Introduction to Corporate Finance

17: International Investment Decisions

Next, multiply each period’s cash flow in €s times the matching spot or forward exchange rate to

obtain a sequence of cash flows in dollars (rounded to the nearest thousand dollars):

Currency Initial investment Year 1 Year 2 Year 3

∈ 2,000,000 × 0.95 900,000 × 0.9319 850,000 × 0.9142 800,000 × 0.8967

$ 1,900,000 839,000 777,000 717,000

All that remains is to discount this project’s cash flows at an appropriate risk-adjusted Australian

interest rate. But how do we determine that rate? Recall that the European discount rate used to calculate

the euro-denominated NPV was 10%, 5% above the European risk-free rate. Intuitively, we might expect

that the comparable Australian rate is 8%, representing a 5% risk premium over the current risk-free rate

in Australia. That intuition is more or less correct. To be precise, use the following formula to solve for

the project’s required return in Australian dollar terms:

.

.

.

(1 r)( 10 10) r7.9%

(1 00 3)

(1 00 5)

+=+

+

+

=

This equation takes the project’s required return in euro terms, 10%, and rescales it to dollar terms by

multiplying by the ratio of risk-free interest rates in each country. We can verify that discounting the dollar-

denominated cash flows using this rate results in the same NPV (again, rounding to the nearest thousand

dollars) that we obtained by discounting the cash flows in euros and converting to dollars at the spot rate.

$, ,

$,

.

$,

.

$,

.

NPV 1 900 000 $,

839000

1 079

777000

1 079

717000

1 079

=− ++ 12 += 3 116000

These calculations demonstrate that a company does not have to ‘take a view’ on currency movements

when it invests abroad. Whether the company hedges a project’s cash flows using forward contracts, or

whether it calculates a project’s NPV in local currency before converting to the home currency at the spot

exchange rate, future exchange rate movements need not cloud the capital budgeting decision.

17-2b COST OF CAPITAL

In the preceding example, we assumed that the project’s cost of capital in Europe was 10%, which

translated into a dollar-based discount rate of 7.9%. But where did the 10% come from? We return to the

lessons of Chapter 11, namely that the discount rate should reflect the project’s risk. One way to assess

that risk is to calculate a beta for the investment. How should a company calculate a beta when it makes

an investment overseas?

If a company’s shareholders cannot diversify internationally, when the company invests abroad it

should calculate a project’s beta by measuring the movement of similar European investments in relation

to the Australian market, not the European market. The reason is that, from the perspective of Australian

investors, the project’s systematic risk depends on its relationship with the other assets that Australian

investors already own. An Australian company planning to build an electronics manufacturing facility

in Germany might compare the returns of existing German electronics companies with returns on an

Australian equity index to estimate a project beta.

In contrast, if the company’s shareholders can diversify internationally, the company should calculate

the project’s beta by comparing the relationship between its returns (or returns on similar investments)