Valuing Cash Flows in More Than One Currency

An analyst modeling a Mexican subsidiary of a US company has cash flows that naturally arrive in pesos, but the parent company reports in dollars and its investors think in dollar returns. Discount the peso cash flows with a dollar cost of capital, or convert everything to dollars first and use a peso rate, and the valuation is silently wrong, often by a lot, because the two currencies have very different inflation and interest-rate environments baked in.

Two consistent routes, not one shortcut

There are exactly two correct ways to value cross-currency cash flows, and they must give the same answer if built consistently.

Route 1, value in local currency. Forecast the cash flows in pesos, discount them with a peso-denominated cost of capital (which will run higher than the dollar rate if peso inflation and risk are higher), get a value in pesos, then convert that single final number to dollars at today's spot rate.

Route 2, value in parent currency. Convert each year's peso cash flow to dollars using a forecast FX rate for that year (not today's spot rate), then discount the resulting dollar cash flows with a dollar cost of capital.

The forecast FX rates used in Route 2 are not guesses, they come from the same interest-rate parity relationship that prices FX forwards: a currency with higher expected inflation is expected to depreciate against one with lower inflation, roughly at the rate of the inflation differential. This is why the two routes agree: Route 1's higher peso discount rate and Route 2's assumed peso depreciation are two ways of expressing the same economic fact.

Worked example

A Mexican operating unit generates a real (inflation-adjusted) peso cash flow next year of MXN 200 million. Peso inflation is forecast at 6%, dollar inflation at 2%, so nominal peso cash flow next year is $200\text{m} \times 1.06 = 212$ million pesos. Spot is MXN 18.00 per USD.

1. Route 1. Peso cost of capital is 13% (roughly the 9% dollar cost of capital plus the ~4-point inflation gap). Discounting: $212 / 1.13 = 187.6$ million pesos in present value. Convert at spot: $187.6\text{m} / 18.00 \approx \textdollar 10.42$ million.
2. Route 2. The forward FX rate for one year out, from interest-rate parity, is roughly $18.00 \times 1.06/1.02 \approx 18.71$ pesos per dollar. Convert the nominal cash flow: $212\text{m} / 18.71 \approx \textdollar 11.33$ million. Discount at the 9% dollar rate: $11.33 / 1.09 \approx \textdollar 10.39$ million.

Both routes land close to $10.4 million; the small gap is rounding in the approximate parity formula, not a modeling error.

What this means in practice

The single most common mistake is using today's spot rate to convert every future year's cash flow, that quietly discards the inflation differential and biases the value upward for any currency expected to depreciate. Analysts also frequently forget to check that the risk-free rate embedded in each currency's cost of capital is genuinely that currency's own rate (a peso-denominated risk-free rate, not a dollar one with a spread bolted on), since mixing risk-free rates across currencies reintroduces the same inconsistency in a subtler form.