Overseas Production: Alternative Approaches 21.5 LO4 There are two approaches for evaluating international capital budgeting projects: Home Currency Approach Foreign Currency Approach

Home Currency Approach LO4 Estimate cash flows in foreign currency Estimate future exchange rates using UIP Convert future cash flows to dollars Discount using domestic required return

Example: Home Currency Approach LO4 Your company is looking at a new project in Mexico. The project will cost 9 million pesos. The cash flows are expected to be 2.25 million pesos per year for 5 years. The current spot exchange rate is 9.08 pesos per Canadian dollar. The risk-free rate in the Canada is 4% and the risk-free rate in Mexico 8%. The dollar required return is 15%. Should the company make the investment?

Foreign Currency Approach LO4 Estimate cash flows in foreign currency Use the IFE to convert domestic required return to foreign required return Discount using foreign required return Convert NPV to dollars using current spot rate

Example: Foreign Currency Approach LO4 Use the same information as the previous example to estimate the NPV using the Foreign Currency Approach Mexican inflation rate from the International Fisher Effect is 8% - 4% = 4% Required Return = 15% + 4% = 19% PV of future cash flows = 6,879,679 NPV = 6,879,679 – 9,000,000 = -2,120,321 pesos NPV = -2,120,321 / 9.08 = -233,516 PV annuity: N = 5; PMT = 2,250,000; I/Y = 19; CPT PV = 6,879,679 Remember that the required return is approximately equal to the real rate + the inflation rate. Difference comes from the level of rounding in the spreadsheet versus rounding the required return.

Repatriated Cash Flows Often some of the cash generated from a foreign project must remain in the foreign country due to restrictions on repatriation Repatriation can occur in several ways Dividends to parent company Management fees for central services Royalties on the use of trade names and patents