Question

1. What are the major unique (cash flows and risks) characteristics for MNCs (multinational corporations) that make the standard (domestic) capital budgeting practices inappropriate and inaccurate?

Answer 1

Multinational companies are constantly acquiring and disposing of assets globally in the normal course of business. Shareholder wealth is created when the MNC makes an investment that will return more (in present value terms) than what it costs. Among the most important decisions that MNC managers face is the choice of capital projects globally. These investments will determine the firm's competitive position in the marketplace, its overall profitability, and, ultimately, its long-run survival.

Multinational capital budgeting, like domestic capital budgeting, focuses on the cash flows of prospective long-term investment projects. It is used both in traditional foreign direct investment analysis, such as the construction of a chain of retail stores in another country, as well as cross-border mergers and acquisitions activity. Capital budgeting for a foreign project uses the same net present value (NPV) discounted cash flow model used in domestic capital budgeting. However, multinational capital budgeting is considerably more complex due to a number of additional factors that need to be considered. Some of these factors are as follows.

Parent versus project cash flows: Parent (that is, home-country) cash flows must be distinguished from project (that is, host-country) cash flows. While parent cash flows reflect all cash flow consequences for the consolidated entity, project cash flows look only at the single country where the project is located. For example, cash flows generated by an investment in Spain may be partly or wholly taken away from one in Italy, with the end result that the net present value of the investment is positive from the Spanish affiliate's point of view but contributes little to the firm's world-wide cash flows.

Financing versus operating cash flows: In multinational investment projects, the type of financing package is often critical in making otherwise unattractive projects attractive to the parent company. Thus, cash may flow back to the parent because the project is structured to generate such flows via royalties, licensing fees, dividends, and so on. Unlike in domestic capital budgeting, operating cash flows cannot be kept separate from financing decisions.

Foreign currency fluctuations: Another added complexity in multinational capital budgeting is the significant effect that fluctuating exchange rates can have on the prospective cash flows generated by the investment. From the parent's perspective, future cash flows abroad have value only in terms of the exchange rate at the date of repatriation. In conducting the analysis, it is necessary to forecast future exchange rates and to conduct sensitivity analysis of the project's viability under various exchange rates scenarios.

Long-term inflation rates: Differing rates of national inflation and their potential effect on competitiveness must be considered. Inflation will have the following effects on the value of the project: a) it will impact the local operating cash flows both in terms of the prices of inputs and outputs and also in terms of the sales volume depending on the price elasticity of the product, b) it will impact the parent's cash flow by affecting the foreign exchange rates, c) it will affect the real cost of financing choices between foreign and domestic sources of capital.

Subsidised financing: In situations where a host government provides subsidised project financing at below-market rates, the value of that subsidy must be explicitly considered in the capital budgeting analysis. If a company uses the subsidised rates in the analysis, there is an implicit assumption that the subsidy will exist through the life of the project. Another approach might be to incorporate the subsidised interest rates into the analysis by including the present value of the subsidy rather than adjusting the cost of capital.

Political risk: This is another factor that can significantly impact the viability and profitability of foreign projects. Whether it be through democratic elections or as a result of sudden developments such as revolutions or military coups, changes in a country's government can affect the attitude in that country towards foreign investors and investments. This can affect the future cash flows of a project in that country in a variety of ways. Political developments may also affect the life and the terminal value of foreign investments.