The foreign exchange market is highly volatile and fast moving as any other financial market on the planet and with capital budgeting, a lot of expertise is necessary to accurately predict future finance options. Capital budgeting is the process of financial analysis that is applied to foreign or domestic projects to determine the projects value and it involves the estimation of the cash flows expected to be derived from the project over time, determinations of initial capital requirements and determination of the appropriate interest rate at which to discount future cash flows.
Evaluation of foreign projects is dependent on the determination and understanding of several risks. First, suppose the revenues and expenses are based on foreign currency, then the parent firm must estimate the exchange rate at which the foreign currency will be converted into the domestic currency based on estimated expected rates of inflation and interest rates in both countries, economic growth in both countries as well as consumer preferences and tastes in the project country.
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Political risk is a major factor must be considered in capital budgeting since the political order of the day will normally dictate whether the parent firm will receive all or part of the cash flows accruing from the project in totality. The political order may bring changes in taxation policy and restrictions in the flow of funds in the course of the project. Comparatively, local firms may be in favor of the political order in terms of their financing requirements or dividend policy. Therefore, domestic capital budgeting may appear easier than international capital budgeting.
From a local view point, a project might appear to have a positive NPV, but this may be very different if the relevant cash flows were observed from the parent firm view point due to exchange rate differences which have potential to erode earnings. The local economy may limit remittance of cash flows and also present inferior investment opportunities compared to other potential investment destinations for the parent firm. Political risk could compound the uncertainty of cash flows and expected dividend payouts. Hence, it is advantageous to carry out capital budgeting from the parent's viewpoint other than from the local viewpoint.