Which of the following is not a method for considering additional risk with international projects?

Capital budgeting is hardly an exact science. If it were, companies would never make bad decisions about expansions, product development, equipment upgrades and other capital projects. The fact that companies do make these kinds of mistakes points to the limitations of capital budgeting.

Cash Flow

1. The single most important step in capital budgeting is also the most difficult to get right: forecasting the cash flows a project will produce. Capital budgeting is simply the process of determining whether the increased revenue from a project justifies the investment required, but that future revenue is only your best estimate. Even up-front costs, which are more immediate and therefore easier to forecast, are still only estimates at this stage. Overestimate revenue or underestimate costs, and a project that looks profitable could become a money-loser. Underestimate revenue or overestimate costs, and you might end up rejecting a project that would have proved profitable.

Time Horizon

1. Forecasting cash flows gets increasingly difficult the farther into the future you go. You can make predictions based only on what you know right now. As you expand the time horizon for a capital project, the likelihood rises that between the time you get started and the time you expect to be reaping the benefits, some disruptive event will change your operating environment. Unforeseen competition, legal and regulatory changes or technological innovations can affect the ultimate success of your project, yet they may be impossible to consider in your capital budgeting process. At the same time the most ambitious projects -- the ones that truly can take your company to the next level -- may take years to develop. As is often the case in finance, getting the reward requires taking the risk.

Time Value

1. One of the most common capital budgeting methods, particularly among small businesses, is the payback period method. It simply requires that a project's forecast cash flows repay its investment within a set amount of time. Say you require payback within five years. If a project has $45,000 in up-front costs and estimates cash flows of $10,000 a year for five years, this project meets your criteria. The problem is that this method doesn't account for the time value of money -- the fact that equal sums of money at different points in time have different values based on a number of factors. If you had to borrow the money for the project at 4 percent annual interest, for example, you actually would lose money, and inflation would add losses on top of that. Other capital budgeting methods consider these issues, but they, too, have limitations.

Discount Rates

1. Capital budgeting methods that attempt to account for the time value of money do so by figuring your cost of capital -- the annual rate it will cost you to finance a project, either by borrowing the money and paying interest or using your own money and not earning a return on it somewhere else. Figuring the proper discount rate, as it's called, is yet another challenge. Even if you peg it fairly accurately, there's always a chance that interest rates will rise or something else will happen to increase your cost of capital down the road, reducing the real value of those future cash flows. If you get the discount rate wrong to start with, your yes-or-no decision on pursuing a project will be based on a flawed assumption.

Valuing long-term business investments can be a challenge because there are many uncertain factors to consider. One way to compare projects is through capital budgeting. In this financial calculation, you value projects based on their projected cash flows. Future cash flows are discounted by your required rate of return for the project. You may want to compare the project's performance under different risk situations. With a few adjustments to the capital budgeting formula, you can compare projects under different risk situations.

1. Increase the required rate of return discount factor for your project's cash flows. This adjustment will reduce the value of future cash flows indicating higher uncertainty for the project.

2. Reduce future cash flows by an estimated loss percentage. Use this adjustment if you believe there is a risk of future payments not being made. For example, multiply each future cash flow by 90 percent if you believe you may not receive 10 percent of your payments.

3. Delay all cash flow payments by a year. This will reduce the value of your project by adding higher discounting. Use this adjustment if you believe your project has a chance of getting delayed before launch.

4. If you believe there is a risk of higher start-up costs, subtract this amount from the project's estimated net present value.

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Fundamentals of Multinational Finance

, 3e (Moffett) 

Chapter 19 

Multinational Capital Budgeting 

19.1 

Multiple Choice and True/False Questions 

1) 

The traditional financial analysis applied to foreign or domestic projects, to determine the 

project's value to the firm is called ________. 

A) 

cost of capital analysis 

B) 

capital budgeting 

C) 

capital structure analysis 

D) 

agency theory 

Answer: 

B 

Topic: 

Capital Budgeting 

Skill: 

Recognition 

2) 

Which of the following is NOT a basic step in the capital budgeting process? 

A) 

Identify the initial capital invested. 

B) 

Estimate the cash flows to be derived from the project over time. 

C) 

Identify the appropriate interest rate at which to discount future cash flows. 

D) 

All of the above are steps in the capital budgeting process. 

Answer: 

D 

Topic: 

Capital Budgeting 

Skill: 

Recognition 

3) 

Of the following capital budgeting decision criteria, which does NOT use discounted cash 

flows? 

A) 

net present value 

B) 

internal rate of return 

C) 

accounting rate of return 

D) 

All of these techniques typically use discounted cash flows. 

Answer: 

C 

Topic: 

Accounting Rate of Return 

Skill: 

Recognition 

4) 

There are no important differences between domestic and international capital budgeting 

methods. 

Answer: 

FALSE 

Topic: 

Capital Budgeting 

Skill: 

Recognition 

5) 

Which of the following is NOT a reason why capital budgeting for a foreign project is more 

complex than for a domestic project? 

A) 

Parent cash flows must be distinguished from project cash flows. 

B) 

Parent firms must specifically recognize remittance of funds due to differing rules and 

regulations concerning remittance of cash flows, taxes, and local norms. 

C) 

Differing rates of inflation between the foreign and domestic economies. 

D) 

All of the above add complexity to the international capital budgeting process. 

Answer: 

D 

Topic: 

Capital Budgeting for Foreign Projects 

Skill: 

Recognition