13.3 International Capital Budgeting

International capital budgeting is crucial for firms expanding globally. It involves estimating foreign cash flows, assessing risks, and calculating returns. The process considers exchange rates, political factors, and country-specific challenges.

Companies use NPV, IRR, and PI to evaluate international projects. They must account for exchange rate risks, political uncertainties, and varying capital structures. Techniques like APV and sensitivity analysis help manage these complexities in global investments.

Capital Budgeting in International Contexts

Key Steps and Considerations

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• The key steps in the international capital budgeting process are the same as for domestic projects
  • Estimating cash flows
  • Assessing risk
  • Calculating expected return
  • Making the investment decision
• Cash flows from international projects must be estimated in the foreign currency and then converted to the domestic currency using expected future exchange rates
• The cost of capital for international projects should reflect the additional risks associated with investing in a foreign country
  • Political risk
  • Exchange rate risk
  • Country-specific risks

Applying Capital Budgeting Techniques

• The net present value (NPV) and internal rate of return (IRR) methods can be applied to international projects using the adjusted cash flows and cost of capital
• The profitability index (PI) can be used to rank international projects when capital is constrained
  • PI is calculated as the present value of future cash flows divided by the initial investment
  • Projects with higher PIs are prioritized when capital is limited

Exchange Rate Risk in Investment Decisions

Types of Exchange Rate Risk

• Exchange rate risk arises from the potential for changes in foreign currency exchange rates to impact the domestic currency value of cash flows from international projects
• Transaction exposure refers to the risk that the domestic currency value of foreign currency cash flows will change due to exchange rate fluctuations
  • Example: A U.S. company has a receivable in euros, and the value of the euro declines relative to the dollar
• Economic exposure refers to the risk that a firm's competitive position will be affected by changes in exchange rates
  • Example: A U.S. exporter becomes less competitive in foreign markets when the dollar appreciates

Managing Exchange Rate Risk

• Techniques for managing exchange rate risk include
  • Matching currency cash flows (natural hedge)
  • Hedging with derivatives (forwards, futures, options)
  • Diversifying across multiple currencies
• Sensitivity analysis can be used to assess the impact of different exchange rate scenarios on project NPV and IRR
  • Involves calculating NPV and IRR under various exchange rate assumptions
  • Helps identify the range of potential outcomes and the project's sensitivity to exchange rate changes

Adjusted Present Value for International Projects

APV Method and Components

• Adjusted present value (APV) is an alternative to the traditional NPV method that separately values the different components of a project's cash flows
• The base-case NPV is calculated using the project's operating cash flows discounted at the unlevered cost of equity (assumes all-equity financing)
• Financing side effects are valued separately and added to the base-case NPV
  • Interest tax shields
  • Subsidies
  • Issue costs

Advantages of APV for International Projects

• The APV method is particularly useful for international projects where the optimal capital structure and financing mix may differ from the firm's domestic operations
• The APV allows for flexibility in incorporating different discount rates for each cash flow component based on their specific risks
  • Operating cash flows may have different risks than financing cash flows
  • Financing side effects can be discounted at the appropriate risk-adjusted rate

Political and Country Risk on Investments

Types of Political and Country Risks

• Political risk refers to the possibility that government actions or political events in a foreign country will adversely affect the value of an investment
• Types of political risks include
  • Expropriation (government seizure of assets)
  • Currency inconvertibility (inability to convert foreign currency to domestic currency)
  • Changes in tax laws or regulations
  • Political instability or violence
• Country risk encompasses the economic, financial, and socio-political risks associated with investing in a particular foreign country
• Factors affecting country risk include
  • Economic stability
  • Level of development
  • Infrastructure
  • Legal system
  • Corruption
  • Social and cultural factors

Assessing and Mitigating Risks

• Higher political and country risks are typically associated with higher required returns and discount rates for international projects
• Techniques for assessing and mitigating political and country risks include
  • Diversification across countries and regions
  • Political risk insurance
  • Joint ventures with local partners
  • Scenario analysis to evaluate potential outcomes under different risk scenarios