Question

what is the limitation of the use of spot exchange rate valuation in the capital budgeting analysis

Answer 1

Capital budgeting analysis involves cashflows that occur at different time periods in future and spot exchange rate cannot be applied to those cashflows it can only be applied those which are occurring now i.e. at time 0, However spot rate is indirectly used for future cashflows. Forcasting of future exchange rate is done with the help of spot exchange rate and the also the pure expectation theory says that expected future exchange rate will be equal to the forward rate and forward rate is calculated with the help of spot exchange rate.

F = f(S0,T,ia,ib,la,lb)

It says that forward rate is a function of spot rate S0, Time T, interest rates ia and ib for country a and b respectively and inflation rates la and lb.

So now we can say that the limitation of use of spot exchange rate in capital budgeting is only the time factor involved in such kind of decisions.