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Overseas Production: Alternative Approaches 21.5

Overseas Production: Alternative Approaches 21.5. LO4. There are two approaches for evaluating international capital budgeting projects: Home Currency Approach Foreign Currency Approach. Home Currency Approach. LO4. Estimate cash flows in foreign currency

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Overseas Production: Alternative Approaches 21.5

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  1. Overseas Production: Alternative Approaches 21.5 LO4 • There are two approaches for evaluating international capital budgeting projects: • Home Currency Approach • Foreign Currency Approach

  2. Home Currency Approach LO4 • Estimate cash flows in foreign currency • Estimate future exchange rates using UIP • Convert future cash flows to dollars • Discount using domestic required return

  3. Example: Home Currency Approach LO4 • Your company is looking at a new project in Mexico. The project will cost 9 million pesos. The cash flows are expected to be 2.25 million pesos per year for 5 years. The current spot exchange rate is 9.08 pesos per Canadian dollar. The risk-free rate in the Canada is 4% and the risk-free rate in Mexico 8%. The dollar required return is 15%. • Should the company make the investment?

  4. Foreign Currency Approach LO4 • Estimate cash flows in foreign currency • Use the IFE to convert domestic required return to foreign required return • Discount using foreign required return • Convert NPV to dollars using current spot rate

  5. Example: Foreign Currency Approach LO4 • Use the same information as the previous example to estimate the NPV using the Foreign Currency Approach • Mexican inflation rate from the International Fisher Effect is 8% - 4% = 4% • Required Return = 15% + 4% = 19% • PV of future cash flows = 6,879,679 • NPV = 6,879,679 – 9,000,000 = -2,120,321 pesos • NPV = -2,120,321 / 9.08 = -233,516

  6. Repatriated Cash Flows LO4 • Often some of the cash generated from a foreign project must remain in the foreign country due to restrictions on repatriation • Repatriation can occur in several ways • Dividends to parent company • Management fees for central services • Royalties on the use of trade names and patents

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