International Investment Appraisal 2l6n1

International Investment Appraisal

Forecasting Exchange Rate Purchasing Power Parity S1 = So x [(1+inflation rate of 1st currency)/ (1+inflation rate of 2nd currency)] EXAMPLE:The Current Dollar Sterling exchange rate is given $/£ 1.7050 Expected Inflation Rates are: Year

USA

UK

1

5%

2%

2

3%

4%

3

4%

4%

Year

Calculation

Future Expected Spot

Year 1

1.7050 x (1.05/1.02)

1.7551

Year 2

1.7551 x (1.03/1.04)

1.7382

Year 3

1.7382 x (1.04/1.04)

1.7382

Find the expected spot rate for next three years. SOULTION:

©ACCA

Impact of Taxation The level of taxation on a project’s profits will depend on the relationship between the tax rates in the home and overseas country. The question will always assume a double-tax treaty  project always taxed at higher rate.

EXAMPLE: What will be the rate of tax on a project carried out in the US by a UK company in each of the following scenarios? Parent co is in UK Scenario' s

UK TAX

A

33%

<

40%

B

33%

=

33%

C

33%

>

25%

US TAX

Scenario A – No further UK tax to pay on the project’s $ profits. Profits taxed at 40% in US. Scenario B – No further UK tax to pay on the project’s $ profits. Profits taxed at 33% in US. Scenario C – Project’s profits would be taxed at 33%. 25% in US and further 8% tax payable in the UK on gross USA earnings ©ACCA

Inter-Company Cash flows Inter-company cash flows, such as transfer prices( inter company transactions), royalties and management charges, can also affect the tax computations. Example: A project carried out by a US subsidiary of a UK company is due to earn revenues of $100m in the US in Year 2 with associated costs of $30m. Royalty payments of $10m will be made by US subsidiary to UK. Assume tax is paid at 25% in the US and 33% ; and assume a forecast $/£ spot rate of $1.50/£. What are the cash flows associated with the project? Year 2

$m

Revenues

100

Costs

(30)

Royalties

(10)

Pre-Tax profit 25% US Tax

8% UK tax on $ profits: $60m/1.50 = £40m : £40m x 0.08 = £3.2m 33% UK Tax on Royalties = £6.7m x 0.33 = £2.2m

(15) 45*

£ Cash Flow

30

Royalties

6.7

After Tax Cash flow

UK Tax on $ profits – 33% - 25% =8%

60

Remit to Parent

UK Tax

UK Tax Computation:

** UK TAX PAYABLE : £ 5.4m

-

*45/1.50

$10m/1.50

(5.4)** £31.3m

©ACCA

Remittance Restriction Remittance occurs where an overseas government places a limit on the funds the can repatriated back to the holding company. This restriction will change the cash flows that are received by the holding company. Example: A project’s after US-tax $ cash flow is as follows ($m): YEAR

0

1

2

3

(10)

3

4

6

In any one year, only 50% of cash flows generated can be remitted back to the parent. The blocked funds can be released back to parent in the year after the end of project Q. Identify the cash flows to be evaluated?

YEAR

1

2

3

Net Cash Flow

3

4

6

Blocked Funds

(1.5)

(2)

(3)

Remit to Parent (Final Cash flows)

1.5

2

3

4

6.5 ©ACCA

Standard Proforma for International Investment Appraisal