Question

Explain the challenges of investment in foreign companies. Be sure to mention their economy, political climate and exchange rate.

Answer 1

Expanding business overseas means reaching new clients or customers and potentially boosting profits. While considering investment in foreign companies, these are the factors to be considered :-

1. Inflation - impact of inflation may weaken a currency so a forecast of this impact needs to be built in the analysis
2. Taxation - we need to build a after tax conservative estimate of cash flows . Large multinationals, such as Apple, Google and Microsoft have sought to invest in countries with lower corporation tax rates. For example, Ireland has been successful in attracting investment from Google and Microsoft.
3. Remittance - Restriction on remitted earnings may be prevalent so we need to read the laws of the host country and consider only income which is remittable by host country
4. Foreign Exchange - Exchange rate movements can adversely impact our earning so we need to adjust the cash flows from the project for inflation rate. A weak exchange rate in the host country can attract more FDI because it will be cheaper for the multinational to purchase assets.

• Major fluctuations can seriously impact the balance of business expenses and profit. For instance, if the company is paying suppliers and production costs in U.S. dollars, but selling in markets with a weaker or more unpredictable currency, the company could end up with a much smaller margin — or even a loss. One way to protect ourself against large fluctuations in currency is to pay suppliers and production costs in the same currency as the one we are selling in. This may mean switching to more local production where possible in order to better balance your outgoings and sales revenue.
• Another option for mitigating the risk of unpredictable currency rates can be setting up a forward contract and agreeing a price in advance for future sales. Of course, this potentially means missing out on greater profit should rates shift in your favor. However, it can protect your sales from the risk presented by unstable currency.

5 Unceratinity - project life, salvage value

6. Financing arrangements - trade finance may be avilable at below market rates so need to build that into our analysis as loan is a cost too

7. Adjustment for political unceratinity and instability - normally a higher discount rate is used to reflect risky nature of investment

• Countries with an uncertain political situation, will be a major disincentive.  
• The EU is seen as a signal of political and economic stability, which encourages foreign investment.
• Changes in governments can bring changes in policy, regulations, and interest rates that can prove damaging to foreign business and investment.
• A growing trend towards economic nationalism also makes the current global political landscape potentially hostile towards international businesses. For instance, companies like Facebook are banned in China, partially in preference for national social networks and also due to government regulation over internet content.

8. State of economy -

• the size of the population and scope for economic growth will be important for attracting investment. For example, Eastern European countries, with a large population, e.g. Poland offers scope for new markets. This may attract foreign car firms, e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer class. Small countries may be at a disadvantage because it is not worth investing for a small population. China will be a target for foreign investment as the new emerging Chinese middle class could have very strong demand for the goods and services of multinationals.
• Also, economic crisis can discourage investment. For example, the recent Russian economic crisis, combined with economic sanctions, will be a major factor to discourage foreign investment.

All else equal, firm's prefer to invest in countries with

• Stable currencies - exchange rate stability exists
• Healthy economies - those with high national growth rates, general macroeconomic stability, liquidity of stock and bond market, level of foreign exchange reserves held by the central bank,
• Minimum political risk - today high political risk exists in countries like Syria, North Korea, Pakistan, Afghanistan, Algeria to name a few.

Inorder to build higher political and economic risk in our project evaluation we can do the following :-

1. Increase the required rate of return
2. Adjust cash flow to reflect specific impact of risk