CH9 - Risk

Question 1

Risk and Policy Decisions

Answer 1

• Type of business area: Economic Volatility, Seasonality, Competitors
• Operating Gearing – the level will determine whether:
• Outsourced or buy internally, lease or buy, Full time staff or freelance?
• Financial Gearing – The trade-off theory
• Accuracy of forecasts – Directors must assess the sensitivity of projects and what level of risk they’re willing to accept.

Question 2

Risk: How to Answer a Question

Answer 2

1. Risk Awareness - Identify the types of Strategic, Tactical and Operational Risk, Regulatory, Fiscal Risk, Economic, Political
2. Risk Monitoring – Information systems and Internal Audits put in place to review the above, review economic predictions, the market, competition.
3. Risk Management – identified risks should be categorized in accordance to their likelihood of occurrence and then be dealt with in the 4 T’s method.

Question 3

1. Risk Awareness

Answer 3

Strategic
* Brand awareness in a new sector – needing to break in, recession, political changes?

Tactical – Changes to forecasts:
* Supply chain potential changes, Payment timings – working capital required, Sales of machinery, Time spent on WIP.

Operational
Production breakdown, breakdown of supply chain, failure of distribution, Staff availability

Question 4

2. Risk Assessment and Monitoring Methods

Answer 4

Internal Audits and Monitoring systems

Information Systems: MIS - Feeding back to allow action to prevent future issues

EIS - Bringing Senior Executives up to date about key issues e.g. Competitor action, currency issues, economic forecasts.

Question 5

3. Risk Management

Answer 5

Tolerate - accept the risk may occur but put systems in place to manage it e.g. a back-up generator.

Transfer – Pass the risk on elsewhere e.g. insurance, fixed price contractors, outsourcing production.

Terminate

Treat -
Mitigation - Comprehensive Control Systems to detect and prevent. Cost shouldn’t be disproportionate
Hedging - FX risk and Interest rate
Diversification - Portfolio of different projects, customers, funding, countries

Question 6

Political Risk

Answer 6

Governments will wish to limit exploitation of their country through remittance of cash out of the host country to the holding company:
Exchange Control Regulations – blocking funds and rationing of currency supply. Forcing the parent to import foreign currency into the country.
Import Quotas – Limiting imports it can buy from the parent to sell in country.
Import Tariffs – Making imports more expensive.
Minimum shareholding offered to resident investors in the country.
Company Structure – All investments have to be joint ventures.
Super Taxes – Higher taxes for foreign businesses.
Expropriating Assets – Seizing foreign property as it’s recognized in international law as the right of the sovereign state provided consideration at fair market value is given.

Question 7

How to Assess Political Risk

Answer 7

Old Hands - Experts (academics, journalists, business owners)
Grand Tours
Surveys - Ranking by key risk variables
Quantitative Measures - GBP, Economic Intelligence Unit Country Risk Model

Question 8

Management of Political Risk: Pre Investment

Answer 8

Planned Local Ownership – Setting and spreading out to the long-term dates on which proportions of company ownership will pass to local nationals. This is so the government can see long-term benefits.

Pre-trading/concession agreements - Agreements regarding rights, transfer of capital, remittance of funds, transfer of products, transfer pricing, taxation, social and economic obligations

Risks:
Host governments in developing countries are very volatile and previous agreements can be nulled.
Wells 1977 argues that once investment has been made, the terms and conditions can still change; if the multinational is more successful than first thought, the local government will want their share of the windfall.

Political Risk Insurance – Possible in the UK with the Export Credits Guarantee Department (ECGD). Protects against expropriation, currency inconvertibility, war and revolution.

Question 9

Management of Political Risk: During Investment Investment

Answer 9

Production Strategies -
o Contracting to local sources and losing control.
o Producing direct in the host country (increased investment in host country).
o Importing from outside the host country e.g. Chrysler importing 50% of components as the plant became worthless without the imported components.

Question 10

Incorporating Risk into Investment Appraisal

Answer 10

Expected Values, CAPM, Sensitivity Analysis, Simulation

Question 11

Value at Risk

Answer 11

Assesses the maximum loss on a given period of time with a given probability. E.g. 95% or 95% confidence that annual return will be at least $4m
HOW: Confidence interval Value 1.65 * Standard Deviation
VaR for a project that lasts n years = Annual VaR * Sq RT n