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Projects
Capital Budgeting
Capital budgeting requires estimation of a project’s
incremental cash flows - which are determined
by estimating worldwide cash flows with and
without the project.
There are two main methods of international capital
budgeting, centralized and decentralized
Centralized requires exchange rate forecasts
Decentralized requires a local-currency cost of
capital.
The method a firm selects should depend on its
comparative advantage in estimating each.
Cost of Capital I
CAPM determines a project’s equity cost of capital -
it prices only the systematic risk of the project.
If risk premia are identical and uncovered interest
parity holds, the only difference between home
and foreign costs of capital will be anticipated
exchange rate changes.
In this case, centralized and decentralized capital
budgeting will deliver identical results - the
foreign cost of capital will perform dual roles of
discounting and adjusting for anticipated
exchange rate changes.
Cost of Capital II
If anticipated deviations from uncovered interest
parity exist, centralized capital budgeting will
deliver higher returns when deviations are
positive and lower when negative.
Centralized is also easier to implement if UIP fails.
If investors do not hold worldwide market portfolio,
decentralized capital budgeting will raise real
capital costs and thereby lower project NPVs
because foreign investor portfolios will co-vary
more with project returns than home country
investor portfolios.
Country Specfic Risk
Adjusted Present Value
Internal External
Financing Foreign Projects
Financing
Internal External
Internal External
Home Foreign
Currency Currency
Financing Foreign Projects
Financing
Internal External
Internal External
External vs. Internal Financing
Internal External
Debt Equity
External Debt vs. External Equity
- tax shields
- interest subsidies
Additionally, the monitoring benefits debt may add
over equity addressed in traditional finance
settings will be applicable here.
Financing Foreign Projects
Financing
Internal External
Home Foreign
Currency Currency
Home vs. Host Country Equity
Home and host currency costs of equity capital
would be identical if uncovered interest parity held
and if all investors held diversified world market
portfolio.
Where investors hold domestically-biased assets,
host country cost of capital is likely to be higher.
The project will likely have higher correlation
between its returns and the local economy.
From the host country investor perspective, the
project will contain more systematic risk.
Home vs. Host Country Equity
From a political risk standpoint, issuing host
country equity is likely to have two divergent
effects:
- political risks (i.e. probability of
expropriation) are likely to be reduced.
- political risks are likely to be more
systematic to risks of host country
shareholders’ portfolios.
Financing Foreign Projects
Financing
Internal External
Home Foreign
Currency Currency
International Debt Financing I
Debt denomination decision is often cast in the
same terms as international capital budgeting:
centralized vs. decentralized debt finance.
An MNC which borrows primarily in the home
country is said to centralize debt finance (though an
MNC certainly can centralize debt finance in any
single country).
An MNC which undertakes borrowing in countries
where operations are located is said to decentralized
debt finance.
International Debt Financing II
Ex-ante deviations from UIP make centralizing debt
finances attractive. If a given currency’s low
interest rates are not expected to be offset by
appreciation of that currency, firms that can access
the low interest rates and centralize debt finance
there will profit.
Even if UIP holds ex-ante, MNCs will generally have
differential access to markets.
Put simply, domestic firms usually enjoy lower
interest rates in home-country debt markets
than foreign firms.
The Debt Denomination Decision