How do you evaluate an international capital budgeting project when you have to deal with foreign currency cash flows?
I'm studying corporate finance for CFA Level II and I'm confused about international NPV analysis. If a US company builds a factory in Brazil, should it discount BRL cash flows at a BRL discount rate, or convert everything to USD first? I've seen two approaches and I'm not sure when to use each one.
International capital budgeting is a key CFA Level II topic. There are two equivalent approaches, and you need to understand both.
Approach 1: Home Currency Approach (Convert then Discount)
- Project future cash flows in the foreign currency (BRL)
- Convert each year's BRL cash flow to USD using forward exchange rates (or PPP-implied rates)
- Discount the USD cash flows at the USD-denominated discount rate (WACC in USD)
Approach 2: Foreign Currency Approach (Discount then Convert)
- Project future cash flows in BRL
- Discount at the BRL-denominated discount rate
- Convert the resulting NPV to USD at the spot exchange rate
Both approaches should give the same answer if forward rates are consistent with the interest rate differential (covered interest rate parity holds).
Worked Example:
Atlas Manufacturing (US) evaluates building a plant in Brazil.
- Investment: BRL 200 million (Year 0)
- Annual BRL cash flows: BRL 60M for 5 years
- Spot rate: 0.20 USD/BRL (5.00 BRL/USD)
- USD WACC: 10%
- BRL WACC: 15% (higher due to higher Brazilian rates)
- Forward rates implied by interest rate parity:
| Year | Forward Rate (USD/BRL) |
|---|---|
| 1 | 0.20 x (1.10/1.15) = 0.1913 |
| 2 | 0.20 x (1.10/1.15)^2 = 0.1830 |
| 3 | 0.20 x (1.10/1.15)^3 = 0.1750 |
| 4 | 0.20 x (1.10/1.15)^4 = 0.1674 |
| 5 | 0.20 x (1.10/1.15)^5 = 0.1601 |
Home Currency Approach:
| Year | BRL CF | Forward Rate | USD CF | PV at 10% |
|---|---|---|---|---|
| 0 | -200M | 0.2000 | -$40.0M | -$40.0M |
| 1 | 60M | 0.1913 | $11.48M | $10.44M |
| 2 | 60M | 0.1830 | $10.98M | $9.07M |
| 3 | 60M | 0.1750 | $10.50M | $7.89M |
| 4 | 60M | 0.1674 | $10.04M | $6.86M |
| 5 | 60M | 0.1601 | $9.61M | $5.96M |
| NPV | $0.22M |
Additional Considerations for International Projects:
- Country risk premium: Add a premium to the discount rate for political risk, expropriation risk
- Tax differences: Consider withholding taxes on repatriated profits
- Blocked funds: Some countries restrict capital repatriation
- Subsidies: Host governments may offer tax holidays or grants
Exam tip: CFA Level II typically asks you to calculate NPV using one of these approaches and may test whether you can derive forward rates from the interest rate differential. The key principle is consistency: match currency-denominated cash flows with the corresponding currency-denominated discount rate.
For more corporate finance content, explore our CFA Level II course on AcadiFi.
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