A U.S.-based company is establishing a project in a politically unstable country

Question

A U.S.-based company is establishing a project in a politically unstable country. It is considering two possible sources of financing. Either the parent could provide most of the financing, or the subsidiary could be supported by local loans from banks in that country. Which financing alternative is more appropriate to protect the subsidiary (explain your answer)? What would happen to the required rate of return on the project in question ? That is, what impact does political instability have on the discount rate used to compute the NPV of the project (explain)?

Explanation / Answer

The country is already politically unstable therefore getting financing in form of local loans from banks in that country is very difficult.The parent could provide most of the financing which is easier to get and manageable and less expensive as compared to the local banks that could charge very highly for the loans they provide locally due to the politically instability and risk in the country.Thus parent providing most of the financing is more appropriate to protect the subsidiary.

The required rate of return on the project would go up because the risk of investing in the already unstable country goes up as the market risk premium for the country would be high and with larger macro risks in the country, the discount rate used to discount the cash flows in project would go up,the uncertainty associated with cash flows would also go up.The beta of the project that is the macro risks associated with the project would be high due to politically instability this would push the required return on equity high ,and since the discount rate is the weighted average of the required return on equity and cost of debt,with increase in required return on equity the discount rate goes up.

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