Investment Decisions

A decision to invest in activities in a given country must consider many economic, political, cultural, and strategic variables. We have been discussing this issue throughout much of this book. We touched on it in Chapters 2 and 3 when we discussed how the political, economic, legal, and cultural environment of a country can influence the benefits, costs, and risks of doing business there and thus its attractiveness as an investment site. We returned to the issue in Chapter 6 with a discussion of the economic theory of foreign direct investment. We identified a number of factors that determine the economic attractiveness of a foreign investment opportunity. In Chapter 7, we looked at the political economy of foreign direct investment and we considered the role that government intervention can play in foreign investment. In Chapter 12, we pulled much of this material together when we considered how a firm can reduce its costs of value creation and/or increase its value added by investing in productive activities in other countries. We returned to the issue again in Chapter 14 when we considered the various modes for entering foreign markets.

One role of the financial manager in an international business is to try to quantify the various benefits, costs, and risks that are likely to flow from an investment in a given location. This is done by using capital budgeting techniques.

Capital Budgeting

Capital budgeting quantifies the benefits, costs, and risks of an investment. This enables top managers to compare, in a reasonably objective fashion, different investment alternatives within and across countries so they can make informed choices about where the firm should invest its scarce financial resources. Capital budgeting for a foreign project uses the same theoretical framework that domestic capital budgeting uses; that is, the firm must first estimate the cash flows associated with the project over time. In most cases, the cash flows will be negative at first, because the firm will be investing heavily in production facilities. After some initial period, however, the cash flows will become positive as investment costs decline and revenues grow. Once the cash flows have been estimated, they must be discounted to determine their net present value using an appropriate discount rate. The most commonly used discount rate is either the firm's cost of capital or some other required rate of return. If the net present value of the discounted cash flows is greater than zero, the firm should go ahead with the project.²

Although this might sound quite straightforward, capital budgeting is in practice a very complex and imperfect process. Among the factors complicating the process for an international business are these:

1. A distinction must be made between cash flows to the project and cash flows to the parent company.

2. Political and economic risks, including foreign exchange risk, can significantly change the value of a foreign investment.

3. The connection between cash flows to the parent and the source of financing must be recognized.

We look at the first two of these issues in this section. Discussion of the connection between cash flows and the source of financing is postponed until the next section, where we discuss the source of financing.