Key14 Overseas investment: incorporating exchange rates
Multinational corporations have projects in different countries whose cash flows are denominated in different currencies. This raises the question of whether to discount these cash flows in terms of our domestic currency or in foreign currency units. As in the case of inflation, it is important to be consistent between cash flows and discount rates.
One approach is to translate all foreign cash flows into our company’s domestic currency and to discount at a home currency discount rate. Suppose a U.S. company has a German project. The initial cost of the project is DM 105, and it is expected to generate a cash flow of DM 126 in one year. Suppose the exchange rate between marks and dollars is currently 1.75 DM/US$, and that we expect this rate to change to 1.8 DM/US$ by next year. Given these current and expected future exchange rates, we can simply translate all cash flows into US$. Thus the initial outlay is equivalent to $60 and the future cash flows is equivalent to $70. IF the discount rate in US$ terms is 10 percent, we can calculate project N.P.V. as $70/1.1-$60=$3.64.
This approach immediately translates all cash flows into our primary currency, and we use our own domestic cost of capital, which we might be able to estimate with some precision. However, to employ this approach effectively, we must be adept at forecasting future exchange rates. This is a perilous business at best.
A second approach is to leave the cash flows denominated in marks, discount at a mark-denominated discount rate, and then translate the resulting present value into US$ at the current exchange rate. This has the advantage that we need not forecast any future exchange rates. However, it does necessitate that we estimate our cost of capital in foreign currency terms.
Which approach is best? IF international capital markets are efficient, both approaches should yield the same result. Suppose currency traders have the same expectation about the DM/US$ exchange rate that we do. An investor in the U.S. could invest US$1 for one year and have US$1.10 by the end of the year. The same investor could first translate the same dollar into DM1.75, invest at the mark-denominated interest rate, rDM, and translate the resulting marks back into dollars at an expected exchange rate of 1/1.8, or rDM=.1314. If so, interest rates in the two countries are in equilibrium and we can use either rate.
If we use the 13.14 percent market-denominated interest rate to discount the first year’s DM 126 million cash flow in our example, we obtain a present value of DM 111.366 million, from which we subtract the initial cost of DM 105 for an N.P.V. of DM 6.366. Translating this into dollars at the current exchange rate then gives us $3.64 million, the same as before.
If we can obtain a food set of foreign interest rates for different terms to maturity, the advantage of this second approach is that we can use the consensus expectations about exchange rate movements, which are built into the relationships between interest rates across countries. This may be preferable to constructing our own exchange rate forecasts.