FREE online courses on Investment Decisions in Exchange Rates - Valuing Direct Foreign Investments

 

The logic underlying the valuation of a capital investment project that generate future cash flows denominated in a foreign currency is similar to that underlying a standard capital budgeting problem.  That is, we should identify the incremental cash flows and discount them at the appropriate weighted average cost of capital.  Foreign investment decisions are complicated by

 

          a.  conversion of foreign exchange to dollars,

          b.  restrictions on the repatriation of cash flows.

 

While accounting for the potential impact of unanticipated future restrictions on the repatriation of future cash flows is particularly difficult, converting a stream of future cash flows denominated in a foreign currency to a projected dollar denominated stream is relatively straightforward.  The net present value of the projected future cash flows can then be determined using the firm's dollar-denominated weighted average cost of capital.  We can summarize this approach to the valuation of investments in foreign countries as follows:

 

          a.  estimate future foreign currency denominated cash flow,

          b.  convert foreign currency to dollars at the “projected” exchange rate,

          c.  determine the net present value using the domestic (U.S.) cost of capital.

 

 

Example:  Valuation of Foreign Investments

 

Consider the following example.  Because of a recent ban on the import of U.S. made tennis rackets to Germany (in retaliation for anticipated restrictions on the import of German-made goods to the U.S.), a U.S. sporting goods manufacturer expects to create a German subsidiary to manufacture and distribute tennis rackets in Germany.

 

The project life is expected to be two years (at which time, an end to protectionist sentiment in the U.S. will lead to an end to trade restrictions).  The required investment in the project is

 

          a.  DM 25,000,000 in plant and equipment,

          b.  DM   5,000,000 in working capital.

 

The projected after-tax cash flows from the project are DM 20,000,000 for the next two years, in addition to DM5,000,000 from the liquidation of working capital in two years.  The spot exchange rate (S$/DM) is $0.6500/DM1 .  The interest rate in the U.S. (RUS ) is 6 percent per year while the German interest rate (RDM ) 11 percent per year.