Question Tag: Modified Internal Rate of Return

(a) Financial Appraisal of Proposed Subsidiary in Nigeria:

As funds will be remitted to the parent company at the end of each year, an appropriate approach to appraising the project is to:

• Forecast foreign currency cash flows.
• Forecast exchange rates.
• Convert foreign currency cash flows to home currency cash flows using spot or forecast exchange rates as appropriate at the end of the year.
• Discount home currency cash flows at the parent company’s domestic cost of capital to obtain project NPV in home currency.

(b) Paper on Risk Exposures Relating to the Nigerian Operation:

Introduction: Foreign operations present additional risks in excess of business risks, collectively referred to as country risk, which is the risk that unexpected changes in the business environment of the host country will affect the value and position of a company. This paper discusses potential political risks, financial risks, and other risks that could affect Ahomka if it proceeds with the Nigerian subsidiary project, and strategies for managing those risks.

Political Risks:

1. Taxes and Tariffs: Changes in Nigeria’s tax rules could increase the corporate tax rate or introduce new taxes, reducing cash flows and company value.
2. Local Content and Labor Regulation: Future regulations could demand higher local content or impose restrictions on expatriate workers, affecting operational plans.
3. Protection of Intellectual Property: Weak protection laws and poor enforcement could lead to losses from intellectual property infringements.
4. Protectionism: Protectionist measures, such as import quotas and currency devaluation, could reduce Ahomka’s expected cash flows.
5. Foreign Exchange Controls: Government interference with the current floating exchange rate regime could affect profit repatriation and increase costs.

Financial Risks:

1. Currency Risk: A strong Ghanaian cedi relative to the naira would reduce remitted cash flows from Nigeria.
2. Inflation Risk: Higher-than-expected inflation in Nigeria could lower cash flows if price increases are insufficient to offset higher operating costs.
3. Interest Rate Risk: Changes in interest rates in Ghana and Nigeria could increase the cost of the loan financing the subsidiary.
4. Payment Delays: Payment delays from Nigerian distributors could lower the project’s net present value.

Agency Problems: Agency problems could arise between head office managers and the subsidiary’s managers, particularly due to conflicts in objectives.

Strategies for Avoiding or Managing the Risks:

1. Negotiate for a Favorable Business Environment: Ahomka could negotiate with the Nigerian government for favorable terms, including tax holidays and favorable local content regulations.
2. Structure Operations to Limit Exposure: Limit technology transfer, establish joint ventures with local partners, or license intellectual property to reduce exposure to political risks and manage blocked funds.
3. Political Risk Insurance: Ahomka could obtain insurance to cover risks such as political violence, expropriation, or remittance restrictions.
4. Hedge Currency Risk: Use financial derivatives like futures and options to manage currency fluctuations.
5. Hedge Interest Rate Risk: Utilize interest rate swaps to manage exposure to interest rate changes.
6. Align Interests to Manage Agency Problems: Use an effective group bonus scheme and performance evaluation that excludes factors beyond the subsidiary’s control.

Conclusion: While foreign investments come with inherent risks, Ahomka can manage these risks effectively. If the NPV remains positive, the project represents a valuable opportunity to enhance shareholder value.