In Practice Exchange Rate Risk Political Risk and Foreign Projects

When computing the cost of capital for the Disney Bangkok project, we adjusted the cost of capital for the additional risk associated with investing in Thailand. While it may seem obvious that an Thai investment will carry more risk for Disney than an investment in the United States, the question of whether discount rates should be adjusted for country risk is not an easy one to answer. It is true that a Thai investment will carry

2 We use the same approach we used to estimate the country risk premium for Brazil in the last chapter. The rating for Thailand is Baa1 and the default spread for the country bond is 1.50%. Multiplying this by the relative volatility of 2.2 of the equity market in Thailand (strandard deviation of equity/standard devaiation of country bond) yields a country risk premium of 3.3%.

more risk for Disney than an investment in the United States, both because of exchange rate risk (the cashflows will be in Thai Baht and not in US dollars) and because of political risk (arising from Thailand's emerging market status). However, this risk should affect the discount rate only if it cannot be diversified away by the marginal investors in Disney.

In order to analyze whether the risk in Thaliand is diversifiable to Disney, we went back to our assessment of the marginal investors in the company in chapter 3, where we noted that they were primarily diversified institutional investors. Not only does exchange rate risk affect different companies in their portfolios very differently - some may be hurt by a strengthening dollar and others may be helped - but these investors can hedge exchange rate risk, if they so desire. If the only source of risk in the project were exchange rate, we would be inclined to treat it as diversifiable risk and not adjust the cost of capital. The issue of political risk is more confounding. To the extent that political risk is not only more difficult to hedge but also more likely to carry a non-diversifiable component, especially when we are considering risky emerging markets, the cost of capital should be adjusted to reflect it.

In short, whether we adjust the cost of capital for foreign projects will depend both upon the firm that is considering the project and the country in which the project is located. If the marginal investors in the firm are diversified and the project is in a country with relatively little or no political risk, we would be inclined not to add a risk premium on to the cost of capital. If the marginal investors in the firm are diversified and the project is in a country with significant political risk, we would add a political risk premium to the cost of capital. If the marginal investors in the firm are not diversified, we would adjust the discount rate for both exchange rate and political risk.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook


Post a comment