A Critical Essay on International Finance

A Critical Essay on International Finance
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Introduction
The business companies emphasize on seeking growth and expansion by continually
investing in new markets and thereby realizing increased revenues and profits. The multinational
companies conduct their operations on a global platform and as such have to undertake decisions
by investing in local or foreign countries. The multinational firm acquires the capital or funds
required to make such investment either from debt or equity resources. The value delivered by a
multinational project is dependent on the expected cash flows and also on the cost of the funds.
The cost of capital acquired is an important aspect in determination of the investment decisions
undertaken by a multinational firm. However, determination of the cost of capital is also
dependent on the characteristics of the investment. The higher is the risk associated with the
investment the greater is the cost of capital and this can be adequately measured by the use of
Capital Asset Pricing Model (CAPM) (Somanath, 2011). In this context, this essay has been
developed for evaluating the application of CAPM model in assessing the cost of capital for a
foreign project.
Literature Review on Critical Evaluation of Capital Asset Pricing Model (CAPM) for
reviewing Cost of Capital for Foreign Projects (Required rate of return is also referred as
cost of capital)
According to information realised from BPP Learning Media (2017), the cost of capital is
the weighted average of the costs that are incurred in acquiring funds for carrying out an
investment that includes both debt and equity sources of finance. The cost of equity is related
with the risk that is undertaken by the equity investors while investing and cost of debt is the risk
perceived by the lenders at the time of investing in a capital project. The relative weight of each
of the component sources of finance reflects their proportion used in financing an investment.
The business firms tend to develop a capital structure that intends to reduce the cost of capital
and maximize the required rate of returns. The cost of capital can be stated as the rate that must
be realized for satisfying the required rate of return on an investment. It has a large impact on the
value of an investment and is used by business managers for selecting an investment option that
is able to provide maximum profits in the future context. For example, if there are two
investment options having same returns, then the option having lower cost of capital will be
selected for investment purpose as it will provide higher profits (BPP Learning Media, 2017).
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According to Park and Matunhire (2011), the cost of capital for domestic projects is
significantly different from that of international projects due to impact of external environmental
factors such as economic, political, legal or technological. The different countries possess
different business environments and thus the required rate of return varies in carrying out
projects in a domestic or global environment. The difference in inherent risks for the firm of each
country is responsible for realizing varying returns for specific projects being carried out by a
multinational firm in different countries. This requires a multinational firm to evaluate the
required rate of return for specific projects as the use of a single rate of return for all the projects
carried out by an international firm can result in providing incorrect results till they are having
similar cost structures and commercial risks. As such, it can be said that it is highly important for
a multinational firm to evaluate whether the rate of return to be realized by a foreign project is
same that of domestic project (Park and Matunhire, 2011). The major factors that are responsible
for causing the difference between costs of capital for multinational projects as compared to the
domestic projects undertaken by an international firm can be discussed as follows:
Size of Project: The projects that are carried out in an international context are bigger in size as
compared with that carried out in domestic environment. The international projects are bigger in
size as therefore borrow higher amount of funds to achieve their determined goals or objectives.
As such, the international projects are often associated with higher risk as compared with
domestic projects due to their higher cost of capital.
Foreign Exchange Risk: The cash flows to be realized from an international project are also
largely impacted by the fluctuations in the exchange rate. This can lead to increasing the risk for
shareholders and lenders who are investing within the project thus leading to its higher cost of
capital. However, it is not always the case that the fluctuations in the exchange rate can result in
negatively impacting the cash flows of multinational corporations. The movement of currency in
a positive manner can help in gaining larger returns from an investment (Gaspar and Arreola-
Risa, 2013).
Increased availability of funds from international markets: The international projects of a
MNC are carried out in a global context and thus are exposed to global investors which make its
relatively easy for a multinational firm to gain funds at a lower cost of capital as compared to the
domestic projects. The subsidiaries of a multinational firm can obtain funds at a lower rate of
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