Question

2. Now relax the assumption that the expected free cash flows are uncorrelated with the spot exchange rate. Give an example where the cash flows of the foreign project are affected by exchange rate risk, and suggest an approach to address this issue when valuing the project. Add your own assumptions to the information above to provide a simple numerical illustration of capital budgeting with exchange rate risk.

Answer 1

When projects are being are operated in another country or sale is being made to another party which is going to make the payment in his home currency then the cash flow is exposed to foreign exchange risk. The foreign country projects are specially exposed to foreign exchange risk if at the end of year, the profit has to be transferred to the parent company. One way to hedge this exposure would be to estimate the cash flows in the currency in which the sale is being made and then enter into either a forward or future contract to exchange the currency. The company cash flow can also be exposed to foreign exchange rate if the raw materials are being imported from other country and payment has to be made in a different currency. The forward is more customized form of contract where forward is more a standardized contract so company can either enter into a forward or future contract. Let’s say the company is expecting to receive 1,000,000 Euro payment next year and the company is headquartered in US, it can enter into a forward contract where it will 1,000,000 Euro into dollar at certain rate say 0.98Euro = $1 US