PROJECT AND PARENT CASH FLOWS

A theoretical argument exists for analyzing any foreign project from the perspective of the
parent company because cash flows to the project are not necessarily the same thing as
cash
flows to the parent company. The project may not be able to remit all its cash flows to the
parent for a number of reasons. For example, cash flows may be blocked from repatriation
by
the host-country government, they may be taxed at an unfavorable rate, or the host
government may require a certain percentage of the cash flows generated from the project
be
reinvested within the host nation. While these restrictions don't affect the net present value
of
the project itself, they do affect the net present value of the project to the parent company
because they limit the cash flows that can be remitted to it from the project.
When evaluating a foreign investment opportunity, the parent should be interested in the
cash flows it will receiveas opposed to those the project generatesbecause those are
the
basis for dividends to stockholders, investments elsewhere in the world, repayment of
worldwide corporate debt, and so on. Stockholders will not perceive blocked earnings as
contributing to the value of the firm, and creditors will not count them when calculating the
parent's ability to service its debt.
But the problem of blocked earnings is not as serious as it once was. The worldwide move
toward greater acceptance of free market economics (discussed in Chapter 2) has reduced
the number of countries in which governments are likely to prohibit the affiliates of foreign
multinationals from remitting cash flows to their parent companies. In addition, as we will see
later in the chapter, firms have a number of options for circumventing host-government
attempts to block the free flow of funds from an affiliate.

ADJUSTING FOR POLITICAL AND ECONOMIC RISK

When analyzing a foreign investment opportunity, the company must consider the political
and
economic risks that stem from the foreign location.4 We will discuss these risks before
looking
at how capital budgeting methods can be adjusted to take them into account.
Political Risk
We initially encountered the concept of political risk in Chapter 2. There we defined it as the
likelihood that political forces will cause drastic changes in a country's business environment
that hurt the profit and other goals of a business enterprise. Political risk tends to be greater
in
countries experiencing social unrest or disorder and countries where the underlying nature of
the society makes the likelihood of social unrest high. When political risk is high, there is a
high
probability that a change will occur in the country's political environment that will endanger
foreign firms there.
In extreme cases, political change may result in the expropriation of foreign firms' assets.
This occurred to U.S. firms after the Iranian revolution of 1979. In recent decades, the risk of
outright expropriations has become almost zero. However, a lack of consistent legislation
and

proper law enforcement, and no willingness on the part of the government to enforce
contracts and protect private property rights, can result in the de facto expropriation of the
assets of a foreign multinational. The Management Focus provides an example from Russia
during the late 1990s.
Political and social unrest may also result in economic collapse, which can render a firm's
assets worthless. This occurred to many foreign companies' assets as a result of the bloody
war following the breakup of the former Yugoslavia. In less extreme cases, political changes
may result in increased tax rates, the imposition of exchange controls that limit or block a
subsidiary's ability to remit earnings to its parent company, the imposition of price controls,
and
government interference in existing contracts. The likelihood of any of these events impairs
the attractiveness of a foreign investment opportunity.
Many firms devote considerable attention to political risk analysis and to quantifying
political risk. Euromoney magazine publishes an annual country risk rating, and
businesses
widely use its assessments of political and other risks. The problem with all attempts to
forecast political risk, however, is that they try to predict a future that can only be guessed at
and in many cases, the guesses are wrong. Few people foresaw the 1979 Iranian
revolution,
the collapse of communism in Eastern Europe, the dramatic breakup of the Soviet Union, or
the
terrorist attack on the World Trade Center in September 2001, yet all these events have had
a
profound impact on the business environments of many countries. This is not to say that
political risk assessment is without value, but it is more art than science.
Economic Risk
Like political risk, we first encountered the concept of economic risk in Chapter 2. There we
defined it as the likelihood that economic mismanagement will cause drastic changes in a
country's business environment that hurt the profit and other goals of a business enterprise.
In
practice, the biggest problem arising from economic mismanagement has been inflation.
Historically, many governments have expanded their domestic money supply in misguided
attempts to stimulate economic activity. The result has often been too much money chasing
too few goods, resulting in price inflation. As we saw in Chapter 9, price inflation is reflected
in a
drop in the value of a country's currency on the foreign exchange market. This can be a
serious
problem for a foreign firm with assets in that country because the value of the cash flows it
receives from those assets will fall as the country's currency depreciates on the foreign
exchange market. The likelihood of this occurring decreases the attractiveness of foreign
investment in that country.
There have been many attempts to quantify countries' economic risk and long-term
movements in their exchange rates. (Euromoney's annual country risk rating also
incorporates
an assessment of economic risk in its calculation of each country's overall level of risk.) As
we
saw in Chapter 9, there have been extensive empirical studies of the relationship between

countries' inflation rates and their currencies' exchange rates. These studies show that there
is a long-run relationship between a country's relative inflation rates and changes in
exchange
rates. However, the relationship is not as close as theory would predict; it is not reliable in
the
short run and is not totally reliable in the long run. So, as with political risk, any attempts to
quantify economic risk must be tempered with some healthy skepticism.

RISK AND CAPITAL BUDGETING

In analyzing a foreign investment opportunity, the additional risk that stems from its location
can be handled in at least two ways. The first method is to treat all risk as a single problem
by
increasing the discount rate applicable to foreign projects in countries where political and
economic risks are perceived as high. Thus, for example, a firm might apply a 6 percent
discount rate to potential investments in Great Britain, the United States, and Germany,
reflecting those countries' economic and political stability, and it might use a 20 percent
discount rate for potential investments in Russia, reflecting the greater perceived political
and
economic risks in that country. The higher the discount rate, the higher the projected net
cash
flows must be for an investment to have a positive net present value.
Adjusting discount rates to reflect a location's riskiness seems to be fairly widely practiced.
For example, several studies of large U.S. multinationals have found that many of them
routinely add a premium percentage for risk to the discount rate they used in evaluating
potential foreign investment projects.6 However, critics of this method argue that it penalizes
early cash flows too heavily and does not penalize distant cash flows enough.7 They point
out
that if political or economic collapse were expected in the near future, the investment would
not occur anyway. So for any investment decisions, the political and economic risk being
assessed is not of immediate possibilities, but rather at some distance in the future.
Accordingly, it can be argued that rather than using a higher discount rate to evaluate such
risky projects, which penalizes early cash flows too heavily, it is better to revise future cash
flows from the project downward to reflect the possibility of adverse political or economic
changes sometime in the future. Surveys of actual practice within multinationals suggest that
the practice of revising future cash flows downward is almost as popular as that of revising
the
discount rate upward.8