The top-down or bottom-up simplification is important, because, in practice, one
or the other is often applied to pro forma income statements for a project as the fastest
way to estimate likely cash flows. Hence, the person doing the calculations is often
an unconscious slave to the accounting methods used in the pro forma analysis, and,
when those methods differ from home country methods, errors are made.
The all-equity method just illustrated is justified for domestic capital budgeting
because the tax shelter created by interest expense is incorporated into the cost-of-
capital calculation. However when this all-equity method is used for an international
project, the project analyst must be aware that only actual foreign taxes paid can be
used as a credit against U.S. taxes levied on grossed up dividends received from the
foreign subsidiary.^1 The hypothetical tax used for the cash flow calculation is not a
valid base for credit against U.S. taxes.
4 • 4 FOREIGN INVESTMENT ANALYSISProjected Income Statement Projected Cash Flow Statement
with New Investment with New InvestmentNew Sales $ 2,000 New Sales $ 2,000
Cost of goods sold –1,000 Cost of goods sold –1,000
Administrative expenses –200 Administrative expenses –200
Amortization of prior Amortization of prior
service pension costs –50 service pension costs 0
Depreciation –150 Depreciation 0
—––—– –––––––
Total expenses $–1,400 Total cash outflow $–1,200
—––—– –––––––
Earnings before interest Cash flow before
and taxes (EBIT) 600 taxes 800
Interest expense –200
—––—–
Pretax earnings $—––—–^400 Less hypothetical tax
Income taxes @ 34% –136 on EBIT (.34) (600) $ –204
—––—– –––––––
Net cash flow to
Net earnings $ 264 equity investors $ 596
—––—–—––—– ––––––––––––––
The project cash flow of $596 can be calculated from the income statement (above left)
by either a top-down or a bottom-up approach.
Top-Down ApproachCash flowEBIT–(TAX RATE) (EBIT)+ DEPRECIATION+AMORTIZATION
600 – (.34) (600) + 150 + 50
596
Bottom-Up ApproachCash flowNET INCOME+DEPRECIATION+AMORTIZATION+(1 – TAX RATE) (INTEREST)
264 + 150 + 50 + (.66) (200)
596
(^1) The grossing up of dividends from foreign affiliates to calculate taxable income for U.S. taxes is
treated more fully in Chapter 30 of this book. Suffice it to say that dividends received from foreign op-
erating affiliates are increased (“grossed up”) by the amount of foreign tax paid on the income which gen-
erated that dividend, a tenative U.S. tax is calculated on this grossed up income, and the actual tax paid