POINT/COUNTER-POINT
Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign
Projects?
POINT: Yes. An MNC’s parent should use the forward rate for each year in which it will receive net cash
flows in a foreign currency. The forward rate is market-determined and serves as a useful forecast for
future years.
COUNTER-POINT: No. An MNC should use its own forecasts for each year in which it will receive net
cash flows in a foreign currency. If the forward rates for future time periods are higher than the MNC’s
expected spot rates, the MNC may accept a project that it should not accept.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
Answers to End of Chapter Questions
1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed from
the parent’s perspective? What additional factors that normally are not relevant for a purely domestic
project deserve consideration in multinational capital budgeting?
2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the capital
budgeting analysis?
List the various techniques for adjusting risk in multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
Explain how simulation can be used in multinational capital budgeting. What can it do that other risk
adjustment techniques cannot?
Multinational Capital Budgeting 2
3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter, explain
the sources of uncertainty surrounding a proposed project in Hungary by a U.S. firm. In what ways is
the estimated net present value of this project more uncertain than that of a similar project in a more
developed European country?
4. Accounting for Risk. Your employees have estimated the net present value of project X to be $1.2
million. Their report says that they have not accounted for risk, but that with such a large NPV, the
project should be accepted since even a risk-adjusted NPV would likely be positive. You have the final
decision as to whether to accept or reject the project. What is your decision?
5. Impact of Exchange Rates on NPV.
a. Describe in general terms how future appreciation of the euro will likely affect the value (from the
parent’s perspective) of a project established in Germany today by a U.S.-based MNC. Will the
sensitivity of the project value be affected by the percentage of earnings remitted to the parent each
year?
b. Repeat this question, but assume the future depreciation of the euro.
6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity of the
net present value to exchange rate forecasts.
7. September 11 Effects on NPV. In August 2001, Woodsen Inc. of Pittsburgh, PA considered the
development of a large subsidiary in Greece. In response to the September 11, 2001 terrorist attack on
Multinational Capital Budgeting 3
the U.S., its expected cash flows and earnings from this acquisition were reduced only slightly. Yet, the
firm decided to retract its offer because of an increase in its required rate of return on the project,
which caused the NPV to be negative. Explain why the required rate of return on its project may have
increased after the attack.
8. Assessing a Foreign Project. Huskie Industries, a U.S.-based MNC, considers purchasing a small
manufacturing company in France that sells products only within France. Huskie has no other existing
business in France and no cash flows in euros. Would the proposed acquisition likely be more feasible
if the euro is expected to appreciate or depreciate over the long run? Explain.
9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered
establishing a theme park in France, were the forecasted revenues and costs associated with the French
park sufficient to assess the feasibility of this project? Were there any other “relevant cash flows” that
deserved to be considered?
10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was
independent of its operations in the United States. The subsidiary’s performance was well above what
was expected. Consequently, when a British firm approached Athens about the possibility of acquiring
the subsidiary, Athens’ chief financial officer replied that the subsidiary was performing so well that it
was not for sale. Comment on this strategy.
11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing
below the cash flow projections developed before the subsidiary was established. Lehigh anticipated
that future cash flows would also be lower than the original cash flow projections. Consequently,
Lehigh decided to inform several potential acquiring firms of its plan to sell the subsidiary. Lehigh then
received a few bids. Even the highest bid was very low, but Lehigh accepted the offer. It justified its
decision by stating that any existing project whose cash flows are not sufficient to recover the initial
investment should be divested. Comment on this statement.
12. Impact of Reinvested Foreign Earnings on NPV. Flagstaff Corp. is a U.S.-based firm with a
subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the next 10
years since the interest rate earned on these securities is so high. Then, after 10 years, it will remit all
Multinational Capital Budgeting 4
accumulated earnings to the United States. What is a drawback of using this approach? (Assume the
securities have no default or interest rate risk.)
13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The
construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years. During
the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2
billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back to
the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5
billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy one
U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.
a. Determine the NPV for this project. Should Brower build the plant?
ANSWER:
Cash Flows:
Year 0 1 2 3
Investment –9
b. How would your answer change if the value of the cedi was expected to remain unchanged from its
current value of 8,700 cedis per U.S. dollar over the course of the three years? Should Brower
construct the plant then?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar over
the course of the three years:
Year 0 1 2 3
Investment –9
Multinational Capital Budgeting 5
14. Impact of Financing on NPV. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiary in
Japan. It is confident that the Japanese yen will appreciate against the dollar over time. The subsidiary
will retain only enough revenue to cover expenses and will remit the rest to the parent each year. Will
Ventura benefit more from exchange rate effects if its parent provides equity financing for the
subsidiary or if the subsidiary is financed by local banks in Japan? Explain.
ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity
15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering
establishing a consumer products division in Germany, which would be financed by German banks.
Santa Monica completed its capital budgeting analysis in August. Then, in November, the government
leadership stabilized and political conditions improved in Germany. In response, Santa Monica
increased its expected cash flows by 20 percent but did not adjust the discount rate applied to the
project. Should the discount rate be affected by the change in political conditions?
16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign
investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume that
several MNCs are likely to consider DFI in this country. The inflation rate in recent years has
averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5 per
hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting analysis for a
project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for each of the
next 10 years. The components produced are to be exported to Piedmont’s headquarters in the United
States, where they will be used in the production of computers. Do you think Piedmont will
overestimate or underestimate the net present value of this project? Why? (Assume that LDC’s
currency is tied to the dollar and will remain that way.)
17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for expansion
in Brazil. Brazil offers considerable potential because it has 150 million people and their demand for
soft drinks is increasing. However, the soft drink consumption is still only about one–fifth of the soft
drink consumption in the U.S. PepsiCo’s initial outlay was used to purchase three production plants
and a distribution network of almost 1,000 trucks to distribute its products to retail stores in Brazil.
Multinational Capital Budgeting 6
The expansion in Brazil was expected to make PepsiCo’s products more accessible to Brazilian
consumers.
a. Given that PepsiCo’s investment in Brazil was entirely in dollars, describe its exposure to exchange
rate risk resulting from the project. Explain how the size of the parent’s initial investment and the
exchange rate risk would have been affected if PepsiCo had financed much of the investment with
loans from banks in Brazil.
b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of the
project in Brazil.
c. What factors did PepsiCo likely consider in deriving its required rate of return on the project in
Brazil?
d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective of
the U.S. parent.
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already had
some existing operations in Brazil. When capital budgeting analysis was used to determine the
feasibility of this project, should the project have been assessed from a Brazil perspective or a U.S.
perspective? Explain.
Multinational Capital Budgeting 7
18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be
financed with U.S. dollars). All cash flows generated from the project were to be reinvested in
Thailand for several years. Explain how the Asian crisis would have affected the expected cash flows
of this project and the required rate of return on this project. If the cash flows were to be remitted to
the U.S. parent, explain how the Asian crisis would have affected the expected cash flows of this
project.
19. Tax Effects on NPV. When considering the implementation of a project in one of various possible
countries, what types of tax characteristics should be assessed among the countries? (See the chapter
appendix)
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion South
Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion and 4
billion won in the two years of operation, respectively. The project has no salvage value. The current
value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain constant
over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per U.S.
dollar after two years. Further assume that the funds are blocked and that the parent company will
only be able to remit them back to the U.S. in two years. How does this affect the NPV of the
project?
ANSWER:
Year 0 1 2
Investment –2
Operating CF 3 4
Net CF –2 3 4
ANSWER:
Multinational Capital Budgeting 8
Year 0 2
21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong,
where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that allows
for alternative exchange rate scenarios. Why would Carson use this approach rather than using the
pegged exchange rate as its exchange rate forecast in every year?
22. Decisions Based on Capital Budgeting. Marathon Inc. considers a one–year project with the Belgian
government. Its euro revenue would be guaranteed. Its consultant states that the percentage change in
the euro is represented by a normal distribution, and that based on a 95 percent confidence interval, the
percentage change in the euro is expected to be between 0 percent and 6 percent. Marathon uses this
information to create three scenarios: 0%, 3%, and 6% for the euro. It derives an estimated NPV based
on each scenario, and then determines the mean NPV. The NPV was positive for the 3% and 6%
scenarios, but was slightly negative for the 0 percent scenario. This led Marathon to reject the project.
Its manager stated that it did not want to pursue a project that had a one-in-three chance of having a
negative NPV. Do you agree with the manager’s interpretation of the analysis? Explain.
23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory in
Brazil, half the initial outlay will be funded by the parent’s equity and half by borrowing funds in
Brazil. Assume that Nike wants to assess the project from its own perspective to determine whether the
project’s future cash flows will provide a sufficient return to the parent to warrant the initial
investment. Why will the estimated cash flows be different from the estimated cash flows of Nike’s
shoe factory in New Hampshire? Why will the initial outlay be different? Explain how Nike can
conduct multinational capital budgeting in a manner that will achieve its objective.
Multinational Capital Budgeting 9
recognized within the cash flow estimates. Nike can determine whether the present value of the cash
flows received by the parent (measured in the manner explained above) exceeds the initial outlay
(measured in the manner explained above) of the project.
Advanced Questions
24. Break–even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the
project will generate total operating cash flows of $3,500,000, measured in today’s dollars using a
required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:
772,740$
)14.1)(000,500,3$000,000,4($
)1(
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3
n
t
t
nk
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CF
IOSV
25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it can
capitalize on its technology. It is risk-averse, but is attracted to the project because of a government
guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand
government at the end of the year. The payment by the New Zealand government is also guaranteed by
a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and
remitted to the parent in one year. The prevailing nominal one–year interest rate in New Zealand is 5%
while the nominal one-year interest rate in the U.S. is 9%. Zistine’s chief executive officer believes that
the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is
that the change in its value will be in accordance with the international Fisher effect. He also believes
that interest rate parity holds. He provides this information to three recent finance graduates that he just
hired as managers and asks them for their input.
a. The first manager states that due to the parity conditions, the feasibility of the project will be the
same whether the cash flows are hedged with a forward contract or are not hedged. Is this manager
correct? Explain.
b. The second manager states that the project should not be hedged. Based on the interest rates, the
IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project
will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a
premium, and therefore the forward rate will generate more U.S. dollar cash flows than the
expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct?
Explain.
ANSWER:
a. The first manager is wrong. The project is more feasible if it hedges, because the expected dollar
cash flows are the same whether Zistine hedges or not, and it can remove uncertainty surrounding
the dollar cash flows if it hedges.
b. The second manager is wrong. The IFE suggests an expected appreciation of the New Zealand
dollar by the same percentage as the forward premium (assuming IRP). Thus, the dollar cash flows
are just as high when hedged, and there is no uncertainty.
Multinational Capital Budgeting 10
c. The third manager’s reasoning is wrong. The forward hedge is expected to generate the same dollar
26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the use
of its technology to firms in Mexico. It already has received orders from Mexican firms that will
generate 3 million Mexican pesos (MXP) in revenue at the end of the next year. However, it might also
receive a contract to provide this technology to the Mexican government. In this case, it will generate a
total of MXP5,000,000 at the end of the next year. It will not know whether it will receive the
government order until the end of the year.
Today’s spot rate of the peso is $.14. The one–year forward rate is $.12. Blustream expects that the
spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to cover
development expenses (regardless of whether the Mexican government purchases the technology). It
will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax
effects. It decides to hedge the maximum amount of revenue that it will receive from the project.
a. Determine the NPV if Blustream receives the government contract.
ANSWER:
Multinational Capital Budgeting 11
c. Now consider an alternative strategy in which Blustream only hedges the minimum peso revenue
that it will receive. In this case, any revenue due to the government contract would not be hedged.
Determine the NPV based on this alternative strategy and assume that Blustream receives the
government contract.
Revenue converted to $:
d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it will
receive, determine the NPV assuming that it does not receive the government contract.
Revenue converted to $:
e. If there is a 50 percent chance that Blustream will receive the government contract, would you
advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may
receive? Explain.