Forecasting Cash Flows  511
­trading drives forward rates to interest rate parity, but you should always ver-
ify that the rates are consistent with inflation and interest rates you are using 
in your cash flow projections and valuation. The forward foreign-exchange 
rate in year t, Xt, should equal the current spot rate, X0, multiplied by the ratio 
of nominal interest rates in the two currencies over the forecast interval, t:
X
X
r
r
t
t
=
+
+




0
1
1
F
D
where rF is the interest rate in foreign currency and rD is the interest rate in 
domestic currency. In our example, the four-year nominal interest rate in 
Switzerland, rF, is 4.16 percent as of January 2020, while the borrowing rate 
in euros, rD, is 4.93 percent for the same period. As the spot exchange rate, 
X0, is 1.200 Swiss francs per euro, the four-year forward rate, X4, should be 
calculated as follows:2
X4
4
1 200 1
4 16
1
4 93
1 165
=
+
+



=
.
.
%
.
%
.
The Fisher effect and interest rate parity imply that the ratio of the inflation 
rates for two currencies over a forecast interval t should also align with the 
forward exchange rate in year t, Xt, and the current spot rate, X0:
X
X
i
i
i
i
i
i
t
F
F
t
F
D
D
t
D
=
+
(
)×
+
(
)×
×
+
(
)
+
(
)×
+
(
)×
×
+
(
0
1
2
1
2
1
1
1
1
1
1
...
...
)








where    it
D = inflation rate in year t in domestic currency
it
F = inflation rate in year t in foreign currency
In the example from Exhibit 27.1, the four-year forward rate ties not only 
with the euro and Swiss franc interest rates but also with the inflation rates:
X4
1 200 1 005 1 010
1 015 1 015
1 010
1 015 1 025 1 025
=
×
×
×
×
×
×



.
.
.
.
.
.
.
.
.
= 1 165
.
2 Interest rate parity implies that whether a company borrows in Swiss francs or euros has no impact on 
value (unless there are any tax implications). You could borrow 1,200 Swiss francs today at 4.16 percent 
interest per year, totaling 1,412 Swiss francs to repay in 2024. At the four-year forward exchange rate, 
this amounts to €1,212 (1,412 ÷ 1.165). Alternatively, you could take up a €1,000 loan today at 4.93 per-
cent annual interest in euros, accruing to a total payment of €1,212 in 2024.

512  Cross-Border Valuation
Conversion of Cash Flows
Conversion of future cash flows should be done only at forward exchange rates 
that are consistent with the interest and inflation rates used in your valuation. 
Otherwise, valuation results are likely to differ depending on the currency 
used in the cash flow projections. Do not rely on “forecast” exchange rates for 
your projections, as these rates could induce a bias in your valuation if they are 
not consistent with your assumptions on inflation and discount rates.
Estimating the Cost of Capital
As when you are forecasting cash flows in different currencies, the most im-
portant rule for estimating costs of capital for cross-border valuations is to 
have consistent monetary assumptions. The expected inflation that determines 
the foreign-currency cash flows should equal the expected inflation included 
in the foreign-currency weighted average cost of capital (WACC) through the 
risk-free rate. Then estimate the cost of capital, depending on the investor’s 
position.
For investors and companies that face little or no restriction on investing 
outside their home markets, the cost of capital is best estimated following a 
global capital asset pricing model (CAPM) that applies equally to foreign and 
domestic investments.
For investors and companies in markets facing capital controls that pre-
vent them from freely investing abroad, we recommend using a so-called local 
CAPM. Since they can invest in domestic assets only, they should estimate the 
cost of capital from a domestic perspective, measuring market risk premium 
and beta versus a (diversified) domestic portfolio.
Many practitioners make ad hoc adjustments to the discount rate to reflect 
political risk, foreign-investment risk, or foreign-currency risk. We don’t rec-
ommend this. As the discussion of emerging markets explains in Chapter 35, 
political or country risk is diversifiable and best handled by using probability-
weighted scenarios of future cash flows.
Finally, keep in mind that estimating a cost of capital is not a mechanical 
exercise with a precise outcome. You should pair the approach outlined in this 
chapter with sound judgment on long-term trends in interest rates and market 
risk premiums (see Chapter 15) to obtain a cost of capital estimate that is suf-
ficiently robust for financial decision making. The following sections and Ap-
pendix G provide further background for our recommendations and practical 
guidelines for estimating the cost of capital in foreign currency.
Global CAPM
For investors and companies able to invest outside their home markets with-
out restrictions, we recommend using a global CAPM. In a global CAPM,