CAPITAL BUDGETING Capital budgeting refers to the evaluation of prospective investment alterna-

tives and the commitment of funds to preferred projects. Long-term commitments of funds expected to provide cash flows extending beyond one year are called capital expenditures. Capital expenditures are made to acquire capital assets, like machines or factories or whole companies. Since

Financial Management of the Multinational Firm 179

risk, and foreign tax regulations. Comparing projects in different countries requires a consideration of how all factors will change over countries.

There are several alternative approaches to capital budgeting. A useful approach for multinational firms is the adjusted present value approach. We work with present value because the value of a dollar to be received today is worth more than a dollar to be received in the future, say one year from now. As a result, we must discount future cash flows to reflect the fact that the value today will fall depending on how long it takes before the cash flows are realized. The appendix to this chapter reviews present value calculations for readers unfamiliar with the concept.

For multinational firms, the adjusted present value approach is pre- sented here as an appropriate tool for capital budgeting decisions. The adjusted present value (APV ) measures total present value as the sum of the present values of the basic cash flows estimated to result from the investment (operations flows) plus all financial effects related to the investment, or

t51 ð11df Þ where 2 I is the initial investment or cash outlay, Σ is the summation

t51 ð11dÞ

operator, t indicates time or year when cash flows are realized (t extends from year 1 to year T, where T is the final year), CF t represents estimated basic cash flows in year t resulting from project operations, d is the discount rate on those cash flows, FIN t is any additional financial effect on cash flows in year t (these will be discussed shortly), and df is the discount rate applied to the financial effects.

CF t should be estimated on an after-tax basis. Problems of estimation include deciding whether cash flows should be those directed to the subsidiary housing the project, or only to those flows remitted to the parent company. The appropriate combination of cash flows can reduce the taxes of the parent and subsidiary.

180 International Money and Finance

Each of the flows in Equation (9.1) is discounted to the present. The appropriate discount rate should reflect the uncertainty associated with the flow. CF t is not known with certainty and could fluctuate over the life of the project. Furthermore, the nominal cash flows from operations will change over time as inflation changes. The discount rate, d, could be equal to the risk-free rate plus a risk premium that reflects the systematic risk of the project. The financial terms in FIN t are likely to be fixed in nominal terms over time. In this case, current market interest rates may

be acceptable as discount rates, df. Consider this example to illustrate the APV approach to capital budgeting decisions. Suppose Midas Gold Extractors has an opportunity to enter a small, developing country and apply its new gold recovery technique to some old mines that no longer yield profitable amounts of ore under conventional mining. Midas estimates that the cost of establish- ing the foreign operation will be $10 million. The project is expected to last for two years, during which period the operating cash flows from the new gold extracted will be $7.5 million per year. In addition, the new operating unit will allow Midas to repatriate an additional $1 million per year in funds that have been tied up in the developing country by capital controls. If Midas applies a discount rate of 10 percent to operating cash flows and 6 percent to the funds that will be freed from controls, then the APV is:

5 210 1 14:85 5 4:85 So the adjusted present value of the gold recovery project equals $4.85

million. The firm can compare this value to the APV of other projects it is considering in order to budget its capital expenditures in the optimum manner.

Capital budgeting is an imprecise science, and forecasting future cash flows is sometimes viewed as more art than science. The typical firm experiments with several alternative scenarios to test the sensitivity of the budgeting deci-

Financial Management of the Multinational Firm 181

for. Cash flows should be adjusted for the threat of loss resulting from govern- ment expropriation or regulation.

CAPITAL BUDGETING Capital budgeting refers to the evaluation of prospective investment alterna-