Multinational Capital Budgeting

Up to now, we have discussed the general environment in which multinational firms operate. In the remainder of the chapter, we will see how international factors affect key corporate decisions. We begin with capital budgeting. Although the same basic principles of capital budgeting analysis apply to both foreign and domestic operations, there are some key differences. First cash flow estimation is more complex for overseas investments. Most multinational firms set up separate subsidiaries in each foreign country in which they operate and the relevant cash flows for the parent company are the dividends and royalties paid by the subsidiaries to the parent. Second these cash flows must be converted into the parent company’s currency hence they are subject to exchange rate risk. For example General Motor’s German subsidiary may make a profit of 100 million marks in 1998 but the value of this profit to GM will depend on the dollar mark exchange rate: How many dollars will 100 million marks buy?

Dividends and royalties are normally taxed by both foreign and home country governments. Furthermore, a foreign government may restrict the amount of the cash that may be repatriated to the parent company. For example some governments place a ceiling, stated as a percentage of the company’s net worth, on the amount of cash dividends that a subsidiary can pay to its parent. Such restrictions are normally intended to force multinational firms to reinvest earnings in the foreign country although restrictions are sometimes imposed to prevent large currency outflows which might disrupt the exchange rate.

Whatever the host country’s motivation for blocking repatriation of profits the result is that the parent corporation cannot use cash flows blocked in the foreign country to pay dividends to its shareholders or to invest elsewhere in the business. Hence from the perspective of the parent organization the cash flows relevant for foreign investment analysis are the cash flows that the subsidiary is actually expected to send back to the parent. The present value of those cash flows is found by applying an appropriate discount rate and this present value is then compared with the parent’s required investment to determine the project’s NPV.

In addition to the complexities of the cash flow analysis. the cost of capital may be different for a foreign project than for an equivalent domestic project, because foreign projects may be more or less risky. A higher risk could arise from two primary sources (1) exchange rate risk and (2) political risk. A lower risk might result from international diversifications.

Exchange rate risk relates to what the basic cash flows will be worth in the parent company’s home currency. The foreign currency cash flows to be turned over to the parent must be converted into U.S. dollars by translating them at expected future exchange rates. An analysis should be conducted to ascertain the effects of exchange rate variations and on the basis of this analysis an exchange rate risk premium should be added to the domestic cost of capital to reflect exchange rate risk. It is sometimes possible to hedge against exchange rate fluctuations but it may not be possible to hedge completely especially on long term projects. If hedging is used the costs of doing so must be subtracted from the project’s cash flows.

Political risk refers to potential actions by a host government which would reduce the value of a company’s investment. It includes at one extreme the expropriation without compensation of the subsidiary’s assets but it also includes less drastic actions that reduce the value of the parent firm’s investment in the foreign subsidiary including higher taxes.  tighter repatriation or currency controls and restrictions on prices charged. The risk of expropriation is small in traditionally friendly and stable countries such as Great Britain or Switzerland. However in Latin American. Africa the Far East and Eastern Europe the risk may be substantial. Past expropriations include those of ITT and Anaconda Copper in Chile, Gulf Oil in Bolivia, Occidental Petroleum in Libya, Enron corporation in Peru and the assets of many companies in Iraq. Iran and Cuba.

Several organizations rate the political risk of countries. For example, International Business Communications a London company, published the International Country risk Guide which contains individual ratings for political financial and economic risk. Alone with a composite rating for each country. Table 18-4 contains selected portions of a recent report. The political variable which makes up 50 percent of the composite rating includes factors such as government corruption and the gap between economic expectations and reality. The

		Political	Financial	Economic	Composite
Rank	Country	Risk	Risk	Risk	Risk
1	Switzerland	93.0	50.0	39.5	91.5
9	United States	78.0	49.0	39.5	83.5
10	Canada	81.0	48.0	37.0	83.0
25	Venezuela	75.0	40.0	36.0	75.5
50	Israel	58.0	33.0	34.5	63.0
75	Panama	47.0	24.0	38.0	54.5
100	Peru	45.0	28.0	21.5	47.5
125	Burma	27.0	9.0	22.5	28.5
129	Liberia	10.0	8.0	12.0	15.0

financial rating looks at such things as the likelihood of losses from exchange controls and loan defaults. The economic rating takes into account such factors as inflation and debt-service costs.

The best or least risky score is 100 for political factors and 50 each for the financial and economic factors and the composite risk is a weighted average of the political, financial and economic factors. The United States is ranked ninth, below Switzerland, Luxembourg. Norway, Austria, Germany, Netherlands, Brunei, and Japan. Liberia. as shown in table 184 is ranked last.

If a company’s management has a serious concern that a given country might expropriate foreign assets it will probably not make significant investments in that country. However companies can take steps to reduce the potential loss from expropriation in three major ways: (1) finance the subsidiary with local capital. (2) structure operations so that the subsidiary has value only as a part of the integrated corporate system and (3) obtain insurance against economic losses from expropriation from a source such as the overseas private Investment Corporation (OPIC). In the latter case insurance premiums would have to be added to the project’s cost.