How can the following affect the capital budgeting decisions of multinational companies: exchange rate risk; political risk; tax law differences; transfer pricing; and a strategic rather than a strictly financial viewpoint. What examples can you provide from your reading of business periodicals to support your ideas?

QUESTION

M5 Discussion: Capital Budgeting and Multinational Companies

Photo Credit: Link Humans, CC BY 2.0

How can the following affect the capital budgeting decisions of multinational companies:

*exchange rate risk
*political risk
*tax law differences
*transfer pricing
*a strategic rather than a strict financial viewpoint

What examples can you provide from your reading of business periodicals to support your ideas? Remember to think about both large and small firms.

READINGS

M5 Points to Ponder

The purpose of this section is to give you some questions or ideas to think about as you read. You do not need to answer these, but sometimes they may give you a way to think about the topics that you did not have before.

All capital budgeting decisions in a firm are made under conditions of uncertainly, as the future is never totally known. How would you recommend that a firm you are familiar with could quantify this uncertainty. While the text summarizes uncertainty in a change in interest rates in the present value process, how would a firm actually make those choices for interest rates? What sources of information might be helpful? What processes for measuring the uncertainty would you recommend and why?

Capital Budgeting Techniques Definitions
Payback Period – Amount of time required for a firm to recover its initial investment in a project, as calculated from cash flows.

Net Present Value or NPV – Sophisticated technique that is found by subtracting a project’s initial investment form the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital.

Internal Rate of Return or IRR – Sophisticated technique that results in a discount rate that equates the NPV of an investment opportunity to $0, when the present value of cash inflows = the initial investment. IRR represents the compound annual rate of return the firm will earn if it invests in the project and receives the given cash inflows.

As you read these three chapters, you will see the importance of concepts you studied in the first two modules. The use of time value of money will be key in the process used to determine the value of each project under consideration in today’s dollars. These concepts are the only way that firms are able to make decisions among alternatives that have different cash flows and different time horizons. In the subsequent chapters you will include the concept of risk – a second bedrock idea that permeates this course. Projects that have different possibilities of success are still worthy of consideration. Later in the course, you will add to this complexity by including the possibility of leasing, in addition to the buying options. You will also find that the concepts of depreciation, taxes and operating cash flow are part of the planning considerations.

As you move to the second chapter in this triad, you will study the three primary techniques of applying capital budgeting. These are defined at left in the clip board. Mastering these will be useful in future chapters, as they are applied in multiple situations. While the concepts are not difficult, you will find that their application can provide many challenges.

Finally this module introduces the concept of risk. As we have discussed earlier in this course, it is not possible in finance to know for sure the likelihood that a particular outcome will occur. Thus, as firms make decisions about long-term investments, they must consider the many risk factors that may intervene. The text provides some of these and we will discuss others as a group.

Overall, the long term investments made by a firm such as machinery, new plants, new technological infrastructures are extremely important in the firm’s long term success. Making sound and well reasoned financial decisions about the alternatives to achieve these goals requires an understanding of the options in today’s dollars as well as an appreciation of the role and likelihood of the relevant risk factors.

Capital Budgeting is extremely important to the success of a firm. The definition on page 396 indicates that in the capital budgeting process, financial managers must think about the many kinds of issues they will meet as they focus on the long term investments for the firm.

ANSWER

Capital Budgeting and Multinational Companies

How can the following affect the capital budgeting decisions of multinational companies: exchange rate risk; political risk; tax law differences; transfer pricing; and a strategic rather than a strictly financial viewpoint. What examples can you provide from your reading of business periodicals to support your ideas?

Capital budgeting involves a huge amount of risk since any decision taken cannot be reversed without making losses. Capital budgeting decisions involve huge amounts of capital and resources, which means that any unwise decisions result in huge losses and problems for an organization. There are various factors that affect capital budgeting decisions. The following are some of these factors and how they influence capital budgeting decisions:

Exchange Rate Risk

Exchange rate risk affects capital budgeting decisions where a loan is taken from foreign banks or financial institutions. In such a case, the foreign institution may charge high-interest rates, and the borrower will need to account for the interest and any future changes in the exchange rate. During the Greek Crisis, organizations from Greece and the Greek region that were operating in foreign countries at the time had to pay huge debts from their foreign capital savings since the Greek currency became valueless (Kouretas & Vlamis, 2010).

Political Risk

When the government changes existing business policies or comes up with new regulations, businesses are affected. An organization may have to change its plans and operations as a result of a change in government policies. Ongoing projects may have to be canceled or an organization will have to develop ways of making the project viable with new regulations and policies. Additional costs may be incurred during the process of adjusting to meet new regulations or requirements. If the government bans the use of coal as a source of fuel, and a company’s ongoing project depended on the use of coal as a fuel source, the company will have to use more capital to re-engineer the project to use a different fuel source.

Tax Law Difference

Companies need to account for taxes and any government fees necessary when making capital budgeting decisions. Depending on the location and type of project, different taxes and payments will be incurred. In the UAE, for instance, no taxes are imposed on projects. In countries like India, double taxation is imposed on the purchase of expensive equipment. The value of a project may be inflated as a result of taxes (Akoum, 2008).

Transfer Pricing

Transfer pricing is a common method used by organizations to avoid taxes in countries that impose high taxes on business operations. Losses are shown in the form of transferred losses in high-tax countries and showing income in low-tax countries (Adams & Drtina, 2008). Transfer pricing has to be considered when making capital budgeting decisions since a company has to determine how much will be incurred in taxes and how much income to expect from new projects.

A Strategic rather than a Strictly Financial Viewpoint

Capital budgeting decisions are made on the basis of future growth or future returns. When decisions are made using a strictly financial viewpoint, a company focuses on what the project will bring financially. When decisions are made using a strategic viewpoint, a company focuses on how a project will contribute to growth and expansion.

References

Adams, L., & Drtina, R. (2008). Transfer pricing for aligning divisional and corporate decisions. Business Horizons, 51(5), 411-417.

Akoum, I. F. (2008). Conducting business in the UAE: a brief for international managers. Global Business and Organizational Excellence, 27(4), 51-66.

Kouretas, G. P., & Vlamis, P. (2010). The Greek crisis: causes and implications. Panoeconomicus, 57(4), 391-404.