Finance for International Business Proofread (Apple: 12/9/2021)

Political risk factors

Literature on the concepts of corporate valuation and the effects of political factors is a growing concept and is available in decent ransom.

(1) Blocked Funds: Blocking of funds arises when the government of the host country restricts the remittance of funds to the foreign country (Clark, 2018). However, it does not affect the ownership rights of the parent company. the MNC can alternatively invest the funds in any security locally, however, the returns will be comparatively lower.

(2) Changing Tax Laws: A change in the tax law can have a positive or negative impact on the investment (Guo & Zheng, 2020). A country with a rigid or poorly designed tax system will discourage the investments which will bring more uncertainty and added project costs

(3) Public attitude towards the firm: It can be in form of purchasing tendency of the consumers which has shifted to local goods. The exporters have very little to do with this risk as every country motivates its consumers to purchase local goods (Giambona, Graham & Harvey, 2017). Therefore, the parent company in Australia must assess the loyalty o the consumers in the host country and enter into a joint venture with a local company instead of exporting goods.

(4) Wars: Any political changes like wars and public revolt against firms can lead to higher taxes, expropriation, reduced FDI incentives, tariffs, and difficulty in currency conversion. It can lead to termination of operation, loss of assets, the decline in income after tax, higher cost for imports, higher operational costs. The MNC is indirectly affected due to additional costs for its employee safety.

(5) Changing attitude of the host government toward the Multinational Corporation:

The host government has the power to control the cash flow of the parent company. it can be in the form of additional taxes, even withhold it, restrict fund transfer, and a new pollution control standard.

Financial Risk Factors

Besides political risk, financial risks must also be considered by the MNC before deciding to invest further or make a new investment decision in a host country (Rafat & Farahani, 2019). An MNC which exports goods to a foreign country is concerned with the demand for its product which is influenced by the economy of the host country.

1. Inflation: The consumers’ purchasing power is affected by the rates of inflation which influences the demand for MNC goods. There is an indirect influence over the country’s interest rates and currency valuation. High inflation rates are directly related to a fall in economic growth.

2. Interest Rates: A higher rate of interest reduces the growth of the economy and lowers the demand for MNC’s products and vice versa.

3. GDP Growth: The real GDP growth, has a positive relationship with the FDI and increases the FDI inflow for a host country.

4. Exchange Rates: The rate of exchange also impacts the country’s export which affects the production of the country and the revenue from it. When the currency is strong, the export demand reduces, and the import increases which causes a decline in the overall production and national income of the host country.

5. Labor Costs: If the labor cost is low, the foreign firms can earn higher output by providing extra incentives to employees. This will help in creating higher revenues.

Analysis

Country risk of India

The OECD risk grade of the country is at 3 indicating a situation that the country can be unable to meet its external debt obligation and can default (exportfionance.gov.au).

Figure 1: Country Risk rating of India (exportfionance.gov.au).

According to the reports from the World Bank’s ease of doing business, India has improved its position and is ranked 63rd. There are few benefits like handling cross-border trading, construction permits, protecting the interests of minors, and easy electricity and credit availability. However, the challenge is associated with starting a new business, registering property, and the tax structures of the country.

Figure 2: Ease of Doing Business (exportfionance.gov.au).

Incorporating country risk into capital budgeting

Country risk can be incorporated into capital budgeting using the adjustment of estimated cash flows or discount rates (Espinoza et al.,2020).

Adjustment of the Discount Rate

The discount rate and the country's risk can be adjusted with each other. Lower the credit rating, more is the perceived risk, and a greater discount rate will have to be applied to the cash flow of the project. there is no precise formula for calculating the discount rate and can lead to the cancellation of a feasible project.

Adjustment of the Estimated Cash Flow

The feasible method to incorporate country risk is using the cash flow estimation. Assuming that there is a 15% chance that the Indian government will block the fund's transfer to the parent country, the parent company in Australia must assess the NPV of the project considering the condition. The Australian government must assess the NPV of the foreign project if there is a chance for the takeover of the software business. Every possible impact on the cash flow and the NPV must be calculated to derive the probability distribution of the NPV. The probability of the project will assess NPV and its size. In this way, the country's risk can be incorporated into the cash flow.

Australia has a 40% chance of withholding tax imposed by the Indian government which will be 30% instead of 20%. There is also an additional 42% chance that the host country will provide Australia a salvage value payment of $6million instead of $12million which is country risk.

If there is an imposition of 20% of withholding tax by the Indian government, the NPV for a 4-year project will be at $638,283. If the salvage value is reduced to $10,000,000 with a 10% withholding rate of taxation. Based on the following criteria, the estimated NPV for the project will be $943,421.

Finally, considering the withholding tax at a higher level and a lower salvage value together, the NPV will be at

The first scenario portrays a situation of joint probability with a $12 million salvage value and a withholding tax rate of 20%. There is a 12% chance that the value of the firm will be affected by the project. therefore, the firm can accept the software business project in India since it has a positive NPV and there is an anticipation of limited loss.

India has a comparative advantage of low labor costs where the employees are paid higher by the foreign firms in comparison to the domestic firms. The employees can be encouraged to produce higher output. Therefore, the Indian government can attract more foreign investors if they cut down their tax rates to reduce the import duties and property rights enforcement.

Recommendations

To reduce the exposure of country risks, the Australian firm must consider the following strategies:

(1) Rely on Unique Innovative Technology: The subsidiary company can employ advanced and innovative technology which will provide the company a competitive advantage over the domestic firms and the government (Muzi, Kizil& Ceylan, 2021).. In case of unfair treatment, the MNC can cut off the supply of this technology.

(2) Use short-term horizon: The Australian company must be reluctant to recover its cash flow at a frequent and quick period such that the losses are minimized at the time of adverse situation. The company can also sell its assets to create further investment.

(3) Hire Local Labor: The local employees must be preferred such that in case o adversity of government takeover, the parent company can pressurize the government to consider the future of the employees (Giambona, Graham & Harvey, 2017). This can delimit the government takeover.

Conclusion

To invest in a foreign country, the subsidiary company must have a competitive advantage over the host country. Through international diversification, an MNC can reduce its exposure to threats of domestic economic condition and can spread its losses. The credit rating for the country is at BBB- rating which reflects a situation of weak revenue generation for the country. However, the debt stock will remain steady with better progress to be seen in the upcoming years. After measuring the country's risk, it can be incorporated into capital budgeting. The investors must be well informed about the policies that are announced by the government for a safe business environment within the country. India needs to improve its credit rating and explore more productive methods to combat the challenges posed by the growth and its tax structures.

References

Bajrami, H. (2019). Theories of foreign direct investment (FDI) and the significance of human capital.

Clark, E. (2018). Political Risk in Hong Kong and Taiwan: Pricing the China Factor. In Evaluating Country Risks for International Investments: Tools, Techniques and Applications (pp. 203-219).