Under most conditions, NPV and IRR lead to the same decision. However, differ-
ent decisions may result under certain circumstances, such as when projects of sub-
stantially different lifetimes are compared or when cash flows fluctuate sharply from
year to year. If NPV and IRR give different decisions, NPV is preferable on theoreti-
cal grounds.^2 Hence, NPV is used in the illustrative example at the end of this chapter.
4.3 INTERNATIONAL COMPLEXITIES. Capital budgeting for a foreign project uses
the one-country framework just described, but with certain adjustments to reflect the
greater complexities in an international situation. Many of the adjustments arise be-
cause of the fact that two separate sovereign nations are involved and the operating
cash flows in the host country are in a different currency than those desired by the
parent company.
(a) Project versus Parent Cash Flows. Project (e.g., host country) cash flows must be
distinguished from parent (e.g., home country) cash flows. Project cash flows gener-
ally follow the domestic, or one-country model, described earlier. However, parent
cash flows reflect all cash flow consequences for the parent company.
(b) Parent Cash Flows Tied to Financing. Because of the above, parent cash flows
depend, in part, on financing. Unlike the domestic situation, financing cannot be kept
separate from operating cash flows. In fact, “clever” financing is often the key to
making an otherwise unattractive foreign investment proposal attractive to the parent
firm. Cash may flow back to the parent because the venture is structured from a fi-
nancial point of view to provide such flows. Fund flows back to the parent on inter-
national projects arise from any of the following, which must be incorporated into the
original investment agreement:
- Dividends.
- Royalties.
4 • 6 FOREIGN INVESTMENT ANALYSISExhibit 4.1. Interaction of Project Cost, Cash Inflows, and Cost of Capital in Capital
Budgeting Analysis.
(^2) Readers should consult a standard domestic financial management text for an explanation of why
NPV is theoretically superior to IRR.