Unformatted text preview: particularly important: exchange rate risk and political risk.
Exchange rate risk reflects the danger that an unexpected change in the
exchange rate between the dollar and the currency in which a project’s cash flows
are denominated will reduce the market value of that project’s cash flow. The
dollar value of future cash inflows can be dramatically altered if the local currency depreciates against the dollar. In the short term, specific cash flows can be
hedged by using financial instruments such as currency futures and options.
Long-term exchange rate risk can best be minimized by financing the project, in
whole or in part, in local currency.
Political risk is much harder to protect against. Once a foreign project is
accepted, the foreign government can block the return of profits, seize the firm’s
assets, or otherwise interfere with a project’s operation. The inability to manage
political risk after the fact makes it even more important that managers account
for political risks before making an investment. They can do so either by adjusting
a project’s expected cash inflows to account for the probability of political interference or by using risk-adjusted discount rates (discussed later in this chapter) in
capital budgeting formulas. In general, it is much better to adjust individual project cash flows for political risk subjectively than to use a blanket adjustment for
In addition to unique risks that MNCs must face, several other special issues
are relevant only for international capital budgeting. One of these special issues is
taxes. Because only after-tax cash flows are relevant for capital budgeting, financial managers must carefully account for taxes paid to foreign governments on
profits earned within their borders. They must also assess the impact of these tax
payments on the parent company’s U.S. tax liability.
Another special issue in international capital budgeting is transfer pricing.
Much of the international trade involving MNCs is, in reality, simply the shipment of goods and services...
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