financial management

chapter16-17.pdf

Home >Business & Finance homework help >Management homework help >financial management

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16 Country Risk Analysis

 Identify the common factors used by MNCs to measure country risk

 Explain how to measure country risk

 Explain how MNCs use the assessment of country risk when making financial decisions

 Explain how MNCs can prevent host government takeovers

Chapter Objectives

What is Country Risk Analysis

 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 to determine whether to implement a new project in a particular country or to continue conducting business in a particular country.

Country Risk Characteristics

Political Risk Characteristics 1. Attitude of consumers in the host country - a tendency of

residents to purchase only locally produced goods.

2. 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.

3. 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. Currency inconvertibility - Some governments do not allow the home currency to be exchanged into other currencies.

Country Risk Characteristics

Political Risk Characteristics (cont)

5. 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

6. Inefficient bureaucracy - Bureaucracy can delay an MNC’s efforts to establish a new subsidiary or expand business in a country.

7. Corruption – Corruption can occur at the firm level or with firm-government interactions. Transparency International has derived a corruption index for most countries (see www.transparency.org).

Exhibit 16.1 Corruption Index Ratings for Selected Countries (Maximum rating = 10. High ratings indicate low corruption.)

Country Risk Characteristics

Financial Risk Characteristics

Economic Growth 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.

Measuring Country Risk

 Macro-assessment of country risk represents an overall risk assessment of a country and considers all variables that affect country risk except those that are firm- specific.

 Micro-assessment of country risk involves assessment of a country as it relates to the MNC’s type of business.

Techniques to Assess Country Risk

 Checklist approach: ratings assigned to various factors

 Delphi technique: collection of independent opinions without group discussion

 Quantitative analysis: use of models such as regression analysis

 Inspection visits: Meetings with government officials, business executives, and consumers to clarify risk.

 Combination of techniques: many MNCs have no formal method but use a combination of methods.

Exhibit 16.2 Determining the Overall Country Risk Rating

Deriving a Country Risk Rating

Governance of the Country Risk Assessment

 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 long-term 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.

Comparing Risk Ratings among Countries

One approach to comparing political and financial ratings among countries is a foreign investment risk matrix (FIRM) that displays the financial (or economic) and political risk by intervals ranging across the matrix from “poor” to “good.”

1. Actual Country Risk Ratings across Countries - MNCs need to periodically update their assessments of each country where they do business.

2. 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.

Incorporating Risk in Capital Budgeting

1. Adjustment of the discount rate: lower risk rating implies higher risk and higher discount rate.

2. Adjustment of the estimated cash flows: adjust estimates for the probability that cash flows may not be realized.

3. Assessing Risk of Existing Projects: review country risk periodically after project has been implemented.

Analysis of Existing Projects

1. An MNC should not only consider country risk when assessing a new project but should also review the country risk periodically after a project has been implemented.

2. If an MNC has a subsidiary in a country that experiences adverse political conditions, it may need to reassess the feasibility of maintaining this subsidiary.

Preventing Host Government Takeovers

Strategies to reduce exposure to a host government takeover include:

1. Use a short-term horizon

2. Rely on unique supplies or technology

3. Hire local labor

4. Borrow local funds

5. Purchase insurance

6. Use project finance

SUMMARY

 The characteristics used by MNCs to measure a country’s political risk include the attitude of consumers toward purchasing locally produced goods, the host government’s actions toward the MNC, the blockage of fund transfers, currency inconvertibility, war, bureaucratic problems, and corruption. These characteristics can increase the costs of international business. The characteristics used by MNCs to measure a country’s financial risk are the country’s gross domestic product, interest rate, exchange rate, and inflation rate.

SUMMARY

 The techniques typically used by MNCs to measure the country risk are the checklist approach, the Delphi technique, quantitative analysis, and inspection visits. Since no one technique covers all aspects of country risk, a combination of these techniques is commonly used. An overall measure of country risk is essentially a weighted average of the political or financial factors that are perceived to comprise country risk. Each MNC has its own view as to the weights that should be assigned to each factor and its own view about each factor’s importance as related to its business. Thus, the overall rating for a country varies among MNCs.

SUMMARY (Cont.)

 Once country risk is measured, it can be incorporated into a capital budgeting analysis by adjustment of the discount rate. The adjustment is somewhat arbitrary, however, and may lead to improper decision making. An alternative method of incorporating country risk analysis into capital budgeting is to explicitly account for each factor that affects country risk. For each possible form of risk, the MNC can recalculate the foreign project’s net present value under the condition that the event (such as blocked funds or increased taxes) occurs.

SUMMARY (Cont.)

 MNCs can reduce the likelihood of a host government takeover of their subsidiary by using a short-term horizon for their operations whereby the investment in the subsidiary is limited. In addition, reliance on unique technology (that cannot be copied), local citizens for labor, and local financial institutions for financing may create some protection from the host government.

17 Multinational Capital Structure and Cost of Capital

 Describe the key components of an MNC’s capital

 Identify the factors that affect an MNC’s capital structure

 Interaction between a subsidiary and parent in capital structure decisions

 Explain how the cost of capital is estimated

 Explain why the cost of capital varies among countries

Chapter Objectives

Components of Capital

 An MNC’s parent may invest its own cash into the subsidiary. The cash infusion in the subsidiary represents an equity investment by the parent, so that the parent is the sole owner of the subsidiary. The subsidiary uses the cash infusion to develop its business operations in the host country.

 An alternative method by which the subsidiary can build more equity is to offer its own stock to the public.

External Sources of Debt

 Domestic Bond Offering - MNCs commonly engage in a domestic bond offering in their home country in which the funds are denominated in their local currency.

 Global Bond Offering - MNCs can engage in a global bond offering, in which they simultaneously sell bonds denominated in the currencies of multiple countries.

 Private Placement of Bonds - MNCs may offer a private placement of bonds to financial institutions in their home country or in the foreign country where they are expanding.

 Loans from Financial Institutions - An MNC’s parent commonly borrows funds from financial institutions.

External Sources of Equity

 Domestic Equity Offering - MNCs can engage in a domestic equity offering in their home country in which the funds are denominated in their local currency.

 Global Equity Offering - Some MNCs pursue a global equity offering in which they can simultaneously access equity from multiple countries.

 Private Placement of Equity - Offer a private placement of equity to financial institutions in their home country or in the foreign country where they are expanding.

The MNC’s Capital Structure Decision

Influence of Corporate Characteristics

 Stability of MNC’s Cash Flows - MNCs with more stable cash flows can handle more debt because there is a constant stream of cash inflows to cover periodic interest payments on debt.

 MNC’s Credit Risk - MNCs that have lower credit risk have more access to credit.

 MNC’s Access to Retained Earnings - Highly profitable MNCs may be able to finance most of their investment with retained earnings and therefore use an equity-intensive capital structure.

 MNC’s Guarantees on Debt - If the parent backs the debt of its subsidiary, the subsidiary’s borrowing capacity might be increased.

 MNC’s Agency Problems - If a subsidiary in a foreign country cannot easily be monitored by investors from the parent’s country, agency costs are higher.

The MNC’s Capital Structure Decision

Influence of Host Country Characteristics  Interest Rates in Host Countries – The cost of loanable funds may

be lower in some countries.

 Strength of Host Country Currencies - If an MNC expects weakness of the currencies in its subsidiaries’ host countries, it may borrow in those currencies rather than rely on parent financing. If the subsidiary’s local currency is expected to appreciate, then the subsidiary may retain and reinvest its earnings.

 Country Risk in Host Countries - If an MNC’s subsidiary is exposed to the risk that the host government might confiscate its assets, the subsidiary may use much debt financing in that host country..

 Tax Laws in Host Countries - Foreign subsidiaries may be subject to a withholding tax when they remit earnings.

Subsidiary Versus Parent Capital Structure Decisions

Some subsidiaries are subject to conditions that favor debt financing, while other subsidiaries are subject to conditions that favor equity financing. 1. Impact of Increased Subsidiary Debt Financing - When a

subsidiary relies heavily on debt financing, its need for its internal equity financing (retained earnings) is reduced.

2. Impact of Reduced Subsidiary Debt Financing - The subsidiary will need to use more internal financing, will remit fewer funds to the parent, and will reduce the amount of internal funds available to the parent.

3. Limitations in Offsetting a Subsidiary’s Leverage - Foreign creditors may charge higher loan rates to a subsidiary that uses a highly leveraged local capital structure because they believe that the subsidiary may be unable to meet its high debt repayments.

Multinational Cost of Capital

MNC’s Cost of Debt: An MNC’s cost of debt is dependent on the interest rate that it pays when borrowing funds.

MNC’s Cost of Equity: An MNC creates equity by retaining earnings or by issuing new stock. An MNC’s cost of equity contains a risk premium (above the risk-free interest rate) that compensates the equity investors for their willingness to invest in the equity.

Comparing Costs of Debt and Equity

 There is an advantage to using debt rather than equity as capital because the interest payments on debt are tax deductible.

 The greater the use of debt, however, the greater the interest expense and the higher the probability that the firm will be unable to meet its expenses.

 As an MNC increases its proportion of debt, the rate of return required by potential new shareholders or creditors will increase to reflect the higher probability of bankruptcy.

Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNCs may differ because of:

1. Size of firm - An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital.

2. Access to international capital markets - MNC’s access to the international capital markets may allow it to obtain funds at a lower cost than that paid by domestic firms.

3. International diversification - If a firm’s cash inflows come from sources all over the world, those cash inflows may be more stable because the firm’s total sales will not be highly influenced by a single economy.

Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNC may differ because of:

4. Exposure to exchange rate risk - An MNC’s cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk.

5. Exposure to country risk - An MNC that establishes foreign subsidiaries is subject to the possibility that a host country government may seize a subsidiary’s assets.

Cost of Equity Comparison Using the CAPM

1. Implications of the CAPM for an MNC’s risk: U.S. based MNC may be able to reduce its beta by increasing its international business.

2. Implications of the CAPM for an MNC’s projects Because many projects of U.S.-based MNCs are in foreign countries, their cash flows are less sensitive to general U.S. market conditions leading lower project betas.

3. Applying CAPM with a World Market Index: A world market may be more appropriate than a U.S. market for determining the betas of U.S.–based MNCs.

Costs of Capital Across Countries

1. Country differences in the cost of debt

 Differences in the risk-free rate - The risk-free rate is the interest rate charged on loans to a country’s government that is perceived to have no risk of defaulting on the loans.

 Differences in the Credit Risk Premium - The credit risk premium paid by an MNC must be large enough to compensate creditors for taking the risk that the MNC may not meet its payment obligations.

 Comparative costs of debt across countries – There is some positive correlation between country cost-of-debt levels over time.

Costs of Capital Across Countries (Cont.)

2. Country differences in the cost of equity

 Differences in the risk-free rate - When the country’s risk-free interest rate is high, local investors would only invest in equity if the potential return is sufficiently higher than that they can earn at the risk- free rate.

 Differences in the Equity Risk Premium - Based on investment opportunities in the country of concern. A second factor that can influence the equity risk premium is the country risk.

SUMMARY

 An MNC’s capital consists of debt and equity. MNCs can access debt through domestic debt offerings, global debt offerings, private placements of debt, and loans from financial institutions. They can access equity by retaining earnings and by issuing stock through domestic offerings, global offerings, and private placements of equity.

 If an MNC’s subsidiary’s financial leverage deviates from the global target capital structure, the MNC can still achieve the target if another subsidiary or the parent take an offsetting position in financial leverage. However, even with these offsetting effects, the cost of capital might be affected.

SUMMARY (Cont.)

 An MNC’s capital structure decision is influenced by corporate characteristics such as the stability of the MNC’s cash flows, its credit risk, and its access to earnings. The capital structure is also influenced by characteristics of the countries where the MNC conducts business, such as interest rates, strength of local currencies, country risk, and tax laws. Some characteristics favor an equity-intensive capital structure because they discourage the use of debt. Other characteristics favor a debt-intensive structure because of the desire to protect against risks by creating foreign debt.

SUMMARY (Cont.)

 The cost of capital may be lower for an MNC than for a domestic firm because of characteristics peculiar to the MNC, including its size, its access to international capital markets, and its degree of international diversification. Yet some characteristics peculiar to an MNC can increase the MNC’s cost of capital, such as exposure to exchange rate risk and to country risk.

 Costs of capital vary across countries because of country differences in the components that comprise the cost of capital. Specifically, there are differences in the risk-free rate, the risk premium on debt, and the cost of equity among countries. Countries with a higher risk-free rate tend to exhibit a higher cost of capital.