Capital Budgeting Theory and Practice

 Project evaluation techniques
Over 35 years have passed since Stonehill and Nathanson (1968) surveyed 110 US and non-US
MNCs to determine their foreign capital budgeting practices. Since then, research on the subject
has not only refined its theoretical base but also expanded the knowledge of actual practices used
by   MNCs. The literature on foreign capital investment theory reveals that business firms should
use discounted cash flow techniques for ranking and selecting overseas projects, because these
methods recognize the time value of money and employ cash flows of a project over its life span.
Table 18.6 (see Case Problem 18) illustrates the extent to which discounted cash flow methods
were   used by MNCs that participated in various surveys from 1980 to 1994. These empirical
studies revealed two important points: first, discounted cash flow approaches are more popular
than rules of thumb; and, second, internal rate of return is more popular than net present value.
Thus, most MNCs use discounted cash flow approaches for ranking and selecting overseas pro-jects. The five studies cited in table 18.6 show that at least half of the respondents used dis-counted cash flow approaches, ranging from 50 percent according to Kelly’s study to 81 percent
in Stanley’s study
 Company goals
Most leading finance textbooks now agree with Anthony (1960) and Donaldson (1963) that a
firm should, first of all, maximize the wealth of stockholders. The best measure of stockholder
wealth is the market value of a firm’s stock, because the market value reflects the effects of all
financial decisions. The financial decisions made by the managers of a firm determine the level
of its stock price by affecting the riskiness and size of its earnings. In other words, the maxi-mization of stockholder wealth depends on the trade-off between risk and return. These rela-tionships are diagramed in figure 18.1. Although practically all financial decisions involve such
risk–return trade-offs, this model is particularly important for capital budgeting decisions because
capital investments are profitable, but they are subject to a variety of risks.
In vestment decisions – usually requiring very large sums of money – are made in expectation
of benefits over an extended period. Once capital budgeting decisions have been made, they are
extremely costly to reverse. Most used plant and equipment have a limited market. In certain
areas, production methods are rapidly outmoded by increasingly higher levels of technology.
More ov er, most financial variables used in the analysis of capital expenditures are not accurately
known in advance. Because investors and business executives are risk averters, efficient manage-ment of capital expenditures has become essential for healthy company growth.

                                  In   other words, more sophisticated capital budgeting techniques may be economically justi-
fied only if they increase the total value of a firm. Academic writers favor “sophisticated” capital
budgeting techniques (e.g., the net-present-value method) over rules of thumb (e.g., the payback
method). They argue that use of sophisticated methods will lead to higher earnings and less risk,
thereby increasing the market price of the common stock. Thus it seems reasonable to suspect
that a significant relationship exists between stock prices and capital budgeting practices. The
hypothesis may be stated in the following way: firms using a more sophisticated capital budget-
ing system enjoy higher stock prices than do firms using a less sophisticated capital budgeting
system.
Risk and performance measures based on the firm’s common stock market values are better
than risk and performance measures based on any other criterion. However, most writers on
capital budgeting reject this view on the grounds that shareholders know little about corporate
capital budgeting practices. Therefore, previous research studies have determined firm risk and
performance measures from accounting data. To investigate the changes and effects of capital
budgeting practices on risk and return, we can examine the results of capital budgeting studies
to test the following two hypotheses:
1Firms using a more sophisticated capital budgeting system have greater profitability than firms
using a less sophisticated system.
2Firm using a more sophisticated capital budgeting system are less risky than firms using a
less sophisticated system.
Our literature review indicated that only a handful of empirical studies had tested these two
hypotheses. Some tested these two hypotheses for domestic investment projects, but these studies
found no significant relationship between budgeting practices and risk or return. We found only
one such study for foreign investment projects. The study of 121 respondents by Stanley and
Block (1984) revealed a strong interest in stockholder wealth maximization as the primary goal
of the firm. In explaining why firms in their study might choose one capital budgeting method
ov er another, the factors of firm size, corporate goals, beta coefficients (systematic risk), and
foreign sales as percent of total sales were used to test for significant relationships. However, their
study failed to establish any significant relationship between capital budgeting practices and earn-
ings performance (stockholder wealth maximization) or risk (beta coefficients). Stanley and
Block, like other researchers, narrowly defined capital budgeting practices as the use or nonuse
of specific capital budgeting methods, such as payback or internal rate of return.
Fo reign investment decisions must be made today on the basis of the likely political climate for
many years to come. Political risk is an assessment of economic opportunity against political
odds. Thus, political risk assessment requires that MNCs evaluate both economic and political
indicators. Political risk management refers to steps taken by companies to protect against eco-
nomic losses from unexpected political events.
When the goals of MNCs and their host countries conflict, MNCs face a variety of political
risks. The primary goal of an MNC is to maximize the wealth of its stockholders. On the other
hand, most host countries desire to develop their economies through greater utilization of local
factors of production, in order to maintain more control over key industries through less reliance
on foreign capital and know-how, and to strengthen their international position through fewer
imports and more exports.
Multinational investors should understand the forces at work when political uncertainty
occurs, so that they can forecast future business climates, establish appropriate objectives, and
take precautionary measures when necessary. In this section, we discuss the nature of political
risks, types of political risks, political risk forecasting, and responses to political risks.
Traditionally, conflicts between MNCs and host countries have occurred over such issues as con-
version of an economy to the style of a specific political system, joint ventures, control of key
industries, contribution to balance of payments, national sovereignty, and economic develop-
ment. Such conflicts are not limited to developing countries. More subtle, yet very real, conflicts
exist between MNCs and developed countries.
It   is frequently difficult to separate political and economic risks. While government decisions
are political by definition, underlying forces behind the decisions may be purely economic. For
example, funds to nonresidents may be blocked because of an unexpected shortage of foreign
exchange or a long-run deficiency of the foreign exchange, instead of certain types of domestic
political pressures. Some government decisions are partly political and partly economic. The
United Nations imposed economic sanctions against Iraq in the fall of 1990 because of Iraq’s
invasion of Kuwait. The Organization of American States imposed economic sanctions against
Haiti in 1994 because of Haiti’s human rights violations. Finally, the USA and several other
Western countries have imposed a variety of economic sanctions against Afghanistan, Cuba, Iran,
Libya, and North Korea for many years.
Countrywide political risks depend on three broad groups of variables: political climate, eco-
nomic climate, and foreign relations. The political climate may be measured by tendencies toward
subversion, rebellion, or political turmoil. Multinational investors should consider such factors
as levels of political violence, the existence of extreme tendencies among political parties, and
recurring governmental crises.
In vestment analysts should make an overall assessment of the economic climate to protect
foreign investment from political risks. Relevant economic factors include the likelihood of gov-
ernment intervention in the economy, levels of interest and inflation rates, persistent balance-of-
payments deficits, levels of foreign debts, and worsening monetary reserves.
Finally, multinational investors should determine the extent to which host countries manifest
hostility toward other countries. Important factors here are incidence of conflict with their neigh-
bors, evidence of an arms race, and sizes of defense budgets.
Empirical studies have revealed some interesting findings about the attitudes of US and British
MNCs toward political risk. Kelly and Philippatos (1982) surveyed 67 US companies to obtain
the perceived importance of five variables in political risk. Goddard (1991) surveyed 51 British
companies to determine the importance of six variables in political risk. Ranked in descending
order of importance, their findings appear in table 18.5. Although there are several different types
of political risk, these risks can be divided into two broad categories for all practical purposes:
actions that restrict the freedom of a foreign company to operate in a given host environment,
and actions that result in the takeover of alien assets.
OPERATIONAL RESTRICTIONS Actions that restrict the freedom of a foreign company include
operational restrictions such as employment policies; locally shared ownership; loss of transfer
freedom; exchange controls; financial, personal, or ownership rights; breaches or unilateral revi-
sions in contracts and agreements; discrimination through taxes or compulsory joint ventures;
and damage to property or personnel from riots, revolutions, and wars.
Funds are usually blocked in the host country when operational restrictions are imposed.
There are a number of ways to remove blocked funds. The most obvious way is to arrange swaps
between corporations. Here, each corporation lends to the other in the country where its own
funds are restricted. Other methods include transfer price adjustments and other adjustments