If an MNC is unsure of the estimated cash flows of a proposed project, it needs to incorporate an

Adjustment for this risk. Three methods are commonly used to adjust the evaluation for risk:

• Risk-adjusted discount rate

• Sensitivity analysis

• Simulation

Each method is described in turn.

Risk-Adjusted Discount Rate

The greater the uncertainty about a project’s forecasted cash flows, the larger should be the
discount rate applied to cash flows, other things being equal. This risk-adjusted discount rate tends
to reduce the worth of a project by a degree that reflects the risk the project exhibits. This approach
is easy to use, but it is criticized for being somewhat arbitrary. In addition, an equal adjustment to
the discount rate over all periods does not reflect differences in the degree of uncertainty from one
period to another. If the projected cashflows among periods have different degrees of uncertainty,
the risk adjustment of the cashflows should vary also.

Consider a country where the political situation is slowly destabilizing. The probability of
blocked funds, expropriation, and other adverse events Is increasing over time. Thus, cashflows sent
to the parent are less certain in the distant future than they are in the near future. A different
discount rate should therefore be applied to each Period in accordance with Its corresponding risk.
Even so, the adjustment will be subjective and may not accurately reflect the risk.

Despite its subjectivity, the risk-adjusted discount rate is a commonly used technique,
perhaps because of the ease with which it can be arbitrarily adjusted. In addition, there is no
alternative technique that will perfectly adjust for risk, although in certain cases some others
(discussed next) may better reflect a project’s risk.

Sensitivity Analysis
Once the MNC has estimated the NPV of a proposed project, it may want to consider alternative
estimates for its input variables.

The two exchange rate scenarios developed earlier represent a form of sensitivity analysis.
Sensitivity analysis can be more useful than simple point estimates because it reassesses the project
based on various circumstances that may occur. Many computer software packages are available to
perform sensitivity analysis.

Simulasi

Simulation can be used for a variety of tasks, including the generation of a probability distribution for
NPV based on a range of possible values for one or more input variables. Simulation is typically
performed with the aid of a computer package.

Example

Reconsider Spartan, Inc., and assume that it expects the exchange rate to depreciate by 3 to 7
percent per year (with an equal probability of all values in this range occurring). Unlike a single point
estimate, simulation can consider the range of possibilities for the Singapore dollar’s exchange rate
at the end of each year. It considers all point estimates for the other variables and randomly picks
one of the possible values of the Singapore dollar’s depreciation level for each of the 4 years. Based
on this random selection process, the NPV is determined. The procedure just described represents
one iteration. Then the process is repeated: The Singapore dollar’s depreciation for each year is
again randomly selected (within the range of possibilities assumed earlier), and the NPV of the
project is computed. The simulation program may be run for, say, 100 iterations. This means that
100 different possible scenarios are created for the possible exchange rates of the Singapore dollar
during the 4-year project period. Each iteration reflects a different scenario. The NPV of the project
based on each scenario is then computed. Thus, simulation generates a distribution of NPVs for the
project. The major advantage of simulation is that the MNC can examine the range of possible NPVs
that may occur. From the information, it can determine the probability that the NPV will be positive
or greater than a particular level. The greater the uncertainty of the exchange rate, the greater will
be the uncertainty of the NPV. The risk of a project will be greater if it involves transactions in more
volatile currencies, other things being equal. ■

In reality, many or all of the input variables necessary for multinational capital budgeting may be
uncertain in the future. Probability distributions can be developed for all variables with uncertain
future values. The final result is a distribution of possible NPVs that might occur for the project. The
simulation technique does not put all of its emphasis on any one particular NPV forecast but instead
provides a distribution of the possible outcomes that may occur. The project’s cost of capital can be
used as a discount rate when simulation is performed. The probability that the project will be
successful can be estimated by measuring the area within the probability distribution in which the
NPV 0. This area represents the probability that the present value of future cashflows will exceed the
initial outlay. An MNC can also use the probability distribution to estimate the probability that the
project will backfire by measuring the area in which NPV < 0.

Simulation is difficult to do manually because of the iterations necessary to develop a

distribution of NPVs. Computer programs can run 100 iterations and generate results within a matter
of seconds. The user of a simulation program must provide the probability distributions for the input
variables that will affect the project’s NPV. As with any model, the accuracy of results generated by
simulation will be dependent on the accuracy of the input.

Controls over International Project Proposals

The feasibility of a project proposed by managers of an MNC is highly dependent on their

estimates of revenue and cost-related cash flows. To the extent that managers are rewarded based
on sales growth within their division, they may be tempted to exaggerate their estimates of cash
inflows in order to ensure that their projects are approved. Proper governance can prevent this type
of agency problem. First, the estimates should be thoroughly examined to determine whether they
are reasonable. Second, a project’s feasibility can be assessed after it has been implemented to
determine whether the estimated cash flows by managers were reasonably accurate. However,
many international projects are irreversible, so an ideal control system would assess the proposal
closely before investing the funds in the project. ■

Kesimpulan

 Capital budgeting may generate different results and a different conclusion depending on
whether it is conducted from the perspective of an MNC’s subsidiary or from the perspective
 of the MNC’s parent. The subsidiary’s perspective does not consider possible exchange rate
and tax effects on cash flows transferred by the subsidiary to the parent. When a parent is
deciding whether to implement an international project, it should determine whether the
project is feasible from its own perspective.
 Multinational capital budgeting requires any input that will help estimate the initial outlay,
periodic cashflows, salvage value, and required rate of return on the project. Once these
factors are estimated, the international project’s net present value can be estimated, just as
if it were a domestic project. However, it is normally more difficult to estimate these factors
for an international project. Exchange rates create an additional source of uncertainty
because they affect the cash flows ultimately received by the parent as a result of the
project. Other international conditions that can influence the cashflows ultimately received
by the parent include the financing arrangement (parent versus subsidiary financing of the
project), blocked funds by the host government, and host government incentives
 The risk of international projects can be accounted for by adjusting the discount rate used to
estimate the project’s net present value. However, the adjustment to the discount rate is
subjective. An alternative method is to estimate the net present value based on various
possible scenarios for exchange rates or any other uncertain factors. This method is
facilitated by the use of sensitivity analysis or simulation.