230 Corporate Finance
for a domestic project, it might raise it to 20 percent for foreign projects. Such adjustments, obviously, do not
have a sound basis. Some academics suggest that it is better to adjust cash flows to account for risks (and not
discount rate) because international risks are unsystematic in nature and hence diversifiable. Remember that
only systematic risk matters in a CAPM universe. Whether or not the discount rate for foreign projects
should be revised depends on how managers view risks in international projects. If the risks are adequately
reflected in the project beta then it is inappropriate to add an additional risk premium to the discount rate.
There are two alternative approaches for valuing overseas investments.
Approach 1
- Forecast foreign currency cash flows using host country tax rate and inflation rate.
- Estimate foreign currency discount rate using project specific capital structure and beta.
- Calculate PV of the free cash flows in foreign currency.
- Convert to home currency using spot exchange rate.
Approach 2
- Forecast foreign currency cash flows using host country tax rate and inflation rate.
- Forecast future exchange rates using parity relationships and convert cash flows to home currency
- Estimate home currency discount rate using project specific capital structure and beta.
- Calculate PV in home currency.
Usually, both the approaches give the same answer.Adjusting Cash Flows
The effect of international risk can be incorporated by charging a premium for political and economic risk
against each year’s cash flows. That is, incorporate the cost of buying insurance to cover the political risk from
an agency like Overseas Private Investment Corporation or Lloyd’s, of London, and the cost of covering
economic risk by a forward cover in the currency market. Another approach is to estimate the probability of
expropriation and the expected value (mean) of cash flows. Once the cash flow in the host country’s currency
is estimated, probabilities are attached to different exchange rates (between local currency and home currency)
forecast by the analyst to translate cash flows into home currency.
Adjusting Discount Rate
Whether or not the discount rate for a foreign project should be adjusted depends on how one views inter-
national risk. Modern finance theory suggests that only systematic risk of a project matters as unsystematic risk
can be diversified away.
A multinational, due to its global focus, can diversify country specific risk as long as cash flows from these
countries are not perfectly positively correlated. Beta is the standard measure of systematic risk; it measures
the sensitivity of asset returns to market returns. What is the appropriate proxy for the market portfolio in
case of multinational investment? Is it the portfolio in the country of operation or that in the home country?
Or may be a global portfolio? In many emerging countries, the stock markets lack depth. More than half the
market capitalization is accounted for by a handful of companies. So the stock market index would be a poor
proxy for market portfolio, which is supposed to represent the portfolio of all risky assets held by the marginal
investor in the company.