|
|
Political
|
Financial
|
Economic
|
Composite
|
Rank
|
Country
|
Risk
|
Risk
|
Risk
|
Risk
|
1
|
Switzerland
|
93.0
|
50.0
|
39.5
|
91.5
|
9
|
United States
|
78.0
|
49.0
|
39.5
|
83.5
|
10
|
Canada
|
81.0
|
48.0
|
37.0
|
83.0
|
25
|
Venezuela
|
75.0
|
40.0
|
36.0
|
75.5
|
50
|
Israel
|
58.0
|
33.0
|
34.5
|
63.0
|
75
|
Panama
|
47.0
|
24.0
|
38.0
|
54.5
|
100
|
Peru
|
45.0
|
28.0
|
21.5
|
47.5
|
125
|
Burma
|
27.0
|
9.0
|
22.5
|
28.5
|
129
|
Liberia
|
10.0
|
8.0
|
12.0
|
15.0
|
Friday, July 12, 2013
Multinational Capital Budgeting
Up to now, we have discussed the
general environment in which multinational firms operate. In the remainder of
the chapter, we will see how international factors affect key corporate
decisions. We begin with capital budgeting. Although the same basic principles
of capital budgeting analysis apply to both foreign and domestic operations,
there are some key differences. First cash flow estimation is more complex for
overseas investments. Most multinational firms set up separate subsidiaries in
each foreign country in which they operate and the relevant cash flows for the
parent company are the dividends and royalties paid by the subsidiaries to the
parent. Second these cash flows must be converted into the parent company’s
currency hence they are subject to exchange rate risk. For example General
Motor’s German subsidiary may make a profit of 100 million marks in 1998 but
the value of this profit to GM will depend on the dollar mark exchange rate:
How many dollars will 100 million marks buy?
Dividends and royalties are
normally taxed by both foreign and home country governments. Furthermore, a
foreign government may restrict the amount of the cash that may be repatriated
to the parent company. For example some governments place a ceiling, stated as
a percentage of the company’s net worth, on the amount of cash dividends that a
subsidiary can pay to its parent. Such restrictions are normally intended to force
multinational firms to reinvest earnings in the foreign country although restrictions
are sometimes imposed to prevent large currency outflows which might disrupt
the exchange rate.
Whatever the host country’s
motivation for blocking repatriation of profits the result is that the parent
corporation cannot use cash flows blocked in the foreign country to pay
dividends to its shareholders or to invest elsewhere in the business. Hence
from the perspective of the parent organization the cash flows relevant for
foreign investment analysis are the cash flows that the subsidiary is actually
expected to send back to the parent. The present value of those cash flows is
found by applying an appropriate discount rate and this present value is then
compared with the parent’s required investment to determine the project’s NPV.
In addition to the complexities
of the cash flow analysis. the cost of capital may be different for a foreign
project than for an equivalent domestic project, because foreign projects may
be more or less risky. A higher risk could arise from two primary sources (1)
exchange rate risk and (2) political risk. A lower risk might result from
international diversifications.
Exchange rate risk relates to
what the basic cash flows will be worth in the parent company’s home currency.
The foreign currency cash flows to be turned over to the parent must be
converted into U.S. dollars by translating them at expected future exchange
rates. An analysis should be conducted to ascertain the effects of exchange
rate variations and on the basis of this analysis an exchange rate risk premium
should be added to the domestic cost of capital to reflect exchange rate risk.
It is sometimes possible to hedge against exchange rate fluctuations but it may
not be possible to hedge completely especially on long term projects. If
hedging is used the costs of doing so must be subtracted from the project’s
cash flows.
Political risk refers to
potential actions by a host government which would reduce the value of a
company’s investment. It includes at one extreme the expropriation without
compensation of the subsidiary’s assets but it also includes less drastic
actions that reduce the value of the parent firm’s investment in the foreign
subsidiary including higher taxes. tighter
repatriation or currency controls and restrictions on prices charged. The risk
of expropriation is small in traditionally friendly and stable countries such
as Great Britain or Switzerland. However in Latin American. Africa the Far East
and Eastern Europe the risk may be substantial. Past expropriations include
those of ITT and Anaconda Copper in Chile, Gulf Oil in Bolivia, Occidental
Petroleum in Libya, Enron corporation in Peru and the assets of many companies
in Iraq. Iran and Cuba.
Several organizations rate the
political risk of countries. For example, International Business Communications
a London company, published the International Country risk Guide which contains
individual ratings for political financial and economic risk. Alone with a
composite rating for each country. Table 18-4 contains selected portions of a
recent report. The political variable which makes up 50 percent of the
composite rating includes factors such as government corruption and the gap
between economic expectations and reality. The
financial rating looks at such
things as the likelihood of losses from exchange controls and loan defaults.
The economic rating takes into account such factors as inflation and
debt-service costs.
The best or least risky score is
100 for political factors and 50 each for the financial and economic factors
and the composite risk is a weighted average of the political, financial and
economic factors. The United States is ranked ninth, below Switzerland, Luxembourg.
Norway, Austria, Germany, Netherlands, Brunei, and Japan. Liberia. as shown in
table 184 is ranked last.
If a company’s management has a
serious concern that a given country might expropriate foreign assets it will
probably not make significant investments in that country. However companies
can take steps to reduce the potential loss from expropriation in three major
ways: (1) finance the subsidiary with local capital. (2) structure operations
so that the subsidiary has value only as a part of the integrated corporate
system and (3) obtain insurance against economic losses from expropriation from
a source such as the overseas private Investment Corporation (OPIC). In the
latter case insurance premiums would have to be added to the project’s cost.
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