568 CHAPTER 15 Multinational Financial Management
rates. An analysis should be conducted to ascertain the effects of exchange rate
variations, and, on the basis of this analysis, an exchange rate risk premium should be
added to the domestic cost of capital to reflect this risk. It is sometimes possible to
hedge against exchange rate fluctuations, but it may not be possible to hedge com-
pletely, especially on long-term projects. If hedging is used, the costs of doing so must
be subtracted from the project’s cash flows.
Politicalriskrefers to potential actions by a host government that would reduce the
value of a company’s investment. It includes at one extreme the expropriation without
compensation of the subsidiary’s assets, but it also includes less drastic actions that re-
duce the value of the parent firm’s investment in the foreign subsidiary, including higher
taxes, tighter repatriation or currency controls, and restrictions on prices charged. The
risk of expropriation is small in traditionally friendly and stable countries such as Great
Britain or Switzerland. However, in Latin America, Africa, the Far East, and Eastern
Europe, the risk may be substantial. Past expropriations include those of ITT and Ana-
conda Copper in Chile, Gulf Oil in Bolivia, Occidental Petroleum in Libya, Enron
Corporation in Peru, and the assets of many companies in Iraq, Iran, and Cuba.
Note that companies can take several steps to reduce the potential loss from ex-
propriation: (1) finance the subsidiary with local capital, (2) structure operations so
that the subsidiary has value only as a part of the integrated corporate system, and (3) ob-
tain insurance against economic losses from expropriation from a source such as the
Overseas Private Investment Corporation (OPIC). In the latter case, insurance premi-
ums would have to be added to the project’s cost.
Several organizations rate countries according to different aspects of risk. For ex-
ample, Transparency International (TI) ranks 91 countries based on perceived corrup-
tion, which is an important part of political risk. Table 15-4 shows selected countries.
TI rates Finland as the most honest country, while Nigeria and Bangladesh are the
lowest two. The United States is tied for fifteenth.
List some key differences in capital budgeting as applied to foreign versus do-
mestic operations.
What are the relevant cash flows for an international investment—the cash flow
produced by the subsidiary in the country where it operates or the cash flows in
dollars that it sends to its parent company?
Why might the cost of capital for a foreign project differ from that of an equiva-
lent domestic project? Could it be lower?
What adjustments might be made to the domestic cost of capital for a foreign
investment due to exchange rate risk and political risk?
International Capital Structures
Companies’ capital structures vary among countries. For example, the Organization for
Economic Cooperation and Development (OECD) recently reported that, on average,
Japanese firms use 85 percent debt to total assets (in book value terms), German firms
use 64 percent, and U.S. firms use 55 percent. One problem, however, when interpret-
ing these numbers is that different countries often use very different accounting conven-
tions with regard to (1) reporting assets on a historical -versus a replacement -cost basis,
(2) the treatment of leased assets, (3) pension plan funding, and (4) capitalizing versus ex-
pensing R&D costs. These differences make it difficult to compare capital structures.
A study by Raghuram Rajan and Luigi Zingales of the University of Chicago at-
tempted to control for differences in accounting practices. In their study, Rajan and
562 Multinational Financial Management
