A simple solution to this estimation problem may be to estimate all cash flows in the foreign currency, but, as we will see in the next section, the expected change in exchange rates will then have to be reflected in the discount rate. 3.4 Valuation The final issue we will examine in this chapter is the effect of a firm’s international operations on its value. Because valuation can be considered an extension of capital budgeting, many of the same principles apply. The expected cash flows to a firm foreign operations be forecast first and then converted using expected exchange rates. Because the total cash flows from foreign operations can be viewed as the cash flows from a portfolio of foreign projects, one advantage analysts have while doing valuation, as opposed to a single capital budgeting project, is that forecast errors in exchange rates may average out, especially if the firm has projects in a large number of countries. The discount rate used to obtain the present value can be adjusted for diversification benefits (which will push it down) and for exchange rate and political risk (which will push it up), taking into account the magnitude of the foreign operations relative to firm value. To illustrate, the valuation of Boeing in Chapter 23 was based on estimated cash flows in dollar terms and a dollar discount rate. In reality, more than 50% of Boeing’s revenues in future years will come from sales overseas, which will expose Boeing to exchange rate and also political risk in foreign countries and provide international diversification benefits. The expected growth rate in Boeing’s earnings and the discount rates used should reflect these effects. As exchange rates move from period to period, the actual earnings reflect may deviate from the expected earnings, even if all the other assumptions hold; these privations should partially average out over the long time horizon that is used in valuation. If stockholders are well diversified internationally, they will not demand an extra premium for this risk, and discount rates will not need to be adjusted. Alternatively, if stockholders are not well diversified, and they perceive the exchange rate risk as a market risk, holders are not well diversified, and they perceive the exchange rate risk as a market risk, the discount rate can be adjusted upward to reflect the additional exchange rate risk. In the case of Boeing, we would argue that the first view is the more realistic one, for it has always depended on overseas sales and is substantially held by institution. There is some evidence that there is still a ‘’home bias’’ in the portfolios held by individuals, whereby domestic holdings in portfolios exceed what they should be, given that a truly diversified investor will hold investments from around the world, in proportion to their market value. As long as this home bias exists, a risk premium will probably be associated with overseas expansion and the exchange rate risk that accrues to firms.
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