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Capital Budgeting Process

Describe about the International Business Finance for the Involvement of Public Companies.

In the last few decades, involvement of public companies in international trading has increased quite significantly. Due to the globalization, the companies can easily offer its quality products and services to the foreign customers. However, though the international trading can provide higher profits to the companies, it involves many high risk factors also. Therefore, it is very important to evaluate any international project through capital budgeting techniques (Bierman Jr. and Smidt 2012).

The analysis of the capital budgeting is done in three stages. In the first stage, the decision analysis is done for knowledge building. In the second step, the option pricing is done in order to establish the position. The third step involves the discounted cash flow for the purpose of making investment decision. It helps in the analysis of the return and risk of the project and forms the basis whether undertaking the project is worthy or not. Process of capital budgeting helps in determining the long term financial and economic profitability of the project. The assessment of the risk involve in undertaking the project is depicted by the capital budgeting.      The new project is undertaken because it might be the proposal for increasing the production or increasing the sales or reducing the costs. The desirability of the project is judged and this needs to match the objectives of the firm, which is leads to increase in the market value. The capital budgeting process analyzes the risk associated with the international proposal along with the uncertainties relating to the cash inflow and cash outflow. The selection of the project is done by the screening process and then the making of the capital budget is done by the different alternatives of acquiring the funds. There are various factors affecting the process of capital budgeting such as capital structure, funds availability, policy of taxation, accounting methods, working capital, and government policy and earning. The acceptance or rejection of the project is done by the “accept and reject decisions”.

Zircon, an US based company, plans to provide technological support to Argentine firms. It has estimated the expected sales and cost of the project. In addition to the ordinary sales, it also expects to get a contract from Argentinean government, but is not sure about it. The project will continue for one year. Within the one year period, the value of the money will fall surely due to the inflation and other economic factors. Therefore, the company should consider the time value of money and evaluate the present value of the net earnings, generated by the project.

Zircon's International Project

The consideration of time value of money is the demonstrative of the fact that the money received now is better than the money received at a later date. If the project is able to generate the money earlier, then the future value of money is poised to increase because the same amount of money can be invested and the interest can be gained over the period of time. The concept of time value of money is an important concept to the investors and it is integral in making the best use of the limited funds available. Time value of money helps in evaluating the total value of money and the international project of Zircon needs to consider the concept of time value of money while undertaking the project. The required rate of return assumed by the company is 18%, which is the discounting rate. Using this rate, the company would able to calculate the present value of the cash inflow by discounting it to the future value.

Moreover, as it is an international project, it also involves the currency related risk. Hedging is very popular tools, used in foreign currency trading, to reduce the risk of change in foreign exchange rates in future. The company has also decided to mitigate the risk by hedging (Chung et al. 2014). In such scenario, as the company is not certain about the government contract, it is unable to decide the exact amount for forward hedging. Therefore, the company should also evaluate the various alternatives of forward hedging to select the best financial plan for the project (Gitman and Zutter 2012).

Management of risk is contemporary factor in the international project as the project is exposed to many risk factor including the risk of fluctuation of the foreign currency. In the event of the relentless competition, the identification of the potential risk is of utmost importance for any commercial activity. The risk strategy development is the complex process which involves experience and special knowledge. In order to avoid the risk, hedging has been given special consideration by the firms to be competitive and avoid unpredictable loses in the modern business environment.

Currency fluctuation is the risk which the international investors are exposed to and the fluctuations leads to uncertainty. The range in the fluctuation of price is getting significantly expanded due to the uncertainties and geopolitical risk in the global market. The firms in an attempt to protect against the risk of violent fluctuation in the price, the practice of hedging is done by using the currency derivatives. Hedging is required for generating the stable and consistent flow of cash and to reduce the risk exposure for the existing cash position.

Time Value of Money

There are two types of hedging, practiced to minimize the foreign exchange risk – forward contract and option. The company has decided to follow the forward contract method of hedging. In this method, the company has to make a contract, under which it will be exchange a specified amount of foreign currency at a fixed exchange rate at the future date even if the future exchange rate will be differs from contract rate (Magee 2013).

Currency hedging by Zircon is would help it in designing the strategy to mitigate the impact of the risk of foreign exchange or currency on the international investment. The strategy is cost effective and simple. It also allows the investor to participate fully in the equity return of the international markets. The risk in the international investment is basically due to the difference between the dollar is worth and what the foreign currency is worth. The currency bet would help in increasing the total return when the peso would be rising against the dollar. On the other hand, when the foreign currency is falling, the return would be reduced. The investors not having strong direction on the direction of the foreign currency should hedge the portion of the foreign currency to reduce their exposure to the fluctuation of the foreign currency.

There are two types of hedging strategy that is there is strategic and tactical hedging. Strategic hedging is mainly for the long term and tactical hedging is mainly for short term allocations. The investor can hedge the foreign currency using different ways. Hedging can be done using the currency swaps. This would involve swap currencies and interest rates with a party in the currency swaps, by exchanging interest payments and not principals in the currency swaps and then calculating the interest payments. The act of hedging with forward contracts involves purchasing of the forward contract and then evaluating the forward contract at the time agreed upon. Forward contract are used to hedge against the currency spikes and drop. Some other hedging options are available to the investors such as buying the foreign currency options, which gives the purchaser to buy or sell the foreign currency contract at the specified date and at the specified price. Buying the spot contracts is the other option available to the investor.

The company has anticipated the future exchange rate and computed the forward contract rate accordingly. The main problem for the company is to decide the contract amount. It is not certain about the government contract. Therefore, it has to evaluate both the scenarios and determine the amount of forward contract, which can be more profitable for the organization.

Currency Hedging

Forward hedging plan is basically done for the hedging of the foreign currency and is customized as per the amount and the delivery date. The forward is between the two parties who are agreeing to buy and sell the asset at the specified date and specified price. The party would have long position if he agrees to buy the underlying asset that is currency in the future. The party would have short position if he agrees to sell the asset in the future. Here, zircon would have long position if he receives the contract form the Argentinian government. On the other hand, if Zircon receives the contract, it would assume the long position. The agreed price by the Zircon and the government is the delivery price. The buyer of the forward contract has the expectation that the currency would appreciate in the future. On the other hand, the seller expects that the currency would depreciate in the future. Here, Zircon is going to receive the large amount of foreign currency form the Argentina as payment for supplying the technology, then it bears the risk of currency depreciation. This would call the company to go ‘short’ in forward currency contracts.

The company may make the forward contract with the maximum revenue of ARS$ 5000,000, expected from the project. However, as the government contract is uncertain, the company has to evaluate this alternative under two different approaches.

If the company will receive the government contract, then the net present value of the project will as follows:

Particulars

Amount

Exchange Rate

Amount

 

(ARS$)

 

(US$)

Initial Investment

 

 

($300,000)

Total Cash Flow from Revenue

$5,000,000

0.12

$600,000

Required Rate of Return

18%

Discounting Factor

0.847

Discounted Cash Flow

 

 

$508,474.58

Net Present Value

 

 

$208,474.58

If the company would make the forward contract for the maximum revenue of ARS$ 5000,000, it will fail to fulfill the forward contract obligations and cannot convert the Peso into Dollar at the fixed exchange rate (Magee 2013). In such scenario, it has to purchase Peso, amounted to ARSS 2000,000, at the future spot rate to cover the deficit amount of the contract. The net present value of the project in such scenario is calculated below:

Particulars

Amount

Exchange Rate

Amount

 

(ARS$)

 

(US$)

Initial Investment

 

 

($300,000)

Total Cash Outflow for Forward Purchase

($2,000,000)

0.13

($260,000)

Total Cash Inflow from Revenue

$3,000,000

0.12

$360,000

Total Cash Inflow from Forward Sales

$2,000,000

0.12

$240,000

Net Cash Inflow

$3,000,000

 

$340,000

Required Rate of Return

18%

Discounting Factor

0.847

Discounted Cash Flow

 

 

$288,135.59

Net Present Value

 

 

($11,864.41)

 

The company may reduce the risk of foreign currency exchange by making the forward contract with the minimum anticipated revenue, which is ARS$ 3000,000. This scenario can also be evaluated under two approaches.

If the company receives the government contract, then the company will convert ARS$ 3000,000 as per the forward contract rate and the balance ARS$ 2000,000 at the future spot rate. The net present value of this situation is shown in the following table:

Particulars

Amount

Exchange Rate

Amount

 

(ARS$)

 

(US$)

Initial Investment

 

 

($300,000)

Total Cash Inflow from Revenue

$3,000,000

0.12

$360,000

Total Cash Inflow from Forward Sales

$2,000,000

0.13

$260,000

Net Cash Inflow

$5,000,000

 

$620,000

Required Rate of Return

18%

Discounting Factor

0.847

Discounted Cash Flow

 

 

$525,423.73

Net Present Value

 

 

$225,423.73

Forward Hedging Plan

If the company does not receive the government contract, then it will convert the ARS$ 3000,000 at the forward contract only. The net present value of the project, in such circumstances, is shown below:

Particulars

Amount

Exchange Rate

Amount

 

(ARS$)

 

(US$)

Initial Investment

 

 

($300,000)

Total Cash Flow from Revenue

$3,000,000

0.12

$360,000

Required Rate of Return

18%

Discounting Factor

0.847

Discounted Cash Flow

 

 

$305,084.75

Net Present Value

 

 

$5,084.75

It can be stated from the above discussions that main hindrance of Zircon for determining the amount for forward contract is the uncertainty of revenue generation. The company is sure about the revenue, to be generated from the Argentinean firms. However, the government contract is not sure. Therefore, it cannot forecast the future cash inflow of the project properly (Christoffersen 2012).

The company is exposed to the revenue that is uncertain as the receiving of the contract form the government of Argentina is not certain. The uncertainty of the revenue generation for the contract of the government is attributable to the various factors and it is indirectly related to the political risk, operation risk, legal and financial risk of Argentina. Zircon is however not assured of the government contract. The financial risk that is attributable to the uncertainty in the generation of the revenue arises from the interest rate risk and the inflation risk. The other factor attributing to the uncertainty of the revenue arises from the fluctuating demand of the technology or change in the preference of technology of the consumers in Argentina. The fluctuation in the cost is another factor affecting the revenue generation.

The present value of the expected future revenue involves the application of the discount rate and the projection of net revenues. If the company is experiencing the higher risk, then the discount rate is also higher for making the adjustment that there is the likelihood that the present revenue would not be realized. The things related to the uncertainty is related to the currency inconvertibility and devaluations. The company can mitigate the risk using the currency swaps. The market of forward contract in Argentina is influenced by many factors that influence the expectation of the future spot exchange rate. The factors can be recession in the economic activities and increase in the rate of unemployment and the ineffectiveness of the government to cope up with the foreign indebtedness. All these factors contribute to preventing in attaining the stability in the exchange market.

In such scenario, if it includes the government contract for estimation purpose, but not receives it in actual, then it can face huge loss. Therefore, to mitigate the risk of such uncertain revenues, Zircon should exclude the government contract for any budgetary estimation (McNeil et al. 2015).

Forward Contract with Maximum Revenue

Conclusion:-

On the basis of the above discussions and calculations, it is clear that though Zircon may generate high amount of earnings from the forward contract with maximum expected revenue, the amount of expected loss for not receiving the government contract in such scenario is also very high.

For the forward contract with the minimum revenue, if the company would not receive the government contract, then it will receive nominal earnings from the project, but will not face any losses.

The forward contracts would help Zircon in eliminating the currency risk as it helps in determining the foreign cost at the upfront. The cash flow required by the organization from the acceptance of the project is obtained by establishing the contract. Forward contract offers the complete hedging of the foreign currency and the organization can match against the time period of exposure and the exposure of the cash size as well. In the currency market, the volume of the market activities are stronger in relation to any other market. The company would experience impressive potential in the profit by trading in the currency market.

This instrument of hedging helps the international companies in protecting against the risk of fall in the value of currency in relation to the other currencies. Zircon should have the forward contract when entering into the market of Argentina as it provides flexibility with respect to the amount to be recovered and helps in eliminating the downside risk exposure. It is also straightforward in organizing and organizing. The unfavorable movements in the future spot rate would be eliminated and there arises the certainty in the future cash flow. Beyond the agreed forward rate, the forward contract also helps in eliminating the adverse movement in the currency.

The forward contracts would help Zircon in eliminating the currency risk as it helps in determining the foreign cost at the upfront. The cash flow required by the organization from the acceptance of the project is obtained by establishing the contract. Forward contract offers the complete hedging of the foreign currency and the organization can match against the time period of exposure and the exposure of the cash size as well. In the currency market, the volume of the market activities are stronger in relation to any other market.

The company would experience impressive potential in the profit by trading in the currency market. This instrument of hedging helps the international companies in protecting against the risk of fall in the value of currency in relation to the other currencies. Zircon should have the forward contract when entering into the market of Argentina as it provides flexibility with respect to the amount to be recovered and helps in eliminating the downside risk exposure. It is also straightforward in organizing and organizing. The unfavorable movements in the future spot rate would be eliminated and there arises the certainty in the future cash flow. Beyond the agreed forward rate, the forward contract also helps in eliminating the adverse movement in the currency.

Hence, it can be concluded that the company should follow the second option and proceed with the project by making a forward contract with minimum anticipated revenue. Then, it can mitigate both the risks, related to currency exchange and uncertainty of revenue.

References & Bibliography:-

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.

Brozik, D. and Zapalska, A., 2014. Foreign currency hedging: A simulation. Developments in Business Simulation and Experiential Learning, 31.

Christoffersen, P.F., 2012. Elements of financial risk management. Academic Press

Chung, K., Park, H. and Shin, H.S., 2014. Mitigating systemic spillovers from currency hedging. In Volatile Capital Flows in Korea (pp. 217-244). Palgrave Macmillan US

Disatnik, D., Duchin, R. and Schmidt, B., 2014. Cash flow hedging and liquidity choices. Review of Finance, 18(2), pp.715-748.

Gitman, L.J. and Zutter, C.J., 2012. Principles of managerial finance. Prentice Hall

Grob, H.L., 2013. Capital budgeting with financial plans: an introduction. Springer-Verlag.

Hise, R.T. and Strawser, R.H., 2013. Application of Capital Budgeting Techniques to Marketing Operations. Readings in Managerial Economics: Pergamon International Library of Science, Technology, Engineering and Social Studies, p.419.

Kashyap, A., 2014. Capital Allocating Decisions: Time Value of Money. Asian Journal of Management, 5(1), pp.106-110

Magee, S., 2013. Foreign currency hedging and firm value: A dynamic panel approach. In Advances in Financial Risk Management (pp. 57-80). Palgrave Macmillan UK

Magee, S., 2013. The effect of foreign currency hedging on the probability of financial distress. Accounting & Finance, 53(4), pp.1107-1127

McNeil, A.J., Frey, R. and Embrechts, P., 2015. Quantitative risk management: Concepts, techniques and tools. Princeton university press

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