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Capital Budgeting & Political Risk

Reading: Chapters 17 and 18

Lecture Outline
 Evaluating Foreign Projects  Cost of Capital for Foreign Projects  Project Evaluation  Political Risk  Managing Political Risk

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Evaluating Foreign Projects
• Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral and economic decisions – as well as reinvestment decisions – it should be justified by traditional financial analysis.
• Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long-term investment projects.

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Evaluating Foreign Projects
• Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. • The basic steps are:
– Identify the initial capital invested or put at risk. – Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment. – Identify the appropriate discount rate to use in valuation. – Apply traditional capital budgeting decision criteria such as NPV and IRR.
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– Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary – cannibalization. – Managers must evaluate political risk. 5 . – Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on cash flows as well as indirect effects on competitiveness. because political events can drastically reduce the value or availability of expected cash flows. – Parent cash flows often depend on the form of financing and other choices.Evaluating Foreign Projects • Capital budgeting for a foreign project is considerably more complex than the domestic case: – Parent cash flows must be distinguished from project cash flows.

this viewpoint violates a cardinal concept of capital budgeting – that financial cash flows should not be mixed with operating cash flows. • Cash flows to the parent are ultimately the basis for dividends to stockholders. 6 . repayment of corporate-wide debt and other purposes that affect the firm’s many interest groups. • However. reinvestment elsewhere in the world.Project versus Parent Valuation • A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent.

Project versus Parent Valuation • Most firms appear to evaluate foreign projects from both parent and project viewpoints (to obtain perspectives on NPV and the overall effect on consolidated earnings of the firm). where possible. If they are unable to earn superior returns on foreign projects. we must pay attention to the project’s local return. and letting those companies carry out the local projects. • Multinational firms should invest only if they can earn a riskadjusted return greater than locally based competitors can earn on the same project. 7 . • In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country. their stockholders would be better of buying shares in local firms.

8 . 2.Project Adjustments How do we adjust for political/country risk: 1. Adjust cashflows – use an expected value of each cashflow based on the probability of different events occurring. Adjust discount rate – add an additional risk premium onto the required rate of return / cost of capital.

need to find a proxy/comparable local company with same risk as project and adjust for any differences in capital structure and risk (see FinAspect). Then adjust for country risk. If not. 9   .Cost of Capital for Projects  Should the cost of capital of foreign projects be higher or lower than that of the company’s domestic investments? Remember:  The cost of capital for a project depends on the risk of the particular project. Can use company beta if project is of same risk and has same capital structure as the company.

5 and 1.  Rio Tinto has a beta of 1. Rio Tinto has discovered that the average beta and D/E of mining projects in China is 1.8. An initial outlay of A$500 million is required and after-tax net cashflows of US$100 million are expected each year from the sale of the mine’s output on world markets.2 and D/E of 0.Example  Rio Tinto is considering undertaking a 5-year mining project in China.  If Rio Tinto wishes to finance the project with 50% equity and 50% debt what is the appropriate WACC for the project and the NPV? 10 .1. However.

4)x1.  Company cost of capital not appropriate for this project .4 and cost of debt = 8%.5 1 + (1-0. tax = 0.9036 11 .1 0. Rm = 12%.to work out the cost of equity for this project we need to unlever and then re-lever the comparable beta. Unlevered Beta = = = Comparable Beta 1 + (1-t)xD/E 1.Example  Assume: Rf = 5%.

4)x1] = 1.9036 x [1 + (1-0.15% 12 .45  The cost of equity (Re) for this project is therefore: Cost of equity = = Rf + Beta (Rm – Rf) 5% + 1.Example  Re-lever the project beta using the project’s D/E: Re-levered Beta = Unlevered Beta x [1 + (1-t)xD/E] = 0.45 (12% – 5%) = 15.

4)(1/2) = 0.4)(4/9) = 0.0958 or 9.08(1-0.0998 or 9.1515(1/2) + 0.08(1-0.58% 13 .134(5/9) + 0.Example  The project WACC is: WACC = Re(E/V) + Rd(1-t)(D/V) = 0. the company’s WACC is: WACC = 0.98%  For comparison.

if we had used the Company WACC instead: NPV = 1.0998 = -3.0998)-5] 0.31/US$.97 million 14 .Example  Convert the US dollar cashflows to Australia dollars at the appropriate exchange rate – for simplicity we will assume a constant rate of A$1.15 million  BUT.  NPV of project is: NPV NPV = -500 + 131 [1-(1+0.

But is this enough?  Should we also adjust the cost of debt?  Are we going to operate in a more or less risky part of the country?  Are we more or less susceptible to political/country risk than the average mining project in China? 15 .Example  Have we adjusted properly for country/political risk?  The comparable beta includes a premium on the cost of equity for the average risk for these types of projects in the country.

The appropriate WACC for the project is determined to be 15%. The tax rate is 20%. The campus will cost A$15 million to set up and is expected to have 100 students in the first year. Annual costs are estimated to be 65% of incremental revenues.Project Evaluation  QIT is thinking about opening a new campus in Tokyo to offer 1-year Masters/MBA degrees and needs our help in determining whether it will be profitable or not. 16 . The average annual fee per student is expected to be ¥5 million in the first year. The number of students and the fees are expected to grow at 5% forever.

 The current exchange rate is ¥100/A$.  Is going ahead with the new QIT campus in Tokyo a good idea? 17 .Project Evaluation  QIT has estimated that 25% of the students attending the new campus would have previously attended its campus in Brisbane. The A$ is expected to appreciate by 10% per year for the next two years and then remain steady.

Project Evaluation  Initial outlay = A$15 million  In the first year: Revenue = 75 x ¥5 million = ¥375 million Costs = 65% x ¥375 million = ¥243.25 million = ¥26.25 million Tax = 20% x ¥131.25 million Profit After Tax = ¥105 million 18 .75 million Net Profit = ¥131.

25% per year.1025 or 10.Project Evaluation  Student numbers and student fees both grow by 5% per year.25% per year  As costs and tax are both a constant percentage of revenues.05) x (1.  So the profits after tax in years 2 and 3 are: Year 2 = ¥105 million x 1.05) -1 = 0.1025 = ¥127.1025 = ¥115.76 million x 1. This means revenues will grow at: (1. this means profit after tax also grows at 10.63 million 19 .76 million Year 3 = ¥115.

778  From Year 3 onwards. A$ amount grows by 10.25% per year as exchange rate is not expected to change.63 million Rate ¥110/A$ ¥121/A$ ¥121/A$ A$ amount A$954.715 A$1.545 A$956.Project Evaluation  Calculate A$ value of Yen profits: Year 1 2 3 ¥ profit ¥105 million ¥115.76 million ¥127. 20 .054.

As long as A$ does not continue to appreciate! 21 .A$15 million + A$954.34 million  So it is a good idea for QIT to go ahead with new campus.545/(1.778/(0.715/(1.Project Evaluation  The NPV is: = .1025)/(1.15)2 + A$1.15)2 = A$3.15-0.15) + A$956.054.

For example:  QIT could expand the campus if it is successful.  QIT could close down the campus if it is not successful.  Each of these options is valuable and the true NPV can be modelled using the probabilities of the different outcomes.Real Options  The true NPV may be different as QIT has a range of embedded real options attached to the project. 22 .

23 . Can also be:  currency or trade controls  changes in tax or labour laws  changes in ownership policies  economic management and political problems etc.Political Risk  Political risk can be described as the influence of nonbusiness events on the value of the firm.  It is more than just expropriation.

Frequency of Expropriations 80 60 Number of firms 40 20 0 1960 62 64 66 68 70 72 74 76 78 80 82 84 86 88 Number of countries expropriating 90 24 .

measure and manage its political risks. it must define and classify these risks. • This text classifies these risks as: – Global-specific – Country-specific – Firm-specific 25 .Political Risk • In order for an MNE to identify.

Political Risk 26 .

but devoted to ranking different types of terrorist threats. – We can expect to see a number of new indices. 27 . similar to country-specific indices. – There are many groups interested in disrupting MNEs operations for the cause of religion. September 11th).e. their locations. and potential targets. anti-globalization. environmental protection and even anarchy.Global-Specific Risks • Predicting global-specific risk: – Global-specific risk is clearly quite difficult to predict (i.

Global-Specific Risks 28 .

29 . – Analysis of trends in these metrics leads many to speculate that the future will resemble the past. the MNE must conduct adequate analysis in preparation for the unknown.Country-Specific Risks • Predicting country-specific risk (macro risk): – Political risk studies usually include an analysis of the historical stability of the country in question. indications of economic stability and trends in cultural and religious activities. – Despite this difficulty. which is often not the case. evidence of present turmoil or dissatisfaction.

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Country-Specific Risks 31 .

32 . it usually limits transfers of foreign exchange out of the country.Country-Specific Risks • Transfer risk is defined as limitations on the MNE’s ability to transfer funds into and out of a host country without restrictions. • When a government runs short of foreign exchange and cannot obtain additional funds through borrowing or attracting new foreign investment. a restriction known as blocked funds.

33 . a firm can analyze the effect of blocked funds on return on investment.Country-Specific Risks • MNEs can react to the potential for blocked funds at three stages: – Prior to making an investment. the desired local financial structure etc. – During operations a firm can attempt to move funds through a variety of repositioning techniques. – Funds that cannot be moved must be reinvested in the local country in a manner that avoids deterioration in their real value because of inflation or exchange depreciation.

Country-Specific Risks • At least six popular strategies are used to move blocked funds: – Providing alternative conduits for repatriating funds – Transfer pricing – Leading and lagging payments – Using fronting loans – Creating unrelated exports – Obtaining special dispensation 34 .

Country-Specific Risks • When investing in some of the emerging markets. MNEs that are resident in the most industrialized countries face serious risks because of cultural and institutional differences: – Differences in allowable ownership structures – Differences in human resource norms – Protection of intellectual property rights – Nepotism and corruption in the host country – Protectionism 35 .

Country-Specific Risks • Ownership structure: – Many countries have required that MNEs share ownership of their foreign subsidiaries with local firms or citizens – This requirement has been eased in most countries in recent years • Human resource norms: – MNEs are often required by host countries to employ a certain proportion of host country citizens rather than staffing mainly with foreign expatriates – It is often very difficult to fire local employees due to host country labor laws and union contracts 36 .

as it is also a problem in industrialized nations such as the US and Japan 37 .Country-Specific Risks • Intellectual property rights: – Intellectual property rights grant the exclusive use of patented technology and copyrighted creative materials – Courts in some countries have historically not done a fair job of protecting these rights • Nepotism and corruption: – There is clearly endemic nepotism and corruption in many important foreign investment locations – Bribery is not limited to emerging markets.

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Country-Specific Risks • Protectionism: – Protectionism is defined as the attempt by a national government to protect certain of its designated industries from foreign competition – Industries that are usually protected are defense. and infant (emerging) industries – Protectionism occurs through the use of tariff and non-tariff barriers 40 . agriculture.

different foreign firms operating within the same country may have very different degrees of vulnerability to changes in hostcountry policy or regulations 41 . – Clearly.Firm-Specific Risks • Predicting firm-specific risk (micro risk): – Assessing the political stability of a country is only a first step. – The real objective is to anticipate the effect of political changes on activities of a specific firm.

42 .Firm-Specific Risks • The firm-specific risks that confront MNEs include: – Business risk – Foreign exchange risk – Governance risk • Governance risk is the ability to exercise effective control over an MNE’s operations within a country’s legal and political environment.

royalties. – The presence of MNEs is as often sought by development-seeking host governments as a particular foreign location is sought by an MNE.Offsetting Firm-Specific Risks • Negotiating investment agreements: – An investment agreement spells out specific rights and responsibilities of both the foreign firm and host government. – An investment agreement should spell out policies on many areas including (among others): • The basis of fund flows (fees. dividends) • The basis for setting transfer prices • The right to export to third-country markets • Methods of taxation 43 .

Offsetting Firm-Specific Risks Take a conservative approach:   Adjust NPV for political risk. Minimize exposure to political risk:    Joint venture Consortium of international companies Use local or international syndicated debt 44 . Political risk may be diversifiable to some extent.

and civil strife • Business income (resulting from political violence) 45 . – OPIC offers insurance for four separate types of political risk: • Inconvertibility • Expropriation • War. revolution. – The US investment insurance and guarantee program is managed by the government-owned Overseas Private Investment Corporation (OPIC).Offsetting Firm-Specific Risks • Investment insurance and guarantees: OPIC – MNEs can sometimes transfer political risk to a home-country public agency through an investment insurance and guarantee program. insurrection.