The Multinational Firms' Bias for Risky Capital Projects

In practice, many multinational firms use a DCF approach when making capital investment decisions. This paper contends that present values of NCF become biased when cash outflows are discounted at any rate higher than the risk-free rate. This bias favors the acceptance of risky projects. To compensate for this bias, this paper suggests: (1) subtracting risk premiums for riskfree rate when discounting uncertain cash outflows; or (2) in the case of long-term projects in high risk classes, determining the dollar reduction in PV caused by discounting positive risky cash flows and then subtracting the same dollar amount from PV for negative cash flows in the same risk class. INTRODUCTION Multinational firms often use the Internal Rate of Return (IRR), the Net Present Value Method (NPV), and to a lesser degree the Profitability Index (PI) to make capital investment decisions. ' All these methods discount the stream of net cash flow (NCF) to find present value (PV). The NPV and PI methods discount uncertain NCF at rates that include a risk premium. Multinational firms which use these methods typically prefer to assign risk premiums subjectively or based upon sensitivity analysis.2 This paper demonstrates that a bias favoring risky capital projects can arise when discounting uncertain NCF at rates that include risk premiums. Due to currency and country risks which can increase the uncertainty of cash outflows, this bias is more critical for multinational than domestic firms. In order to understood this bias for risky projects, the first section of this paper discusses the conventional application of risk premiums when using the NPV method. In this section, we argue that the current practice of discounting NCF's requires that both cash inflows and outflows must be from the same risk class. On the other hand, the distributive property of mathematics allows cash inflows and outflows to be discounted separately. We suggest that this is a better approach for multinational comp[anies which are considering risky projects, especially when cash inflows and outflows are in different risk classes due to currency and country risks. In the second section, we identify the previously unnoticed risk bias which arises from the conventional practice of discounting uncertain NCF. In the third section, we offer a modification to the risk-adjusted discount rate which provides a less biased NPV for risky capital projects. CONVENTIONAL CAPITAL BUDGETING METHODOLOGY In the textbook approach, NCF is typically found by subtracting a project's cash outflows from cash inflows over each period of the project's life. NPV is found by discounting NCF's at a rate which includes a risk premium for risky projects. A project becomes acceptable if its NPV is greater than zero. The practice of combining cash inflows and outflows to find NCF must adhere to the distributive property of mathematics which states that: (A+B)/C = A/C + B/C This mathematical property requires that both A and B have common denominators in order for A and B to be combined in the numerator. From a capital investment perspective, if (A) is cash inflow and (B) is cash outflow in the same time period, the distributive property states that they can be combined only if they have common denominators. In order to have common denominators, these cash flows must have the same discount rate, implying they are from the same risk class.3 In his finance textbook, Van Home (1995) alludes to the distributive property to find NPV. He states that discounting NCF is one alternative, but that cash inflows and outflows can be discounted separately: "Another way to express the acceptance criteria (in the NPV method) is to say that the project will be accepted if the present value of cash inflows exceeds the present value of cash outflows. " The following example demonstrates the significance of the distributive property to the calculation of NCF. Assume Project A provides a one period cash inflow of $100 and outflow of $80. …