“With the U.S. economy’s spectacular performance over the last decade, why bother with the political instability, the double-digit inflation, and the local currencies [of foreign markets] that can implode overnight? One reason: ‘That’s where the growth is,’ says Robert Gluck, vice president and treasurer of Bestfoods . . . Few U.S. companies, however, are chasing that growth. While strategic planners are willing to make large, risky technology investments of uncertain benefit, the same isn’t true of foreign investments, whose risks and rewards are similarly difficult to quantify.”
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…The standard practice is to apply the principles of the capital asset pricing model (CAPM), where the net present value (NPV) of estimated future cash flows from an investment is calculated. If the NPV is greater than the cost of the project, then the investment makes sense. For North American investments, the future cash flows are discounted using the firm’s average weighted cost of capital. With overseas investments, the process gets more complicated. Not only does the investment carry more systematic risk (such as inflation and currency devaluation) and sovereign risk (such as unfavorable legal or tax changes, expropriation of assets, or war), but it also carries more nonsystematic risk–risk specific to the venture at hand. These could include product acceptance, start-up cost overruns, or labor problems.
Rather than isolate and quantify these elements of risk, most companies simply add on a premium to the firm’s domestic cost of capital to reflect the extra risk. Thus, a hurdle rate for an investment in China might be set at cost of capital plus 5 percent. Brazil might get a 10 percent premium. “There’s a lot of ad hoc decision-making when it comes to setting hurdle rates,” says Rafael Resendes, of capital markets advisory firm Applied Finance Group, in Chicago. Instead of systematically analyzing risks and potential returns, executives end up making or not making investments for subjective, strategic reasons. The problem is, because of home market bias, many executives end up artificially inflating the costs of capital in foreign markets, and consequently passing up good projects.