International capital budgeting decisions are similar to domestic capital decisions but are more demanding due to additional considerations that must be taken into account. Such additional considerations may include foreign currency considerations, transfer pricing and political (country) risk.
Exchange rate risk is one of the additional considerations that has to be taken into account. Exchange rate risk refers to the risk that arises due to fluctuations in the exchange rate between foreign and domestic currency. To counteract this risk, at least partly, organization may use various techniques. Particular cash flows can be hedged in the short-term. Further, an organization can borrow in the foreign market in the foreign currency to counteract long-term exchange rate risk.
Transfer prices is another consideration to be taken into account and refer to internal prices (which are different from market prices) on goods which are moving from one subsidiary to another within multinational corporation (MNE). It arises due to the tendency of multinational corporations (MNEs) to price products exchanged between subsidiaries at prices which are not aligned with the market prices to minimize the overall tax that the organization (MNE) has to pay.
Transfer prices have distorting and misleading effects on the capital budgeting decisions. In other words, due to transfer prices, the value of the cash flows and that of the project is likely to be distorted. This occurs because value of costs and incremental cash flows are distorted and therefore incorrect data is used in the capital budgeting analysis.
To counteract distorting and misleading effects of transfer prices on capital budgeting decisions, MNEs need to make few adjustments. Firstly, MNEs need to use market prices in capital budgeting decisions. Secondly, any fees and royalties paid from one subsidiary to another or to parent as well as appropriate fixed costs must be added back to the cash inflows.
Political (Country) Risk
Political (country) risk is another consideration that must be taken into account and refers to risks associated with doing business in particular country. Political risks may include difficulties with transferring returns on investment (repatriating profits) from the foreign country to domestic due to foreign government’s actions or even expropriation.
Political risk can be partly counteracted by sharing risks via partnerships with local businesses that will have a better understanding of how to most efficiently and safely conduct business in that specific country. Discount rates (cost of capital) should reflect the level of political risk.
Other country risks include domestics uprisings such as the May 2010 demonstrations in Bangkok, Thailand which effectively shutdown the commercial hub of the country. Such an upheaval would have impact the both domestic (delays in building hotels etc) and international decisions (changes in forex, country risk profiles, international insurance rates etc).
Overall, international capital budgeting decisions incorporate all the issues that must be considered when operating domestically. However, there are also few additional considerations that must be taken into account. The adjusted present value technique is often used to incorporate such additional risks into calculations.
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