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Unit 13: Cross-border Capital Budgeting

4. Anticipate the differences in the rates of national inflation as they can result in changes in Notes
competitive position and thus in cash flows over a period of time.
5. The possibility of foreign exchange risk and its effect on the parent’s cash flows.

6. If the host country provides some concessionary financing arrangements and/or other
benefits, the profitability of the foreign project may go up.
7. Initial investment in the host country may benefit from a partial or total release of blocked
funds.
8. The host country may impose various restrictions on the distribution of cash flows
generated from foreign projects.
9. Political risk must be evaluated thoroughly as changes in political events can drastically
reduce the availability of expected cash flows.

10. It is more difficult to estimate the terminal value in multinational capital budgeting
because potential buyers in the host or parent company may have widely different views
on the value to them of acquiring the project.

13.1 Problems and Issues in Foreign Investment Analysis

Some of these issues in foreign investment analysis are as follows:

Foreign Exchange Risk

Multinational firms investing abroad are exposed to foreign exchange risk – the risk that the
currency will appreciate or depreciate over a period of time. Understanding of foreign exchange
risk is important in the evaluation of cash flows generated by the project over its life cycle. To
incorporate the foreign exchange risk in the cash flow estimates of the project, first an estimate
is made of the inflation rate in the host country during the life span of the project. The cash flows,
in terms of local currency, are then adjusted upwards for the inflation factor. Then the cash flows
are converted into the parent’s currency at the spot exchange rate multiplied by an expected
depreciation or appreciation rate calculated on the basis of purchasing power parity. In certain
specific situations, the conversion can also be made on the basis of some exchange rate accepted
by the management.
Remittance Restrictions

Where there are restrictions on the repatriation of income, substantial differences exist between
project cash flows and cash flows received by the parent firm. Only those flows that are remittable
to the parent are relevant from the MNC’s perspective. Many countries impose a variety of
restrictions on transfer of profits, depreciation and other fees accruing to the parent company.
Project cash flows consist of profits and depreciation charges whereas parent’s cash flows consist
of the amounts that can be legally transferred by the affiliate.
In cases where the remittances are legally limited, the restrictions can be circumvented to some
extent by using techniques like internal transfer prices, overhead payments, and so on. To
obtain a conservative estimate of the contribution by the project, the financial manager can
include only the income which is remittable via legal and open channels. If this value is positive
no more additions are made. If it is negative, we can add income that is remittable via other
methods (not necessarily legal). Another adjustment in multinational capital budgeting is the
problem of Blocked Funds. Accounting for blocked funds in the capital budgeting process depends
on the opportunity cost of blocked funds.

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