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CA Final · Advanced Financial Management · International Financial Management

A parent company is concerned about the risk that the host government may expropriate its foreign project in a future year. In international capital budgeting, which treatment is generally preferred for this risk?

The preferred approach is to reduce the expected cash flows by the probability-weighted loss from expropriation. It is a specific event with an estimable likelihood and loss, and cash flow adjustment reflects its timing and size. A flat discount-rate premium treats the risk as if it grows evenly over time, which is a poor fit.

  1. AAdjust the expected cash flows downwards by the probability-weighted loss from expropriationCorrect
  2. BRaise the discount rate by a fixed premium for every year of the project
  3. CIgnore it, because the host country's currency risk already covers it
  4. DEvaluate the project only from the subsidiary's perspective, as the parent bears no loss

Explanation

Expropriation is a discrete event with an estimated probability and loss, so it is best captured by adjusting the expected cash flows. A uniform discount-rate premium penalises early cash flows too heavily and cannot reflect the timing or size of the loss. Currency risk is a separate matter, and the parent's perspective is what matters in any case.

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