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 Long-Term Asset and Liability
Part 4 Management
Existing host
country tax laws
Estimated cash
flows of
Potential Revision multinational
in Host country tax Exchange rate
projections project
laws or other
provisions

Country risk Multinational cash

analysis budgeting decisions
MNC’s access to
foreign financing

MNC’s cost of
capital
Required return on
multinational
International project
interest rates on Risk unique to
long-term funds multinational
project
 Chapter 16

Country Risk Analysis

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Chapter Objectives
• Identify the common factors used by MNCs to measure a country’s political
risk and financial risk.
• Explain the techniques used to measure country risk.
• Explain how MNCs use the assessment of country risk when making
financial decisions.

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 Why Country Risk Analysis is
Important (1)
• Country risk represents the potentially adverse impact of a country’s political and
financial 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 or
to continue conducting business in a particular country

• Financial managers must understand:

how to measure country risk and
incorporate country risk within their capital budgeting analysis
so that they can make investment decisions that maximize their MNC’s value

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Valuation Model for an MNC
(Chapter 1)
m 
n 

E CFj , t E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t )= expected cash flows denominated in currency j
to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to dollars at the end of period t
k = the weighted average cost of capital of the whole
MNC
CF1*ER1 CF2*ER2 CFn*ERn
NPV = + +...+ - IO
(1+k)
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1
(1+k) 2
(1+k) n
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Why Country Risk Analysis Is
Important (2)
• Country risk analysis can be used:
o To devise a risk management strategy appropriate for a country
o As a screening device to avoid conducting business in countries with excessive
risk
o To revise its investment or financing decisions considering recent events.

• Types of country risk:

Political Risk
Financial Risk

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 Political Risk (1)
• Caused by the political events or actions of the Govt. of the host country

An extreme form of political risk is the possibility that the host country will
take over a subsidiary.

1. Peaceful Expropriation: In some cases, compensation is awarded in an

amount determined by the host country's government.

2. Forced Expropriation: In other cases, the govt. the company’s assets are
seized without providing adequate compensation.

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 Political Risk (2)
1) Peaceful Expropriation (with compensation)
• Example: Venezuela’s oil industry nationalization (2007)
President Hugo Chávez’s government took control of several foreign-owned oil
projects.
Companies like Total (France) and Statoil (Norway) accepted the government’s terms
and received compensation.

2) Forced Expropriation (without compensation)

• Example: Cuba (1959–1960)
After the Cuban Revolution, Fidel Castro’s government seized U.S.-owned sugar
mills, banks, and utilities without compensation.
The U.S. government later imposed an embargo in response.

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Political Risk Factors (1)
1) Attitude of consumers in the host country,
2) Actions of host government,
3) Blockage of fund transfers,
4) Currency inconvertibility,
5) War
6) Inefficient bureaucracy, and
7) Corruption

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 Political Risk Factors (2)
• Attitude of consumers in the host country
o All countries tend to encourage consumers to purchase from locally
owned-manufacturers
o Examples: More Huawei phones in China, Fewer Japanese cars in South
Korea, fewer US agricultural products in Europe

A mild form of political risk for exporters.

Even if exporter decides to set up a subsidiary, consumer preference for
domestic products could limit its success.
In this case, a joint venture with a local company may be more feasible
than an exporting strategy.

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 Political Risk Factors (3)
• Actions of the host government
o The host government may enact laws that serve local companies:

Impose special environmental restrictions that affect production costs (e.g.,

Pollution control standards, carbon emission, water treatment)

Impose additional corporate taxes (e.g., VAT, Withholding Tax)

MNCs can also be hurt by a lack of piracy restrictions, such as failure to enforce
copyright laws.

Strict labor laws (e.g., minimum wage, social security benefits)

Host govt. may take actions against an MNC’s operations in that country in
Forretaliation forFinancial
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Google Restriction in China

Closure of McDonald's restaurants in Russia

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Political Risk Factors (4)
• Blockage of fund transfers
o Subsidiaries of MNCs often send funds back to headquarters for loan
repayments, purchases of supplies, administrative fees or for remitting earnings.
o Subsidiaries will have to undertake projects (reinvest earnings) in the host
country that may not be optimal for the MNC (e.g., UAE: 10% of earnings in reserve).

• Currency inconvertibility
o Some governments do not allow the home currency to be exchanged into other
currencies (e.g., Malaysian credit controls after Asian crisis 1997).
o Some governments only allow currency exchanges from the govt. approval
retailers (e.g., Chinese Banks)

o Limiting the volume of currency that may be converted.

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Political Risk Factors (5)
• Threat of War
o Conflicts with neighboring countries or internal turmoil may jeopardize the safety of
employees who attempt to establish export markets for the MNC
 Landlocked Switzerland has good neighbors (rule of law, stable economies, trade).
 Landlocked Uganda has hostile neighbors (e.g., Rwanda genocide in the 90s, DR Congo, South
Sudan)

o Threat of war leads to volatile business cycles (economic instability), which makes
cash flows generated from such countries more uncertain.

• Inefficient Bureaucracy
o Bureaucracy can delay an MNC’s efforts to establish a new subsidiary
 Government employees expect “gifts” before they approve applications by MNCs.
 Lack of government organization (structure) may delay the approval process as it has to
go through different sections of the bureaucracy.
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Political Risk Factors (6)
• Corruption
o Corruption can occur at firm level (insider) or with firm-government interactions
For example, an MNC may lose revenue because a government contract is awarded
to a local firm that paid off (bribe) a government official.

o Corruption can increase the cost of conducting business or reduce revenue.

o Laws defining corruption and their enforcement vary among countries

In the United States, for instance, it is illegal to pay a high-ranking government
official in return for political favors, but it is legal for U.S. firms to contribute to a
politician’s election campaign.

o Transparency International has derived a corruption index for most countries

(see [Link]).
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Corrupti
on
Percepti
on index
2022

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Political Risk Factors (7)
• Government Ownership
• Some governments maintain ownership in firms that are major exporters and
therefore may restrict any foreign investments.
 The Chinese government has granted billions of dollars of subsidies over the years to its
auto manufacturers and auto parts suppliers.
 The U.S. government bailed out General Motors in 2009 by investing billions of dollars
to purchase a large amount of its stock.

• Country Security Laws

• Governments may impose certain restrictions when national security is a
concern, which can affect on trade.
 For example: Govt. can restrict the export of military equipment to a hostile county

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 Political Risk Factor Description Example
Government Stability The likelihood that the government remains in power without Venezuela’s frequent political
disruptions or collapse. upheavals.
Govt. Change and Policy The potential for changes in government, leading to shifts in US-China trade policy changes
Shifts economic or trade policies. post-2016 election.
Corruption and High levels of corruption or inefficiency within government Nigeria's ranking in the
Bureaucracy institutions that can increase business costs. Corruption Perception Index.
Risk of terrorism, civil unrest, or war disrupting business Ongoing conflicts in Syria
Political Violence operations. affecting business continuity.
Expropriation and The possibility of government seizing private businesses or Argentina’s nationalization of
Nationalization investments. YPF in 2012
Foreign Relations and Diplomatic tensions or sanctions that limit trade or business Sanctions imposed on Russia
Sanctions operations. affecting global businesses
Trade and Investment Changes in trade agreements, tariffs, or restrictions on foreign Brexit impacting trade with the
Policies direct investment. EU.
Judicial System and Rule of Weaknesses in the legal system, including difficulties enforcing Inconsistent property rights
Law contracts and property rights. enforcement in Zimbabwe.
Unpredictable changes in regulations, such as new labour laws or Brazil's fluctuating
Regulatory Changes environmental standards. environmental regulations.
Sudden tax increases or fiscal policy changes that can impact India’s retrospective tax policy
Tax Policy and Fiscal Risks profitability. dispute with Vodafone.

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Political Risk Factors
(8)
‘Does political risk deter FDI inflow? An analytical approach using panel data
and factor analysis’, Goswami, G. G. and Haider, S. Journal of Economic Studies,
Vol. 41 No. 2, 2014, pp. 233-252.

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Financial Risk Factors (1)
• Related to the economic growth of the host country

o The current and potential state of a country’s economy is important since a

recession can severely reduce demand for MNC products.

MNCs like 3M, DuPont, IBM, and Nike, were adversely affected by a weak
European economy in the 2008–2010 period.

o A country’s economic growth is dependent on several financial factors:

 Interest rates
Exchange rates,
Inflation, etc.
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Financial Risk Factors (2)
• Interest Rates
High interest rates can discourage borrowing by firms (investments) and by
consumers (spending) and thus can reduce the demand for MNC’s products.
Governments commonly attempt to maintain low interest rates when they want to
stimulate the economy.

• Exchange rates
A weak currency of a foreign country may reduce the demand for the MNC’s exports
to that country
A weak currency also reduces MNC’s earnings when remitted to the parent company

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Financial Risk Factors (3)
• Inflation
Inflation can affect consumers’ purchasing power and their demand for an MNC’s
goods.
In addition, it affects the MNC’s expenses associated with operations in the country.

• Fiscal Policy (Revenue Vs. Spending)

Some countries use expansionary fiscal policies that involve massive spending and
low taxes revenues to stimulate their economy.
 However, this type of policy results in a large national budget deficit and therefore
increases the amount of funds borrowed by the government (T-bills, T-Bonds).
 For MNCs, it becomes difficult to borrow money as it increases the interest rates.
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Financial Risk Factors (4)
• Fiscal Policy: A Case of Greece

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Financial Risk Factors (5)
• Other financial risk factors
Industry competition
Industry growth
National income
Cost of labor and other resources

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 Financial Risk Factor Description Example
The risk that fluctuations in the exchange rate will Companies holding assets in a volatile
Exchange Rate Risk negatively impact business transactions. currency like the Argentine peso.
The risk that changing interest rates will affect the cost of Impact of rising interest rates on
Interest Rate Risk borrowing or investment returns. businesses with high debt in the US.
The risk that rising inflation will erode the value of Hyperinflation in Zimbabwe causing
Inflation Risk returns or increase operational costs. business instability.
Sovereign Debt Risk The risk that a country may default on its national debt, Greece's debt crisis in 2009 causing
impacting its ability to attract foreign investment. investor uncertainty.
The risk that borrowers may default on their obligations, High credit risk in emerging markets with
Credit Risk leading to financial losses for lenders or investors. weak credit ratings.
Capital Flight Risk The risk that large-scale withdrawal of capital from a Russia experiencing capital flight during
country will destabilize its economy. sanctions.
The risk of losses due to fluctuations in financial markets, Stock market crash in the US in 2008
Market Risk including stock markets and bond markets. affecting global investors.
Banking Sector Stability The risk that the country’s banking system may collapse, Cyprus banking crisis in 2013 affecting
leading to loss of savings and credit availability. investor confidence.
The risk of government restrictions on currency China’s capital controls limiting foreign
Foreign Exchange Controls conversion or movement of capital across borders. currency exchange.
The risk that a country may restrict or delay the Venezuela restricting profit repatriation
Repatriation Risk repatriation of profits earned by foreign companies. for foreign investors.
The risk of sudden or unpredictable changes in taxation India’s retrospective tax disputes with
Taxation Risk policies that could affect profitability. foreign companies like Vodafone.

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Most critical risk to firm operations %
Country’s Risk
Govt. Regulations / legal decisions
Currency interest rate volatility
64
51
Factors
Political and social disturbances 46
Corporate Governance 30
Survey of top 1,000 multinationals (2004) –
Absence of rule of law 29
Theft of intellectual property 28 percentage of total respondents listing item as a
Terrorist attack 26 critical risk
Security threats to employees and assets 26
Source: FDI Confidence Index, Copyright A.T.
Disruption of key supplier/customer/partner 23 Kearney, 2004. All rights reserved. Reprinted with
Product quality and safety problems 20 permission
IT disruption 19
Employee fraud or sabotage 10
Natural disasters 6
Activist attacks on global or corporate brands 5
Types of Country Risk Assessment
(1)
• A macro-assessment of country risk is an overall risk assessment of a
country except those that are unique to a particular firm or industry.

• A micro-assessment of country risk is the risk assessment of a country that

relates to the MNC’s type of business (e.g., Exports, FDI).

• The overall assessment thus consists of macro-political risk, macro-

financial risk, micro-political risk, and micro-financial risk.

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Types of Country Risk Assessment
(2)

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Techniques of Assessing Country
Risk (1)
• Once a firm identifies all the macro- and micro-factors of country risk
assessment, it may wish to implement a system for evaluating these factors
and determining a country risk rating.

• Various techniques are available to achieve this objective.

• Among the most popular techniques are the following:

Checklist approach,
Delphi technique,
Quantitative analysis,
Inspection visits, and
Combination of techniques.
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 Measuring Country Risk
• Checklist Approach: (Macro-assessment)
o A list of financial and political risk factors for assessing the country’s risk is
identified.
o Numerical values (low risk 1 - high risk 5) and weights (relative degree of
importance) are then assigned to these factors
 Factors with a greater risk (what is the actual situation of factor? - - > Good/Bad)
should be assigned higher numerical values.
 Factors with a greater importance (what factor matters most? - - > Firm’s
priority) are assigned greater weights.
o The assigned numerical values of factors are multiplied by their respective
weights to derive overall political and financial risk ratings.

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Measuring Country Risk (2)
• Checklist approach (Micro-assessment)

o Next, the weights are assigned to the overall political and financial ratings
according to their relative importance to the specific project of MNC.
 An MNC considering direct foreign investment in a foreign country must be highly
concerned about political risk (e.g., Expropriation, Blockage of funds, Taxes)
 An MNC planning to export the goods to that country should be more concerned with
financial risk (e.g., Exchange rate, inflation, interest rate, national income)

o Multiplying the overall political and financial ratings with their weights and
summing up to give the overall country risk rating.

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Exercise: Checklist Approach (Mexico)

Cougar
considers
projects only in
countries that
have a rating of
less than
3.3

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Assigning ratings and weight
to political and financial risk Determining the Relative
factors Importance of factors
Ratings
Political Factors (1 low risk – 5 high risk) Weights

Blockage of funds
transfer 3 20%
Bureaucracy 4 40%
Corruption 5 20%
Security issues related
to drug-trafficking 3 10%
Attitude of customers 4 10%
Ratings
Financial Factors (1 low risk – 5 high risk)

Interest rate 3 20%

Inflation rate 4 10%
Exchange Rate 3 20%
Labor market
conditions 1 10%
Industry growth 2 40%
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 1 2 3 4=2x3

Solution POLITICAL RISK

FACTORS
RATING ASSIGNED BY COMPANY TO
FACTOR
(WITHIN A RANGE OF 1–5)
WEIGHT ASSIGNED BY COMPANY TO
FACTOR ACCORDING TO IMPORTANCE
WEIGHTED VALUE OF FACTOR

Blockage of fund transfers 3 20% 0.6

Bureaucracy 4 40% 1.6
Corruption 5 20% 1.0
Security issues 3 10% 0.3
Attitude of customer 4 10% 0.4
100% 3.9
= Political Risk Rating
FINANCIAL RISK
Cougar FACTORS
considers Interest rate 3 20% 0.6
projects only in Inflation rate 4 10% 0.4
countries that Exchange rate 3 20% 0.6
have a rating of Labor market conditions 1 10% 0.1
less than Industry Growth 2 40% 0.8
3.3, therefore, 100% 2.5
it decides not = Financial Risk Rating
to pursue the 1 2 3 4=2x3

project in CATEGORY RATING AS DETERMINED ABOVE WEIGHT ASSIGNED BY COMPANY WEIGHTED RATING
TO EACH RISK CATEGORY
Mexico.
Political risk 3.9 80% 3.12
Financial risk 2.5 20% 0.50
3.62
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Measuring Country Risk (3)
• Checklist Approach (Cont.…)
o Note that there is clearly a degree of subjectivity in:

I. Identifying the relevant political and financial factors

II. Predicting the numerical values (risk level) of factors that cannot be
measured objectively.
III. Determining the relative importance (weight) of each factor

Some factors (such as real GDP growth) can be measured objectively from
available data.
Other factors (such as probability of entering a war) must be subjectively
measured.
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Measuring Country Risk (4)
• Checklist Approach (Cont.…)

• The procedures for quantifying country risk will vary with:

The assessor
The country being assessed, and
Type of operations being planned.

• Firms use country risk ratings when screening potential projects, and when
monitoring existing projects.

• A substantial amount of information about countries is available on the Internet.

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 Example 2 (Country Risk Analysis of
France) Ratings
Political Factors (1 low risk – 5 high risk) Weights

Blockage of funds
transfer 1 5%
Bureaucracy 3 30%
Labor laws &
unions 2 20%
Social Unrest 3 30%
Government
Instability 5 15%
Ratings
Financial Factors (1 low risk – 5 high risk)

Interest rate 2 15%

Inflation rate 2 20%
Exchange Rate 2 20%
Tax Burden 3 25%
Debt to GDP Ratio 4 20%
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 1 2 3 4=2x3

Solution POLITICAL RISK

FACTORS
RATING ASSIGNED BY COMPANY TO
FACTOR
(WITHIN A RANGE OF 1–5)
WEIGHT ASSIGNED BY COMPANY TO
FACTOR ACCORDING TO IMPORTANCE
WEIGHTED VALUE OF FACTOR

Blockage of fund transfers 1 5% 0.05

Bureaucracy 3 30% 0.90
Labor laws and unions 2 20% 0.40
Social Unrest 3 30% 0.90
Government instability 5 15% 0.75
100% 3.00
= Political Risk Rating
FINANCIAL RISK
FACTORS
Interest rate 2 15% 0.30
Inflation rate 2 20% 0.30
Exchange rate 2 20% 0.40
Tax Burden 3 25% 0.75
Debt to GDP ratio 4 20% 0.80
100% 2.55
= Financial Risk Rating
1 2 3 4=2x3
CATEGORY RATING AS DETERMINED ABOVE WEIGHT ASSIGNED BY COMPANY TO WEIGHTED RATING
EACH RISK CATEGORY

Political risk 3.00 80% 2.40

Financial risk 2.55 20% 0.51
2.91
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Techniques of Assessing Country
Risk (2)
• Delphi technique:
• Involves collecting various independent opinions from specific employees or
outside consultants who have some expertise in assessing a given country’s risk
characteristics.

• The MNC attempts to determine some consensus opinions about the country’s
perceived risk.

• The firm then sends this summary of the survey back to the survey respondents
and asks for additional feedback regarding its summary of the country’s risk.
• The experts are allowed to adjust their answers in the subsequent rounds.

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Techniques of Assessing Country
Risk (3)
• Quantitative analysis techniques
• Techniques such as regression analysis can be applied to historical data
to assess the sensitivity of the business to various risk factors.
For example, a firm could regress a measure of its business activity (e.g.,
percentage increase in sales) against country financial characteristics
(e.g., real growth in GDP) over a series of previous months or quarters.

• The historical trends of various country characteristics are not always useful
for anticipating an upcoming crisis.

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Techniques of Assessing Country
Risk (4)
• Inspection visits
• Involve traveling to a country and meeting with government officials,
firm executives, and consumers to clarify uncertainties.

• Indeed, some variables (such as culture) may be difficult to assess

without a trip to the host country.

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Techniques of Assessing Country
Risk (5)
• Combination of Techniques
• Often, firms use a variety of techniques for making country risk
assessments.

• For example, they may use the checklist approach to develop an overall
country risk rating, and some of the other techniques (Delphi technique)
to assign weights to the factors.

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Comparing Risk Ratings Among
Countries
• One approach to comparing political and financial ratings among countries
is the foreign investment risk matrix (FIRM).

• The matrix displays financial (or economic) and political risk by intervals
ranging from ‘poor’ to ‘good’.

• Each country can be positioned on the matrix based on its political and
financial ratings.

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Actual Country Risk Ratings Across
Countries
Interest rates and credit ratings 2018
Country/Region Rating Interest rate Country/Region Rating Interest rate
Switzerland AAA 0.0 Australia AAA 2.7
Japan A+ 0.1 New Zealand AA 2.8
Germany AAA 0.5 United States AA+ 3.0
Sweden AAA 0.6 Saudi Arabia A- 3.2
Finland AA+ 0.7 South Africa BB+ 3.2
France AA 0.8 Greece B+ 4.2
Ireland A+ 1.1 Russia BBB- 8.2
Spain A- 1.4 Kenya B+ 8.3
United Kingdom AA 1.5 Nigeria B 8.5
Canada AAA 2.3 Ghana B- 11.0
Italy BBB 2.6 Egypt B 16.8

Note: Interest rates are of 10-year government bonds, inflation is based on Consumer Price Index
Source: EIU
Incorporating Country Risk in Capital
Budgeting (1)
• If the risk rating of a country is acceptable, the projects related to that
country deserve further consideration.

• Country risk can be incorporated into the capital budgeting analysis of a

proposed project either by:

1. Adjusting the discount rate, or

2. Adjusting the estimated cash flows through inputs.

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Incorporating Country Risk in Capital
Budgeting (2)
• Adjustment of the discount rate
o The higher the perceived country risk, the higher the discount rate that
should be applied to the project’s cash flows.

o This approach is convenient in that one adjustment to the capital budgeting

analysis can capture country risk.

o However, there is no precise formula for adjusting the discount rate to

incorporate country risk.

o The adjustment is somewhat arbitrary and may therefore cause feasible

projects to be rejected or infeasible projects to be accepted.
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 Adjustme
nt
in
Discount
Rate

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Incorporating Country Risk in Capital
Budgeting (3)
• Adjustment of the estimated cash flows
o By estimating how the cash flows could be affected by each form of country
risk (through change inputs), the MNC can determine the probability
distribution (events, probabilities) of the net present value of the project.

o Acceptance/rejection decisions on the project will be based on its assessment

of the probability that the project will generate a positive NPV and of the size
of possible NPV outcomes.

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Adjustment of country risk
factors

Example:
Tax deductible Expense Capital
Budgeting
Analysis:
Add back Depreciation Spartan Ltd.

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Capital Budgeting Analysis: Spartan Ltd. (After
adjustment)

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Capital Budgeting Analysis: Spartan Ltd. (After
adjustment)

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Capital Budgeting Analysis: Spartan Ltd. (After
adjustment)

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Adjustment in country risk factors: Spartan
Ltd.
Withholding Tax

Salvage Value

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Spartan, Ltd: Summary of Estimated NPVs
Across Possible Scenarios
 Advance Question: 19

Withholding Tax Salvage Value

Possible Tax Probability of
Possible Tax Probability of Rate Outcome
Rate Outcome Outcome Occurring Outcome Occurring
0% 80% 300,000 dinar 50%
10% 20% 100,000 dinar 50%
100% 100%

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
 Advance Question: 20

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Applications of Country Risk
Analysis (1)
• As a result of the crisis that culminated in the Gulf War in 1991, many
MNCs reassessed their exposure to country risk and revised their
operations accordingly.

• The 1997–1998 Asian crisis caused MNCs to realize that they had
underestimated the potential financial problems that could occur in the
high-growth Asian countries.

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Applications of Country Risk
Analysis (2)
• The largest project financed by the International Financial Corp. (IFC) is the
$1.34 billion Mozal aluminum smelter in Mozambique.
• The IFC’s investment in the smelter involves the extension of $133 million
of credit, which is more than Mozambique’s annual GDP.
• The credit risk of the government of Mozambique is very high, as is the
political risk inherent in the project, especially since the country has
experienced 20 years of civil war.
• The project is managed by Mitsubishi, BHB Billiton, and the Industrial
Development Corp. of South Africa.
• The plant and the aluminum output serve as collateral for the loan.
• The project has had a major impact on the economy of Mozambique.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Reducing Exposure to Host
Government Takeovers (1)
• The potential benefits of FDI can be offset by country risk, the most severe of
which is a host government takeover.

• To reduce the chance of a takeover by the host government, firms often:

• Use a short-term horizon

Rely on Unique Supplies or Technology
Hire Local Labor
Borrow Local Funds
Purchase Insurance
Use Project Finance (Special purpose vehicle)
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Reducing Exposure to Host Government
Takeovers (2)
• Use a short-term horizon
o This technique concentrates on recovering cash flow quickly so that losses are
minimized in the event of expropriation.
 An MNC may phase out its overseas investment by selling off its assets to local investors
or the government in stages over time

• Rely on unique supplies (resources) or technology (process)

o A subsidiary can bring in supplies from its headquarters (or a sister subsidiary) that
cannot be duplicated locally
o In this way, the host government will not be able to take over and operate the
subsidiary without those suppliers.

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Reducing Exposure to Host Government
Takeovers (3)
• Hire local labor
o The local employees can apply pressure on their government if they are
affected by the takeover.
o It is easy to hire local employees for a foreign company.

• Borrow local funds

o Government takeover would reduce the probability that the banks would
receive their loan repayments promptly
o The local banks can apply pressure on their government if they are affected
by the takeover

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Reducing Exposure to Host
Government Takeovers (4)
• Purchase insurance
o Investment guarantee programs offered by the home country, host country,
or an international agency insure to some extent various forms of country
risk.
o The World Bank has established an affiliate, called the Multilateral Investment
Guarantee Agency (MIGA) to provide political insurance for MNCs with direct
foreign investment in less developed countries.
o The U.S. government provides insurance through the Overseas Private
Investment Corporation (OPIC) to cover risk associated with country risk.

For use with International Financial Management,

5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox
Reducing Exposure to Host
Government Takeovers (4)
• Use project finance
o Separate business from MNC, highly leverage, limited equity
Many of the world’s largest infrastructure projects are structured as “project
finance” deals.
Project finance deals are heavily financed with credit often based on a separate
legal entity known as a Special Purpose Vehicle (SPV), therefore limiting the
MNC’s exposure.
The loans are secured by the project’s future revenues and are ‘non-recourse’ so
that the creditor is entitled only to the assets and cash flows of the project itself.
A host government is unlikely to take over this type of project because it would
have to assume the existing liabilities due to the credit arrangement.
For use with International Financial Management,
5th edn, ISBN 978-1-4737-7050-8 © Jeff Madura and Roland Fox