Exchange rate risk is yet another significant variable to be considered in assessing foreign
direct investment. This risk is very much there while undertaking investments in
underdeveloped countries. As a result, repatriable cash flows (converted into the
currency of the parent) diminish on account of periodic devaluation of local currency.
Exchange rate changes are normally preceded by relatively higher or lower local rates of
inflation than in the home country.
- Effects of inflation may vary from firm to firm.
Besides operating profits and cash flows, inflation is also likely to have an impact on
working capital requirements of corporate firms; these are likely to go up in view of
increased input costs (say material, labor, power and so on) on the one hand and increase
in required cash balances, and investments in debtors on the other.
Multinational firms will like to invest in countries with stable currencies, stable
governments, sound economic health, stable economic policies and the least political
risks (in terms of expropriation).
- Cost of capital and financial structure
The unifying theme guiding management in financial decisions is maximization of
shareholders’ wealth in the long run.
The cost of capital has been used as the discount rate/minimum required rate of return to
determine the net present value of the proposed international investment.
Sound capital structure apart, the determination of correct weighted average cost of
capital is also important to evaluate capital budgeting decisions. In fact, it constitutes an
integral part of investment decisions. In operational terms, it is the minimum required
rate of return expected to be earned by the proposed investment.
Therefore, the correct determination/estimation of the cost of capital is of vital
significance to a corporate firm and so of optimal capital/financial structure (as it yields
the lowest cost of capital).
- General principles
First, it is assumed that it is possible to forecast cash flows (associated with financing
decisions) with a sufficient degree of precision and accuracy in order to be useful in
future.
Second, apart from forecasting the likely exchange rate (spot as well as future), a time
interval for forecasting cash flows needs to be chosen.