The feasibility of a project is dependent on the

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The feasibility of a project is dependent on the probability distribution of the scenarios (appreciation, stability, and depreciat ion) for the foreign currency during the project’s lifetime. If there is a high probability that the foreign currency will depreciate, the project should not be accepted. Some U.S.-based MNCs consider projects in countries where the local currency is tied to the dollar. They may conduct a capital budgeting analysis that presumes the exchange rate will remain fixed. It is possible, however, that the local currency will be devalued at some point in the future, which could have a major impact on the cash flows to be received by the parent. Some MNCs may hedge some of the expected cash flows of a new project. In this case, they should evaluate the project based on hedged exchange rates applied to the expected cash flows that are to be hedged. Inflation Capital budgeting analysis implicitly considers inflation since variable cost per unit and product prices generally have been rising over time. In some countries, inflation can be quite volatile from year to year and can therefore strongly influence a project’s net cash flows. Inaccurate inflation forecasts can lead to inaccurate net cash flow forecasts. Although fluctuations in inflation should affect both costs and revenues in the same direction, the magnitude of their changes may be very different. The joint impact of inflation and exchange rate fluctuations may be partially offsetting effect from the viewpoint of the parent. The exchange rates of highly inflated countries tend to weaken over time. Thus, even if subsidiary earnings are inflated, they will be defla ted when converted into the parent’s home
currency if the subsidiary’s currency weakens due to its high inflation as suggested by purchasing power parity. However, MNCs cannot presume that exchange rate effects will perfectly offset inflation effects in a host country. Therefore, MNCs should attempt to explicitly account for any effects on inflation by using proper estimates of future costs or price charges, and future exchange rates. Financing Arrangement Many foreign projects are partially financed by foreign subsidiaries. Domestic capital budgeting problems would not include debt payments in the measurement of cash flows because all financing costs are captured by the discount rate. However, it is important to account for debt payments in multinational capital budgeting in order to accurately estimate the amount of cash flows that are ultimately remitted to the parent and converted into the parent’s home currency. When a subsidiary uses a portion of its funds to pay interest expenses on its debt, the amount of funds to be converted into the parent currency would be overstated if the payment of foreign interest expenses is not explicitly considered.

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