Incorporating Country Risk In The Valuation Of Offshore Projects

Offshore projects, especially those in emerging economies, are generally viewed as more risky, and thus as contributing less to shareholder value, than otherwise comparable domestic investments. Emerging economies are typically more volatile than the economies of industrialized countries. They also present a greater array of risks that are (perceived as being) primarily of a downside nature, such as currency inconvertibility, expropriation, civil unrest, and general institutional instability. Further, because such risks are relatively unfamiliar to the investing companies, the companies are likely to make costly errors in early years and to require more time to bring cash flows and rates of return to acceptable steady‐state levels. To reflect these higher risks and greater unfamiliarity, many companies include an extra premium in the discount rate they apply to offshore and, particularly, emerging‐market projects. However, the basis for these discount rate adjustments is often arbitrary. Such adjustments do not properly reflect objective information available about either the nature of these risks, or about the ability of management to manage them. Nor do they take into account the reality that the risks stemming from unfamiliarity fall over time as the firm progresses along the learning curve. As a result, companies often “over discount” project cash flows in compensating for these risks, and thus unduly penalize offshore projects. More important, adjusting for country risk using arbitrary adjustments to the discount rate fails to focus management's attention on strategic and financial actions can be taken to reduce risk—notably, actions capable of transferring some of the company's exposures to specific risks to different parties with comparative advantages in bearing those risks. This paper outlines a four‐step procedure for assessing overseas risks that integrates these various aspects: ▪ Classify risks in terms of various stakeholders' comparative advantage in risk‐taking based on their: (a) existing portfolio of assets; (b) access to information; and (c) capabilities for reducing risk. ▪ Allocate risk through project structuring and financial engineering to exploitthese comparative advantages. ▪ Adjust resulting cash flows (relative to their most‐likely levels) for (a) the impact of “asymmetric” risks; (b) learning effects; and (c) potential competitive options and/or barriers to entry resulting from comparative advantage in dealing with risks. ▪ Discount resulting expected cash flows at a risk‐adjusted discount rate that reflects the covariance of the cash flows with the benchmark portfolio.