accounting for sovereign risk when investing in emerging markets

VOLUME 23 | NUMBER 2 | SPRING 2011

APPLIED CORPORATE FINANCEJournal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

In This Issue: Risk and Valuation

Downsides and DCF: Valuing Biased Cash Flow Forecasts 8 Richard S. Ruback, Harvard Business School

CARE/CEASA Roundtable on Managing Uncertainty and Risk 18 Panelists: Steve Galbraith, Maverick Capital; and

Neal Shear. Moderated by Trevor Harris, Columbia University

How the U.S. Army Analyzes and Copes with Uncertainty and Risk 34 Major Hugh Jones, U.S. Military Academy

Accounting for Sovereign Risk When Investing in Emerging Markets 41 V. Ravi Anshuman, Indian Institute of Management

Bangalore, John Martin, Baylor University, and Sheridan

Titman, University of Texas at Austin

Accounting for Risk and Return in Equity Valuation 50 Stephen Penman, Columbia Business School

Morgan Stanley’s Risk-Reward Views: Unlocking the Full Potential of Fundamental Analysis

59 Guy Weyns, Juan-Luis Perez, Barry Hurewitz, and

Vlad Jenkins, Morgan Stanley

How Corporate Diversity and Size Influence Spinoffs and Other Breakups 69 Gregory V. Milano, Steven C. Treadwell, and Frank Hopson,

Fortuna Advisors LLC

The Three-Factor Model: A Practitioner’s Guide 77 Javier Estrada, IESE Business School

Valuing Companies with Cash Flow@Risk 85 Franck Bancel, ESCP Europe, and Jacques Tierny, CFO,

Gemalto

Valuing an Early-Stage Biotechnology Investment as a Rainbow Option 94 Peter A. Brous, Seattle University

Terminal Value, Accounting Numbers, and Inflation 104 Gunther Friedl, Technische Universität München, and

Bernhard Schwetzler, HHL Leipzig Graduate School

of Management

Comment on “Terminal Value, Accounting Numbers, and Inflation” by Gunther Friedl and Bernhard Schwetzler

113 Michael H. Bradley, Duke University, and

Gregg A. Jarrell, University of Rochester

Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 41

Accounting for Sovereign Risk When Investing in Emerging Markets

1. There have been even more extreme cases of political turmoil and risk throughout history. For example, between 1910 and 1929, Mexico had a revolution, a counterrevo-

lution, a counter-counterrevolution, two military coups, three coup attempts, and two presidential assassinations.

2. Garcia-Sanchez, et al. (2010).

W

by V. Ravi Anshuman, Indian Institute of Management Bangalore, John Martin, Baylor University, and Sheridan Titman, University of Texas at Austin

hen investing in emerging markets, companies face the ever present risk of partial or full expro-priation by an unfriendly host government. Recent examples include the actions of Vene-

zuelan President Hugo Chavez, who in 2010 announced the takeover of more than 60 domestic and foreign oil field service companies, and President Rafael Correa of Ecua-dor, who announced a plan to force foreign oil companies to accept service contracts in place of profit-sharing agreements. Although these are extreme cases, they serve to emphasize the importance of weighing the effects of political or sovereign risk when investing in developing economies.1

When accounting for political risk, analysts typically add a sovereign default premium to the rate that is used to discount the investment’s cash flows. And as a result of this practice, it is not uncommon for projects in emerging markets to be evaluated with discount rates of 20% or more. But since the cash flows produced by these investments are unlikely to be highly correlated with the returns on world stock markets, the required rate of return suggested by finance theory and described in academic textbooks is often substantially lower.

In short, there is a pronounced “disconnect” between the textbook approach and industry practice. Textbooks suggest that investment projects be valued by first calculating expected cash flows that account for all possible risks, including the political risk of expropriation, and then discounting those flows at rates that reflect their systematic or market-wide risk.2 In practice, however, cross-border investment projects are typically evalu-ated using cash flow estimates that ignore the possibility of unfavorable political events. As a result, these promised cash flows are higher than the true expected cash flows. To account for political risk, the rate used to discount project cash flows includes a risk premium for both the project’s systematic invest-ment risk and the risk of expropriation (political risk). And in this fashion, political risk is incorporated into project analysis through an adjustment of the discount rate rather than the project’s expected cash flows.

There are at least two plausible explanations for the practice of adjusting discount rates rather than cash flows for political risk. The most important may have a lot to do with the possi-

bility that the project analysis will be observed by the firm’s external constituencies, including the host government. Making the estimated cost and probability of expropriation explicit in the analysis is likely to create a source of contention. At the same time, the promised cash flow forecast, which assumes no political risk, will in most circumstances provide a better ex post performance benchmark than a forecast that accounts for the possibility of political expropriation. Indeed, cash flows that account for political risk will provide an inappropriately low benchmark for managers in the event there is no expropriation. And for both of these reasons, then, companies tend to use the promised cash flows and discount them at higher-than-CAPM rates that reflect the probability of default.

In this paper, we will provide some insights about how the valuation approach used by practitioners differs from the standard textbook approach. Our objective is not to justify one method or the other, but rather to lay out some common pitfalls that can arise with each. Our discussion of invest-ments in emerging markets focuses not only on how the different valuation approaches account for political risk, but also on how they can influence how contracts are structured and how this can in turn influence political risk. We conclude with a discussion of how companies can structure projects in emerging markets in ways that minimize political risk.

Incorporating Political Risk into Project ValuationMost participants in capital budgeting surveys say they use discounted cash flow (DCF) analysis to value their prospective investments. Academics tend to cite these studies as reflecting their influence on industry practice. But as we noted in the introduction, while companies do evaluate investment oppor-tunities by discounting future cash flows, the approach taken when evaluating investments in emerging markets can be very different from the approach suggested in textbooks. In the pages that follow, we describe what we refer to as the textbook approach and compare it to the approach more commonly used in industry.

To compare the textbook DCF approach to the practitioner DCF approach, we start with a simple model of an invest-ment with a known initial investment outlay that produces a

42 Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011

3. We will not delve into the various methods that have been recommended in the literature for making the political risk adjustment but simply refer the interested reader to Estrada (2007).

4. Note that the present value of the expected cash flows for the project is equal to the following:

= =C(1 – p)t ProjectValue (1 + r)t

C x (1 – p) r + p

t = 1

∞

market risk premium, and SR is the systematic risk or beta of the investment. Using this approach, the present value of the promised cash flow in year t is calculated as

PV = c (1 + k)t

(3)

Equivalence Between Textbook Valuation and Industry PracticeIn the simple case described above, the traditional textbook DCF approach and the industry DCF approach generate the same PV if the sovereign default-adjusted return (k) is chosen appropriately. To find this rate, we set equations (1) and (3) equal to one another and solve for the discount rate as follows:

k = – 1 1 + r 1 – p

(3)

By rearranging terms we define the sovereign default premium (k-r) as follows:

(4)(k – r) = (1 + r) x p 1 – p

An Illustrative CaseTo illustrate the size of the sovereign default premium that results in the correct value of an investment using the indus-try DCF approach, consider an investment that generates an expected cash flow each year in perpetuity equal to $10 if there is no expropriation. Moreover, the probability of expro-priation in any given year is assumed to be 4%, indicating that the expected cash flow for year one is $9.96. If we further assume that the required rate of return given the systematic risk of the project (r) is equal to 8%, the present value of the investment’s expected cash flows calculated using Gordon’s growth model would be $80:4

= = $80.00$10 x (1 – .04)ProjectValue .08 + .04

Using the industry DCF model, we could calculate the value of the project as follows,

= = $80.00$10ProjectValue k

Solving for k gives us 12.5%, and hence the political risk premium (k – r) is equal to 4.5%.

As this example suggests, when discounting yearly or quarterly cash flows, the increase in the discount rate needed to account for sovereign default risk is somewhat larger than the probability of default. This difference (.5% in the above example) is somewhat lower when we discount

constant stream of future annual cash flows equal to C. The cash flows are expected to continue forever, unless and until the project is expropriated by the host country’s government. Note that since there is some risk of expropriation, C is higher than the expected cash flow from the investment.

The Textbook Valuation Approach—Adjust Cash Flows The textbook DCF approach calculates the value of an invest-ment project by discounting the project’s expected future cash flows using a risk-adjusted rate of return that reflects only the systematic, or general market, risk of the investment. To esti-mate the expected cash flow from an investment in another country, we must take into account the risk of expropriation. For example, for an investment to provide a cash flow equal to C at time t, the company must survive until time t. If the probability of expropriation by the government during the period t-1 to t is equal to p(t), then the probability of the firm surviving until time t equals [1-p(t)]t where we refer to p(t) as the “marginal” probability of default at time t. In that case, the probability of surviving until year t can be expressed as [1-p(t)]t and the expected cash flow at time t, assuming that 100% of the project cash flows are expropriated in the event of default, is equal to C [1-p(t)]t.

For convenience, we begin our analysis by assuming that p(t) = p is a constant. In this case, the probability of survival is equal to (1-p) t , which decreases over time, indicating that expropriation becomes more and more inevitable with time. If the discount rate that captures the systematic risk of the investment’s cash flows is represented by r, then the present value of the expected cash flow occurring at time t (PV) can be expressed as follows:

PV = c(1 – p)t (1 + r)t (1)

where C(1-p)t is the expected cash flow for period t that accounts for the possibility of expropriation.

Industry Practice—Adjust the Discount RateIndustry participants typically adjust the discount rate rather than the cash flows to account for expropriation risk. Present values are then calculated by discounting what we will refer to as the project’s promised project cash flows (C) at a discount rate k that reflects both the systematic risk of the project, r, plus a risk adjustment, A, for the risk of expropriation.3

Conceptually we can think of k as follows:

k = r + A = rf + MRPW x SR + A (2)

where rf is the risk free rate of interest, MRPw is the world

43Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011

where p is the implied probability of expropriation in year t. Using the earlier example to illustrate, Table 1 contains the implied probability of expropriation that corresponds to differ-ent political risk premiums:7

The implied annual probabilities of expropriation may not seem extreme. For example, even for a 12% sovereign risk premium (i.e., k = 20%), the implied annual probability of expropriation is just 10%. But when we look out over the life of a 20- or 30-year project, the cumulative probability of default by the end of year 20 is almost 88%, and by 30 this probability is over 95%. This raises a question about the reasonableness of using a sovereign risk premium of 12%, which is not uncommon.

Figure 1 shows the relationship between the cumulative probability of a project’s being expropriated over its life and

quarterly rather than yearly cash flows, and lower yet when we discount monthly cash flows. But when we discount cash flows in continuous time, the sovereign risk premium found in Equation (4) would be exactly equal to the probability of default, p(t).5 For example, in the preceding example the sovereign risk premium would be 4% in the continuous time case rather than 4.5%.

Default Probabilities Implied by Sovereign Risk Premiums Note that equation (4) can also be used to solve for the prob-ability of expropriation (p) implied by a particular sovereign risk premium by using the following equation:6

(5)p = k – r 1 + k

Table 1 Implied Probability of Expropriation

ProjectDiscountRate

Discount RateAdjusted forExpropriation Risk

SovereignRisk Premium

Implied AnnualProbabilityof Expropriation

Cumulative Probability of Expropriation by the end of

r k (k-r) P Year 20 Year 30

8% 8.00% 0.00% 0.00% 0.00% 0.00%

8% 13.68% 5.68% 5.00% 64.12% 78.51%

8% 20.00% 12.00% 10.00% 87.84% 95.76%

8% 27.06% 19.06% 15.00% 96.12% 99.24%

Figure 1 Cumulative Probability of Expropriation

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

0 5 10 15 20 25 30 35

Cum

ulat

ive

Pro

babi

lity

of E

xpro

pria

tion

15% annual Pb of ExpropriationSovereign risk premium (k-r) = 19.06%

10% annual Pb of ExpropriationSovereign risk premium (k-r) = 12%

5% annual Pb of ExpropriationSovereign risk premium (k-r) = 5.68%

Year

5. See Equation (4A) in the Appendix.6. In the continuous time case, the implied probability is exactly equal to the sover-

eign risk premium.

7. We can easily solve for the implied probability by equating the present value of the perpetual cash flow stream using the traditional DCF model equal to the corresponding present value using the industry model, i.e.,

= C(1 – p) r + p

Ck

And solving for p as follows:

p = k – r 1 + k


project. As a result, if we use the industry DCF approach and discount promised rather than expected cash flows, the appro-priate discount rate should vary over the life of the project. For instance, using the three discount rates given in Table 2, we would calculate the value of the project’s promised future cash flows to be $725.37 million.

Since industry practitioners tend to use a single discount rate, it is informative to “back out” the single discount rate that, when applied to these cash flows, results in the same value. As it turns out, the single discount rate that results in a $725 million value for the above project is 13.34%. Note that this discount rate implies a uniform annual probability of expropriation of 8.24%, which is less than the probability of expropriation in the intermediate years, but greater than the probability of expropriation in both the early and final stages of the investment’s life.

Figure 2 shows the implied cumulative probability of expropriation under the single discount rate of 13.34% along with the cumulative expropriation probability using the actual expropriation rates that change over time. Under the single discount rate, the cumulative expropriation rate by year 3 is about 22%, but by year 25 it is nearly 90%! These numbers indicate that the single discount rate results in cumulative probabilities of default (an expropriation event) that are too high (compared to actual probabilities of default) in the very early stages and the final stages of a project’s life, and cumulative rates that are too low in the intermediate stages of a project’s life.

The use of a single discount rate with this approach creates a problem for companies that tend to use the same discount rates in specific countries regardless of the growth rates of the investment projects that they evaluate. To illustrate how this common practice can bias the evaluation of investment projects, let’s consider a second project, which is identical to the first, except that cash flows grow at an annual rate of 5%. Using the appropriate multiple discount rates, we calculate the value of this project to be $1.103 billion. However, if we apply the same single discount rate of 13.34%, which was appropriate for the no-growth project, the present value of these growing cash flows is calculated as $1.065 billion. Thus, the use of a single discount rate undervalues the 5% growth project by about 3.5%. And in cases where the growth rate in cash flows is higher, say 10%, the undervaluation is as high as 9.76%.

the annual probability of expropriation for implied annual probabilities of 5%, 10%, and 15%. The clear message from this figure is that the cumulative probability of expropriation grows dramatically in the early years of a project’s life, even when the annual probability of expropriation in any given year is very low.

The Term Structure of Expropriation Risk PremiumsUp to now, we have assumed that the probability of expro-priation in any given year is a constant, p. This assumption allows us to come up with a single discount rate that can be used to value each of the project’s cash flows. But for a vari-ety of reasons, the risk of expropriation might be expected to change over the life of the investment. For some investments, the probability of expropriation may be relatively low initially and then increase over time. The growing risk of expropria-tion could be the result of an increasing likelihood of a regime change or the fact that the size of the investment has grown with the passage of time. On the other hand, if the investment is not expropriated within, say, 10 years, we might expect the risk of expropriation thereafter to be declining as the value of the investment depreciates.

The above argument suggests that there should be a “term structure” of expropriation premiums. What this means is that the appropriate discount rate for discounting an invest-ment’s promised cash flows (if done correctly) will be different for each year of the investment’s productive life. In other words, there will be a term structure of discount rates that corresponds to the changing risk of expropriation over the project’s life.

To illustrate the problems that can arise when the term structure of sovereign default premiums is ignored, consider the valuation of an investment opportunity with the follow-ing characteristics:

• A 30-year life with annual cash flows of $100 million. • The risks of the project are such that the appropriate

discount rate is 4% in the absence of sovereign (expropria-tion) risk.

• The term structure of sovereign risk-adjusted discount rates (and associated implied annual probabilities of expro-priation) are shown in Table 2:

As can be seen in Table 2, the project is characterized by probabilities of expropriation that vary over the life of the

Table 2 Term Structure of Sovereign Risk-Adjusted Discount Rates

Term Year Appropriate Sovereign Risk Adjusted Discount Rate

Implied AnnualProbability of Expropriation

Initial stage 1-3 10% 0.0545

Intermediate stage 4-10 20% 0.1333

Final stage 11-30 8% 0.0370


8. In 2005 the Chavez regime began rewriting contracts between Venezuela and the major foreign oil companies, including Exxon Mobil, Chevron, British Petroleum, Royal Dutch Shell, ConocoPhillips and others. The net result was an increase in royalty rates

from 16% to 33%. (Dan Molinski, Chavez: “US Oil Firms Pay $3B a Year in Royalties to Venezuela,” Wall Street Journal (April 20, 2010).

a pre-tax cash flow of $350 million per year, which must be shared with PDVSA. Your challenge is to design a contract that is acceptable both to your firm’s corporate headquarters and to Venezuelan public officials.

Given the high probability of expropriation, we assume that your company uses a 20% discount rate to calculate the present value of the investment’s promised cash flows. Consequently, you must come up with a way to share the oil revenues so that the promised cash flows to your company have an internal rate of return of at least 20%. If we assume that the systematic risk of this project warrants an 8% required rate of return, then the 20% discount rate implies a 12% sovereign risk premium, which reflects an annual probability of expropriation equal to 10%. This probability of expropriation in turn implies that by year 15 the cumulative probability of expropriation will be 79.41%, and that by year 20 this cumulative probability will have risen to 87.84%. Therefore, by making the investment your company has entered into a contract with the Venezuelans with the knowledge that the project will very likely be expropriated.

One can imagine that in this situation such expectations can be self-fulfilling. The Venezuelans may see that your numbers imply a 10% probability of expropriation in any given year, and realize that they are effectively providing your company with a major windfall if they do not expropriate the investment. This situation raises a question as to whether you can structure a contract that allows your firm to earn a high rate of return without having a negative influence on the probability of expropriation by the host government.

To understand when this methodology undervalues projects with growing cash flows, one should first note from the above figure that the single discount rate discounts promised cash f lows too heavily after year 17. Since the present value of no-growth cash flows are quite low after year 17, there is very little bias associated with these cash flows being undervalued. But when cash flows are growing, a much higher portion of the project’s present value is attrib-utable to the later cash flows, which means that applying a discount rate that is too high to the post-year-17 cash flows of a growing project could have a significant downward bias on estimates of value.

Expropriation Risk and Contract DesignThe risk of expropriation can be influenced by the design of project contracts, particularly those provisions that govern how the cash flows are to be shared over the life of the invest-ment. Suppose that you are working for a major international energy company and have been given the task of negotiating a contract to extract heavy oil located in the Orinoco region of Venezuela. Your company has both the capital and the exper-tise needed to extract the oil, which makes the firm a good partner for PDVSA, the Venezuelan national oil company. But expropriation risk is high in Venezuela, which is an important impediment to reaching an agreement.8

To make this investment more concrete, let’s assume that it requires an initial investment of $2 billion, and results in the extraction of 10 million barrels of oil per year at a per barrel extraction and transportation cost of $40 per barrel. If we assume the oil can be sold for $75 barrel, this implies

Figure 2 Term Structure of Cumulative Default Probability

0.00

0.20

0.40

0.60

0.80

1.00

1 6 11 16 21 26

Actual Default Rates

Single Discount Rate

Year


To illustrate how a BOT agreement might make an investment more valuable, consider a Venezuelan energy investment with a 30-year project life, an initial outlay of $2 billion, annual cash flow of $35 million, and a required return of 8%. Assume further that the sponsor’s share of cash flow is 70% while the host government gets the remaining 30%.

The key to understanding how a BOT agreement can create value for this kind of project relates to the potential impact of the BOT agreement on the likelihood that the host government might extract value out of the project sponsor by expropriating part or all of the project’s future cash flows. The likelihood of expropriation is reflected in the term structure of sovereign risk premiums and the implied probabilities of expropriation.

Consider the term structures for the proposed investment using the two contractual arrangements shown in Table 3: the first (Case A) without the BOT agreement, and the second (Case B) with a BOT agreement that calls for transferring the project to the host government in year 20, after which time the sponsor forfeits all future cash flows.

The lower sovereign risk premiums in Case B stem from the effect of the sponsor’s scheduled transfer of ownership of the project to PDVSA after year 20 in reducing the probabil-ity of expropriation in the years 4-20. In the example, the sovereign risk adjusted discount rate declines from 23% to 20% for years 4-10 and from 16% to 8% for years 11-30. This change, in essence, reflects a decline in the sovereign risk premium from 15% to 12% for year 4-10 and from 8% to 0% for years 11-20. Note that the change in the term structure of sovereign risk premiums results in a 10.4% single discount rate corresponding to the BOT agreement, as compared to 20% for the original term.

Because of the reduction in the risk of expropriation under the BOT agreement, the sponsor’s valuation of the

Structuring Project Cash Flows The key to structuring a contract that is mutually acceptable to both parties is to allocate the cash flows in each year to the party that will value them the most. For example, as we just illustrated, the cash flows that are anticipated in the very distant future have little value to the foreign company that is making the investment since they are discounting them at a 20% rate. At the same time, the host government, with both better information about (and, indeed, control over) the level of expropriation risk, should use a lower discount rate value when valuing these far-off cash flows, thereby placing a much higher value on them. Consequently, in the face of very high risk of expropriation it may make economic sense to struc-ture the sharing of cash flows from the investment in a way that allows the foreign investor or project sponsor to get more cash in the early years of the project’s life (a practice known as “front-loading”) and offers the host government more of the more distant cash flows.

Front-loading Project Cash Flows Using BOT AgreementsBuild-operate-transfer (BOT) and build-own-operate-transfer (BOOT) agreements are contract designs that can accomplish front-loading of project cash flows to the proj-ect sponsor while reducing the risk of expropriation. These arrangements call for the sponsor to turn over the property to the host government before the project’s useful life has expired. By placing the turnover of the project in the initial investment agreement, the project sponsor reduces the host government’s incentive to expropriate. Furthermore, by building the eventual transfer of ownership of the assets into the agreement, the foreign investor can incorporate the economic consequences of the transfer into its analysis of investment cash flows.

Table 3 Managing the Risk of Expropriation using BOT Agreements

Case A: No BOT Agreement (30-year investment)

Appropriate Sovereign Risk Adjusted Discount Rate (k)

Sovereign Risk Premium

Implied Probability of Expropriation

Years 1-3 10% 2% 1.82%

Years 4-10 23% 15% 12.37%

Years 11-30 16% 8% 6.90%

Single sovereign required rate of return 20% 12% 10.00%

Case B: With the BOT Agreement (20-year investment)

Appropriate Sovereign Risk Adjusted Discount Rate (k)

Sovereign Risk Premium

Implied Probability of Expropriation

Years 1-3 10% 2% 1.82%

Years 4-10 20% 12% 10.00%

Years 11-20 8% 0% 0.00%

Single sovereign required rate of return 10.40% 2.4% 2.17%


lenders, the number of potential victims of an act of expropri-ation is greatly expanded, which could reduce the likelihood of an expropriation event. Second, the use of debt reduces the probability of expropriation because of the possibility of a sponsor bankruptcy, which could have unwanted effects on the host government and local stakeholders. Finally, as an historical matter, debt has typically been honored such that where debt financing is available, its use reduces the amount of equity that is exposed to expropriation.

In cases where there is substantial political risk, it is often suggested that the project sponsor use substantial amounts of non-recourse debt spread among a large number of power-ful international banks. Forcing the project sponsor to seek financing from a large set of international banks provides a good reality check on the project. If the banks are unwilling to provide the financing, this is an indication that the risks of political expropriation are unacceptable.

Asset Ownership Versus Control Over Project EarningsThe risk of expropriation is often linked to the ownership of natural resources. One final way of avoiding this risk is to separate ownership from control over the development and exploitation of the assets. For example, the project sponsor could leave the ownership of the natural resources with the host government and earn its return in the form of payments for work or service contracts.

SummaryMajor investment projects in emerging market countries are often quasi-public in nature, involving a private entity and the government of the host country. This situation makes it difficult for the private investor to make its assessment of the political risk of expropriation explicit in the analysis. In theory, political risk is project-specific and should be accounted for in the estimation of the expected investment cash flows. But in practice, the political risk associated with this type of invest-ment is typically accounted for implicitly by adjusting the investment’s required rate of return or the discount rate. As

project cash flows for years 1-20 increases. And as can be seen in Table 4, this increase is only partly offset by the loss of the value of the cash flows for years 21-30 that are forfeited in the BOT agreement. Under the BOT agreement, the sponsor anticipates a $481 million NPV, which represents an increase of almost $665 million over Case A. This increase is attrib-utable to the increase in the risk-adjusted value of the cash flows from years 1-20 of $691.5 million (net of the -$26.5 in lost value from the cash flows that would have been received in years 21-30).

Under the BOT agreement, moreover, the IRR to the project sponsor based on the 20 years of promised cash flows is 16.7%—and thus below the targeted 20%—while the corresponding IRR for PVDSA is somewhat higher at 18.5% (because under the BOT agreement PVDSA now receives 100% of the cash flows for years 21-30). But if neither party earns the 20% rate of return the project sponsor is seeking, then why should the project sponsor take on the project? The answer lies in the fact that, thanks to the lower risk of an expropriation event, the corresponding sovereign risk premium drops to just 2.4%, causing the required rate of return to fall from 20% to 10.4%.

Project FinancingProject financing offers another creative way to address the problem of political risk. In the case of project financing, the foreign investment is isolated from the other assets of the investing firm so that any losses due to expropriation are limited to the assets of the project. Furthermore, in order to secure project financing the investor generally requires the support of powerful financial institutions, which might include the major money center banks and quasi-government agencies like the IFC and the World Bank. The idea is that adding additional “prominent victims” of a sovereign default can reduce the probability of default.

What’s more, the use of debt financing in general also has some potential advantages when financing foreign invest-ments. First, by syndicating the debt among a large group of

Table 4 Adding Value by Using BOT Agreements

Case A Case B

No BOT With BOT

($ millions) Agreement Agreement Change in NPV

NPV to the Sponsor $ (183.14) $ 481.82 $ 664.96

Analysis of the Change in NPV

Increased value of Years 1-20 cash flows $ 691.49

Lost value of Years 21-30 cash flows -26.52

Net Change in NPV $ 664.96


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Benjamin Esty, 2000, “Financing the Mozal Project,” HBS Case #200-005.

Javier Garcia-Sanchez, Lorenzo Preve, and Virginia Sarria-Allende, “Valuation in Emerging Markets: A Simula-tion Approach,” Journal of Applied Corporate Finance, Summer 2010.

Julia Hanna, 2006, “Political Turmoil and Mexico’s Economy, Working Knowledge,” Harvard Business School (July 19), http://hbswk.hbs.edu/item/5458.html.

Jeremy Morgan, 2010, “Venezuela seen Paying Price for Chavez Expropriation of Oil Contractors,” Latin American Herald Tribune, Caracas, Wednesday February 24.

James M. Poterba and Lawrence H. Summers, 1995, “A CEO Survey of U.S. Companies’ Time Horizons and Hurdle Rates,” Sloan Management Review, 37, 1 (Fall), pp. 43-53.

Raymond Vernon, 1971, Sovereignty at Bay: The Multina-tional Spread of U.S. Enterprises (Basic Books).

Louis T. Wells and Eric S. Gleason, 1995, “Is Foreign Infrastructure Investment Still Risky?” Harvard Business Review, September-October.

we discuss in the paper this, approach disguises the specific assumptions being made about the risk of appropriation and makes it difficult to assess this risk properly.

Senior executives should not slavishly follow the dictates of standard practice. Although the analysis of the project that is shared with the host government may incorporate an implicit adjustment to the discount rate for political risk, we have argued that more explicit analysis of the antici-pated risk of expropriation should be incorporated into the analysis of expected project cash flows. This analysis could involve making specific assumptions about the term structure of expropriation risk over the life of the investment. Once this analysis is complete, and the expected NPV has been computed, a political risk premium can be calculated that produces the same NPV for the project. The latter would then be the basis for negotiations with the host government.

Finally, it is important to note that the political risk of making investments in emerging economies can be managed to some extent. Investments can be structured in ways that reduce political risk by structuring project cash flows in ways that better align the incentives of the project sponsor and government of the host country. Only when the opportunities for structuring the investment have been fully exploited can the project’s cash flows be estimated and valued.

v. ravi anshuman is Professor of Finance at the Indian Institute of

Management Bangalore.

john martin is Carr P. Collins Professor of Finance at Baylor Univer-

sity’s Hankamer School of Business.

sheridan titman holds the Walter W. McAllister Chair in Financial

Services at the University of Texas at Austin, and is also director of the

University’s Center for Energy Finance Research and Education.


Appendix—Continuous Time Model of the Default SpreadIn general, where the probability of expropriation is allowed to vary over time, the sovereign default premium (k-r) defined earlier in Equation (4) will be given by,

k – r = (1 + r)(p(t)) [1 – p(t)]

(1A)

Unlike in Equation (4), where the sovereign risk premium is constant over time, Equation (1A) suggests that the sover-eign risk premium could change over time with changes in p(t). Specifically, the sovereign risk premium is increasing in the probability of default (p). It is also increasing in r, which reflects the systematic risk of the project. This latter result is not intuitive. It will be easier to see why this is the case if we turn our attention to continuous time discounting.

In the discrete case, the probability of survival, Q(t), is given by [1-p(t)]t, reflecting a geometric rate of change. In the continuous time case, the geometric rate converges to an exponential rate, and the probability of survival until time t is given by e-p(t)t. Consequently, the present value equations (1) and (3) are transformed as follows:

PV = Ce –p(t)te –rt (2A)

PV = Ce –kt (3A)

Equating Equations (2A) and (3A) we find that the sover-eign risk premium (default spread) in the continuous time case is given by:

k – r = p(t) (4A)

The sovereign risk premium is increasing the instantaneous probability of default, p(t), as in the discrete time case. However, notice that in the continuous time case, the default spread is independent of the underlying riskiness of cash flows (r). Thus, our earlier finding of a relationship between sover-eign risk premium and the cash flow riskiness (r) is purely an artifact of discrete time compounding as it vanishes in the continuous time case.

Equation (4A) is both simple and elegant. It says that sovereign risk default spread mimics the instantaneous default probability. Thus the premium one has to add to account for sovereign risk is exactly equal to the instantaneous probability of expropriation. Consequently, if p(t) changes over time the default spread changes in exactly the same way.

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