Discussion Issues and Derivations
Should discount rates be adjusted for foreign projects?
- Should exchange rate risk be hedged?
The question of whether exchange rate risk should be hedged cannot be answered without looking at whether exchange rate risk is diversifiable or non-diversifiable risk. If exchange rate risk is diversifiable, it is not clear what potential gain there is from hedging it. One potential benefit might be a reduction in default risk which then allows the firm to borrow more. Keeping these two factors in mind, we would draw the following conclusions:
a. Firms with a wide, diverse and institutional stockholder base (who can diversify globally) and little or no default risk (because they have a policy of not using debt) have little or nothing to gain by hedging exchange rate risk. The costs will outweigh the benefits.
b. Firms with a wide, diverse and institutional stockholder base which want to borrow to capacity will gain by managing exchange rate risk because they will see an increase in debt capacity and firm value.
c. Closely held firms and private firms will gain from managing exchange rate risk, because their owners cannot diversify away this risk.
The question of whether discount rates should be adjusted for foreign projects requires an analysis of two factors. The first is whether and how much of the risk is diversifiable to your investors. If it is, it should not affect your discount rate. If it is not, it should affect your discount rate. Breaking the risk on foreign projects into exchange rate and political risk, it can be argued that firms with a wide, diverse and institutional stockholder base should not adjust their discount rates for foreign projects to reflect exchange rate risk. (Thus, a dollar cost of capital of 12% should apply to both US and Brazilian projects). Political risk is a tougher call. While the diversification argument still applies, political risk is much more difficult to hedge away or diversiy. To that extent, it would make sense to push up the discount rates for projects in extremely risky countries.