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Answers to End of Chapter Questions
1. Forms of Country Risk. List some forms of political risk other than a takeover of a subsidiary by the
host government, and briefly elaborate on how each factor can affect the risk to the MNC.
Identify common financial factors for an MNC to consider when assessing country risk. Briefly
elaborate on how each factor can affect the risk to the MNC.
ANSWER: Forms of political risk include the possibility of (1) blocked funds, (2) changing tax laws,
Financial factors include inflation, interest rates, GNP growth, and labor costs. These factors can
2. Country Risk Assessment. Describe the steps involved in assessing country risk once all relevant
information has been gathered.
ANSWER: First, a rating must be assigned to each factor. Then, a weight must be assigned. Finally,
3. Uncertainty Surrounding the Country Risk Assessment. Describe the possible errors involved in
assessing country risk. In other words, explain why country risk analysis is not always accurate.
ANSWER: Errors occur due to (1) assigning inaccurate ratings to factors and (2) weighting the
4. Diversifying Away Country Risk. Why do you think that an MNC’s strategy of diversifying projects
internationally could achieve low exposure to overall country risk?
ANSWER: If the MNC can set up foreign projects in countries whose country risk levels are not
5. Monitoring Country Risk. Once a project is accepted, country risk analysis for the foreign country
involved is no longer necessary, assuming that no other proposed projects are being evaluated for that
country. Do you agree with this statement? Why or why not?
ANSWER: Disagree! The country risk must be monitored continuously, since if risk becomes too
6. Country Risk Analysis. If the potential return is high enough, any degree of country risk can be
tolerated. Do you agree with this statement? Why or why not? Do you think that a proper country
risk analysis can replace a capital budgeting analysis of a project considered for a foreign country?
Explain.
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Country Risk Analysis 2
ANSWER: Disagree! If country risk is so high that there is great danger to employees, no expected
return is high enough to warrant the project.
7. Country Risk Analysis. Niagara, Inc., has decided to call a well-known country risk consultant to
conduct a country risk analysis in a small country where it plans to develop a large subsidiary.
Niagara prefers to hire the consultant since it plans to use its employees for other important corporate
functions. The consultant uses a computer program that has assigned weights of importance linked to
the various factors. The consultant will evaluate the factors for this small country and insert a rating
for each factor into the computer. The weights assigned to the factors are not adjusted by the
computer, but the factor ratings are adjusted for each country that the consultant assesses. Do you
think Niagara, Inc. should use this consultant? Why or why not?
ANSWER: No! The consultant’s program has not allowed for the weights on importance for each
8. Micro-Assessment. Explain the micro-assessment of country risk.
ANSWER: A micro-assessment of country risk assesses risk factors as related to the firm’s particular
9. Incorporating Country Risk in Capital Budgeting. How could a country risk assessment be used to
adjust a project’s required rate of return? How could such an assessment be used instead to adjust a
project’s estimated cash flows?
ANSWER: For countries with a lower country risk rating (implying high risk), the project’s required
10. Reducing Country Risk. Explain some methods of reducing exposure to existing country risk, while
maintaining the same amount of business within a particular country.
ANSWER: Some of the more common methods to reduce country risk are:
1. use a short-term horizon
2. hire local labor
These and other methods are discussed in the chapter.
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Country Risk Analysis 3
11. Managing Country Risk. Why do some subsidiaries maintain a low profile as to where their parents
are located?
ANSWER: Some subsidiaries are concerned that the public in the country where they are located
12. Country Risk Analysis. When NYU Corp. considered establishing a subsidiary in Zealand, it
performed a country risk analysis to help make the decision. It first retrieved a country risk analysis
performed about one year earlier, when it had planned to begin a major exporting business to Zenland
firms. Then it updated the analysis by incorporating all current information on the key variables that
were used in that analysis, such as Zenland’s willingness to accept exports, its existing quotas, and
existing tariff laws. Is this country risk analysis adequate? Explain.
ANSWER: No. A country risk analysis used for an exporting project incorporates different
13. Reducing Country Risk. MNCs such as Alcoa, DuPont, Heinz, and IBM donated products and
technology to foreign countries where they had subsidiaries. How could these actions have reduced
some forms of country risk?
ANSWER: When MNCs donate products and/or technology to foreign countries where they have
14. Country Risk Ratings. Assauer Inc. would like to assess the country risk of Glovanskia. Assauer has
identified various political and financial risk factors, as shown below.
Political Risk Factor Assigned Rating Assigned Weight
Blockage of fund transfers 5 40%
Bureaucracy 3 60%
Financial Risk Factor Assigned Rating Assigned Weight
Interest rate 1 10%
Inflation 4 20%
Exchange rate 5 30%
Competition 4 20%
Growth 5 20%
Assauer has assigned an overall rating of 80 percent to political risk factors and of 20 percent to
financial risk factors. Assauer is not willing to consider Glovanskia for investment if the country risk
rating is below 4.0. Should Assauer consider Glovanskia for investment?
ANSWER:
Determine the combined country risk rating:
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Country Risk Analysis 4
Since the weighted rating is below 4.0, Assauer will probably not consider the investment.
15. Effects of September 11. Arkansas Inc. exports to various less developed countries, and its
receivables are denominated in the foreign currencies of the importers. It considers reducing its
exchange rate risk by establishing small subsidiaries to produce products. By incurring some
expenses in the countries where it generates revenue, it reduces its exposure to exchange rate risk.
Since September 11, 2001, when terrorists attacked the U.S., it has questioned whether it should
restructure its operations. Its CEO believes that its cash flows may be less exposed to exchange rate
risk but more exposed to other types of risk as a result of restructuring. What is your opinion?
ANSWER: Arkansas Inc. could be more exposed to political risk as a result of establishing
Advanced Questions
16. How Country Risk Affects NPV. Hoosier, Inc., is planning a project in the United Kingdom. It
would lease space for one year in a shopping mall to sell expensive clothes manufactured in the U.S.
The project would end in one year, when all earnings would be remitted to Hoosier, Inc. Assume that
no additional corporate taxes are incurred beyond those imposed by the British government. Since
Hoosier, Inc., would rent space, it would not have any long-term assets in the United Kingdom, and
expects the salvage (terminal) value of the project to be about zero.
Assume that the project’s required rate of return is 18 percent. Also assume that the initial outlay
required by the parent to fill the store with clothes is $200,000. The pretax earnings are expected to
the £300,000 at the end of one year. The British pound is expected to be worth $1.60 at the end of
one year, when the after-tax earnings are converted to dollars and remitted to the United States. The
following forms of country risk must be considered:
The British economy may weaken (probability = 30%), which would cause the expected pretax
earnings to be £200,000.
The British corporate tax rate on income earned by U.S. firms may increase from 40 percent to 50
percent (probability = 20 percent).
These two forms of country risk are independent. Calculate the expected value of the project’s net
present value (NPV) and determine the probability that the project will have a negative NPV.
ANSWER: Sensitivity analysis can be used to measure the net present value under each possible
scenario, as shown in the attached exhibit. There are four possible scenarios. The most favorable
scenario is a strong British economy and a relatively low (40%) British tax rate. This scenario results
in after-tax dollar earnings of $288,000 in one year. The NPV is determined by obtaining the present
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Country Risk Analysis 5
The expected net present value of the project is positive. Yet, the NPV is expected to be negative for
The example was simplified in that the project has a planned life of only one year, and there was no
terminal value for the project. However, a more complicated example could be analyzed by using
EXHIBIT FOR QUESTION 16
Pretax Pound Earnings After-Tax Pound Earnings After-Tax Dollar Earnings Estimated NPV
British Corp.
Tax Rate=40% (Prob.=80%)
1.18 $200,000 $44,068
Strong British
Economy
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Country Risk Analysis 6
British Corp.
Tax Rate=50% (Prob.=20%)
1.18 $200,000 $3,390
British Corp.
1.18 $200,000 $ - 37,288
Weak British Economy
British Corp.
1.18 $200,000 $ - 64,407
17. How Country Risk Affects NPV. Explain how the capital budgeting analysis in the previous
question would need to be adjusted if there were three possible outcomes for the British pound along
with the possible outcomes for the British economy and corporate tax rate.
ANSWER: A simplification of the example provided is that only one expectation for the British
pound’s value was assumed. In reality, Hoosier Inc. may create a probability distribution for the
18. J.C. Penney’s Country Risk Analysis. Recently, JC Penney decided to consider expanding into
various foreign countries; it applied a comprehensive country risk analysis before making its
expansion decisions. Initial screenings of 30 foreign countries were based on political and economic
factors that contribute to country risk. For the remaining 20 countries where country risk was
considered to be tolerable, specific country risk characteristics of each country were considered. One
of JC Penney's biggest targets is Mexico, where it planned to build and operate seven large stores.
a. Identify the political factors that you think may possibly affect the performance of the JC Penney
stores in Mexico.
ANSWER: Perhaps the most likely political factor is the blockage of fund transfers or currency
b. Explain why the JC Penney stores in Mexico and in other foreign markets are subject to financial
risk (a subset of country risk).
ANSWER: The economy in Mexico is volatile, and if economic conditions deteriorate, the demand
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Country Risk Analysis 7
c. Assume that JC Penney anticipated that there was a 10 percent chance that the Mexican
government would temporarily prevent conversion of peso profits into dollars because of political
conditions. This event would prevent JC Penney from remitting earnings generated in Mexico
and could adversely affect the performance of these stores (from the U.S. perspective). Offer a
way in which this type of political risk could be explicitly incorporated into a capital budgeting
analysis when assessing the feasibility of these projects.
ANSWER: The expected cash flows of the project could be re-estimated based on the scenario that
d. Assume that JC Penney decides to use dollars to finance the expansion of stores in Mexico.
Second, assume that JC Penney decides to use one set of dollar cash flow estimates for any
project that it assesses. Third, assume that the stores in Mexico are not subject to political risk.
Do you think that the required rate of return on these projects would differ from the required rate
of return on stores built in the U.S. at that same time? Explain.
ANSWER: If JC Penney generated a single set of cash flow estimates for the establishment of a
given store in Mexico, it would likely use a required rate of return that is higher than that used for a
proposed store in the U.S. The higher required rate of return on new stores in Mexico is attributed to
the greater degree of uncertainty associated with the new stores in Mexico than new stores in the U.S.
e. Based on your answer to the previous question, does this mean that proposals for any new stores
in the U.S. have a higher probability of being accepted than proposals for any new stores in
Mexico?
ANSWER: No. The U.S. markets have less potential because JC Penney has stores in most U.S.
markets (as mentioned in the case). Therefore, the estimated cash flows would be lower for U.S.
19. How Country Risk Affects NPV. Monk, Inc. is considering a capital budgeting project in Tunisia.
The project requires an initial outlay of 1 million Tunisian dinar; the dinar is currently valued at $.70.
In the first and second years of operation, the project will generate 700,000 dinar in each year. After
two years, Monk will terminate the project, and the expected salvage value is 300,000 dinar. Monk
has assigned a discount rate of 12 percent to this project. The following additional information is
available:
There is currently no withholding tax on remittances to the U.S., but there is a 20 percent chance
that the Tunisian government will impose a withholding tax of 10 percent beginning next year.
There is a 50 percent chance that the Tunisian government will pay Monk 100,000 dinar after two
years instead of the 300,000 dinar it expects.
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Country Risk Analysis 8
The value of the dinar is expected to remain unchanged over the next two years.
a. Determine the net present value (NPV) of the project in each of the four possible scenarios.
b. Determine the joint probability of each scenario.
c. Compute the expected NPV of the project and make a recommendation to Monk regarding its
feasibility.
ANSWER:
a.
Scenario 1: No withholding taxes, 300,000 dinar salvage value
Year 0 Year 1 Year 2
Dinar remitted by subsidiary 700,000700,000
Scenario 2: 10% withholding tax, 300,000 dinar salvage value
Year 0 Year 1 Year 2
Dinar remitted by subsidiary 700,000700,000
Year 0 Year 1 Year 2
Dinar remitted by subsidiary 700,000700,000
Withholding tax 70,000 70,000
Dinar remitted after withholding tax 630,000630,000
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Country Risk Analysis 9
Cumulative NPV –$306,250 $101,116
Scenario 4: No withholding taxes, 100,000 dinar salvage value
Year 0 Year 1 Year 2
Dinar remitted by subsidiary 700,000700,000
Withholding tax 0 0
a. The joint probabilities for the four cases are shown below:
Scenario 1: No withholding taxes, 300,000 dinar salvage value = 80% × 50% = 40%
b. E(NPV) = $295,536(40%) + $212,723(10%) + $101,116(10%) + $183,929(40%)
20. How Country Risk Affects NPV. In the previous question, assume that instead of adjusting the
estimated cash flows of the project, Monk had decided to adjust the discount rate from 12 percent to
17 percent. Reevaluate the NPV of the project’s expected scenario using this adjusted discount rate.
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Country Risk Analysis 10
ANSWER:
Year 0 Year 1 Year 2
Dinar remitted by subsidiary 700,000700,000
Withholding tax 0 0
The project still has a positive NPV of $230,342 and should be accepted. Notice that the NPV
obtained using t adjusted discount rate is very close to the expected NPV when the cash flows are
adjusted.
21. The Risk and Cost of Potential Kidnapping. In 2004 following the war in Iraq, some MNCs
capitalized on opportunities to rebuild Iraq. However, in April 2004, some employees were kidnapped
by local militant groups. How should an MNC account for this potential risk when it considers direct
foreign investment (DFI) in any particular country? Should it avoid DFI in any country in which such
an event could occur? If so, how would it screen the countries to determine which are acceptable? For
whatever countries the MNC is willing to consider, should it adjust its feasibility analysis to account
for the possibility of kidnapping? Should it attach a cost to reflect this possibility or increase the
discount rate when estimating the net present value? Explain.
Answer: This question can lead to an interesting class discussion. Some students will suggest that an
MNC should never pursue opportunities in countries where such events could occur. Yet, this could
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