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Define the following terms:

international investment
multinational corporation
home country
host country
exchange rate risk
political risk
transaction exposure

16.2 What are the benefits of international investment for the two main parties
involved, the MNC and the host country.
16.3 Explain why the host-country as an entity is recognized as a party to
international investment, whilst the home country is not.
16.4 By performing simulation experiments with alternative combinations of
parameter values and introducing new variables (or conditions) to example
16.1, establish a mix of cash flows to Lekano and Durango which would result
in a positive NPV for both parties. In your experiments, possible compensation
payments to Lekano by Sri Lankan government and U.S. government tax
exemption for Durango may be considered.
16.5 Assume that the subsidiary Lekano in example 16.1 can raise SL Rs 600
million of the required initial SLRs 800 million from the countrys national
provident fund as a loan at 11% per annum. Explain how this new financing
arrangement would affect the calculated NPV results, and discuss how
Lekanos transaction exposure to possible Sri Lankan Rupee depreciation
would be reduced.
16.6 Explain how both the RADR and the CE approaches might be employed to
assess a project under an international risk scenario.
Answer to Q16.1
Definition of terms:
International investment. This occurs where a firm domiciled within one country
invests in a foreign country. For example, a firm domiciled in Canada invests in a

project within Argentina. International investment is identified as a special case of
capital budgeting, as it introduces an additional set of risks which pertain to the
transfer of resources across international borders.
Multinational corporation. A multinational corporation (MNC) is a firm which has
business interests extending beyond its national boundaries. These interests are
usually structured in the form of subsidiary corporations which are used as the
vehicle whereby investment in the foreign country is carried out.
Home country. This is the country where the MNC is domiciled. In the
Canadian/Argentinean example above, the home country would be Canada.
Host country. This is the country where the foreign investment resides. In the
Canadian/Argentinean example above, the host country would be Argentina.
Exchange rate risk. This is one of the extra risks which firms face when they invest
internationally. It is defined as the unexpected future variability of currency
exchange rates between the home and host countries. For example, the future
exchange rates between the Canadian dollar and the Argentine peso will be subject
to variability, and this variability puts at risk the expected flow of cash back into the
Canadian MNC.
Political risk. This is one of the extra risks which firms face when they invest
internationally. It is defined as the variability in future cash flows caused by the
uncertainty of host country government action affecting the host country project, or
the repatriation of resources and funds from the project, to the home country. For
example, a host country government may seize the project with or without payment
of compensation, or the project may be physically damaged or stopped by riot or
civil war. The host country government may limit or block the outward flow of
Expropriation. This is a particular risk within the general set of political risks. It
means the seizure, with or without payment of compensation, of the physical project
within the host country. This seizure can be an action of the host country
government, or a host country unofficial government installed by a coup dtat.
Transaction exposure. This is a particular form of exchange rate risk. It is that risk
which causes variability in cash flows pertaining to fixed contractual amounts of
currency. Its formal definition is: future exchange gains and loses on foreign
currency denominated transactions or financial obligations already committed. This
type of risk differs from exchange rate risk, in that future transactions can be
restructured to lessen exchange rate risk, but transactions relating to transaction
exposure risk cannot.

Answer to Q 16.2
The benefits of international investment are:
For the MNC
Shareholder wealth creation
International diversification
Cheaper resources
Economies of scale
Diversified raw material supply
Possible lower taxes
Cultural awareness
Closer international ties

For the host country.

Economic development
Exposure to new skills
Local employment
Skill development
Local taxes received
Infrastructure development
International outlook
Increased consumer wellbeing.

Answer to Q 16.3
Recognition of the host country.
Ironically, in international investment, the host country government is often carefully
analysed whilst the home country government is not. This occurs because within the
home country, the firm has established itself as a successful entity, and is functioning
well within the domestic political scene. Both the firm and the government understand
each others attitudes and behaviours.
With a host country, these attitudes and behaviours are unknown, and in some cases
the firm may presume that the host country government is either hostile to foreign
investment, or is at least merely tolerant of foreign operations. Where less than full
support is shown by the host country, then there is the added risk of negative host
country intervention in the project. In such a case, the MNC will need to know the
likely outcomes of such behaviour, and will need to establish risk reduction measures.
Answer to Q 16.4
One possible mixture is the amount of management fees and the amount of capital
repatriation as shown in the Excel file titled Q 16.4 Excel Solutions.xls.
The outcomes are: an annual management fee of Rs 162.2003 million paid by Lekano
to Durango, and a capital compensation of Rs 248.7814 million paid to Lekano by the
Sri Lankan government for acquisition of the project at the end of year 3.
The management fee is computed by setting an NPV goal of a nominal Rs 0.01
million for Lekno, and using Goal Seek. This computation is shown on sheet 2. This
management fee is then held constant, and a second Goal Seek is used to compute the
value of the final compensation to give Durango a nominal NPV of US$ 0.01 million.
This computation is shown on sheet 3.

An alternative approach, suggested in the question, is for Durango to seek some form
of US government tax exemption or reduction for its investment in Sri Lanka. This
argument may be tenable on the basis of foreign assistance or a special economic
relationship. A computation using Goal Seek to adjust the US tax rate is shown on
sheet 4. On this sheet, the minimum annual management fee of Rs 162.2003 million,
and the original compensation amount of Rs 200 million, are retained, to give a
positive NPV for Lekano. The resulting necessary maximum tax rate that could be
levied by the US government, so that Durango can earn a positive NPV, is 10.59%
The point is that given the working spreadsheet, various mixtures of cash flows and
tax rates could be modelled for parent/subsidiary, and parent/host country
government, negotiation. Obviously, these are the minimum amounts that would
form a base for negotiation. Various other mixtures could be tested as well.
Answer to Q 16.5
Raising investment capital with Sri Lanka has several benefits. Some of these are:
local attachment to the project, closer ties between the government or semigovernment financing sector and the company, reduced risk of expropriation or
blockage of fund flows, possible cheaper borrowing rates and reduction of borrowing
transaction costs; and reduction in exchange rate transaction exposure. Given these
risk reducing benefits, the required rate of 22% per annum for the project could be
reduced. This reduction is based on a reduction in the risk premium within the rate of
return. Chapter 16 repeats the argument from Chapter 7, that the Risk Adjusted
Discount Rate contains three components: the risk free rate r, the average risk
premium for the firm u, and an additional risk factor estimating the difference
between the firms average risk, and that of the project, a. The equation for the Risk
Adjusted Discount Rate is:
k = r +u+a

Currently, k is 22%. If component a represents exchange rate/ transaction exposure

risk, with NPF financing this will reduce. How far it will reduce is open to question,
and in practice this fall will be very difficult to estimate. For purposes of discussion,
let us assume that the RADR, k, will fall from 22% to 14%pa. The calculated NPVs at
this rate will be: Lekano Rs 360.82 million, positive, and Durango US$ 1.49 million
negative. These results are an improvement on the original values of Rs 220 million
positive, and US$ 2.48 million negative.
See Excel file titled Q 16.5 Excel Solution.xls.
Answer to Q 16.6
The solution to Q16.5 demonstrates one way in which the RADR approach can be
used to account for various risks within an international setting. In concept this will be
simple to apply, but in practice the calculation of the RADR will be very difficult.
One approach would be to use various published guides of comparative levels of
international risk, published by both commercial and government agencies. One such
guide is available at: (sighted in June 2002).

The same approach could be taken with the certainty equivalent. This factor could be
applied to the projects expected future cash flows, which would then be discounted at
the risk free rate. The comparative international risk guide would help shape the value
of the CE factor. An example of an applied CE factor is shown in Excel file titled Q
16.6 Excel Solutions.xls. In this computation the assumed certainty equivalent factor
is 0.8, and the related risk free rate is 9.00% per annum. The resulting NPV for
Durango is US$ 2.33 million negative.