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International Capital Budgeting

NET PRESENT VALUE ANALYSIS

KW Corporation is an American firm manufacturing flat-packed kit wardrobes. Its export business has risen to the point that it is considering establishing a small manufacturing operation overseas in Narnia. KW`s decision to invest overseas should be based on the same criteria as a decision to invest in the United States ¤that is, the company needs to forecast the incremental cash flows from the project, discount the cash flows at the opportunity cost of capital, and accept those projects with a positive NPV. Suppose KW`s Narnian facility is expected to generate the following cash flows in Narnian leos:

The interest rate in the United States is 5 percent. KW`s financial manager estimates that the company requires an additional expected return of 10 percent to compensate for the risk of the project, so the opportunity cost of capital for the project is 5 + 10 = 15 percent.

Notice that KW`s opportunity cost of capital is stated in terms of the return on a dollar-denominated investment, but the cash flows are given in leos. A project that offers a 15 percent expected return in leos could fall far short of offering the required return in dollars if the value of the leo is expected to decline. Conversely, a project that offers an expected return of less than 15 percent in leos may be worthwhile if the leo is likely to appreciate.

You cannot compare the project`s return measured in one currency with the return that you require from investing in another currency. If the opportunity cost of capital is measured as a dollar-denominated return, consistency demands that the forecast cash flows should also be stated in dollars.

To translate the leo cash flows into dollars, KW needs a forecast of the leo/dollar exchange rate. Where does this come from? We suggest using the simple parity relationships in Figure 6.1. These tell us that the expected annual change in the spot rate (the southeast box in Figure 6.1) is equal to the difference between the interest rates in the two countries (the northwest box). For example, suppose that the financial manager looks in the newspaper and finds that the current exchange rate is 2 leos to the dollar (sL/$ = 2.0), while the interest rate is 5 percent in the United States (r$ = .05) and 10 percent in Narnia (rL = .10). Thus the manager sees right away that the leo is likely to depreciate by about 5 percent a year.8 For example, at the end of 1 year

Expected spot = spot rate ГЧ expected change rate in Year 1 in Year 0 in spot rate

The forecast exchange rates for each year of the project are calculated in a similar way as follows:

Year Forecast Exchange Rate

0 Spot exchange rate = L2.00/$

1 2.00 ГЧ (1.10/1.05) = L2.095/$

2 2.00 ГЧ (1.10/1.05)2 = L2.195/$

3 2.00 ГЧ (1.10/1.05)3 = L2.300/$

4 2.00 ГЧ (1.10/1.05)4 = L2.409/$

5 2.00 ГЧ (1.10/1.05)5 = L2.524/$

The financial manager can use these projected exchange rates to convert the leo cash flows into dollars:9

Year 0 1 2 3 4 5

Cash flow Ј 7.6 2.0 2.5 3.0 3.5 4.0

($ millions) 2.00 2.095 2.195 2.300 2.409 2.524

= Ј$3.8 = $.95 = $1.14 = $1.30 = $1.45 = $1.58

Now the manager discounts these dollar cash flows at the 15 percent dollar cost of capital:

NPV = Ј 3.8 + .95 + 1.14 + 1.30+ 1.45 + 1.58 1.15 1.152 1.153 1.154 1.155 = $.36 million, or $360,000

Notice that the manager discounted cash flows at 15 percent, not the United States risk-free interest rate of 5 percent. The cash flows are risky, so a risk-adjusted interest rate is appropriate. The positive NPV tells the manager that the project is worth undertaking; it increases shareholder wealth by $360,000.

THE COST OF CAPITAL FOR FOREIGN INVESTMENT

We did not say how KW arrived at a 15 percent dollar discount rate for its Narnian project. That depends on the risk of overseas investment and the reward that investors require for taking this risk. These are issues on which few economists can agree, but we will tell you where we stand.10

Remember that the risk of an investment cannot be considered in isolation; it depends on the securities that the investor holds in his or her portfolio. For example, suppose KW`s shareholders invest mainly in companies that do business in the United States. They would find that the value of KW`s Narnian venture was relatively unaffected by fluctuations in the value of United States shares. So an investment in the

Narnian furniture business would appear to be a relatively low-risk project to KW`s shareholders. That would not be true of a Narnian company, whose shareholders are already exposed to the fortunes of the Narnian market. To them an investment in the Narnian furniture business might seem a relatively high-risk project. They would therefore demand a higher return (measured in dollars) than KW`s shareholders.

9 Suppose KW`s managers do not go along with what market prices are telling them. For example, perhaps they believe that the leo is likely to appreciate relative to the dollar. Should they plug their own currency forecasts into their present value calculations? We think not. It would be stupid to undertake what might be an unprofitable investment just because management is optimistic about the currency. Given its exchange rate forecast, KW would do better to pass up the investment in wardrobe manufacturing and buy leos instead.

10Why don`t economists agree? One fundamental reason is that economists have never been able to agree on what makes one country different from another. Is it just that they have different currencies? Or is it that their citizens have different tastes? Or is it that they are subject to different regulations and taxes? The answer affects the relationship between security prices in different countries.