There are difficulties in estimating the values of the inputs inserted into the present value formula, which are discussed in turn.2 The analysis notes particular complications introduced by the international orientation of an investment project. There are three preliminary issues.
The first relates to the degree of disaggregation. The more specific the information required, the easier it is to acquire and the more accurate it is likely to be, which argues in favour of as much disaggregation as possible. However, the longer the lines of communication, the greater is the likelihood of distortion, both deliberate and inadvertent. When these lines of communication cross international borders, the problems multiply. Any inputs used should come from independent sources of information.
The Investment Process and Decision Making: the Financial Perspective 67
This raises a second issue – the existence of correlations between the different variables. Such dependencies can cause complications in esti- mation, since the value attached to one variable is conditional on the value of another. The greater the level of disaggregation, the greater the probability of the existence of such dependencies. For example, the investment costs incurred may influence the nature of the ongoing inputs required. For international projects, these interdependencies are particularly important (Buckley 1996: 159).
A third issue relates to whether attention is focused on the cash flows generated by the project in the host country or on the remit- table cash flows available to the shareholders in the home country (Buckley 1996: 162–164).3There might be a significant disparity in such cash streams because of linkages with other parts of the multi- national’s empire, which have an impact on the net cash position of the parent. For example, there must be a deduction from net cash streams for any export sales by the parent or other subsidiaries which are replaced by the new sales sourced in the host country. It is also necessary to take account of such issues as relative tax rates, exchange controls, remittance policy, fluctuations in exchange rates, even differences in the relevant discount rate (Moosa 2002: 106).
Where there are exchange controls, the relevant cash flows to the parent may consist of a mixture of management fees (net of any costs), royalties, interest on loans, dividend remittances allowed, and repayments for loans extended by the home country enterprise.
Another relevant issue is the exchange rate used to convert into the home currency. Often this is an exchange rate which fails to reflect purchasing power parity, i.e. involves relative inflation rates out of line with expected movements in the exchange rate.
The perspective adopted is partly an issue of who owns and who controls the enterprise (Moosa 2002: 104). If the project is controlled by the subsidiary but the subsidiary is fully owned by the parent, a focus on the subsidiary is probably appropriate. It seems appropriate to make the basis for any appraisal of the project itself, and then to con- sider the project from the perspective of the parent company, if there are notable differences in the relevant cash streams. The account below is written on the assumption that the local managers have full auton- omy and remit all profits to the parent. If this is not the case, issues such as the possible blocking of transfers of profits, forced retention of profits or the imposition of withholding taxation, become relevant, as does the movement of the relevant exchange rates. It is necessary to
distinguish actual differences in such policies from the threat of action which might create such differences.
Cash flows
The Xs are the revenues minus the costs for relevant years during the lifetime of the project, which vary from year to year, even turning negative in some years. The net cash streams are estimated as earn- ings before tax, then as earnings after allowance for tax payments.
Tax rates are a problem where there are differences in the rates between home and host countries and where credits granted may be variable. There may be some discretion as to where the cash flows appear, which raises the whole question of transfer pricing (Vonnegut 2000).
The main uncertainty arises from the primary variables which underpin the revenue and cost streams.
• Revenues are the number of sales times relevant prices, both of which need to be forecast. The further into the future the appraisal is aimed, the more uncertain are the values of both variables. Some methods of forecasting, such as univariate or multivariate analysis, are sophisticated, others take full account of the uncertainty con- cerning both unknowns. Sales reflect the overall growth of the market for any relevant product or service and the market share attained by the relevant enterprise.
Decision makers can consider prices in real, not nominal, terms.
Futures markets provide information on the movement of prices over the lifetime of a project, but often not the whole lifetime. Future changes are to some degree under the control of the decision makers concerned with the relevant project. The managers of the enterprise may consider that their information is better than that held by the market.
• Costs are both variable and fixed. Variable costs such as wages, raw material, component and energy input costs, fluctuate with the level of output or sales. The process of learning by doing and the movement down the experience curve will affect future cost levels. It is necessary to anticipate different cost scenarios. Fixed costs are incurred irrespective of output levels and should be included in K. The initial capital costs, K, generate streams of The Investment Process and Decision Making: the Financial Perspective 69
costs, including depreciation allowances and interest charges. The former may be matched by maintenance and upgrading expendi- tures. There is much difference in the way in which depreciation is estimated in different countries and different industries. There is some difficulty in moving from cash streams to earnings streams because of the arbitrary nature of costs such as taxes, interest payments and depreciation allowances.
The movement of prices and cash streams may reflect the anticipated strategy of other players and the level of competition in the relevant sector of the economy. The degree of competition in any market and the interaction between the strategies of competitors creates a risk for the enterprise making an investment decision since what the competi- tors do has a direct influence on prices, output sold and even on the level of costs.
Discount rate
There are two elements to any discount rate, time and risk elements.
The latter disappears in an environment of certainty, when the dis- count rate is a risk-free rate, perhaps LIBOR (London Interbank Offered Rate) or the rate on a treasury bill issued in New York. Even a rate of time discount may differ from period to period, from person to person or from organisation to organisation. The discount rate can be nominal or real, that is, it can ignore or take account of the rate of inflation, provided all cash streams are consistently measured.
Choice of an appropriate discount rate is central to any attempt to consider uncertainty. This means selecting an appropriate risk premium to be added to the rate of time preference. Once uncertainty is introduced there are many complicating issues:
• Individuals attach different utility to income
• Risk may differ from period to period
• Risk may differ from one kind of project to another.
There may be different rates for cost reducing investments, capacity expanding investments or investments introducing new products, or for different business units at different points in their life cycle (Hull 1980: 13–14).
• Risk may differ from country to country
• Risk may differ from one cash stream to another
Since the discount rate is intended to correct for the specific risk in each period, there should be multiple rates. Using a single rate reflects implicit assumptions (Mandron 2000: 998–1001):
• that uncertainty dissipates at a constant rate with time (the shape of the probability distribution of cash flows expected in adjacent periods is unchanging).
• all cash flows have identical per-period-risk.
Clearly, these are illegitimate assumptions. In the words of Mandron, The traditional DCF model is ill-suited for projects characterised by varying degrees of risk resolution across time (Mandron 2000: 999).
The discount rate can be interpreted as the target rate of return for the project or as the cost of capital, often the weighted average cost of capital. It should be a marginal rather than an average rate. It is often assumed that the debt/equity ratio remains constant, which removes the problem of average versus marginal cost. In simplified cases, a 100% equity financing is assumed in order to avoid the uncertainty created by debt leverage (Mandron 2000: 1004–5). The cost of capital on any project depends on the use to which the capital is put since the latter determines the level of risk. The separation principle between investment decisions and finance decisions falls down in practice (Mandron 2000: 1003).
Initial investment cost
Capital costs are those incurred independently of the level of output but necessary to the operation of the relevant project, in the simplest situation all incurred today (year 0). The capital costs include the working capital required to start operations and any promotional or distributional costs associated with the sale of a new product. The capital costs are usually incurred over a number of years and are flexible in their timing. Any such instalments need to be discounted to give a present value.
The cost of the investment may not be fully known, particularly for international projects. Sometimes the parent company contributes existing equipment. There may be some ambiguity about the valua- tion of equipment provided by an enterprise to a subsidiary abroad rather than that bought on the market or constructed by the relevant enterprise. The valuation can be the current purchase price of equip- ment in a similar state of wear and tear, the net realisable value of the equipment, or the present value of future earnings generated by The Investment Process and Decision Making: the Financial Perspective 71
the equipment. These values may differ. This issue of the relevant valuation is discussed at some length by Buckley (1996: 164–167).
Project lifetime
The choice is initially arbitrary. Depreciation is likely to assume a given life, particularly if it is based on the straight-line method which simply divides the capital cost by the number of years of life.
Salvage value
This term is the most difficult one to estimate. The further into the future a project is likely to conclude, the less is its influence on present value. This value can reflect net revenue streams beyond the termination date.
In practice the estimation of the values to go into the formula occurs after a long assessment process in which the key decision makers deal with many uncertainties. The same appraisal framework can be adopted, even if the future cash streams are not fully known. There are two possibilities:
• The uncertainty yields either discrete possibilities or the limits of a feasible range of values. It is common to assume a normal distribu- tion of returns with the extremes clearly specified, and common to attach probabilities to all future outcomes. Often, a weighting by probability and the averaging of possible outcomes is the approach adopted in finance texts. The Xs are, in that case, the mean expected values of these distributions. Averaging different scenario outcomes is a dangerous procedure if there are a limited number of possibilities. The nature of the distribution is important, particularly if there is a skewness or kurtosis implying the possibility of nasty outcomes.
• Alternatively the uncertain streams could be reduced to certainty equivalents, that is, the managers could state cash flows which, if obtained for certain, are equally as desirable as the projected uncer- tain cash flows. This may be difficult to achieve.
In both cases the estimation is done as if all the values were known with certainty. This has prompted Vonnegut to comment, ‘The ENPV rule [expected net present value] is flexible in that a wide range of uncertainties and probabilities can be incorporated into the state space for each time period.’ (Vonnegut 2000: 84).