♣
Martin Holmén
Department of Economics, Uppsala University
Bengt Pramborg
*
Stockholm University School of Business
Current version: May 2, 2005
PRELIMINARY DRAFT. PLEASE DO NOT QUOTE
Extended Abstract
We survey Swedish firms’ capital budgeting techniques for Foreign Direct Investments (FDIs) and focus on whether and how foreign exchange rate risks, macroeconomic risks and country-specific political risks are taken into account. The survey results are related to information about each firm’s FDI per country and the riskiness of each FDI is classified according to country forecasts. Our findings suggest that in general firms use different capital budgeting methods as complements rather than substitutes. The Net Present Value method is used frequently by most firms, but the payback method is even more frequently used. Further, we find that firms adjust for macroeconomic risks quite commonly. Over 40 percent of the firms adjust forecasted cash flows and/or discount rates for foreign exchange risk while roughly 30 percent of the firms adjust forecasted cash flows and/or discount rates for inflation and business cycle risks. Sixty-five percent of the firms make adjustments for country specific political risks by increasing the discount (hurdle) rate, decreasing forecasted cash flows, shortening the payback period, or requiring higher earnings multiples. Importantly, 43 percent of the firms use different decision criteria for FDIs in countries with high political risk (developing countries) as compared to
FDIs in countries with low political risk (OECD countries). Our cross-sectional analysis indicates that the use of the net present value method (the payback method) decreases (increases) with the risk of expropriation. We conclude that in the presence of large unsystematic risks (e.g. risk of expropriation) firms implicitly adjust for the shortcomings associated with the net present value method by relying more on the payback method. This type of behavior might partly explain why a number of surveys have found that the payback method is frequently used despite of its theoretical drawbacks. In terms of European integration, the results of this study suggests that if the political risk of new members decrease, firms may be more willing to use NPV as compared to the payback method when evaluating FDIs in these countries, thus promoting a more long-term view of investments and a more efficient capital allocation.
Key words: Capital budgeting, Foreign direct investments, Political risk, Expropriation risk
JEL classification: G31
♣
Financial support from Jan Wallanders och Tom Hedelius foundation (Pramborg) and The Bank of Sweden
Tercentenary Foundation (Holmén) is gratefully acknowledged.
*
Corresponding author: Bengt Pramborg. Postal address: School of Business, Stockholm University, SE-10691
Stockholm, Sweden; E-mail address: bpg@fek.su.se
; Tel.: +46 8 6747427.

Stulz (1999) points out that the way capital budgeting is taught and practiced presents a paradox. Typically, students in corporate finance are taught that a project will increase shareholder value if the net present value of the project is positive. The net present value is computed by forecasting the project’s cash flow and discounting them at a discount rate that reflects the price charged by the capital markets for the risk of the cash flow. Thus, it is only the project’s systematic risk that affects its value. The project’s idiosyncratic risk does not affect its value. Capital markets imperfections such as asymmetric information and the impossibility of complete contracts are mostly ignored when it comes to the way capital budgeting is taught.
1
In practice, although the net present value method is the most used method, it is by no means the only technique used. Graham and Harvey (2001) report that over 50 percent of the
CFOs in their survey always or often use the payback method in capital budgeting decisions, compared to the 75 percent that use the net present value method. Are CFOs aware of the shortcomings of the net present value method in the presence of capital market imperfections and use the payback method as an indicator of a project’s riskiness? Ehrhardt and Brigham
(2003, p 265) suggest that managers use the Payback method to approximate the riskiness of a project.
In this paper we investigate capital budgeting techniques for Foreign Direct Investments
(FDIs), using a sample of Swedish firms, in order to shed light on whether total risk affects the capital budgeting process. FDIs in politically unstable countries could result in large unsystematic risks similar to the examples discussed by Stulz (1999). For example, if the host country expropriates the investment it could result in a 100 percent loss. However, the risk of expropriation is probably unsystematic, i.e. it is not priced by shareholders holding well
1
This absence is remarkable given that capital market imperfections are an integral part when teaching corporate capital structure.
1

diversified portfolios. Does that imply that corporations do not consider these types of risks when taking decisions whether to invest in foreign countries or not? Or do unsystematic risks affect corporate decisions, for example when corporations estimate the cost of capital in the
capital budgeting process?
2
The purpose of the paper is twofold: 1) to provide survey evidence on firms’ capital budgeting methods for foreign direct investments, and 2) to investigate the potential impact from country specific political risk on the capital budgeting process.
Several surveys concerning firms’ capital budgeting practices have been conducted.
3
Most capital budgeting surveys focus on what methods the firms use when evaluating investment possibilities. Frequently it is analyzed how capital budgeting methods vary with firm type, e.g. differences between large and small firms. Many studies also address the question whether capital budgeting methods are changing over time, in particular whether the use of the net present value method is increasing over time. Graham and Harvey (2001) also analyse whether the education of the CFO is related to the firm’s capital budgeting procedures.
Our survey differs from previous surveys in some dimensions. First, we focus on capital budgeting for FDIs and survey firms’ use of different capital budgeting methods for this purpose. This is interesting because firms’ FDIs will (most likely) be exposed to exchange rate risks and the host countries’ macroeconomic and political risks. In this regard, standard textbooks (e.g. Brealey and Myers, 2000, p 808) suggest that firms should not let their views
2
The probability of expropriation could easily be included in the cash flow estimates. However, given capital market imperfections, expropriation of the firm’s FDI might severely affect the whole firm. These types of
3 effects are more difficult to incorporate into a NPV analysis.
For the U.S., see e.g. Schall et al (1978), Moore and Reichart (1983), Trahan and Gitman (1995) and Graham and Harvey (2001). For the U.K., see e.g. Sangster (1993), Pike (1996), and Arnold and Hatzopoulos (2000). For
Sweden, see e.g. Segelod (2000) and Sandahl and Sjögren (2003). Some of these studies, in particular Graham and Harvey (2001) do not only consider capital budgeting but also cost of capital and capital structure issues.
2

on future exchange rates enter into the investment decision.
4
We survey whether firms capital
budgeting methods are consistent with this argument, i.e. whether or not estimated cash flows and/or the cost of capital are adjusted for foreign exchange rate risk and other macroeconomic risks.
Second, we survey how firms manage political risks when investing abroad. Several
authors
5
have suggested that firms could manage political risks by pre-investment planning,
e.g. buying insurance, structuring the investment, and/or developing local stakeholders. We survey to what extent firms use these pre-investment strategies to manage political risks.
Finally, we survey whether firms use more stringent investment criteria and/or different
decision criteria when investing in countries with high political risk.
6
Third, we relate each firm’s capital budgeting methods to its actual portfolio of FDIs.
Thus, we are able to investigate whether the capital budgeting methods of a firm that has all its FDIs in OECD countries differ from the methods used by firms with some of their FDIs in emerging markets. In particular, we focus the analysis on whether firms use the payback method (as proxy for short-termism) instead of the theoretically correct NPV method when the risk of expropriation is perceived to be high.
7
The collected survey data of Swedish firms is combined with unique data on Swedish firms’ FDIs. This data set includes each firm’s FDI per country. The riskiness (e.g. expropritation risk) of each FDI can then be classified according to the Economist’s
Intelligence Unit’s (EIU’s) country forecasts. Our sample consists of 145 firms and 1152
4
The argument is that the firm could hedge the foreign exchange risk using forward contracts. Thus, the NPV could be calculated by translating the estimated cash flows at the forward exchange rate and then discounting
5 these cash flows at the domestic cost of capital.
6
See e.g. Bradley (1977), Robock (1971), and Shapiro (1981).
Admittedly, political risks are not limited to overseas investments. However, in some parts of the world
7 unanticipated actions by governments and courts towards foreign companies are much more likely.
Several authors have discussed and modeled how firms should incorporate the risk of expropriation in their capital budgeting for FDIs. See e.g. Clark (1997 and 2003), Mahajan (1990), Pointon and Hooper (1995),
Shapiro (1978), and Stonehill and Nathanson (1968).
3

FDIs. The average firm in our sample has FDIs in eight countries and has 25 percent of its assets in foreign countries.
Our main results are as follows. The survey responses indicate that larger firms are more likely to use the net present value method or the internal rate of return method when evaluating FDIs. Public firms are more likely to use the net present value method and earnings multiples. Larger firms and public firms are also more likely to use real option methods when evaluating FDIs. The different capital budgeting methods in general appear to be complements rather than substitutes. Sixty-nine percent of the firms in our sample use the net present value method while 79 percent use the payback method.
We also survey whether the capital budgeting process for FDIs involves adjusting forecasted cash flows and/or discount rates for macro economic risks. Over 40 percent of the firms adjust forecasted cash flows and/or discount rates for foreign exchange risk while roughly 30 percent of the firms adjust forecasted cash flows and/or discount rates for inflation and business cycle risks. We survey whether firms make adjustments for country specific political risks. Sixty-five percent of the firms responded that they adjust for country specific political risks by one or more of the following methods; increasing the discount (hurdle) rate, decreasing forecasted cash flows, shortening the payback period, or requiring higher earnings multiples. In addition, 43 percent of the firms indicated that they use different decision criteria for FDI in countries with high political risk (developing countries) as compared to FDIs in countries with low political risk (developed countries). Our cross-sectional analysis indicates that the use of the NPV method (the Payback method) when evaluating FDIs decreases
(increases) with the risk of expropriation in the country in which the firm has FDI. CFOs might be aware of the shortcomings associated with the net present value method in the presence of large unsystematic risks (e.g. risk of expropriation) and capital market imperfections and therefore rely more on the payback method. This type of behavior might
4

partly explain why a number of surveys have found that alternative methods such as the
Payback method is frequently used despite of its theoretical drawbacks (see e.g. Graham and
Harvey, 2001; Sandahl and Sjögren, 2003).
The rest of the paper is organized as follows. The next section describes our questionnaire, the data, and defines the variables used in the empirical analysis. We then present our survey results. Finally, we provide a summary and a conclusion in section 4.
Because detailed public data are not available on firms’ capital budgeting methods, we employ a questionnaire to determine firms’ use of different capital budgeting methods. In an attempt to increase the response rate, the questionnaire was deliberately kept as short as possible. The survey contains four different questions (see Appendix A for an English translation of the survey):
(1) Popularity of different capital budgeting methods: The first question asks respondents to rank how often they use each of a number of capital budgeting methods.
(2) Adjustments of cash flows and discount rates: The second question asks respondent to indicate whether they adjust cash flows and/or the discount rate for different macroeconomic risks.
(3) Methods to manage country specific political risk: The third question asks respondents to rank how often they use each of a number of methods to manage country specific risks. These methods include adjustments of cash flows and discount rates as well as e.g. purchasing political risk insurance.
(4) Different decision criteria: Finally, the respondents were asked to indicate whether they use different decision criteria for investments in developing countries and developed countries.
5

The questionnaire was sent, in September 2003 with a follow-up in November of the same year, to Swedish firms that (1) responded to a survey from the Swedish central bank
(Riksbanken) in the spring of 2003 regarding how much foreign direct investment the firm had invested as of December 2002, and (2) responded that it had foreign direct investment
(we exclude firms with no reported foreign direct investments). A total of 497 firms met both criteria and 200 firms responded. Out of these 145 responses are usable (54 firms responded that the questions were irrelevant for them, for example because the FDIs were made some
years back in time. For one firm there is no accounting data).
8
Thus, the ratio of usable
responses to total number of recipients is 0.291.
Since we sent the questionnaire to firms that responded to Riksbanken that they had FDIs in place, we ascertain that we have a sample containing firms with FDIs. Further, the
Riksbanken survey asked respondent to specify their FDIs on a country-by-country basis, which Riksbanken has kindly let us share. Thus, we have information as to which countries, and therefore the implied political risk these FDIs are exposed to. From the Economist
Intelligence Unit (EIU) we gathered information for 61 countries on expropriation risk . With this data we create a firm-specific political risk variable, defined as the weighted average of the EIU index values, weighted by the relative share of total FDI in each country. The firms in our sample have FDIs in more than 120 countries, so our index is not complete. However, for most firms, the index covers more than 90% of their total FDI. For the 13 firms with lower index coverage, there are only six countries missing, namely the three Baltic states, Bermuda,
Luxembourg, and the United Arab Emirates. For these countries, we set the risk measure on
8
We received various comments from the firms that considered the questionnaire irrelevant. Common reasons were that the firm “makes almost no investments in foreign countries”, that the firm “had made no FDIs during the last five years”, that the firm “did not make FDIs anymore”, that the firm “was sold to another company recently”, and that the firm “had recently gone bankrupt”.
6

par with countries we estimated were similar in terms of political risk.
9
We also use two
robustness tests to handle these, which we discuss in detail below.
We complement the data from the survey and the risk indices with publicly available information on firm characteristics. We use indicator variables to classify firms on industry belonging, and whether firms are listed on the Swedish stock exchange or not. Further, we use common accounting variables for firm size, liquidity, leverage, and investment rate.
Table 1 reports descriptive statistics for our sample and formalizes our variable definitions.
[Insert Table 1: Sample description and variable definitions]
Earlier surveys (see e.g. Graham and Harvey, 2001) have found that larger firms, more highly levered firms, and public firms more commonly use the NPV method. We therefore include these variables as explanatory variables. Although Graham and Harvey (2001) do not find empirical support, they argue that it may be rational for cash constrained firms to use the payback method. We include liquidity to proxy for this, and in addition we include the investment rate to proxy for how much capital firms need. Firms with low liquidity and high investment rate may be more inclined to use the payback method. Further, it is possible that firms with substantial fixed assets differ in their capital budgeting methods as compared to firms with relatively more short-term assets. We include two explanatory variables; an industry dummy for firms in capital intense industries, and the ratio of current assets to total assets. We define manufacturing, construction, transport, and real estate as capital intense industries. Finally, we include variables to reflect different aspects of firms’ FDIs. The first variable, %FDI, measures the proportion FDIs of a firm’s total assets, which can be interpreted as being a proxy of how important FDIs are to a firm. The second variable measures the implied expropriation risk of a firm’s FDIs. It is a value-weighted average of
9
We set the expropriation risk (which ranges from “1” to “5”, “5” being the riskiest) of the Baltic states,
Bermuda and the United Arab Emirates to “2”, which is on par with for example Bulgaria, Slovakia, and Saudi
Arabia while Luxembourg received a “1”, the ranking for countries with lowest risk.
7

each host country’s expropriation risk. The weights are the proportions of the firm’s total
FDIs that the firm had invested in a particular country. The third variable is the valueweighted GDP-per-capita growth of the host countries where a firm has FDIs. The weights are defined as for the expropriation risk variable. Segelod (2000) found that firms may adjust their payback periods when they make capital budgeting decisions based on the growth prospects of the host country. It is possible that this also affects the decision to use different methods, and we include this last variable to control for this.
An example clarifies the last two variables. If a firm has 25% of its FDIs in Luxembourg
(Expropriation risk = “1”, and GDP-per-capita growth = 3.76%), and 75% of its FDIs in the
United Arab Emirates (Expropriation risk = “2”, and GDP-per-capita growth = 0.84%), the firm will have a value for Exprop Risk of ( 0 .
25
⋅
1
+
0 .
75
⋅
2 ) = 1.75, and a value for GDP
Growth of ( 0 .
25
⋅
3 .
76
+
0 .
75
⋅
0 .
84 ) = 1.57.
Panel B in table 1 shows descriptive statistics at the host country level. The expropriation risk index is quite skewed and most countries (31(32) out of 61(67) countries) have the lowest possible ranking of “1”. Only a few countries have an index value larger than “2”. The numbers in parentheses include the six countries with our own estimated risk, see footnote 9.
Further, countries are ranked based on how much FDI they have received. It can be seen that
Norway is the country where most sample firms had FDIs, followed by other countries in
Northern Europe. In contrast, the country that received most FDIs in terms of amount is the
U.S., followed by North European economies.
This section contains our main results. First, in section 3.1, we report on the survey results and perform univariate tests (pairwise rank correlations). The indicated relationships are further investigated in section 3.2, by means of cross-sectional regressions.
8

3.1 Desciptive statistics and univariate tests
Question 1 of the survey asked respondents to rank how often they used different capital budgeting methods. Figure 1 displays the results. The bars in the figure (referring to the lefthand vertical scale) show the proportion of firms that use each method at least seldom. It is evident that a majority of firms uses each method, except for Real Options. The line shows how often each method was used, including only users in the calculation. The possible values ranges from “1” = “seldom” to “4” = “always” (right-hand scale). It is evident that those firms that adopted a method used it quite frequently, Real Options again being the exception. The frequency is on average close to “3” = “almost always” for most methods, but few firms
(12%) use Real Options, and those that use the method uses it infrequently (average ranking being between “seldom” and “sometimes”).
[Insert Figure 1: Capital Budgeting Methods]
Table 2 displays Spearman rank correlations between the explanatory variables (firm
characteristics) and the frequency with which each capital budgeting method is used.
10
It is
evident that the use of the NPV method is positively related to firm size and public firms.
Also, firms with low liquidity and a large share of fixed assets use NPV more frequently.
Except for the result regarding liquidity, the findings are as we expect. We will discuss this further below, but note that liquidity is negatively related to size, which may explain this result (see Appendix B). We also note that public firms are more likely to use earnings multiples than other firms. Perhaps, because they have to communicate their earnings to analysts and the public, this becomes an important metric to consider for these firms. This argument is supported by the prevalence to smooth earnings by public firms as widely discussed in the business press of recent years. There is a negative correlation between the use
10
In Appendix B, pairwise rank correlations between the firm characteristic variables are tabulated.
9

of the Payback method and liquidity, which supports the notion that firms that are capital constrained use the payback method (Graham and Harvey, 2001). Finally, we note that all correlations between the different capital budgeting methods are positive and most are significant. This suggests that the methods are complements rather than substitutes.
[Insert Table 2, rank correlations]
The second question of the survey asked the respondents to indicate whether they adjust cash flows and/or the discount rate for three different macroeconomic risks, namely foreign exchange (FX) risk, inflation risk, and business cycle risk. Figure 2 displays the results.
[Insert Figure 2: Adjustments]
It is evident that many firms (although for each alternative a minority) did adjust their estimates for macroeconomic risk. The proportions that adjust cash flows relative to the discount rate (more firms adjust cash flows than the discount rate) are similar for FX risk and business cycle risk, but quite different when adjusting for inflation risk, where the discount
rate is more commonly adjusted.
11
[Insert Table 3, rank correlations]
Table 3 displays Spearman Rank correlations. Large firms adjust cash flows more often than small firms do. Adjustments are also made more frequently when firms have investments in countries with larger expropriation risk and countries with large GDP Growth. However, note that these two variables are positively correlated (see Appendix B).
The third question of the questionnaire asked the respondents to rank how often they managed country specific risks, and the fourth and final question asked the respondents to indicate whether they used different decision criteria in countries with high political risks versus countries with low political risks. Figure 3 displays the pertinent results.
[Insert Figure 3: Methods for Country Specific Risks]
11
It could be that this simply implies that firms interpret this question as to whether they adjust for the level of inflation when making nominal estimates, and not the risk of changes in inflation.
10

The figure shows that the involvement of local partners is used by more than 75% of the sample firms. The firms that involve local partners on average use this strategy “sometimes”.
The second most used method is to limit dependence on one partner. In terms of adjusting their investment criteria for country specific political risks, our findings indicate that more than 50% of the sample firms require higher returns, adjust cash flow and/or earnings estimates, and use shorter payback methods.
12
Interestingly, 43% of the respondents indicate
that they use different decision criteria when making FDIs in countries with high political risk as compared to countries with low political risk. Comments we received include that the firm simply “refrains from investments in countries with high political risk”, that the firm “use higher hurdle rates for these investments”, and that the firm “use a shorter payback period”.
This suggests that firms do consider this (mostly idiosyncratic) risk and that it is an important factor for firms making foreign investment decisions.
Table 4 displays rank correlations. The positive correlations between the methods suggest that they are complements rather than substitutes. Also, it is noteworthy that for firms with higher expropriation risk in their FDIs it is more common to buy political risk insurance, to require higher returns, and to use shorter payback periods. However, since larger firms also are characterized by higher expropriation risk (Appendix B) size could contribute in explaining the use of political risk insurance and to require higher returns.
[Insert Table 4, rank correlations]
In sum, this section has provided descriptive statistics on firms capital budgeting methods for FDIs. In order to provide further evidence as to which factors may explain the use of different methods, and in particular whether country specific political risks may explain differences in capital budgeting methods, we use cross-sectional regressions.
12
In untabulated results from cross-sectional logit and ordered logit regressions, we find that firms’ use of shorter payback period is positively related to the weighted expropriation risk and negatively related to the weighted GDP growth of the host countries. This confirms the findings of Segelod (2000) and suggests that country specific political risks are important when firms make investment decisions.
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3.2 Cross-sectional regressions
In this section we report logit regressions with the use of the NPV method and the payback method as dependent variables, respectively. We first report logit regressions with an indicator variable for whether the firm uses the NPV and the Payback method. Second, we report a logit regression with an indicator variable for whether the firm uses the payback method more frequently than the NPV method as dependent variable. Third, we report ordered logit model where the frequency by which the NPV and the payback methods are used, respectively. Finally, we report an ordered logit regression with a variable defined as the frequency by which the payback method is used minus the frequency by which the NPV method is used as dependent variable.
Our first hypothesis is that firms rely less on the NPV method when there are large unsystematic risks. The hypothesis is based on the conjecture that managers are aware of the shortcomings of the traditional NPV method in terms of how total risks may influence the firm negatively. Estimated cash flows can be adjusted for the probability of expropriation.
However, due to capital market imperfections expropriation of the firm’s FDIs may adversely affect the whole firm. It is unclear whether managers know how to incorporate such effects in the NPV analysis.
Our second hypothesis is that firms rely more on the payback method when there are large unsystematic risks. One source of unsystematic risk for FDIs is risk of expropriation.
When the risk of expropriation increases, the importance of short run returns also increases.
Therefore managers may choose the payback method in the presence of expropriation risk.
We focus on the NPV and the payback method since it can still be argued that the NPV method is the theoretically most correct method while the payback method is the method associated with the most substantial theoretical drawbacks.
12

We use the weighted average expropriation risk of firms’ portfolios of FDIs (Exprop
Risk) as a proxy for unsystematic risk and include it as an independent variable in the regressions to test our two hypotheses. We also include the percentage of FDI of total assets
(% FDI) as an independent variable.
The descriptive analysis indicates that larger firms and public firms more frequently use the NPV method. We therefore include a size variable and a public firm indicator variable as control variables. The descriptive statistics also indicated that the fraction of current assets is negatively correlated with the use of NPV method. We include current asset ratio to control for the effect of capital intensity on the choice of capital budgeting method and we also include an indicator variable for firms active in capital intensive industries (Industry). Firms with large investment programs may want to finance these with internally generated funds.
With costly external financing, they may be interested in the payback period of their investments. We also control for firm leverage and firm investment rate. Finally, we include the weighted average GDP growth in the countries in which the firm has FDIs (GDP growth).
Segelod’s (2000) results indicate that managers accept longer payback periods if the host country is expected to experience rapid GDP growth. Since GDP growth may have a substantial impact on the investment decisions of firms we include this as a control variable.
Firms may be less inclined to use the payback method in this case since expected profits grow over time.
The estimated logit regression models are reported in table 5 panel A. Model 1 indicates that the use of the NPV method indeed declines with the risk of expropriation. The expropriation risk variable is negatively significant at the 10 percent level of significance.
This result is in line with out first hypothesis, i.e. that firms are less likely to use the NPV method when there are large unsystematic risks. Model 2 supports our second hypothesis that firms more frequently rely on the payback method when the perceived risk of expropriation is
13

high. In model 2, the expropriation risk variable is positively significant at the 5 percent level.
Model 3 presents stronger results in line with our two hypotheses. The dependent variable indicates whether the firm uses the payback method more frequently than the NPV method when evaluating FDI. The expropriation risk variable is positively significant at the 5 percent level.
[Insert Table 5, cross-sectional regression]
Larger and public firms are more likely to use the NPV method while firms with a large proportion of current assets are less likely to use both the NPV method and the payback method. Leverage is negatively related to the payback method.
In panel B we report similar models estimated by ordered logit procedures. In model 1
(model 2) the dependent variable is equal to 0 if NPV (payback) never is used, 1 if NPV
(payback) seldom is used, 2 if NPV (payback) sometimes is used, 3 if NPV (payback) almost always, and 4 if NPV (payback) always is used when evaluating FDIs. In Model 3 the dependent variable is equal to the frequency by which payback (0 to 4) is used when evaluating FDIs minus the frequency by which NPV (0 to 4) is used when evaluating FDIs.
Thus, the variable varies between –4 and 4.
The results are similar to those reported in panel A. The frequency by which NPV is used declines with the risk of expropriation. The expropriation risk variable is negatively significant at the 5 percent of significance in model 1 and positively significant at the 5 percent level in model 3. However, it is insignificant (but positive) in model 2. The results for the control variables are also similar to the ones reported above, i.e. large and public firms more frequently use the NPV method while current asset ratio (leverage) is negatively related to the use of the NPV method (payback method).
14

We survey Swedish firms’ capital budgeting techniques for Foreign Direct Investments
(FDIs) and focus on whether and how macroeconomic risks and country specific political risks are taken into account. The survey results are related to information about each firm’s
FDI per country. Almost half of the firms adjust forecasted cash flows and/or discount rates for macroeconomic risks. Furthermore, almost two thirds of the firms adjust for country specific political risks by increasing the discount (hurdle) rate, decreasing forecasted cash flows, shortening the payback period, and/or requiring higher earnings multiples. Importantly,
43 percent of the firms use different decision criteria for FDIs in countries with high political risk (developing countries) as compared to FDIs in countries with low political risk (OECD countries).
Our cross-sectional analysis indicates that the use of the net present value method (the payback method) decreases (increases) with the risk of expropriation. We conclude that in the presence of large unsystematic risks (i.e. expropriation risk) firms are reluctant to rely on the traditional NPV method since it does not take such risks into account. Furthermore, large unsystematic risks like expropriation also increase the importance of short run returns which might explain why firms choose to rely on the payback method. This type of behavior might partly explain why a number of surveys have found that the payback method is frequently used despite of its theoretical drawbacks.
15

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Stulz, R. M., 1999. What’s wrong with modern capital budgeting?, Financial Practice and
Education, 9, 7-11.
Trahan, E. A. and L. J. Gitman, 1995, Bridging the theory-practice gap in corporate finance: a survey of chief financial officers, Quarterly Review of Economics and Finance, 35, 73-87.
17

1.
How often do you use the following methods in order to determine which foreign direct investments or purchases should be made in foreign countries?
Method ...
Always Almost
Always
Sometimes Seldom Never a) Net Present Value or Adjusted Present Value b) Internal (or Modified Internal) Rate of Return c) Earnings multiples (e.g. P/E) d) Payback period e) Accounting rate of Return (e.g. ROI, ROCE) f) Real Options evaluation g) Other: *)
*) Comment : ………………………………………………………………………………………………........
………………………………………………………………………………………………………………….
2.
When you evaluate a foreign investment, do you adjust the discount rate and/or cash flows for the following macroeconomic factors?
Risk factor ...
Cash flows Discount rate
No adjustment a) Foreign exchange risk b) Inflation risk (unexpected inflation) c) Business cycle risk d) Other: *)
*) Comment: ……………………………………………………………………………………………………...
……………………………………………………………………………………………………………………
3.
Do you use any of the following methods to manage country specific political risk?
*
Method .... a) Buy political risk insurance b) Limit technology transfer to foreign units c) Involve local partners d) Limit dependence on one single partner e) Use more stringent investement criteria:
… higher required return/ internal rate of return
… adjust cash flow and/or earnings estimates
… shorter payback period
… higher required earnings multiples
… other: *)
Always Almost
Always
Sometimes Seldom Never
*) Comment: ……………………………………………………………………………………………………
………………………………………………………………………………………………………………….…
4.
Do you use different decision criteria for investments in countries with high political risk (developing countries) as compared to investments in countries with low political risk (developed countries)?
Yes …….
If your response is yes, please comment how they differ (please continue on the back of this paper).
No ………
Comment: …………………………………………………………………………………………………………
Yes, I would like to receive information about the results from your survey. My email address is : …………...........
* Political risk includes e.g. risk for revolution and war, but also risk of expropriation, restrictions on repatriations, loss of patents, copyrights and technology, and other forms of protectionism.
18

The table reports Spearman Rank correlation coefficients for firm characteristic variables. The firm characteristic variables are defined as follows : Size is the book value of total assets; Leverage is long term debt divided by total assets; Liquidity is the ratio of current assets to short-term debt; Current Asset Ratio is the ratio of current assets to total assets; %FDI is the book value of foreign assets to total assets; Investment rate is change in fixed assets from previous year plus depreciation; Public is an indicator variable that is assigned the value one for listed firms; Industry is an indicator variable that is assigned the value one for firms in capital intensive industries; Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs. Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropriation rating scores countries between 1 and 5, with
5 being high and 1 being non-existent. Significance is indicated with *, **, and *** for the 10%, 5%, and the 1% level, respectively. The number of observations is 142.
Risk
GDP
Growth Asset
Ratio
Rate
Size 0.15* –0.06
Liquidity
Current Asset Ratio
Investment Rate
Public
Industry
%FDI
Exprop Risk 0.22***
19

Table 1
Descriptive statistics
The table displays variable definitions and descriptive statistics. Panel A displays firm characteristics, and Panel B displays statistics on firms’ FDI:S. All variables are defined using book values unless stated otherwise. The data sources are: FR , Financial Reports ending in the year 2002; SSE , The Stockholm Stock Exchange; RB , Riksbanken (the Swedish Central Bank); EIU , the Economist Intelligence Unit; and
WB , the World Bank. The risk of expropriation rating scores countries between 1 and 5, with 5 indicating highest risk and 1 lowest risk. The descriptive statistics include: Q1, the first quartile; Median; Q3, the third quartile; and the mean value. Panel B displays statistics on the top five countries in terms of how many sample firms that had FDIs in the country (in parenthesis); and on the top five counties regarding how much FDI the country received (percentage of total FDI in parenthesis). Also, Panel B displays country statistics on: the expropriation index for countries with FDIs (average of 1995 to 2002), where the risk of expropriation rating scores countries between 1 and 5, with 5 indicating highest risk and 1 lowest risk.; and the GDP growth per capita (average of 1995 to 2002).
Panel A: Firm Characteristics
Size
Leverage
Investment rate
Total assets (MSEK)
Long term debt
÷
total assets
Liquidity Current assets
÷
short-term debt
Current asset ratio Current assets
÷
total assets
(yearly change in fixed assets + depreciation)
÷
fixed assets
Public Indicator variable for listed firms
Industry
%FDI
Exprop risk
GDP growth
Indicator variable for firms in capital intense industries foreign direct investment
÷
total assets
A country-weighted average of expropriation risk
A country-weighted GDP per capita growth rate (%)
Panel B: Country data
Expropriation risk in countries with FDI ( Total no. is 61 (67))
GDP growth in countries with FDI ( Total no. is 67)
Top five countries with FDI:
No. of firms
1. Norway (81)
2. Denmark (73)
3. Finland (71)
4. Germany (63)
5. Great Britain (56)
Total amount
1. USA (28.3%)
2. Germany (12.9%)
3. Great Britain (11.7%)
4. The Netherlands (7.2%)
5. Denmark (5.6%)
EIU
WB
RB
FR
FR
FR
FR
477 2005 6218 3610
0.09 0.21 0.35 0.25
1.31 1.71 2.46 2.49
0.02 0.06 0.12 0.09
FR
SSE
RB
RB, FR
–0.02 0.08 0.21 0.13
- - - 0.35
- - - 0.66
0.06 0.18 0.35 0.25
RB, EIU
RB, WB 2.59 2.90 3.29 3.04
1 (1) 1 (1.5) 2 (2) 1.65 (1.67)
20

Table 2
Spearman rank correlations, Question 1
The table reports Spearman Rank correlation coefficients for firm characteristic variables and responses to question one regarding the use of different capital budgeting methods. The firm characteristic variables are defined as follows: Size is the book value of total assets; Leverage is long term debt divided by total assets; Liquidity is the ratio of current assets to short-term debt;
Current Asset Ratio is the ratio of current assets to total assets; %FDI is the book value of foreign assets to total assets; Investment rate is change in fixed assets from previous year plus depreciation; Public is an indicator variable that is assigned the value one for listed firms;
Industry is an indicator variable that is assigned the value one for firms in capital intensive industries; Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs.
Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropriation rating scores countries between 1 and 5, with 5 being high and 1 being non-existent. The responses to the questions takes values from 0-4, where a higher value indicates more often (see the survey in the Appendix). Significance is indicated with *, **, and *** for the 10%, 5%, and the 1% level, respectively. The number of observations is 142.
Size
Multiples Return
Real
Options
0.52*** 0.26*** 0.15* 0.05 0.19** 0.24***
–0.07 –0.18** 0.01
Current Asset Ratio –0.22*** –0.25*** 0.12
Investment Rate –0.06
0.07 –0.04
–0.02 –0.06 0.06 0.05
–0.08
0.09
Industry
Exprop Risk
GDP growth
-0.05
0.00
–0.03 0.00 –0.08 0.05 -0.03
–0.05 –0.07 –0.00 -0.01 –0.16*
IRR
Payback 0.24*** return 0.12
21

Table 3
Spearman rank correlations, Q2
The table reports Spearman Rank correlation coefficients for firm characteristic variables and responses to question two regarding the adjustment of cash flows and/or discount rates for different types of risk. The firm characteristic variables are defined as follows: Size is the book value of total assets; Leverage is long term debt divided by total assets; Liquidity is the ratio of current assets to short-term debt; Current Asset Ratio is the ratio of current assets to total assets; %FDI is the book value of foreign assets to total assets; Investment rate is change in fixed assets from previous year plus depreciation; Public is an indicator variable that is assigned the value one for listed firms; Industry is an indicator variable that is assigned the value one for firms in capital intensive industries; Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs. Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropriation rating scores countries between 1 and 5, with 5 being high and 1 being non-existent. The responses to the questions takes the values 0 = no and 1 = yes (see the survey in the Appendix). Significance is indicated with *, **, and
*** for the 10%, 5%, and the 1% level, respectively. The number of observations is 139.
Adjust cash flows
FX risk
Business cycle risk
FX risk
Adjust discount rate
Inflation risk
Business cycle risk
Size 0.26*** 0.11
Leverage
Liquidity
Current Asset Ratio
Investment rate
Public
Industry
%FDI
Exprop Risk
GDP Growth
Adjust cash flows
Adjust discount rate
FX risk
Inflation risk
Business cycle risk
FX risk
Inflation risk
–0.11 –0.11 –0.14 –0.02 0.03 –0.02
–0.06 –0.13 0.02 0.01 –0.06 0.05
0.21** 0.19** 0.01 0.01 –0.01 0.05
0.22*** 0.05 0.04 0.07 0.02 –0.05
0.40*** 0.35***
0.27***
0.01
0.11
0.12
0.13
0.07
0.33***
–0.06 0.16** 0.06
0.29*** 0.22***
0.33***
22

Table 4
Spearman rank correlations, Q3 and Q4
The table reports Spearman Rank correlation coefficients for firm characteristic variables and responses to question 3 and 4 regarding the use of different methods to manage country specific risk. The firm characteristic variables are defined as follows: The firm characteristic variables are defined as follows: Size is the book value of total assets; Leverage is long term debt divided by total assets; Liquidity is the ratio of current assets to short-term debt; Current Asset Ratio is the ratio of current assets to total assets; %FDI is the book value of foreign assets to total assets; Investment rate is change in fixed assets from previous year plus depreciation; Public is an indicator variable that is assigned the value one for listed firms; Industry is an indicator variable that is assigned the value one for firms in capital intensive industries. Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs. Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropriation rating scores countries between 1 and 5, with 5 being high and 1 being non-existent. The responses to question 3 takes values from 0-4, where a higher value indicates more often, and the responses to question 4 takes the values 0 = no and 1 = yes (see the survey in the Appendix). Significance is indicated with *, **, and *** for the 10%, 5%, and the 1% level, respectively. The number of observations is
134 for question 3, and 117 for question 4. insurance Tech transfer partners Dependence one partner
Higher
Required return/IRR
Adjust CF and/or earnings estimates
Shorter payback
Higher earnings multiples
Different decision criteria
Current Asset Ratio
Investment rate
–0.03
–0.05
–0.00
–0.07
–0.07 –0.11
–0.19** –0.01
–0.15*
–0.16*
–0.05
–0.04
–0.04
–0.03
0.08
–0.10
0.06
–0.05
%FDI –0.03 0.10
Expropriation Risk
GDP Growth
0.15*
–0.18**
0.11
–0.16*
0.07
0.10
0.13
–0.09
0.17**
–0.02
0.11
–0.03
Buy insurance
Limit tech transfer
Local partners
Limit dependence one partner
Higher required return/IRR
Adjust CF and/or earnings estimates
Shorter payback
Higher earnings multiples
0.19**
–0.11
0.16*
–0.10
0.38*** 0.16*
0.24***
0.26***
0.40***
0.52***
0.28***
0.22***
0.26***
0.24***
0.26***
0.29***
0.33***
0.32***
0.30***
0.38***
0.23*** 0.28***
0.31*** 0.43***
0.53*** 0.56*** 0.60***
0.61*** 0.57***
0.73***
–0.09
–0.15
0.21**
0.21**
0.26***
0.19**
0.15
0.22**
0.30***
23

Table 5
Logit and ordered logit regressions with the frequency by which the NPV method and the Payback method, respectively, are used when evaluating Foreign Direct Investments
The table reports estimated logit (panel A) ordered logit regressions (Panel B) with the frequency by which the NPV method and the Payback method are used when evaluating Foreign Direct Investments (FDIs). In panel A Model 1 (Model 2) the dependent variable is equal to 1 if NPV (Payback) is used when evaluating FDIs, and zero otherwise. In panel A Model 3 the dependent variable is equal to one if Payback is used more frequently than NPV when evaluating FDIs, and zero otherwise.
In panel B Model 1 (Model 2) the dependent variable is equal to 0 if NPV (Payback) never is used, 1 if NPV (Payback) seldom is used, 2 if NPV (Payback) sometimes is used, 3 if NPV (Payback) almost always, and 4 if NPV (Payback) always is used when evaluating FDIs. In panel B Model 3 the dependent variable is equal to the frequency by which Payback (0 to 4) is used when evaluating FDIs minus the frequency by which NPV (0 to 4) is used when evaluating FDIs. Thus, the variable varies between -4 and 4. Coefficients are reported with z-values in parenthesis. Reported z-values are asymptotically robust to heteroscedasticity (White, 1980). Significance is indicated with *, **, and *** for the 10%, 5%, and the 1% level, respectively. The number of observations is 142. Exprop Risk is defined as the value weighted expropriation risk of the firm’s FDIs. Expropriation risk estimates are collected from EIU Country Forecasts. The risk of expropriation rating scores countries between 1 and 5, with 5 being high and 1 being non-existent. %FDI is equal to the book value of the firm’s all FDIs divided by the book value of total assets. Public Dummy is equal to one if the firm is listed on a stock exchange, and zero otherwise. Size is equal to the natural logarithm of the book value of total assets in the end of 2002. Leverage is equal to the book value of long term debt divided by the book value of total assets in the end of 2002. Current Asset Ratio is equal to current assets divided by total assets. Investment rate is equal to the change in fixed assets from previous year plus depreciation. Industry Dummy is equal to one if the firm is active in a capital intense industry, and zero otherwise. GDP growth is equal to the value weighted GDP growth per capita in 2002 in the countries in which the firm has FDIs.
Panel A: Logit Regressions
NPV Payback
Model 3
Payback vs NPV
Exprop Risk
% FDI
Public Dummy
–1.4162
(–1.72)*
0.7977
(0.64)
1.2709
(2.42)**
2.7583
(2.41)**
–1.0199
(–1.00)
0.1396
(0.28)
1.9271
(2.01)**
–0.5275
(–0.58)
–0.7346
(–1.74)*
Size 0.4596 –0.3598
(2.75)*** (0.76) (–3.37)***
–0.7498
(–1.12) (–2.99)*** (–0.85)
Current Asset Ratio
Investment Rate
Industry Dummy
GDP Growth
Wald Chi2 p-value Chi2
–4.0377
(–1.90)*
–0.3606
(–0.95)
–0.3338
(–0.59)
–0.1209
(–0.47)
24.21
0.004
–3.8462
(–1.94)*
–0.2859
(–0.53)
–0.6692
(–1.21)
–0.4836
(–1.45)
17.96
0.036
1.1016
(0.59)
0.4570
(0.97)
–0.1805
(–0.43)
–0.3431
(–1.45)
30.43
0.000
24

Panel B: Ordered Logit Regressions
NPV Payback
Model 3
Payback vs NPV
Expropriation Risk -1.6062 0.9138 1.8366
% FDI
(-2.08)**
0.4564
(0.49)
0.6309
(1.24)
-0.1874
(-0.24)
0.1608
(2.46)**
-0.7127
(-0.88)
-0.4632 Public Dummy
(1.76)*
(4.28)***
(0.46)
(0.60)
(-1.43)
Size 0.4798 -0.2178
(-3.50)***
-1.2164
Current Asset Ratio
Investment Rate
Industry Dummy
GDP Growth
Wald Chi2 p-value Chi2
(-0.74)
-3.7476
(-2.51)**
-0.2108
(-0.58)
-0.2130
(-0.54)
0.0589
(0.28)
42.96
0.000
(-2.43)**
-1.5962
(-1.05)
0.0477
(0.16)
-0.1757
(-0.55)
-0.2543
(-1.18)
9.13
0.425
(-1.32)
0.5801
(0.56)
0.1554
(0.54)
-0.2322
(-0.73)
-0.2037
(-0.93)
43.9
0.000
25

Figures
1
0.75
0.5
0.25
4
3
2
0 1
NPV IRR Earnings multiples Payback Accounting return Real options
Proportion Mean (users only)
Figure 1: The relative popularity of different Capital Budgeting Methods.
The figure displays the proportion of firms that used each method and the frequency of usage for firms that used each method, respectively. The bars (scale on left vertical axis) present the proportions of firms that used each method, and the line (scale on right vertical axis) presents the mean rank of each method, calculated from firms that used each method, respectively. The rank is in the range 1–4, where 1 = seldom, 2 = sometimes, 3 = almost always, and 4 = always (the number of observations is 142).
26

0.3
Foreign Exchange
0.2
0.1
Inflation Business Cycle
0
Cash flows only
Discount rate only
Both Cash flows only
Discount rate only
Both Cash flows only
Discount rate only
Both
Figure 2: Adjustments of Cash Flows and Discount Rates.
The figure displays the proportion of firms that adjusted cash flows and/or discount rates for different macroeconomic risks (the number of observations is 139).
27

1
0.75
0.5
0.25
Insurance and management
Investment criteria
4
3
2
0
Buy insurance
Limit tech transfer
Local partners
Limit dependence one partner
Higher required return/IRR
Adjust CF and/or earnings estimates
Shorter payback
Higher earnings multiples
Different decision criteria
1
Proportion Mean (users only)
Figure 3: Methods to manage country specific political risk.
The figure displays the proportion of firms that used each method and the frequency of usage for firms that used each method, respectively. The bars (scale on left vertical axis) present the proportions of firms that used each method, and the line (scale on right vertical axis) presents the mean rank of each method, calculated from firms that used each method, respectively. The rank for all but the last question is in the range 1–4, where 1 = seldom,
2 = sometimes, 3 = almost always, and 4 = always (number of observations is 139). For the last question, only the proportion is displayed (number of observations is 117).
28