Factors Determining the Currency to Analyze an International Capital Budgeting Opportunity
The evaluation of an international capital budgeting opportunity is similar to the local capital budgeting decision (Moran 63). The company needs to estimate future cash flows from its investment in the international market over the period in the same way as it does for local investments. However, the value of these cash flows is affected by the exchange rate of the international currency to the local currency.
There are different factors, which affect the decision regarding the choice of currency for appraising international capital projects. These include the exchange rate risk, which is determined by the fluctuations observed in the value of the international currency. If the international currency depreciates against the local currency, then the company will receive fewer funds dominated in the local currency. On the hand, if the foreign currency appreciates against the local currency, then the company will receive more funds dominated in the local currency. However, in this case, the company may incur higher tax payment in the home country if it is subject to double taxation. Therefore, it is recommended that multinational investment decisions should always be valued in terms of the local currency (Madura 297).
Moreover, it could be stated that the currency exchange rate is affected by several other economic factors, which must also be taken into consideration when deciding on the approach to be used for calculating the net present value of the international project. The economic conditions of the international market also affect the currency choice for evaluating the international project. If the economic conditions are weakening, then they are likely to affect the value of currency negatively. For example, if the inflation rate in the international market is increasing, then the demand for its currency will increase locally, and it will cause the value of its currency to depreciate. Therefore, in this case, using foreign currency for investment appraisal will not be appropriate.
Furthermore, if the interest rate in the international market is higher, then it may be feasible for the company to retain its funds in that market and earn a higher return (Brigham and Houston 673). Therefore, in this case, it is appropriate to use foreign currency for appraisal. Furthermore, if the company plans to raise funds for the project in the international market, then it should consider using the foreign currency for investment appraisal as the cost of capital would be affected by sources of finance available in the international market.
Discounting Foreign Currency Cash Flows and Converting the NPV to Home Currency or Converting All Foreign Currency Flows to Home Currency and Finding the NPV
The second question refers to the two approaches to calculating the net present value of an international project (Pizzutilo 58). The two approaches are expected to generate the same net present value. This argument can be explained by considering an example of an international capital budgeting opportunity. In both cases, the first step is to determine post-tax cash flows in the overseas currency. If these cash flows are converted to the home currency and discounted by using the company’s cost of capital, then the net present value obtained would be the same as the other approach. The alternative approach is to convert the company’s cost of capital to an overseas equivalent for discounting cash flows denominated in the foreign currency (Eun and Resnick 438). The net present value of the internal project is then converted to the home currency, which will be equal to the value obtained in the previous approach.
Works Cited
Brigham, Eugene F. and Joel F. Houston. Fundamentals of Financial Management. 14th ed., Cengage Learning, 2016.
Eun, Cheol S. and Bruce G. Resnick. International financial management. 7th ed., McGraw-Hill Education, 2015.
Madura, Jeff. International Financial Management. 13th ed., Cengage Learning, 2015.
Moran, Alan. Managing Agile: Strategy, Implementation, Organisation and People. Springer, 2015.
Pizzutilo, Fabio. “Rethinking Multinational Enterprises’ Capital Budgeting in the Globalized New Millennium.” Journal of Finance and Economics 2.3 (2014): 58-59.