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
RISK-FREE RATES AND INFLATION
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 PrivateRaise.com
?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% --
?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
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?
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