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Investing in Foreign

Operations

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Explain the various non-DCF and DCF techniques of project appraisal. Which of'
the technique is best and why?

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"Financial appraisal is said the key most appraisal of any project". Explain and
bring out its relationship with other appraisals tialnely technical, market,
environmental economical & social.

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How does APV differ from other techniques of financial appraisal of projects?
Why is it more suitable for international project appraisal?

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Write biief notes on the following :
a)
Real option value
b)

Portfolio approach to project appraisal.

the value of the firm is jeopardised. a number of factors. Should it be higher.10 Key Words 12.COST OF CAPITAL FOR FOREIGN INVESTMENTS Structure 1 h 12.1 Objectives I Introduction Weighted Average Cost of Capital for Foreign Projects 122 12.7 All-Equity Cost of Capital for Foreign Projects 12.3 Cost of Various Sources of Funds 12. This cost is used as a discount rate.11 Terminal Questions/Euercises 12. .5.4 Cost of Foreign Debt Capital 12.9 Let Us Sum Up 12. For any given investment.1 INTRODUCTION An important question for multinational corporations is to decide what their required return on foreign investments should be.5. the cost of capital is the minimum risk adjusted return required by investors for undertaking an investment. However. that the net present value 01' the future cash flows of the project exceeds or at least be equal to. The cost of capital is the basic measure of financial performance of a firm.0 12. If the silrplus earned by the investment project does not cover the return payable to creditors and shareholders.2 Capital Asset Pricing Model 12. the project's cost ( ' capital. It is imperative. Alternatively the yield from the project should be equal to or exceed this cost. 12.1 Dividend Valuatio~iModel 12. therefore. lower or the same as that ifor domestic projects? 6 It is a complex question colnprising as it does.8 Comparing the Cost of Capital in Developing Countries 12.5 Cost of Equity Capital 12. The investment project has to generate sufficient surplus to repay the loans of creditors.ents 12.0 OBJECTIVES After studying this unit you should be able to : 0 explain the cost of equity capital 0 discuss capital asset pricing model 0 explain the cost of foreign debt capital 0 examine discount rates for foreign investments calculate the weighted average cost of capital for foreign projects 0 e explain the all-equity cost of capital for foreign projects compare the cost of capital in developing countries. It should also earn sufficient return which the shareholders might have obtained in some other investment. which the multinational corporation do not have to take into account in deciding the hurdle rate l'or their domestic investments.6 Discount Rates for Foreign Investr. the appropriate cost of capital for foreign projects should be known to avoid pitfalls later on.

3 x 0.1 x 0. Supposing a company is financed with 60% ordinary share capital. Let us take an example to estimate the weighted average cost of capital. 6% and 14% respectively.6 x 0. The after-tax costs of equity debt and preference capital are 20%. the cost of equity is equivalent to the return on the firm's equity shares given its particular debt-equity ratio. different discount rates are used. These rates must reflect the value of these specific projects to the firm. the weighted average cost of capital of this firm is : 0. This weighted average cost of the capital is used as a discount rate in evaluating the specific foreign investment. is the cost of equity combined with tlie after-tax cost of debt. ke. A negative value disqualifies the investment. Market values. The weighted average cost of capital (WACC) of the prqject as well as that for the company is whole. for different projects in view of the risk profile of the specific project(s) undertaken by MNC.06 + 0. 'This weighted average cost of capital (KO) is computed as : KO = (I-L)Ke+Lid(l-t) Where. its calculation and i comparative evaluation of cost of capital in developing countries. this is not possible. WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS 12. A single required rate can only be used if all the projects which the MNC wants to invest in are broadly similar in their financial structures and commercial risks.14 If the"net present value of the cash flows of the project discounted at the WACC is positive. of capital on foreign projects is on finding a required rate of return for a specific project rather than for a firm as a whole. Weights are to be used in the proportion of the firm's capital structure accounted for by each source of capital. KO = Weighted cost of capital L = debt ratio (debt to total assets) of the parent company Ke = cost of the equity capital id (1-t) = after-tax cost of the debt. Thus the emphasis in calculating the cost . investing in many countries. we assume that the financial structure and the risk of the project is similar to that for the firm as a whole.I I Investing in Foreign Operations The required rate of return indicated by the cost of capital is used by the MNCs as a discount rate to allocate their funds globally for various projects. because this cost keeps on changing depending on the market values of equity and debt. . Both value weights are taken from firms balance sheet and market weights are based on current market prices of bonds and stock.20 + 0. 30% debt and 10% preference capital. Similarly in calculating the weighted average cost Of capital. In this unit you will learn in detail about the concept of cost of capital in the context of foreign inveslment. the existing historical mix is not relevant as future debt and equity components in the firm's capital structure are important. Hence. For an MNC. the investment may be undertaken. Using these as weights. and not the book values are used.2 Whenever we use a required return on equity for a particular investment.

To illustrate this poinr.3 Let us suppose that a subsidiary company has decided to finance a project as follows: p = Parent Company Fund R = Amount taken from retained earnings of the Subsidiary D = Amount taken in Foreign Debt T = Total cost of capital T = Cost of (P + R + D) The cost of capital of these three components must be calculated first to know the total cost of capital. They are calculated as follows: Cost of Parent Company's Funds : The required rate of return on parent company'i fund is the marginal cost of capital (KO).COST OF VARIOUS SOURCES OF FUNDS 12. Any investment in a foreign country must also provide the . tax and devaluation (appreciation) of loeal currency is to also be considered.t) where Ks = cost of retained earnings t = tax rate on repatriation Cost of Foreign Debt : The following formula given below will be discussed under heading 12.loan pl* (minus) devaluation (appreciation). if there is no change in the riskiness of the firm.S. parent borrows U. in above formula it will be : ~Rfd = a .4 Rf(1-t)(1 + a ) + a percentage appreciation of foreign currency COST OF FOREIGN DEBT CAPITAL hes st of debt in comlnon parlance is the rate of'interest on debt.4 Rfd Rf(l-t)(l-d)-d flfd = Cost of foreign debt Rf = where I 4 t ! 1 = d = ' Foreign interest rate Percentage depreciation of foreign currency 1 aiI E t : If there is appreciation of foreign currency. If there is a change in risk perceptions. Thus the cost of foreign currency debt should be nominal rate of interest ov foreign currency . dollors 100 million @ 8% p. . and Cost of Capital for Foreign Investments.S. = 12.a for one year. In case of foreign debt. assume Indian subsidiary of a U. the cost of capital K: is calculated by formula: KO'= KO+ (I-L) (Kel-Ke) KO* = Cost of capital in changed conditions of riskiness Ke' = Cost of equity based on new perceptions of riskiness Ke = Company's cost of equity capital L = Debt ratio of the parent company The'Cost of Retained Earnings : It is given by formula Ks = Ke x (1 .narginal rate of return as of the parent company.

The equity share * . 13% i. + R.Pei -0 ( I + r)" It is better to project an average rate of currency change our the life of the debt. The required rate of return is equal to the basic yield (internal rate of return).Pei -Peg + I (l+r)" t=i ( C r P ei = = = Internal rate of return Principal amount value of foreign currency at the end of the year i In case of taxes. The effective cost of foreign currency loan to Indian subsidiary will be approximately. The cot of foreign currency loan will be 5% i. In mathematical farm it is Rr = R.e.t) t=i (1 + ry +-.d Rf = the rate of interest t = tax rate d = devaluation d can be formed out by formula (eo . 8% (nominal) . = risk free rate of return riskpremium = IS The holders of equity capital claim that portion of profits which remains after the paylnent of interest to the lenders and dividends to the preference shareholders. interest is paid at the end of each year and principal is repaid in a lumpsum at the end of loan period the cost of debt in such case in the absence of taxes. the formula will be -pea + C rf Pei(1.Investing in Foreign Opcrstio~ls the rupee depreciates in that year by 5%.d ) ( I . in addition to the risk premium.e. In case of floatation costs the first term in both formula will read as: -pe.F) where F = floation costs. (1 . which covers the time value of money. Rfd = Rf(l . If there is an appreciation the above formula will be : a = the appreciation of the currency If debt is taken for a long period. 8% (nominal) + 5% (devaluation) and if the rupee appreciates by 30%. t COST OF EOUITY CAPITAL - 12.5 The cost of equity capital for a firm is the minimum rate of return necessary to induce investors to buy or hold the shares of the firm.ei) eo . Rr = required rate of return R. R. where eo is the exchange rate on the of borrowing and ei is the expected exchange rate at the end of the year.3% (appreciation).t ) . Foreign currency equivalent cost of local currency debt of foreign subsidiary can be computed by the following formula already explained above. is given by formula : n rf Pei +-.

an equilibrium exists beb4een an asset's required return and its associated risk. The approach to determining the cost of equity capital for a particular project is based on Capital Asset Pricing Model. if tlie past performance does not provide a reliable indioator of the future. it may not be suitable as a convenient choice'of a discount rate to evaluate the firm's foreign investment project.1 Dividend Valuation Model I n a dividend valuation model the cost of equity capital can be calculated by. expected future earnings will have to be calculated. which have been undertaken by the firm. Two models are used for this purpose 12.. . alternatively.2 capital Asset Pricing Model . However. All the projects have different risks. holders face the risk of variable cash flows and expect a higher return than the internal rate of return on the capital invested by them. If similar experience replicates. the estimation will be more or less current. (CAPM). only if the new project has a similar risk profile and financial structure to that of existing projects. = equilibrium expected return for asset i. Thus the better approach seems to be to take a project specific required rate of return.which.will give a better idea of tlie riskiness of the particular project. Cost o f Capit:tl 'for Fat-eign l n v e s t n ~ e ~ ~ t s . Even in the case of the dividend valuation model. One can. In this model. This latter view of the required return (as a weighted average return of all the returns on individual activities) gives a better idea of the cost of equity capital of a firm from the conceptual point of view. Divl = expected dividend in year I Po = current price of the share g = average expected annual growth rate of dividends I From the equation above. the expectations of future earnings can be reliable. we derive : The growth rate of dividends.following formula : Div l Po = Ke . g can be estimated from the historical data. . However. This internal rate of return would equal the discounted value of all future income streams accruing to them equil to the net worth of shareliolders. This is expressed by the forrhula : Where R. A new project to be undertaken by the firm may not be similar in nature to the other projects.5. 12. also look upon the required rate of discount as the weighted average return of all the returns which are available on the various activities of the firm.g Where Ke = company's cost of equity capital.5.

because financial trouble arising out of high total risk... pi (R..RJ. The CAPM assures that the total variability of an asset's return can be attributed to two sources : I) market-wide influences that affect assets to some extent. Where the returns and the financial structure of a new investment are likely to be similar to those of earlier investments. On the other hand.RJ. In addition to the systematic risk reflected in the premium on the appropriate discount rate. systematic risk cannot be eliminated. In effect..Rf) = the market risk premium. such as a strike. Rm)to2(Rill). 2) other risks. expected return on the market portfolio consisting of all risky assetb. The risk-free return (RJ is kn.. . = R. will hurt the interests of customers. where Cov (R Rill) refers to the covarisnce between returns on security i.. For example.tate of the economy and. However. The unsystematic risk is largely irrelevant to the highly diversified holder of securities because the effects of such disturba?~cescancel out in the portfolio. Although CAPM states that only a systematic component of the risk will be rewarded by a risk premium. Hence the investor should be compensated For bearing this risk. The inverse relation between risk and the expected cash flows exists. If the project's cash flows are volatile and uncertain.H I:ol. that the history will repeat itself and the past patterns will be good indicators the future returns. suppliers and employees. that are specific to a given firm.non-diversifiable risk. The former type of risk is usually ternled systematic 01. no matter llow well diversified a stoclc portfolio is... which is the excess return expected.. Similarly a firm which is trying hard to survive can get suppliers only at higher than usual prices. the management may be unable to take a longterm view of the firm's prospect. covariance (R. the company-wide cost of equity capital can be used as a discount rate to evaluate the new investment.. This distinction between the syste~naticrisk and unsystematic risk provides the theoretical foulidation to the evaluation of risk in the multinational corporation. . If we are looking into the future. = PI = rate of rel~rnon a risk frze ass. we should know the risk premium [Rill . The latter risk is called unsystematic or diversifiable risk. = the systematic or non-diversifiable risk of the asset. this does not mean that the total risk (the combination of systematic and ~cnsystematicrisk) is unimportant to the value of the firrn. the total risk may have a negative impact on the firm's expected cash flows. it cannot be so. potential customers will be nervous about purchasing a product which they may have difficulty in getting serviced if the firm goes out of business. It will lead them to adopt hitand-run strategies making tnost of current opportunities. So we depend on past patterns assuming that there is a good chance.Investing i n QPCI. T 4s .cig~l tions R. (R. where : PI bi measures the correlation between returns on a particular asset and returns on the market portfolio.own. such as the . a projectspecific discount rate has to be used.) is the variance of returns on the market pol-tfolio. Where8the returns and the financial structure of the new investment are not similar to those of other projects. and the rnarket portfolio. In the above equation the risk-premium associated with a particular asset i is assumed to equal . apd the o2(R.e&usually the yield on say 365 days goverument treasu~ysecurifly . We [nay make a fortune if we have this knowledge for future for every year to come.

.for inflation was about 7.... Evidence . equities yielded a real return of only 1 per cent per annuln in their... Fisher and Loric analysed colnmon stock returns for the period from 1926 to 1965...Treasury bills 3. 3 How is the cost of capital calculated in dividend valuation model? 12.........................0 I - - 12.3 per cent.6 DISCOUNT RATES FOR FOREIGN INVESTMENTS U. lbotson and sinquefield in their annual publication of stocks bonds... There have been two or three classic studies of US equity returns...al) Note : The end years are from 1986 to 1990. The 'arithmetic mean is calculated as : .R..... study.. The beginning year is 1926.... bills and inflation yearbooks use 1926 as the base year and calculate the realised yields on ordinary shares. The real before-tax rate of return.... (Rrbased on U.........S. U.....5 Inflation 3.. Ritter and Urisli (1984) measuring equity yields over the period 1968 to 1983 obtained different returns..(R.... For example..1 5..S... long-term corporate bonds. as follows : Total annual returns from U..............lower return than immediately before 1987.... immediately following .... The choice of the base year and the end year can influence the realised return.... etc....1 32 1 R......7 Long-term government bonds 4.......5 Long-tenn corporate bonds 52 - 5. adjusted ........0 Ordinary shares - 5.1987 stock market crash would yield a.7 per cent annum over the forty years period.....6.. .5 - (Calculated byilbbotsm et.. Investments over long run from 1926 Arithmetic Mean (Yo) - 12.R. Treasury Bills) \ i 8.. The U... The before-tax return including dividends and capital gains over the whole period was 9.... ...S..S...S................ The returns would vary according to the choice of the end year........... based) bn long term government bonds 72 R.Check Your Progress A C ~ s tof Capital for Foreign Investments 1 What is cost of equity capital? why is it calculated? 2 What is the formula for CAPM model? ......

Tax at standard rate (capital gains tax excluded) . equity returns in ~.5 7. Their ~~esults over the period from 1919 to 197 1 suggest a real net of tax return of over 7 3/4 per ccent.8 Sorrrce : bferrel cntrl S'.S.A.1 10. Securities R. bonds etc. r c t ~rns (%) Tax cxanpt Tilx it1 2S0/0 (capital gains tax csc luded) I__ 12..S. They calculated an arithmcticnl averilge of the risk 52 I .net of sllare holder t a I910 U. returns from 1802 onwards. Siege1 (1994) calculated U. cquities in a similar manner to lbbotson in the U. Securities) K.. investnment. RIII).R. Siegel uses a single finishing year of 1992 while lbbotson et.S. in Britain.K..S. as shown in the following table. Where Rpis the annual rate of return in year t.ealterrns afld. Merret and Sykes studied real returns accruing from U.. .kc.K. more than 1 per cent higher than colnparable relurns ti0111 U.S.(based on long-term Govt..R.K.S. Rctur~lssince 1980 (Arithmetic mean) Co~n~non stock (nonnal) Common stock (Real) tong-tenn Govt. Securities) The British Evidence There have bee11 some studies of returns on ordinary shiires. L1.S. The rcti~rnscalculated by Siege1 ti-on1 1926 are mostly similar to those calculated by Ibbotson and Signefield. and U... ' U.K. The trend of U.I I ~ ~ v c s t i nill g 1:orcign Arthmetic mean Operations = n n --t. (based on long-term Gavt.at use a range of various terminating dates. Securities Short term Govt.1971 1I. returns ('%I) Period - 1919 39 Tax exempt. .s (1973) Di~ilsolland Marsh (1982) co~nputedI-etulnsto investment in 1J. They focused up011 Rill net of tax and in real tern1:i rather than (R. retur~lsIias been i~lcreasitlgover tllc last two hundred years. equity investalunc in net oP tas terns. I-le shows that the earl~er-to1020 the risk pre1niu111was much lower than that after 1925.1 = R.

it fiu& not be included in the cdst of equity. Total annual returns from U.Allerr et.S. .A.R.RF) may be due to higher inflation rates. some adjustlnent would have to bc made. based) on long term government bonds) .K.S.K.r * - 'Officer (1989) reports arithmetic mean of excess return of 7. Diltir In U.S.45 per cent per nnnum. The question of choosing the allpiopriate discount rate f6r developing countries is addressed to the question of whether we should add a fu'r'fher country risk premium in choosing the appropriate discount rate.(R. higher risk premium reflected in higher returns and the higher value of (RM . One may argue that an investment in a developing country project would provide greater diversification as the ec~no~liics. The answer depends upon whether the country-risk is systematic or unsystematic. U. Developing Countries The research data over a long period for rgturnen equity is not available for developing countries.K. Allen et. beginning in 1919 and ending at 1st January 1980.Jreasury bills Inflation . Investment in equities in the etherl lands is reported to be 6. (R. U.R. Arithmetic mean (%) .premium (RII1.R. These are presented with Ibbotson's data to facilitate comparison. the risk is a systematic one and is not captured in the beta of the project in the other country.9 per cent per annun] accruing to equity investors in Australia over a period of 1882 to 1987. D~trr Ibbotsorr ct. returns in the format lbbotson has done from U.. based on U. If however. Evidence from other countries We do not have a complete picture of excess returns over a seventy or eighty year period from other countries in the world. during the period under consideration. This is a real return adjusted ftom inflation from the nominal return of 11.K Arithmetic mean ("%) Ordinary shares .S.itl ..S.) appears to be 8 314 per cent gross of taxes and about 8 per cent on an after tax basis. These returns are calculated from 1919 and the end year is 1980.of the developing countries are less integrated with those . . If the risk is unsystematic..) based on equity returns and the treasury bill rate for individual years.al (1987) reported U.K. data from 1926) U.lent bonds Intermediate terrn Goverritnent bonds13 months govt bills U. The value of (Rm. investments from 1919 (also U.8 per cent per pnnurn from 1947 to 1993... For relatively long periods.R. Treasu~ybills) - U.itI.S. Small Company Ordinary shares Long-term corporate bonds Long-term Govern1.) (R.) (R..

l/(li-0. Thus the project's cost of capital is : In actual practice. Then p* can be estimated by reference to the firt11's equity price pe. Example : If: Ordinary share price P = 0. the effects of debt-financing arc: to be separated..calculate the all equity rate. the risk-free return (based on governnient securities) is 12% and the required return on the market is estimated at 22*h. a Zambian copper llline may reprerellt a capital project in the less developing country (LDC) but its syste~llaticrisk will be near to that in the industrialised country because the world demand and the world price of copper are dependent on economies of industrialised countries.rr) Where K* = The expected all equity discount rate.79 x I .7 A rlunlber of adjustlnents have to be made to arrive at the WACC for a foreign proiecl These ad-iustments relate to determining the cornporlents of various types of capital in the targeted capital structure assutnptions regarding the risk l~rotilesof the firm and the project etc.6)]= 0. Ke. we depend upon the Capital Asset Pricinp Model discussed earlier in tllis unit. The expected rate of return to be used as n discount factol.1 ' = 34% Then all equity Beta P* would. the Beta associated with tlie ~ln-leveragedcash llows The t'ollo~vingexample would illustrate lliis concept. Thus for example.15. pe/[l + (I -t) D/E] Where t is the f i m s marginal tax rate. P* = . D/E is the current debt eql~ityratio. it may not be possible to estimate p* very precisely. Example : Suppose a foreign project has a betn of 1. I 9 To transform pe into p*.. p* = All equity Beta i.be = [l.TllilS systematic risk in projects in developing countries may not be for below that in the project ill the developed country. ALL EQUITY COST OF CAPITAL FOR FOREIGN PROJECTS 12. This is called an-levering._ _ I I of developrd countries With increasing globalisation this not exactly the sit~ation. To. Thus it is suitable to use an all equity cost of capital as tlie discount ratc.66 x 0.. + p* (r. I n other words be is the beta that appears in the estimate of the firm's cost of equity capital i.e. If the foreign project is quite similar in risk to the firm's average project..6 Debt equity ratio Marginal tax rate = 1. 01.e. is : K* = r. .converting a levered equity beta to its un-levered all-equity value.

the projects. If the economy of the host country moves in different direction than tlle eco'nomy of the home country o f the multinational conipany.- 12. However. There have been empirical studies on . Tlie globalisation interdependence among countries. can be offset by gains in India and China and in developed countries. The executives of . the investors may prefer a lower return on an internationally . the returlis from the foreign project are less highly correlated. They may ask for a higher return from a single country company. The component of risk which leads to' variable returns and which cannot be eliminated through diversification is systematic risk. If companies follow the route of diversification through direct foreign investments. The corporates should continue investing abroad so long as there are profitable opportunities. with she returns of project in the home country. are less closely tied to United States or tlie Europear? economy. . but tlie unsystematic risk would greatly very. South Asian countries. The use of any risk premium ignores the fact tliat the risk of an overseas investment in the context of the firm's and otlier investments will be less than the pro. However.998.multinational firnis should pay ~nucliless attention to the ilnportance of the risk premiuni.ject:i even in developing countries ]nay not be much below the average risk for all . In this case the systematic risk of a foreign' project could be lower tlian tlie sy~tematicrisk of its domestic counterpart. since the South Asian debacle since 1977 and the Russian debacle in 1. Now that barriers to international portfolio investments are being raised (Malaysia re-imposed capital controls recently). In normal tinies. However tlie risk that the lnultinational corpo.rations face in foreign projects is the unsystematic risk. 'The cost of capital can also be calculated on dividend valuation model. rl~e shareholders would be benefited. or NIFTY coniparable to say the New York stock exchange index Fan nieasure the general market risk affecting the counlry. It can be said.jects. The domestic share price rid ex sucll as the BSE sensex. have this effect. 'The reason is tliat by now most econotnies of developing countries are tied to the world economy. one may conclude that the observation about ignoring the risk prenliu~nmay have to be tempered by a careful study of tlie systematic risk and by property assessing tlie pro.actically tlie same for foreign projects. Hence. LET US SUM UP Tlie cost of capital is tlie basic measure of perforniance of a firm. Tlius the systematic risk [nay be pl. despite the South Asian debacle in 1997 that the econoniies of less developing countries.8 COMPARING THE COST OF CAPITAL IN DEVELOPING COLTNTRPES - C'i~stof Cnpitql for Furcign Investnicg4s I .ject's total risk. the systematic risk affecting tlie company resulting from the general econonlic conditions is related to the nature of the economy of the host country. in wliicli the foreign pro-ject of tlie multinational company is undertaken. the corporate diversification can be the preferred option. say. it is possible to diversify this risk by the individual investor. Thus automatic risk premium for a foreign project is not a necessity. o n tlie otlier hand. If the l?iultinationalcorporations are taking the diversification route where costs do not exceed benefits.diversified company. These unsystematic risk may be high. Tlie set back in investments in. but they need not affect the discount rate which 1s to be used in foreign pro.iectts Beta. the above observatio~iis true in the light of empirical evidence and the relevance of CAPM. Tlie approach to determine the cost of equity capital for a particular project is based on Capital Asset ~ricin'gModel. A caveat has to be entered liere. Tliis can be eliminated ~liroughdiversification at the level of the individual investor. even thougll the political risks are high in the developing cauntries. the dependence on foreign investments for pushing up tlie GDP etc. the systematic risk of pro. The cost of equity capital for a firm is the minimum rate of return necessary to i~id~lce investors to buy or hold shares of the firm.

A. and not in other countries. 3 Write a short-note on various studies done in U. The cost of debt is the rate of interest on debt.1 1 TERM~NALQUESTIONSIEXERCISES I Define cost of equity.A. If risk perceptions change what happens to cost of equity? 2 Explain the CAPM model in relati011to cost of capital. Cost of capital : The minimum rate of return for the firm must earn on its investments in order to snt~sfythe expectatio~isof investors who provide the funds for tile future. The risk that cannot be r~agnified. Milltinational Corporation should study risk premium while investing overseas.To calculate all equity cost of capital the us'e of CAPM is made. Systematic Risk : It is also called non-diversified risk of' an asset on niarket risk. . The weights may be based on market or book values. tax and devaluation (appreciation) of local currency is to be co~lnected. and U. .10 KEY WORDS CAPM : This Model is used to determine the cost of equity capital. 4 How all equity cost of capital for foreign project is arrived at? 5 How is cost of all sources of funds calculated? . on Piscounted tbr foreign investments.S.Discoutited Rhtes for foreign investments in U. 12. and U. In case af foreign debt.S.K. It is better to calculate a weighted average cost of capital.K. 12. Weighted Average Cost of Capital : The cost of capital calculaled by assigning weights on the basis of book values of each component of the baalance sheet or market value of securities.

I 1 I I .1 Introduction 13.11 Let Us Sum Up 13. . have all combined to make the life difficult for the internahonal investors. customs and having a different currency. . laws.1 Pre-investment Planning 13.9 Postexpropriation Policies Multilateral Investment Guarantee Agency Influence of Tax Policy on Foreign Investments International Tax Rules and Financing ayd Investment Decisions 13.5.8 13.UNIT 113 POLITICAL RISK AND TAX ASPECTS Structure ---.5 Measuring Political Risk Managing Political Risk 13. measured and managed and what is the effect of tax policy on foreign investments. In block 2 you learnt in detail about transaction risk. you will learn about political risk and how this risk is assessed. i3. All international trade and investments face political risk though in different degrees. translation risk. etc.. translation risk and economic risk.2 Political Risks in Today's World 13.6 13. Let us now learn about political risk.G' Objectives 13.2 Operating Policies 13. political risk and interest risk. Indonesia to Uganda.1 INTRODUCTION 1 ' As you know there are different types of currency risks namely transaction risk. every year. Zaire.3 Assessment of Political Risk 13. multinational enterprises and individual investors have been negatively influenced by events in various countries* from Afghanistan to Iraq. '13.7 13. 13.5.12 Key Words 13.Political risk is the risk associated with doing business in or with other country having different culture. the entrenched parochial sentiments of: national and' supranational groups. traditions. In this unit.4 13.2 PQLITICAL RISKS IN TODAY'S WORLD The fragmentation of the international political system. economic risk.0 OBJECTIVES I After studying this unit you should be able to : Q explain political risk analyse how political risk is assessed and measured * identify why muItinational corporation invest in foreign countries * examine how tax policy affects foreign investments.13 Terminal Questions/Exercises 13. At one time or another. and a community of nations where onethird 'of the national governments change.10 Possible Issues in the Taxation of Business Investment Abroad 13.