The parent company therefore has great discretion in

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Unformatted text preview: from one of a parent company’s subsidiaries to another subsidiary located abroad. The parent company therefore has great discretion in setting transfer prices, the prices that subsidiaries charge each other for the goods and services traded between them. The widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and incremental cash flows. Finally, MNCs often must approach international capital projects from a strategic point of view, rather than from a strictly financial perspective. For example, an MNC may feel compelled to invest in a country to ensure continued access, even if the project itself may not have a positive net present value. This motivation was important for Japanese automakers who set up assembly plants in the United States in the early 1980s. For much the same reason, U.S. investment in Europe surged during the years before the market integration of the European Community in 1992. MNCs often invest in production facilities in the home country of major rivals to deny these competitors an uncontested home market. MNCs also may feel compelled to invest in certain industries or countries CHAPTER 10 Risk and Refinements in Capital Budgeting 433 to achieve a broad corporate objective such as completing a product line or diversifying raw material sources, even when the project’s cash flows may not be sufficiently profitable. Review Question 10–4 Briefly explain how the following items affect the capital budgeting decisions of multinational companies: (a) exchange rate risk; (b) political risk; (c) tax law differences; (d) transfer pricing; and (e) a strategic rather than a strict financial viewpoint. LG4 10.4 Risk-Adjusted Discount Rates The approaches for dealing with risk that have been presented so far enable the financial manager to get a “feel” for project risk. Unfortunately, they do not explicitly recognize project risk. We will now illustrate the most p...
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