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 receive--as opposed to those the project generates--because 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 Economical Risk

When analyzing a foreign investment opportunity, the company must consider the political and economic risks that stem from the foreign location. We will discuss these before looking at how capital budgeting methods can be adjusted to take risks 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 US firms after the Iranian revolution of 1979. Social unrest may also result in economic collapse, which can render worthless a firm's assets. This has 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. For example, Union Carbide, the US multinational chemical giant, has an elaborate procedure for incorporating political risk into its strategic planning and capital budgeting process.³ Euromoney magazine publishes an annual "country risk rating," which incorporates assessments of political and other risks (see Table 20.1 and the associated description). 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, or the dramatic breakup of the Soviet Union, yet all these events have had a profound impact on the business environments of the countries involved. This is not to say that political risk assessment is without value, but it is more art than science.