BUS 553 Module 7 Evaluating Foreign Investment Example

Worth It to the Plant or Worth It to the Parent? Evaluating a Packaging Maker's Investment Near Chennai

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MBA Program, Aspen University

BUS 553: Global Corporate Finance

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Month Day, Year

Worth It to the Plant or Worth It to the Parent? Evaluating a Packaging Maker's Investment Near Chennai

Hoosier Pharma Pack, a composite manufacturer in Indianapolis, makes blister packs, bottles and closures for pharmaceutical companies. India's generic drug manufacturers, which supply a large share of the world's generic medicines, increasingly need packaging that meets U.S. and European regulatory standards. Hoosier proposes a $28 million plant in an industrial zone near Chennai to serve them. The board wants to know whether the plant is worth building, and whether its value to Hoosier's shareholders, who are paid in dollars, matches its value as a stand-alone business in India. This paper evaluates the investment from both perspectives.

Forecasting Rupee Cash Flows

The plant would sell to Indian drug makers in rupees. After a two-year ramp-up, it is expected to generate annual revenue of about 3.4 billion rupees and operating cash flow of about 620 million rupees, rising with volume and inflation over a ten-year horizon. Costs, including labor, utilities and most resin purchases, would also be in rupees, with some specialized films imported and paid in dollars.

Projecting the Exchange Rate

Converting rupee cash flows at today's exchange rate for every future year would overstate their dollar value if the rupee continues to weaken, as it has over long periods. A consistent approach projects the exchange rate from expected inflation: with Indian inflation expected to run about 2 percentage points above U.S. inflation, the rupee is projected to depreciate by roughly 2% a year against the dollar. This keeps the conversion consistent with a dollar discount rate.

Project and Parent Perspectives

Shapiro (2013) explains that a foreign project should be evaluated from the parent's perspective, using the cash flows the parent actually receives, while also understanding the project's stand-alone economics. The two differ. The Indian subsidiary will pay Hoosier royalties for its designs and fees for management services, which are deductible in India but taxed in the United States. Dividends from India are subject to withholding tax, and Indian rules and the subsidiary's own working capital needs may delay distributions. Cash retained to fund growth in India benefits the parent only when it eventually returns.

Why India, and Why Now

Several conditions make the timing attractive. Indian generic manufacturers are expanding exports to regulated markets, which require packaging that meets strict standards for moisture protection and child resistance. Many currently import such packaging or buy it from a small number of local suppliers with long lead times. Government incentives for pharmaceutical manufacturing have encouraged new capacity in Tamil Nadu, where Chennai's port and industrial zones serve both domestic and export customers. Hoosier's existing relationships with three Indian drug makers that already buy from its U.S. plant provide an anchor for early volume.

Risks Specific to the Project

Beyond currency and politics, the plant faces operating risks: securing reliable power and water, training staff to meet pharmaceutical quality standards, and competing with Indian packaging firms that may improve quickly. Customers must audit and approve the plant before buying, which can take a year or more. These risks are reflected in the base case through a two-year ramp-up and in a slower-approval scenario, which reduces parent value by about $1.8 million.

The Discount Rate

Building a discount rate for an emerging market investment is a practical challenge. Godfrey and Espinosa (1996) proposed a method based on U.S. market returns adjusted for the investment country's risk: a dollar-based required return that scales the U.S. equity premium by the ratio of the foreign market's volatility to the U.S. market's, with a further adjustment for the share of that volatility attributable to country risk, and adding a sovereign yield spread. Applied to India, it yields a dollar cost of equity for the project of about 14%, compared with about 10% for Hoosier's U.S. operations.

Lessard (1996) cautioned that adding country premiums to discount rates can double-count risks, such as expropriation or currency controls, that are better reflected in expected cash flows or covered by insurance. To avoid double-counting, the analysis applies the 14% rate but does not separately reduce the base case cash flows for those political risks, instead examining them in a separate scenario and through insurance options.

The Results

In local terms, the plant is strongly positive. The parent's value is lower because of withholding taxes, U.S. taxes on royalties and fees, and timing. A faster-falling rupee reduces the parent's dollar value sharply even though the project's rupee value is unchanged, showing the importance of the parent's perspective.

Comparing With Exporting From Indiana

The alternative of continuing to ship from Indianapolis would avoid country risk but lose customers. Freight and import duties add about 18% to the delivered cost of Hoosier's packaging in India, and lead times of eight to ten weeks do not suit drug makers that schedule production monthly. Two of its three Indian customers have said they will qualify a local supplier within two years. The real comparison, therefore, is not between the Chennai plant and today's exports but between the plant and a shrinking export business.

Safeguards

Several steps would protect the parent's value. Contracts with export-oriented drug makers, whose own revenue is largely in dollars, could be priced partly in dollars or include currency adjustment clauses. Hoosier could finance part of the plant with rupee borrowing, so that a weaker rupee reduces the dollar value of both earnings and debt. Political risk insurance against expropriation and currency transfer restrictions should be priced. Royalty and fee arrangements should follow arm's-length rules to avoid tax disputes.

Recommendation

After weighing both perspectives, Hoosier should approve the plant. It is valuable as a stand-alone business and remains positive for the parent under the base case and the weaker-rupee case. Approval should be conditioned on securing anchor customer agreements with currency adjustment clauses and on financing about a third of the plant with rupee debt.

Conclusion

A foreign investment can look attractive in local currency and less so to the parent that must receive dollars. Projecting exchange rates consistently, separating project from parent cash flows, building a defensible emerging market discount rate and avoiding double-counted country risk show that Hoosier's Chennai plant creates value for its shareholders, especially if its contracts and financing reduce exposure to the rupee.

References

Godfrey, S., & Espinosa, R. (1996). A practical approach to calculating costs of equity for investments in emerging markets. Journal of Applied Corporate Finance, 9(3), 80-90. https://doi.org/10.1111/j.1745-6622.1996.tb00300.x

Lessard, D. R. (1996). Incorporating country risk in the valuation of offshore projects. Journal of Applied Corporate Finance, 9(3), 52-63. https://doi.org/10.1111/j.1745-6622.1996.tb00298.x

Shapiro, A. C. (2013). Multinational financial management (10th ed.). Wiley.