Madura14e Ch16 Final

Chapter 16
Country Risk Analysis
Jeff Madura, International Financial Management, 14 th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned,
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter Objectives
• 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.
Jeff Madura, International Financial Management, 14 th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, 2
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 (1 of 3)
Political Risk Characteristics
• Attitude of consumers in the host country — A tendency of residents to
purchase only locally produced goods.
• Laws enacted by 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).
• Currency inconvertibility — Some governments do not allow the home
currency to be exchanged into other currencies.
Political Risk Characteristics (continued)
• 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.
• 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 index for
most countries (see www.transparency.org). (Exhibit 16.1)
Exhibit 16.1 Corruption Index Ratings for Selected
Countries (maximum rating = 10; high ratings indicate
low corruption) (1 of 2)
Country Corruption Index Country Corruption Index
New Zealand 89 Australia 76
Denmark 88 Hong Kong 76
Finland 85 Iceland 76
Switzerland 85 Austria 76
Singapore 85 Belgium 75
Norway 84 Ireland 73
Netherlands 82 Japan 73
Canada 81 Estonia 73
Luxembourg 81 France 72
United Kingdom 80 United States 71
Germany 80 United Arab Emirates 70
Exhibit 16.1 Corruption Index Ratings for Selected
Countries (maximum rating = 10; high ratings indicate
low corruption) (2 of 2)
Country Corruption Index Country Corruption Index
Taiwan 63 India 41
Israel 61 China 39
Slovenia 60 Indonesia 38
Poland 60 Thailand 36
Czech Republic 59 Brazil 35
Spain 58 Russia 29
South Korea 57 Iran 28
Italy 52 Mexico 28
Saudi Arabia 49 Venezuela 18
Malaysia 47 Iraq 18
Greece 45 Afghanistan 16
Financial Risk Characteristics
• Economic Growth is influenced by:
o Interest rates: Higher interest rates tend to slow growth and reduce demand for
MNC products.
o Exchange rates: Strong currency may reduce demand for the country’s exports,
increase volume of imports, and reduce production and national income.
o Inflation: Inflation can affect consumers’ purchasing power and their demand for
MNC goods.
Measuring Country Risk (1 of 5)
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
Deriving A Country Risk Rating (Exhibits 16.2 and 16.3)
An overall country risk rating using a checklist approach can be developed
from separate ratings for political and financial risk.
• First, the political factors are assigned values within some range.
• Next, these political factors are assigned weights. The assigned values of
the factors times their respective weights can then be summed to derive a
political risk rating.
• The process is then repeated to derive the financial risk rating.
• Once the political and financial ratings have been derived, a country’s
overall country risk rating as it relates to a specific project can be
determined by assigning weights to the political and financial ratings
according to importance.
Exhibit 16.2 Determining the Overall Country Risk Rating
Exhibit 16.3 Derivation of the Overall Country Risk
Rating Based on Assumed Information (1 of 2)
(1) (2) (3) (4) = (2) × (3)
RATING ASSIGNED BY COMPANY WEIGHT ASSIGNED BY
TO FACTOR (WITHIN A RANGE OF COMPANY TO FACTOR WEIGHTED VALUE OF
POLITICAL RISK FACTORS 1−5) ACCORDING TO IMPORTANCE FACTOR
Blockage of fund transfers 4 30% 1.2
Bureaucracy 3 70 2.1
100% 3.3 = Political risk rating
FINANCIAL RISK
FACTORS
Interest rate 5 20% 1.0
Inflation rate 4 10 0.4
Exchange rate 4 20 0.8
Industry competition 5 10 0.5
Industry growth 3 40 1.2
100% 3.9 = Financial risk rating
Exhibit 16.3 Derivation of the Overall Country Risk
Rating Based on Assumed Information (2 of 2)
(1) (2) (3) (4) = (2) × (3)
WEIGHT ASSIGNED BY
COMPANY TO EACH RISK
CATEGORY RATING AS DETERMINED ABOVE CATEGORY WEIGHTED RATING
Political risk 3.3 80% 2.64
Financial risk 3.9 20 0.78
100% 3.42 = Overall

country risk rating
Deriving A Country Risk Rating (continued)
• Governance of the Country Risk Assessment
o MNCs need a proper governance system to ensure that managers fully consider
country risk when assessing potential projects.
o 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.”
• Each country can be positioned in its appropriate location on the matrix
based on its political rating and financial rating.
Incorporating Risk in Capital Budgeting (1 of 2)
Adjustment of the discount rate: Lower 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. (Exhibits 16.4, 16.5, 16.6, and 16.7)
• Accounting for uncertainty: Could account for the uncertainty of country
risk characteristics while also allowing for uncertainty in the other variables
as well.
Exhibit 16.4 Analysis of Project Based on a 20
Percent Withholding Tax: Spartan, Inc.
YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4
14. S$ remitted by subsidiary S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
15. Withholding tax imposed on S$1,200,000 S$1,200,000 S$1,520,000 S$1,680,000
remitted funds (20%)
16. S$ remitted after withholding S$4,800,000 S$4,800,000 S$6,080,000 S$6,720,000
taxes = (14) − (15)
17. Salvage value S$12,000,000
18. Exchange rate of S$ $.50 $.50 $.50 $.50
19. Cash flows to parent = [(16) + $2,400,000 $2,400,000 $3,040,000 $9,360,000
(17)] × (18)
20. PV of parent cash flows (15% $2,086,956 $1,814,745 $1,998,849 $5,351,610
discount rate)
21. Initial investment by parent $10,000,000
22. Cumulative NPV −$7,913,044 −$6,098,299 −$4,099,450 $1,252,160
Exhibit 16.5 Analysis of Project Based on a
Reduced Salvage Value: Spartan, Inc.
14. S$ remitted by subsidiary S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
15. Withholding tax imposed on S$600,000 S$600,000 S$760,000 S$840,000
taxes = (14) − (15)
18. Exchange rate of S$ $.50 $.50 $.50 $.50
19. Cash flows to parent= [(16) + $2,700,000 $2,700,000 $3,420,000 $7,280,000
(17)] × (18)
discount rate)
22. Cumulative NPV −$7,652,174 −$5,610,586 −$3,361,880 $800,484
Exhibit 16.6 Analysis of Project Based on a 20 Percent
Withholding Tax and a Reduced Salvage Value: Spartan, Inc.
14. 5$ remitted by subsidiary S$6,000,000 S$6,000,000 S$7,600,000 S$8,400,000
15. Withholding tax imposed on S$1,200,000 S$1,200,000 S$1,520,000 S$1,680,000
taxes = (14) − (15)
18. Exchange rate of S$ $50 $0.50 $0.50 $0.50
19. Cash flows to parent= [(16) + $2,400,000 $2,400,000 $3,040,000 $6,860,000
(17)] × (18)
discount rate)
22. Cumulative NPV −$7,913,044 −$6,098,299 −$4,099,450 −$177,223
Exhibit 16.7 Summary of Estimated NPVs across
the Possible Scenarios: Spartan, Inc.
WITHHOLDING TAX
IMPOSED BY
SINGAPORE SALVAGE VALUE
SCENARIO GOVERNMENT OF PROJECT NPV PROBABILITY
1 10% S$12,000,000 $2,229,867 (70%)(60%) = 42%
2 20% S$12,000,000 $1,252,160 (30%)(60%) = 18%
3 10% S$7,000,000 $800,484 (70%)(40%) = 28%
4 20% S$7,000,000 −$177,223 (30%)(40%) = 12%
E(NPV) = $2,229,867(42%) + $1,252,160(18%) + $800,484(28%) − $177,223(12%) = $1,364,801
Incorporating Risk in Capital Budgeting (2 of 2)
Analysis of Existing Projects

• 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.
• 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:
• Use a short-term horizon
• Rely on unique supplies or technology
• Hire local labor
• Borrow local funds
• Purchase insurance
• Use project finance
Summary (1 of 4)
• 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 (2 of 4)
• 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 may be used. An overall measure of
country risk is essentially a weighted average of the political or financial
factors that are perceived to constitute 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 (3 of 4)
• 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 (4 of 4)
• 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.

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Chapter 16

Country Risk Analysis

Financial risk 3.9 20 0.78

100% 3.42 = Overall

E(NPV) = $2,229,867(42%) + $1,252,160(18%) + $800,484(28%) − $177,223(12%) = $1,364,801

Analysis of Existing Projects

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