International Capital Budgeting

INTERNATIONAL CAPITAL BUDGETING

Numerous approaches for evaluating investment projects are available, but the most commonly used methods include net present value, internal rate of return and payback period. To calculate the net present value of a project, a firm’s financial officers estimate the cash flows the project will generate in each time period and then discount them back to the present.

i)             Net present value

Financial officers must decide which interest rate, called the rate of discount, to use in the calculation, based on the firm’s cost of capital. The firm will undertake only projects that generate a positive net present value.  The net present value approach can be used for both domestic and international projects. However several additional factors must be considered when determining whether to undertake an international project. These factors are risk adjustment, currency selection and choice of perspective for the calculation.

 The amount of risk adjustment should reflect the degree of riskiness of operating in the country in question such religious conflict and civil war warrant the use of much larger adjustment for potential investments. The determination of currency in which the project should be evaluated depends on the nature of the investment. If the project is an integral part of the business of an oversea subsidiary, use of the foreign currency is appropriate.

MNCs often impose arbitrary accounting charges on the revenues of the operating units for the unit’s use of corporate trademark or cover general corporate overhead. These arbitrary  charges may reduce the perceived cash flows generated by the project but not the real cash flows returned to the parent. Similarly fees assessed against the subsidiary for the use of corporate trademarks, brand names, or patents should not be considered in the net present value calculation because the parent firm incurs no additional cost regardless of whether the subsidiary undertakes the project. The importance of currency controls in determining the attractiveness of a project also may be a function of the parent’s overall strategy.

ii)            internal rate of return

Financial officers first estimate the cash flows generated by each project under consideration in each time period. They then calculate the interest rate – called the internal rate return- that makes the net value of the project just equal to zero. Then they compare the project’s internal rate of return with the hurdle rate – the minimum rate of return the firm finds acceptable for its capital investment.  The hurdle rate may vary by country to account for differences in risk.

iii)           Payback Period

Payback period is the number of years it will take the firm to recover or payback the original cash investment from the project’s earnings.  The Payback Period technique has the virtue of simplicity. A project that earns large early profits but whose later profits diminish steadily over time may be selected over a project that suffers initial  start-up losses but makes large continuous profit after that. Adjustments must be made to eliminate intracorporate charges that have no real effect on corporate cash flows.