Multinational Financial Management: International Capital Budgeting Although the
ID: 2733353 • Letter: M
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Multinational Financial Management: International Capital Budgeting
Although the same basic principles of capital budgeting apply to both foreign and domestic operations, there are some key differences. First, cash flow estimation is more complex for overseas investments. Most multinational firms set up separate subsidiaries for each foreign country in which they operate. The relevant cash flows for the parent company are the dividends and royalties paid by the subsidiaries to the parent. The process of sending cash flows from a foreign subsidiary back to the parent company is known as -Select-reinvestmentrepatriationrevaluationCorrect 1 of Item 1 of earnings. Second, these cash flows must be converted into the parent company's currency, so they are subject to exchange rate risk. Dividends and royalties are normally taxed by both foreign and home-country governments. In addition, a foreign government may restrict the -Select-reinvestmentrepatriationrevaluationCorrect 2 of Item 1 of these earnings to the parent company. From the perspective of the parent company, the relevant cash flows for foreign investment analysis are those that the subsidiary is actually expected to send back to the parent.
In addition to the complexities of the cash flow analysis, the cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky. Higher risks might arise from exchange rate risk and political risk. A lower risk might result from the benefits of international diversification.
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Quantitative Problem: International Machinery Company (IMC) is a Swedish multinational manufacturing company. Currently, IMC's financial planners are considering undertaking a 1-year project in the United States. The project's expected dollar-denominated cash flows consist of an initial investment of $2,350 and a cash inflow the following year of $3,850. IMC estimates that its risk-adjusted cost of capital is 18%. Currently, 1 U.S. dollar will buy 6.2 Swedish kronas. In addition, 1-year risk-free securities in the United States are yielding 4%, while similar securities in Sweden are yielding 3%.
a. If the interest parity holds, what is the forward exchange rate of Swedish krona per U.S. dollar? Round your answer to 2 decimal places. Do not round intermediate calculations.
Swedish krona per U.S. dollar
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b. If IMC undertakes the project, what is the net present value and rate of return of the project for IMC in home currency? Round your answer to 2 decimal places. Do not round intermediate calculations.
NPV: Swedish kronas
Rate of return: %
Explanation / Answer
The process of sending cash flows from a foreign subsidiary back to the parent company is known as -Select-repatriation of earnings.
In addition, a foreign government may restrict the repatriation of these earnings to the parent company.
If interest rate parity holds
forward exchage rate= spot rate* (1+risk free rate in US)/(1+risk free rate in Sweden)
=(6.2*(1+4%))/(1+3%)
=6.26
forward exchage rate,1 USD=6.26 Swedish krona
Thus 6.26 swedist krona per us dollar will be forward exchange rate.
B. If IMC undertakes the project, what is the net present value and rate of return of the project for IMC in home currency? Round your answer to 2 decimal places. Do not round intermediate calculations.
Initial investment is of $2350 and exchange rate is 1USD= 6.2 Swedish Kronas
Thus 2850 will correspond to 2350*6.2=14570 Swedish Kronas
A cash inflow the following year of $3,850 and forward exchange rate is 1USD = 6.26 Swedish Kronas
Thus 3350 will correspond to 3850*6.26=24101 Swedish Kronas
Initial Investment= 14570
Year 1 cash flow = 24101 Swedish Kronas
IMC estimates that its risk-adjusted cost of capital is 18%
Thus PV of a cash flow= 24101/(1+18%)
PV of a cash flow=20424.58
NPV= PV of a cash flow- initial investment
=20424.58-14570
NPV=5854.58 Swedish kronas
Rate of return= Final- initial invesment/ initial investment*100
=(24101-14570)/14570*100
Rate of return=65.41%
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