Political Risk Analysis

While undertaking large capital investment proposals it is important for the companies to consider the various aspects connected with the evaluation of a capital expenditure project. In the instant case since the company would like to invest ? 55 million in a foreign country like Ruritania it is all the more important that a careful analysis of the proposed capital investment is done and the various issues involved evaluated in a proper perspective. Just any other domestic capital project is being evaluated, for the international investment also we need to calculate the ‘Net Present Value’ (NPV) future cash flows expected out of the project.

The NPV of the project depends on the initial investment or initial cash flow, expected future cash flows and the cost of capital. Based on the comparison of the NPV of the future cash flows with the proposed capital investment the feasibility of the project can be established. While working out the NPV the effect of the factors like Sales creation (additional sales), cannibalization (loss of sales), opportunity cost, transfer pricing and fees and royalties on the future cash flows should be taken into account.

The Internal Rate of Return (IRR) and the payback period are some of the other factors that need to be carefully looked into while deciding on the capital investment. The following issues have a direct bearing on the analysis of the capital budgeting of a large value. A careful distinction must be made between the cash flows of the parent company and the cash flows of the project. It is possible to evaluate the project either on a standalone basis or the net impact of the new project on the parent company may also be analysed on a consolidated basis.

“Multinational firms should compare their projects with host country projects and invest only if they can earn a risk-adjusted return greater than local based companies can earn on the same project. If not the firm can invest on host country bonds which pay the risk free rate adjusted for inflation”. (Chapter 18) The ways in which the moneys can be returned to the parent company has a significant role to play on the capital budgeting. The project may pay back in the form of dividends, intra-firm debt, intra-firm sales, Royalties and licence fees and transfer pricing.

Out of these methods, those advantageous to the company should be considered and adopted. Consideration of the inflation rates in both the countries should be accommodated in the cash flows and the NPV calculations as the cash flows are expected over a period of time when there will be the impact of the inflation on the cash flows from the project. Anticipated changes in the Exchange rate should also be provided for in the calculations.

The fact that using a subsidized loan facility from the host country for the project may vitiate the workings of the cash flows as this may reduce the cost of capital. Under such circumstances it is better to use the opportunity cost of capital to get a fair result. There may also be political risks by changing policies in expropriation. “Companies conducting foreign projects analyse prior to the implementation of a foreign project also the factor of political risk, which is connected to such government restrictions” (Dr.

Ing. Anna Polednakova) Such restrictions may take the form of various legislations and restrictions from the foreign government concerning the expropriation of funds by the company, currency controls, tax increases, other causes for potential political unrest, the country’s relationship with the country of the investing company and the changes in the economic growth of the country. The company has to take into account all these factors before deciding on the investment in the country of Ruritania.

Especially with the speculation that the government of the country Ruritania is going to peg the value of its currency ‘Crown’ against a major international currency is posing a real threat which needs to be carefully analysed before a decision is taken. However the fact that the country is negotiating for membership of the European Union is a positive factor that van be considered in favour of the proposal, as the country once joins the EU there will be no separate currency and it would be better for the company to deal with this country.

Thus making an investment decision on a large capital outlay in a foreign country exposes the company to risks of varying degrees especially with respect to the foreign exchange. Since the investment proposal has the ramifications of an international nature it becomes important that the company considers the currency exchange risks both in the short term and in the long term.

These risks take the form of transaction exposure risk that relate to the current financial transaction between the parent company and the overseas project which is of a short term nature, translation exposure risks related to the valuation of assets and liabilities of the firm and economic exposure relating to the long term effect on the business of the company which has a potential of becoming a transaction exposure.

The company would be able to mitigate the effect of these currency exposure risks by adopting various techniques like hedging etc. Moreover, the company has to calculate the NPV of the future of cash flows of the international capital investment proposal. There is the need to analyse the political risks involved in the investment also. With a careful analysis and evaluation of all these factors that have an impact on the capital investment decision, the company can decide on the investment in the foreign nation.

As aforesaid, it would be better to consider the investment in the home country for a like project and compare the risk adjusted return from the overseas project. If the returns from the overseas project are not matching to the revenues occurring locally the company would do well to invest the funds in the bonds domestically which would provide inflation adjusted return without any accompanying risks.