It is easy to see the elegance of the financial theory used in the ‘hard’. It tackles the assessment of investment projects from three different perspectives – the financial, the strategic and the organizational.
Risk and Home Country Bias
The FDI decision must also be placed in the context of the investment decision-making process in general. The fourth section offers a critique of this approach in the context of the foreign direct investment decision.
Different approaches to risk
Most financial risk is unsystematic and accounts for about 70% of the variability in the price of an individual stock (Buckley 1996: 27). All companies have risk management of their core activities as one of their core competencies, the so-called business risk.
The ‘hard’ approach to risk
The analysis assumes that systematic risk is reflected firstly in the risk premium linked to a particular asset and secondly in the level of. One significant aspect of risk is the propensity for a change in the level of risk itself.
How risk is measured
The main weakness of the variance approach, especially when estimated ex post, is that it misrepresents the risk situation. What is relevant is the downsize risk (Aaker and Jacobson 1990), the negative behavior of returns as represented by the lower half of the distribution.
Problems with the conventional approach
Another problem arises regarding the credibility of the commitment to any business relationship. There is a process of self-selection that could undermine the effective functioning of the market.
The peculiarities of foreign direct investment (FDI)
The analysis then turns to risk response by considering the risk appetite, or degree of risk aversion, of those facing the risk. In the third the focus is on the interaction between incidence, impact and response and on the universality of risk.
Integrating the treatment of risk
The present book seeks to stay within this terminology, only adjusting it to take into account the FDI orientation of the analysis. In an excellent paper published in 1992, Kent Miller emphasized the fragmented state of treatment of risk, which he described as reflecting a tendency to take a particularistic approach, analyzing specific uncertainties in isolation rather than taking an integrated risk management perspective (for a comment ). on Miller's article, see Werner and Brouthers 1996).
A definition of risk
As there is still considerable confusion in the use of the two concepts, risk and uncertainty, the ambiguity needs to be clarified. This is the source of the distinction between finance and business risk already discussed in the introduction.
Incidence, impact and response: the universality of risk
It is impossible to objectively measure the frequency of events that are the source of the types of risk described above (White 1987 and 1992). These are the same three elements – unexpected events, an indicator or target that is negatively affected, and the response of decision makers.
Types and levels of risk
The classification lacks coherence, mainly because the source of the risk is considered irrelevant to an analysis that concentrates on the impact. The relevant level can be defined by the source of the risk-generating event, by its area of influence or by the location of risk responses.
The risk appetite
This is the degree to which external contingencies threaten the value of the enterprise (Miller. Another source of the risk premium is the riskiness of the risk environment, mitigated by the degree of exposure of the respective enterprise.
The risk/return trade-off
The second section explains the most important consequences of a bias in the home country in investment decisions. Section four examines the arguments for home country bias and the relative immobility of capital.
The nature of FDI
Another source of ambiguity is that each of the terms in the term FDI lacks precise meaning. Portfolio investment can indirectly support an increase in production capacity if efficient transfer of the relevant goods can be carried out.
What is the problem?
In such a world arbitrage – the riskless exploitation of price differences for profit – would cause all relevant prices to be equalised. The problem is the interaction in the balance of payments between the current and the capital accounts.
The definition and measurement of home country bias
If the matching item streams do not appear, there is what has been described as a transfer problem. There is more bias in the labor markets than in the capital markets, more bias in physical than financial investments.
Home country bias and the immobility of capital
For any country, there is no reason why saving and investment activity should be correlated - the correlation should be zero. Provincial boundaries apparently not.' The evidence certainly suggests that domestic markets are integrated in a way that is untrue at the international level.
The causes of home country bias
Levi refers to both direct barriers such as legal restrictions on holding foreign shares and discriminatory tax treatment, and indirect barriers such as 'the difficulty of finding and interpreting information about foreign securities and the reluctance to associate with foreigners' (Levy 1996 : 451). In the past, there has been a tendency to explain home country biases through a particular area of government policy: erecting barriers that either prevented the relevant flows or changed the price system in favor of one's own.
Home country bias and country risk
It is of the nature of competitive advantage that some companies have more information and knowledge in relevant areas than others. Ignorance can be reduced to a cost by assuming that the ignorance can be dispelled by devoting the necessary resources to appropriate information gathering.
Different Perspectives on Investment Appraisal
How is it possible to take into account the overall strategic situation in the assessment of a project. In the third section, there is an analysis of the difficulties in estimating the various inputs in the present value formula.
The possibility and cost of mistakes
In a situation of strategic shift, the company finds that its strategy increasingly does not correspond to the changing external environment due to the rejection of projects that could maintain its competitive advantage. They enjoy most, if not all, of the advantages, but only a small fraction of the disadvantages (Chapter 7): the burden of any failure and eventual bankruptcy falls largely on the creditors due to the existence of limited liability.
Investment appraisal
Usually there are investment costs, denoted as K, currently all incurred at the beginning of the project. If there is some reversibility, at all times there is a known salvage value, including at the end of the project's life a fictitious value, Sn.
The inputs into the estimation of present value
The movement of prices and financial flows can reflect the expected strategy of other players and the level of competition in the relevant sector of the economy. This has prompted Vonnegut to say: 'The ENPV [expected net present value] rule is flexible in the sense that a wide range of uncertainties and probabilities can be accommodated for any time period in the state space.' (Vonnegut 2000: 84) .
Implications of the analysis
These issues point to the centrality of strategy as the context in which any specific investment project must be assessed – an issue that is dealt with in chapter 5. Once the assumption that everyone is a price taker in a perfect market is relaxed, the question of price becomes a strategic one relevant to the treatment of all stakeholder groups.
Incorporating uncertainty
The value of the option to wait can convert a negative net present value into a positive value. There is a sense in which the opposite is true – the greater the risk, the more potentially beneficial the project.
The real options approach
Despite efforts to link real options to financial markets, the usual method of valuing the underlying asset is to use the discounted value of the free cash flows generated by the sale of chips or oil. The fourth section discusses how an individual investment project can only be properly assessed within the context of the company's overall strategy.
Strategy and the nature of the enterprise
Such an approach, as with the contractual approach, reduces the importance of boundaries between the enterprise and the outside world. The strategic view of the enterprise sees the enterprise as consisting primarily of a set of resources, capabilities, or competencies (Wernerfelt 1984).
The full range of investment options
Any strategy has as its starting point a set of options for the use of the investment funds available to the company. In the words of (Foss) Optimal flexibility corresponds to the plan of action that enables the firm to obtain the set of options that maximizes the net present value of the firm.'.
Strategic risk
This will affect the value of the net cash flows that go into the appraisal. If negative, it can be negatively correlated with the term for the value of waiting.
Strategy and the individual investment project
In two articles, Luehrman (1998a and 1998b) has shown how it is possible to reduce the number of variables in two option metrics - the value-cost metric (S divided by the present value of X) and the volatility metric (σ√ t) . The size of the difference between the two rates, established by Jagannathan and Meier - the hurdle premium, indicates the value of waiting.
Control of risk and an appropriate information strategy
It is the activity of identifying relevant information in the changing environment of the enterprise. It may be possible to define upper and lower limits for the values of the relevant options.
Direct investment as the preferred mode of entry
In the first section, there is an overview of the network of stakeholder groups relevant to any investment decision. The fifth section deals with the relationship between creditors and owners in connection with a company's capital structure.
A coalition of stakeholders
In the third part, the mechanisms for distributing risk and value created by investment projects among relevant stakeholder groups are analyzed. As the company grows, there is increasing specialization of organizational units and increasing proliferation of stakeholder groups with different interests in the company's performance.
The structure of the enterprise
Two issues are at the heart of risk management in the modern business – limited liability and bankruptcy.1 The ultimate risk for most stakeholder groups is business failure. Limited liability is a legal device whose function is "to protect owners of businesses from personal liability in the event of corporate default" (Moss.
Value and risk distribution
They are usually lowest at the beginning and end of the life cycle. The importance of the different stakeholder groups varies depending on where in the life cycle of the relevant product(s) the company is.
Ownership and control
There is a tendency for managers to prefer to use free cash flows to expand the enterprise. However, there is always the option of selling their shares and rearranging their asset portfolio to suit their risk tolerance.
Capital structure and risk: creditors and owners
Equity is equivalent to a put option that shareholders have on the underlying value of the company, with a strike price equal to the face value of the debt (Doherty 2000: 181). The higher the debt-to-equity ratio, the greater the risk that a failed investment will cause the company to become insolvent, with attendant bankruptcy costs.
The decision-making process
The political model highlights the existence of many stakeholders with influence on decision-making but different interests. It considers relevant issues such as negotiations and negotiation; championing of positions, projects or people and bias in decisions; opportunism – use of trickery and distortion, selective disclosure and withholding of information; the universality of conflict and coalition building.
The Different Types of Risk
The second section provides a definition of global risk – analyzing how this risk differs from other types. In the third section there is an examination of the different perception of different types of global risk.
The sources of generic risk
The conventional approach to the inclusion of risk in the evaluation of an investment project also combines the two phases, that of risk assessment and project evaluation. The discussed problems make it appropriate to fully separate two phases in the inclusion of risk in the evaluation of an investment project.
The nature of global risk
It is not difficult to accept a ranking according to the extent of the relevant impact, going from crisis to disaster to disaster. Terrorism can occur anywhere, but it is more likely to occur in certain parts of the world.
The perception of global risk
Production may be interrupted or there may be costs associated with taking risk reduction measures, some imposed on the enterprise, some voluntarily undertaken. Such strategic responses may give the firms involved a temporary competitive advantage, but, if successful, may cause imitation by competitors.
The incorporation of global risk
Opportunism may dictate that one airline steals a march on the others by being perfunctory in that security check - costs are lowered, at least in the short term. If reinsurance becomes more profitable, a simple solution to an efficient market is for new reinsurance companies to establish themselves and raise capital in the market.
The nature and classification of industry risk
Much work has gone into improving the industry's ability to predict the occurrence of shocks. There is a risk of personal injury arising from the nature of the product.
The components of industry risk
Product market risks take a variety of forms – the impact of unexpected changes in consumer tastes, changes in the availability of goods that somehow substitute the relevant product, and problems with the supply of a complementary good. In the second section, there is an identification of the important elements of country risk.
The nature of country risk
A critical part of the infrastructure is the legal system that influences the nature of political risk. Where this occurs, the exchange rate may reflect a persistent upgrade in the value of the currency.
The sub-components of country risk
The next section considers each of the sub-components in turn, grouped within the different categories. It goes further and attempts to group the subcomponents into groups within the four component classes.
The components of country risk
The issues are twofold – the degree of legitimacy in the transfer of power and whether a successor government maintains existing policies regarding FDI. The impact of the external threat depends on the degree of resistance and the duration of any hostilities.
The conceptual framework of country risk
For firms involved in overseas investment, there is the issue of when to use Western or to use local rules.
Assessment: weighting and the use of quantitative proxies
There should be a good theoretical justification for each part of the country risk, which can then be scored out of a hundred. In case of an obvious overlap between different subcomponents, or even components, the elements that have a significant correlation should be merged.
The country risk exposure of international investment projects
The possibility of the latter two events occurring should be included in the country risk index level. The second part provides an analysis of the non-systematic risks specific to the company and how such risks should be classified.
The nature of enterprise and project risk
The third section introduces the notion of the risk filter, showing the way in which higher levels of systematic risk affect the risk exposure of the enterprise. Projects by expanding the range of assets available to the enterprise for use as inputs in other projects increase the overall value of the enterprise.
A conceptual framework of enterprise risk
A supplier may experience problems for a host of reasons beyond the control and even knowledge of the business in question. Whatever is done sends signals to all the stakeholders about the economic health of the business.
The conceptual framework of all risk
The situation is more complicated for a conglomerate, as the relative importance of different elements in the taxonomy is likely to vary from business unit to business unit.
The risk filter
Such risk also affects the business in the context of the nature of the relevant asset exposure. For foreign direct investment, this is crucially important as it implies the influence of country risk on the company.
Different patterns of risk
It is also important to consider the identity of the stakeholders and the nature of their interests in the project. Each enterprise is identified by the nature of its main activities and the assets that support these activities.
How to quantify enterprise and project risk
As the analysis above has shown, it is difficult to come up with a complete quantification of the different types of risks. After obtaining such a quantification, it is difficult to weight the different types of risk and adjust the values included in the present value formula accordingly.
Responses to Risk and the Determinants of FDI
