Question

How should a firm adjust the capital budgeting analysis for investment in a country where the currency is extremely volatile?

Answer 1

If the currency is extremely volatile then the risk associated with the investment will be quite high. In such a case, the WACC (or cost of capital) should either be adjusted to account for the additional risk, by adding a risk premium. The firm can also incorporate the risk in its cash flow estimates and use the firm specific WACC. In case, cash flow estimates are adjusted for the risk, a sensitivity analysis is conducted (by using a range of values for each input variable) to see how the NPV changes. The range of NPVs will indicate whether the project will have a return at least equal to the WACC. If the range has some negative values then the investment may not be feasible.

To gauge the effect of exchange rate changes, the firm may evaluate the project by computing the NPV of only the equity investment in the project. The debt payments are accounted for in this method, so exchange rate fluctuation is captured. The present value of equity cash flows can be compared to the equity investment. This can be computed for a range of values to figure out an optimal capital structure which has the best NPV for the investment.