9.2 FDI POLICY IN INDIA The origin of FDI in India can be traced back to 1500 A.D. when the Portuguese set up their first textile unit in Calicut, followed by the British East India Company in 1600 A.D. and the Dutch East India Company in 1602 A.D. They came to our country as merchants and later turned industrialists and some of them became rulers. Fierce competition followed between these merchants and industrialists from these countries till 1800 A.D. Finally, British East India Company emerged successful and colonized India. Political subordination of India was the best protection for the British and MNCs' market from Japanese competition. The entry of FDI into India on a commercial scale began in 1875 with initial investments in the field of mining, tea plantation, railways, insurance, generation and distribution of electricity and wholesale and retail trade. Foreign Direct Investment after Independence Foreign Direct Investment after Independence Up to August 1947, the policy of the Government of India was one of permitting unconditional and unrestricted inflow of foreign capital due to political dependency. After independence, the Government of India's policy with regard to foreign capital was formulated, for the first time, in the Industrial Policy Resolution of 6 April 1948. The government recognized participation of foreign capital and enterprise, particularly as regards to industrial technique and knowledge for rapid industrialization of the economy . It is also observed that private foreign capital, particularly of the direct equity type, has a general tendency to avoid sectors such as agriculture, public utilities, social overheads, and to go into only lucrative industries. This is not surprising because considerations such as profit incentives and export and import incentives are generally absent in the case of sectors like agriculture, public utilities, and social overheads. Another reason why private capital is not attracted to these sectors is the fact that most of the projects in these sectors have comparatively long maturity, the waiting period being too much for private investors to bear, low return on investment, and uncertainty of projects. FDI Policy during 1960-1980 During this period, the FDI policy of India was more restrictive due to the need to develop local industries. In 1973, the Foreign Exchange Regulation Act (FERA) came into force, requiring all foreign companies operating in India, with up to 40 per cent equity, to register under Indian corporate legislation. Government initiated the following measures such as: No FDI was allowed without transfer of technology. Renewals of foreign collaborations were restricted. Foreign Exchange Regulation Act, 1973 was restricted to FDI in certain core or high priority industries. 151 CU IDOL SELF LEARNING MATERIAL (SLM)
Equity participation was restricted to 40 per cent. The policy essentially aimed at retaining majority domestic ownership and effective control in foreign enterprises and thus was characterized by a cautious welcome to foreign investments. For technology transfer and royalty payment, a selective licensing regime was followed. Technical collaborations were permitted for import substitution, technology upgradation, and for export-oriented enterprises Foreign collaborations were encouraged in designated protected industries which included drugs and pharmaceutical, aluminium, heavy electrical enterprises, fertilizers, machine tools and extensive concessions and tax advantages were offered to attract multinational companies. Thus, in this phase, government was trying out the outcomes of FDI on various sectors keeping in mind the future and growth prospects of indigenous companies. Development pattern of India during the first three decades (1950-1980) after attaining independence in 1947 was featured by strong centralized planning, government ownership of basic and key industries, excessive regulation and control of private enterprise, trade protectionism through tariff and non-tariff barriers and a cautious and selective approach towards foreign capital. It was a quota, permit, and license regime all the way and was guided and controlled by a bureaucracy that was trained in colonial style. This so called inward- looking, import substitution strategy of economic development began to be widely questioned with the beginning of 1980s. Policy makers started realizing the drawbacks of this strategy which inhibited competitiveness and efficiency and produced a much lower rate of growth than expected. FDI policy in this period was not export oriented and was restrictive in nature, which could not result in making balance of payment situation favourable. Thus, measure was taken as a part of structural adjustment program to make our economy more liberal and norms for FDI were also liberalized. FDI Policy from 1980s to 1990s In the 1980s, as a part of the industrial policy resolutions, the attitude towards FDI was liberalized. However, inward looking regulatory regime continued until the early 1980s. This period was the period of opening up and gradual liberalization. However, through the new economic policy and the new industrial policy of 1991, a series of policy measures were announced to liberalize the FDI environment in the country and policies towards foreign multinationals were radically revised. Rules and procedures regarding remittance of profits, dividends, and royalties were relaxed. A fast channel was set up for expediting clearances of FDI proposals. Government introduced a series of measures through 1985-industrial policy, to reduce control on industries, particularly large ones. These measures described as New 152 CU IDOL SELF LEARNING MATERIAL (SLM)
Economic Policy, coincided with the policy framework of the Seventh Five-Year Plan (1985- 1990). The process of economic reforms initiated in 1985 got a big boost after the announcement of a new industrial policy on 24\"^ July 1991. The new policy aimed at competitive and market- oriented economy in place of the controlled and protected economy FDI Policy since 1991 In July 1991, the first-generation reforms created conducive environment for foreign investment in India. This actually started the process of liberalization of FDI policy. One of the measures undertaken was that foreign investment and technology collaboration was welcomed to obtain higher technology, to increase exports and to expand the production base. Many concessions were announced for foreign equity capital in 1991-1992. The foreign equity capital limit was raised to 51 per cent. FDI was allowed in exploration, production, refining of oil and marketing of gas. NRIs and Overseas Corporate Bodies were allowed to invest 100 per cent equity in high priority areas as well as in export houses, hotels and tourism related industries. The most significant step was replacement of Foreign Exchange Regulation Act (FERA), 1973 with Foreign Exchange Management Act, 1999 (FEMA). The object of the Act is to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India. Licensing was eliminated, and firms in all but a few sectors were allowed to start operations without government approval. The impact of de-licensing was most evident in sectors like steel, automobiles, FMCG and consumer electronics which witnessed a surge in entry of new firms. Automatic route for FDI is permitted. Except for certain specified activities, no prior approval from exchange control authorities i.e., Reserve Bank of India is required. Many new sectors were open for FDI. FDI Policy since 2000 The dividend balancing condition was removed. To make the investment in India attractive, investment and returns on them are made freely repatriable, except where the approval is subjected to specific conditions such as lock-in period on original investment, dividend cap, foreign exchange neutrality, etc. as per the notified sectoral policy. The condition of dividend balancing that was applicable to FDI in 22 specified consumer goods industries stands withdrawn for dividends declared after 14th July 2000 (Govt, of India, DIPP, and Press Note No. 7 of 2000 series). FDI is freely allowed in all sectors including the services sector, except a few sectors where the existing and notified sectoral policy does not permit FDI beyond a ceiling. 153 CU IDOL SELF LEARNING MATERIAL (SLM)
FDI for virtually all items/activities can be brought in through the Automatic Route under powers delegated to the Reserve Bank of India (RBI), and for the remaining items/activities through Government approval. Government approvals are accorded on the recommendation of the Foreign Investment Promotion Board (FIPB) (Source: SIA, Manual on FDI, Policy and Procedures, Govt, of India, May 2003). Foreign equity up to 100 per cent has been permitted for operating subsidiaries by NBFCs. (Govt, of India, Dept. of Industrial Policy and Promotion, Press Note No. 2 (2001 series), dated 17\"\" April 2001 For drugs and pharmaceutical, hotels and tourism sectors, foreign equity is permitted up to 100 per cent under the automatic route. For internet service providers with gateways, radio paging and end to end bandwidth, equity capital has been raised from 49 per cent to 74 per cent, subject to approval by FIPB (Govt, of India, Dept. of Industrial Policy and Promotion, Press Note No. 4 (2001 series), dated 21'' May 2001.) For integrated township, housing and built-up infrastructure, 100 per cent foreign equity was allowed under the automatic route in 2005 (Govt, of India, Dept of Industrial Policy and Promotion, Press Note No. 2 (2005 series), dated 3\"* March 2005. In the year 2000, a paradigm shift occurred, wherein, except for a negative list, all the remaining activities were placed under the automatic route (Govt, of India, DIPP, Press Note 2 of 2000). The insurance and defence sectors were opened up to a cap of 26 per cent (Press Note 10 of 2000, 4 of 2001 and 2 of 2002). In the case of Insurance services, there is the main issue of 26 per cent cap on foreign investment besides restrictions like minimum capitalization norms, funds of policy holders to be retained within the country, compulsory exposure to rural and social sectors and backward classes. For the defence sector, the entry of foreign investor will be allowed depends on the \"State of Art\". The cap for telecom services were increased from 49 per cent to 74 per cent (press Note 5 of 2005). FDI was allowed up to 51 per cent in single brand retail (Press Note 3 of 2006). Limits on payment of royalty were removed (Press Note 8 of 2009). Government has allowed FDI, in Limited Liability Partnerships (Press Note 1 of 2011). In March 2005, the government announced a revised FDI policy, an important element of which was the decision to allow FDI up to 100 per cent foreign equity under the automatic route in townships, housing, built-up infrastructure and construction-development projects. 154 CU IDOL SELF LEARNING MATERIAL (SLM)
The year 2005 also witnessed the enactment of the Special Economic Zones Act, which entailed a lot of construction and township development that came into force in February 2006. FDI up to 100 per cent is permitted under the automatic route for the establishment of SEZs. Proposals not covered under the automatic route require approval by FIPB. FDI up to 100 per cent is permitted under the automatic route for setting up 100 per cent Export Oriented Units (EOUs), subject to sectoral policies. FDI up to 100 per cent is permitted under the automatic route for the establishment of Industrial Parks. Proposals for FDI/NRI (Non-Residents Indian) investment in Electronic Hardware Technology Park (EHTP) and Software Technology Park (STP) units are eligible for approval under the automatic route, subject to certain parameters listed by the government. The raising of sectoral caps in services sector from 2004-2005 has resulted in services sector attracting more FDI inflows. One of the prime reasons for attracting FDI towards the services was growth potential and quick returns available to foreign investors in our country The changes in the policies are well reflected in FDI inflows. The policy changes initiated during the second decade of reforms were very effective to attract more quantum of FDI The change in the reporting practice which introduced new items, especially reinvested earnings of the already established ones, did contribute significantly to the reported higher total inflows. India adopted the international practice of reporting FDI inflows data and started giving out the information for the year 2000-01 onwards. Till then reinvested earnings and other capital provided by foreign direct investors were not being reported as part of the inflows data. Thus, the reported inflow figures have better comparability from 2000-01 onwards and the earlier figures suffer from a degree of underestimation. This was introduced following the recommendations of the RBI Committee on Compilation of Foreign Direct Investment in India, October 2002. This DIPP fact sheet shows that during 2000-2001 total FDI inflows were US $ 4029 million. The FDI inflows kept on rising year wise. It touched US $ 8961 million in 2005-2006, which means that FDI inflow increased by US $ 4932 million therefore rose by 122.4 per cent between 2000 and 2005. In 2006-2007 it galloped to US $ 22826 million, means in a year it showed tremendous increase in FDI inflows. This is due to more liberalizing FDI policy towards the infrastructure and services sector. From 2004 onwards government has allowed 100 per cent FDI in infrastructure and most of the tertiary sector which has been reflected in getting more than double FDI in 2006-2007. The same policy continued further and reflected in rise FDI up to US $ 37763 million during 2009- 2010. The year 2010 received US $ 27024 million, a 155 CU IDOL SELF LEARNING MATERIAL (SLM)
reduction in FDI inflows. So, during the ten years i.e., from 2000 to 2010, FDI inflow amount rose by US $ 22995 million. (US $ 27024 million - US $ 4029 million). Thus, it shows that FDI was increased by 570.73 per cent. As a result of the various steps that have been taken, India's FDI policy is now quite open and comparable to many countries. Caps on FDI shares are now applicable to only a few sectors, mainly in the services sector. Barring attempts at protecting Indian entrepreneurs with whom the foreign investors had already been associated with either as joint venture partners or technology licensors, it has been a case of progressive liberalization of the FDI policy regime. Simultaneously, the government has continuously strived to remove the hurdles in the path of foreign investors both at the stage of entry and later in the process of establishing the venture, in order to maximize FDI inflows. Much of the foreign investment can now take advantage of the automatic approval route seeking prior permission of the Central Government. These include air transport services, ground handling services, asset reconstruction companies, private sector banking, broadcasting, commodity exchanges, credit information companies, insurance, print media, telecommunications and satellites and defence production. 9.2.1 Recent Development in FDI Policies -2010 onwards The changes in FDI policies after 2010 are also discussed here to know the latest development happening in our economy. Mostly government has relaxed the caps in various sectors. FDI in sectors like Telecom and defence has been relaxed. One hundred per cent Foreign Investment is allowed in Telecom and defence on case-by-case basis. The 100 per cent FDI in defence is only for the state-of-the-art technology coming to India and Ministry of defence will decide what the state of the Art is. • The DIPP has considered the basic nature of Foreign Institutional Investors (FIIs) investments and done away with the requirement of getting prior consent from the FIPB. But the FDI investments will continue to happen through approval. • This new rule is in line with the FDI policies for infrastructure companies that are active in the securities markets like stock exchanges, clearing corporations, and depositories. Investment by Foreign Venture Capital Investors (FVCIs) From now on, FVCIs registered with SEBI will be permitted to invest in securities being traded at a well-known stock exchange such as the following: Equity, Indian Venture Capital Undertaking debentures (IVCU), Equity linked instruments, Venture Capital Fund debentures. Debt, Units of VCF schemes, Debt instruments, Units of VCF funds. 156 CU IDOL SELF LEARNING MATERIAL (SLM)
They can buy these through a third party or participate through private purchase or arrangement. Investment by Qualified Foreign Investors (QFIs) The union government has allowed QFIs to invest in equity shares and Depository Participants (DPs) of listed companies. They can also invest in equity shares of organizations that have been offered publicly according to regulations and guidelines laid down by the SEBI The new FDI policy has brought about some provisions that had been previously approved. Some of them may be mentioned as below: Allowing investment by international Venture Capital and Private Equity firms in secondary deals Liberalized policy for transferring convertible debentures and shares of financial services companies. FDI Routes in India FDI can come into India in two ways i.e., is Automatic Route and Government Approval Route. Automatic Route: According to the current policy, FDI can come into India in two ways. Firstly, FDI up to 100 per cent is allowed under the automatic route in all activities/sectors except a small list that require approval of the Government. FDI in sectors/activities under automatic route does not require any prior approval either by the Government or RBI. The investors are required to notify the Regional office concerned of RBI within 30 days of receipt of inward remittances and file the required documents with that office within 30 days of issue of shares to foreign investors. Government Approval Route: In some specified sectors, prior approval of government is required in a time bound and transparent manner by the Foreign Investment Promotion Board (FIPB). For all activities that are not covered under the automatic route, government approval through the FIPB is necessary. The foreign direct investments under the Automatic approvals and Government approval are regulated by the Foreign Exchange Management Act, 1999 (FEMA). All proposals for foreign investment requiring Government approval are considered by the Foreign Investment Promotion Board (FIPB). The FIPB also grants composite approvals involving foreign investment/foreign technical collaboration.\" 157 CU IDOL SELF LEARNING MATERIAL (SLM)
FIPB ensures a single-window approval for the investment and acts as a screening agency. FIPB approvals are normally received in 30 days. RBI introduced automatic approval system in 1992 to facilitate more convenient entry to foreign investors. From 1996, FDI inflows on acquisition of shares have also been included and have been rising continuously since 2004 whereas FDI Inflows through NRI's route have been declining especially since 2002. However, during post-policy period, the actual investment flows through the automatic route of the RBI against total FDI flows remained rather insignificant. This was partly due to the fact that crucial areas like electronics, services and minerals were left out of the automatic approval route. Another limitation was the ceiling of 51 per cent on foreign equity holding was imposed on these sectors. An increasing number of proposals were cleared through the FIPB route while the automatic approval route was relatively unimportant. However, since 2000 automatic approval route has become significant and accounts for a large part of FDI inflows as a result of opening of above-mentioned sectors for FDI. FDI Related Institutions There are three primary institutions in India that handle FDI related issues. These are: The Foreign Investment Promotion Board (FIPB) The Secretariat for Industrial Assistance (SIA) The Foreign Investment Implementation Authority (FIIA) Foreign Investment Promotion Board (FIPB), 1991 The Foreign Investment Promotion Board (FIPB), Department of Economic Affairs (DEA), Ministry of Finance is the nodal single window agency for all matters relating to FDI as well as promoting investment in the country. It considers and recommends FDI proposals, which do not come under the automatic route. Its objectives are to promote FDI by undertaking and facilitating investment promotion activities in our country and abroad. Secretariat for Industrial Assistance (SIA) It has been set up by the Government of India in the Department of Industrial Policy and Promotion in the Ministry of Commerce and Industry to provide a single window for entrepreneurial assistance, investor facilitation, receiving and processing all applications which require Government approval, conveying Government decisions on applications filed, assisting entrepreneurs and investors in setting up projects (including liaison with other organizations and State Governments) and in monitoring implementation of projects. Foreign Investment Implementation Authority (FIIA), 1999 The Government of India has set up the Foreign Investment Implementation Authority (FIIA) to facilitate quick translation of FDI approvals into implementation. It functions for 158 CU IDOL SELF LEARNING MATERIAL (SLM)
assisting the FDI approval holders in obtaining various approvals and resolving their operational difficulties. FIIA has been interacting periodically with the FDI approval holders and following up their difficulties for resolution with the concerned Administrative Ministries and State Governments. India's Share in the World FDI Net Inflows The data of FDI net inflows for India and World have been taken from the Balance of Payment Table given in the database of World Bank Data Bank from 1995-2011 (Table 3.4). Source of the FDI, net inflows (BOP, current US $) is World Bank, International Debt Statistics, and World Bank and OECD GDP estimates. Data are in current U.S. dollars. To analyse the position of India in different year's scenario, shares of India in the World FDI inflows have been calculated from 1995-2011. Table 9.1 Percent Share of India in World FDI Net Inflows Table 9.1 shows, per cent share of India in world FDI net inflows. In the year 1995, we could manage up to 0.67 per cent of world FDI. Slowly India's share started increasing year after year. Till the year 2000, it rose to 0.27 per cent. In the second decade of economic reforms, due to opening up of infrastructure and tertiary sector for FDI, rise in FDI per cent is seen. In the year 2001, it was 0.75 per cent, in 2005 it was 0.52 per cent, and in 2010 it could grab 1.93 per cent of world FDI. Thus, India's share in world FDI is still very minimal but has started increasing slowly and needs to grow at a faster pace 159 CU IDOL SELF LEARNING MATERIAL (SLM)
Sources of FDI in India India has broadened the sources of FDI in the period of reforms. There are nearly 140 countries investing in India in 2010 as compared to 15 countries in 1991. Thus, the number of countries investing in India increased after reforms. After liberalization of economy, countries like Mauritius, U.S.A, Japan, U.K., Netherlands, Germany, Singapore, France, South Korea, Malaysia, Switzerland, Italy and many more countries predominantly appears on the list of major investors. The details are shown below. Table 9.2 Major Investing Countries in India During 2000- 2010 The analysis in Table 9.2 presents the major investing countries in India during 2000- 2010. Mauritius is the largest investor in India during the decade. FDI inflows from Mauritius constitute about 41.87 per cent of the total FDI in India and it enjoys the top position on India's FDI map. Mauritius has low rates of taxation and an agreement with India on double tax avoidance regime. To take advantage of that situation, many companies have set up dummy companies in Mauritius before investing to India. The fact is that most investment coming to India from the United States is being routed through that country. In addition, major parts of the investments from Mauritius to India are actually round tripping by Indian firms. This Double Taxation Avoidance Agreement (DTAA) type of taxation treaty has been made out with Singapore also, and it is the second largest investing country in India, which contributes 9.10 per cent of total FDI, followed by USA (7.50 per cent), Netherlands (4.36 per cent), Japan (3.98 per cent), UK (3.96 per cent), Cyprus (3.63 per cent), Germany (2.29 per cent), France (1.77 per cent), and Switzerland (1.46 per cent) respectively. Overall, countries categorized as tax havens accounted for much higher share of nearly 70 per cent of the total FDI inflows during the more recent period. 160 CU IDOL SELF LEARNING MATERIAL (SLM)
9.3 CROSS BORDER MERGERS AND ACQUISITIONS Cross border Mergers and Acquisitions or M&A are deals between foreign companies and domestic firms in the target country. The trend of increasing cross border M&A has accelerated with the globalization of the world economy. Indeed, the 1990s were a “golden decade” for cross border M&A with a nearly 200 percent jump in the volume of such deals in the Asia Pacific region. This region was favoured for cross border M&A as most countries in this region were opening up their economies and liberalizing their policies, which provided the much, needed boost to such deals. Of course, it is another matter that in recent years, Latin America and Africa are attracting more cross border M&A. This due to a combination of political gridlock in countries like India that are unable to make up their minds on whether the country needs more foreign investment, the saturation of China, and the rapid emergence of Africa as an investment destination. Further, the fact that Latin America is being favoured is mainly due to the rapid growth rates of the economies of the region. Having said that, it must be remembered that cross border M&A’s actualize only when there are incentives to do so. In other words, both the foreign company and the domestic partner must gain from the deal as otherwise; eventually the deal would turn sour. Given the fact, that many domestic firms in many emerging markets overstate their capabilities in order to attract M&A, the foreign firms have to do their due diligence when considering an M&A deal with a domestic firm. This is the reason why many foreign firms take the help of management consultancies and investment banks before they venture into an M&A deal. Apart from this, the foreign firms also consider the risk factors associated with cross border M&A that is a combination of political risk, economic risk, social risk, and general risk associated with black swan events. The foreign firms evaluate potential M&A partners and countries by forming a risk matrix composed of all these elements and depending upon whether the score is appropriate or not, they decide on the M&A deal. Third, cross border M&A also needs regulatory approvals as well as political support because in the absence of such facilitating factors, the deals cannot go through. A company in one country can be acquired by an entity (another company) from other countries. The local company can be private, public, or state-owned company. In the event of the merger or acquisition by foreign investors referred to as cross-border merger and acquisitions will result in the transfer of control and authority in operating the merged or acquired company. Assets and liabilities of the two companies from two different countries are combined into a new legal entity in terms of the merger, while in terms of acquisition, there is a transformation process of assets and liabilities of local company to foreign company (foreign investor), and automatically, the local company will be affiliated. Since the cross- border M&As involving two countries, according to the applicable legal terminology, the state where the origin of the companies that acquire (the acquiring company) in other 161 CU IDOL SELF LEARNING MATERIAL (SLM)
countries refer to as the Home Country, while countries where the target company is situated refers to as the Host Country. In corporate merger, the headquarter of the new company can be in two states, for instance, on the merger between the Dutch Royal Shell, where the company’s headquarters are in The Hague, Netherlands, with its registered office at the Shell Centre in London, United Kingdom. The headquarter can also be in a state of Home country, such as the merger between Daimler-Benz AG with the American automobile manufacturer Chrysler Corporation 9.3.1 Effects of Cross Border Merger and Acquisitions Generally, it has been observed that cross border merger and acquisitions are a restructuring of industrial assets and production structures on a worldwide basis. It enables the global transfer of technology, capital, goods and services and integrates for universal networking. Cross border M&A’s leads to economies of scale and scope which helps in gaining efficiency. Apart from this it also benefits the economy such as increased productivity of the host country, increase in economic growth and development particularly if the policies used by the government are favourable. Let’s look at those effects in detail. Capital Builds Up: Cross border merger and acquisitions contribute to capital accumulation on a long-term basis. In order to expand their businesses, it not only undertakes investment in plants, buildings and equipment’s but also in the intangible assets such as the technical know-how, skills rather than just the physical part of the capita1. Employment creation: Sometimes it is seen that the M&A’s that are undertaken to drive restructuring may lead to downsizing but would lead to employment gains in the long term. The downsizing is sometimes essential for the continued existence of operations. When in the long run the businesses expand and becomes a successful it would create new employment opportunities. Technology handover: When companies across countries come together it sustains positive effects of transfer of technology, sharing of best management skills and practices and investment in intangible assets of the host country. This in turn leads to innovations and has an influence on the operations of the company. Cross Border Merger and Acquisitions- issues and Challenges: Looking at the underlying dynamics cross border merger and acquisitions are quite similar to that of domestic M&A’s. But because the former is huge and international in nature, they 162 CU IDOL SELF LEARNING MATERIAL (SLM)
pose certain unique challenges in terms of different economic, legal and cultural structures. There could be huge differences in terms of customer’s tastes and preferences, business practices, the culture which could pose as a huge threat for companies to fulfil their strategic objectives. In this scenario this article discusses these issues and challenges briefly. Political concerns: Political scenario could play a key role in cross border merger and acquisitions, particularly for industries which are politically sensitive such as defence, security etc. “Not only considering these aspects it is also important to concern of the parties like the governmental agencies (federal, state and local), employees, suppliers and all other interested should be addressed subsequent to the plan of the mergers is known to public. In fact, in certain cases there could be a requirement of prior notice and discussion with the labour unions and other concerned parties. It is important to identify and evaluate present or probable political consequences to avoid any probability of political risk arising. Cultural challenges: This could pose a huge threat to the success of cross border merger and acquisitions. History has seen huge mergers that have failed because of the cultural issues they have had. When there are cross border transactions there are issues that arise because of the geographic scope of the deal. Various factors such as differing cultural backgrounds, language necessities and dissimilar business practices have led to failed mergers in spite of being in the age where we can instantly communicate. Research proposes that intercultural disagreement is one of the major pointers of failure in cross-border merger and acquisition. Hence irrespective of what the objective behind the alliance is businesses should be well aware of the of the intercultural endangerment and prospects that come hand in hand with the amalgamation process and prepare their workforce to manage these issues. In order to deal with these challenges’ businesses, need to invest good amount of time and effort to be well aware of the local culture with the employees and other concerned parties. It is better to over communicate, and conforming things tirelessly would be the key. Legal Considerations Companies wanting to merge cannot overlook the challenge of meeting the various legal and regulatory issues that they are likely to face. Various laws in relation to security, corporate and competition law are bound to diverge from each other. Hence before considering the deal it is important to review the employment regulations, antitrust statute and other contractual requirements to be dealt with. These laws are very much part of both while the deal is under process and also after the deal has been closed. While undergoing the process of reviewing these concerns it could indicate that the potential merger or acquisition would be totally incompatible and hence it is recommended to not go ahead with the dea1. 163 CU IDOL SELF LEARNING MATERIAL (SLM)
Tax and Accounting Considerations Tax matters are critical particularly when it comes to structuring the transactions. The proportion of debt and equity in the transaction involved would influence the outlay of tax; hence a clear understanding of the same becomes significant. Another factor to decide whether to structure an asset or a stock purchase is the issue of transfer taxes. It is very important to alleviate the tax risks. Countries also follow different accounting policies though the adoption of International Financial Reporting Standards (IFRS) has reduced this to an extent; many countries have yet to implement it. If the parties in the merger are well aware about the financial and accounting terms in the deal, it would aid in minimizing the confusion. Due Diligence Due diligence forms a very important part of the M&A process. Apart from the legal, political and regulatory issues we discussed above there are also infrastructure, currency and other local risks which need thorough appraisal. Due diligence can affect the terms and conditions under which the M&A transaction would take place, influence the deal structure, affect the price of the deal. It helps in revealing the danger area and gives a detailed view of the proposed transactions. There are countless other issues as every deal has its own favour and differences. But it is of course very important to identify and tackle those challenges to help close a dea1. In spite of the issue, we have discussed above the number of cross border transactions have increased quite radically over the past few decades. Though there have been a few economic crises and the situation has not been so conducive, it had not disturbed the upward trend in cross border M&A activity. More and more companies want to go global as they offer great opportunities which are comparatively cheaper option for companies to build itself internally. Looking at the M&A sentiments around the world it shows that the businesses acquisition emphasis is changing from domestic to cross border transactions because of the various benefits it offers . Cross-Border Merger and Acquisition Motives Underlying motive for Cross Border M&As by large companies today cannot be separated from the current globalization. Merger and Acquisitions can be functionally classified as: Horizontal M&As (between competing firms in the same industry): They have grown rapidly recently because of the global restructuring of many industries in response to technological change and liberalization. By consolidating their resources, the merging firms aim to achieve synergies (the value of their combined assets exceeds the sum of their assets taken separately) and often greater market power. Typical industries in which 164 CU IDOL SELF LEARNING MATERIAL (SLM)
such M&As occur are pharmaceuticals, automobiles, petroleum and, increasingly, several services industries. Vertical M&As (between firms in client supplier or buyer-seller relationships): Typically, they seek to reduce uncertainty and transaction costs as regards forward and backward linkages in the production chain, and to benefit from economies of scope. M&As between parts and components makers and their clients (such as final electronics or automobile manufacturers) are good examples. Conglomerate M&As (between companies in unrelated activities): They seek to diversify risk and deepen economies of scope.’ Outlined, motives underlay the cross-border M&As: It strives to increase the profitability or revenue enhancement, cost reduction, market development, and power and efficiency gains. Some literatures take important note by conducting studies on connection of cross border M&As with some indicators as discussed in the following sub-sub chapter. Foreign Direct Investment Motive Over the past few decades, economic development has become globalized, and some trends indicate progress toward the development of international networks in all spheres. One of the trends is an increasing of Foreign Direct Investment (FDI). FDI is a long-term active participation from foreign country to other countries usually in the form of management participation, joint ventures, or transfer technology and know-how. FDI is divided into two types, namely inward and Outward FDI, both of which will result in net FDI inflow. Basically, the flow of FDI into a country can be done in two ways, through green-field investment, or by making mergers and acquisitions of local companies. The relation between net FDI inflow with Cross Border M&As, is reflected by the complexity of companies in adoption with regional strategies and intricate network structures that have facilitated intra-regional economic interdependency. This condition might become one of the region’s attractiveness to international investors upon the growth of net FDI inflow. Afterward, it is important to build intergovernmental efforts towards creating the appropriate environment for the companies following the huge net FDI inflow. Thus, the increasing of net FDI inflow could be followed by several cross-border activities, for example, Cross Border M&As in term of investment, and the expansion of operations. The main motivation of doing Cross Border M&As is related to financial performance. In most cases, financial motive is more visible than other motives. It is related to the purpose of doing mergers and acquisitions, in which the decision is based on interests of the 165 CU IDOL SELF LEARNING MATERIAL (SLM)
shareholders and the board of directors. In practice, financial motive is done by private equity, for instance, when they propose management buyouts (MBO) or sell the merged companies in the next couples of years in order to take advantage from the margin of increasing company’s value. There are several activities underlying this motive Economy of Scale This refers to the fact that the combined company can often reduce its fixed costs by removing duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit margins. Increased Revenue or Market Share This assumes that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices. Resource Transfer Resources are unevenly distributed across firms and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources. Geographical or another Diversification This is designed to smooth the earnings results of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholder. From these perspectives, financial motive arises as efficiency gains increased because Cross Border M&As intensify synergies between firms that in turn leverages economy of scale or scope. Furthermore, the diversification creates an opportunity for investors to develop their business in a larger scale, geographically or by type of business. Thus economically, this circumstance might create gain in value and efficiency. Strategic Motive Strategic motive is a more complex motive behind Cross Border M&As, it might change the market structure and as such have an impact on companies’ profits, moreover, it might even be reduced to zero, this is the so-called merger paradox. In general, the aim of this motive is to eliminate double activities in integrated companies due to enlarge economics of scale, for instance, by creating new supply chains or diversity of product, and extending market share. Practically, this motive can be as follow: Cross-sell 166 CU IDOL SELF LEARNING MATERIAL (SLM)
For example, a bank buying a stockbroker could then sell its banking products to the stockbroker’s customers, while the broker can sign up for the bank’s customers for brokerage accounts. Or a manufacturer can acquire and sell complementary products. Synergy For example, managerial economies such as the increased opportunity of managerial specialization. Another example is purchasing economies due to increased order size and associated bulk-buying discounts. Usually, Strategic perspective of Cross Border M&As is derived by technological, regulatory, and to some extent also financial consideration, it can be explained by the fact that most of this motive is conducted through horizontal merger of companies, whereas integrated functions (eliminating double activities, i.e., in Research and Development function) are an important factor in companies’ decisions to engage such merger or acquisitions. Types of Cross Borders Cross border merger and acquisitions are of two types Inward and Outward. Inward cross border M&A’s involve an inward capital movement due to the sale of a domestic firm to a foreign investor conversely outward cross border M&A’s involves outward capital movement due to purchase of a foreign firm. In spite of these differences, inward and outward M&A’s are closely linked as on a whole M&A transaction comprise of both sales and purchase. Everyone will be wondering why firms go for cross border merger and acquisitions or what induces them to leave their home country. Well, there are various driving forces which differ across sectors. Few factors which generally encourage firms for cross border M&A’s include: Globalization of financial markets. Market pressures and falling demand due to international competition. Seek new market opportunities since the technology is fast evolving. Geographical diversification which would result in exploring the assets in other countries. Increase company’s efficiency in producing the goods and services. Fulfilment of the objective to grow profitably. Increase the scale of production. Technology share and innovation which reduces costs. These factors have been supported with government policies such as regulatory reforms, privatization which has led to access to targets for potential acquisitions. There have been innumerable merger and acquisitions in the past many who have been successful and others who unfortunately doomed. Recent trends show that in spite of economic uncertainties cross 167 CU IDOL SELF LEARNING MATERIAL (SLM)
border merger and acquisitions are gaining importance and considered to be a vital tool for growth Let’s consider this example from past of Daimler-Chrysler Merger which was a cross border M&A where Daimler-Benz was a German automotive company and Chrysler Corporation an American automobile manufacturer. This German American marriage took place in the year 1998 and was considered as a “merger of equals”.47 As the word suggest cross border includes activities that take place between two different countries. Hence, we could imply that the cross-border merger and acquisitions are basically those transactions wherein the target firm and the acquirer firm are of different home countries. This deal is such in which the assets and processes of the firms in different countries are combined to form a new legitimate entity.” International Growth in Relation with Cross Border Mergers and Acquisitions The most fundamental motives to conduct cross border M&As is growth. Companies who seeking for expand have two options and should choose between internal growth and M&As growth. In the former case, if a company seeks to expand within its own business, the company could face that internal growth is not reluctant to be a satisfaction alternative. For instance, the company may find difficulty in maximizing the opportunity because of a limited period of time, whereas internal growth may not suffice. As the company grows slowly, the competitors could respond very quickly and might be taken as dominant in given market share that a company may have dissipated over time by the actions of competitors. Thus to balance this condition, a company could choose M&As growth by acquiring company which has the resources, such as facilities, well established managements, and other resources available for additional competition purpose in the market. International Growth of Economy Cross border M&As may become one alternative for companies who have been successful in their product within national market to expand revenue and profit. Whereas cross border M&As facilitates the companies with opportunities of tapping new market rather than pursuing further growth in internal market. For instance, cross border deals may enable companies to utilize country specific know how of the acquired companies, the staff, and also the distribution network they might have, these will provide more advantages for acquiring companies. Carrying this condition, the key element to be considered is whether such cross- border M&As provide opportunity cost relate with the risk adjusted return. Opportunity cost is reflected by what can be achieved to the next base use of the invested capita1. In European Union (EU), since the development of many areas of regulations to reduce cross countries barriers, cross border deals (including M&As) become significantly increased. In certain Asian markets, cross border deals are still secluded because of the resistance of some countries to foreign acquirers, however, there are signs that this condition will be changed 168 CU IDOL SELF LEARNING MATERIAL (SLM)
rapidly. Within 1970-2000, according to many research and studies in global investments, international growth in economy has considerably effected by globalized world on corporations. The fastest way to achieve growth is through cross border M&As by acquiring other markets in international scope. Although, to enter new markets will certainly create additional risks for investors, many companies that have previously been involved in cross border deals (M&As’ waves) may become references for those who conduct such deals to reduce the risks. International growth of economy is marked by significant activities in many areas of industry such as automobile, telecommunication, and other corporate matters. Operating Synergy of Company Combinations The purpose of company combinations through merger is to enhance its revenue or to reduce its cost through synergies. Revenue enhancing may be more difficult than cost reducing to achieve. However, the company combinations through revenue enhancements can produce new opportunity, for instance, sharing of marketing by enabling cross-marketing by each merger partner’s products with a broader line of markets, whereas each company could sell more products and services. This condition may lead to the comparative advantage between the two merged companies as a result the exchange from their conducts. Cross-marketing also provides the opportunity to enable faster growth in revenue enhancement of each merger partner rather than exploiting their own market. Even though the sources of revenue enhancements are huge, but to achieve such enhancements is not an easy way. That was why, cost related synergies through cost reductions also become a very important in planning for merger deals. In general, the merger of two companies may have certain specific facilities and those are duplicative, for example, if both companies have their own distribution networks and research development division that could create similar result. These activities maybe pointed to be eliminated and build more effective and efficient synergy through company combinations’ scheme. Operating synergy in company combinations tend to look for cost-reduction synergies as a main source than revenue- enhancement. The reason lays on the fact that cost-reduction may come to decrease as a result of an increased of the size/scale of company’s operations. Whereas revenue enhancements are vaguely referred to as merger benefits, but these enhancements usually are not clearly defined, and companies sought to these purposes may find hardly quantified objectives. 9.4 SUMMARY The current FDI policy aims at simplification of procedures and practices through which more quantum of investment can be pulled in our country for rapid development. Started with limited number of sectors and restrictive equity caps, list of sectors has been expanded incrementally and cautiously and equity caps have been liberalized. More and more sectors have been shifted from FIPB route to automatic route. 169 CU IDOL SELF LEARNING MATERIAL (SLM)
Now, only few sectors are left where FDI is banned, such as atomic energy, lottery business, gambling and business of chit fund. A large number of sectors including mining, banking, insurance, telecommunication, construction and management of ports, harbours, roads, and highways, airlines and defence equipment have been thrown open to private and foreign owned companies By implementing such a broad nature FDI policy, the Government is welcoming foreign investors to invest in our country. The nature of policies adopted since the independence period were motivated by the stability and sovereignty issues. Afterwards, the FDI policies got cautious welcome in order to protect the indigenous industries. These policies got tremendous momentum after the acceptance of economic reforms of 1991. The same approach is continued till today and the Government is liberalizing the caps on various sectors with proper justification considering the interest of our industries. Now the Government also has to focus on the spread of FDI in various regions as well as different sectors of our country in order to have an overall development of our country. It has been noticed that only few regions got more chunk of FDI than the rest. But there should be equitable and balanced development in all regions of the country. In the next chapter, researcher has examined the region wise inflow of FDI in our country and its implications on our country and society. On a whole cross border merger and acquisitions can provide great benefits to companies and also increase its share price but as we saw there are a lot of factors which need to be taken into consideration to avoid any glitches. It is extremely vital for the business structures of both the countries involved in M&A transactions and learn from cases like that of Daimler-Chrysler. Most critical factors which separate the successful M&A transactions from the others, who fail, are thorough and planned preparation and commitment of time and other resources. Considering all this the prominence and importance of cross border transactions clearly illustrates the business mindsets to access the global markets and grow. Cross-border mergers and acquisitions have shown tremendous growth over time primarily due to a desire to circumvent tariffs and nontariff barriers arising from arms-length international trade and taxes; to obtain new options for financing; to access technology; and to distribute research and development costs over a broader base. Several factors put in place to moderate this growth include protecting key industries, limiting controlling interest levels, and restricting remittances of profits and dividends. We need to focus on cross-border mergers and acquisitions (M&A), and their financial and economic (both macro and micro) underpinnings, which affect their 170 CU IDOL SELF LEARNING MATERIAL (SLM)
direction and magnitude. In general terms, empirical analysis supports the fact that both host countries and the foreign country’s stock and bond prices are major causal factors that influence cross-border mergers and acquisitions. A company must have a clear vision and strategy as to why it should expand globally. The due diligence and analysis that is required will make it easier to find the right M&A target in a foreign market that matches the buying company’s profile, and one that can be successfully integrated. It’s common to see companies bring in independent advisors to support M&A activities at this stage, and even earlier, as these advisors are not tied to the success of the deal and can provide their expertise throughout the lifecycle. 9.5 KEYWORDS Joint ventures: A joint venture is a business entity created by two or more parties, generally characterized by shared ownership, shared returns and risks, and shared governance. Subsidiary: subsidiary company or daughter company is a company owned or controlled by another company, which is called the parent company, parent, or holding company. The subsidiary can be a company, corporation, or limited liability company. In some cases, it is a government or state-owned enterprise. Mergers: is an agreement that unites two existing companies into one new company. There are several types of mergers and also several reasons why companies’ complete mergers. Mergers and acquisitions are commonly done to expand a company's reach, expand into new segments, or gain market share. Acquisitions: acquisitions are transactions in which the ownership of companies, other business organizations, or their operating units are transferred or consolidated with other entities. FDI: A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. It is thus distinguished from a foreign portfolio investment by a notion of direct control. 9.6 LEARNING ACTIVITY India's FDI inflows grew by 81% in Nov 2020 to $10.15 bn, equity at $8.5 bn. India has attracted total FDI inflow of USD 58.37 billion during April to November 2020. India's Foreign Direct Investment (FDI) saw a significant jump in November 2020 1. Discuss the key changes made to FDI policy in India and effect on inflow of USD. 171 CU IDOL SELF LEARNING MATERIAL (SLM)
……………………………………………………………………………………………… ……………………………………………………………………………………………… 9.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain key reforms of FDI Policy since 1991. 2. Explain Cross border Mergers and Acquisitions. 3. Explain Legal considerations during Merger and Acquisitions. 4. Explain types of cross borders. 5. Explain International growth in relation with cross border mergers and acquisitions. Long Questions 1. Explain advantages and disadvantages to FDI. 2. Explain issues and challenges in Cross Border Merger and Acquisitions. 3. Explain Effects of Cross Border Merger and Acquisitions. 4. Explain motive during cross-border merger and acquisition. 5. Explain operating synergy of company. B. Multiple Choice Questions 1. The foreign direct investment includes___________. a. Intellectual Property b. Human Resource c. Tangible Good d. Intangible Goods 2. As per the Companies Act 2013, if a foreign investor owns more than 10 % shares in a listed company, it will be treated as? a. Foreign Direct Investment b. Foreign Portfolio Investment c. Foreign Institutional Investment d. Both b and c 3. The Foreign Exchange Regulation Act (FERA) came into force a. 1973 b. 1974 172 CU IDOL SELF LEARNING MATERIAL (SLM)
c. 1975 d. 1976 4. Identify a factor that doesn’t play an important role in attracting FDI. a. Laws, rules and regulations b. Administrative procedures and efficiency c. Infrastructure related factors d. Language 5. The country that attracts the largest FDI inflow is ________. a. India b. China c. USA d. Brazil Answers: 1-(c), 2-(a), 3-(a), 4-(d), 5-(b) 9.8 REFERENCES Textbooks: Daniels & Joseph P. & Van Hoose David, International Monetary and Financial Economics, South-Western , Thompson Learning, USA, 1988. Holland, John, International Financial Management, Black West, Publishers, UK. Levi, Maurice D, \"International Finance\", Tata McGraw Hill Publishing Company Ltd., New Delhi, 1988. Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffee. Corporate Finance, 5th ed. New York, NY: Irwin/McGraw-Hill, 1999. Seth, AK, \"International Financial Management\", Galgotia Publishing Company, New Delhi, 1998. Shapiro, Alan C, Multinational Financial Management, PHI, New Delhi, 2002. 173 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-10: INTERNATIONAL CAPITAL STRUCTURE AND COST OF CAPITAL STRUCTURE 10.1 Learning Objectives 10.2 Introduction 10.3 Cost of Capital 10.3.1 Factors Effecting Cost of Capital 10.4 Capital Structure 10.4.1 Capital Structure of MNC Versus Domestic Firm 10.4.2 Cost Minimizing Approach to Global Capital Structure 10.5 Summary 10.6 Keywords 10.7 Learning Activity 10.8 Unit End Questions 10.9 References 10.0 LEARNING OBJECTIVES After studying this unit, student will be able to: Explain cost of capital and factor effecting. Explain capital structure. Describe cost minimizing approach. 10.1 INTRODUCTION A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and debt (borrowed funds). The fi rm’s cost of retained earnings reflects an opportunity cost: what the existing shareholders could have earned if they had received the earnings as dividends and invested the funds themselves. The fi rm’s cost of new common equity (issuing new stock) also reflects an opportunity cost: what the new shareholders could have earned if they had invested their funds elsewhere instead of in the stock. This cost exceeds that of 174 CU IDOL SELF LEARNING MATERIAL (SLM)
retained earnings because it also includes the expenses associated with selling the new stock (flotation costs). The fi rm’s cost of debt is easier to measure because the firm incurs interest expenses as a result of borrowing funds. Firms attempt to use a specific capital structure, or mix of capital components, that will minimize their cost of capital. The lower a fi rm’s cost of capital, the lower is its required rate of return on a given proposed project. Firms estimate their cost of capital before they conduct capital budgeting because the net present value of any project is partially dependent on the cost of capital Cost of equity capital is the cost of using the capital of equity shareholders in the operations. This cost is paid in the form of dividends and capital appreciation (increase in stock price). Most commonly, the cost of equity is calculated using following formula: The formula for Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk Premium – Risk-Free Rate) Cost of Debt Capital Cost of debt capital is the cost of using bank’s or financial institution’s money in the business. The banks are compensated in the form of interest on their capital. The cost of debt capital is calculated using following formula. Cost of Debt Capital = Interest Rate * (1 – Tax Rate) Figure 10.1 Weighted Average Cost of Capital (WACC) Most of the times, WACC is referred as a cost of capital because of its frequent and vast utilization especially when evaluating existing or new projects. Weighted average cost of capital, as the term itself suggests, is the weighted average of all types of capital present in the capital structure of a company. Assuming these two types of capital in the capital structure i.e., equity and debt, the WACC can be calculated by following formula: WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt. 175 CU IDOL SELF LEARNING MATERIAL (SLM)
Cost of Capital for MNCs The cost of capital for MNCs may differ from that for domestic firms because of the following characteristics that differentiate MNCs from domestic firms: Size of Firm: An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital. Furthermore, its relatively large issues of stocks or bonds allow for reduced flotation costs (as a percentage of the amount of financing). Note, however, that these advantages are due to the MNC’s size and not to its internationalized business. A domestic corporation may receive the same treatment if it is large enough. Nevertheless, a fi rm’s growth is more restricted if it is not willing to operate internationally. Because MNCs may more easily achieve growth, they may be more able than purely domestic firms to reach the necessary size to receive preferential treatment from creditors. Figure 10.2 Cost of Capital for MNCs Access to international capital markets: MNCs are normally able to obtain funds through the international capital markets. Since the cost of funds can vary among markets, the MNC’s access to the international capital markets may allow it to obtain funds at a lower cost than that paid by domestic fi rms. In addition, subsidiaries may be able to obtain funds locally at a lower cost than that available to the parent if the prevailing interest rates in the host country are relatively low the use of foreign funds will not necessarily increase the MNC’s exposure to exchange rate risk since the revenues generated by the subsidiary will most likely be denominated in the same currency. In this case, the subsidiary is not relying on the parent for financing, although some centralized managerial support from the parent will most likely still exist. 176 CU IDOL SELF LEARNING MATERIAL (SLM)
International diversification: As explained earlier, a fi rm’s cost of capital is affected by the probability that it will go bankrupt. If a fi rm’s cash inflows come from sources all over the world, those cash inflows may be more stable because the fi rm’s total sales will not be highly influenced by a single economy. To the extent that individual economies are independent of each other, net cash flows from a portfolio of subsidiaries should exhibit less variability, which may reduce the probability of bankruptcy and therefore reduce the cost of capital. Exposure to exchange rate risk: An MNC’s cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk. If foreign earnings are remitted to the U.S. parent of an MNC, they will not be worth as much when the U.S. dollar is strong against major currencies. Thus, the capability of making interest payments on outstanding debt is reduced, and the probability of bankruptcy is higher. This could force creditors and shareholders to require a higher return, which increases the MNC’s cost of capital. Overall, a firm more exposed to exchange rate fluctuations will usually have a wider (more dispersed) distribution of possible cash flows in future periods. Since the cost of capital should reflect that possibility, and since the possibility of bankruptcy will be higher if the cash flow expectations are more uncertain, exposure to exchange rate fluctuations could lead to a higher cost of capital. Exposure to country risk: An MNC that establishes foreign subsidiaries is subject to the possibility that a host country government may seize a subsidiary’s assets. The probability of such an occurrence is influenced by many factors, including the attitude of the host country government and the industry of concern. If assets are seized and fair compensation is not provided, the probability of the MNC’s going bankrupt increases. The higher the percentage of an MNC’s assets invested in foreign countries and the higher the overall country risk of operating in these countries, the higher will be the MNC’s probability of bankruptcy (and therefore its cost of capital), other things being equal. Other forms of country risk, such as changes in a host government’s tax laws, could also affect an MNC’s subsidiary’s cash flows. These risks are not necessarily incorporated into the cash flow projections because there is no reason to believe that they will arise. Nevertheless, there is a possibility that these events will occur, so the capital budgeting process should incorporate such risk. 10.3 COST OF CAPITAL An understanding of why cost of capital varies across different countries provides an insight into the reasons for competitive superiority of some MNCs in some countries. Knowledge of differences in cost of capital in different countries may enable an MNC to formulate suitable strategy regarding procurement of funds from those countries where they are available at lower cost. An appreciation of cost of capital across the globe can throw light on the differences existing in the pattern of capitalization of different MNCs. 177 CU IDOL SELF LEARNING MATERIAL (SLM)
As such, the following paragraphs are devoted to discussion of country differences in the cost of debt and cost of equity. Country Differences in the Cost of Debt: Cost of debt to an MNC is the function of two variables, viz; risk-free rate of interest in the currency borrowed and the premium for additional risk required by creditors. Since risk-free interest rate and risk premium differ from country to country, cost of capital will not be the same in different countries. There are various reasons for country differences in the risk-free rate and in the risk premium. Country Differences in the Risk-free Rate: Differences in the risk-free interest rate in different countries depend on supply of and demand for funds. A host of factors such as tax laws, demographics, monetary policies and state of economy influence supply of and demand for funds. Tax laws in different countries differ in terms of tax rate, exemption and incentives, thus influencing differently the supply of funds to the corporate sector and hence the interest rate. Corporate demand for funds may also vary because of provisions of depreciation and investment tax credits and consequently interest rate differs. Demographic condition of a country impacts demand and supply of funds and thereby the interest rate. A country with a majority of population being younger will have higher interest rate, for the fact that youngsters are relatively less thrifty and demand more money to satisfy their varied needs. Monetary policy of Central bank of a country directly influences interest rate at which funds can be borrowed by MNCs. The Central bank following tight monetary policy to curb inflationary tendencies in the country will raise bank rate and hence the interest rate. Because of varying levels of economic development, interest rates differ across countries. Thus, in relatively advanced countries and so also highly developed and integrated financial markets interest rate on debt is always lower than the less developed nations. Country Differences in the Risk Premium: Amount of premium to compensate for the risk arising out of borrowers' inability to repay the loan differs from country to country, depending on economic conditions, relationships between corporations and creditors, government intervention, and degree of financial leverage. In case of economic stability, possibility of the country experiencing recession is relatively low and so also the borrowers defaulting in repayment. Under such a situation, risk premium is likely to be low. Risk premium will be relatively lower in countries where the relationships between corporations and creditors are very cordial, as in Japan, the latter having greater concern for the former's financial health and always ready to help their client to get over the illiquidity crisis. In such a situation amount of risk premium will be less. 178 CU IDOL SELF LEARNING MATERIAL (SLM)
Governments in some countries like the UK and India intervene actively to rescue failing firms, particularly those partly owned by them and provide all kinds of financial support to them. However, in the USA, the probability of Government intervention to rescue firms from incipient sickness is low. Hence, risk premium in the case of the former will be lower than the latter. Risk premium also differs across countries because of varying degree of financial leverage of firms in those countries. For instance, firms in Japan and Germany have a higher degree of financial leverage than firms in the USA. Obviously, the high leverage firms would have to pay a higher risk premium, with other factors being equal. In fact, the reason for higher leverage of the firm is their unique relationship with creditors and governments. Country Differences in the Cost of Equity: Cost of equity representing opportunity cost is a risk-free interest rate that the shareholders could have earned on the investment, plus a premium to reflect the risk of the firm. As risk- free interest rates, noted above, vary among countries, the costs of equity obviously differ among countries. In countries with tremendous investment opportunities offering higher interest rates, cost of equity will be higher in comparison to those countries with limited business opportunities. According to McCauley and Zimmer, country's cost of equity can be estimated by first applying the price/earnings multiple to a given stream of earnings. The cost of capital is related to the price-earnings multiple. A high price earnings multiple signifies that the firm receives a high price when selling new stock for a given level of earnings and hence the cost of equity financing is low. There is, however, need to adjust to the price-earnings multiples for the effects of a country's inflation, earnings growth and other factors. Combining the Costs of Debt and Equity The costs of debt and equity can be combined to obtain an overall cost of capital after providing weightage to debt and equity in terms of their respective proportions. The weighted cost of capital so computed will tend to be comparatively lower for firms situated in countries like Japan which is known for relatively low risk-free interest rate. Further, the price-earnings multiples of Japanese firms are generally high which allow them to garner equity share capital at a relatively low cost 10.3.1 Factors Effecting Cost of Capital Market Opportunity Unquestionably, most fundamental price deciding factor for anything in this world is the law of demand-supply. Cost of capital is also not away from this fundamental law. When the demand for capital increases, the cost of capital also increases and vice versa. The demand is influenced greatly by the available market opportunities. If there are a lot of production opportunities in the market, more and more entrepreneurs will explore those opportunities to 179 CU IDOL SELF LEARNING MATERIAL (SLM)
create profitable ventures. Entrepreneurs, then, would require capital to implement their business ideas. So, cost of capital is directly related to the market opportunities available in the market. Capital Provider’s Preferences An individual who has some additional funds has two straight choices – save money or consume it. It is completely a personal choice but to a great extent, it is impacted by the culture of a society. For example, Japanese people are more bent towards saving compared to the US. Another important factor that determines the utility of capital is the interest rate or returns available to their funds. Naturally, higher returns would enforce higher savings. Risk ‘High-risk high-return’ principle works here too. If the venture where investment is required has a high level of risk, the return required by the investor would also be very high to compensate the risk. On the other hand, the businessman taking up the venture may not opt for a too high cost of capital because it may put the viability of the overall project at stake. So, this is how risk plays a key role deciding the capital transactions in the market. Inflation All capital providers try to invest in a manner that maximizes returns. The lower benchmark for investing has always been the inflation. At the minimum, an investment should beat the inflation and there should be some real income. Real income is nothing but the actual return less inflation. In simple words, you invested money which could buy you a particular basket of things a year ago. After a year when your investment is matured and you receive money, you would at least expect that money should be able to buy that same basket of things. If the matured money falls short of buying you the same basket, you have diminished the value of your money in last one year. If the money is more than just buying that basket, you have earned real income on your investment. Economic and Other Factors Affecting Cost of Capital Trade Activity Economic boom and recession also play a very important role in determining the cost of capital by impacting the interest rates in the market. Foreign Trade Surpluses or Deficits A foreign trade deficit creates a need for borrowing from other countries. Borrower countries will have their own opportunity cost of capital based on the interest rates available with other countries. Higher the borrowings and higher will be the interest rates. That will impact the capital market. 180 CU IDOL SELF LEARNING MATERIAL (SLM)
Country Risk Country risk is the risk associated with political, social, economic environment of a country. To understand with an example, assume a country has trends of suddenly changing the tax rates, regulations relating to trade and commerce etc. An international investor would resist investing in that country because their policy can put any business at stake suddenly. This will reduce the flow of international capital in the country and thereby increase the cost of capital. Exchange Rate Risk Investment in countries other than the home country has a bearing of exchange rate risk on them. The real return of an investor depends on two factors The performance of the investment in the foreign country. The performance of the currency of that country in comparison to home currency. At the time of maturity of the investment, if the home currency weakens, the net realization in home currency would also be reduced. That can affect an investor’s decision of investing in other countries, especially whose currency rates fluctuate a lot. Individual Company Factors Affecting Cost of Capital Capital Structure Policy All companies try to optimize their capital structure with a policy that suits their individual situations. New acquisition of capital will depend a lot on the capital structure policy and therefore the capital structure policy of the said company will have a bearing on its cost of capital. Dividend Policy A dividend policy of a corporation decides how much percentage of profits it will retain and how much will be distributed as dividends. If a company retains higher percentage of profits in the business, it is effectively adding a capital at the cost of equity. Accordingly, the overall cost of capital will be impacted. Investment Policy A company is nothing but a set of different projects it takes up. It is very important to note that different projects would have different risk profile. If a company is adding a project with higher risk compared to overall risk level of the organization, it is effectively increasing the risk of the organization. With this increase in risk, the required rate of return will also increase. This is how, investment policy impacts the cost of capital 181 CU IDOL SELF LEARNING MATERIAL (SLM)
10.4 CAPITAL STRUCTURE The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each type of capital has its benefits and drawbacks, and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure regarding risk/reward payoff for shareholders. This is true for Fortune 500 companies as well as small business owners trying to determine how much of their start-up money should come from a bank loan without endangering the business. Equity Capital Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: Contributed capital: The money that was originally invested in the business in exchange for shares of stock or ownership Retained earnings: Profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion Many consider equity capital to be the most expensive type of capital a company can use because its \"cost\" is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a long-established firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products. Debt Capital The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The cost depends on the health of the company's balance sheet—a triple AAA rated firm can borrow at extremely low rates vs. a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital. There are different varieties of debt capital: Long-term bonds: Generally considered the safest type because the company has years, even decades, to come up with the principal while paying interest only in the meantime. Short-term commercial paper: Used by giants such as Walmart and General Electric, this amounts to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. 182 CU IDOL SELF LEARNING MATERIAL (SLM)
Vendor financing: In this instance, a company can sell goods before they have to pay the bill to the vendor. This can drastically increase the return on equity but costs the company nothing. One secret to Sam Walton's success at Walmart was selling Tide detergent before having to pay the bill to Procter & Gamble, in effect, using P&G's money to grow his retail enterprise. Policyholder \"float\": In the case of insurance companies, this is money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for auto accidents or medical bills. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers. Seeking the Optimal Capital Structure Many middle-class investors believe the goal of life is to be debt-free. When you reach the upper echelons of finance, however, that idea is less straightforward. Many of the most successful companies in the world base their capital structure on one simple consideration— the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at a 15% return, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure—particularly if your sales and cost structure are relatively stable. If you sell an essential product people must have, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a booming market. Again, this is where managerial talent, experience, and wisdom come into play. The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher-return products, and more. This is the reason you often see highly profitable consumer staples manufacturers take advantage of long-term debt by issuing corporate bonds. To truly understand the idea of capital structure, the DuPont model provides insight into how capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a donut shop or are considering investing in publicly traded stocks, it's the knowledge you simply must-have if you want to develop a better understanding of the risks and rewards facing your money. 183 CU IDOL SELF LEARNING MATERIAL (SLM)
10.4.1 Capital structure of MNC versus domestic firm There is no consensus on its issue because some characteristics of MNC may favour a debt intensive capital structure while other characteristics may favour an equity intensive capital structure. The arguments are as follows: A debt intensive capital structure would favour a firm that has stable net cash inflows since it could readily make the interest payments on debt with these cash inflows. Since the MNCs are often well diversified geographically, the diversification reduces risk, therefore, the impact of any single event on net cash flow is tolerable. Consequently, an MNC will be able to handle a greater debt burden as a percentage of capital than a purely domestic firm. The other characteristics of an MNC that might cause its cash flow to be more volatile than a purely domestic firm are: The earnings of subsidiary company earnings are subject to host government tax rules that could change over time. Host government could force the local subsidiaries to maintain all earnings within the country. This is the case of blocked funds which destabilizes the net cash flows from the subsidiary to the parent. In the absence of cash flow, it may not be able to make its periodic interest payments to creditors. In this case, MNCs should maintain an equity intensive capital structure. However, a well-diversified MNC would not face this kind of problem; The MNCs are affected by exchange rate variations, their net cash flows may be more unstable, e.g. if rupee strengthens, an Indian 4 based MNC may generally prefer that its subsidiaries remain their earnings by reinvesting in them in their respective countries. However, if the capital structure is highly leveraged, the MNC’s parent may need rupee inflows immediately to make its interest payments to creditors. If an MNC is well diversified among countries, then the subsidiary earnings are in a variety of currencies. Therefore, the strengthening of rupee against one or a few currencies will not significantly reduce the total amount of rupees received by the Indian headquarters after converting foreign earnings from various countries into rupees. The MNC could therefore maintain a debt intensive capital structure even though it relies on foreign subsidiary earnings to make interest payments on its outstanding debt. Studies on US MNCs indicate that the MNCs had significantly lower financial leverage than the domestic firms but that the results varied significantly among industries. Thus, we see that the capital structure decision should be made individually by each firm as after considering all characteristics that might affect its ability to make periodic interest payments on outstanding debt. MNCs that generate more stable net cash flows can maintain a leveraged capital structure. While adapting to the local capital structure following advantages and disadvantages should be borne in mind: 184 CU IDOL SELF LEARNING MATERIAL (SLM)
The main advantages are as follows: A localized financial structure reduces the criticism of foreign affiliate that had been operating with too high a debt ratio. A localized financial structure helps in evaluating the returns on investments, relative to local competitors in the same industry. In economies where interest rates are relatively high because of scarcity of capital, the penalty paid for borrowing local funds reminds the management that unless the returns on the assets, i.e., negative leverage they are probably misallocating the scarce resources. The disadvantages of localized capital structures are: A subsidiary might be having the comparative advantage only in sourcing of capital from the parent. Therefore, once it starts adopting the local capital structure, it loses the comparative advantage. If the financial structure of each subsidiary company is localized, the consolidation of the balance sheet of all the subsidiaries may not conform to any particular financial structure. This feature could increase perceived financial risk. This may push the consolidated debt ratio out of discretionary range of acceptable debt ratios in the flat area of the cost of capital. A multinational firm will not be able to replace the high-cost debt of an affiliate with low-cost debt if the markets are segmented and the Fisher effect does not operate. The debt ratio of a foreign affiliate, in reality, is cosmetic. The lenders look towards parent rather than the subsidiary for amortisation of loans. 10.4.2 Cost Minimizing Approach to Global Capital Structure The cost-minimizing approach to determining foreign-affiliate capital structures would be to allow subsidiaries with access to low-cost capital markets to exceed the parent-company capitalization norm, while subsidiaries in higher-capital-cost nations would have lower target ratios. These costs must be figured on an after-tax basis, considering the company's worldwide tax position. A subsidiary’s capital structure is relevant only insofar as it affects the parent’s consolidated worldwide debt ratio. Foreign units are expected to be financially independent after the parent’s initial investment. The rationale for this policy is to ‘avoid giving management a crutch.” By forcing foreign affiliates to stand on their own feet, affiliate managers presumably will be working harder to improve local operations, thereby generating the internal cash flow that will help replace parent financing. Moreover, the local financial institutions will have a greater incentive to monitor the local subsidiary’s performance because they can no longer look to the parent company to bail them out if their loans go sour. 185 CU IDOL SELF LEARNING MATERIAL (SLM)
However, companies that expect their subsidiaries to borrow locally had better be prepared to provide enough initial equity capital or subordinated loans. In addition, local suppliers and customers are likely to shy away from a new subsidiary operating on a shoestring if that subsidiary is not receiving financial backing from its parent. The foreign subsidiary may have to show its balance sheet to local trade creditors, distributors, and other stakeholders. Having a balance sheet that shows more equity demonstrates that the unit has greater staying power. 10.5 SUMMARY Cost of capital of an investor, in financial management, is equal to return, an investor can fetch from the next best alternative investment. In simple words, it is the opportunity cost of investing the same money in different investment having similar risk and other characteristics. From a financing angle, cost of capital is simply the cost which is paid for using the capital. Alternatively, a percentage return on investment that convinces an investor to invest in a particular project or company is the appropriate cost of capital for that investor The cost of capital may be lower for an MNC than for a domestic firm because of characteristics peculiar to the MNC, including its size, its access to international capital markets, and its degree of international diversification. Yet, some characteristics peculiar to an MNC can increase the MNC’s cost of capital, such as exposure to exchange rate risk and to country risk. Costs of capital vary across countries because of country differences in the components that comprise the cost of capital. Specifically, there are differences in the risk-free rate, the risk premium on debt, and the cost of equity among countries. Countries with a higher risk-free rate tend to exhibit a higher cost of capital An MNC’s capital structure decision is influenced by corporate characteristics such as the stability of the MNC’s cash flows, its credit risk, and its access to earnings. The capital structure is also influenced by characteristics of the countries where the MNC conducts business, such as stock restrictions, interest rates, strength of local currencies, country risk, and tax laws. Some characteristics favour an equity intensive capital structure because they discourage the use of debt. Other characteristics favour a debt intensive structure because of the desire to protect against risks by creating foreign debt. Given that the relative costs of capital components vary among countries, the MNC’s capital structure may be dependent on the specific mix of countries in which it conducts operations 186 CU IDOL SELF LEARNING MATERIAL (SLM)
10.6 KEYWORDS Financial Structure: Composition of capital raised by a firm- for example, the mix between debt and equity. Multinational Corporation (MNC): It refers to a firm that has business activities and interests in multiple countries. Optimal Capital Structure: That mix of debt and equity capital at which the company has the lowest cost of capital and the lowest level of risk. Internal Rate of Return (IRR): The discount rate that equates the present value of cash inflows with that of cash outflows. High-risk high-return: According to the risk-return trade-off, invested money can render higher profits only if the investor will accept a higher possibility of losses. 10.7 LEARNING ACTIVITY The Sports Exports Company has considered a variety of projects, but all of its business is still in the United Kingdom. Since most of its business comes from exporting footballs (denominated in pounds), it remains exposed to exchange rate risk. On the favourable side, the British demand for its footballs has risen consistently every month. Jim Logan, the owner of the Sports Exports Company, has retained more than $100,000 (after the pounds were converted into dollars) in earnings since he began his business. At this point in time, his capital structure is mostly his own equity, with very little debt. Jim has periodically considered establishing a very small subsidiary in the United Kingdom to produce the footballs there (so that he would not have to export them from the United States). If he does establish this subsidiary, he has several options for the capital structure that would be used to support it: Use all of his equity to invest in the firm, Use pound-denominated long-term debt, or Use dollar-denominated long-term debt. The interest rate on British long-term debt is slightly higher than the interest rate on U.S. long-term debt. 1. What is an advantage of using equity to support the subsidiary? What is a disadvantage? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 187 CU IDOL SELF LEARNING MATERIAL (SLM)
2. If Jim decides to use long-term debt as the primary form of capital to support this subsidiary, should he use dollar-denominated debt or pound denominated debt? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 10.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Why does cost of capital for MNCs differ from that for domestic firms? 2. How does internationally diversified operations of an MNC affect its cost of capital? 3. Why is cost of capital different across countries? 4. List out the factors contributing to differences in the risk-free rate and risk premium. 5. How would you set cut-off rate of an MNC for evaluating a foreign project? What specific adjustments are required to be made? Long Questions 1. Explain how characteristics of MNCs can affect the cost of capital. 2. Explain why managers of a wholly owned subsidiary may be more likely to satisfy the shareholders of the MNC 3. What factors affect a company's cost of capital? Why do multinational companies usually enjoy a lower cost of capital than purely domestic companies? 4. What are the complicated factors in measuring the cost of debt for multinational companies? 5. How can financing strategy be used to reduce foreign exchange risk? B. Multiple Choice Questions 1. The term \"capital structure\" refers to: a. Long-term debt, preferred stock, and common stock equity. b. Current assets and current liabilities. c. Total assets minus liabilities. d. Shareholders' equity. 2. Differences in the risk-free interest rate in different countries depend on supply of and demand for _______________. a. Funds 188 CU IDOL SELF LEARNING MATERIAL (SLM)
b. Currency c. Products d. None of these 3. In countries with tremendous investment opportunities offering higher interest rates, cost of equity will be _____________. a. Higher b. Lower c. No impact d. None of these 4. Real income is ____________. a. Actual return plus inflation b. Actual return multiple inflation c. Actual return less inflation d. None of these 5. New acquisition of capital will depend a lot on the ______________. a. Capital structure policy b. Foreign Direct investment c. Tax policy d. None of these Answers 1-(a), 2-(a), 3-(a), 4-(a), 5-(a) 10.9 REFERENCES Textbooks: Jeff Madura,(2006) International Financial Management, Thomson South Westeren Fuad A. Abdullah (1987), Financial Management for the Multinational Firm, Prentice Hall International, USA. Aliens Michel and Israel Shakel, \"Multinational Corporations vs Domestic Corporations: Financial Performance and Characteristics\", Journal of International Business Studies 17, (Fall 1986). Robert N.Mc Causley and Steven A. Zimmer, \"Explaining International Differences in the Cost of Capital\", FRBNY Quarterly Review, (Summer 1989), pp. 7-28. Kwang Chul Lee and C.Y. Kwok Chuck, \"Multinational Corporations vs. Domestic Corporations: International Environment Factors and Determinants of Capital Structure\", Journal of International Business Studies, Summer 1988, pp. 195-217. 189 CU IDOL SELF LEARNING MATERIAL (SLM)
Financial Management. Brigham and Ehrhardt ; 2019. Folger J. How do interest rates affect the weighted average cost of capital (WACC) calculation? Investopedia. March 2019 190 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-11: INTERNATIONAL CAPITAL BUDGETING STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2 Capital Budgeting Techniques 11.2.1 The Adjusted Present Value model (APV) 11.3 Importance of Capital Budgeting 11.4 Summary 11.5 Keywords 11.6 Learning Activity 11.7 Unit End Questions 11.8 References 11.0 LEARNING OBJECTIVES After studying this unit, student will be able to: Explain capital budgeting and different technics. Explain importance of capital budgeting. Explain net present value and adjusted present value. 11.1 INTRODUCTION Capital budgeting is a process that helps in planning the investment projects of an organization in long run. It takes all possible consideration into account so that the company can evaluate the profitability of the project. It is useful for evaluating capital investment project such as purchasing equipment, the rebuilding of equipment etc. The benefit from an investment may be in form of a reduction in cost or in form of increased revenue. Importance of capital budgeting can be understood from its impact on the business Businesses exist to earn profit except for non-profit organization. Capital budgeting is very important for any business as it impacts the growth & prosperity of the business in the long term. It creates accountability & measurability. Some of the popular techniques are net 191 CU IDOL SELF LEARNING MATERIAL (SLM)
present value, internal rate of return, payback period, accounting rate of return & profitability index. Objectives of capital budgeting is to determine whether or not a proposed capital investment will be a profitable one over the specified time period. to select between investment alternatives. Capital budgeting at the international level addresses the issues related to exchange rate fluctuations capital market segmentation. international financing arrangement of capital and related to cost of capital. international taxation. country risk or political risk etc. Capital budgeting involves two important decisions at once: a financial decision and an investment decision. By taking the project, the business has agreed to make a financial commitment to a project, and that involves own set of risk. Project delay, cost overruns & regulatory restriction that can all delay & increase the cost of the project. In addition to a financial decision, a company is also making an investment in its future direction and growth. It is likely to have an influence on future projects that business considers & evaluates. So the capital investment decision must be taken considering both perspectives i.e. financial & investment. In December 2009 ExxonMobil, the world’s largest oil company, announced that it was acquiring XTO Resources in the U.S. for $41 billion. It was one of the largest natural gas companies. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas. Essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil considers and evaluates for many years to come. It can be said that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is useful for making successful capital investment decisions Significance of Capital Budgeting Capital budgeting is an essential tool in financial management Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments 192 CU IDOL SELF LEARNING MATERIAL (SLM)
It helps in exposing the risk and uncertainty of different projects It helps in keeping a check on over or under investments The management is provided with an effective control on cost of capital expenditure projects Ultimately the fate of a business is decided on how optimally the available resources are used 11.2 CAPITAL BUDGETING TECHNIQUES There are different methods adopted for capital budgeting. The traditional methods or non- discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR. Payback Period Method As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability. Payback period = Cash outlay (investment) / Annual cash inflow Example Project A Project B 1,00,000 Cost 1,00,000 1,00,000 Expected future cash flow 5,000 5,000 Year 1 50,000 None Year 2 50,000 Year 3 1,10,000 1,10,000 Year 4 None 1 year TOTAL 2,10,000 Payback 2 years Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B. Accounting Rate of Return Method (ARR) 193 CU IDOL SELF LEARNING MATERIAL (SLM)
This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected. This method considers the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also, it is not consistent with the firm’s objective of maximizing the market value of shares. ARR= Average income/Average Investment Discounted Cash Flow Method The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique considers the interest factor and the return after the payback period. Net Present Value (NPV) Method This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task. The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be: where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known. 194 CU IDOL SELF LEARNING MATERIAL (SLM)
NPV = PVB – PVC where, PVB = Present value of benefits PVC = Present value of Costs Internal Rate of Return (IRR) This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment. It can be determined by solving the following equation: If IRR > WACC then the project is profitable. If IRR > k = accept If IR < k = reject Profitability Index (PI) It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows. PI = PV cash inflows/Initial cash outlay A, 195 CU IDOL SELF LEARNING MATERIAL (SLM)
PI = NPV (benefits) / NPV (Costs) All projects with PI > 1.0 are accepted. Example of Capital Budgeting Capital budgeting for a small-scale expansion involves three steps: recording the investment’s cost, projecting the investment’s cash flows and comparing the projected earnings with inflation rates and the time value of the investment. For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to \"pay back\" on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ($20,000) is actually worth $15,385 when your account for inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only $385 in real value after the first year. 11.2.1 The Adjusted Present Value model (APV) To continue on with our discussion, we need to expand the NPV model. To do this In a famous article, Franco Modigliani and Merton Miller (1963) derived a theoretical statement for the market value of a levered firm (Vl) versus the market value of an equivalent unlevered firm (Vu). They showed that Assuming the firms are ongoing concerns and the debt the levered firm issued to finance a portion of its productive capacity is perpetual, Equation 8a can be expanded as: where ‘i’ is the levered firm’s borrowing rate, I = iDebt, and Ku is the cost of equity for an all-equity financed firm. The average cost of capital can be stated as: K = (1 - λ)Kl + λi(1 - τ) 196 CU IDOL SELF LEARNING MATERIAL (SLM)
Where Kl is the cost of equity for a levered firm, and λ is the optimal debt ratio. In their article, Modigliani-Miller showed that K can be stated as: K = Ku (1 - τλ) What this implies is that regardless of how the firm (or a capital expenditure) is financed, it will earn the same NOI. If λ = 0 (i.e., a levered firm), then Ku > K and I > 0, thus Vl > Vu. It is necessary to add the present value of the tax savings the levered firm receives. The main result of Modigliani and Miller’s theory is that the value of a levered firm is greater than an equivalent unlevered firm earning the same NOI because the levered firm also has tax savings from the tax deductibility of interest payments to bondholders that do not go to the government. The following example clarifies the tax savings to the firm from making interest payments on debt. Table 11.1 Comparison of Cash Flows Available to Investors Tax savings from interest payments. Table 11.1 provides an example of the tax savings arising from the tax deductibility of interest payments. The exhibit shows a levered and an unlevered firm, each with sales revenue and operating expenses of $ 100 and $ 50, respectively. The levered firm has interest expense of $ 10 and earnings before taxes of $ 40, while the unlevered firm enjoys $ 50 of before-tax earnings since it does not have any interest expense. The levered firm pays only $ 16 in taxes as opposed to $ 20 for the unlevered firm. This leaves $ 24 for the levered firm’s shareholders and $ 30 for the unlevered firm’s shareholders. Nevertheless, the levered firm has a total of $ 34 (= $ 24 + $ 10) of funds available for investors, while the unlevered firm has only $ 30. The extra $ 4 comes from the tax savings on the $ 10 before-tax interest payment. By direct analogy to the Modigliani-Miller equation for an unlevered firm, we can convert the NPV into the adjusted present value (APV) model: 197 CU IDOL SELF LEARNING MATERIAL (SLM)
The APV model is a value-additivity approach to capital budgeting. That is, each cash flow that is a source of value is considered individually. Note that in the APV model, each cash flow is discounted at a rate of discount consistent with the risk inherent in that cash flow. The OCFt and TVT are discounted at Ku. The firm would receive these cash flows from a capital project regardless of whether the firm was levered or unlevered. The tax savings due to interest, τIt, are discounted at the before-tax borrowing rate, i, as in equation 8b. It is suggested that the tax savings due to risky than operating cash flows if tax laws are not likely to change radically over the economic life of the project. The APV model is useful for a domestic firm analysing a domestic capital expenditure. If APV ≥ 0, the project should be accepted. If APV < 0, the project should be rejected. Thus, the model is useful for a MNC for analysing one of its domestic capital expenditures or for a foreign subsidiary of the MNC analysing a proposed capital expenditure from the subsidiary’s viewpoint. 11.3 IMPORTANCE OF CAPITAL BUDGETING Long-term Goals For the growth & prosperity of the business, long-term goals are very important for any organization. A wrong decision can be disastrous for the long-term survival of the firm. Capital budgeting has its effect in a long-time span. It also affects companies’ future cost & growth. Involvement of a Large Number of Funds Capital Investment requires a large number of funds. As the companies have limited resources, the company has to make a wise & correct investment decision. The wrong decision would harm the sustainability of the business. The large investment includes the purchase of an asset, rebuilding or replacing existing equipment. Irreversible Decision The capital Investment decisions are generally irreversible as it requires large amounts of funds. It is difficult to find the market for that asset. The only way remains with the company is to scrap the asset & incur heavy losses. Monitoring & Controlling the Expenditure 198 CU IDOL SELF LEARNING MATERIAL (SLM)
Capital budget carefully identifies the necessary expenditure and R&D required for an investment project. Since a good project can turn bad if expenditures aren’t carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process. Figure 11.1 Importance of Capital Budgeting Transfer of Information The time that project starts off as an idea, it is accepted or rejected; numerous decisions have to be made at a various level of authority. The capital budgeting process facilitates the transfer of information to appropriate decision makers within a company. Difficulties of Investment Decision The long-term investment decisions are difficult because it extends several years beyond the current period. Uncertainty indicates a higher degree of risk. Management loses his flexibility and liquidity of funds in making investment decisions so it must consider each proposal very thoroughly. Maximization of Wealth Long-term investment decision of the organization helps in safeguarding the interest of the shareholder in the organization. If the organization has invested in a planned manner, the shareholder would also be keen to invest in that organization. This helps in the maximization of wealth of the organization. Any expansion is fundamentally related to further sales and future profitability of the firm and assets acquisition decisions are based on capital budgeting. 199 CU IDOL SELF LEARNING MATERIAL (SLM)
11.4 SUMMARY Planning to purchase a new asset is quite the process. The company needs an installation plan, operating staff, and of course a financial plan. Budgeting is a cash-based concept. A company could have over $10 million in sales, but if there is no cash available for the purchase, it could be difficult to make. There are three types of capital budgeting techniques to consider for your budgeting purposes. Payback Method, this is the simplest way to budget for a new asset. The payback method is deciding how long it will take a company to pay off an asset. For example, a company plans to buy a new IT server for $500,000, and that server is predicted to generate $50,000 cash each year. This capital budgeting scenario implies that the purchase can be paid off in 10 years. The quicker the payback period is, the quicker the company is able to recover the cost of the new piece of equipment. The Net Present Value (NPV) method is like the payback method; except for one important detail money does not keep the same value over time. In this method, the difference between the asset cost and discounted cash flows from the asset is calculated. The term ‘present value’ is used because future cash flows drop in value. When the discounted future cash flows exceed the cost of the asset, the project is expected to be profitable. However, if the costs exceed the future cash flows, that project is not expected to be profitable. The largest advantage for the NPV method over the payback method is the fact it accounts for the decrease in value of the dollar over time. However, a large drawback is that the NPV method is based on assumptions. If the company experiences unexpected pitfalls after money is invested, the calculations could be incorrect causing uncertainty in the profit margin. The internal rate of return (IRR) method is the most complex of the three. This method compares the return on the asset to the cost of financing the project. It is similar to and includes the net present value method to calculate the rate of return. If the IRR is above the cost, the project is expected to be profitable. But yet, if the costs exceed the return, the project is expected to have a loss. Capital budgeting is an important tool for leaders of a company when evaluating multiple opportunities for investment of the firm’s capital. However, this is not the only step in budgeting for a new asset. 200 CU IDOL SELF LEARNING MATERIAL (SLM)
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