International investment decisions

A Nigerian company can earn a higher return abroad, but not for free. The currency may fall, the government may block dividends, a new tax may appear and the roads may not carry the goods. The finance manager must value a foreign project in the right currency, at the right discount rate and with the right cash flows, which are not always the cash flows the project produces locally.

This topic covers the factors that restrict foreign investment (political, fiscal and exchange rate risk, exchange controls and tax), the features of foreign investment appraisal, the two DCF methods under market perfection, the two-stage approach under market imperfection, the difficulty of choosing an international cost of capital, the international CAPM and borrowing in the currency of the investment. The previous topic covered options and the Black-Scholes model.

The May 2014 and November 2014 Pathfinder papers did not include a stand-alone question on this topic.

Key terms in plain English

Syllabus check

This topic is in syllabus area A (investment appraisal and corporate finance policy). It covers:

• explaining the risks of cross-border investment;
• appraising cross-border investments using data given, including identifying cash flows and deriving a discount rate;
• explaining the difficulties of arriving at an international cost of capital.

CAMA 2020 and foreign investment

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

Factors restricting foreign investment

Companies invest abroad for good returns, and developing countries may offer strong growth. They may be held back by:

• weak infrastructure (transport and communication) and a low standard of education;
• political risk: the government may nationalise assets, add taxes, impose exchange controls or run unfriendly policies;
• general economic risk: the economy may not grow as expected;
• exchange rate risk;
• exchange controls, which restrict buying foreign currency, paying interest or dividends abroad, or moving capital out;
• taxation on remittances.

Fiscal risk and tax

Fiscal risk is the risk of tax changes after the project has started, such as a windfall tax on oil profits. A large company may negotiate assurances, though promises can be broken; paying a royalty that grows with output may make the government less likely to tax profits again. A withholding tax on dividends and interest paid to a foreign parent reduces the cash received.

Double taxation agreements let the parent set off tax paid abroad against tax at home, so profits are not taxed twice.

Features of foreign investment appraisal

• The project may be high risk, needing a special cost of capital, perhaps from the CAPM with a project beta.
• Most cash flows are in the foreign currency, some in the parent’s.
• In a developing country, inflation is likely, so cash flows must allow for it and be discounted at the money (nominal) cost of capital.
• There may be restrictions on payments out, so the profits cannot be paid at once as dividends.

DCF appraisal under market perfection

A Nigerian company can (1) discount foreign cash flows at a foreign rate and convert the NPV at the spot rate, or (2) convert each flow to naira at a forecast future spot rate and discount at a naira rate. With perfect capital markets the two give the same answer, because future spot rates are linked to current rates by inflation and interest rate differentials (PPP, IRP or the international Fisher effect).

1. Method 1:
   PV of inflows = 45,455 + 41,322 + 37,566 = 124,343
   NPV = ₵24,343
   × 50 = about ₦1,217,000.
2. Method 2:
   forecast spot = 50 × 1.08 ÷ 1.10 = 49.09, then 48.20 and 47.32.
   Naira flows: ₦2,455k, ₦2,410k and ₦2,366k.
   Discount at 8% (0.926, 0.857, 0.794): PV = 2,273 + 2,066 + 1,878 = ₦6,217k
   less ₦5,000k = ₦1,217k, the same.

DCF appraisal under market imperfection

If there are imperfections, such as exchange controls, do the analysis in two stages.

Stage 1: NPV of the project in foreign currency cash flows at an appropriate rate; if it is positive and the risk is acceptable, go to Stage 2: value the project from the parent’s viewpoint, in home currency, using the cash actually received (dividends, interest and so on, less costs borne at home), discounted at a suitable rate, often the WACC.

Cash flows differ because of costs at head office, restrictions on remittances and changes in the exchange rate. The project is viable only if both NPVs are positive.

ICAN’s example (continued): the Ghanaian government bans repatriation for two years, so all cash is remitted in year 3. Stage 1 is the same (₵24,343 positive). Stage 2: the year 3 remittance is 150,000 × 47.32 = ₦7,098k; × 0.794 = ₦5,636k; less ₦5,000k = ₦636k. The project is still accepted, but its NPV is much smaller than the ₦1,217k under perfection.

International cost of capital

The discount rate should be the opportunity cost of capital over the project’s life. The CAPM (R_E = R_F + β(R_M − R_F)) uses one source of risk, systematic risk, measured by beta. Problems in an international setting:

• Which country’s market should be used? With perfect, integrated markets it would not matter; in practice values may differ widely.
• How to deal with political risk, which the CAPM does not include. A multi-factor model needs the risk quantified, which is hard; adjusting cash flows is also hard.
• Two bidders from different countries (a Nigerian and an Australian company bidding for a South African miner) may value it differently because world markets are not fully integrated.
• If there is no comparable local project (for example hydro-electric power in India for a US company), which beta should be used, and whose equity premium?

There is no single correct approach; state your assumptions and justify them.

International CAPM

The principles can be applied to a world market portfolio. But difficulties remain: which security is risk-free (perhaps government debt in a stable currency), what the world portfolio contains, and how to hold such a portfolio (direct investment, global companies and funds).

Some researchers argue that certain markets are integrated, so a portfolio can be defined for that group; emerging markets often show weak correlation with developed ones and so fall outside it.

International sources of finance

Borrowing in the currency of the investment reduces currency risk in two ways. It matches foreign assets and liabilities, reducing translation risk (a project of 20 million foreign units financed by a 20 million loan has no net translation exposure). It lets the project’s foreign receipts pay the interest and repayments, reducing transaction risk.

This depends on a large, active local capital market and on the company being able to borrow in it. A local bank loan may be possible; a local-currency corporate bond market is much less likely. International bonds are practical only in major currencies such as the dollar and euro.

The rules in more depth

Why inflation is in the cash flows

If the discount rate is a money rate (it includes expected inflation), the cash flows must be money flows too.

Why the two methods agree under perfection

The forecast spot rates embody the same interest and inflation differences that separate the two discount rates.

Why a two-stage test is needed

A project can create value locally but yield little to the parent if cash is trapped or taxed.

Why there is no single cost of capital

Markets are not integrated and risks such as political risk are not in the CAPM.

Effect on analysis

State the method, the currency of each flow, the discount rates, the remittance assumptions and the risks left outside the NPV.

Worked examples

1. PV of inflows.
   90,000 × 2.4018 = ₵216,162.
2. NPV = 216,162 − 200,000 = ₵16,162.
3. In naira.
   16,162 × 50 = ₦808,100.

1. Year 1 spot = 50 × 1.08 ÷ 1.10.
2. = ₦49.09.
3. The naira strengthens against the cedi because its rate is lower.

1. Assets and liabilities are in the same currency.
2. A move in the exchange rate changes both equally.
3. Translation risk on the net position is nil.

1. Tax = ₶4,000.
2. Net remitted = ₶36,000.
3. A treaty may allow the parent to claim credit for the tax at home.

How to score full marks

• List risks that fit the country in the question.
• Decide on method and say why (perfection or not).
• Keep each cash flow in the right currency.
• Forecast spot rates with PPP or IRP when needed.
• For restrictions, do Stage 1 and Stage 2.
• Explain the limits of the discount rate chosen.

Common mistakes in the exam

• Discounting foreign cash flows at the home rate without converting.
• Ignoring blocked remittances and withholding tax.
• Leaving inflation out of the cash flows.
• Using the wrong direction in the forecast spot formula.
• Accepting a project on Stage 1 alone.
• Saying there is one correct international cost of capital.

Quick revision

• Risks: political, fiscal, exchange rate, controls, tax.
• Perfect markets: two methods, same NPV.
• Imperfect: Stage 1 foreign NPV, Stage 2 parent NPV, both positive.
• Cost of capital: no consensus; CAPM omits political risk.
• Borrow in the investment currency to cut risk.
• CAMA 2020: ss. 305, 308, 377(1), 378, 385.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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