Pursuing a potential investment opportunity in Country X

Client has expressed interest to pursue a potential investment opportunity in Country X. We have been engaged to explore this potential opportunity and determine the methodology to derive the required return of such investment. A potential investment should be made only if the expected return rightly compensates the risk taken up by the investor in this pursuit. As such, the higher the risks involved in an investment opportunity, the higher the required return should be set.

In order to perform the quantification of the required return for this potential equity venture in country X, a commonly-used model by equity analysts have been adopted. The model is as follows:

RX = iRF-US + ERPUS + SSX + CEX

where

RX – required return for country X

iRF-US – risk-free (RF) interest rate in the U.S.

ERPUS – U.S. equity risk premium

SSX – sovereign spread to Country X

CEX – extra return for taking on the currency exchange risk with respect to Country X

While this model has established a relationship between the required return for the risk in this equity investment, there are also limitations to it. To better reflect the required return for this investment, it is also advisable to include a factor which accounts for the possible volatility between the U.S. and Country X which may not have a systematic correlation. In addition, a measure of dispersion for the parameters used in the above formula should also be included in the formula to better account for the inherent risks which may be borne by the investor. Do note, however, that the limitations were not addressed in the following analysis.

Data

Based on the report produced by our internal equity analysts, the following information has been concluded for Country X.

iRF-US = 6.75%

ERPUS = 5.50%

SSX = 5.75%

CEX = 0.00%

Thus, RX = iRF-US + ERPUS + SSX + CEX = 18.0%

However, as this report only reflects the financial parameters of Country X at a particular point in time, this may not clearly reflect the required return for the investment pursuit which may be some time after this report is produced. Market dynamics may have caused upward or downward swings to the parameters above. Hence, it is pivotal for the company to obtain the latest financial indicators of Country X before a decision on the investment is made. This information can be obtained from the regular market updates by reputable sources and reliable financial publications.

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It has also been reported that the sovereign rating for Country X is BB and the inflation had varied between -2% to +3% over the last 5 years. This is a concern as rating below BBB may indicate that Country X has a history of default. Hence, the reported inflation rate may not be a true reflection of the inflation experienced in Country X.

External forces, which may pose a great impact on sovereign spread and currency exchange risk, have also been identified and categorized accordingly. According to a study on the “Determinants and Impact of Sovereign Credit Ratings” by Cantor and Packer (1996), five factors which will directly influence the sovereign spread of a certain country are as follows:

Per capita income

Inflation

External debt

Economic development

Default history

Similarly, Dr Allen L. Hammond, in his paper entitled “Global Scenarios for the 21st Century”, has also highlighted the above influences under the category of economic forces. The other external forces mentioned in his study include:

Cultural and social changes

– increase in global crime, materialism, bribery, poverty, illegal migration, surge in violence, philanthropy

Governmental changes

– political climate, governmental regulations and policies

Information technology

– extensive network of fiber which interconnects the world

Demographic

– increase in global population, shortages in fertile land

Environment impact

– climate change, pollution, health concerns

All the above factors provide a further insight on the variables which may potentially increase or reduce the required rate of return by the investment pursuit.

Analysis based on Futurism Scenarios

This analysis explored three possible scenarios for Country X.

Market World

Characteristics:

Free market, private enterprise, global market integration

Economic reform, privatization, deregulation

External factors which will affect SSX and CEX are as follows:

Economic forces

Doubling of trade and economic output

Financial integration increasing global productivity and competitiveness

Higher financial capital through savings effectively improving external balance

Reduction of red tape and illegal activities such as infringement of property rights and corruption

Cultural and social changes

Reduction of red tape and illegal activities such as infringement of property rights and corruption

Increasing importance of education in advances in science

Governmental changes

Increasing democracy and deregulation of policies

Information technology

Refinement and spread of extensive network

Environmental impact

Reduction in pollution through competitive pressure, legal framework and efficient technology

The increase in trade and economic output leads to a better GDP growth for the country and increasing the per capita income. In addition, a better external balance also reduces the possibility of default. A fall in red tape, corruption and a surge in deregulation also translate into a higher possibility for economic boom. This should thus reduce the SSX from 5.75% to approximately 2 – 3%.

Further to that, increase in productivity alongside cultural improvement such as advances in sciences and education will lead to an increase in employment. A surge in employment rate will also increase the inflation rate in the country. Hence, the CEX should increase to about 3 – 5%.

Therefore, under the Market World, the required return ranges around 17.25 – 20.25%.

Fortress World

Characteristics:

Unattended social and environmental issues

Growing income disparity between the rich and poor

Foresees impending social instability, conflict and chaos

External factors which will affect SSX and CEX are as follows:

Economic forces

Concentrated economic growth results in impoverishment in rural areas

Continuous corruption, political instability and globally organized crime prevent further growth

Withdrawal of foreign direct investment and transnational corporation worsen external balance

Cultural and social changes

Clashes and chaos increasing violence and conflicts within the country

Incoming migrant ignites further racial and ethnic tension

Governmental changes

Frequent change in ruling party and instability in politics turn potential foreign investments away from the country

Demographic

Flood of illegal migrants into rich countries continue to hamper productivity

Information technology

Declining growth due to chaotic condition and lack of funds for further advancement

Environmental impact

Higher cost of environment clean up due to ineffective waste management and pollution

Increasing cost of health care as a result of deteriorating environmental conditions

Strain in economic conditions and continuous bribery and illegal activities hampered the conduciveness of economic growth. This reiterates the fall in GDP growth and per capita income in rural areas. Constant change in ruling party also dampens investors’ confidence to pursue economic interest in the country. Also, with the withdrawal of foreign direct investment and transnational corporations, external balance deteriorates due to lesser capital inflow. This translates into a higher SSX to about 15 – 20%. This is justified by the increased risks which potential investors will have to borne to invest in such conditions. As such, with higher risks, investors should be rightly compensated with a higher return.

Higher cost of treating waste and pollution alongside higher cost of healthcare increases susceptibility to diseases. This could result in a further decrease in population following the exodus of illegal migrants into richer countries. Economic downturn, thus results in a surge in unemployment rate, which in turns causes deflation. Hence, CEX is likely to fall to -5 – 0%.

Therefore, under the Fortress World, the required return ranges around 22.25 – 30.25%.

Transformed World

Characteristics:

Social, political and economic reform

Assumes human ingenuity and compassion can extend opportunity to all mankind

External factors which will affect SSX and CEX are as follows:

Economic forces

Lower labor costs increases productivity and growth

Cultural and social changes

Higher conscience about healthy lifestyle

Higher level of education which results in a reduction in poverty, drug abuse, other social illness and expands social ministry of religious teachings

Increase in private philanthropy which results in better support for rural communities and the poor

Governmental changes

Political stability and revamp of policies in favor of ‘greener’ and more efficient use of resources

Increase in efficiency following lower corruption and red tapes

Energy related taxes reduces social security and other employment taxes

Information technology

Increase in private philanthropy and higher provision for research in sciences and technology

Environmental impact

Higher efficiency in energy consumption

New consumerism encourage ‘green’ technology

Reduction in urban air pollution

Per capita income and GDP growth increase simultaneously with the lower labor costs and higher level of employability in the general population. In addition, political stability and lower taxes in both individual and industrial sector also encourages investments, both domestic and international. Increase in investors’ confidence is also expected with the fall in red tape and corruption. Hence, the SSX is expected to fall to about 2 – 3%.

Cultural and social changes also result in higher demand for better quality products. With the higher level of employment rate, inflation is also deemed to increase. In addition, increase in demand for better quality products and lifestyle in general will result in an increase in cost of living. In addition, a better environmental condition also results in a higher level of population thus sustaining or increasing the current working population. These translate into a higher inflationary pressure and could result in a higher CEX ranging between 5 – 7%.

Hence, the resulting required rate of return in the Transformed World is expected to range between 19.25 – 22.25%.

Conclusion and recommendation

While the required rate of return calculated based on the data provided by the equity analysts is 18%, it should be emphasized that due consideration should be given to the data used to consider its reliability and accuracy – particularly with regards to SSX and CE­X.

Based on the analysis on the three different scenarios, it can be summarized that the required rate of returns are expected to range between 17 – 20% under the Market World, 19 – 22% under the Transformed World and 22 – 30% under the Fortress World. It can be seen that the presumptions for Market World and Transformed World is rather consistent with the research conducted by the equity analysts. Having said that, it should be noted that further investigation and market updates need to be obtained before making a decision on the investment.

The required rate is higher under the presumption of Fortress World because the risks involved in the investment would be much greater. On the other hand, the risks involved in the Market World and Transformed World scenarios are lesser due to various reasons highlighted above. Nonetheless, it should also be highlighted that the ultimate required return reasonable for the investor is also highly contingent on the investor’s risk tolerance and appetite. Other things which should be taken into consideration include the investors’ company culture and policy in pursuing a foreign investment.

It is also useful for the investor to consider other possible scenarios to ensure that all possible angles of the investments have been fully considered and accounted for. This is in line with a better risk management to ensure that the investment is fruitful. Hence, regular statistics on the key indicators mentioned above should be obtained to further verify the scenarios above and to investigate the impact of the external forces experienced by Country X. This will ensure that the right combination of investment strategy and monitoring can be undertaken to prevent any potential losses.