Transfer pricing in international investment appraisal

It is a bit difficult to explain the calculations in full here in this box, but I will do my best and you should get the idea.
I will have to explain in two stages (at first ignoring transfer price) but then bringing it in, so be patient 🙂

For international investment appraisal itself, you might (for example) have a UK company investing in a project in the US. You will be given the cash flows for the project in dollars and so you set up the cash flows in the normal way (all in dollars), calculate the US tax in the normal way (in dollars) and end up with a net cash flow (in dollars). We then assume that the net cash is all remitted to the UK (unless told different) and so we convert the dollar cash flows to pound cash flows each year (you will probably need to forecast the exchange rates using the formula).
When you have the cash flows in pounds, you then bring in any extra UK tax, and discount the final (pound cash flows) at the UK companies WACC.

The relevance of transfer pricing is that you might be told that the US subsidiary buys some of its materials from the UK owning company. You will be told the price (this is the transfer price) but probably told it in pounds.

So…….when you are setting up the dollar cash flows, you will need to bring in the cost of these materials (converting from pounds to dollars at the relevant exchange rate each year). And then carry on with the dollar flows as above (with US tax as normal).

When you have converted the net cash flows to pounds, you then think about the pound flows – in addition to the converted dollar flows, the UK company is also receiving the money for the materials, and there might be extra UK tax. When you have added all these together and have the net pound cash flows, you discount at the WACC.

I hope I am making sense here – the idea is not difficult. Its just that there is a lot of calculating to do (especially since there is likely to be inflation to deal with).

The reason in practice that this might happen is partly because the US subsidiary might not be able to get the material elsewhere (and therefore has to ‘buy’ it from the UK company). Also, however, it is a way for the UK company to make sure it gets some cash back to the UK. (There is always the risk that the foreign country might decide to stop (or limit) remittances of profits back to the UK). Also, it is a way of trying to save tax – if the foreign country has a high rate of tax and the UK a low rate of tax, then it would be good to charge the foreign subsidiary a high price for the materials (so low US profit and low US tax). It means more income taxable in the UK, but if the tax rate in the UK is lower then this is great.

For that reason, countries have rules to try and make sure that the price charged is a ‘fair’ price.

However, at P4 this is just for a discussion part of a question. In the calculation part you will be told the price charged and you just do the arithmetic.

Phew! 🙂
I do hope you could follow all that!!!

A good question to look at is Question 1 Part (a) from the ‘Global Pilot Paper – from June 2013 exams’ which you can find on the ACCA website.

You are welcome 🙂

It is not a question of adjustments – it is applying standard investment appraisal procedures, and there is certainly no set number. It depends on the particular question.

Things that are likely to need considering besides the tax and the transfer price, are royalties paid from the foreign business, how it is financed (and therefore whether an APV approach is needed, and if so whether there is any subsidised lending), what cost of capital to use (usually depending on a calculation of the relevant beta), and, of course, there is often inflation to deal with.
All of these are techniques you should be familiar with anyway (and are covered in our lectures) but you can only really grasp by practicing many questions from your Revision Kit.