Multinational WACC

The appraisal of projects is a complicated area, especially if investments take place in countries other than the domestic country. It is common to confront additional challenges, eg: Which perspective to take? Is it the project's cash flows in the host country or, those cash flows expected to be repatriated to the head office?. The receipt of net cash flow in the domestic currency is usually exposed to foreign exchange risk; What is the systematic risk on an international project? and Political/country risk.

There are 2 approaches in discounting overseas project cash flows: Discount the overseas cash flows at the overseas discount rate to create a overseas NPV. Then convert this NPV at the current spot exchange rate to give the NPV in home currency; Convert each of the estimated future overseas cash flows into home currency. Then discount these to generate a home currency NPV. Problem: Difficult to hedge project cash flows against currency risk.

Overall, however, overseas projects should be evaluated from the parent point of view. That is, after allowing for restrictions on cash repatriation. By diversifying internationally the variance (standard deviation) of the investor's or the firm's portfolio is generally reduced and therefore the equity risk premium can be reduced.

Shareholders with an internationally diversified portfolio will theoretically measure the systematic risk of an individual share in terms of a worldwide portfolio and global betas. Many investors are not fully diversified internationally and firms can lower risk for shareholders through international diversification

International diversification of operations can lower the fluctuations in shareholder returns back home, which is a force that lowers the cost of capital. However, many institutional investors are diversified internationally (among developed economies) and so required returns are determined by these international diversified investors.

In many parts of the world the financial markets are illiquid and function poorly, and the cost of capital is relatively high - global accessibility of finance outside of the home base has led to greater availability of finance at lower cost.

There are factors raising the cost of capital when sourced abroad. These include foreign exchange risk, asymmetric information and political/economic risk. There is thus a trade-off between the benefits and additional costs of raising funds overseas.

The cost of debt for a MNC is higher in some countries than in others due to: - The risk free rate of return being higher. - The risk premium being higher.

The cost of debt for large firms can generally be estimated using publicly available information such as the bond yields incurred by other firms in that country carrying the same risk as the proposed project.

If a firm diversifies its portfolio of projects internationally there is an argument that it will have less cash flow variability and therefore the risk, as perceived by lenders would be lower, resulting in a lower cost of debt. However, this is frequently more than offset by the agency costs of debt, political risks, foreign exchange risks and asymmetric information costs.