Question

Explain why unfavorable economic or political conditions affect the MNC’s cash flows, required rate of return, and valuation

Answer 1

Unfavourable economic or political conditions will have the following effect on MNCs :

• Cashflows - adverse effect, meaning that cash realizations may decrease or get delayed
• Required rate of return will increase, this is because overall risk will increase - such as policitcal risk, economic risk, interest rate risk, market risk, credit risk etc.
• Valuations will decrease in general. This is related to the point above on required rate of return. Since, the rate of return expected by investors increases, this increases the discounting factor/ hurdle rate, thus pulling down the valuations. Also, investors will prefer allocating their investments to less riskier assets (such as dollar, bank deposits, gold etc) from more riskier assets

In the context of an MNC, unfavourable conditions could impact sales and profitability from its target markets. It goes without saying that consumer demand in general would be subdued due to lower confidence levels and liquidity in the system (such as Covid-19 pandemic). Furthermore, this could also impact currency rates. For instance, if the MNC is generating its cashflows from emerging markets, however, if the currency from these markets have depreciated, this would result in a forex loss. Uncertain political scenarios can also pose regulatory challenges in repatriating cash into home country.

As explained in the earlier part, the required rate of return will increase since the overall risk perception of the market increases in such circumstances. In the past it has been observed that rate of interest has increased dramatically during times of war, recession, political uncertainties, structural change in systems (brexit) etc.

Valutations of any asset class reflects the confidence of markets in general. Uncertain economic and political conditions would most likely have an adverse impact on confidence level of investors. It has been observed that investors tend to sell riskier assets such as equities, exposure to emerging markets, low-yield bonds etc. to less riskier assets such as gold, dollar, yen, high yield or government bonds etc. On a fundamental level, unfavourable macro-environment result in lower demand for not only discretionary items but also essentials. This could be because of lower disposable income in the hands of general public. This could further have a ripple effect on investments done by government and private sector enterprises, thereby pushing the economy into a vicious cycle. This would certainly have a negative impact on valuations. For example, real-estate prices had drastically plummetted during the 2008-09 global recession.