ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 7: Other aspects of capital investment appraisal

Using the NPV method of project selection, the financial analysis focuses entirely on

the project selection stage. All the different possible outcomes for the project are

considered, and these are aggregated into a single expected value of future cash

flows. The NPV analysis does not consider all the future decisions that might be

made during the project management stage that will be contingent or dependent on

how the project develops.

Example

A simple example is a management decision about whether to invest in Project A or

Project B, which are mutually exclusive projects. Both projects would last for ten

years. Estimated cash flows have been prepared and evaluated for each project and

Project A has a higher NPV.

However, with Project B there would be an opportunity to withdraw from the

project after five years if the returns are poor and the project is value-destroying.

This option does not exist with Project A.

Simple NPV analysis would not consider the real option with Project B to withdraw

after five years, and Project A would be selected. With a real options analysis, the

comparison between Project A and Project B would put a value on the real option

with Project B, and take this option into consideration when making the choice

between the two projects.

Real options: analysing project management risk and flexibility

The NPV approach to project appraisal helps management with the project selection

process but is not concerned with active risk management. In making choices

between alternative projects for investment, it does not allow for the different

amounts of flexibility (real options) that each project provides. For example, one

project involving the use of more expensive but more flexible technology might

have a lower NPV than an alternative investment involving the use of cheaper but

more rigid technology. The flexible use of the more expensive technology provides a

real option with value, but with simple NPV analysis this factor would be ignored.

An approach to project appraisal using real options considers all the different

possibilities that might arise during the project management stage of a capital

investment project. Instead of starting with an ‘aggregate’ or ‘expected value’

scenario of what might happen in the future, real options analysis starts by trying to

identify all the future events or developments that might occur that would affect the

project’s value. The differing ‘volatilities’ of alternative investments are critical, and

some projects will involve more uncertainty than others.

Once the risk profile of each investment alternative has been understood, the next

step in the analysis is to identify the major project management decisions that could

be made (the real options available with each investment alternative). Real options

provide flexibility for project management, and these real options should be

evaluated and taken into consideration (both at the project selection stage and

during project management).

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4.4 Different types of real option

There are different types of real option. The examination syllabus refers to real

options to ‘delay, expand, re-deploy and withdraw’. A more detailed analysis of the

types of real option is set out below.

Scale up

Make sequential, incremental

investments as the markets grow.

This type of real option includes

start-up options.

Invest/grow options

Switch up

A speedy commitment to a first-

generation of a technology might

give a company an advantage if

the opportunity eventually occurs

to switch to a next-generation of

the technology. This might be

called a ‘market power option’.

Scope up

Real option that provides an

opportunity to increase the scope

or range of activities. For example,

investing in one industry might

give a company the opportunity to

invest in another industry at the

same time and at a low cost.

Defer/delay/learn

options

Sundry

start

Option to delay an investment

until new information is available

or new skills are acquired. A

deferral option.

Scale

down

Option to reduce the size of a

project part-way through its life,

or to disinvest entirely and

withdraw from the investment.

This option might be used if new

information changes the expected

payback from the project.

Divest/withdraw/reduce

options

Switch

down

Where the company has invested

in flexible assets, there might be

an option to switch to a more cost-

effective use of the assets

Scope

down

There might be an option for a

company to reduce the scope of its

operations at a low cost if it is

discovered that there is no

potential for further business

development.

Chapter 7: Other aspects of capital investment appraisal

4.5 The valuation of real options

To estimate the value of a project using a real options approach, it is necessary to

identify when and under what conditions each real option would be exercised, and

a value has to be calculated for each option. For each real option that is identified for

a particular project, the following data should be obtained:

 When the option will be available during the project life, and for how long.

 How the option might have a positive effect on the value of the project, and

what that effect might be.

 What additional investment would be needed to exercise the option.

 Whether any additional investment is needed now to make the option available

in the future.

 Whether the exercise of the option will then make other follow-up options

available at a later time.

Each investment project should be assessed both for their NPV and the value of the

future opportunities they might provide during the project management stage, such

as the opportunity to expand in the same or related markets, or the flexibility to

change the level or scale of operations, or for the ease of halting further expenditure

or withdrawing entirely from an investment at a low cost.

Real options analysis puts a financial value to flexibility in the management of

projects, and the value of real options is therefore higher when the project risk and

uncertainty is high.

However, the real options approach has an important weakness. A considerable

amount of academic research has been carried out into the valuation of real options,

but a simple and satisfactory approach to valuation has not yet been established.

Some academics believe that real options can be valued using a model based on the

Black-Scholes option pricing model. This is a pricing model for financial options,

which is described in a later chapter.

Some companies have also used a real options approach to project evaluation,

particularly where real options can have a significant impact on capital investment

project selection – for example in the pharmaceuticals industry and other industries

where expenditure on research and development is high, and also in mining (where

mining leases might include important real options for the mining company).

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Paper P4

Advanced Financial Management

CHAPTER

International investment and

financing decisions

Contents

1 Factors affecting foreign investment decisions

2 Estimating exchange rates and the impact of

exchange rate movements on investment

decisions

3 DCF appraisal: investment in a developing

country

4 International sources of finance

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Factors affecting foreign investment decisions

 Factors restricting foreign investment

 Exchange rate risk (currency risk)

 Political risk

 Exchange controls

 Taxation and international investment

 Fiscal risk

1 Factors affecting foreign investment decisions

1.1 Factors restricting foreign investment

International companies invest in other countries because they hope to make a good

financial return from their investment, and attractive opportunities might exist in

other countries. Developing countries might be particularly attractive for foreign

investment because these countries might be expected to achieve considerable

economic growth in the future.

However, investments by private companies in developing countries might be

restricted for several reasons.

 The country might not have an infrastructure of transport and communication

systems to support commerce and trade. International companies might be

reluctant to invest in capital projects in companies where the road network is

inadequate for transporting heavy goods or large quantities of goods.

 The general standard of education of the local population might be low.

International companies might need its employees to have certain basic skills,

and if standards of education are low, these skills might not exist (and might be

difficult to create with training programmes).

 There is always a political risk, that the government of the country will take

measures against foreign investors. For example, there have been examples in

the past of governments forcing foreign companies to sell their assets to

domestic companies, or taking a business into state ownership. A foreign

government might also impose measures such as restrictions on foreign currency

dealings or the imposition of withholding tax on payments of dividends and

interest to foreign companies.

 There is a general economic risk that the economy of a developing country will

not develop as well as expected. It might be difficult for a foreign company to

make a good return on an investment in a country with a weak economy.

Companies considering a major capital investment in another country also need to

consider:

 the exchange rate risk

 the risk of exchange controls and similar cash flow restrictions

 taxation on remittances to the parent company’s country.

Chapter 8: International investment and financing decisions

1.2 Exchange rate risk (currency risk)

Exchange rate risk, also called FX risk and currency risk, is the financial risk from

the possibility (or probability) that foreign currency exchange rates will change. The

risk is greater when a foreign exchange rate is volatile, and moves by fairly large

amounts over time, often both up and down. Two aspects to exchange rate risk are:

 transaction risk

 translation risk.

Transaction risk

Transaction risk affects any company that receives income or makes payments in a

foreign currency. It is the risk that when a quantity of foreign currency will be

received or paid at a time in the future, the exchange rate might move between

‘now’ and the time that receipt or payment of the currency will occur. As a

consequence of the exchange rate movement the amount of money received or paid

in the company’s own currency (domestic currency) will be less or more than

originally expected.

Exchange rates can move favourably as well as adversely, but the main concern for

risk management is with the possibility and consequences of an adverse exchange

rate movement.

Example

A UK company has bought goods from a foreign supplier and must pay $700,000

for them in three months’ time. The current exchange rate is £1 = $2, and the

company therefore expects to pay £350,000 in three months.

If the exchange rate changes so that after three months it is £1 = $1.75, and the

company has done nothing to hedge its currency exposure (hedging is described in

a later chapter), it will have to pay £400,000 to acquire the dollars to pay the

supplier. Due to the exposure to currency transaction risk and the adverse

movement in the exchange rate, the UK company has to pay £50,000 more than

originally expected.

Transaction risks can affect international companies investing in another country in

two ways:

 the foreign investment might purchase goods from other countries, or sell goods

to other countries, and so will be exposed continually to transaction risks on its

trading

 more significant for the purpose of the examination, the multinational parent

company will require its foreign subsidiary to remit the profits from the venture

to the parent, in the form of interest or dividends. Transaction exposures exist

over the entire life on the capital investment project, because the interest

payments or dividend payments from the foreign investment must be converted

into the parent company’s own currency. Changes in the exchange rate will

affect the amount of dividends that the parent company receives in its own

currency.

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Translation risk

Translation risk is a financial reporting risk for companies with foreign investments.

For the purpose of preparing consolidated financial accounts, the financial

statements of foreign subsidiaries must be translated into the reporting currency of

the parent multinational. Changes in the exchange rate create gains or losses on

translation, which affect the reported results of the group.

For example, suppose that a foreign subsidiary has net assets of 20 million francs at

the beginning of a financial year for its parent company, whose domestic currency is

dollars. The exchange rate is $1 = 4 francs at the beginning of the year and $1 = 5

francs at the end of the year.

Due to the adverse movement in the exchange rate during the year, the net

investment at the beginning of the year, which had a value on translation of $5

million, will only be included in the consolidated balance sheet at a value of $4

million at the end of the year, a fall in value on translation of $1 million.

International companies may therefore wish to consider the consequences of

translation risk for their reported consolidated statements.

1.3 Political risk

Political risk is the risk for an international company that the government of a

foreign country might take action that affects the operations or profitability of its

investment in its country, or places restrictions on the ability of the foreign

subsidiary to remit interest or dividends to the parent country.

Political action against an international company might include the nationalisation

of some or all of the assets of its foreign subsidiary, punitive additional tax charges

or exchange controls. The government might simply pursue economic policies and

other policies that are ‘unfriendly’ to businesses and to foreign businesses in

particular.

1.4 Exchange controls

Exchange controls are actions by a government that:

 restrict or prevent the ability of its own nationals to buy foreign currency in

order to make payments to foreign suppliers

 restrict or prohibit the payment if interest or dividends to foreign investors,

including payments from subsidiary companies to their foreign parent

 restrict the flow (payments) of capital out of the country.

Chapter 8: International investment and financing decisions

Example

An international company is considering whether to make an investment in

Francland. The estimated after-tax cash flows from the project (all in francs) have

been estimated as follows:

Year 000 francs

0 (2,000)

1 800

2 1,000

3 1,200

4 600

Taxation is ignored for the purpose of simplifying this example.

The cost of capital for evaluating all aspects of this project is 16%.

The government of Francland has announced that there will be a total ban on the

payment of any dividends overseas to foreign investors or parent companies. In the

second and third years companies in Francland will be able to remit up to 70% of

their annual profits for that year. All exchange controls will be removed entirely

from the end of Year 4.

The exchange rate is expected to be as follows, at the end of each year:

Year Forecast rate (francs to $1)

0 5.0

1 5.2

2 5.4

3 5.7

4 6.0

Required

(a) Calculate the NPV of the project if no exchange controls were in place and the

foreign subsidiary remitted all available profits as dividends to the parent

company.

(b) Calculate the NPV of the project allowing for the exchange controls, assuming

that the foreign subsidiary remits the maximum permitted dividends each

year to the parent company.

Answer

(a) Ignoring exchange controls

Year Franc cash

flow

Exchange

rate

$ cash flow Discount

rate 16%

FR 000 $000 $000

0 (2,000) 5.0 (400.0)

1.000 (400.0)

1 800 5.2 153.8

0.862 132.6

2 1,000 5.4 185.2

0.743 137.6

3 1,200 5.7 210.5

0.641 134.9

4 600 6.0 100.0

0.552 55.2

NPV

+ 60.3

Paper P4: Advanced Financial Management

(b) Allowing for the exchange controls

Year Franc cash

flow:

Remitted

to the

parent

Exchange

rate

$ cash

flow

Discount

rate 16%

FR 000 FR 000

$000 $000

0 (2,000) (2,000)

5.0 (400.0)

1.000 (400.0)

1 800 0

5.2 0.0

0.862 0.0

2 1,000 700

5.4 129.6

0.743 96.3

3 1,200 840

5.7 147.4

0.641 94.5

4 600 2,060

6.0 343.3

0.552 189.5

NPV

(19.7)

Mainly because of the exchange controls, a project that would otherwise be a

worthwhile investment should be avoided.

1.5 Taxation and international investment

Taxation affects investment decisions, and it is necessary to estimate the tax

payments for a proposed capital investment project in another country. Taxation is

considered in more detail in a later chapter, with respect to international or

multinational companies. Briefly, however, there are two important aspects to tax

on the profits and distributions of foreign subsidiaries.

 Withholding tax. Some countries levy a withholding tax on interest or dividends

paid by companies to foreign investors, including foreign parent companies.

Withholding tax is additional tax, reducing the net cash flows for the parent

company from its foreign subsidiary.

 Double taxation agreements. Many countries have double taxation agreements

with each other. The purpose of a double taxation agreement is to prevent

punitive taxation by taxing profits twice, once in each country. A double

taxation agreement allows an international company to set off the tax payable in

its own country on the profits of or income received from a foreign subsidiary,

against the tax already paid by the subsidiary in its own country. The effect of

double taxation agreements is to help to make international investments more

attractive by avoiding excessive and punitive tax on the pre-tax returns that the

investments make.

Example

An international company pays tax on its worldwide profits in its own country at

the rate of 25%. It has a subsidiary in a foreign country where the rate of tax on

profits is only 12%, but dividends paid to a foreign investor are subject to additional

withholding tax of 10%. This is 10% of the cash paid as dividends.

The parent company intends to remit as much as possible from its foreign

subsidiary in the form of dividends. The foreign subsidiary makes a profit before

tax of 1,000,000 dinars. (The exchange rate is $1 = 1 dinar and has been fixed at this

rate for a long time.) There is a double taxation agreement between the two

countries.

The subsidiary will pay tax on profits in its own country at 12%, or 120,000 dinars.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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