International Accounting, T. Doupnik Ch 12

Front 1

Capital budgeting involves three steps

Back 1

: project identification and definition, evaluation and selection, and monitoring and review.

Front 2

Capital budgeting techniques

Back 2

Payback period
Return on investment
Net present value
Internal rate of return

Front 3

Payback period - Japan (large investment in technology)

Back 3

.Represents the length of time it takes to recoup the initial investment
Equal to the initial investment amount divided by the annual after-tax cash flows
The project will be accepted if the payback period does not exceed a predetermined length.

weaknesses:
> ignores the time value of money,
-ignores cash flows beyond payback period
- only consider the length of time required to recoup the initial investment regardless of the investment's total profitability.
+):
>simple to use and understand
>measures liquidity and risk

Front 4

Return on investment

Back 4

Represents an average annual return on the initial investment

= the average annual net income / by the initial investment (asset book value)

The project will be accepted if the return on investment exceeds a predetermined minimum rate.
The primary weaknesses
> ignores the time value of money
>ignores possible cash outlays subsequent to initial investment.
>using accounting numbers rather than cash flows
positive:
> consider the entire period of an investment
> data readily available
>consistent with other financial measures

Front 5

Discounted Cash Flow (US)Techniques / Net present value

Back 5

= present value of net future cash flows less the initial investment

Requires the estimate of minimum rate of return to be used as the discount rate
The project will be accepted if the net present value is equal to or greater than zero.

weaknesses:
> cannot be used for comparing projects of different sizes
> favors large investments

+)
>consider time value of money
>uses realistic discount rate for investments
>additive for combined projects

Front 6

Internal rate of return

Back 6

Represents the discount rate that results in a net present value of zero It is equal to the discount rate that causes the net present value of future cash flows to equal the initial investment The project will be accepted if the IRR is greater than the companies desired rate of return (hurdle rate). weaknesses: > it sometimes requires unrealistic assumptions about reinvestment of funds, >manual calculation is difficult. +) > consider time value of money >easy for comparing projects requiring different amounts of investment

Front 7

Performance evaluation measures

Back 7

Financial measures are based directly on financial statement data.
Examples include net profit, return on investment, and comparison of budgeted to actual profit.
Nonfinancial measures are based on data not obtained directly from financial statements.
Examples include market share, relationship with host country government, and labor turnover.

Front 8

Performance evaluation – Balanced scorecard

Back 8

This approach gives “balanced” consideration to both financial and nonfinancial measures.
It considers the perspectives of four stakeholder groups.
Shareholder’s perspectives are considered by financial performance measures.
The internal business perspective is reflected in business process measures.
Innovation and learning perspectives and customer’s perspectives are also considered.

Front 9

Responsibility centers

Back 9

The idea of responsibility centers is to identify the activities that individual units perform and for which they should be held accountable.
Cost centers are responsible for producing output using a certain amount of resources.
Profit centers are responsible for costs and revenues.
Investment centers have the responsibilities of a profit center plus responsibility for investment decisions.
Return on investment (ROI) is the most common performance measure for an investment center.

Front 10

Separating managerial and unit performance

Back 10

In an international context a number of factors exist that cause a disconnect between manager performance and unit performance.
These factors that the manager cannot control are known as uncontrollable items.
Responsibility accounting implies that managers should not be held accountable for uncontrollable items.
Uncontrollable items include those controlled by the parent, the host government, or controlled by others.

Front 11

Choice of currency in measuring profit

Back 11

Profit can be measured in either the local currency or parent currency.
Local currency is appropriate if the subsidiary is not expected to pay parent currency dividends.
Otherwise, parent currency is appropriate.
When parent currency is used, the company also must choose a translation method.
Further, a decision must be made about whether to include the translation adjustment in the profit measure.

Front 12

Capital budgeting

Back 12

The fundamental concepts of capital budgeting are the same in either a domestic or international context.
Large, long-term investments are referred to as capital investments.
Capital budgeting is a key activity in selecting capital investments.
Capital budgeting involves three steps: project identification and definition, evaluation and selection, and monitoring and review.

Front 13

Steps in capital budgeting

Back 13

Project identification and definition provides a clear basis for understanding the project and predicting the associated cash flows.
Evaluation and selection involves identifying cash flows and then using one or more of the capital budgeting methods to evaluate the project.
Monitoring and review involves updating the analysis and project plan during the implementation stage.

Front 14

Multinational Capital Budgeting

Back 14

Capital budgeting in an international context is complicated by several factors.
These factors relate primarily to the risk associated with future cash flows.
These risks are generally categorized as political risk, economic risk, and financial risk.
Taxes, rate of inflation, import duties, dividend restrictions, and cash flow limitations imposed by governments also must be considered.

Front 15

Political Risk

Back 15

This refers to the likelihood that political events will impact cash flows.
Nationalization and expropriation of assets is the most extreme form of political risk.
Political risk is also associated with changes in foreign exchange controls, repatriation restrictions, tax rules, and labor laws.
This risk can vary significantly from one country to another.

Front 16

Economic Risk

Back 16

This refers to the likelihood that changes in the host country economy will impact cash flows.
Inflation is the most significant of economic risks.
Inflation affects the ability of the local population to purchase goods and also impacts the overall cost structure of a business.
There are also costs associated with manager time and effort to respond to inflation.

Front 17

Financial Risk

Back 17

This refers to the likelihood that changes in currency values, interest rates, and other financial factors will impact cash flows.
Foreign exchange risk is also a component of financial risk.
Whether to evaluate the project based on host country or parent country cash flows is affected by foreign exchange risk.

Front 18

Evaluation base / project cash flow (in local currency)

Back 18

factors should be considered:
1. Taxes
2. Rate of inflation
3. Political Risk

Front 19

Evaluation base / parent company perspective (in parent currency)

Back 19

1. The form in which cash flow is remitted to the parent. (dividends, interest, royalty - diffr. withholding tax rates).
2. Expected changes in the exchange rate over the project's life.
3. Political Risk

Front 20

TWO WAYs of incorporation of factors for evaluation bases

Back 20

1. estimation of a future cash flow
preferable, but more difficult
2. discount rate is adjusted to compensate the risk of those factors -> present value of expected future cash flow

Many companies adjust discount rate, because it's more easier, the adjusting cash flow.