Risk Analysis in Capital Investments 229The discount rate used in capital budgeting has the time value of money and an adjustment for risk. It is
difficult to separate the two. So, some finance theorists suggest that the Certainty Equivalent method is
better (and hence be used). Instead of making ad hoc adjustments to cash flow and/or discount rate, an
analyst can selectively choose the appropriate method as and when the situation warrants. For instance,
political risk, in case of international projects, is one of the significant sources of risk. Most multinationals
buy insurance from international agencies like OPIC and Lloyds. In this case it is easier to adjust cash flow
than discount rate. In other words, the adjustment depends on the risk in question.SURVEY RESULTS
Gitman and Mercurio (1982) conducted a survey of Fortune 1000 companies and found that 39 percent
respondents (118) risk-adjust cash flows of project, 32.2 percent risk-adjust the cost of capital applied to
each project, 19.5 percent risk-adjust both the cash flows and the discount rate and the rest use some other
technique. The summary of their findings is shown in Exhibit 11.9.Exhibit 11.9 Risk-adjustment procedure in Fortune 1000 companies
Procedures Percentage of 118 responses
Risk-adjust cash flows of each project 39 percent
Risk-adjust cost of capital of each project 32.2 percent
Risk-adjust both 19.5 percent
Use some other technique 9.3Their study indicates that almost one-third of the respondents (177) do not differentiate project risk
specifically in sharp contrast to financial theory.PROJECT VALUATION IN EMERGING MARKETS
The DCF methodology for evaluating a project involves estimation of cash flows and discount rate. If the
NPV is positive, the project can be accepted; if negative, the project should be rejected. Estimating cash
flows for a foreign project is just an extension of domestic counterpart except that the cash might be more
variable or volatile. More specifically, international capital budgeting involves:- Estimation of cash flows specific to that project
- Estimation of discount rate specific to that project.
Managers evaluating an international project need to address two questions: Should the project be evaluated
from the perspective of managers in the country in which the project is located or that of the parent company?
Should the cash flows be adjusted downwards or should the discount rate be raised to account for differential
political and economic risks? An international project can be evaluated in two stages. In the first stage, the
project is evaluated from the subsidiary’s perspective. In the second stage, the amount and timing of profits
repatriated (after paying taxes) to the parent company is estimated. It is common practice to make ad hoc
adjustments to cash flows or discount rates. For instance, if a company were to use 15 percent discount rate