ACCA AFM Syllabus B. Advanced Investment Appraisal - International investment and financing decisions - Notes ^{1 / 3}

It includes the following steps:

1. Identification of relevant cash flows.

2. Dealing with inflation to assess real or nominal cash flows.

3. Dealing with tax, including the tax savings on capital allowances.

4. Dealing with inter-company transactions, such as management charges and royalties and cash flow remittance restrictions.

5. Estimating future exchange rates (spot rates).

6. Dealing with double taxation arrangements.

7. Estimating the appropriate cost of capital (discount factor).

Parent or project viewpoint?

As the objective of financial management is to maximise shareholder wealth, and the vast majority of the shareholders are likely to be located in the parent country, it is essential that projects are evaluated from a parent currency viewpoint.

Accordingly, the following four-step procedure is recommended for calculating project cash flows:

1. Compute local currency cash flows from a subsidiary viewpoint as if it were an independent entity;

2. Calculate the amount and timing of transfers to the parent company in parent's currency;

3. Translate the PV of cash flows to parent's currency

4. Calculate NPV in parent's currency

Project discount rates

In the same way as for domestic capital budgeting, project cash flows should be discounted at a rate that reflects their systematic risk. 

Many firms assume that overseas investment must carry more risk than comparable domestic investment and therefore increase discount rates accordingly.

This assumption, however, is not necessarily valid. Although the total risk of an overseas investment may be high, in the context of a well-diversified parent company portfolio much of the risk may be diversified away. 

Because of the lack of correlation between the performance of some national economies, the systematic risk of overseas investment projects may in fact be lower than that of comparable domestic projects.

It must therefore be realised that the automatic addition of a risk premium simply because a project is located overseas does not always make sense, and any increase in the discount rates used for foreign projects should be viewed with caution.

Value of a project and exchange rate

An appraisal of an international project requires estimates of the exchange rate.

• Exchange rate risk

  - is the risk that arises from the fact that the cash flows are denominated in a foreign currency.