International project appraisal is an integral part of the Advanced Financial Management syllabus.
The purpose of this series of articles is to assist your preparation for the exam by demonstrating how to attempt exam questions on this area of the syllabus. Coupled with a comprehensive mode of study and revision, you should be ready for whatever the exam may contain. International project appraisal will be a large component of your studies, and I will demonstrate a systematic method of answering a question on this topic for each section of the exam.
In this article, I will demonstrate how to answer a ‘Section B’ style 25-mark question.
Penn Co is successful company based in a European country where the local currency is the dollar and inflation has been stable at 5% pa. Income tax is charged on company profits at the rate of 25% and is payable in the same year as the profits are earned.
The company is listed on several major stock exchanges as it has operations all over the globe. Its market capitalisation is $655m. The company has bonds with varying maturities trading at $145m.
The treasury department of the company regularly computes the company’s nominal cost of capital and this has been fairly stable at 10%. However, when Penn Co have carried out projects in developing markets it has used a nominal risk-adjusted rate of 12%.
Penn Co’s primary business is construction and laying of train tracks and tramlines. Their main consumers are governments due to Penn Co’s position as the market leader. Penn Co has a record of completing long and complex contracts within schedule, as well as conducting its business in an ethical manner.
The CEO of Penn Co recently attended a trade delegation to Africa where he met the prime minister of the fast developing country called Zanadia. The prime minister and his political team provided Penn’s CEO with an outline of a contract that the Zanadian government would like to award to Penn Co.
Zanadia is situated on the African West coast, with the local currency being the dinar. Although being relatively small when compared to its neighbours, its economy has grown at over 15% pa for the past five years, but this has led to an inflation rate currently running at 30% pa. The democratically elected government has taken full credit for this economic prosperity.
The prime minister is adamant that the performance of the country is a result of trade links he created with European-based multinational corporations (MNCs). He believes that by encouraging investment from these entities in his country, the MNCs will generate substantial returns with minimal risk, as many of the projects are government contracts.
There has been varied success when European MNCs have invested in Zanadia, with political interference, particularly from the prime minister, being blamed for below par returns. Rumours have been rife that the prime minister has been ordering his government to make ad hoc requests for payments to be made at various times during the contracted period. The government themselves have stated that, on a very rare basis, penalty charges have been levied when companies have not been keeping to schedule.
The Zanadian government’s latest project is to create an environmentally friendly electric tramline network to connect all areas of Enat, which is Zanadian’s capital city. The project will ultimately take 20 years to complete. However, the initial contract will be to lay the tramline to connect Enat to the national airport located 23 kilometres away. Providing this is completed to the satisfaction of the Zanadian government, they will extend the contract to allow initial supplier connect the rest of the city.
Following the recent meeting between the prime minister and the CEO of Penn Co, the prime minister has authorised his government officials to release financial projections to Penn Co to allow it to assess the financial viability of the contract.
The government will pay a fixed price of dinar 5000m for the initial contact to lay the tramline between Enat and the national airport. This will be paid in stages:
Machinery needs to be purchased in Zanadia at a cost of dinar 1000m at the start of the project. The other costs will be locally incurred labour costs, which are estimated to be 30% of the revenue. All values are given in nominal terms. The government has already purchased sufficient materials from a low cost provider based in the US for the initial 23 kilometres of the tramline. They only require Penn Co to lay and test the tramline.
The government taxes company profits at 40% and this is to be paid in the year in which the profit is earned. The government has no provision to offset tax allowable depreciation (TAD).
The current spot rate Dinar/$ 150 – 175 and this is expected to change in the future based upon the relative inflation rates.
After two years, the prime minister will personally review the work carried out by Penn Co and he expects to extend the contract to complete Enhat’s city tramline. The exact terms of this contract extension will be subject to negotiation but the returns are expected to be substantial.
(a) Prepare a financial assessment of the project covering the initial two-year period assuming Penn Co appraises projects by discounting nominal $m cash flows at the appropriate cost of capital. State clearly any assumptions that you make. (11 marks)
(b) Explain the main risks and issues faced by Penn Co if it chooses to undertake this project. (14 marks)
The key to a good Advanced Financial Management answer is to have a clear plan when answering the question. Knowing where to start and how to progress through in a smooth and efficient way is vital.
The 25-mark question needs to be completed in 45 minutes, allowing 1.8 minutes per mark. A split of 20 minutes for part (a) and 25 minutes for part (b) is a good starting point in terms of allocation, but with students often finding the numerical elements challenging, allowing a minimum of 20 minutes for part (b) will give flexibility.
What are you been asked to do? Read the requirements and understand the key words. Match them to your Advanced Financial Management knowledge.
In this case:
(a) Compute a net present value in $m. ‘Nominal’ cash flows means adjusted for relevant inflation. ‘Appropriate’ cost of capital – my initial thoughts are either the company’s weighted average cost of capital (WACC) or a risk adjusted WACC. I need to list out any assumptions I make.
(b) ‘Risks and issues’ – I assume I will be able to derive most of these from the main body of the question coupled with the relevant Advanced Financial Management knowledge areas.
From experience, most candidates attempt the question in the order it is set. There are no instructions that says you have to do this. Decide which order you feel most comfortable with, but ensure you make a valid attempt at both parts of the question.
As for me, I would attempt Part (b) first. I feel I am more likely to be in control of my time this way. However, I will show my answer in the order the question was set.
I understand the requirements. Now, I need to digest the details of the question. My approach is a simple one.
Part (a) – Answer
To address this requirement I need to show a disciplined approach. Let me break this down into stages and explain my thought process for each step.
(1) Dinar cash flows
|Project cash flows||(1,000)||210||420||840||630|
The points to notes here:
(2) Spot rates and conversion to $m
|Project cash flows||(1,000)||210||420||840||630|
|Spot rate (W1) Dinar/$||150||196||217||243||269|
|Free cash flows ($m)||(6.67)||1.07||1.94||3.46||2.34|
The question stated that the current spot rate was dinar 150 – 175/$. As Penn Co needs to sell $s initially, the bid rate of dinar 150/$ will apply. As all other cash flows are receipts in dinars, a working is needed to compute the projected offer spot rates via the purchasing power parity theory (PPPT) formula.
|6 months||(175 + 217) / 2||196|
|12 months||175 x 1.30 / 1.05||217|
|18 months||(217 + 268) / 2||243|
|24 months||217 x 1.30 / 1.05||269|
The PPPT formula is used to calculate the annual spot rates. The intervening half-year rates are average values.
Finally, many students fail to convert the foreign cash flows into the home currency correctly. Based on my experience, I have seen many answers where confusion has reigned supreme, as students are not sure whether to divide or multiply. In this case the project cash flows are in dinars and our spot rates are dinar/$. We divide the dinar cash flows to convert to $m.
(3) Final answer
Discounting at the risk adjusted WACC of 12% (see assumptions below) should be the easy part. The discount factors for 12 and 24 months can be taken from the tables provided at the back of the exam. Those same tables provide the formula to use to calculate the six-month and 18-month discount factors remembering that r = 0.12 and n = 0.5 and 1.5 respectively.
The requirement invites the students to state any assumptions. Here is a sample of some that could be made:
Part (b) – Answer
As stated above, students could choose to ‘front load’ the answer to this requirement. My thought process here is to derive as many relevant points from the information in the scenario that relate to ‘risks and issues’ and expand on these. The examiner is looking for students to apply their knowledge to the details given in the question. It is these points that will ensure you achieve a sound pass mark for this requirement.
In addition, I will include the relevant factual points that can be found in any of the Advanced Financial Management approved textbooks. They will certainly earn some marks.
International project appraisal questions are challenging, but far from impossible. Students need to follow a disciplined approach. The format is very similar to when preparing a standard ‘home country based’ NPV which candidates have practised many times as it is part of both Financial Management and Advanced Financial Management.
For projects based abroad it is about starting with the relevant nominal foreign currency cash flows. The key differences are the computation of the spot rates and conversion of foreign currency cash flows to domestic currency values. Discounting at risk-adjusted rates should not be unexpected given the change in risk levels when investing abroad.
There are certain skills that we have not seen tested above such as royalties, transfer pricing and double taxation. These will be part of my next article when we return to Penn Co and look at another international project it is considering as an investment opportunity.
Sunil Bhandari, freelance tutor