Page 222 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 13: Cross-border Capital Budgeting

Stonehill and Nathanson have suggested a three-stage financial analysis of foreign projects. In Notes
the first stage, project cash flows are computed and analysed from the viewpoint of the subsidiary
or the affiliate as if it were a separate entity. The second stage involves evaluation of the profit
on the basis of forecasts of cash flows which will be transferable to the parent company. In the
third and last stage, the analysis from the viewpoint of the parent company is widened to
include indirect benefits or costs from the company as a whole, which are attributable to the
foreign project in question.

Did u know? Various surveys conducted over a period of time show that MNCs evaluate
foreign projects from both the parent’s and the project’s viewpoints. Surveys conducted by
Stonehill and Nathanson (1968), Baker and Beandsley (1973), Oblak and Helm (1980),
Bavishi (1981), Stanley and Block (1983) reveal that firms calculate and evaluate rates of
returns by using cash flows to and from the parent as well as to and from foreign project
alone.
Thus, most firms generally evaluate foreign projects from both parent and project viewpoints.
Evaluating and analysing cash flows from both viewpoints reveals important aspects about the
project’s competitiveness and its contribution to the company as a whole. The project viewpoint
provides a closer approximation of the effect on consolidated earnings per share, which all
surveys mention is of major concern to practising managers. The parent’s viewpoint gives
results closer to the traditional meaning of net present value in capital budgeting.

Adjustment for Risk: Cash Flows versus Discount Rate Adjustment

Another important dimension in multinational capital budgeting is whether to adjust cash
flows or the discount rate to account for the additional risk that arises from the foreign location
of the project.
Traditionally, MNCs have adjusted the discount rate by moving it upwards for riskier projects
to reflect the political and foreign exchange uncertainties. A significant number of firms that use
the DCF technique in domestic projects also assign different hurdle rates for different projects,
depending on their risk categories. Adjusting the discount rate is quite a popular method with
MNCs mainly because of its simplicity and the rule that the required rate of return of a project
should be in accordance with the degree of risk which it is exposed to.
However, combining all risks into a single discount rate has several drawbacks.

Example: The political risk and uncertainties attached to a project relate to possible
adverse events that might occur in the distant future but cannot be foreseen at the present.
Adjusting the discount rate for political risk thus penalises early cash flows too heavily while
not penalising distant cash flows enough. As far as the foreign exchange risk is concerned,
adjusting the discount rate to offset the exchange risk is an oversimplification. This is so because
only adverse exchange rate movements are expected whereas it is entirely possible for a MNC
to many times gain from favourable overall currency movements during the life of the project.

The other alternative is to adjust cash flows rather than the discount rate in treating risk. The
annual cash flows are discounted using the applicable rate for that type of project either at the
host country or at the parent country. Probability and certainty equivalent techniques like
decision tree analysis are used in economic and financial forecasting. Cash flows generated by
the project and remitted to the parent during each time period are adjusted for political risk,
exchange rate and other uncertainties by converting them into certainty equivalent. The method
of adjusting the cash flows rather than the discount rate is generally the more popular method

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