Google Answers Logo
View Question
Q: International capital budgeting ( Answered 4 out of 5 stars,   0 Comments )
Subject: International capital budgeting
Category: Business and Money
Asked by: trickdady-ga
List Price: $20.00
Posted: 02 Sep 2005 16:33 PDT
Expires: 02 Oct 2005 16:33 PDT
Question ID: 563709
I dont understand if I am given the inflation rates of two contries
how to use them to help me figure out the NPV of a capital budgeting
problem I am working on.  If I had the interest rate of the countries
I would have no problem.  I know the purchasing power parity can help
me but I dont know how?

Any help is apprciated.

Request for Question Clarification by omnivorous-ga on 02 Sep 2005 19:32 PDT
Trickdaddy --

There are 2 ways to approach a problem like this -- but it really
depends what the issues are in the problem?

One way is to estimate the relationship betwen interest rates & the
inflation rate, as they're highly interdependent.

But if the problem is really something like: "how do we compare
projects in countries with 2 different inflation rates?" the only
issue may be the delta between the rates.

Can you be a little more specific on the problem?

Best regards,


Clarification of Question by trickdady-ga on 03 Sep 2005 08:29 PDT

my spot rate for two countries is 1$/70DM  and my two inflation rates
are 12% for DM and 3% for US.  Being that I am from the US I want to
invest 180000 DM in a project with expected cashflows of 140000 DM for
twoo years. the discount rate is 12%.

If I were working with Interest rates this would be a breeze but I
have inflation rates and it is throughing me off a bit.
Subject: Re: International capital budgeting
Answered By: omnivorous-ga on 04 Sep 2005 10:06 PDT
Rated:4 out of 5 stars
Trickdady ?

Given the parameters that you?ve supplied, it appears that what you?re
seeking is what to do when you have the following situation:
1.	U.S. inflation 3%
2.	Project discount rate: 12% (9% over inflation)
3.	German inflation 12%
4.	Dollar-mark exchange rate = $1 = 70 DM

Importantly here we do NOT have: 
?	U.S. risk-free rate
?	German risk-free rate
?	Any currency futures



The risk-free rate is the lowest return provided investors.  It is
typically a government-backed bond, which has no default risk but
which does carry inflation risks and volatility.

What?s the REAL return on Treasury bills (U.S.) or gilts (U.K.)?  Some
argue that it?s zero -- ?Also, we assume that, on average, the
inflation rate roughly equates to the risk-free rate,? says this white
paper from
?Returns, Volatility and Interest Rates? (undated)

However, modern economies often have inflation-adjusted Treasury
offerings (or gilts) that offer a real return.  If you check current
Federal Reserve numbers, the 5-year inflation-indexed T-bills are
providing an average REAL rate of 1.49% --

Federal Reserve
?Selected Interest Rates? (Sept. 2, 2005)

You would be safe to assume a similar number in your capital budgeting
question, especially since it?s important to remember that all of our
numbers in these exercises are ESTIMATES of needed market returns. 
Note that the 5-year CPI for the U.S. is 2.48%; the 2-year is 2.4%, so
we're not far off your assumed inflation of 3%.


Inflation is 9% higher in Germany, so you may be safe making the
assumption that your project discount rate increases by 9% to 21%. 
There are several problems with this:

*  a higher-inflation economy may have more opportunity, carrying a
higher volatility, as pointed out in the excellent article by Aswath
Damodaran (linked below) on international investment issues.  In this
case the premium would be more than 9%, which is why he would argue
for using German risk-free rates (though we don?t have those either).

*  Currency risks.  For these Damodaran recommends using exchange rate
futures to account for differences in currency risk (a separate issue
from political risk) and inflation --

Stern/NYU School of Business
?Estimating Risk-free Rates,? (Damodaran, undated)


So, it would seem fair to evaluate the German project on the basis of
a 21% discount rate, based on a U.S. risk-free rate that?s about 4.5%;
a U.S. discount rate of 12%; and a difference in U.S.-German inflation
of 9%.

Is it underestimating the cost-of-capital?  Perhaps ? given the local
market risks.  But probably not, given the fact that Germany is one of
the G-5 countries, with a large and stable economy.

To that, I?d add the investment methodology of Warren Buffet, CEO of
Berkshire-Hathaway and one of the most successful corporation managers
in the U.S.  Buffet only discounts projects by the T-bill rate when
doing capital analysis, ignoring the market-risk premium taught in
modern finance classes --
?More Warren Buffet Books?

Google search strategy:
"international investment" "capital budgeting"
?risk free rate? inflation
?Warren Buffet? ?discount rate?

If there are any issues with this Answer, please let us know via a
Clarification Request before rating it.

Best regards,


Request for Answer Clarification by trickdady-ga on 05 Sep 2005 12:31 PDT
Thx.  Consider this issue closed.

Clarification of Answer by omnivorous-ga on 05 Sep 2005 12:49 PDT
Thanks Trickdady!
trickdady-ga rated this answer:4 out of 5 stars

There are no comments at this time.

Important Disclaimer: Answers and comments provided on Google Answers are general information, and are not intended to substitute for informed professional medical, psychiatric, psychological, tax, legal, investment, accounting, or other professional advice. Google does not endorse, and expressly disclaims liability for any product, manufacturer, distributor, service or service provider mentioned or any opinion expressed in answers or comments. Please read carefully the Google Answers Terms of Service.

If you feel that you have found inappropriate content, please let us know by emailing us at with the question ID listed above. Thank you.
Search Google Answers for
Google Answers  

Google Home - Answers FAQ - Terms of Service - Privacy Policy