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Country Risk and Political Risk:

Country Risk and Political Risk

Importance of country risk:

Importance of country risk Has adverse impact on cash flow. Monitor countries for doing business Major decision like divesting or franchising can be taken easily Helps in revising financing and investing decision.

Political risk factors:

Political risk factors Attitudes of consumers in host country Local preference by consumers Countries exert pressure on consumers( Walmart ) Joint venture better if loyal consumers Host Govt. Actions Additional corporate taxes Fund transfer restrictions High Import duties Extra taxes, subsidize competitors Lack of restrictions

Political risk factors(cont.):

Political risk factors(cont.) Fund transfers blockage Some countries block fund transfer to parent company Lower return for subsidiaries Currency Inconvertibility Countries block currency conversion Parent company exchanges currency for goods War Has an impact on the business High cost due to safety of employees Eg . French tourism affected by differences with US on IRAQ war.

Political risk factors(cont.):

Political risk factors(cont.) Bureaucracy High govt. bureaucracy deterrent Slow decision making Eg . India, Eastern Europe Corruption Increases the cost of conducting business Loss in revenue Double standards exist in major countries(U.S)

Financial Risk Factors:

Financial Risk Factors Current & Potential state of Economy Subsidiary is affected by the demand of its product Recession reduces demand Economic growth Indicators Interest rates: High interest rates reduces demand and vice versa. Exchange rates: Strong currency reduces demand for country exports, increases imports. Inflation: Affect consumers purchasing power and therefore demand

Types of Country Risk Assessment:

Types of Country Risk Assessment Macro-assessment of Country risk Consideration of all risk factors at macro level Remains same for the country irrespective of industry Political factors Relationship between both the govt. Stability of the govt. Attitude of people towards MNC Financial Factors GDP growth Inflation Interest Rates etc.

Types of Country Risk Assessment(cont.):

Types of Country Risk Assessment(cont.) Micro-assessment of Country Risk Specific to the Industry Risk varies with firm, industry and project of concern Sensitivity of the firm’s business to real GDP growth, inflation needs Overall assessment Macropolitical risk Macrofinancial risk Micropolitical risk Macropolitical risk

Techniques to Assess Country Risk:

Techniques to Assess Country Risk Checklist Approach Ratings are assigned to various risk factors(1-5) Some factors subjectively measured Weights are assigned to different factors Delphi Technique Collection of independent opinions Based on subjective opinions No group discussion, individual opinions

Techniques to Assess Country Risk(cont):

Techniques to Assess Country Risk(cont) Quantitative Analysis Regression analysis can be used to assess risk Risk modeling can be done Inspection Visits Meeting govt. officials Better judgment of inter-country relationship

Country Risk Rating:

Country Risk Rating Different country risk assessors have their own individual procedures for quantifying country risk. Although most procedures involve rating and weighting individual risk factors, the number, type, rating, and weighting of the factors will vary with the country being assessed, as well as the type of corporate operations being planned. One can also use risk ratings provided at certain reliable websites.

Overall risk rating:

Overall risk rating Financial Factors Weights Interest rate 20% Inflation rate 10 Exchange rate 20 Industry competition 10 Industry growth 40 Overall country risk rating 20% Political risk rating Financial risk rating 80% 20%

Country risk measurement:

Country risk measurement Firms may use country risk ratings when screening potential projects, or when monitoring existing projects. For example, decisions regarding subsidiary expansion, fund transfers to the parent, and sources of financing, can all be affected by changes in the country risk rating .

Comparing Risk Ratings Among Countries:

Comparing Risk Ratings Among Countries One approach to comparing political and financial ratings among countries is the foreign investment risk matrix (FIRM ) . The matrix measures financial (or economic) risk on one axis and political risk on the other axis. Each country can be positioned on the matrix based on its political and financial ratings.

The Foreign Investment Risk Matrix (FIRM):

Unclear Zone Acceptable Zone Unacceptable Zone Financial Risk Rating Political Risk Rating Acceptable Unacceptable Stable Unstable The Foreign Investment Risk Matrix (FIRM)

Actual Country Risk Ratings Across Countries:

Actual Country Risk Ratings Across Countries Some countries are rated higher according to some risk factors, but lower according to others. On the whole, industrialized countries tend to be rated highly, while emerging countries tend to have lower risk ratings. Country risk ratings change over time in response to changes in the risk factors.

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Incorporating Country Risk in Capital Budgeting:

Incorporating Country Risk in Capital Budgeting If the risk rating of a country is in the acceptable zone, the projects related to that country deserve further consideration. Country risk can be incorporated into the capital budgeting analysis of a project by adjusting the discount rate, or by adjusting the estimated cash flows.

Incorporating Country Risk in Capital Budgeting:

Incorporating Country Risk in Capital Budgeting Adjustment of the Discount Rate The higher the perceived risk, the higher the discount rate that should be applied to the project’s cash flows. Recalculation of discount rate being arbitrary Adjustment of the Estimated Cash Flows By estimating how the cash flows could be affected by each form of risk, the MNC can determine the probability distribution of the net present value of the project.

Estimation of NPV:

Estimation of NPV Scenario Withholding tax imposed Salvage value of project NPV Probability 1 10% $12 mn $ 2.23 mn 0.7*0.6=42% 2 20% $ 12mn $ 1.25 mn 0.3*0.6=18% 3 10% $ 7 mn $ 0.8 mn 0.7*0.4=28% 4 20% $ 7 mn -$0.17 mn 0.3*0.4=12% E(NPV)= $2.23*0.42 + $1.25*0.18 + $0.8*0.28 + (- $0.17)*0.12 =$1.36 Capital budgeting planning with scenario estimations. Probability of the two risks are accounted for by constructing the cash flow statement and hence NPV under both

Applications of Country Risk Analysis:

Applications of Country Risk Analysis Alerted by its risk assessor, Gulf Oil planned to deal with the loss of Iranian oil, and was able to avoid major losses when the Shah of Iran fell four months later. Decisions such as subsidiary expansion, fund transfers to parent, sources of financing can be affected by periodic risk assessments. However, while the risk assessment of a country can be useful, it cannot always detect upcoming crises.

Applications of Country Risk Analysis:

Applications of Country Risk Analysis Iraq’s invasion of Kuwait was difficult to forecast, for example. Nevertheless, many MNCs promptly reassessed their exposure to country risk and revised their operations. The 1997-98 Asian crisis also showed that MNCs had underestimated the potential financial problems that could occur in the high-growth Asian countries. Thus, preparation to revise the operations in order to reduce exposure should always be there.

Reducing Exposure to Host Government Takeovers:

Reducing Exposure to Host Government Takeovers The benefits of FDI can be offset by country risk, the most severe of which is a host government takeover. To reduce the chance of a takeover by the host government, firms often use the following strategies: Use a Short-Term Horizon This technique concentrates on recovering cash flow quickly.

Reducing Exposure to Host Government Takeovers:

Reducing Exposure to Host Government Takeovers Rely on Unique Supplies or Technology In this way, the host government will not be able to take over and operate the subsidiary successfully. Hire Local Labor The local employees can apply pressure on their government.

Reducing Exposure to Host Government Takeovers:

Reducing Exposure to Host Government Takeovers Borrow Local Funds The local banks can apply pressure on their government. Purchase Insurance To cover risk of expropriation. For e.g. US government provides insurance through Overseas Private Investment Corporation, MIGA of World Bank

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Minimize exposure Form joint ventures with local companies. Local government may be less inclined to expropriate assets from their own citizens. Join a consortium of international companies to undertake FDI. Local government may be less inclined to expropriate assets from a variety of countries all at once.

Using Project Finance:

Using Project Finance Many of world’s largest infrastructure projects are structured as project finance deals limiting exposure of MNCs. Key points - MNC exposure limited due to limited amount of equity invested in the project - A bank may guarantee payments to MNC - The deals are secured by future revenues from production A host government is unlikely to take over this project as it would have to assume the existing liabilities due to credit arrangement.

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