International Financial

Management (MAF612)
Chapter 4 – International Capital
Budgeting
 Topics to be covered
• Review of Domestic Capital Budgeting

• The Adjusted Present Value Model

• Capital Budgeting from the Parent Firm’s

Perspective
• Risk Adjustment in the Capital Budgeting Process

• Sensitivity Analysis

2
 Review of Domestic Capital Budgeting
1. Identify the SIZE and TIMING of all relevant cash flows on a
time line.

2. Identify the RISKINESS of the cash flows to determine the

appropriate discount rate.

3. Find NPV by discounting the cash flows at the appropriate

discount rate.

4. Compare the value of competing cash flow streams at the

same point in time.
3
 International Capital Budgeting
• You have two equally valid approaches:

– Change the foreign cash flows into dollars at the exchange

rates expected to prevail. Find the $NPV using the dollar cost
of capital.

– Find the foreign currency NPV using the foreign currency cost
of capital. Translate that into dollars at the spot exchange rate.

• If you watch your rounding, you will get exactly the same answer
either way.

4
 Capital Budgeting from the Parent Firm’s
Perspective
One recipe for international decision makers:

1. Estimate future cash flows in foreign currency.

2. Convert to the home currency at the predicted

exchange rate.
Use PPP, IRP et cetera for the predictions.

3. Calculate NPV using the home currency cost of

capital.
5
 Capital Budgeting from the Parent Firm’s
Perspective: Example
A U.S. MNC is considering a European opportunity. The
size and timing of the after-tax cash flows are:

–€600 €200 €500 €300

0 1 2 3
The inflation rate in the euro zone is € = 3%, the
inflation rate in dollars is p$ = 6%, and the business risk
of the investment would lead an unlevered U.S.-based
firm to demand a return of Kud = i$ = 15%.
6
 Capital Budgeting from the Parent Firm’s
Perspective: Example

–€600 €200 €500 €300

0 1 2 3
$1.25
The current exchange rate is S0($/€) =
€
Is this a good investment from the perspective of the
U.S. shareholders?
To address that question, let’s convert all of the cash
flows to dollars and then find the NPV at i$ = 15%.
7
 Capital Budgeting from the Parent Firm’s
Perspective: Example
–$750
–€600 €200 €500 €300

0 1 2 3

CF0 = (€600)× S0($/€) =(€600)×$1.25 = $750

€

Finding the dollar value of the initial

$1.25
cash flow is easy; convert at the spot S0($/€) =
€
rate:
8
 Capital Budgeting from the Parent Firm’s
Perspective: Example
–$750 $257.28
–€600 €200 €500 €300

0 1 2 3
The exchange rate expected to prevail in the first year, S1($/€),
can be found with PPP:
1 + $ 1.06 $1.25
S1($/€) =  S0($/€) =  = $1.2864/€
1 + € 1.03 €

CF1 = €200 × S1($/€) = €200 × $1.2864/€ = $257.28

9
 Capital Budgeting from the Parent Firm’s
Perspective: Example
–$750 $257.28 $661.94
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 $1.25

CF2 =    €500 = $661.94
1.03 1.03 €

10
 Capital Budgeting from the Parent Firm’s
Perspective: Example
–$750 $257.28 $661.94 $408.73
–€600 €200 €500 €300

0 1 2 3

1.06 1.06 1.06 $1.25

CF3 =     €300 = $408.73
1.03 1.03 1.03 €

11
 Capital Budgeting from the Parent Firm’s
Perspective: Example

–$750 $257.28 $661.94 $408.73

0 1 2 3
Find the NPV using the cash flow menu of your financial
calculator and and interest rate i$ = 15%:
CF0 = –$750
CF1 = $257.28
CF2 = $661.94 I = 15
CF3 = $408.73 NPV = $242.99
12
 Capital Budgeting from the Parent Firm’s
Perspective: Alternative
Another recipe for international decision makers:

1. Estimate future cash flows in foreign currency.

2. Estimate the foreign currency discount rate.

3. Calculate the foreign currency NPV using the foreign

cost of capital.

4. Translate the foreign currency NPV into dollars using

the spot exchange rate
13
Foreign Currency Cost of Capital Method

– €600 €200 €500 €300

0 1 2 3

€ = 3% Let’s find i€ and use that on the euro

cash flows to find the NPV in euros.
i$ = 15%
Then translate the NPV into dollars
p$ = 6% at the spot rate.
$1.25
The current exchange rate is S0($/€) =
€ 14
 Foreign Currency Cost of Capital Method

• Before we find i€ let’s use our intuition.

• Since the euro-zone inflation rate is 3% lower than

the dollar inflation rate, our euro denominated
discount rate should be lower than our dollar
denominated discount rate.

15
 Finding the Foreign Currency Cost of
Capital: i€
Recall that the Fisher Effect holds that
(1 + e) × (1 + $) = (1 + i$)

real inflation nominal

rate rate rate
So for example the real rate in the U.S. must be 8.49%

(1 + i$) 1.15
(1 + e) = e= – 1 = 0.0849
(1 + $) 1.06
16
 Finding the Foreign Currency Cost of
Capital: i€
If Fisher Effect holds here and abroad then
(1 + i$) (1 + i€)
(1 + e$) = and (1 + e€) =
(1 + $) (1 + €)

If the real rates are the same in dollars and euros (e€ = e$)
we have a very useful parity condition:
(1 + i$) (1 + i€)
=
(1 + $) (1 + €)
17
 Finding the Foreign Currency Cost of
Capital: i€
If we have any three of these variables, we can find the
fourth:
(1 + i$) (1 + i€)
= In our example, we want to find i€
(1 + $) (1 + €)
(1 + i$) × (1 + €)
(1 + i€) =
(1 + $)
(1.15) × (1.03)
i€ = –1
(1.06)
i€ = 0.1175
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International Capital Budgeting: Example

– €600 €200 €500 €300

0 1 2 3

Find the NPV using the cash flow menu and i€ = 11.75%:
CF0 = –€600
I = 11.75
CF1 = €200
NPV = €194.39
CF2 = €500
$1.25 = $242.99
CF3 = €300 €194.39 ×
€ 19
 – €600 €200 €500 €300

0 1 2 3
€200 €500 €300
NPV = –€600 + + + = €194.39
1.1175 (1.1175)2 (1.1175)3

$1.25 = $242.99
€194.39 ×
€

–$750 $257.28 $661.94 $408.73

0 1 2 3
$257.28 $661.94 $408.73
NPV = –$750 + + + = $242.99
1.15 (1.15) 2
(1.15) 3
20
 Computing IRR
Recall that a project’s Internal Rate of Return (IRR) is
the discount rate that gives a project a zero NPV.

€200 €500 €300

NPV = –€600 + + + = €0
1+IRR€ (1+IRR€)2 (1+IRR€) 3

IRR€ = 28.48%

$257.28 $661.94 $408.73

NPV = –$750 + + + = $0
1+IRR$ (1+IRR$) 2
(1+IRR$) 3

IRR$ = 32.23%
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 Computing IRR
€200 €500 €300
NPV = –€600 + + + = €0
1+IRR€ (1+IRR€) 2
(1+IRR€) 3

CF0 = –€600
CF1 = €200 IRR€ = 28.48%
CF2 = €500
CF3 = €300

22
 Computing IRR
$257.28 $661.94 $408.73
NPV = –$750 + + + = $0
1+IRR$ (1+IRR$) 2
(1+IRR$) 3

CF0 = –$750
CF1 = $257.28 IRR$ = 24.85%
CF2 = $661.94
CF3 = $408.73

23
 Converting from IRR$ to IRR€
• Use the same IRP and PPP conditions that we
used to convert from one discount rate to
another.
1+IRR$ 1+IRR€In our example, it was easy to find IRR€
=
(1 + $) (1 + €) Finding IRR$ without converting all cash
flows into dollars is straightforward:

(1+IRR€)(1 + $) (1.2848)(1.06)

(1+IRR$) = i€ = –1
(1 + €) (1.03)
IRR$ = 32.23%
€ = 3%, p$ = 6% 24
 Risk Adjustment in the Capital Budgeting
Process

• Clearly risk and return are correlated.

• Political risk may exist along with business risk,
necessitating an adjustment in the discount
rate.

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 Sensitivity Analysis

• In sensitivity analysis, different estimates are

used for expected inflation rates, cost and
pricing estimates, and other inputs to give the
manager a more complete picture of the
planned capital investment.
• Lends itself to computer simulation.
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End