Question

Choose ONE:

Capital budgeting typically requires some type of sensitivity analysis. In the case of international capital budgeting from the project perspective, analysts consider political risk, foreign exchange risk and foreign exchange risk. Identify and discuss the important aspects of these two types of risk considerations.

What is real option analysis? How does it differ from the discounted cash flow approach to project evaluation? Why do some decision-makers prefer the real option approach over the DCF approach? Make sure you fully defend your response with your research / comments from the textbook, lecture and outside sources.

Compared to a greenfield investment, list advantages and disadvantages of a cross-border merger or acquisition.

Answer 1

The impact of political risk and foreign exchange risk in international capital budgeting is that these two type of risks increases the cost of capital for international projects. With the increase in cost of capital the required rate of returns from international projects also increases.

Political risks arise from the fact that the capital budgeting investment is susceptible to change in rules applicable to an industry after an investment is made. Take a hypothetical example of Toyota. Toyota is considering making significant investments in Thailand to manufacture diesel powered SUVs. Recently the Thai Government banned the use of diesel vehicles after a period of 14 years, after which they will have to be sold as scrap. This has increased the cost of capital for Toyota and hence the rate of return required from their proposed investment has also increased to make the investment viable.

Foreign exchange risk arises from the volatility in exchange rates between the currencies of the home country and currency of the country in which investment is being made. When the exchange rates are volatile then the risk element of the investment increases due to variability in returns and cash flows. The variability in returns and cash flows occur as the investing company has to transfer values from one currency to another currency.

(I have selected the first one).