12.11 Investment decisions
The process of investment in land, equipment, buildings, working capital, raw material deposits and other assets for future economic gain needs careful analysis. The process of quantifying the costs, benefits and risk of investment options is called capital budgeting.
Capital budgeting
Capital budgeting f or a foreign project is basically the same as for a domestic project. The firm estimates the cash flow from the project, applies an appropriate discount rate of return (DRR) to determine the project's net present value (NPV) and proceeds with the project if the net present value of the discounted cash flow (DCF) is greater than zero.
Among the factors which complicate capital budgeting in an international firm are:
- distinguishing cash flow to a project from cash flow to the parent company
- political and economic risks
- recognising the link between the course of finance - which is fundamentally private or institutional investors - and cash flow to the parent company. An explanation follows in the next paragraph.
The parent company provides the money for the foreign project but the cash generated by the investment flows to the project. If profits cannot be repatriated to the parent because of host country tax or reinvestment policies, the NPV of the project to the parent company will be adversely affected. Capital budgeting of foreign investment opportunities must keep in mind the interests of investors who are concerned with dividends received, not with cash generated by the project. This problem with FDI is not as serious as it once was because host governments are usually concerned with making investment in their country attractive to MNEs.
Political risk
The concept of political risk is easy to grasp: the assessment of future political risk is a more difficult proposition. To illustrate the point, let's pose a rhetorical question.
How many MNE financial controllers could see that:
- the Islamic revolution in Iran in 1979 would lead to the expropriation of foreign assets?
- the fall of the Berlin Wall in 1989 would lead to investment opportunities in the Soviet bloc?
- the Union Carbide disaster at Bhopal in India in 1984 would threaten the continued existence of the company?
Economic risk
We discussed economic risk in Chapter 6. You may recall that the discussion focused on inflation rates and currency exchange rates. If you do not remember, it would be a good idea to pause here and re-read Chapter 6. However, as with political risk, quantifying economic risk is also a chancy business.
We end this discussion on investment decisions by referring to your textbook. In the next reading, note that Hill's (2005) summary of 'Risk and capital budgeting' brings these two topics together by saying that the discount rate for 'risky' countries carries a premium. The example Hill cites (2005, pp. 672-673) to illustrate the point is that a DRR of 6% might suffice for Britain , the US and Germany , but 20% might be more appropriate for Russia .
In your text
Hill 2005, Chapter 20, pp. 667-673.
We now consider the second of the three basic decisions - financing.
Previous Page