Conditions under which the capital expenditure of a foreign subsidiary might have a positive NPV in total currency terms but be unprofitable from the parent firms perspective
The Net Present Value (NPV) of a capital project is the current value of all cash inflows together with those at the termination of the project less the current value of all cash outflows (Ross et al., 2008). There are other methods of evaluating the capital expenditures including the IRR and the payback method, however, NPV takes into consideration the discounting factors and compensates conflicts that may accrue from the other methods (Ross et al., 2008). The rule of NPV is to accept a project if the NPV ≥ 0 and to reject the project if NPV < 0. This NPV decision rule is considered to be the superior framework for evaluating capital budgeting expenditure (Eun & Resnick, 2007).
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The goal of any investment is to maximize the returns. Maximizing on returns translates into the optimization of the shareholder’s wealth. In essence, big firms normally open their subsidiaries in foreign countries in order to maximize the wealth of the shareholders. These subsidiaries make capital investments that are expected to benefit the parent firm. However, this would not be the case depending on many factors including the inflation rates of the host country, differences in tax regimes, remittance restriction, and the exchange rate (Ross et al., 2008). Therefore, financial managers of parent firms have the obligation of optimizing the shareholder’s wealth.
The valuation method for these capital investments should provide a clear indication that the parent firm would benefit from such investments (Ross et al., 2008). As indicated, NPV and APV are the most commonly used valuation methods. During the analysis of the capital investments, a condition may exist in which a subsidiary of a parent firm may have a positive NPV or APV from its perspective yet have a negative NPV or APV from the perspective of the parent firm. This scenario occurs if certain cash flows cannot be sent back to the parent firm majorly due to the transmittal limitations of the host nation (Emery et al., 2007).
Moreover, this condition occurs when the home currency is expected to increase in value considerably over the life of the project resulting in unappealing cash flows when changed into the home currency of the parent company (Eun & Resnick, 2007). Finally, the perspectives may differ under the circumstances that the tax rate of the home country is higher making the capital project be loss-making from the viewpoint of the parent firm. The impact of the conditions is that the capital project becomes unbeneficial and unappealing to the parent firm and its stakeholders (Emery et al., 2007).
In conclusion, a capital investment might have a positive net present value (NPV) from the foreign subsidiary perspective but a negative NPV from the parent firm’s perspective under two conditions. First, if all the host countries’ cash flows are illegal to be sent back to the parent firm (Emery et al., 2007). Secondly, when the assumptions of purchasing power parity (PPP) do not hold. In the condition that purchasing power parity does not hold, the real exchange rate value will decrease in terms of the host country currency resulting in after-tax cash-flows yielding a reduced amount of units of the home currency (Eun & Resnick, 2007). This would be unexpected from the perspective of the parent firm. Further, this would yield a negative NPV.
Emery, D., Finnerty, J. & Stowe, J. (2007). Corporate financial management. New Jersey, NJ: Pearson-Prentice Hall.
Eun, C., & Resnick, B. (2007). International financial management. New York, NY: McGraw-Hill.
Ross, S., Westerfield, R. & Jaffe, J. (2008). Corporate finance. New York, NY: McGraw-Hill/Irwin.