Chapter 11: International Financial Management
1. Core Concepts & Theoretical Architecture
International Capital Budgeting & Project vs. Parent Cash Flows
Cross-Border Investment Complexities: Evaluating cross-border capital investment proposals entails distinct risks beyond domestic capital budgeting:
- Exchange Rate Risk: Unanticipated movements in currency exchange rates alter the home-currency value of foreign subsidiary cash flows.
- Sovereign / Political Risk: Expropriation, nationalization, unexpected changes in foreign tax laws, restrictions on profit repatriation, or exchange controls.
- Tax Frictions: Multiple jurisdictions, foreign corporate taxes, bilateral double taxation avoidance agreements (DTAA), and cross-border withholding taxes.
Project vs. Parent Cash Flows: The Net Present Value (NPV) of a foreign project from the subsidiary's viewpoint is often vastly different from the NPV from the parent's viewpoint:
| Dimension | Project (Foreign Subsidiary) Cash Flows | Parent Company Cash Flows |
|---|---|---|
| Operating Cash Inflows | Local currency revenues minus local operating expenses and local corporate taxes. | Only funds that can be legally repatriated back to the parent country. |
| Withholding Taxes | Not applicable at subsidiary level. | Deducted upon dividend or fee remittance (TDS by host government). |
| Intra-Group Cash Transfers | Treated as operating expense (royalties, management fees, technical know-how fees). | Treated as valid cash inflows to parent, enhancing parent returns. |
| Blocked Funds | Available for local reinvestment. | Zero value to parent until exchange controls or moratoria are relaxed. |
Two Alternative Discounting Approaches:
- Home Currency Approach:
Step 1: Estimate project cash flows in foreign currency.
Step 2: Convert foreign cash flows into home currency using forecast exchange rates (via PPP or Forward Parity: $S_t = S_0 \times \frac{1+I_h}{1+I_f}$).
Step 3: Discount home currency cash flows at the parent company's home cost of capital ($k_h$). - Foreign Currency Approach:
Step 1: Estimate project cash flows in foreign currency.
Step 2: Discount foreign cash flows at foreign risk-adjusted discount rate ($k_f$), calculated using the Fisher parity relationship: $$1 + k_f = (1 + k_h) \times \frac{1 + I_f}{1 + I_h} \quad \text{or} \quad (1 + r_f)(1 + RP)$$
Step 3: Convert foreign currency NPV into home currency at the current spot exchange rate ($S_0$).
If international parity conditions (PPP and Fisher Effect) hold, both the Home Currency Approach and the Foreign Currency Approach yield mathematically identical Net Present Values.
🎯 ICAI Exam Traps & Key Pointers
- Always Distinguish Project vs Parent: In exam questions (e.g. Illustration 1 & PQ 2), ICAI specifically asks: "Advise the US Company on financial viability." You must calculate cash flows from the PARENT perspective after accounting for host taxes, withholding taxes, and exchange conversions.
- Risk Premium Adjustment (PQ 1): When deriving foreign risk-adjusted discount rate from domestic rate and risk-free rates, use $(1 + r_h)(1 + RP) = (1 + k_h)$.
International Sources of Finance (ADRs, GDRs, FCCBs & ECBs)
American Depository Receipts (ADRs): Negotiable US dollar-denominated certificates issued by a US depository bank, representing a specified number of shares of a non-US company deposited with a foreign custodian bank. Traded on US stock exchanges (NYSE, NASDAQ) and cleared via Depository Trust Company (DTC).
| Level of ADR | Trading Venue | SEC Registration & Reporting | Capital Raising Capability |
|---|---|---|---|
| Level I (Unlisted) | Over-The-Counter (OTC) Pink Sheets | Exempt under Rule 12g3-2(b); minimal SEC compliance. | Cannot raise fresh capital (trading existing shares only). |
| Level II (Listed) | Organized US Exchanges (NYSE / NASDAQ) | Full SEC registration (Form 20-F) and US GAAP / IFRS reconciliation. | Cannot raise fresh capital (listing for liquidity/prestige). |
| Level III (Public Offering) | Organized US Exchanges (NYSE / NASDAQ) | Most rigorous; Form F-1 prospectus and full US GAAP disclosure. | Can raise fresh public equity capital in the US market. |
| Rule 144A (Private Placement) | Private PORTAL system among QIBs | Exempt from SEC registration under Rule 144A. | Can raise capital privately from Qualified Institutional Buyers (QIBs). |
Global Depository Receipts (GDRs): Dollar-denominated negotiable certificates issued by an international depository bank (e.g. Bank of New York Mellon, Citibank) representing shares of a foreign company, listed and traded primarily on European exchanges (London Stock Exchange, Luxembourg Stock Exchange).
Impact of GDRs on Indian Capital Market (Theoretical Q2):
- Broadening Investor Base: Provides access to global institutional capital without depressing domestic share prices.
- Lower Cost of Capital: Indian corporates raise equity capital at competitive international pricing and narrower discount spreads.
- Enhanced Corporate Governance: Requires compliance with international financial reporting standards (IFRS) and increased transparency.
- Two-Way Fungibility: Allows conversion of domestic shares into GDRs and cancellation of GDRs into underlying domestic equity shares, aligning domestic and international share prices.
Foreign Currency Convertible Bonds (FCCBs): Debt instruments denominated in foreign currency issued by an Indian corporate, carrying a fixed coupon rate and an embedded option allowing bondholders to convert the bonds into equity shares of the issuer at a predetermined conversion price before maturity.
External Commercial Borrowings (ECBs): Commercial loans raised by eligible Indian resident entities from recognized non-resident lenders, regulated strictly by RBI guidelines on minimum average maturity, all-in-cost ceilings, and permissible end-uses.
🎯 ICAI Exam Traps & Key Pointers
- Theory Question 1 & 2: Short note on Instruments of International Finance (ADR, GDR, FCCB, ECB) and Impact of GDRs on Indian Capital Market are direct 4-mark theoretical questions.
International Financial Services Centres (IFSC) & GIFT City
International Financial Centre (IFC): A dedicated jurisdiction that provides world-class financial services to non-residents and residents in foreign currencies. An IFSC caters to international finance outside the domestic economy's standard capital and tax boundaries.
GIFT City (Gujarat International Finance Tec-City): India's premier operational multi-services Special Economic Zone (SEZ) hosting India’s first International Financial Services Centre (GIFT IFSC) in Gandhinagar, Gujarat.
Regulatory Architecture: Regulated by a unified single statutory authority—the International Financial Services Centres Authority (IFSCA) established under the IFSCA Act, 2019, replacing fragmented oversight by RBI, SEBI, IRDAI, and PFRDA.
Key Fiscal Incentives in GIFT IFSC:
- 100% Corporate Income Tax holiday for any 10 consecutive years out of a 15-year block.
- Minimum Alternate Tax (MAT) / Alternate Minimum Tax (AMT) reduced to 9% (or 0% for companies opting for new tax regime).
- Exemption from Goods and Services Tax (GST) on transactions executed on IFSC exchanges.
- Exemption from Securities Transaction Tax (STT), Commodity Transaction Tax (CTT), and Stamp Duty on exchange trades.
Sovereign Wealth Funds (SWFs)
Definition of Sovereign Wealth Funds: Government-owned specialized investment funds established from state-owned foreign exchange assets, fiscal surpluses, natural resource revenues (e.g., petroleum exports), or privatization proceeds.
Key Objectives:
- Stabilization Funds: Insulate national economies and government budgets from highly volatile global commodity price swings.
- Savings Funds: Accumulate wealth across generations, converting non-renewable resource revenues into diversified global financial assets (e.g., Norway's Government Pension Fund Global).
- Reserve Investment Funds: Enhance long-term yields on surplus foreign exchange reserves beyond low-yielding US Treasury bonds.
- Strategic Development Funds: Catalyze domestic industrial infrastructure and technological modernization (e.g., India's National Investment and Infrastructure Fund - NIIF).
Santiago Principles: A set of 24 voluntary governance and transparency guidelines established by the International Working Group of Sovereign Wealth Funds (IWG) to ensure SWF investments are guided strictly by commercial and economic objectives rather than geopolitical motives.
International Cash, Inventory & Receivables Management
Multinational working capital management synchronizes short-term liquidity across borders while navigating currency, tax, and capital friction:
Multinational Cash Management Techniques:
- Centralized Cash Pooling: Subsidiaries transfer surplus cash balances daily into a master multi-currency pooling account, reducing idle cash and borrowing spreads.
- Multilateral Netting: An automated centralized matrix that offsets cross-border intra-group receivables and payables, eliminating duplicate bank wire transfer fees and FX bid-ask spreads.
- Transfer Pricing: Setting intra-company prices for goods, services, patents, and technical fees to legitimately optimize group-wide corporate tax liabilities and bypass currency repatriation restrictions.
- Managing Blocked Funds: Bypassing host-country profit remittance freezes via:
- Exporting local goods or services produced by the subsidiary.
- Executing parallel loans / back-to-back cross-border financing.
- Increasing management fees, head-office overhead allocations, and royalty charges.
International Receivables Management: Evaluates factoring vs. forfeiting, currency denomination, and export credit insurance (e.g. ECGC in India).
2. ICAI Study Material Illustrations (Worked in Full)
International Capital Budgeting: US Pharma Joint Venture in India (Perfect Inc.)
Perfect Inc., a U.S. based Pharmaceutical Company, has received an offer from Aidscure Ltd., an Indian firm, to set up a manufacturing unit in Baddi (H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a royalty @ US $0.01 per bottle. The initial investment will be ₹ 200 crores for machinery and factory. The scrap value at the end of Year 5 is estimated at ₹ 5 crores. Plant capacity is 5 crore bottles per annum, operating at full capacity. Selling price is ₹ 12 per bottle, and variable cost is ₹ 4 per bottle.
Depreciation is charged on straight-line basis. Indian corporate tax rate is 30%, and withholding tax on dividends and royalties is 10%. Perfect Inc.'s required rate of return for such projects is 12%. The current spot rate is ₹ 62 / US$. Expected Rupee depreciation is 3% per annum.
Required: Advise Perfect Inc. on the financial viability of the proposal from the Parent perspective.
Step 1: Annual Operating Cash Flows in India
- Annual Production = 5 Crore bottles
- Gross Sales Revenue = $5 \text{ Cr} \times \text{₹ } 12 = \mathbf{\text{₹ } 60.00 \text{ Crores}}$
- Variable Operating Cost = $5 \text{ Cr} \times \text{₹ } 4 = \text{₹ } 20.00 \text{ Crores}$
- Depreciation = $\frac{\text{₹ } 200 \text{ Cr} - \text{₹ } 5 \text{ Cr}}{5 \text{ years}} = \mathbf{\text{₹ } 39.00 \text{ Crores per annum}}$
Step 2: Perfect Inc. Entitlements and Cash Flows
- Revenue Share (55%): $55\% \times \text{₹ } 60 \text{ Cr} = \text{₹ } 33.00 \text{ Crores}$.
Less: 55% share of Operating Costs & Depreciation.
Net Share of Indian Profit after Indian Tax (30%) remitted as dividend. - Royalty Entitlement: $5 \text{ Cr bottles} \times \text{US } \$0.01 = \mathbf{\text{US\$ } 5,00,000 \text{ per annum}}$.
Converted to INR and subject to 10% Withholding Tax.
Step 3: Convert Net Remittances to USD at Forecasted Exchange Rates
Forecast Exchange Rate: $S_t = 62 \times (1 + 0.03)^t$.
Discount parent dollar cash flows at Perfect Inc.'s hurdle rate (12%):
$$\text{NPV}_{\text{USD}} = \sum_{t=1}^{5} \frac{\text{Net USD Cash Inflow}_t}{(1.12)^t} + \frac{\text{Salvage Value}_5}{(1.12)^5} - \text{Initial USD Outlay}_0$$Where Initial Outlay in USD = $\frac{\text{₹ } 200 \text{ Crores}}{\text{₹ } 62} = \mathbf{\text{US\$ } 32.258 \text{ Million}}$.
Cross-Border Project Evaluation in Nepal (Its Entertainment Ltd)
Its Entertainment Ltd., an Indian Amusement Company, is planning to establish a Grand Water Park in Nepal. The company spent ₹ 20,00,000 on market research. Estimated cost of construction is Nepalese Rupee (NPR) 450 crores, completed in 1 year (half paid at beginning, half at year-end). Working capital required at end of Year 1 is NPR 65 crores.
Operating cash flows run for 5 years post-construction. Exchange rate: INR 1 = NPR 1.60. Indian cost of capital is 12%.
Evaluate: Project viability in Indian Rupees.
1. Sunk Cost: Market research expense of ₹ 20 Lakhs is a sunk cost and ignored.
2. Convert NPR cash flows into Indian Rupees at the pegged exchange rate ($\text{INR} = \frac{\text{NPR}}{1.60}$).
3. Construction Outlay in INR:
$$\text{Year 0 Outlay} = \frac{\text{NPR } 225 \text{ Cr}}{1.60} = \mathbf{\text{₹ } 140.625 \text{ Crores}}$$
$$\text{Year 1 Outlay (Construction + WC)} = \frac{\text{NPR } 225 \text{ Cr} + 65 \text{ Cr}}{1.60} = \frac{\text{NPR } 290 \text{ Cr}}{1.60} = \mathbf{\text{₹ } 181.25 \text{ Crores}}$$
4. Discount net Rupee operating cash inflows at parent cost of capital (12%).
Foreign Currency Approach vs. Home Currency Approach (Opus Technologies Ltd - China)
Opus Technologies Ltd., an Indian IT company, is planning an investment through a wholly owned subsidiary in China with a 2-year life. Chinese inflation is 8% p.a., and Indian inflation is 5% p.a.
- Initial Outlay: Land = CN¥ 30,00,000 (resold at CN¥ 35,00,000 after 2 years). Office Complex = CN¥ 15,00,000 (depreciated SLM over 2 years to zero).
- Operating Inflows: Year 1 = CN¥ 25,00,000; Year 2 = CN¥ 30,00,000.
- Chinese corporate tax rate = 25%. Current spot exchange rate: 1 CN¥ = ₹ 10.00.
- Parent cost of capital in India = 14% p.a.
Required: Calculate the project NPV using (i) Home Currency Approach, and (ii) Foreign Currency Approach.
Step 1: Compute Chinese Operating Cash Flows (CN¥)
- Annual Depreciation = $\frac{15,00,000}{2} = \text{CN¥ } 7,50,000$
- Year 1: PBT = $25,00,000 - 7,50,000 = 17,50,000$. Tax (25%) = $4,37,500$.
$$\text{Operating CF}_1 = \text{PAT } (13,12,500) + \text{Depr } (7,50,000) = \mathbf{\text{CN¥ } 20,62,500}$$ - Year 2: PBT = $30,00,000 - 7,50,000 = 22,50,000$. Tax (25%) = $5,62,500$.
$$\text{Operating CF}_2 = \text{PAT } (16,87,500) + \text{Depr } (7,50,000) = \text{CN¥ } 24,37,500$$
Terminal Recovery: Land (CN¥ 35,00,000) less Tax on Capital Gain $25\% \times (35L - 30L) = 1,25,000 \implies \text{Net Salvage} = \text{CN¥ } 33,75,000$.
$$\text{Total Year 2 Inflow} = 24,37,500 + 33,75,000 = \mathbf{\text{CN¥ } 58,12,500}$$
Step 2: Home Currency Approach
Forecast Exchange Rates via Relative PPP ($I_{\text{India}} = 5\%, I_{\text{China}} = 8\%$):
$$S_1 = 10.00 \times \frac{1 + 0.05}{1 + 0.08} = 10 \times \frac{1.05}{1.08} = \text{₹ } 9.7222 \text{ / CN¥}$$ $$S_2 = 9.7222 \times \frac{1.05}{1.08} = \text{₹ } 9.4522 \text{ / CN¥}$$Rupee Cash Flows:
- Year 0 Outlay = $45,00,000 \times 10.00 = -\text{₹ } 450.00 \text{ Lakhs}$
- Year 1 Inflow = $20,62,500 \times 9.7222 = +\text{₹ } 200.52 \text{ Lakhs}$
- Year 2 Inflow = $58,12,500 \times 9.4522 = +\text{₹ } 549.41 \text{ Lakhs}$
Discount at Indian WACC (14%):
$$\text{NPV} = -450.00 + \frac{200.52}{1.14} + \frac{549.41}{(1.14)^2} = -450.00 + 175.89 + 422.75 = \mathbf{+\text{₹ } 148.64 \text{ Lakhs}}$$Step 3: Foreign Currency Approach
Calculate Chinese discount rate ($k_{\text{China}}$) using International Fisher Effect:
$$1 + k_{\text{China}} = (1 + k_{\text{India}}) \times \frac{1 + I_{\text{China}}}{1 + I_{\text{India}}} = 1.14 \times \frac{1.08}{1.05} = 1.17257 \implies k_{\text{China}} = 17.26\%$$ $$\text{NPV}_{\text{CN¥}} = -45,00,000 + \frac{20,62,500}{1.17257} + \frac{58,12,500}{(1.17257)^2}$$ $$\text{NPV}_{\text{CN¥}} = -45,00,000 + 17,58,957 + 42,27,511 = +\text{CN¥ } 14,86,468$$ $$\text{Convert to INR at Spot (₹ 10)} = 14,86,468 \times 10 = \mathbf{+\text{₹ } 148.65 \text{ Lakhs}}$$GDR Sizing & Cost of Capital (X Ltd - US Expansion)
X Ltd. is interested in expanding its operations and planning to install a manufacturing plant in the US. For the proposed project, it requires funds of $ 10 million net of issue expenses. Estimated floatation cost is 2%. To finance this project, it proposes to issue GDRs.
Additional Information:
- Current domestic share price: ₹ 300
- Each GDR represents 2 underlying equity shares.
- GDR issue price is fixed at a 10% discount to the domestic market price.
- Exchange Rate: $ 1 = ₹ 60.00
- Expected dividend next year ($D_1$): ₹ 15 per share
- Dividend growth rate ($g$): 10% per annum
Required: Compute (i) Number of GDRs to be issued, and (ii) Cost of the GDR issue.
Step 1: Gross Funds Required in USD
$$\text{Gross Issue Size} = \frac{\text{Net Funds Required}}{1 - \text{Floatation Cost}} = \frac{\$ 10,00,000}{1 - 0.02} = \mathbf{\text{US\$ } 10.204 \text{ Million (\$ 1,02,04,082)}}$$Step 2: Pricing of Each GDR
1 GDR = 2 Domestic Shares.
$$\text{Domestic Market Price of 2 Shares} = 2 \times \text{₹ } 300 = \text{₹ } 600$$ $$\text{Issue Price after 10% Discount} = 600 \times (1 - 0.10) = \mathbf{\text{₹ } 540 \text{ per GDR}}$$ $$\text{GDR Issue Price in USD} = \frac{\text{₹ } 540}{\text{₹ } 60} = \mathbf{\text{US\$ } 9.00 \text{ per GDR}}$$Step 3: Number of GDRs to be Issued
$$\text{Number of GDRs} = \frac{\text{Gross Issue Size in USD}}{\text{Issue Price per GDR}} = \frac{\$ 1,02,04,082}{\$ 9.00} = \mathbf{11,33,787 \text{ GDRs}}$$Step 4: Cost of GDR Capital ($K_e$)
Net proceeds realized per GDR = $\$ 9.00 \times (1 - 0.02) = \$ 8.82 = \text{₹ } 529.20$.
Annual dividend per GDR ($D_1$) = $2 \text{ shares} \times \text{₹ } 15 = \text{₹ } 30$.
$$K_e = \frac{D_1}{\text{Net Proceeds per GDR}} + g = \frac{\text{₹ } 30}{\text{₹ } 529.20} + 0.10 = 0.05669 + 0.10 = \mathbf{15.67\% \text{ p.a.}}$$- Number of GDRs to be issued = 11,33,787 GDRs.
- Cost of GDR Capital = 15.67% per annum.
3. Test Your Knowledge (TYK) - Complete ICAI Questions & Answers
Theoretical Question 1: Instruments of International Finance
Write a short note on Instruments of International Finance.
Comprehensive Note on Key Instruments of International Finance
International finance provides entities with avenues to raise capital globally, diversify funding sources, lower borrowing costs, and hedge currency and interest rate risks. The principal international financial instruments include:
| Instrument | Issuing Currency / Market | Salient Characteristics |
|---|---|---|
| Eurobonds | Denominated in a currency other than that of the country in which they are issued (e.g., USD-denominated bonds issued in London/Luxembourg). | Unregulated, bearer form, tax-free at source, issued through international syndicates across multiple global financial centres simultaneously. |
| Foreign Bonds | Denominated in the domestic currency of the foreign country where issued (e.g., Yankee bonds in USA in USD, Samurai bonds in Japan in JPY, Bulldog bonds in UK in GBP). | Subject to local market regulations (e.g., US SEC registration for Yankee bonds) and investor disclosures. |
| Fully Hedged Bonds | Issued in foreign currency with embedded forward/swap contracts. | Eliminates currency risk by locking in exchange rates for both coupon servicing and principal redemption at the outset. |
| Floating Rate Notes (FRNs) | Variable coupon linked to benchmark (e.g., SOFR, EURIBOR) plus spread. | Protects investors and issuers against unexpected interest rate fluctuations; coupons reset periodically (typically every 3 or 6 months). |
| Euro Commercial Paper (ECP) | Short-term unsecured promissory notes issued in the Euromarket. | Maturities typically range from 7 to 365 days; highly flexible, low-cost short-term liquidity facility for top-rated multinational corporations. |
| Foreign Currency Convertible Bonds (FCCBs) | Foreign currency debt instrument carrying an equity conversion option. | Carries a lower coupon rate than plain vanilla debt due to the equity upside option. If stock price rises above conversion price, bonds convert into equity (GDRs/shares); otherwise redeemed as debt at maturity. |
| ADRs & GDRs | Negotiable depository receipts denominated in USD/EUR representing underlying domestic equity shares deposited with a domestic custodian. | ADR: Traded on US stock exchanges (NYSE/NASDAQ) under SEC regulations. GDR: Traded globally on European exchanges (London, Luxembourg) offering worldwide investor reach. |
| External Commercial Borrowings (ECBs) | Commercial bank loans, buyers'/suppliers' credit, or securitized instruments from recognized non-resident lenders. | Governed by RBI regulations in India (Framework for ECB under Automatic vs Approval route, minimum average maturity period, and all-in-cost ceilings). |
Theoretical Question 2: Impact of GDRs on Indian Capital Market
What is the impact of GDRs on Indian Capital Market?
Impact of Global Depository Receipts (GDRs) on the Indian Capital Market
The introduction and widespread utilization of GDR issues by Indian corporate entities have had profound structural, financial, and regulatory impacts on the domestic capital market:
- Broadening and Deepening the Capital Base: GDRs allow Indian corporates to tap massive international institutional capital without saturating or exerting downward liquidity pressure on domestic financial markets.
- Reduction in Cost of Capital: Indian companies access capital at globally competitive rates. Lower required returns from international investors decrease the corporate Weighted Average Cost of Capital (WACC), making ambitious capital expenditure viable.
- International Brand Equity and Visibility: Listing on prestige exchanges like the London Stock Exchange (LSE) or Luxembourg Stock Exchange enhances the global standing, credibility, and brand recognition of Indian firms, facilitating cross-border M&A, joint ventures, and global commercial tie-ups.
- Higher Corporate Governance and Disclosure Standards: Issuing GDRs requires adherence to international accounting standards (IFRS / US GAAP), quarterly reporting, and stringent disclosure norms. This benchmark pulls up governance practices across the broader domestic industry.
- Integration with Global Financial Markets: GDRs establish price arbitrage linkages between domestic stock exchanges (BSE/NSE) and international bourses. Through two-way fungibility, any price divergence is swiftly arbitraged away, enhancing pricing efficiency and liquidity in underlying domestic shares.
- Foreign Exchange Reserves Inflow: GDR proceeds provide non-debt-creating foreign exchange inflows into the country, bolstering national foreign exchange reserves and providing macro-economic stability.
- Expansion of Domestic Investor Base Awareness: Global analyst coverage of Indian blue-chips stimulates institutional foreign portfolio investment (FPI) into the domestic cash equity market.
Practical Question 1: ABC Ltd - US Project Evaluation (Foreign Currency Approach)
ABC Ltd. is considering a project in US, which will involve an initial investment of US $ 1,10,00,000. The project will have 5 years of life. Current spot exchange rate is ₹ 48 per US $. The risk free rate in US is 8% and the same in India is 12%. Cash inflow from the project is as follows:
| Year | Cash Inflow (US $) |
|---|---|
| 1 | US $ 20,00,000 |
| 2 | US $ 25,00,000 |
| 3 | US $ 30,00,000 |
| 4 | US $ 40,00,000 |
| 5 | US $ 50,00,000 |
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is 14%.
Step 1: Determine the Risk-Adjusted Discount Rate in Foreign Currency (US $)
In the Foreign Currency Approach, cash flows are discounted in US Dollars using a dollar risk-adjusted discount rate ($r_{\$}$).
The project risk premium is embedded in the domestic (Indian) required rate of return:
$$\text{Domestic Required Rate of Return } (r_e) = 14\%$$
$$\text{Domestic Risk-Free Rate } (r_{f,\text{India}}) = 12\%$$
$$\text{US Risk-Free Rate } (r_{f,\text{US}}) = 8\%$$
Using the Fisher / International parity relationship to isolate the pure risk premium factor:
$$(1 + r_{f,\text{India}}) \times (1 + \text{Risk Premium}) = (1 + r_e)$$
$$(1 + 0.12) \times (1 + \text{Risk Premium}) = 1 + 0.14 = 1.14$$
$$1 + \text{Risk Premium} = \frac{1.14}{1.12} = 1.017857 \approx 1.0179$$
Now, applying this risk premium to the US Dollar risk-free rate:
$$(1 + r_{\$}) = (1 + \text{Risk Premium}) \times (1 + r_{f,\text{US}}) = 1.017857 \times 1.08 = 1.099286 \approx 1.099$$
$$\mathbf{r_{\$} = 1.099 - 1 = 0.099 = 9.90\%}$$
Step 2: Calculate Present Value of Dollar Cash Inflows at 9.9%
| Year | Cash Inflow ($ Million) | PV Factor @ 9.9% | Present Value ($ Million) |
|---|---|---|---|
| 1 | $2.00 | 0.910 | $1.820 |
| 2 | $2.50 | 0.828 | $2.070 |
| 3 | $3.00 | 0.753 | $2.259 |
| 4 | $4.00 | 0.686 | $2.744 |
| 5 | $5.00 | 0.624 | $3.120 |
| Total Present Value of Cash Inflows | $12.013 Million | ||
| Less: Initial Investment Outlay | $11.000 Million | ||
| Net Present Value in US Dollars ($\text{NPV}_{\$}$) | +$1.013 Million | ||
Step 3: Convert Dollar NPV into Indian Rupees
$$\text{Spot Exchange Rate } (S_0) = ₹ 48 / \$$$
$$\text{Rupee NPV} = \text{Dollar NPV} \times S_0 = \$1.013 \text{ Million} \times ₹ 48 = \mathbf{₹ 48.624 \text{ Million}}$$
The Net Present Value of the US project is positive at +$1.013 Million or ₹ 48.624 Million. ABC Ltd. should accept the investment proposal.
Practical Question 2: USA Software Development Unit in India
A USA based company is planning to set up a software development unit in India. Software developed at the Indian unit will be bought back by the US parent at a transfer price of US $10 millions. The unit will remain in existence in India for one year; the software is expected to get developed within this time frame.
The following operating costs are projected:
- Rent: ₹ 15,00,000
- Manpower: 80 software professionals at ₹ 400 per hour for 10 hours a day for 365 days
- Administrative and other costs: ₹ 12,00,000
- Corporate Tax Rate in India: 30%
- Withholding Tax on Repatriation: 10%
Advise the US Company on the financial viability of the project. The rupee-dollar rate is ₹ 48/$. Note: Assume software can be sold in the US at $12.0 million.
Proforma Profit and Loss Account & Repatriation Analysis
ICAI evaluates this problem presenting the standard tax treatment along with two alternative interpretations regarding withholding tax:
Method 1: Standard ICAI Approach (Withholding Tax Deducted from Post-Tax Earnings)
| Particulars | Amount (₹) | Amount (₹) |
|---|---|---|
| Revenue ($10,000,000 \times ₹ 48/$) | ₹ 48,00,00,000 | |
| Less: Operating Costs: | ||
| • Rent | ₹ 15,00,000 | |
| • Manpower ($80 \times 10 \text{ hrs} \times 365 \text{ days} \times ₹ 400/\text{hr}$) | ₹ 11,68,00,000 | |
| • Administrative & other costs | ₹ 12,00,000 | (₹ 11,95,00,000) |
| Earnings Before Tax (EBT) | ₹ 36,05,00,000 | |
| Less: Corporate Income Tax @ 30% | (₹ 10,81,50,000) | |
| Earnings After Tax (EAT) | ₹ 25,23,50,000 | |
| Less: Withholding Tax (TDS) @ 10% on Repatriation | (₹ 2,52,35,000) | |
| Net Amount Repatriable to US Parent (in ₹) | ₹ 22,71,15,000 | |
| Net Amount Repatriated in US Dollars (₹ 22,71,15,000 ÷ 48) | $ 4.7315 Million $\approx$ $ 4.73 Million |
Transfer price paid to Indian unit: $10.000 Million
Less: Net Repatriation received back: $4.7315 Million
Net Cost of Development to Parent = $5.2685 Million $\approx$ $5.27 Million
Since the US parent sells the software in the US market for $12.0 Million, the expected net profit is $12.0M - $5.27M = $6.73 Million. Therefore, setting up the unit in India is highly financially viable.
Method 2: Alternative Treatment (No Withholding Tax on Post-Tax Remittance)
If assumed that because the Indian corporate income tax (30%) is already paid, no additional withholding tax applies on repatriation:
- Earnings After Tax = ₹ 25,23,50,000
- Repatriation in Dollars = ₹ 25,23,50,000 ÷ 48 = $ 5,257,292 ($5.257 Million)
- Net Cost of Development to Parent = $10.0M - $5.257M = $4.743 Million
- Net Profit on US sale = $12.0M - $4.743M = $7.257 Million
- Advise: Highly viable.
Method 3: Alternative Treatment (Withholding Tax Credited Against Corporate Tax)
If withholding tax @ 10% is deducted upfront on EBT (₹ 3,60,50,000) and full tax credit is taken against 30% corporate tax (leaving balance net corporate tax ₹ 7,21,00,000), total tax paid remains 30% (₹ 10,81,50,000):
- Total Tax Liability = ₹ 10,81,50,000
- Repatriable amount = ₹ 25,23,50,000 = $ 5,257,292
- Net Cost to Parent = $4.743 Million; Project is financially viable.
Practical Question 3: XY Limited - African Retail Expansion
XY Limited is engaged in large retail business in India. It is contemplating for expansion in an African country. The exchange rate for the currency of the proposed African country is extremely volatile. Rate of inflation is also very high.
Estimated projected cash flows, in real terms, in India as well as African country for the first three years are as follows:
| Cash Flows (Real Terms) | Year 0 | Year 1 | Year 2 | Year 3 |
|---|---|---|---|---|
| Cash flows in Indian ₹ ('000) | -50,000 | -1,500 | -2,000 | -2,500 |
| Cash flows in African Rands ('000) | -2,00,000 | +50,000 | +70,000 | +90,000 |
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. You are required to calculate the Net Present Value of the proposed investment considering the following:
- Current Spot Exchange Rate: 1 African Rand = ₹ 6.00 (or ₹ 1 = African Rand 0.1667; here 1 Rupee = African Rand exchange rate at start is 6 Rands per Rupee or Spot rate = ₹ 6 / Rand; Note: as per ICAI solution, Current Spot Rate is African Rand 6.00 / ₹ 1).
- Annual Inflation Rate: India = 10% p.a., African country = 40% p.a.
- Discount Rate: 20% to reflect high risk. (PVIF @ 20%: Year 1 = 0.833, Year 2 = 0.694, Year 3 = 0.579).
- Ignore taxation.
Step 1: Inflation Factors and Forward Exchange Rates (Purchasing Power Parity / IRP)
$$\text{Inflation in India } (I_{\text{India}}) = 10\% \text{ p.a.}$$
$$\text{Inflation in African Country } (I_{\text{Africa}}) = 40\% \text{ p.a.}$$
$$\text{Spot Rate } S_0 = \text{African Rand } 6.00 \text{ per } ₹ 1$$
| Year | India Inflation Factor $(1.10)^t$ | Africa Inflation Factor $(1.40)^t$ | Expected Exchange Rate (African Rand / ₹ 1) $S_t = S_0 \times \frac{(1 + I_{\text{Africa}})^t}{(1 + I_{\text{India}})^t}$ |
|---|---|---|---|
| 0 | 1.000 | 1.000 | 6.0000 |
| 1 | 1.100 | 1.400 | $6.00 \times \frac{1.40}{1.10} = \mathbf{7.6364}$ |
| 2 | 1.210 | 1.960 | $6.00 \times \frac{1.96}{1.21} = \mathbf{9.7190}$ |
| 3 | 1.331 | 2.744 | $6.00 \times \frac{2.744}{1.331} = \mathbf{12.3696}$ |
Step 2: Conversion of Real Cash Flows into Nominal Cash Flows
1. Indian Cash Flows (₹ '000):
- Year 0: $-50,000 \times 1.00 = -₹ 50,000$
- Year 1: $-1,500 \times 1.10 = -₹ 1,650$
- Year 2: $-2,000 \times 1.21 = -₹ 2,420$
- Year 3: $-2,500 \times 1.331 = -₹ 3,327.50$
2. African Cash Flows (Rand '000 converted to ₹ '000):
- Year 0: $-\text{Rand } 2,00,000 \div 6.00 = -₹ 33,333.33 \approx -₹ 33,333$
- Year 1: Real $\text{Rand } 50,000 \times 1.40 = \text{Nominal Rand } 70,000 \div 7.6364 = +₹ 9,166.6 \approx +₹ 9,167$
- Year 2: Real $\text{Rand } 70,000 \times 1.96 = \text{Nominal Rand } 1,37,200 \div 9.7190 = +₹ 14,116.7 \approx +₹ 14,117$
- Year 3: Real $\text{Rand } 90,000 \times 2.744 = \text{Nominal Rand } 2,46,960 \div 12.3696 = +₹ 19,965.1 \approx +₹ 19,965$
Step 3: Net Cash Flows & Discounting at 20% (₹ '000)
| Year | Indian CF (1) | African CF in ₹ (2) | Net Cash Flow $(1)+(2)$ | PVF @ 20% | Present Value (₹ '000) |
|---|---|---|---|---|---|
| 0 | -50,000 | -33,333 | -83,333 | 1.000 | -83,333 |
| 1 | -1,650 | +9,167 | +7,517 | 0.833 | +6,262 |
| 2 | -2,420 | +14,117 | +11,697 | 0.694 | +8,118 |
| 3 | -3,327.50 | +19,965 | +16,637.50 $\approx$ +16,637 | 0.579 | +9,633 |
| NPV of Operating Period (Years 0 to 3) | -₹ 59,320 ('000) | ||||
Step 4: Terminal Value Calculation (Indefinite Horizon)
Year 3 nominal cash flow of ₹ 16,637 thousand continues indefinitely:
$$\text{Terminal Value at Year 3} = \frac{\text{Nominal CF}_3}{k} = \frac{₹ 16,637}{0.20} = ₹ 83,185 \text{ ('000)}$$
$$\text{PV of Terminal Value at Year 0} = ₹ 83,185 \times \text{PVIF}_{20\%, 3} = ₹ 83,185 \times 0.579 = \mathbf{+₹ 48,164 \text{ ('000)}}$$
Step 5: Overall Project Net Present Value
$$\text{Total Project NPV} = -₹ 59,320 + ₹ 48,164 = \mathbf{-₹ 11,156 \text{ ('000)}} = \mathbf{-₹ 1,11,56,000}$$
Since the Total Net Present Value is negative by -₹ 11,156 thousand (-₹ 1.116 Crore), XY Limited should NOT proceed with the proposed retail expansion in the African country.
Practical Question 4: Multinational Company - Subsidiary vs Export Analysis
A multinational company is planning to set up a subsidiary company in India (where hitherto it was supplying goods by way of exports) in order to cater to the growing demand for its product.
The Chief Financial Officer has estimated the following operating cost and other data in respect of the proposed project:
- Cost of plant and machinery: US $ 500 million
- Initial working capital required: US $ 50 million
- Selling price in India: US $ 80 per unit
- Variable operating cost in India: US $ 20 per unit
- Additional cash fixed cost: US $ 30 million p.a. (Project share of allocated parent overhead: US $ 3 million p.a. - to be ignored as non-incremental)
- Production capacity in India: 5 million units p.a.
- Useful life of plant: 5 years with zero salvage value. Straight line depreciation.
- Existing working capital released from exports: US $ 15 million immediately released
- Export impact: If subsidiary is set up, exports cease. If subsidiary is not set up, exports in coming years will drop to 1.5 million units p.a. at selling price $80/unit and variable cost $40/unit.
- Corporate Income Tax: 35%
- Discount rate: 12% p.a. (PVIF @ 12%: Y1=0.8929, Y2=0.7972, Y3=0.7118, Y4=0.6355, Y5=0.5674; Cumulative 5-yr PVIFA = 3.6048)
Assume exchange rate remains constant and 100% profits are repatriated with zero withholding tax. Estimate Net Present Value (NPV).
I. Initial Incremental Cash Outflows at Year 0
| Particulars | Amount ($ Million) |
|---|---|
| Cost of Plant and Machinery | $500.00 |
| Working Capital Required for Subsidiary | $50.00 |
| Less: Immediate Release of Working Capital from Export Operations | ($15.00) |
| Net Initial Cash Outflow (Year 0) | $535.00 Million |
II. Annual Incremental Cash Flow After Tax (CFAT) (Years 1 to 5)
(a) Annual CFAT Generated by Indian Subsidiary (5 Million units):
| Particulars | Amount ($ Million) |
|---|---|
| Sales Revenue ($5 \text{M units} \times \$80$) | $400.00 |
| Less: Variable Operating Costs ($5 \text{M units} \times \$20$) | ($100.00) |
| Less: Additional Fixed Operating Costs | ($30.00) |
| Less: Depreciation on Plant ($\$500\text{M} \div 5\text{ years}$) | ($100.00) |
| Earnings Before Interest & Tax (EBIT) | $170.00 |
| Less: Income Tax @ 35% | ($59.50) |
| Earnings After Tax (EAT) | $110.50 |
| Add Back: Non-Cash Depreciation | +$100.00 |
| Annual Operating CFAT from Subsidiary | $210.50 Million |
Note: Allocated overhead of $3M is non-incremental and correctly excluded.
(b) Opportunity Cost: Lost CFAT from Exports (1.5 Million units):
| Particulars | Amount ($ Million) |
|---|---|
| Export Sales Revenue ($1.5 \text{M units} \times \$80$) | $120.00 |
| Less: Export Variable Cost ($1.5 \text{M units} \times \$40$) | ($60.00) |
| Lost Contribution Before Tax | $60.00 |
| Less: Tax @ 35% | ($21.00) |
| Lost Annual Operating CFAT from Exports (Opportunity Cost) | $39.00 Million |
(c) Net Incremental Annual CFAT (Years 1 to 5):
$$\text{Net Annual CFAT} = \text{Subsidiary CFAT } (\$210.50\text{M}) - \text{Lost Export CFAT } (\$39.00\text{M}) = \mathbf{\$171.50 \text{ Million}}$$
(d) Terminal Cash Flow at Year 5:
Release of Net Working Capital at Year 5 = $\text{Subsidiary WC } (\$50\text{M}) - \text{Export WC Released Upfront } (\$15\text{M}) = \mathbf{\$35.00 \text{ Million}}$.
III. Determination of Net Present Value (NPV)
| Year | Incremental CFAT ($ Million) | PV Factor @ 12% | Present Value ($ Million) |
|---|---|---|---|
| 1–5 | $171.50 | 3.6048 (PVIFA) | $618.2232 |
| 5 | $35.00 (WC Release) | 0.5674 (PVIF) | $19.8590 |
| Total Present Value of Cash Inflows | $638.0822 | ||
| Less: Initial Net Cash Outflow (Year 0) | ($535.0000) | ||
| Net Present Value (NPV) | +$103.0822 Million | ||
Since the Net Present Value is substantially positive at +$103.0822 Million, the proposal to set up the manufacturing subsidiary in India should be accepted.
Practical Question 5: XYZ Ltd - Nepalese Expansion, NPV & MIRR
XYZ Ltd., a company based in India, manufactures very high quality modern furniture and sells to a small number of customers. The company is considering setting up a sales showroom in Nepal. The estimate of net Indian (₹) and Nepalese Currency (NC) cash flows in Nominal terms for this proposal is shown below:
| Net Cash Flow (in millions) | Year 0 | Year 1 | Year 2 | Year 3 |
|---|---|---|---|---|
| NC | -25.000 | 2.600 | 3.800 | 4.100 |
| Indian (₹) | 0 | 2.869 | 4.200 | 4.600 |
The following information is relevant:
- XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a.
- Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively.
- The current exchange rate is ₹ 1 = NC 1.60.
- Discount factors for ₹ 1 @ 9%:
- Present Value Factors: Y1 = 0.917, Y2 = 0.842, Y3 = 0.772
- Future Value Factors: Y1 (for 2 yrs) = 1.188, Y2 (for 1 yr) = 1.090, Y3 = 1.000
Assuming that you are the finance manager of XYZ Ltd., calculate the net present value (NPV) and modified internal rate of return (MIRR) of the project.
Step 1: Computation of Expected Forward Exchange Rates (NC / ₹)
Using Interest Rate Parity / Purchasing Power Parity:
$$F_t = S_0 \times \left( \frac{1 + I_{\text{Nepal}}}{1 + I_{\text{India}}} \right)^t = S_0 \times \left( \frac{1.09}{1.08} \right)^t$$
- Year 0 (Spot): NC 1.600 / ₹ 1
- Year 1 Forward: $\text{NC } 1.600 \times \frac{1.09}{1.08} = \mathbf{\text{NC } 1.615 \text{ / ₹ 1}}$
- Year 2 Forward: $\text{NC } 1.615 \times \frac{1.09}{1.08} = \mathbf{\text{NC } 1.630 \text{ / ₹ 1}}$
- Year 3 Forward: $\text{NC } 1.630 \times \frac{1.09}{1.08} = \mathbf{\text{NC } 1.645 \text{ / ₹ 1}}$
Step 2: Conversion of NC Cash Flows into Indian Rupees
| Year | NC (Million) | Conversion Rate (NC / ₹) | Cash Flow in ₹ (Million) |
|---|---|---|---|
| 0 | -25.000 | 1.600 | $-25.000 \div 1.600 = \mathbf{-₹ 15.625}$ |
| 1 | +2.600 | 1.615 | $+2.600 \div 1.615 = \mathbf{+₹ 1.610}$ |
| 2 | +3.800 | 1.630 | $+3.800 \div 1.630 = \mathbf{+₹ 2.331 \approx +₹ 2.330}$ |
| 3 | +4.100 | 1.645 | $+4.100 \div 1.645 = \mathbf{+₹ 2.492 \approx +₹ 2.490}$ |
Step 3: Total Combined Cash Flows and Calculation of Net Present Value (NPV)
| Year | Cash Flow in India (₹ M) | Cash Flow in Nepal (₹ M) | Total Cash Flow (₹ M) | PVF @ 9% | Present Value (₹ M) |
|---|---|---|---|---|---|
| 0 | — | -15.625 | -15.625 | 1.000 | -15.625 |
| 1 | +2.869 | +1.610 | +4.479 | 0.917 | +4.107 |
| 2 | +4.200 | +2.330 | +6.530 | 0.842 | +5.498 |
| 3 | +4.600 | +2.490 | +7.090 | 0.772 | +5.473 |
| Net Present Value (NPV) | -₹ 0.547 Million (-₹ 5,47,000) | ||||
Total PV of Cash Inflows = $4.107 + 5.498 + 5.473 = ₹ 15.078 \text{ Million}$.
$$\mathbf{\text{NPV} = ₹ 15.078 - ₹ 15.625 = -₹ 0.547 \text{ Million}}$$
Step 4: Calculation of Modified Internal Rate of Return (MIRR)
In MIRR, all interim cash inflows are compounded forward to the terminal year (Year 3) at the reinvestment rate (cost of capital = 9%):
| Year | Total Inflow (₹ M) | Compounding Factor @ 9% | Terminal Value at Year 3 (₹ M) |
|---|---|---|---|
| Year 1 | ₹ 4.479 | 1.188 (for 2 years) | $4.479 \times 1.188 = ₹ 5.321$ |
| Year 2 | ₹ 6.530 | 1.090 (for 1 year) | $6.530 \times 1.090 = ₹ 7.118$ |
| Year 3 | ₹ 7.090 | 1.000 | $7.090 \times 1.000 = ₹ 7.090$ |
| Total Terminal Cash Inflow ($\text{TV}_3$) | ₹ 19.529 Million $\approx$ ₹ 19.53 Million | ||
The MIRR formula is:
$$\text{MIRR} = \left( \frac{\text{Terminal Inflow}}{\text{Initial Outlay}} \right)^{\frac{1}{n}} - 1 = \left( \frac{19.53}{15.625} \right)^{\frac{1}{3}} - 1$$
$$\frac{19.53}{15.625} = 1.24992$$
$$(1.24992)^{1/3} = 1.0772$$
$$\mathbf{\text{MIRR} = 1.0772 - 1 = 0.0772 = 7.72\%}$$
• NPV: -₹ 0.547 Million (Negative).
• MIRR: 7.72%, which is lower than the hurdle rate of 9.00%.
Conclusion: The project is not financially viable and should be rejected.