Step 4) Determination the risk and discount rate
In these parts I am going to have a good look the problems of cash flows forecasted and I have a good look situations which is understand as situations that appropriate for methods. It is ad hoc method. In this part I am going to contemplate how the risk is to take into consideration to the contract (invest project). Of course I mean the discount rate which I use when I calculate NPV. The opportunity cost of capital depends on the risk of the project.
Figure 2.7
The most important problem is how risk is defined, what the links are between risk and opportunity cost of capital, and how decision maker can cope with risk in practical situation. Handling all levels of risks is very important in cross-border transactions. There are same risks:
| GLOBAL RISKS - World economy - Geopolitics - Financial markets COUNTRY RISKS INCLUDE F/X - Macro and micro BANK SYSTIM RISKS - Individual bank INDUSTRY RISKS - Individual company EXTRAORDINARY RISKS - Terrorism “the unthinkable” | CORPORATE BUSINESS RISKS - Revenue/expenses demand & supply - Market and competition - Flexibility to meet change management competence - Running operation CORPORATE FINANCIAL RISKS - F/x and interest - Availability - Transportation - Counterparty risks |
Figure 2.8
The risk that potentially can be eliminated by somehow is a unique risk. Unique risk stems from the fact that many of the perils that surround an individual company are peculiar to that company and perhaps it immediate competitors. But there is some risk that we can not avoid. This risk generally knows as market risk. Market risk stems from the fact that there are other economy wide perils that threaten all businesses. The market risk is measured by β.
The development of modern theories linking risk and return, decision maker adjusted for risk in capital budgeting. They understand that risky projects are less valuable than safe one. Therefore they demanded higher rate of return from risky projects, or they based their decision about risky project on conservative forecasts cash flow.
Most companies start with the company cost of capital as a benchmark risk-adjusted discount rate for new investment. The company cost of capital is the opportunity cost of capital for investment in the firm as whole. It is usually calculated as a weighted average cost of capital, that is, the average rate of return demanded. In part two we considered how to value a capital investment project by a four-step:
1. Forecast after-tax cash flows.
2. Asses the project’s risk.
3. Estimate the opportunity cast of capital.
4. Calculate NPV, using the opportunity cost of capital as the discount rate.
Now we are going to include value contributed be invest decisions. There are adjusting the discount rate. The adjustment is typically downward, to account for value interest tax shields. This is approach, which is implemented via the after-tax weighted-average cost of capital (WACC).
Country risk analysis
When the company has cross-border transactions from the home to abroad there is uncertainty and risk higher than in home market. Even with good information with lot of figures and indicators it is difficult to make conclusions in another country than in home country market. This additional risk that appears a firm does cross-border business transaction or transaction between foreign countries is counter risk.
Obviously, companies find it important to calculate and forecast country risk and find strategies to reduce its impact. Because of globalization the value cross-border transaction market is growing. That is why the companies that want to stay competitive have to widen the activities beyond their home markets to foreign market. Most firms become exposed to country risk and want to evaluate it and reduce it.
The concept of country risk used commonly classifications of the world’s country. Such classifications reflect level of a country GDP, growth in its GDP and the structural development. They also reflect different challenges in risk assessment.
Country risk has an equally strong bearing on exporting and importing activities as well as on all contractual cross-border agreement. Country risk depend on what kind of transaction is contemplated which branch of industry is concerned, the geographical location of activities etc.
The country risk is subdivided into five components – political risk, financial risk, economic risk, social risk and transaction (micro) risk. All companies need a strategy for its cross-border market expansion. Analyses of country risks provide the business intelligence for global market expansion strategy. Sometime it is very difficult estimate the country risk there are a lot of problems for example with objective information’s but analytical efforts and critical mood always a strong platform for decision than doing nothing.
Information needed for country analysis can be produced in several ways. Hard statistical information can be found through desk research. Economic and financial information can be found in written report from several organizations for exampleу Organization for Economic Cooperation and Development (OECD), International Bank for Reconstruction and Development (IBRD), International Monetary Found (IMF) est. Specialized country risk institutions published country risk information as well as ratings and assessment of political, financial and social risk.
There are lot of methods to acquire information for example trade promotions organizations like Trade Council or Import-Export Agencies, consultation with “experts”, the Delphi technique, the scenario technique, making checklist is widely used method, and econometric models.
There are same international institutions with focus on country risk:
- Business Environment Risk Intelligence (BERI). DERI produces Index called “Profit Opportunity Recommendations” (POR), “Political Risk Index” is based on ten political and social variables, and “Operating Risk Index” is created from 15 economic, finance and structural variables.
- Country Risk Group (CRG). This institute makes projections based on macro risk. There are Political Risk, Security Risk, and Travel Risk.
- Economic Intelligence Unit (EIU) have the department the “Country Risk Services”(CRS).EIU assesses a composite country risk on the basis four types of risk – political risk(22%), economic risk (28%), economic structure risk (27%), and Liquidity Risk (23%). Ratings are on a scale A-E.
- Euromoney provides a full country risk ratings based on nine variables – economic risk (25%), political risk (25%), debt indicator (10%), debt in default (10%), credit ratings (10%), access to bank finance (5%), access to short-term finance(5%), access to capital market (5%), and discount on forfeiting (5%). Ratings are made on a 1-10 scale. Euromoney also composes a Corruption, Perception index with data from Transparency International.
- Political Risk Services Group (PRSG) published two systems for evaluating the country risk faced by global business. PRS deals with risk related to the general business climate as to regime stability, turmoil, financial transfer, direct investment, and export. The International Country Risk Guide System (ICRS) the composite country risk index is created by dividing the sum of three by tow. Thus, formula used is:
CPFER= 0.5(PR+FR+ER) (2.10)[12]
CPFER - composite political, financial, and economic risk ratings.
PR – total political risk indicator
FR – total financial risk indicator
ER - total economic risk indicator
In the end, there is same useful website about country risk www.globalfindata.com, www.econ.yale.edu/~shiller, finance.yahoo.com, www.duke.edu/~charvey, www.prsgroup.com, www.economist.com, www.ebrd.com, www.worldbank.com, www.bis.org, www.aig.com.