International Capital Budgeting Decisions

Opening Case 18: External Factors Affecting Foreign Project Analysis

Foreign-exchange rates, interest rates, and inflation are three external factors that affect multinational companies (MNCs) and their markets. Changes in these three factors stem from several sources, such as economic conditions, government policies, monetary systems, and political risks. Each factor is a significant external variable that affects areas such as policy decisions, strategic planning, profit planning, and budget control. To minimize the possible negative impact of these factors, MNCs must establish and implement policies and practices that recognize and respond to their influences.

These three factors - exchange rates, interest rates, and inflation - affect sales budgets, expense budgets, capital budgeting, and cash budgets. However, they are particularly useful when evaluating international capital budgeting alternatives. Foreign-exchange rates have the most significant effect on the capital budgeting process. A foreign investment project will be affected by exchange rate fluctuations during the life of the project, but these fluctuations are difficult to forecast. There are methods of hedging against exchange rate risks, but most hedging techniques are used to cover short-term positions.

The cost of capital is used as a cutoff point to accept or reject a proposed project. Because the cost of capital is the weighted average cost of debt and equity, interest rates play a key role in a capital expenditure analysis. Most components of project cash flows - revenues, variable costs, and fixed costs - are likely to rise in line with inflation, but local price controls may not permit internal price adjustments. A capital expenditure analysis requires price projections for the entire life of the project. In some countries, the inflation rate may exceed 100 percent during a 3-year period, a condition known as hyperinflation. These and other factors related to inflation make the capital budgeting process extremely difficult.

Source. Paul V. Mannino and Ken Milani, "Budgeting for an International Business," Management Accounting, Feb. 1992, pp. 36-41.

The basic principles of analysis are the same for foreign and domestic investment projects. However, a foreign investment decision results from a complex process, which differs, in many aspects, from the domestic investment decision.

Relevant cash flows are the dividends and royalties that would be repatriated by each subsidiary to a parent firm. Because these net cash flows must be converted into the currency of a parent company, they are subject to future exchange rate changes. Moreover, foreign investment projects are subject to political risks such as exchange controls and discrimination. Normally, the cost of capital for a foreign project is higher than that for a similar domestic project. Certainly, this higher risk comes from two major sources, political risk and exchange risk.

This chapter is composed of four major sections. The first section describes the entire process of planning capital expenditures in foreign countries beyond 1 year. The second section examines how international diversification can reduce the overall riskiness of a company. The third section compares capital budgeting theory with capital budgeting practice. The fourth section covers political risk analysis.

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