List some key differences in capital budgeting as applied to foreign versus domestic operations.

Sample Response

The basic principles of capital budgeting are the same for both domestic projects and foreign projects. However due to geographical and political carriers, capital budgeting of a foreign project is a bit complex to certain extent. A foreign project experiences variation mainly in cash flow estimations, project analysis, and the various risks faced by the firms.

Exposure to risks: A foreign project experiences additional risks as compared to a domestic project, which are as follows.

Exchange rate risks: Foreign cash flows are needed to be converted in home currency before considering them as revenues. Fluctuations in the currency exchange rates may create variances in the actual and the budgeted foreign cash flows. Thus, an additional risk premium should be added to the actual cost of capital to determine the effective cost of capital of a foreign project.
Political risk: Certain policies of the host government may lower the value of investment of multinational corporations. Political risks mainly comprise repatriation risks and expropriation risks. Repatriation refers to the process and policy of remitting the foreign cash flows to the home country. Host governments may restrict this by limiting their maximum amount of foreign currency conversion. Also, the host government may seize certain assets of the firm citing many reasons. This is a part of expropriation risk. Apart from repatriation and expropriation risks, multinational corporations are also exposed to corruption risk. The financial stability, political environment, and cultural patterns determine the degree of corruption risk, which the firms might face.
Taxation risk: Some of the countries impose taxes on repatriated earnings. Thus, the cash flows remitted from the foreign countries are again taxed by the home country. This demotivates the desire of the firm to bring back the foreign earnings to home country.

Cash flow estimations: A foreign project is usually initiated due to its ability to yield higher cash flows. However, host government's restrictions on their forex transactions may limit the amount of funds which are to be repatriated to their home country. As a result, the domestic investors who are interested in dollar dividends, may not get sufficient returns. Moreover, if enough cash flows are not remitted to the parent company, it may affect the liquidity of the firm in domestic business.
Project Analysis: The most critical part of the capital budgeting is an estimation of future cash flows. Even the estimated future cash flows need to be converted into the home currency. For a short run, it is manageable to estimate the exchange rates. However, the estimates of the forward exchange rates are not credible in the long run. Thus, for analysing the foreign cash flows, understanding of the foreign markets along with the interest rate parity is of utmost importance.