This paper reviews whether capital budgeting techniques process differ across industries, countries or firms of different sizes and looks into the challenges for Multinational Corporations. The paper considers the study that was done by Ryan (2002) in US on whether capital budgeting has changed with time in Fortune 1000.

The study shows that for many years the capital budgeting during ancient times was done by non-discounting techniques of capital budgeting. The managers believed that they were simple to understand. However, over the years due to thegrowth of industries and the technology many people have shifted to the discounting forms of capital budgeting from the non-discounting. The most common type of discounting technique is the Net Present Value. This is a change of what the initial managers of corporations believed.  However, over the years managers have come into an agreement with the academics over the applications of discounted forms of capital budgeting.

The paper also sought to determine the challenges that the capital budgeting techniques face in MNCS. The challenges can be broadly be classified as economic and political challenges. The economic challenges include; the inflation, financial crisis, time value for money and currency changes. The political factor provides a conducive environment for the stable application of the capital budgetingtechniques in these MNCs. There are other challenge which include; inability to determine the payback period and the required rate of return, the difference between the project cash flow and the parent company and the cost of capital in the MNCs.

Introduction

Capital budgeting is a technique that is used to evaluate long term investments or projects in an entity. It is a planning process for projects that requires huge investments. The process of capital budgeting has formal methods that are used in the appraisal of the project. They include: Accounting rate of return, Payback period, Internal rate of return, Net present value, Profitability index, Equivalent annuity, Modified internal rate of return and Real options valuation. The Net present value (NPV) and Internal rate of return (IRR) are commonly used in the evaluation of the project.

The methods of capital budgeting are important to the management. They ensure that the shareholders wealth is maximized. This is because theyconsider appraising the projects with positive returns. Over the last four decades companies have used the non-discounted techniques to analyse the projects cash inflows and cash outflows. However, today the most common form of capital budgeting is the discounted one, NPV. The paper discusses the capital budgeting decisions applied by the Fortune 1000 companies (Gerrans 1995).

The paper is subdivided into three sections; the various forms of capital budgeting and their applicability in different industries, firms or countries, challenges facing capital budgeting in multinational corporations and conclusion.

Determinants of Exchange Rate Volatility

Exchange rates results from the different valuation of currencies of different countries. The exchange rates are very dynamic responding to various changes in the economy. The effects of these changes are always evident with various commodities changing and prices of goods and services responding to the various changes in the value of the different currencies. The currencies of different countries are affected by the changes in demand and supply of the currency in an economy. As such the rise in demand of a currency will result to the rise in the value of the currency. The effect will be similar to the when the value reduces and due to the increase in supply of the commodity.

Consumer spending is another cause of the change in the value of the currency. This is because the consumer spending directly affects the demand and supply of currency. It is hence explained that the exchange rate of a country reflects the supply and demand of money.  The economy of a given country determines the value of the given specific currency. When the economy of a country falters the consumer spending will decline, as a consequence the trading activities within the country declines. This means that the countries money supply reduces the demand of the currency falls and in effect the value of the currency declines.  The value of the currency will be poor compared to other stronger economies currencies. In the case of a booming economy the value of the currency will increase and the total gain to the economy will reflect on the change in the value of the currency. Only government intervention can inhibit the currency not to respond to the effects of demand and supply.

The macroeconomic factors that influence the trend on currencies involve:

Interest Rates

The interest rates from the central banks will affect the rate at which banks and other financial institutions charge individuals and business when borrowing from the institutions. The interest rates are used by the governments to control the economy. For example in case the economy is underperforming the government will reduce the interest rate and it will be cheaper to borrow. As such the economy will have increased money supply due to increased consumer spending. The resultant effect will be a boost of the local currency. In case the inflation is too high the central bank will increase the value of the interest rate resulting to a decrease in the value of money supply.

Employment

Employment levels in an economy determine the value of the changes in the consumer supply. When the unemployment levels increase this slows down the economy and as such the country’s currency value will decline. The increasing unemployment reduces the confidence in an economy lending to the decline in demand of commodities. The general effects will be a rise in the supply of the currency lending to the depreciation of the currency.

Economic Growth

Economic growth rate affects the currency rate of country. A strong economic growth rate results in the increase in the value of the currency. This is because there is an increase in demand in such a country. However, the country may grow so rapidly resulting to inflation, as such the government will raise interest rates to reduce the aggregate demand and as a result the value of the currency will go down.

Trade Balance

This is the value of exports less the value of total imports. A positive figure from the difference indicates that the country favourable balance of trade. In case of a negative figure then the country has a deficit in its balance of trade.  The balance in trade will affect the demand and supply the currency. When a country has more exports than imports it means that the country will have more foreign transactions and the demand of the currency increases so as to purchase the goods and services. This will in effect mean that a country currency will increase in value because of the rise in demand. If there are more imports than exports resulting to a deficit the county will have an excess supply of the currency, this may result to devaluation of the currency if there is no government intervention.

Central Banks Actions

The governments of different economies have different way they affect the economic policies. a majority of the government through their central banks have intervened in the economy through the interest rates. As such most of the options available have the countries have been exploited. In this regard the most government have resulted to having a low interest rate which is almost fixed. To be able to influence economic growth and intervene in the economic markets, the governments are using other measures. Some measures that have been used by the governments includes; quantitative easing, this involves the use of government bonds to provide extra security to corporations so as they may be more liquid. The effects of the government bonds will be an increase in money supply which many have a positive or negative effect on the currency. An increase in money supply may result to devaluation of the currency if not well observed.

External Economic Conditions

A country’s economic condition may be strong enough to have highly valued currency. However, external economic conditions will dictate the nature of the exchange. For example, when the world was facing a financial crisis the demand of goods in most markets fell while most banks had strict credit policies. The resultant effect will be a fall in the value of the worlds strong currencies.

Regression Analysis

The regression analysis uses the country growth rate, inflation rate and interest rates for thirty years to determine the effects on the value of exchange rates. The results of the effects on the exchange rate of SAR to US dollar are given below.

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

dim

1

.530a

.281

.198

.1234488

ANOVAs

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

.155

3

.052

3.383

.033a

Residual

.396

26

.015

Total

.551

29

A. Predictors: (Constant), Gdp, Int, Inf

B. Dependent Variable: Exg

 Coefficients

Model

Unstandardized Coefficients

Standardized Coefficients

T

Sig.

B

Std. Error

Beta

1

(Constant)

3.569

.068

52.294

.000

inf

.004

.009

.085

.460

.649

int

.028

.016

.307

1.822

.080

gdp

.004

.002

.374

2.015

.054

a. Dependent Variable: exg

The results show that the R and are R squared are 0.530 and 0.281 respectively as such only 0.281 of I of the variables used by this analysis explain the effects on the exchange rates. As such there are many other variable that explain the changes in the interest rates.

The analysis shows that inflation rate and the exchange rate are positively correlated although the magnitude of the correlation is weak (0.004), the results also indicate that the inflation rate are not statistically significant in determining the exchange rates (t-stat 0.460, f-stat 0.649).The probability of occurrence of an error in this data is very low.

The results hence indicate that the inflation rate is not a key element in determining the exchange rates. This can be attributed by the fact that inflation results from various elements which affect the exchange rate either positively or negatively. Inflation is thus not significant in determining the direction of the exchange rate even though when inflation increases the exchange rate also increases weaken the SAR against the use dollar (Gerrans 1995).

The other independent variable in the analysis is interest rates. The analysis shows that the interest rates will be positively correlated to exchange rates. However, the magnitude of the relationship is weak (0.028).  Further analysis indicates that interest rate is significant in the determination of exchange rates (t-stat-1.822). The results hence shoe that increase in the interest rates will led to an increase in the exchange rate of SAR to US dollar an increase of interest by one unit led to the increase of exchange rate by 0.028 units. The increase in interest rate will cause the SAR to weaken against the US Dollar. These results can be attributed to the fact that increase in interest rate reduces purchasing power and the money supply reduces, as such the demand of the currency reduces reducing the value of the currency. The statistics also indicate a strong significant level the relationship. This means that the effect of the interest rates will reflect in the exchanges rates.

The other independent variable is economic growth rate. The analysis shows that there is a positive relation between the economic growth and the interest rate. The magnitude of this relationship is very weak (0.004). However, further analysis indicates that the Economic growth rate is very significant (t-stat 2.015). This analysis shows that the contribution of Economic growth in the exchange rates is weak but significant. This may be attributed to the fact that economic growth rate reflects on the aggregate demand in the economy but and includes various individual factors that affect the interest rates.

US Dollar against the Euro regression analysis

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

dimension0

1

.451a

.204

.112

.0530747

a. Predictors: (Constant), gdp, int, inf

ANOVAb

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

.019

3

.006

2.218

.110a

Residual

.073

26

.003

Total

.092

29

a. Predictors: (Constant), gdp, int, inf

b. Dependent Variable: exg

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

1

(Constant)

.758

.029

25.836

.000

inf

-.008

.004

-.402

-2.059

.050

int

.007

.007

.188

1.059

.299

gdp

.000

.001

.024

.125

.901

a. Dependent Variable: exg

The above is a regression analysis of the factor that affects the exchange rate between the US dollar and the Euro. The   analysis has R (0.451) and the R squared is (0.204). As such the result show that there is other various factor that affect the rate of exchange between the US dollar and the Sterling pound.

According to this analysis, the inflation rate is weakly negatively correlated with the exchange rate while the value of the statistical significance shows that inflation is statistically significant (2.509)

US Dollar to the Sterling Pound Analysis

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

dimension0

1

.567a

.321

.243

.13955

a. Predictors: (Constant), gdp, int, inf

ANOVAb

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

.240

3

.080

4.104

.016a

Residual

.506

26

.019

Total

.746

29

a. Predictors: (Constant), gdp, int, inf

b. Dependent Variable: exg

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

T

Sig.

B

Std. Error

Beta

1

(Constant)

1.579

.077

20.471

.000

inf

.018

.010

.318

1.764

.090

int

.003

.018

.031

.188

.853

gdp

.004

.002

.352

1.954

.062

a. Dependent Variable: exg

Various Forms of Capital Budgeting

There various forms of capital budgeting techniques that have been applied over the years in order to appraise a long term project or an investments. These techniques are broadly classified as discounting and non-discounting capital budgeting techniques. The discounting techniques include Net present value and internal rate of return. The non-discounting techniques include the payback period, Profitability index, Equivalent annuity, Modified internal rate of return and Real options valuation.

In the last four decades different industries and firms preferred the use of non-discounting capital budgeting techniques over the discounting techniques. During that time the financial managers and the academics did not agree which was the best capital budgeting technique. The most commonly used techniques were the payback technique and accounting rate of return technique. The preference to non-discounting techniques is because of the less sophistication and limited application of computer technology during that time unlike the massive use of discounting techniques today.

Different industries apply different methods of capital budgeting in the evaluation of the projects. The techniques that different companies use depend on the nature of the company and the size of the company. Majority of the companies use the discounting techniques such as NPV, however, there those industries that have continued to use non-discounting techniques. When the company is small, in most cases it is not sophisticated. The projects that these small industries have sometimes are short term projects with small lifespan. These companies usually prefer non discounting methods of capital budgeting because they are cheap and also easy to apply and understand (Gerrans 1995).

In the past few years, the mangers have preferred the use of IRR over the NPV. This is because most managers have perceived the percentage return as easily understood to the absolute increase in the dollar value in shareholder wealth. According to Evans and Forbes in 1993 said that IRR is a more cognitive measure of comparison.

In the recent past the managers have started moving from IRR to NPV.  The academics have for a long time been in support of NPV. This is because of the following reasons; the NPVgives the expected change in the shareholders wealth when one is given the projected cash flow and discount rate and it also assumes that when the project takes longer time the proceeds are reinvested at the cost of capital. The NPV also shows the amount of dollar that is expected to increase to the shareholders upon the acceptance of the project when NPV is positive.

Capital budgetingtechniques differ from different firms and countries. According to Ryan (2002) when she conducted a survey in US, different countries have different techniques of the projects analysis. The process of adoption of a common type of capital budgeting has come a long way. Today most companies especially the multinational companies have adopted the use of NPV in their appraisal of the projects that they have.

The size of the company is also a factor the determination of the type capital budgeting that will be required. The study that was conducted in 2002 using the Pearson Chi-square test indicated that there is a positive relationship between the size of a firm or capital budget and the use of capital budgeting techniques. The Pearson Chi-square usually shows the differences between two or more groups. The size of the company or the project underway is significant in the determination of rates of return that are required in the capital budgeting techniques (Gerrans 1995).

Challenges Facing Capital Budgeting in Multinational Corporations

Capital budgeting is faced with both economic and political risks in MNCs. When the industries are evaluating project they should put into consideration of the economic changes that can occur in the economy.

The economic challenges that occur in the economy include; the inflation, financial crises, time value for money and currency fluctuations.

Inflation

Inflation is the constant general increase in the prices for goods. The method of capital budgeting that is used in appraisal of the company’s project should in a position to take care of this. Inflation affects the projects that are being appraised. The discounting methods take account of the inflation through the discounting rate. The non-discounting rates however they do not take account of the inflation in the economy. When the economy becomes affected by inflation the projects that are being appraised are too affected. The way that the project was evaluated becomes affected. The project is adversely affected. This goes down the line to the MNCs which use these techniques in appraising their projects. The techniques may give the wrong results when affected by the inflation.

Financial crisis

A financial crisis is an economic risk to capital budgeting technique of evaluation of long term project. A financial crisis is an external force that affects the projects that the industries or the governments have. The method that was used in the analysis of the projects is also affected and the results that they give become futile. The firm may suffer financial loss due the global financial crises. The MNCs will not be in a position to get the required information due the effect of the financial crisis.

Time Value of Money

The time value of money is also an economic factor that affects the capital budgeting techniques. The methods of capital budgeting evaluate the projects in monetary terms. The value of money depreciates with time. The techniques are used to evaluate future inflows and outflows of a certain project and determine their viability in the current time. When the technique does not take into consideration of this, it will be affected adversely. There are other techniques such as discounting techniques which take into account of the time value of money. This is taken care by the discounting factor. When it is expected that the value of the money will change significantly, the discounting rate is usually set at a high. The non-discounting especially payback period method usually consider minimising the payback period. This will reduce the time in which the value of money will be affected. It therefore ensures that the industry or the firm s not affected so much.

Political Risk

The capital budgeting techniques are also affected by the political stability of a country. The political stability ensures that the evaluated project stick to what had been evaluated by the any capital budgeting technique. When there is political instability the cost of administration of the projects that are underway increases. The instability also disrupts the cash inflows and cash outflows of the projects that are under way. The technique of appraisal becomes very hard to use because it doesnot show the correct value of the project.

There are other draw backs that affect the capital budgeting techniques;

Required Rate of Return

The determination of the required rate of return on the capital budgeting technique is an obstacle that thesemethods face. The required rate of return takes into account the foreseeable and non foreseeable factors that affect the project over time. They include both the economic factors such as inflation and political factors such as elections and war. The determination of the required rate of return is not with any certainty. It is usually determined through subjective manner.

Payback period

The payback period is the time that the project under way should able to recover the initial amount that has been invested. The time in which the project is able to recover its initial amount is important in project evaluation. During economic crises or political instability it should be maintained at the shortest period of time. The challenge that faces the capital discounting technique in multinational companies is to determine the minimum or the optimum payback period.

 The multinational companies face the challenge of using different capital budgeting techniques because they are from different countries. They therefore exhibit different cash flows. It becomes hard for the MNC to coordinate their activities because one technique in a certain country is favourable to a certain project which might be unfavourable to another country.

The Foreign Tax Regulations

The capital budgeting techniques for MNC are faced with the challenge of foreign tax regulations. Different countries have different types of tax regulations that govern the country. These tax affect the capital budgeting techniques because when a certain country instils or keeps on altering the regulations it will hamper with the cash inflowsand outflows of the company involved. The problem will be transferred to the subsidiary companies (Gerrans 1995).

The Cost of Capital

The cost of capital in MNC is high.  The maintenance of the projects from different companies from different countries is high. The methods of capital budgeting are affected by this. This cost is factored in by the capital budgeting.

Conclusion

The application of capital budgeting techniques varies from one country to another and amongst firms. The techniques are generally classified into the discounting techniques and non-discounting techniques. In older days, the most common form of capital budgeting technique was the non-discounting techniques. Over the years the managers did disagree with academics over which is the appropriate form of technique that should be used to evaluate long term projects. The mangers referred the non-discounted techniques whereas the academics preferred the discounted techniques.

The reasons behind the massive application of non-discounting capital budgeting techniques are due to the limited use of technology and less sophistication of the industries during that era. The trend over the years has changed. The managers stared through adoption of IRR. This technique was more considered to the NPV.

The capital budgeting techniques is faced with many challenges in MNCs. These challengesinclude both the economic and political challenges. The economic factors include the inflation, financial crises, time value for money and currency fluctuations. They affect the way the techniques evaluated the business. They may cause the technique to overstate the expected cash flows and outflows. The political stability of a country also affects the capital budgeting process. When there is political stability in a country the MNC companies are able to thrive properly. The are other challenges that affect the capital budgeting in multinational companies, these include; the  foreign tax regulations, the difference between the project cash flows and the parent company, determination of the required rate of return and the cost of capital.

Order now

Related essays