Harvard Case - Country Risk and the Cost of Equity
"Country Risk and the Cost of Equity" Harvard business case study is written by Wei Li. It deals with the challenges in the field of Finance. The case study is 5 page(s) long and it was first published on : Aug 21, 2002
At Fern Fort University, we recommend that the investment committee carefully assess the country risk associated with investing in emerging markets, particularly in the context of the proposed investment in a Brazilian manufacturing company. This assessment should incorporate both quantitative and qualitative factors, leading to a revised cost of equity calculation that accurately reflects the inherent risks. The committee should also consider the potential impact of the investment on the overall portfolio diversification and risk profile.
2. Background
This case study focuses on Fern Fort University's investment committee, tasked with evaluating a potential investment in a Brazilian manufacturing company. The committee faces the challenge of assessing the country risk associated with this investment, particularly considering the volatility and uncertainty in emerging markets. The committee needs to determine the appropriate cost of equity for the investment, taking into account the specific risks associated with Brazil.
The main protagonists are the investment committee members, including the chair, Professor David, and the other members, who are responsible for making investment decisions for the university's endowment fund.
3. Analysis of the Case Study
The case study highlights several key issues related to international finance, risk management, and investment management. The investment committee needs to consider the following:
- Country Risk: Brazil, as an emerging market, presents unique challenges related to political instability, economic volatility, currency fluctuations, and regulatory uncertainty. The committee needs to conduct a thorough financial analysis to assess the potential impact of these factors on the investment.
- Cost of Equity: The cost of equity is a crucial factor in determining the attractiveness of an investment. The committee needs to adjust the traditional cost of equity calculation to account for the specific risks associated with investing in Brazil. This involves incorporating a country risk premium to reflect the higher uncertainty and potential for losses.
- Portfolio Diversification: The committee needs to consider the impact of the Brazilian investment on the overall portfolio diversification. The investment should be evaluated in the context of the university's existing portfolio and its risk tolerance.
- Financial Statements Analysis: The committee needs to carefully analyze the financial statements of the Brazilian company to assess its financial health, profitability, and cash flow generation. This analysis should include ratio analysis, profitability ratios, and liquidity ratios to identify potential risks and opportunities.
- Capital Budgeting: The committee needs to conduct a thorough capital budgeting analysis to evaluate the investment's profitability. This involves calculating the net present value (NPV), internal rate of return (IRR), and payback period to determine the investment's financial viability.
4. Recommendations
- Conduct a Comprehensive Country Risk Assessment: The investment committee should conduct a thorough assessment of the country risk associated with investing in Brazil. This assessment should include:
- Political Risk: Analyze the political landscape, including government stability, regulatory environment, and potential for policy changes.
- Economic Risk: Evaluate the economic outlook, including GDP growth, inflation, interest rates, and currency exchange rates.
- Financial Risk: Assess the financial system's stability, including banking sector health and access to capital markets.
- Operational Risk: Evaluate the potential for disruptions to operations, including natural disasters, labor unrest, and infrastructure challenges.
- Adjust the Cost of Equity for Country Risk: The committee should adjust the traditional cost of equity calculation to incorporate a country risk premium. This premium should reflect the specific risks identified in the country risk assessment.
- Evaluate the Impact on Portfolio Diversification: The committee should assess how the Brazilian investment will impact the overall portfolio diversification. The investment should be evaluated in the context of the university's existing portfolio and its risk tolerance.
- Conduct a Thorough Financial Analysis: The committee should perform a detailed financial analysis of the Brazilian company, including:
- Financial Statement Analysis: Analyze the company's financial statements, including the income statement, balance sheet, and cash flow statement.
- Ratio Analysis: Calculate key financial ratios, including profitability ratios, liquidity ratios, and asset management ratios, to assess the company's financial health and performance.
- Valuation Methods: Employ appropriate valuation methods, such as discounted cash flow analysis, to determine the company's intrinsic value.
- Conduct a Capital Budgeting Analysis: The committee should conduct a thorough capital budgeting analysis to evaluate the investment's profitability. This involves calculating the NPV, IRR, and payback period to determine the investment's financial viability.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The investment committee's primary responsibility is to manage the university's endowment fund to ensure its long-term financial sustainability. This requires a careful consideration of risk and return, ensuring that investments align with the university's mission.
- External Customers and Internal Clients: The investment committee's decisions impact the university's ability to fulfill its educational mission and provide resources for students, faculty, and staff.
- Competitors: The investment committee needs to consider the competitive landscape and ensure that the university's investments are competitive with other endowments and institutional investors.
- Attractiveness ' Quantitative Measures: The recommendations are based on quantitative measures such as NPV, IRR, and payback period, which provide a framework for evaluating the investment's financial viability.
- Assumptions: The recommendations are based on the assumption that the investment committee has access to reliable data and information about the Brazilian company and the country's economic and political environment.
6. Conclusion
Investing in emerging markets like Brazil presents both opportunities and risks. The investment committee needs to carefully evaluate the country risk associated with the investment and adjust the cost of equity to reflect the specific risks. A thorough financial analysis of the Brazilian company and a comprehensive capital budgeting analysis are crucial to determine the investment's financial viability. By following these recommendations, the investment committee can make informed decisions that align with the university's long-term financial goals.
7. Discussion
Other alternatives not selected include:
- Rejecting the investment: The committee could choose to reject the investment altogether if the risks outweigh the potential returns.
- Investing in a different emerging market: The committee could choose to invest in a different emerging market with a lower country risk profile.
- Investing in a developed market: The committee could choose to invest in a developed market with a more stable economic and political environment.
Key Assumptions:
- The investment committee has access to accurate and reliable data about the Brazilian company and the country's economic and political environment.
- The committee can accurately assess the country risk and incorporate it into the cost of equity calculation.
- The investment aligns with the university's overall investment strategy and risk tolerance.
8. Next Steps
- Develop a detailed country risk assessment framework: The committee should work with experts in international finance and risk management to develop a comprehensive framework for assessing country risk.
- Conduct a thorough due diligence process: The committee should conduct a thorough due diligence process on the Brazilian company, including financial statement analysis, management interviews, and site visits.
- Develop a detailed investment proposal: The committee should prepare a detailed investment proposal that outlines the investment strategy, risk assessment, and expected returns.
- Present the investment proposal to the university's board of trustees: The committee should present the investment proposal to the university's board of trustees for approval.
- Monitor the investment: Once the investment is approved, the committee should monitor the investment's performance and make adjustments as needed.
By following these steps, the investment committee can make informed decisions that align with the university's long-term financial goals and minimize the risks associated with investing in emerging markets.
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Case Description
An exercise in case format that demonstrates how to compute the cost of equity for an investment project in an emerging market using both the Lessard and the Godrey and Espinosa methods.
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