BAHIR DAR UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

Book chapter Review Assignment For: International Business Finance

Submitted to: Tilahun A. (PhD)

Feb. 2022

Bahir dar, Ethiopia.

About the Author: Jeff Madura is the SunTrust Bank Professor of Finance at Florida Atlantic
University. He received his Ph.D. from Florida State University and has written several highly
regarded textbooks, including Financial Markets and Institutions. His research on international
finance has been published in numerous journals, including the Journal of Financial and
Quantitative Analysis; Journal of Money, Credit and Banking; Financial Management; Journal of
Financial Research; and Financial Review. He has received multiple awards for excellence in
teaching and research and has served as a consultant for international banks, securities firms, and
other multinational corporations. He has also served as director for the Southern Finance
Association and Eastern Finance Association and as president of the Southern Finance
Association. (Madura, J. (2020).
1. Introduction
Capital budgeting may generate different results and a different conclusion depending on
whether it is conducted from the perspective of an MNC’s subsidiary or from the perspective of
the MNC’s parent. The subsidiary’s perspective does not consider possible exchange rate and tax
effects on cash flows transferred by the subsidiary to the parent. When a parent is deciding
whether to implement an international project, it should determine whether the project is feasible
from its own perspective.
Multinational businesses (MNCs) evaluate universal ventures by comparing the advantages and
costs of these ventures using multinational capital budgeting. Calculating the project's net present
value is the most common approach of capital budgeting. A similar technique is often used in
multinational capital budgeting. However, multinational capital budgeting is complicated by
particular conditions of international projects that affect future cash flows or the discount rate
used to discount cash flows. To maximize the value of the MNC, financial managers must grasp
how to apply capital budget to international projects.
 2. Multinational Capital budgeting overviews
2.1.Subsidiary Versus Parent Perspective
Normally, MNC decisions should be made from the standpoint of the parents. The financial
inflows to the subsidiary from net income after taxes can differ significantly from those to the
parent. Tax differentials, restricted remittances, excessive remittances, and exchange rate
movements can all contribute to differences in cash flows between subsidiaries and parent.
2.2. Input for Multinational Capital Budgeting
Regardless of the long-term project to be considered, an MNC will normally require forecasts of
the economic and financial characteristics related to the project. Each of these characteristics is
briefly described below:
 Initial investment: The parent’s initial investment in a project may constitute the major
source of funds to support a particular project. Funds initially invested in a project may
include not only whatever is necessary to start the project but also additional funds, such
as working capital, to support the project over time.
 Price and consumer demand: A long-term capital budgeting analysis necessitates
forecasts for not just the immediate future, but also the project's estimated lifetime.
Future prices will almost certainly be affected by the future inflation rate in the host
country (where the project will be implemented), but this rate is unknown. As a result,
future inflation rates must be predicted in order to construct product price estimates
throughout time. A precise estimate of consumer demand for a product is extremely
important when predicting a cash flow timetable, yet future demand is sometimes
impossible to forecast.
 Costs: can be variable and fixed cost. Variable-cost forecasts can be developed from
assessing prevailing comparative costs of the components. On a periodic basis, the fixed
cost may be easier to predict than the variable cost since it normally is not sensitive to
changes in demand. It is, however, sensitive to any change in the host country’s inflation
rate from the time the forecast is made until the time the fixed costs are incurred.
 Tax laws: Under some circumstances, the MNC receives tax deductions or credits for tax
payments by a subsidiary to the host country. Withholding taxes must also be considered
if they are imposed on remitted funds by the host government because after-tax cash
flows are necessary for an adequate capital budgeting
  Restrictions on remitted funds: In some cases, a host government will prevent a
subsidiary from sending its earnings to the parent. This restriction may reflect an attempt
to encourage additional local spending or to avoid excessive sales of the local currency in
exchange for some other currency.
 Exchange rates: Any international project will be affected by exchange rate fluctuations
during the life of the project, but these movements are often very difficult to forecast.
While it is possible to hedge foreign currency cash flows, there is normally much
uncertainty surrounding the amount of foreign currency cash flows. Since the MNC can
only guess at future costs and revenue due to the project, it may decide not to hedge the
projected foreign currency cash flows.
 Salvage (liquidation) value: The after-tax salvage value of most projects is difficult to
forecast. It will depend on the success of the project and the attitude of the host
government toward the project. Some projects have indefinite lifetimes that can be
difficult to assess, while other projects have designated specific lifetimes, at the end of
which they will be liquidated. This makes the capital budgeting analysis easier to apply.
 Required rate of return: An MNC can estimate its cost of capital in order to decide
what return it would require in order to approve proposed projects.
Calculation of NPV: As stated earlier, NPV is a popular method of capital budgeting. Although
several capital budgeting techniques are available, a commonly used technique is to estimate the
cash flows and salvage value to be received by the parent and compute the NPV of the project, as
shown here:

Where:
IO = initial outlay (investment)
CFt = cash flow in period t
SVn = salvage value
k = required rate of return on the project
n = lifetime of the project (number of periods)
2.3.Adjusting Project Assessment For Risk
If an MNC is unsure of the estimated cash flows of a proposed project, it needs to incorporate
an adjustment for this risk. Three methods are commonly used to adjust the evaluation for risk:
 Risk-adjusted discount rate
 Sensitivity analysis
 Simulation
Let us discus each one by one as below
 Risk-Adjusted Discount Rate
The greater the uncertainty about the project's projected cash flows, the higher the discount rate
applied to the cash flows, the other things being equal. This risk-adjusted discount rate tends to
reduce project costs to a level that reflects the project's demonstrated risk. This approach is easy
to use, but it has been criticized for being somewhat biased. In addition, the equivalent
adjustment of the discount rate in all periods does not reflect the difference in the degree of
uncertainty from one period to another. If projected cash flows have varying degrees of
uncertainty between periods, the adjustment of cash flows for risk must also differ.
 Sensitivity Analysis
Once the MNC has estimated the NPV of a proposed project, it may want to consider alternative
estimates for its input variables.
Assume the demand for the subsidiaries of ABC Company was estimated to be 60,000 in the first
2 years and 100,000 in the next 2 years. If demand turns out to be 60,000 in all 4 years, how will
the NPV results change? Alternatively, what if demand is 100,000 in all 4 years? Use of such
what-if scenarios is referred to as sensitivity analysis. The objective is to determine how
sensitive the NPV is to alternative values of the input variables. The estimates of any input
variables can be revised to create new estimates for NPV. If the NPV is consistently positive
during these revisions, then the MNC should feel more comfortable about the project. If it is
negative in many cases, the accept/reject decision for the project becomes more difficult.
  Simulation
Simulations can be used for a variety of tasks, including generating a probability distribution for
the NPV based on a range of possible values for one or more input variables. In the real world,
most or all of the input variables required for multinational capital budgeting are: The future is
uncertain. A probability distribution can be developed for any variable. with uncertain future
value The end result is a distribution of possible NPVs that may arise for the project. The
modeling approach does not focus on any specific NPV forecast, but instead provides a
distribution of possible outcomes that may occur.
The capital cost of the project can be used as the discount rate when running the simulation. The
probability of a project success can be estimated by measuring the area within a probability
distribution where the NPV is 0. This field represents the probability that the present value of
future cash flows will exceed the initial outlay. A multinational company can also use a
probability distribution to estimate the probability that the NPV will be 0. The simulation is
difficult to perform manually due to the iterations needed to develop an NPV distribution. The
software can execute 100 repetitions and produce results in seconds. The simulator user must
provide a probability distribution of the input variables that will affect the NPV of the project.
Like other models, the accuracy of the results generated by the simulation depends on the
accuracy of the.
3. EVALUATION
In the chapter of the book Input for Multinational Capital Budgeting like Initial
investment, price and consumer demand, tax law, exchange rate, cost,: restrictions on
remitted funds Salvage (liquidation) value: and required rate of return, are listed and
briefly discussed, but the other inputs like fixed cost and project life cycle are not
described and included in the input of multinational capital budgeting.
(http://mays.tamu.edu/center-for-international-business-studies/wp-
content/uploads/sites/14/2016/02/Chapter-14-Compatibility-Mode.pdf)
From subsidiary versus parent perspective, this book recommended MNC decisions
should be based on the parent’s perspective. Although the author has some good points,
he didn’t explain from the subsidiaries point of view because as the reviewers saw the
subsidiary’s perspective should also be used because it will be responsible for
administering the project. In addition, since the subsidiary is a subset of the MNC, what
is good for the subsidiary would appear to be good for the MNC
(https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/International%20Financial%20
Management%20(2008)/15.%20Chapte%2014%20-
%20Multinational%20Capital%20Budgeting.pdf)
In this chapter the author stated about exchange rate as one of the input for multinational
capital budgeting and it affects the international projects. However he didn’t tell us the
way to hedge it. As per our understanding we can overcome this problem by using long-
term forward contracts or currency swap arrangements.
(https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/International%20Financial%20
Management%20(2008)/15.%20Chapte%2014%20-
%20Multinational%20Capital%20Budgeting.pdf)
Sensitivity analysis is a financial model that determines how target variables are affected
based on changes in other variables known as input variables. This model is also referred
to as what-if or simulation analysis. It is a way to predict the outcome of a decision given
a certain range of variables.
(https://www.investopedia.com/terms/s/sensitivityanalysis.asp#:~:text=Sensitivity%20an
alysis%20is%20a%20financial,a%20certain%20range%20of%20variables.
 In general we have learned so many points from this chapter as Capital budgeting is
important for multinational companies (MNC) because it creates accountability and
measurability. The capital budgeting process is a measurable way for businesses to
determine the long-term economic and financial profitability of any investment project. A
capital budgeting decision is both a financial commitment and an investment. However
this chapter didn’t briefly explain the issues raised.
4. CONCLUSION
Although the author has some good points, we didn’t believe that this chapter is enough to create
a better understanding on the issues related to multinational capital budgeting, this is because it is
not simple, clear and lacks hypothetical examples. To sum-up, the author has both strengths and
weaknesses as we clearly stated in the evaluation section.
Reference
https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/International%20Financial%20Manage
ment%20(2008)/15.%20Chapte%2014%20-%20Multinational%20Capital%20Budgeting.pdf

https://www.investopedia.com/terms/s/sensitivityanalysis.asp#:~:text=Sensitivity%20analysis%2
0is%20a%20financial,a%20certain%20range%20of%20variables.

http://mays.tamu.edu/center-for-international-business-studies/wp-
content/uploads/sites/14/2016/02/Chapter-14-Compatibility-Mode.pdf

http://mays.tamu.edu/center-for-international-business-studies/wp-
content/uploads/sites/14/2016/02/Chapter-14-Compatibility-Mode.pdf
Madura, J. (2020). International financial management. Cengage Learning