Don't Get Charged Twice!

Tax is one of the most confusing parts of international finance, but here is the simple version. Most countries have Double Tax Treaties. This means you don't get punished twice for the same profit.

Key Terms:

- Withholding Tax: A tax the foreign government takes immediately when money leaves their country (like a "border toll").
- Double Taxation Relief: Usually, you pay the highest of the two tax rates. If the foreign tax is $ 20\% $ and your home tax is $ 30\% $, you pay $ 20\% $ abroad and the remaining $ 10\% $ at home.

Did you know? If the foreign tax rate is higher than your home tax rate, you usually don't get a refund from your home government. You just pay the higher foreign rate and pay nothing at home.

4. Remittance Restrictions (Blocked Funds)

Sometimes, a foreign government might say: "You can make a profit here, but you can only send $ 50\% $ of it back to your home country." The rest must stay in a local bank account.

How to handle this in NPV:
Only include the cash that actually reaches the parent company in your NPV calculation. If money is blocked, it's not "lost," but for the purpose of the parent's NPV, it doesn't count until it can be brought home (or unless it earns interest that can be remitted later).

5. Specific Risks in International Projects

Investing abroad is riskier than staying at home. Here are the big two you need to mention in your written answers:

A. Political Risk

This is the risk that a government changes the rules. - Expropriation: The government seizes your assets (the "Nightmare Scenario").
- Changes in laws: New safety regulations or minimum wage hikes.
- Strategy: To manage this, companies might use Joint Ventures with local partners to look "less foreign."

B. Economic Risk

This is the risk that the foreign economy collapses or exchange rates move wildly against you. - Strategy: Diversify by having projects in many different countries.

Mnemonic for International Risk: "PEST"
Political (Government changes)
Economic (Exchange rates/Inflation)
Social (Cultural differences in products)
Technological (Different infrastructure standards)

6. Summary and Key Takeaways

- Convert then Discount: Always bring cash flows back to the home currency before applying the home discount rate.
- PPP is your friend: Use the inflation-based formula to predict future exchange rates.
- Tax is a "Top-Up": You generally pay the higher of the two countries' tax rates.
- Cash is King: Only value the money that can actually be remitted (sent home) to the parent company.

Final Encouragement: International NPV is just a long puzzle. Take it one step at a time: calculate local flows, subtract local tax, convert the currency, then finish with the home tax and discount rate. You've got this!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is the "Foreign to Domestic" approach in international NPV analysis?

It is a two-stage method where a project's cash flows are first calculated in the foreign currency and then converted to the home currency to determine the Net Present Value.

What are the key steps in the international NPV calculation process?

The process involves: 1) Calculating local foreign cash flows, 2) Deducting foreign tax, 3) Determining remittable funds, 4) Converting to home currency via exchange rates, 5) Adjusting for domestic tax, and 6) Discounting at the home rate.

Which discount rate should be applied to the final home-currency cash flows in an international project?

You must always use the home country's (parent company's) required rate of return to discount cash flows that have been converted into the home currency.

What is the core principle of Purchasing Power Parity (PPP) in forecasting exchange rates?

PPP logic suggests that exchange rate movements are driven by inflation differences: the currency of the country with higher inflation will depreciate relative to the currency with lower inflation.

What is the formula for forecasting future spot rates using PPP?

$ S_1 = S_0 \times \frac{1 + i_f}{1 + i_d} $, where $ S_1 $ is the expected spot rate, $ S_0 $ is the current rate, and $ i_f $ and $ i_d $ are the foreign and domestic inflation rates respectively.

How does Double Taxation Relief work for international projects?

Under Double Taxation Relief, a company generally pays the higher of the two countries' tax rates, ensuring they are not taxed twice on the same profit.

How should remittance restrictions (blocked funds) be treated in an NPV calculation?

Only cash flows that can be legally remitted (sent back) to the parent company should be included in the NPV; blocked funds are ignored unless they can be remitted at a later date.

What is expropriation and how can a company mitigate this political risk?

Expropriation is when a foreign government seizes a company's assets; it can be mitigated by entering into Joint Ventures with local partners to reduce the company's foreign profile.

What does the "PEST" mnemonic stand for in the context of international risk?

PEST stands for Political, Economic, Social, and Technological risks that a company faces when investing internationally.

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