Table 20.1

Euromoney Magazine's Country Risk Ratings

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 political and economic turmoil 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, a study of large US multinationals found that 49 percent of them routinely added a premium percentage for risk to the discount rate they used in evaluating potential foreign investment projects.⁴ However, critics of this method argue that it penalizes early cash flows too heavily and does not penalize distant cash flows enough.⁵ They point out that if political or economic collapse were expected in the near future, the investment would not occur anyway. (This is borne out today in the case of Russia; Western companies are not investing there because they perceive the imminent danger of political and economic collapse.) So for any investment decisions, the political and economic risk being assessed is not of immediate possibilities, but rather of 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.⁶

Financing Decisions

When considering its options for financing a foreign investment, an international business must consider two factors. The first is how the foreign investment will be financed. If external financing is required, the firm must decide whether to borrow from sources in the host country or elsewhere. The second factor is how the financial structure of the foreign affiliate should be configured.

Source of Financing

If the firm is going to seek external financing for a project, it will want to borrow funds from the lowest-cost source of capital available. As we saw in Chapter 11, firms increasingly are turning to the global capital market to finance their investments. The cost of capital is typically lower in the global capital market, by virtue of its size and liquidity, than in many domestic capital markets, particularly those that are small and relatively illiquid. Thus, for example, a US firm making an investment in Denmark may finance the investment by borrowing through the London-based eurobond market rather than the Danish capital market.

However, host-country government restrictions may rule out this option. The governments of many countries require, or at least prefer, foreign multinationals to finance projects in their country by local debt financing or local sales of equity. In countries where liquidity is limited, this raises the cost of capital used to finance a project. Thus, in capital budgeting decisions, the discount rate must be adjusted upward to reflect this. However, this is not the only possibility. In Chapter 8, we saw that some governments court foreign investment by offering foreign firms low-interest loans, lowering the cost of capital. Accordingly, in capital budgeting decisions, the discount rate should be revised downward in such cases.

In addition to the impact of host-government policies on the cost of capital and financing decisions, the firm may wish to consider local debt financing for investments in countries where the local currency is expected to depreciate on the foreign exchange market. The amount of local currency required to meet interest payments and retire principal on local debt obligations is not affected when a country's currency depreciates. However, if foreign debt obligations must be served, the amount of local currency required to do this will increase as the currency depreciates, and this effectively raises the cost of capital. (We looked at this issue in Chapter 11 when we considered foreign exchange risk and the cost of capital.) Thus, although the initial cost of capital may be greater with local borrowing, it may be better to borrow locally if the local currency is expected to depreciate on the foreign exchange market.