Question

Describe the items that would be included on a spreadsheet if you were to conduct a multinational capital budgeting analysis of investing dollars to expand your existing language business in a different location.

Assume that you recognize your limitations in predicting the future exchange rate of the invoice currency for your expanded business. You think that there are several possible exchange rate scenarios, each with equal probability of occurrence. Explain how you could use this information to estimate the future NPV and make a decision about whether to accept or reject the project.

Now assume that there is also much uncertainty about the demand for your service by individuals. Explain how you can attempt to incorporate this uncertainty along with the uncertainty of exchange rate movements so that you can make a decision about whether to accept or reject the project.

Explain how you would derive a required rate of return for your capital budgeting analysis. What type of information would you use to derive the required rate of return?

Answer 1

The items which are included in the spread sheet of capital budgeting analysis of a mulinational company can be explained in following points:

1) Initial investment of setting the business at other location

2) Increase or change in direct cost or variable cost of material supplied by language business

3) Change in fixed cost like rent or lease expenses of other location.

4) Salvage value of the plant and machinery to calculate depriciation and net cash flow

4) Depriciation charged as it will be deducted from taxable income

5) Taxes

6) The discount rate to convert the net cash flow into present value.

Thus, above items will be included in the capital budgeting analysis. If the present value of net cash flow is positive after considering above factors, the investmet can be done to expand the business.

Calculation of NPV when uncertainty of exchange rate exists: Following process is followed to determine NPV in such cases:-

1) Sensitivity analysis will be used to calculate NPV is such cases

2) The potential change in exchange rates are determined like +-5% or +-10% etc

3) NPV will be calculated for this potential changes

4) Equal probabilities will be assigned to above calculated NPVs.

5) Thus, the distribution of NPVs are assessed.

6) If the positive NPV is determined, project is accepted otherwise project is rejected.

Calculation of NPV when uncertainty of exchange rate exists: Following process is followed to determine NPV in such cases:-

1) Sensitivity analysis will be used to calculate NPV is such cases

2) The potential change in exchange rates are determined like +-5% or +-10% etc

3) Potential change in demand are also determined like +-5% or +-10% etc

4) NPV will be calculated for each possible potential changes

5) Probabilities will be assigned to above calculated NPVs.

6) The distribution of NPVs are assessed.

7) If the positive NPV is determined project is accepted otherwise project is rejected.

Calculation of required rate of return (RRR):

Required rate of return is the minimum rate which should be earned by an project to make it worth investing. The project is accepted when it earns equal to or more than the required rate of return. The project is rejected if it earns less then the required rate of return. It is calculated by using following formula:

  

where:

Rf is the risk free rate of the rate of return which can be earned by investing the same amount in risk free market instruments. Thus, Rf is required to derived RRR.

Rm is the risk prevailent in the market regarding our project. It may be risk of uncerain demand or exchange rate. This information is used to derive RRR

B is the beta of our project. Beta is the relative measure of volatility which shows the relation of our project's performance and market risk. Thus, the beta is also calculated to derive RRR.

By determining above values, RRR is calculated.