364 PART 3 Long-Term Investment Decisions
foreign direct investment
The transfer of capital, manager-
ial, and technical assets to a
foreign country.
LG4Companies face both long-term and short-term currency risksrelated to both
the invested capital and the cash flows resulting from it. Long-term currency risk
can be minimized by financing the foreign investment at least partly in the local
capital markets rather than with dollar-denominated capital from the parent
company. This step ensures that the project’s revenues, operating costs, and
financing costs will be in the local currency. Likewise, the dollar value of short-
term, local-currency cash flows can be protected by using special securities and
strategies such as futures, forwards, and options market instruments.
Political riskscan be minimized by using both operating and financial strate-
gies. For example, by structuring the investment as a joint venture and selecting a
well-connected local partner, the U.S. company can minimize the risk of its oper-
ations being seized or harassed. Companies also can protect themselves from hav-
ing their investment returns blocked by local governments by structuring the
financing of such investments as debt rather than as equity. Debt-service pay-
ments are legally enforceable claims, whereas equity returns (such as dividends)
are not. Even if local courts do not support the claims of the U.S. company, the
company can threaten to pursue its case in U.S. courts.
In spite of the preceding difficulties, foreign direct investment,which involves
the transfer of capital, managerial, and technical assets to a foreign country, has
surged in recent years. This is evident in the growing market values of foreign
assets owned by U.S.-based companies and of foreign direct investment in the
United States, particularly by British, Canadian, Dutch, German, and Japanese
companies. Furthermore, foreign direct investment by U.S. companies seems to
be accelerating.Review Questions
8–5 Why is it important to evaluate capital budgeting projects on the basis of
incremental cash flows?
8–6 What three components of cash flow may exist for a given project? How
can expansion decisions be treated as replacement decisions? Explain.
8–7 What effect do sunk costsand opportunity costshave on a project’s incre-
mental cash flows?
8–8 How can currency riskand political riskbe minimized when one is mak-
ing foreign direct investment?8.3 Finding the Initial Investment
The terminitial investmentas used here refers to the relevant cash outflows to be
considered when evaluating a prospective capital expenditure. Because our discus-
sion of capital budgeting is concerned only with investments that exhibit conven-
tional cash flows, the initial investment occurs attime zero—the time at which the
expenditure is made. The initial investment is calculated by subtracting all cash
inflows occurring at time zero from all cash outflows occurring at time zero.
The basic format for determining the initial investment is given in Table 8.2.
The cash flows that must be considered when determining the initial investment