10-country risk lecture PDF

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10/19/2018

Country Risk Analysis FINA 7320 Dr. Lynn Kendall

What is country risk? Country risk is the potentially adverse impact of a country’s environment on an MNC’s cash flows. An MNC conducts country risk analysis when it applies capital budgeting: • Start a new project in a particular country? • Continue doing business in a particular country?

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Political Risk Factors  Attitude of consumers in the host country – is there a tendency of residents to purchase only locally produced goods?  This could be an advantage if a firm is going to manufacture or produce in the host country  This could be a disadvantage if the firm was going to try to export U.S. made goods into the country. 3

Political Risk Factors  Actions of the host government - A host government might impose pollution control standards and additional corporate taxes, as well as withholding taxes and fund transfer restrictions.  Blockage of fund transfers - A host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds). 4

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Political Risk Factors  Currency inconvertibility - Some governments do not allow the home currency to be exchanged into other currencies.  War – Conflicts with neighboring countries or internal turmoil can affect the safety of employees hired by an MNC’s subsidiary or by salespeople who attempt to establish export markets for the MNC 5

Political Risk Factors  Inefficient bureaucracy - Bureaucracy can delay an MNC’s efforts to establish a new subsidiary or expand business in a country.  Corruption – Corruption can occur at the firm level or with firm-government interactions. Transparency International has derived a corruption perception index for most countries (see www.transparency.org).  Corruption 6

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20LeastCorruptCountries(2017)

Country Rank Country/Territory 1 NewZealand 2 Denmark 3 Finland 3 Norway 3 Switzerland 6 Singapore 6 Sweden 8 Canada 8 Luxembourg 8 Netherlands 8 UnitedKingdom 12 Germany 13 Australia 13 HongKong 13 Iceland 16 Austria 16 Belgium 16 UnitedStatesofAmerica 19 Ireland 20 Japan

20MostCorruptCountries(2017)

2017 Score 89 88 85 85 85 84 84 82 82 82 82 81 77 77 77 75 75 75 74 73

Country Rank Country/Territory 161 Cambodia 161 Congo 161 DemRep oftheCongo 161 Tajikistan 165 Chad 165 Eritrea 167 Angola 167 Turkmenistan 169 Iraq 169 Venezuela 171 Korea,North 171 EquatorialGuinea 171 GuineaBissau 171 Libya 175 Sudan 175 Yemen 177 Afghanistan 178 Syria 179 SouthSudan 180 Somalia

2017 Score 21 21 21 21 20 20 19 19 18 18 17 17 17 17 16 16 15 14 12 9

Financial Risk Characteristics  Financial risks are affected by Economic Growth, which is influenced by:  Interest rates: Higher interest rates tend to slow growth and reduce demand for MNC products  Exchange rates: Strong currency may reduce demand for the country’s exports, increase volume of imports, and reduce production and national income.  Inflation: Inflation can affect consumers’ purchasing power and their demand for MNC goods.

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Measuring Country Risk Macro-assessment of country risk • Country specific, but nothing industry or firm-specific Micro-assessment of country risk • Risk assessment for a country as it relates to the MNC’s type of business.

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Governance of the Country Risk Assessment is important. • MNCs need a proper governance system to ensure that managers fully consider country risk when assessing potential projects. • One solution is to require that major longterm projects use input from an external source (such as a consulting firm) regarding the country risk assessment of a specific project and that this assessment be directly incorporated in the analysis of the project. 10

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Measuring Country Risk Comparing Risk Ratings among Countries • Foreign investment risk matrix (FIRM) – Displays the financial (or economic) and political risk by intervals ranging across the matrix from “poor” to “good.”  Country Risk Ratings MNCs need to periodically update their assessments of each country where they do business.  Impact of the Credit Crisis - Many countries experienced a decline in their country risk rating due to the credit crisis in 2008. Countries especially reliant on international credit were adversely affected when credit was difficult to access.

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Country Risk Analysis overview: Coface

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Specific country analysis

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Incorporating Risk in Capital Budgeting

Adjustment of the discount rate •

Higher risk rating implies higher risk and higher discount rate.

Adjustment of the estimated cash flows •

Adjust estimates for the probability that cash flows may not be realized.

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Example: Blade’s: Build it or buy it? •

The company in this example is Blades Inc. Blades is considering whether it is better to manufacture their roller blades in a new facility in Thailand or to acquire an existing manufacturer known as Skates’n’Stuff, which Blades could buy for 1mm Thai bhat. – The manufacturer has rejected Blades’ lower offer of 900,000 Thai bhat, stating that a minimum bid must be at least 950,000. – If Blades could buy the existing manufacturer for 900,000, it would be an attractive acquisition.

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However Blades decides to go, the roller blades manufactured in Thailand are planned for internal, Thai consumers.

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Blades’ CFO wants to review the discount rate used for the firm’s NPV analysis because upon review, 25% is the only discount rate used by the analysts. The CFO believes that purchasing an existing manufacturer might be associated with a lower level of country risk than establishing a new subsidiary in Thailand.

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Country Risk Assessment – Political Risk Factors • The CFO has pulled together detailed political information for Thailand, including: • Consumers in Asian countries prefer to purchase goods produced by Asians • New permits and licenses needed for subsidiary – Permit and license barriers for Blades’ industry are relatively low

• Thai government expected to implement capital controls

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Country Risk Assessment – Financial Risk Factors • Thailand’s economy has been weak lately • High interest rates in Thailand • High inflation in Thailand • Forecasts indicate that the Thai baht may depreciate in the future

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Development of a Country Risk Rating • How to weight political risk vs. financial risks – How do you think the two types of risks should be weighted?

• Political risks to use are consumer attitudes, capital controls and Thai bureaucracy, but there may be others you think are important, such as political instability… – How do you want to weight each political factor?

• Financial risks should include interest rates, exchange rates and inflation, but are there others you think Blades should consider? – How do you weight each factor?

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Macro vs. micro assessment • Macro assessment is on a country level • Micro assessment is on industry and/or firm level • Blades’ CFO has asked you to decide if the political and financial risk associated with Thailand is higher or lower for a manufacturer of leisure products such as Blades as opposed to some other industry such as a food processor. – Political risks should be no different than other industries – Leisure products would have higher financial risk 19

Quantitative Assessment • The next step is to conduct a quantitative country risk analysis for Blades, Inc. based on the information provided. • Once you have the factors, you will need to assess the rank: 1 = low risk factor up to 5 = very high risk factor • This analysis is best conducted in Excel. • Analysis 1: Establishment of a new subsidiary – Then, repeat for acquiring the existing company – Remember that risk factors do not change and the weight of these political factors should not change – Political risk factor rankings are expected to be different between the 2 analyses, but is there any reason that the financial factor ranks should change? – Analysis 2: Acquisition of a Skates’n’Stuff 20

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Factor analysis sample template Weight

Political Risk Factors

Financial Risk Factors

Rank(high Weig number= Factors hts highrisk) Weight 1 wt1 rank1 2 wt2 rank2 3 wt3 rank3 (includeallthatyoufeelis appropriate) totalwt

Weight 1 wt1 rank1 2 wt2 rank2 3 wt3 rank3 (includeallthatyoufeelis appropriate) totalwt

CountryRiskScore

=PoliticalriskratingWeightedScores wt1*rank1 wt2*rank2 wt3*rank3 sumofwt*factor nowmultiplybythefactor wt categorywt. =Financialrisk rating wt1*rank1 wt2*rank2 wt3*rank3 sumofwt*factor nowmultiplybythefactor wt categorywt. sumoftheweighted factorscores

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Work as 2 groups to discuss the relevant factors and complete the analyses, then we will discuss Open“1‐SampleTemplate”underUnit10forthisunit Haveonepersonforeachgroup“run”thespreadsheet asyoudiscussthefactorsandweightsasagroup. Wewillthendiscussasagroup.

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Consensus and discussion • Consensus factor analysis • What about comparing factors for establishing vs. acquiring an existing firm?

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Adjusting cash flows for unknown outcomes • What if it is possible the host country will increase their withholding tax? – What are the likelihoods of the various rates?

• What is the range of possible salvage values? – What are the probabilities of the various salvage values?

• How to factor both these issues into one analysis? Open 2-Cash Flow Adjustments spreadsheet from Unit 10 24

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Move to Excel

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Don’t ignore existing projects • Periodic reviews of existing projects should be conducted • Are there changes that should be made to operations that would reduce the overall risk? • Are there changes that now make the existing project non-viable? – Should the firm sell the holding? 26

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How to prevent host government takeovers, the most severe country risk • Use a short term horizon, concentrate on recovering cash flows quickly – Minimize replacement of worn out equipment – Maybe sell off assets over time to local investors or to the local government

• Rely on unique suppliers or technology – If the host government can’t duplicate the inputs locally, it becomes less attractive for the host country takeover

• Hire local labor – Employees may pressure local government to avoid takeover, but this may have a very limited effect 27

How to prevent host government takeovers, the most severe country risk • Borrow local funds – Now the local banks are on your side – But, if the government guarantees that the loans will be repaid, this strategy will have a limited effect

• Purchase insurance to cover expropriation risk – Premiums based on coverage and company’s risk

• Use project finance – Heavily financed with credit – Lower financial risk to parent firm – Project financing deals are secured by project cash flows – Creditor is only entitled to project cash flows and assets 28

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Next week • Read Chapters 18 and 19 before class • Term project: Close out your stocks in the next day or so. Your final reports are due by next Wednesday night. – Follow the instructions under “Term Project” for specific items to complete and formatting guidelines. – Review the grading rubric as you prepare your reports.

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Exercises • Open 3-Grecia_Tovar template from Unit 10 • I have a handout on the setup

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