International Capital Budgeting

International capital budgeting involves evaluating investment projects located in different countries. It extends domestic capital budgeting principles but adds layers of complexity. The primary difference lies in the increased risk profile, primarily due to currency fluctuations, political instability, and differing economic environments. Successful international capital budgeting demands a comprehensive understanding of these risks and their impact on project cash flows and valuations.

Example: Imagine a US-based company considering building a manufacturing plant in Brazil. This requires assessing not only the direct costs and revenues but also understanding the Brazilian real's volatility against the US dollar, the political stability of Brazil, and the country's economic growth prospects.

Currency risk, also known as exchange rate risk, arises from fluctuations in exchange rates. This risk can impact the value of international projects significantly. There are three main types:

• Transaction Risk: The risk that the value of a company’s transactions will change due to exchange rate fluctuations. (e.g., An American company sells goods to a French customer invoiced in Euros. If the Euro depreciates against the USD, the American company will receive less in dollars.)
• Translation Risk: The risk that a company's financial statements will be affected by exchange rate changes. (e.g., A US-based company consolidates the financial statements of its UK subsidiary. Fluctuations in the GBP/USD exchange rate will affect the reported values on the parent company's balance sheet and income statement.)
• Economic Risk: The risk that changes in exchange rates will affect a company's competitive position. (e.g., A weakening of the Japanese Yen relative to the Euro could make Japanese goods cheaper in Europe, potentially increasing sales and profits for Japanese companies.)

Managing Currency Risk:

• Hedging: Using financial instruments to reduce exposure to currency fluctuations. Includes:
  • Forward Contracts: Agreements to buy or sell a currency at a predetermined exchange rate on a future date.
  • Currency Options: Giving the right, but not the obligation, to buy or sell a currency at a specific exchange rate (the strike price) on or before a specific date.
  • Natural Hedging: Matching revenues and expenses in the same currency (e.g., financing a project in a foreign currency with revenues generated in that same currency).
• Adjusting Cash Flows: Considering the impact of potential exchange rate movements on project cash flows. Discounting these cash flows by an appropriate risk-adjusted discount rate.

Example: Using Forward Contracts
A US company is expecting to receive €1,000,000 in one year. The current spot rate is $1.10/€ and the 1-year forward rate is $1.12/€. To hedge, the company could enter into a forward contract to sell the Euros at $1.12/€. If the spot rate in a year is actually $1.05/€, the company would have gained from the hedging, receiving $1,120,000 instead of $1,050,000. If the spot rate is $1.20/€, they would have lost out, but still have security in knowing exactly how much money they will get.

Political risk encompasses the potential for adverse actions by a foreign government that can affect a company's operations and profitability, including: expropriation, changes in tax laws, restrictions on repatriation of funds, and war. Country risk includes broader economic and social factors influencing investment success. These can include: inflation, interest rates, economic stability, and the legal and regulatory environment.

Assessing Political Risk:

• Qualitative Analysis: This involves researching the political climate, government stability, corruption levels, and legal systems of the host country. Sources include: government agencies, risk assessment services (e.g., PRS Group, Moody's, S&P), and news sources.
• Quantitative Analysis: This involves incorporating adjustments to the discount rate or cash flows.
  • Adjusting the discount rate: Using a country risk premium (CRP) based on sovereign bond spreads or similar metrics to reflect the added risk.
  • Reducing Cash Flows: Adjusting projected cash flows based on the probability of adverse events, like expropriation or currency controls.

Example: Incorporating Political Risk
An American company invests in a factory in a country. The political environment is unstable, with a 10% chance of expropriation. The project’s unlevered cost of capital is 12%. Calculate a political risk-adjusted net present value (NPV) considering the impact of possible loss of assets if expropriation occurs. This would include assigning a value to the assets that would be lost, and incorporating this risk into the cashflow analysis. Additionally, a country risk premium should be added to the cost of capital to reflect country-specific risks.

Calculating the cost of capital in an international setting requires adjusting the traditional weighted average cost of capital (WACC) to account for foreign operations. This involves:

• Identifying the appropriate benchmark cost of equity: Using the Capital Asset Pricing Model (CAPM) with a global market index (e.g., MSCI World Index) and possibly incorporating a country risk premium.
• Determining the cost of debt: Considering the borrowing rates in the foreign country or the parent company's borrowing costs.
• Calculating the WACC: Weighing the cost of equity and the cost of debt, considering the capital structure of the project or the company.
• Adjusted Present Value (APV) Approach: Consider the project’s unlevered cash flow and add the present value of financing side effects (like tax shields from debt financing). This can be particularly useful when dealing with projects in countries with different tax rates. The APV provides a simpler means to deal with the project’s specific risks, without trying to use a risk-adjusted discount rate.

Example: A US company wants to calculate the cost of capital for a project in Canada. The company’s cost of equity is 10%, cost of debt is 5%, and has a 60/40 debt-to-equity ratio. Applying the same capital structure and rates for the Canadian project would result in a WACC of 7%. However, if we know that the project is in a high-tax jurisdiction, then the APV method will allow for that information to be included directly in the analysis of the project's economic viability.

Transfer pricing involves the setting of prices for goods and services exchanged between related companies (e.g., a parent company and its subsidiary) across international borders. The method chosen by the company will impact project profitability, tax liabilities, and ultimately the investment decisions. Careful consideration must be paid to the tax regulations of the countries involved. Sophisticated strategies can include strategies to shift profits to low-tax jurisdictions. These strategies may be illegal or be subject to penalties, so compliance with international tax regulations is critical.

Impact on International Investment Decisions:

• Project Profitability: Transfer prices directly affect the profitability of projects. Higher transfer prices increase the profits of the selling unit and reduce the profits of the buying unit. Conversely, lower transfer prices have the opposite effect.
• Tax Implications: Transfer pricing can be used (legally or illegally) to shift profits to jurisdictions with lower tax rates, thereby minimizing the overall tax burden of the company. However, tax authorities scrutinize transfer prices to ensure that they reflect the market value of the transactions and are not used for tax avoidance.
• Investment Decisions: Transfer pricing affects project profitability and the location of where projects get developed. For example, a company may choose to locate a manufacturing facility in a country with lower labor costs and then use transfer prices to shift profits to a country with a lower corporate tax rate, making the investment more attractive.