INTRO TO CORPORATE FINANCE AND INVESTMENTS

TOPIC: INTERNATIONAL CAPITAL BUDGETING

Professor
M. Max Croce,
SDA Professor

SDA Bocconi Asia Center I Capital Markets

 Outline

 International Capital Budgeting: rules of thumb

 Example: International co-movements matter

SDA Bocconi Asia Center I Capital Markets

 Rules of Thumb of Capital Budgeting

Undertake a project when NPV>0.

Challenges associated to the NPV approach.
Forecast future cash-flow
Find the appropriate discount rate

Rules of thumb for the discount rate:

The discount rate must match the riskiness of the cash-flows (CAPM helps)
The discount rate should match the duration of the project
In international finance: must account for FX risk

SDA Bocconi Asia Center I Capital Markets

 Foreign Projects: Multiple Approaches

Approach #1:
discount all foreign cash-flows using foreign discounts rates
Convert the foreign NPV in local currency using the sport FX
Very often misleading!

Approach #2:
Convert all foreign cash-flows into local units accounting for FX risk
Discount future cash-flows using appropriate local discount rates

SDA Bocconi Asia Center I Capital Markets

 A Risky Foreign Project that Becomes Safe
 Consider an investment in Macroland for 1 MCL—their currency is called MCL. The project lasts one period and is
expected to pay 1.065 MCL with a spread of +/- 10%.
 The short-term rate in India is 6%, whereas in Macroland you have 2%. The CAPM-beta of this project is
estimated to be 1 and the market risk premium in Macroland is 5%.
 The spot price INR/MCL S=100, E[S’]= 100, and the forward rate is F= (1.06/1.02)*S = 104. The FX co-moves
negatively with the cash-flows of the project (i.e., if the cash flow appreciates by 10%, the FX depreciates by 10%)
NOTE: F is approximated to be 104.

Method 1: compute NPV in MCL and then convert at spot FX.

 NPV = (-1 + 1.065/(1+ .02 + 1*.05) )*S = -.005*100 = -0.5<0 [Project rejected in Macroland and hence in India]

Method 2: compute cash-flows in INR using F and discount using Indian rates.
 NPV = -1*S + 1.065/ (1 + .06 +1*.05) * F = -100 + 1.065*104/1.11 = – 0.21 [Project rejected in India: WRONG, WHY?]

 Method 3: realize that the FX is a perfect natural hedge! Use Indian risk-free rate.
NPV = -1*S + (1.065*S)/ (1 + .06) = 0.50 [Great project from an Indian perspective!]
SDA Bocconi Asia Center I Capital Markets
 THANKS YOU

SDA Bocconi Asia Center I Capital Markets