ASSGINMENT CHAPTER 16.

COUNTRY RISK ANALYSIS

1. Key West Co. exports highly advanced home entertainment system components to its
subsidiary shops on islands in the Caribbean. The components are purchased by
consumers to improve their home entertainment systems. These components are not
produced in other countries. Explain how political risk factors could adversely affect the
profitability of Key West Co.

It is important to have previous feedback from the intended countries to understand the country's
current regulations. It is possible to fall under different barriers if you don't understand the
political factors that play a key role, such as government restrictions on subsidiary shops,
blockage of funds, and social efforts such as protesting against the manufacturing country or
only acquiring domestic goods, which makes imported goods uninteresting to consumers.

2. Using the information in question 1, explain how financial risk factors could adversely
affect the profitability of Key West Co.

It is possible for residents to be subject to higher inflation or higher interest rates, which would
reduce the amount of income that can be allocated to exports. And also, depreciation of the local
currencies could raise the local prices for goods exported from the U.S.

3. Given the information in question 1, do you expect that Key West Co. is more concerned
about the adverse effects of political risk or financial risk?

Probably the biggest concern is financial risk. In the absence of substitute products in other
countries, political risk factors are unlikely because Key West produces the product.

4. Explain what types of firms would be most concerned about an increase in country risk as
a result of the terrorist attack on the United States on September 11, 2001.

As a result of this event, firms that have offices in populated areas had a higher country risk.
Moreover, it weighed the risk for firms whose employees frequently travel overseas and for
firms who provide travel and office services.

5. Rockford Co. plans to expand its successful business by establishing a subsidiary in

Canada. However, it is concerned that after two years the Canadian government will
either impose a special tax on any income sent back to the U.S. parent or order the
subsidiary to be sold at that time. The executives have estimated that each of these
scenarios has a 15 percent chance of occurring. They have decided to add four percentage
points to the project’s required rate of return to incorporate the country risk that they are
concerned about in the capital budgeting analysis. Is there a better way to more precisely
incorporate the country risk of concern here?

According to Rockford, three scenarios can be used to estimate the NPV:

1) Include a special tax when estimating cash flows back to the parent, probability of scenario =
15 %.
2) Assume the project ends in two years and include a salvage value when estimating the PV,
probability of scenario = 15 %.
3) Assume no Canadian government intervention, probability of scenario = 70 %. 
This results in three estimates of NPV, one for each scenario. It is less arbitrary than the method
considered by executives.