Can someone compare the advantages of using a higher discount rate and forecasting lower cash flows to evaluate such projects.
When using capital budgeting techniques to evaluate a potential foreign project, a firm needs to recognize the specific political and economic risks (including foreign-exchange risk) arising from that foreign location.
When a project is being evaluated to see the profitability of the project and decide if it would benefit the company to set up the project all the accompanying risks have to be taken into consideration.
In the case of a foreign project the number of factors that have to be accounted for becomes even larger. There are political risks and economic risks that may be specific to the nation in which the project is being set up but not present where the company is situated.
A lower cash flow accounts for increased costs and reduced sales. This could be due to the economic conditions in the country the project is based in. For example, the government may decide to increase interest rates to curb inflation which would reduce consumption. Also, there is a possibility of political unrest and a complete change in government policies that could drastically alter the import and consumption regime in the country.
Increasing the discount rate accounts for factors that include foreign exchange rate fluctuations. If the currency of the nation that the project is to be located in depreciates it would decrease the amount that the company receives in terms of its currency even if the sales revenue in the nation where the project is located remains the same. A higher discount rate can also accommodate changes in the interest rate scenario of the nation that could make it more expensive to borrow funds.