Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

The finance department of Beela Electronics has been criticized the company‟s board of directors for not undertaking an assessment of the political risk of the company‟s potential direct investments in Africa. The board has received an interim report from a consultant that provides an assessment of the factors affecting political risk in three African countries. The report assesses key variables on a scale of –10 to +10, with –10 the worst possible score and +10 the best.

The consultant suggests that economic growth and political stability are twice as important as the other factors.

The consultant states in the report that previous clients have not invested in countries with a total weighted score of less than 30 out of a maximum possible 100 (with economic growth and political stability double weighted). The consultant therefore recommends that no investment in Africa should be undertaken.

(a) Discuss whether or not Beela electronics should use the technique suggested the consultant in order to decide whether or not to invest in Africa.

(b) Discuss briefly how Beela might manage political risk if it decides to invest in Africa.
(a) The consultant‟s report should not be used as the only basis for the African investment decision,because:

The decision should be taken after evaluating the risk/return trade-off; financial factors (e.g. the expected NPV from the investments); strategic factors; and other issues including political risk. Political risk is only one part of the decision process (although in extremely risky countries it might be the most important one).

The scores for the three countries are:

Country 1      29
Country 2     24
Country 3     28

Just because previous clients have not invested in countries with scores of less than 30 does not mean that Beela should not. The previous countries may not have been comparable with these in Africa. This decision rule also ignores return. If return is expected to be very high, a relatively low score might be acceptable to Beela.

The factors considered the consultant might not be the only relevant factors when assessing political risk. Others could include the extent of capital flight from the country, the legal infrastructure, availability of local finance and the existence of special taxes and regulations for multinational companies.

The weightings of the factors might not be relevant to Beela.

Scores such as these only focus on the macro risk of the country. The micro risk, the risk for the actual company investing in a country, is the vial factor. This differs between companies and between industries. A relatively hi-tech electronics company might be less susceptible to political actions than, for example, companies in extractive industries where the diminishing bargain concept may apply.

There is no evidence of how the scores have been devised and how valid they are.

(b) Prior to investing Beela might negotiate an agreement with the local government covering areas of possible contention such as dividend remittance, transfer pricing, taxation, the use of local labour and capital, and exchange control. The problem with such negotiations is that governments might change, and a new government might not honour the agreement.

The logistics of the investment may also influence political risk:

If a key element of the process is left outside the country it may be viable for the government to take actions against accompany as it could not produce a complete product. This particularly applies when intellectual property or know-how is kept back.

Financing locally might deter political action, as effectively the action will hurt the local providers of finance.

Local sourcing of components and raw materials might reduce risk.

It is sometimes argued that participating in joint ventures with a local partner reduces political risk, although evidence of this is not conclusive.

Control of patents and processes the multinational might reduce risk, although patents are not recognized in all countries.

Governments or commercial agencies in multinations‟ home countries often offer insurance against political risk.

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