Chapter 16
Country Risk Analysis
Lecture Outline
Why Country Risk Analysis Is Important
Political Risk Factors
Attitude of Consumers in the Host Country
Actions of Host Government
Blockage of Fund Transfers
Currency Inconvertibility
War
Bureaucracy
Corruption
Financial Risk Factors
Indicators of Economic Growth
Types of Country Risk Assessment
Macro-Assessment of Country Risk
Micro-Assessment of Country Risk
Techniques to Assess Country Risk
Checklist Approach
Delphi Approach
Quantitative Analysis
Inspection Visits
Combination of Techniques
Measuring Country Risk
Variation in Methods of Measuring Country Risk
Using the Country Risk Rating for Decision Making
Comparing Country Risk Ratings Across Countries
Actual Country Risk Ratings Across Countries
Incorporating Country Risk in Capital Budgeting
Adjustment of the Discount Rate
Adjustment of the Estimated Cash Flows
How Country Risk Affects Financial Decisions
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279
Reducing Exposure to Host Government Takeovers
Use a Short-term Horizon
Rely on Unique Supplies or Technology
Hire Local Labor
Borrow Local Funds
Purchase Insurance
Use Project Finance
Chapter Theme
This chapter attempts to acquaint the student with various forms of risk that must be considered by a
multinational corporation. Methods used to assess country risk are defined. It should be emphasized
that country risk is often difficult to assess. Furthermore, it may change over time. A firm should
incorporate the country risk assessment in its decision of whether to begin (or continue) business in a
particular country. If it decides to conduct business there, it should continue to assess country risk as it
decides whether to expand in that country.
Topics to Stimulate Class Discussion
1. How would you rate the country risk of the U.S.? Would your rating change if you lived in a
foreign country? Why?
2. Some people say that you cannot separate the political and financial risk of a country. What does
this mean?
3. If you use a country risk rating system based on a scoring range of 0 to 100 (100 representing a
very safe country), and Country Z earns a score of 77, are you going to invest in that country?
Explain your answer. The point is to realize that the ratings are subjective, and it would help to
consider a probability distribution of possible outcomes before finalizing a decision.
POINT/COUNTER-POINT:
Does Country Risk Matter for U.S. Projects?
POINT: No. U.S.-based MNCs should consider country risk for foreign projects only. A U.S.-based
MNC can account for U.S. economic conditions when estimating cash flows of a U.S. project or
deriving the required rate of return on a project, but it does not need to consider country risk.
COUNTER-POINT: Yes. Country risk should be considered for U.S. projects. Country risk can
indirectly affect the cash flows of a U.S. project. Consider a U.S. project in which supplies are
produced and sent to a U.S. exporter. The demand for the supplies will be dependent on the demand
for the exports over time, and the demand for exports over time may be dependent on country risk.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue.
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ANSWER: In some cases, country risk could influence cash flows. When assessing a U.S. project, an
MNC should consider the ultimate source of the products that it produces, so that it can determine
whether the cash flows may be affected by country risk.
Answers to End of Chapter Questions
1. Forms of Country Risk. List some forms of political risk other than a takeover of a subsidiary by
the host government, and briefly elaborate on how each factor can affect the risk to the MNC.
Identify common financial factors for an MNC to consider when assessing country risk. Briefly
elaborate on how each factor can affect the risk to the MNC.
ANSWER: Forms of political risk include the possibility of (1) blocked funds, (2) changing tax
laws, (3) public revolt against the firm, (4) war, and (5) a changing attitude of the host government
toward the MNC. The forms of country risk mentioned here can cause reduced demand for the
subsidiary’s product, higher taxes, or restrictions of fund transfers.
Financial factors include inflation, interest rates, GNP growth, and labor costs. These factors can
affect the cost of production or revenues to the subsidiary.
2. Country Risk Assessment. Describe the steps involved in assessing country risk once all relevant
information has been gathered.
ANSWER: First, a rating must be assigned to each factor. Then, a weight must be assigned.
Finally, the weighted ratings can be consolidated to derive an overall political risk and financial
risk rating, and (if desired) an overall country risk rating.
3. Uncertainty Surrounding the Country Risk Assessment. Describe the possible errors involved
in assessing country risk. In other words, explain why country risk analysis is not always accurate.
ANSWER: Errors occur due to (1) assigning inaccurate ratings to factors and (2) weighting the
importance of the factors improperly.
4. Diversifying Away Country Risk. Why do you think that an MNC’s strategy of diversifying
projects internationally could achieve low exposure to overall country risk?
ANSWER: If the MNC can set up foreign projects in countries whose country risk levels are not
highly correlated over time, then it reduces the exposure to the possibility of high country risk in
all of these areas simultaneously.
5. Monitoring Country Risk. Once a project is accepted, country risk analysis for the foreign
country involved is no longer necessary, assuming that no other proposed projects are being
evaluated for that country. Do you agree with this statement? Why or why not?
ANSWER: Disagree! The country risk must be monitored continuously, since if risk becomes too
high, the MNC should divest its subsidiaries in that country.
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6. Country Risk Analysis. If the potential return is high enough, any degree of country risk can be
tolerated. Do you agree with this statement? Why or why not? Do you think that a proper country
risk analysis can replace a capital budgeting analysis of a project considered for a foreign country?
Explain.
ANSWER: Disagree! If country risk is so high that there is great danger to employees, no
expected return is high enough to warrant the project.
No. Country risk analysis is not intended to estimate all project cash flows and determine the
present value of these cash flows. It is intended to identify forms of country risk and their potential
impact. This is important information for capital budgeting but is not a substitute for capital
budgeting.
7. Country Risk Analysis. Niagara, Inc., has decided to call a well-known country risk consultant to
conduct a country risk analysis in a small country where it plans to develop a large subsidiary.
Niagara prefers to hire the consultant since it plans to use its employees for other important
corporate functions. The consultant uses a computer program that has assigned weights of
importance linked to the various factors. The consultant will evaluate the factors for this small
country and insert a rating for each factor into the computer. The weights assigned to the factors
are not adjusted by the computer, but the factor ratings are adjusted for each country that the
consultant assesses. Do you think Niagara, Inc. should use this consultant? Why or why not?
ANSWER: No! The consultant’s program has not allowed for the weights on importance for each
rating to be flexible, depending on the country or firm project of concern. Therefore, the program
will definitely assign improper weights to some factors.
8. Micro Assessment. Explain the micro assessment of country risk.
ANSWER: A micro-assessment of country risk assesses risk factors as related to the firm’s
particular projects.
9. Incorporating Country Risk in Capital Budgeting. How could a country risk assessment be
used to adjust a project’s required rate of return? How could such an assessment be used instead to
adjust a project’s estimated cash flows?
ANSWER: For countries with a lower country risk rating (implying high risk), the project’s
required rate of return could be increased (by increasing the discount rate on NPV analysis).
To adjust cash flows, consider each key form of country risk and re-estimate cash flows if that
form of risk occurs. For example, if the host government may block funds temporarily, estimate
the NPV of the project if that occurs. Re-estimate the NPV for any other forms of country risk as
well. This process results in a distribution of possible NPVs that can be assessed to determine
whether a project should be accepted.
10. Reducing Country Risk. Explain some methods of reducing exposure to existing country risk,
while maintaining the same amount of business within a particular country.
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ANSWER: Some of the more common methods to reduce country risk are:
1.
2.
3.
4.
5.
use a short-term horizon
hire local labor
borrow local funds
obtain insurance
create joint ventures
These and other methods are discussed in the chapter.
11. Managing Country Risk. Why do some subsidiaries maintain a low profile as to where their
parents are located?
ANSWER: Some subsidiaries are concerned that the public in the country where they are located
will harm their employees or damage the facilities as an act of protest against the home country of
subsidiaries.
12. Country Risk Analysis. When NYU Corp. considered establishing a subsidiary in Zealand, it
performed a country risk analysis to help make the decision. It first retrieved a country risk
analysis performed about one year earlier, when it had planned to begin a major exporting
business to Zenland firms. Then it updated the analysis by incorporating all current information on
the key variables that were used in that analysis, such as Zenland’s willingness to accept exports,
its existing quotas, and existing tariff laws. Is this country risk analysis adequate? Explain.
ANSWER: No. A country risk analysis used for an exporting project incorporates different
information than an analysis used to assess the feasibility of establishing a subsidiary.
13. Reducing Country Risk. MNCs such as Alcoa, DuPont, Heinz, and IBM donated products and
technology to foreign countries where they had subsidiaries. How could these actions have
reduced some forms of country risk?
ANSWER: When MNCs donate products and/or technology to foreign countries where they have
subsidiaries, they may receive more favorable treatment from the consumers in that country, their
employees that work for their subsidiaries, and the host governments.
14. Country Risk Ratings. Assauer Inc. would like to assess the country risk of Glovanskia. Assauer
has identified various political and financial risk factors, as shown below.
Political Risk Factor
Blockage of fund transfers
Bureaucracy
Assigned Rating
5
3
Assigned Weight
40%
60%
Financial Risk Factor
Interest rate
Inflation
Exchange rate
Competition
Growth
Assigned Rating
1
4
5
4
5
Assigned Weight
10%
20%
30%
20%
20%
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Assauer has assigned an overall rating of 80 percent to political risk factors and of 20 percent to
financial risk factors. Assauer is not willing to consider Glovanskia for investment if the country
risk rating is below 4.0. Should Assauer consider Glovanskia for investment?
ANSWER:
Determine the combined country risk rating:
Political risk rating = (5 × 40%) + (3 × 60%) = 3.8
Financial risk rating = (1 × 10%) + (4 × 20%) + (5 × 30%) + (4 × 20%) + (5 × 20%) = 4.2
Weighted rating = (3.8 × 80%) + (4.2 × 20%) = 3.88
Since the weighted rating is below 4.0, Assauer will probably not consider the investment.
15. Effects of September 11. Arkansas Inc. exports to various less developed countries, and its
receivables are denominated in the foreign currencies of the importers. It considers reducing its
exchange rate risk by establishing small subsidiaries to produce products. By incurring some
expenses in the countries where it generates revenue, it reduces its exposure to exchange rate risk.
Since September 11, 2001, when terrorists attacked the U.S., it has questioned whether it should
restructure its operations. Its CEO believes that its cash flows may be less exposed to exchange
rate risk but more exposed to other types of risk as a result of restructuring. What is your opinion?
ANSWER: Arkansas Inc. could be more exposed to political risk as a result of establishing
subsidiaries in other countries. Thus, its cash flows may be subject to more uncertainty with the
exposure to political risk than if it continues to export and is subject to exchange rate risk.
Advanced Questions
16. How Country Risk Affects NPV. Hoosier, Inc., is planning a project in the United Kingdom. It
would lease space for one year in a shopping mall to sell expensive clothes manufactured in the
U.S. The project would end in one year, when all earnings would be remitted to Hoosier, Inc.
Assume that no additional corporate taxes are incurred beyond those imposed by the British
government. Since Hoosier, Inc., would rent space, it would not have any long-term assets in the
United Kingdom, and expects the salvage (terminal) value of the project to be about zero.
Assume that the project’s required rate of return is 18 percent. Also assume that the initial outlay
required by the parent to fill the store with clothes is $200,000. The pretax earnings are expected
to the £300,000 at the end of one year. The British pound is expected to be worth $1.60 at the end
of one year, when the after-tax earnings are converted to dollars and remitted to the United States.
The following forms of country risk must be considered:
•
The British economy may weaken (probability = 30%), which would cause the expected
pretax earnings to be £200,000.
•
The British corporate tax rate on income earned by U.S. firms may increase from 40 percent to
50 percent (probability = 20 percent).
These two forms of country risk are independent. Calculate the expected value of the project’s net
present value (NPV) and determine the probability that the project will have a negative NPV.
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ANSWER: Sensitivity analysis can be used to measure the net present value under each possible
scenario, as shown in the attached exhibit. There are four possible scenarios. The most favorable
scenario is a strong British economy and a relatively low (40%) British tax rate. This scenario
results in after-tax dollar earnings of $288,000 in one year. The NPV is determined by obtaining
the present value of these earnings (discounted at the required rate of return of 18%) and
subtracting the initial outlay of $200,000. The NPV resulting from the most favorable scenario is
$44,068. The joint probability of a strong British economy and the 40% tax rate is the product of
the probabilities of these two situations (assuming that the situations are independent). Given a 70
percent probability for the strong British economy and an 80 percent probability for the 40%
British tax rate, the joint probability is 70% × 80% = 56%.
The NPV and joint probability for each of the other three scenarios are also estimated in the
exhibit, following the same process as discussed above. The expected value of the project’s NPV
can be determined as the sum of the products of each scenario’s NPV and joint probability, as
shown below:
E(NPV) = ($44,068 × 56%) + ($3,390 × 14%) + (–$37,288 × 24%) + (–$64,407 × 6%)
= ($24,678) + ($475) + (–$8,949) + (–$3,864)
= $12,340
The expected net present value of the project is positive. Yet, the NPV is expected to be negative
for two of the four possible scenarios that could occur. Since the joint probabilities of these two
scenarios add up to 30 percent, this implies that there is a 30 percent chance that the project will
result in a negative NPV.
The example was simplified in that the project has a planned life of only one year, and there was
no terminal value for the project. However, a more complicated example could be analyzed by
using spreadsheet software to conduct the sensitivity analysis. The analyst would need to develop
some “compute” statements that lead to an estimate of NPV. Each scenario causes a change in one
or more of the numbers to be input when estimating the NPV.
EXHIBIT FOR QUESTION 16
Pretax Pound Earnings
After-Tax Pound Earnings
After-Tax Dollar Earnings
British Corp.
Tax Rate=40% (Prob.=80%)
£300,000 × (1–.40) = £180,000
£180,000 × $1.60=$288,000
Estimated NPV
$288,000
( 1.18)
Strong British Economy
£300,000
(Prob. = 70%)
British Corp.
Tax Rate=50% (Prob.=20%)
− $200,000 = $44,068
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285
£300,000 × (1–.50) = £150,000
$240,000
£150,000 × $1.60 = $240,000
( 1.18)
£120,000 × $1.60 = $192,000
$192,000
− $200,000 = $3,390
British Corp.
Tax Rate=40% (Prob.=80%)
£200,000 × (1–.40) = £120,000
( 1.18)
− $200,000 = $ - 37,288
Weak British Economy
£200,000
(Prob. = 30%)
British Corp.
Tax Rate =50% (Prob.=20%)
£200,000 × (1–.50) = £100,000
£100,000 × $1.60 = $160,000
$160,000
( 1.18)
− $200,000 = $ - 64,407
17. How Country Risk Affects NPV. Explain how the capital budgeting analysis in the previous
question would need to be adjusted if there were three possible outcomes for the British pound
along with the possible outcomes for the British economy and corporate tax rate.
ANSWER: A simplification of the example provided is that only one expectation for the British
pound’s value was assumed. In reality, Hoosier Inc. may create a probability distribution for the
pound’s value one year from now. If Hoosier Inc. used three possible outcomes for the pound, this
would expand the number of possible scenarios. For each of the four scenarios in the previous
question, there would now be three possible outcomes for the pound’s value, resulting in a total of
12 possible scenarios.
18. J.C. Penney’s Country Risk Analysis. Recently, J.C. Penney decided to consider expanding into
various foreign countries; it applied a comprehensive country risk analysis before making its
expansion decisions. Initial screenings of 30 foreign countries were based on political and
economic factors that contribute to country risk. For the remaining 20 countries where country risk
was considered to be tolerable, specific country risk characteristics of each country were
considered. One of J.C. Penney’s biggest targets is Mexico, where it planned to build and operate
seven large stores.
a. Identify the political factors that you think may possibly affect the performance of the J.C.
Penney stores in Mexico.
ANSWER: Perhaps the most likely political factor is the blockage of fund transfers or currency
inconvertibility, because the currency (the peso) is sometimes volatile and could require special
controls in some periods.
b. Explain why the J.C. Penney stores in Mexico and in other foreign markets are subject to
financial risk (a subset of country risk).
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ANSWER: The economy in Mexico is volatile, and if economic conditions deteriorate, the
demand for many products sold at the J.C. Penney stores will decline. While some economies are
more stable than Mexico’s economy, any country is subject to a possible weakening of the
economy. Therefore, J.C. Penney stores in any country could experience weak sales due to
financial risk.
c. Assume that J.C. Penney anticipated that there was a 10 percent chance that the Mexican
government would temporarily prevent conversion of peso profits into dollars because of
political conditions. This event would prevent J.C. Penney from remitting earnings generated
in Mexico and could adversely affect the performance of these stores (from the U.S.
perspective). Offer a way in which this type of political risk could be explicitly incorporated
into a capital budgeting analysis when assessing the feasibility of these projects.
ANSWER: The expected cash flows of the project could be re-estimated based on the scenario
that the Mexican government restricts the conversion of currencies. The net present value of the
project can be re-estimated as well. Thus, the capital budgeting analysis results in a distribution of
NPVs based on possible scenarios.
d. Assume that J.C. Penney decides to use dollars to finance the expansion of stores in Mexico.
Second, assume that J.C. Penney decides to use one set of dollar cash flow estimates for any
project that it assesses. Third, assume that the stores in Mexico are not subject to political risk.
Do you think that the required rate of return on these projects would differ from the required
rate of return on stores built in the U.S. at that same time? Explain.
ANSWER: If J.C. Penney generated a single set of cash flow estimates for the establishment of a
given store in Mexico, it would likely use a required rate of return that is higher than that used for
a proposed store in the U.S. The higher required rate of return on new stores in Mexico is
attributed to the greater degree of uncertainty associated with the new stores in Mexico than new
stores in the U.S. Even though there is more potential for profits from new stores in Mexico, there
is more uncertainty about the future cash flows generated by those stores. The Mexican economy
is more volatile than the U.S. economy, so the demand for products in Mexico is subject to more
uncertainty. Also, the exchange rate movements will affect the dollar earnings that are generated
by the stores in Mexico. Since the exchange rate movements are very uncertain, so are the dollar
earnings that will be received by the U.S. parent.
e. Based on your answer to the previous question, does this mean that proposals for any new
stores in the U.S. have a higher probability of being accepted than proposals for any new
stores in Mexico?
ANSWER: No. The U.S. markets have less potential because J.C. Penney has stores in most U.S.
markets (as mentioned in the case). Therefore, the estimated cash flows would be lower for U.S.
projects. Even though the required rate of return may be higher for a proposed store in Mexico, the
dollar cash flows should be much higher, which could result in a higher probability of accepting
this type of project.
19. How Country Risk Affects NPV. Monk, Inc. is considering a capital budgeting project in
Tunisia. The project requires an initial outlay of 1 million Tunisian dinar; the dinar is currently
valued at $.70. In the first and second years of operation, the project will generate 700,000 dinar in
each year. After two years, Monk will terminate the project, and the expected salvage value is
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287
300,000 dinar. Monk has assigned a discount rate of 12 percent to this project. The following
additional information is available:
•
•
•
There is currently no withholding tax on remittances to the U.S., but there is a 20 percent
chance that the Tunisian government will impose a withholding tax of 10 percent beginning
next year.
There is a 50 percent chance that the Tunisian government will pay Monk 100,000 dinar after
two years instead of the 300,000 dinar it expects.
The value of the dinar is expected to remain unchanged over the next two years.
a. Determine the net present value (NPV) of the project in each of the four possible scenarios.
b. Determine the joint probability of each scenario.
c. Compute the expected NPV of the project and make a recommendation to Monk regarding its
feasibility.
ANSWER:
a.
Scenario 1: No withholding taxes, 300,000 dinar salvage value
Year 0
Dinar remitted by subsidiary
Withholding tax
Dinar remitted after withholding tax
Salvage value
Exchange rate
Cash flows to parent
PV of parent cash flow
Initial investment by parent
$700,000
Cumulative NPV
Year 1
Year 2
700,000700,000
0
0
700,000700,000
300,000
$.70
$.70
$490,000
$700,000
$437,500
$558,036
–$262,500
$295,536
Scenario 2: 10% withholding tax, 300,000 dinar salvage value
Year 0
Dinar remitted by subsidiary
Withholding tax
Dinar remitted after withholding tax
Salvage value
Exchange rate
Cash flows to parent
PV of parent cash flow
Initial investment by parent
$700,000
Cumulative NPV
Year 1
Year 2
700,000700,000
70,000
70,000
630,000630,000
300,000
$.70
$.70
$441,000
$651,000
$393,750
$518,973
–$306,250
$212,723
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International Financial Management
Scenario 3: 10% withholding tax, 100,000 dinar salvage value
Year 0
Dinar remitted by subsidiary
Withholding tax
Dinar remitted after withholding tax
Salvage value
Exchange rate
Cash flows to parent
PV of parent cash flow
Initial investment by parent
$700,000
Cumulative NPV
Year 1
Year 2
700,000700,000
70,000
70,000
630,000630,000
100,000
$.70
$.70
$441,000
$511,000
$393,750
$407,366
–$306,250
$101,116
Scenario 4: No withholding taxes, 100,000 dinar salvage value
Year 0
Dinar remitted by subsidiary
Withholding tax
Dinar remitted after withholding tax
Salvage value
Exchange rate
Cash flows to parent
PV of parent cash flow
Initial investment by parent
$700,000
Cumulative NPV
Year 1
Year 2
700,000700,000
0
0
700,000700,000
100,000
$.70
$.70
$490,000
$560,000
$437,500
$446,429
–$262,500
$183,929
a. The joint probabilities for the four cases are shown below:
Scenario 1: No withholding taxes, 300,000 dinar salvage value = 80% × 50% = 40%
Scenario 2: 10% withholding tax, 300,000 dinar salvage value = 20% × 50% = 10%
Scenario 3: 10% withholding tax, 100,000 dinar salvage value = 20% × 50% = 10%
Scenario 4: No withholding taxes, 100,000 dinar salvage value = 80% × 50% = 40%
b. E(NPV) = $295,536(40%) + $212,723(10%) + $101,116(10%) + $183,929(40%)
= $223,170
Since the expected NPV is positive, and since the NPV is positive in each individual scenario,
Monk should undertake the project.
20. How Country Risk Affects NPV. In the previous question, assume that instead of adjusting the
estimated cash flows of the project, Monk had decided to adjust the discount rate from 12 percent
to 17 percent. Reevaluate the NPV of the project’s expected scenario using this adjusted discount
rate.
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289
ANSWER:
Year 0
Dinar remitted by subsidiary
Withholding tax
Dinar remitted after withholding tax
Salvage value
Exchange rate
Cash flows to parent
PV of parent cash flow
Initial investment by parent
$700,000
Cumulative NPV
Year 1
Year 2
700,000700,000
0
0
700,000700,000
300,000
$.70
$.70
$490,000
$700,000
$418,803
$511,359
–$281,197
$230,342
The project still has a positive NPV of $230,342 and should be accepted. Notice that the NPV
obtained using t adjusted discount rate is very close to the expected NPV when the cash flows are
adjusted.
21. The Risk and Cost of Potential Kidnapping. In 2004 following the war in Iraq, some MNCs
capitalized on opportunities to rebuild Iraq. However, in April 2004, some employees were
kidnapped by local militant groups. How should an MNC account for this potential risk when it
considers direct foreign investment (DFI) in any particular country? Should it avoid DFI in any
country in which such an event could occur? If so, how would it screen the countries to determine
which are acceptable? For whatever countries that it is willing to consider, should it adjust its
feasibility analysis to account for the possibility of kidnapping? Should it attach a cost to reflect
this possibility or increase the discount rate when estimating the net present value? Explain.
ANSWER: This question can lead to an interesting class discussion. Some students will suggest
that an MNC should never pursue opportunities in countries where such events could occur. Yet,
this could occur anywhere, so the students must attempt to decide how much risk they should be
willing to take. The question is complicated because human lives are involved. MNCs may
consider the potential cost of paying kidnappers, but there are some other costs such as the moral
of the company and the long-term effect on kidnapped employees (even if they are rescued) that
are difficult to measure.
22. Integrating Country Risk and Capital Budgeting. Tovar Co. is a U.S. firm that has been asked
to provide consulting services to help Grecia Company (in Greece) improve its performance.
Tovar would need to spend $300,000 today on expenses related to this project. In one year, Tovar
will receive payment from Grecia, which will be tied to Grecia’s performance during the year.
There is uncertainty about Grecia’s performance and about Grecia’s tendency for corruption.
Tovar expects that it will receive 400,000 euros if Grecia achieves strong performance following
the consulting job. However, there are two forms of country risk that are a concern to Tovar Co.
There is an 80 percent chance that Grecia will achieve strong performance. There is a 20 percent
chance that Grecia will perform poorly, and in this case, Tovar will receive a payment of only
200,000 euros.
While there is a 90 percent chance that Grecia will make its payment to Tovar, there is a 10
percent chance that Grecia will become corrupt, and in this case, Grecia will not submit any
payment to Tovar.
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International Financial Management
Assume that the outcome of Grecia’s performance is independent of whether Grecia becomes
corrupt. The prevailing spot rate of the euro is $1.30, but Tovar expects that the euro will
depreciate by 10 percent in one year, regardless of Grecia’s performance or whether it is corrupt.
Tovar’s cost of capital is 26 percent. Determine the expected value of the project’s net present
value. Determine the probability that the project’s NPV will be negative.
ANSWER:
First, the expected spot rate of the euro in one year is $1.30 × (1 – .10) = $1.17.
Here are the results of each of four scenarios:
1. If the Greek firm performs well and there is no corruption, the net present value of the project
is:
[(400,000 euros × $1.17)/1.26] – $300,000 = $71,428
2. If Grecia performs well and there is corruption, there will not be a payment to Tovar, so the
net present value of the project is –$300,000.
3. If the Grecia performs poorly and there is no corruption, the net present value of the project is:
[(200,000 euros × $1.17)/1.26] – $300,000 = –$114,286
4. If Grecia performs poorly and there is corruption, there will be no payment to Tovar, so the
net present value of the project is –$300,000.
Summary of Scenarios:
Scenario
Regarding
Performance
Strong
Strong
Weak
Weak
Probability
Regarding
Performance
80%
80%
20%
20%
Scenario
Strong/Not corrupt
Strong/Corrupt
Weak/Not corrupt
Weak/Corrupt
Scenario
Regarding
Corruption
Not corrupt
Corrupt
Not corrupt
Corrupt
Joint Probability
80% × 90% = 72%
80% × 10% = 8%
20% × 90% = 18%
20% × 10% = 2%
Probability
Regarding
Corruption
90%
10%
90%
10%
NPV
$71,428
–$300,000
–$114,286
–$300,000
NPV
$71,428
–$300,000
–$114,286
–$300,000
Expected Value of NPV = (72% × $71,428) + (8% × –$300,000) + 18% (–$114,286)
+ 2% (–$300,000) = ($51,428) + (–$24,000) + (–$20,571) + (–$6,000) = –$857.
There is a 28% chance that the project’s NPV will be negative.
23. Capital Budgeting and Country Risk. Wyoming Co. is a non-profit educational institution that
wants to import educational software products from Hong Kong and sell them in the U.S. It wants
to assess the net present value of this project since any profits it earns will be used for its
Chapter 16: Country Risk Analysis
291
foundation. It expects to pay HK$5 million for the imports. Assume the existing exchange rate is
HK$1 =$.12. It would also incur selling expenses of $1 million to sell the products in the U.S. It
would be able to sell the products in the U.S. for $1.7 million. However, it is concerned about two
forms of country risk. First, there is a 60% chance that the Hong Kong dollar will be revalued to
be worth HK$1 = $.16 by the Hong Kong government. Second, there is a 70% chance that the
Hong Kong government imposes a special tax of 10% on the amount that U.S. importers must pay
for Hong Kong exports. These two forms of country risk are independent, meaning that the
probability that the Hong Kong dollar will be revalued is independent of the probability that the
Hong Kong government will impose a special tax. Wyoming’s required rate of return on this
project is 22%. What is the expected value of the project’s net present value? What is the
probability that the project’s NPV will be negative?
ANSWER:
Revenue
Import cost ( in HKD)
Exchange rate
Import cost in $
Gross profit
Selling expense
Cash flow
NPV
Scenario 1: No
Tax or
Exchange Rate
Adjustment
$1,700,000
5,000,000
$0.12
$600,000
$1,100,000
$1,000,000
$100,000
$81,967
Scenario 2:
10% Tax
$1,700,000
5,500,000
$0.12
$660,000
$1,040,000
$1,000,000
$40,000
$32,787
Scenario 3:
Exchange Rate
Adjustment
$1,700,000
5,000,000
$0.16
$800,000
$900,000
$1,000,000
–$100,000
–$81,967
Scenario 4:
10% Tax
and
Exchange
Rate
Adjustment
$1,700,000
5,500,000
$0.16
$880,000
$820,000
$1,000,000
–$180,000
–$147,541
Expected NPV of the project is:
($81,967 × .12) + ($32,787 × .28) + (–$81,967 × .18) + (–$147,541 × .42) = –$57,704
There is a 60% probability that the project’s NPV will be negative.
24. Accounting for Country Risk of a Project. Kansas Co. wants to invest in a project in China, It
would require an initial investment of 5,000,000 yuan. It is expected to generate cash flows of
7,000,000 yuan at the end of one year. The spot rate of the yuan is $.12, and Kansas thinks this
exchange rate is the best forecast of the future. However, there are 2 forms of country risk.
First, there is a 30% chance that the Chinese government will require that the yuan cash flows
earned by Kansas at the end of one year be reinvested in China for one year before it can be
remitted (so that cash would not be remitted until 2 years from today). In this case, Kansas would
earn 4% after taxes on a bank deposit in China during that second year.
Second, there is a 40% chance that the Chinese government will impose a special remittance tax of
400,000 yuan at the time that Kansas Co. remits cash flows earned in China back to the U.S.
The two forms of country risk are independent. The required rate of return on this project is 26%.
There is no salvage value. What is the expected value of the project’s net present value?
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International Financial Management
ANSWER:
Yuan remitted by subsidiary
Withholding tax
Interest rate
Yuan after interest earned
Yuan remitted after taxes
Exchange rate of yuan
Cash flow to parent
PV of parent cash flow (26%)
Initial investment in U.S. $
NPV
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Scenario 1:
No Country
Risk
7,000,000
NA
NA
NA
NA
$0.12
$840,000.00
$666,666.67
–$600,000.00
$66,666.67
30%
40%
Scenario 2:
Remittance
Scenario 3:
Must be
400,000 Yuan Scenario 4:
Invested for 1 Remittance Both Country
Year
Tax
Risks
7,000,000
7,000,000
7,000,000
NA
400,000
400,000
0.04
NA
0.04
7280000
NA
7280000
NA
6,600,000
6,880,000
$0.12
$0.12
$0.12
$873,600.00
$792,000.00
$825,600.00
$550,264.55
$628,571.43
$520,030.23
–$600,000.00 –$600,000.00 –$600,000.00
–$49,735.45
$28,571.43
–$79,969.77
NPV
$66,666.67
–$49,735.45
$28,571.43
–$79,969.77
NPV ×
Probability
$28,000.00
–$8,952.38
$8,000.00
–$9,596.37
Probability
70% × 60%
30% × 60%
70% × 40%
30% × 40%
Probability
0.42
0.18
0.28
0.12
Total NPV
$17,451.25
25. Accounting for Country Risk of Projects. Slidell Co. (a U.S. firm) considers a foreign project in
which it expects to receive 10 million euros at the end of this year. It plans to hedge receivables of
10 million euros with a forward contract. Today, the spot rate of the euro is $1.20, while the oneyear forward rate of the euro is presently $1.24, and the expected spot rate of the euro in one year
is $1.19. The initial outlay is $7 million. Slidell has a required return of 18%.
There is a 20% chance that political problems will cause a reduction in foreign business, such that
it would only receive 4 million euros at the end of one year. Determine the expected value of the
net present value of this project.
ANSWER:
Normal conditions:
Dollar cash flows = 10,000,000 euros × $1.24 = $12,400,000
NPV = ($12,400,000/1.18) – $7,000,000 = $3,508,474
Political problem:
Dollar cash flows = 4,000,000 × $1.24 = $4,960,000
But the forward contract on the remaining 6,000,000 euros converts to ($1.24 – $1.19) ×
6,000,000 = $300,000
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293
So the total cash flow is $5,260,000.
NPV = $5,260,000/1.18 = $4,457,627
$4,457,627 – $7,000,000 = –$2,542,373
E(NPV) = (.8 × $3,508,474) + (.2 × –$2,542,373) = $2,298,305
Solution to Continuing Case Problem: Blades, Inc.
1. Based on the information provided in the case, do you think the political risk associated with
Thailand is higher or lower for a manufacturer of leisure products such as Blades as opposed to,
say, a food producer? That is, conduct a micro-assessment of political risk for Blades, Inc.
ANSWER: Based on the information provided in the case, the political risk for a manufacturer of
leisure products appears to be lower for a manufacturer of leisure products such as Blades. This is
because the number of licenses and permits required for Blades’ industry is relatively few
compared to other industries.
2. Do you think the financial risk associated with Thailand is higher or lower for a manufacturer of
leisure products such as Blades as opposed to, say, a food producer? That is, conduct a microassessment of financial risk for Blades, Inc. Do you think a leisure product manufacturer such as
Blades will be more affected by political or financial risk factors?
ANSWER: The level of financial risk in Thailand is higher for a manufacturer of leisure products
such as Blades, Inc. This is because consumers will first eliminate purchases of these types of
products as opposed to more essential products such as food in the event of an economic
turndown. Consequently, Blades would suffer more from high levels of interest rates and inflation
in Thailand than producers of more essential items.
A leisure product manufacturer such as Blades will probably be more affected by financial risk
factors than political risk factors in Thailand. Financial risk factors can have a devastating effect
on the consumption of “luxury” items such as roller blades. Political risk factors will affect Blades
if the Thai government imposes controls or restrictions that would make it more difficult for
Blades, Inc. to operate efficiently in Thailand, which is currently not the case.
3. Without using a numerical analysis, do you think establishing a subsidiary in Thailand or
acquiring Skates’n’Stuff will result in a higher assessment of political risk? Of financial risk?
Substantiate your answer.
ANSWER: Establishing a subsidiary in Thailand will probably result in a higher level of political
risk than acquiring Skates’n’Stuff. Asian consumers prefer to purchase from Asian producers. If
Blades acquires Skates’n’Stuff and retains the company’s management and employees, the
acquisition will result in a lower level of political risk than the establishment of a subsidiary.
The financial risk associated with Thailand will probably not differ substantially between the two
approaches of direct foreign investment. If the Thai economy enters a recession, demand for
Blades’ products will be affected negatively, regardless of whether it establishes a subsidiary in
Thailand or purchases Skates’n’Stuff.
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International Financial Management
4. Using a spreadsheet, conduct a quantitative country risk analysis for Blades, Inc., using the
information Ben Holt has provided for you. Use your judgment to assign weights and ratings to
each political and financial risk factor and determine an overall country risk rating for Thailand.
Conduct two separate analyses for (a) the establishment of a subsidiary in Thailand and (b) the
acquisition of Skates’n’Stuff.
ANSWER: (See spreadsheet below.) There is no one correct answer to this question. The
estimates provided in the attached spreadsheet are somewhat arbitrary, but students should at least
use the information provided to assign a rating. However, because of the higher political risk
associated with the establishment of a subsidiary (as opposed to the acquisition of Skates’n’Stuff),
the establishment of a subsidiary should result in a higher (i.e., less favorable) country risk rating
for the establishment of a subsidiary.
(1) Establishment of a Subsidiary in Thailand
(1)
Political Risk Factor
Attitude of Thai
Consumers
Capital Controls
Bureaucracy
Financial Risk Factor
Interest Rates
Inflation Level
Exchange Rates
(2)
(3)
Rating Assigned Weight Assigned
by Blades to
by Blades to
Factor (within a Factor According
range of 1-5)
to Importance
4
30%
4
2
5
3
4
(4) = (2) × (3)
Weighted
Value
of Factor
1.2
40%
30%
100%
1.6
0.6
3.4
35%
30%
35%
100%
1.75
0.9
1.4
4.05
= Political risk rating
= Financial risk
rating
Chapter 16: Country Risk Analysis
(1)
Category
Political Risk
Financial Risk
295
(2)
(3)
(4) = (2) × (3)
Rating as
Determined
Above
3.4
4.05
Weight Assigned
by Blades to
Each Risk
Category
40%
60%
100%
Weighted
Rating
1.36
2.43
3.79
(3)
(4) = (2) × (3)
= Overall country
risk rating
(2) Acquisition of Skates’n’Stuff
(1)
Political Risk Factor
Attitude of Thai
Consumers
Capital Controls
Bureaucracy
Financial Risk Factor
Interest Rates
Inflation Level
Exchange Rates
(1)
Category
Political Risk
Financial Risk
(2)
Rating Assigned Weight Assigned
by Blades to
by Blades to
Factor (within a Factor According
range of 1-5)
to Importance
3
30%
4
1
5
3
4
Weighted
Value
of Factor
0.9
40%
30%
100%
1.6
0.3
2.8
35%
30%
35%
100%
1.75
0.9
1.4
4.05
(2)
(3)
(4) = (2) × (3)
Rating as
Determined
Above
2.8
4.05
Weight Assigned
by Blades to
Each Risk
Category
40%
60%
100%
Weighted
Rating
1.12
2.43
3.55
= Political risk rating
= Financial risk
rating
= Overall country
risk rating
5. Which method of direct foreign investment should utilize a higher discount rate in the capital
budgeting analysis? Would this strengthen or weaken the tentative decision of establishing a
subsidiary in Thailand?
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International Financial Management
ANSWER: Establishing a subsidiary should utilize a higher discount rate in the capital budgeting
analysis. This would reduce the NPV associated with establishing a subsidiary in Thailand. Since
the capital budgeting analysis indicated that establishing a subsidiary would be preferable to the
acquisition of Skates’n’Stuff, this adjustment would weaken the tentative decision of establishing
a subsidiary in Thailand.
Solution to Supplemental Case: King, Incorporated
a. There are several government-related issues to consider. Some of these issues are listed below:
1. Will Bulgaria’s government allow the firm to establish the subsidiary? Or will it require
that King, Inc. participate in a joint venture with the government? This issue is relevant
because it could affect the risk and return of the project.
2. What is the corporate tax rate to be charged on profits earned by King, Inc. in Bulgaria?
3. What is the withholding tax rate to be imposed on profits remitted to the parent of King,
Inc.?
4. What are Bulgaria’s plans regarding privatization? If Bulgaria encourages privatization,
this may allow for other competitors to compete against King, Inc.
5. Will Bulgaria require King, Inc. to incur any additional expenses for environmental
reasons? In past years, Eastern Bloc countries have not focused on environmental
problems, but this issue is now receiving more attention.
6. What is the government’s monetary and fiscal policy? Any effect that these policies have
on the economy could influence the demand for the food products to be marketed by
King, Inc.
7. What are the political relations between Bulgaria and other Eastern Bloc countries? Will
King, Inc. be able to transport the products produced in Bulgaria to other countries
without incurring any taxes or bureaucratic inconveniences?
8. Would King, Inc. be able to sell the subsidiary at market value if it desired to divest the
project in the future? Or would the selling price be dictated by the government?
b. The demand could be affected by:
1. The economies of the various Eastern Bloc countries (not just Bulgaria) that are targeted
for this project; all the factors that affect economic conditions such as government
policies, interest rates, etc. need to be assessed for each of these countries.
2. Consumer preferences for the food products; King, Inc. must assess consumer preferences
in these countries.
c. The cost of production could be affected as follows:
Chapter 16: Country Risk Analysis
297
1. Changes in wage rates in Bulgaria would affect the labor cost incurred by King, Inc.
2. Changes in inflation could affect the cost of obtaining the necessary ingredients for
production.
3. The cost of leasing the plant may be dictated by the government or be influenced by
inflation.
Small Business Dilemma
Country Risk Analysis at the Sports Exports Company
The Sports Exports Company produces footballs in the U.S. and exports them to the United Kingdom.
It also has an ongoing joint venture with a British firm that produces some sporting goods for a fee.
The Sports Exports Company is considering the establishment of a small subsidiary in the United
Kingdom.
1. Under the current conditions, is the Sports Exports Company subject to country risk?
ANSWER: Yes. While the firm’s exposure to country risk is quite limited, it should still recognize
the risk that does exist. The country risk can be segmented into political risk and financial risk.
The firm’s cash flows could be adversely affected if British consumers reduce their demand for
the U.S. firm’s products as a form of protest against the U.S. (Although the type of product being
sold is not likely to be the target of a major protest). The firm is not exposed to other forms of
political risk because it does not have any of its own assets based in the United Kingdom at this
time.
The firm is exposed to financial risk factors such as the potential for a weak economy in the
United Kingdom, which could result in a weak demand for the firm’s products.
2. If the firm does decide to develop a small subsidiary in the United Kingdom, will its exposure to
country risk change? If so, how?
ANSWER: The exposure to country risk would now increase, because the subsidiary would now
be subject to British tax laws, which could change at any time. Also, the subsidiary could be
subject to the possibility of a government takeover. However, such a risk is normally considered to
be very low in a country such as the United Kingdom.