Using country risk analysis in capital budgeting
Once the degree of country risk has been determined, the next step is to decide whether or not the risk is tolerable.If it is felt that the risk is too high, then the firm does not need to analyze the feasibility of a project to be undertaken in that country.Of course, it may be argued that no risk is too high if the rate of return on the underlying project is high enough to compensate for the risk.However, in some cases the risk is considered to be so high that the country is deemed to be off limits.This would be the case if, for example, the country has a tendency to experience civil war or kidnapping of foreign personnel for ransom.This would also be the case if the probability of confiscation were too high as judged from historical experience.
Country risk analysis can be incorporated into capital budgeting analysis by adjusting the discount rate or the cash flows, as we have seen before.The higher the country risk, the higher the discount rate applied to the project’s cash flows.If, for example, blocked funds are anticipated, then the discount rate may be raised from 8 percent to l0 percent.The problem with this procedure is that there is no precise formula for adjusting the discount rate for country risk, which makes adjustment rather arbitrary.The use of a shorter payback period can be used for the same purpose.However, neither of these two methods provides a detailed examination of the risk involved or a true reflection of the investor’s fear.This is why it may be preferable to incorporate country risk analysis by adjusting the cash flows.
Suppose that a project is analyzed under three scenarios derived from country risk analysis: (i)that nothing will happen; (ii)that the host country will block a certain percentage of the funds to be transferred to the parent firm; and (iii)that the project will be confiscated after a few years.Suppose also that these scenarios produce three net present values (NPV1,NPV2, and NPV3, respectively)with probabilities p1, p2 and p3, respectively.The NPV of the project in this case should be calculated as the expected NPV, which is the weighted average of NPV1, NPV2 and NPV3, where the weights are the probabilities.Hence
In general, there are three approaches to the integration of country risk into capital budgeting:
● Adjusting the expected cash flows to account for losses due to country risk.
● Measuring the effects of country risk on the outcome of investment as the value of an insurance policy that reimburses all losses resulting from an event.
● Using option valuation theory to derive the pricing of country risk, particularly the risk of expropriation.If the likelihood of expropriation depends on project outcomes, then the only proper valuation technique is contingent claims analysis.It is arguable that standard valuation approaches, such as the adjustment of future cash flows, are adequate only when the probability of expropriation is independent of the value of the project.