International Dimensions of Capital Budgeting

The massive multinational corporations (MNCs), whose names are household words around the globe and which have power that is the envy and fear of many governments grew large by making foreign direct investments, FDI.  Project evaluations, generally referred to as capital budgeting, are discussed in a domestic context in almost all introductory corporate finance courses. However, in the international arena, capital budgeting involves complex problems that are not shared in a domestic context.  These include, for example, the dependence of cash flows on capital structure – the amount of debt versus equity used in company financing – because of cheap loans from foreign governments.  This makes the cost of capital to the corporation different than the opportunity cost of capital of shareholders, where the latter is the correct discount rate.  There are also exchange-rate risks, country risks, multiple tiers of taxation, and sometimes restrictions on repatriating income.  There are several approaches to capital budgeting for traditional domestic investments, including net present value (NPV), adjusted present value (APV), interest rate of return, and payback period.  A question that arises in all capital budgeting applications, whether the investment project being evaluated is foreign or domestic, concerns the choice of the “nominal” versus the “real” discount rate.  The answer is that the choice does not matter, provided we are consistent.  That is, we reach the same conclusion if we discount nominal cash flows (those not adjusted for inflation) by the nominal discount rate, or real (inflation adjusted) cash flows by the real discount rate.  However, if cash flows are easier to forecast in today’s prices, as a practical matter it will be easier to use the real cash flows and discount at the real rate.  Capital budgeting decisions are very crucial for the success of any organization. They are long term and irreversible in nature. Firms have to invest present cash in anticipation of future returns. As future is always uncertain these decisions are complex in nature. These decisions in international context assume further significance, as the very nature of foreign investment is complex.