Country Risk incorporating into capital budgeting 1 Country Risk incorporating into capital budgeting 8 Foreign Direct Investment is an investment that a multinational corporation makes in a host country where they act as a parent company and have control and earn a private return. The collaboration between companies, the cross-border partnership can facilitate long-term business solutions. Foreign firms through geographic diversification can safeguard themselves from supply chain disruption and can enhance the economic prospects of both host country and parent country. One of the perplexing issues faced in international business lies within the political and financial risk in project investment. Political risk can be defined as the risk which affects the cash flow of any company dealing in international business and investment which is affected by a change in government action. A subject matter of paradox gets its exposure when several authors and scholars vouch for the way capital budgeting is explained and practiced. The general observation in a corporate finance world is the increase in the value of shareholders with NPV being positive. The project cash flow can be forecasted followed by discounting method at a discounting rate to reflect the price that the capital market is charging for the risk in cash flow; hence the derivation for NPV (Guo & Zheng,2020). The investors only consider the systematic risk of the project while ignoring the imperfection that is captured in the capital market in the case of capital budgeting. It is also believed that that quantification of the political risk is a difficult task even for investors. In this paper, we will explore the country's risk in a broader aspect and incorporate it with the concepts of capital budgeting. It will also contain empirical evidence of FDI for an Australian company, AUF, investing in a software development business in India. The aim is to investigate the country-specific political and financial risk associated with India and its effect on the capital budgeting decision-making process. To ensure optimality, the key decision-makers often use a rule of thumb while dealing with the high deliberation cost involved in the political risk; thereby supporting the concepts of bounded rationality. Reviewed Literature FDI involves mergers and acquisitions, reinvesting profits earned from operations carried out in the different countries, the building of new facilities, and company loans. FDI is the control over the firm and can be in any form including joint venture, technological transfer, and enterprise. Globalization has made a severe impact on living standards and trade and has raised the FDI in the international market as well. 1.1. Theories The competitive position of the Australian firms in the global market makes it an acquirer of companies in host countries where the parent firm through its dynamic capability owing to their knowledge and utilization of the available resources hel ...

1. Country Risk incorporating into capital budgeting 1
Country Risk incorporating into capital budgeting 8
Foreign Direct Investment is an investment that a multinational
corporation makes in a host country where they act as a parent
company and have control and earn a private return. The
collaboration between companies, the cross-border partnership
can facilitate long-term business solutions. Foreign firms
through geographic diversification can safeguard themselves
from supply chain disruption and can enhance the economic
prospects of both host country and parent country. One of the
perplexing issues faced in international business lies within the
political and financial risk in project investment. Political risk
can be defined as the risk which affects the cash flow of any
company dealing in international business and investment which
is affected by a change in government action. A subject matter
of paradox gets its exposure when several authors and scholars
vouch for the way capital budgeting is explained and practiced.
The general observation in a corporate finance world is the
increase in the value of shareholders with NPV being positive.
The project cash flow can be forecasted followed by discounting
method at a discounting rate to reflect the price that the capital
market is charging for the risk in cash flow; hence the
derivation for NPV (Guo & Zheng,2020). The investors only
consider the systematic risk of the project while ignoring the
imperfection that is captured in the capital market in the case of
capital budgeting. It is also believed that that quantification of
the political risk is a difficult task even for investors.
In this paper, we will explore the country's risk in a broader
aspect and incorporate it with the concepts of capital budgeting.
It will also contain empirical evidence of FDI for an Australian
company, AUF, investing in a software development business in
India. The aim is to investigate the country-specific political
and financial risk associated with India and its effect on the
capital budgeting decision-making process. To ensure

2. optimality, the key decision-makers often use a rule of thumb
while dealing with the high deliberation cost involved in the
political risk; thereby supporting the concepts of bounded
rationality. Reviewed Literature
FDI involves mergers and acquisitions, reinvesting profits
earned from operations carried out in the different countries, the
building of new facilities, and company loans. FDI is the
control over the firm and can be in any form including j oint
venture, technological transfer, and enterprise. Globalization
has made a severe impact on living standards and trade and has
raised the FDI in the international market as well.
1.1. Theories
The competitive position of the Australian firms in the gl obal
market makes it an acquirer of companies in host countries
where the parent firm through its dynamic capability owing to
their knowledge and utilization of the available resources helps
it gain a competitive advantage in the international business.
Therefore, FDI can promote the conjunction of the competitive
position between a parent and a host country (Muzi, Kizil&
Ceylan, 2021). The foreign firms can reduce their set up costs
by integrating technological advantage and know-how which
will reduce the price in the host country. the consumers will
enjoy a higher quality of goods at lower prices. The output of an
MNC can be the input of a host country, this implies that FDI
has the potential to create demand in such countries leading to
an upward shift in the upstream and downstream domestic
investment in the host country.
The product life cycle is a firm concept that describes any
change in a country’s trade position in the long run (Paul &
Singh, 2017). It asserts that there is a shift in the competitive
advantage from one nation to the lower cost nations as a product
matures through its life cycle. The comparative advantage lies
with the parent country due to the technological know-how over
the other. in the third stage of the product life cycle, the less
developed nations become the manufacturing hub for the MNC’s
pertaining to the advantages where they indulge in exporting the

3. manufactured products to the advanced nations.
Market imperfect trade theory arises from the international
market where several companies are the owners of market
shares (Bajrami, 2019). Firms have shown imitative behavior
were to sustain competitive advantage firms are often observed
to have followed the internationalization of competitors.
1.2. Country Risk
The country risk is the degree of uncertainty involved with the
cash flows of the MNCs due to the adverse impact on the
country’s environment (Deligonul, 2020). A country runs a risk
analysis while starting a new project in some country or for
decision making to continue the existing business.
Political risk factors
Literature on the concepts of corporate valuation and the
effects of political factors is a growing concept and is available
in decent ransom.
(1) Blocked Funds: Blocking of funds arises when the
government of the host country restricts the remittance of funds
to the foreign country (Clark, 2018). However, it does not affect
the ownership rights of the parent company. the MNC can
alternatively invest the funds in any security locally, however,
the returns will be comparatively lower.
(2) Changing Tax Laws: A change in the tax law can have a
positive or negative impact on the investment (Guo & Zheng,
2020). A country with a rigid or poorly designed tax system will
discourage the investments which will bring more uncertainty
and added project costs
(3) Public attitude towards the firm: It can be in form of
purchasing tendency of the consumers which has shifted to local
goods. The exporters have very little to do with this risk as
every country motivates its consumers to purchase local goods
(Giambona, Graham & Harvey, 2017). Therefore, the parent
company in Australia must assess the loyalty o the consumers in
the host country and enter into a joint venture with a local
company instead of exporting goods.
(4) Wars: Any political changes like wars and public revolt

4. against firms can lead to higher taxes, expropriation, reduced
FDI incentives, tariffs, and difficulty in currency conversion. It
can lead to termination of operation, loss of assets, the decline
in income after tax, higher cost for imports, higher operational
costs. The MNC is indirectly affected due to additional costs for
its employee safety.
(5) Changing attitude of the host government toward the
Multinational Corporation:
The host government has the power to control the cash flow of
the parent company. it can be in the form of additional taxes,
even withhold it, restrict fund transfer, and a new pollution
control standard.
Financial Risk Factors
Besides political risk, financial risks must also be considered by
the MNC before deciding to invest further or make a new
investment decision in a host country (Rafat & Farahani, 2019).
An MNC which exports goods to a foreign country is concerned
with the demand for its product which is influenced by the
economy of the host country.
1. Inflation: The consumers’ purchasing power is affected by
the rates of inflation which influences the demand for MNC
goods. There is an indirect influence over the country’s interest
rates and currency valuation. High inflation rates are directly
related to a fall in economic growth.
2. Interest Rates: A higher rate of interest reduces the growth of
the economy and lowers the demand for MNC’s products and
vice versa.
3. GDP Growth: The real GDP growth, has a positive
relationship with the FDI and increases the FDI inflow for a
host country.
4. Exchange Rates: The rate of exchange also impacts the
country’s export which affects the production of the country and
the revenue from it. When the currency is strong, the export
demand reduces, and the import increases which causes a
decline in the overall production and national income of the

5. host country.
5. Labor Costs: If the labor cost is low, the foreign firms can
earn higher output by providing extra incentives to employees.
This will help in creating higher revenues.
Analysis
Country risk of India
The OECD risk grade of the country is at 3 indicating a
situation that the country can be unable to meet its external debt
obligation and can default (exportfionance.gov.au).
Figure 1: Country Risk rating of India (exportfionance.gov.au).
According to the reports from the World Bank’s ease of doing
business, India has improved its position and is ranked 63rd.
There are few benefits like handling cross-border trading,
construction permits, protecting the interests of minors, and
easy electricity and credit availability. However, the challenge
is associated with starting a new business, registering property,
and the tax structures of the country.
Figure 2: Ease of Doing Business(exportfionance.gov.au).
Incorporating country risk into capital budgeting
Country risk can be incorporated into capital budgeting using
the adjustment of estimated cash flows or discount rates
(Espinoza et al.,2020).
Adjustment of the Discount Rate
The discount rate and the country's risk can be adjusted with
each other. Lower the credit rating, more is the perceived risk,
and a greater discount rate will have to be applied to the cash

6. flow of the project. there is no precise formula for calculating
the discount rate and can lead to the cancellation of a feasible
project.
Adjustment of the Estimated Cash Flow
The feasible method to incorporate country risk is using the
cash flow estimation. Assuming that there is a 15% chance that
the Indian government will block the fund's transfer to the
parent country, the parent company in Australia must assess the
NPV of the project considering the condition. The Australian
government must assess the NPV of the foreign project if there
is a chance for the takeover of the software business. Every
possible impact on the cash flow and the NPV must be
calculated to derive the probability distribution of the NPV. The
probability of the project will assess NPV and its size. In this
way, the country's risk can be incorporated into the cash flow.
Australia has a 40% chance of withholding tax imposed by the
Indian government which will be 30% instead of 20%. There is
also an additional 42% chance that the host country will provide
Australia a salvage value payment of $6million instead of
$12million which is country risk.
Year 0
Year 1
Year 2
Year 3
Year 4
$ remitted by a subsidiary
$8,000,000
8,000,000
$6,600,000
$7,800,000
The withholding tax imposed on remitted funds(20%)

7. $1,600,000
$1,600,000
$1,320,000
$1,170,000
$ remitted after withholding tax
$4,400,000
$4,400,000
$5,280,000
$6,630,000
Salvage value
$12,000,000
Exchange rate of $
$0.50
$0.50
$0.50
$0.50
Cash flow to the parent
$2,200,000
$2,200,000
$2,640,000
$9,315,000
PV of parent cash flow @15% rate of discount
$1,913,043
$1,663,516
$1,735,843
$5,325,881
Initial Investment by parent

8. $10,000,000
Cumulative NPV
-$8,086,957
-$6,423,441
-$4687,598
$638,283
If there is an imposition of 20% of withholding tax by the
Indian government, the NPV for a 4-year project will be at
$638,283. If the salvage value is reduced to $10,000,000 with a
10% withholding rate of taxation. Based on the following
criteria, the estimated NPV for the project will be $943,421.
Year 0
Year 1
Year 2
Year 3
Year 4
$ remitted by a subsidiary
$8,000,000
$8,000,000
$6,600,000
$7,800,000
A withholding tax imposed on remitted funds (10%)
$800,000
$800,000
$660,000
$780,000
$ remitted after withholding tax

9. $7,200,000
$7,200,000
$5,940,000
$7,020,000
Salvage value
$7,500,000
Exchange rate of $
$0.50
$0.50
$0.50
$0.50
Cash flow to the parent
$3,600,000
$3,600,000
$2,970,000
$7,260,000
PV of parent cash flow @15% rate of discount
$3,130,434
$2,722,117
$1,952,823
$4,150,929
Initial Investment by parent
$10,000,000
Cumulative NPV

10. -$6,869,566
-$4,147,449
-$2,194,626
$1,956,303
Finally, considering the withholding tax at a higher level and a
lower salvage value together, the NPV will be at
Year 0
Year 1
Year 2
Year 3
Year 4
$ remitted by a subsidiary
$8,000,000
8,000,000
$6,600,000
$7,800,000
A withholding tax imposed on remitted funds (20%)
$1,600,000
$1,600,000
$1,320,000
$1,560,000
$ remitted after withholding tax
$4,400,000
$4,400,000
$5,280,000
$6,240,000
Salvage value

11. $7,500,000
Exchange rate of $
$0.50
$0.50
$0.50
$0.50
Cash flow to the parent
$2,200,000
$2,200,000
$2,640,000
$6,870,000
PV of parent cash flow @15% rate of discount
$1,930,435
$1,663,516
$1,735,843
$3,927,945,
Initial Investment by parent
$10,000,000
Cumulative NPV
-$8,069,565
-$6,406,049
$4,670,206
$742,261
The first scenario portrays a situation of joint probability with a
$12 million salvage value and a withholding tax rate of 20%.
There is a 12% chance that the value of the firm will be affected

12. by the project. therefore, the firm can accept the software
business project in India since it has a positive NPV and there is
an anticipation of limited loss.
No
Withholding tax rate
Salvage value of the project
NPV
Joint probability
1
10%
$12,000,000
$2,229,867
42%
2
20%
$12,000,000
$638,283
18%
3
10%
$7,500,000
$1,956,303
28%
4
20%
$7,500,000
$742,261
12%
India has a comparative advantage of low labor costs where the
employees are paid higher by the foreign firms in comparison to
the domestic firms. The employees can be encouraged to
produce higher output. Therefore, the Indian government can
attract more foreign investors if they cut down their tax rates to
reduce the import duties and property rights enforcement.
Recommendations
To reduce the exposure of country risks, the Australian firm

13. must consider the following strategies:
(1) Rely on Unique Innovative Technology: The subsidiary
company can employ advanced and innovative technology which
will provide the company a competitive advantage over the
domestic firms and the government (Muzi, Kizil& Ceylan,
2021).. In case of unfair treatment, the MNC can cut off the
supply of this technology.
(2) Use short-term horizon: The Australian company must be
reluctant to recover its cash flow at a frequent and quick period
such that the losses are minimized at the time of adverse
situation. The company can also sell its assets to create further
investment.
(3) Hire Local Labor: The local employees must be preferred
such that in case o adversity of government takeover, the parent
company can pressurize the government to consider the future
of the employees (Giambona, Graham & Harvey, 2017). This
can delimit the government takeover.Conclusion
To invest in a foreign country, the subsidiary company must
have a competitive advantage over the host country. Through
international diversification, an MNC can reduce its exposure to
threats of domestic economic condition and can spread its
losses. The credit rating for the country is at BBB- rating which
reflects a situation of weak revenue generation for the country.
However, the debt stock will remain steady with better progress
to be seen in the upcoming years. After measuring the country's
risk, it can be incorporated into capital budgeting. The
investors must be well informed about the policies that are
announced by the government for a safe business environment
within the country. India needs to improve its credit rating and
explore more productive methods to combat the challenges
posed by the growth and its tax structures.

14. References
Bajrami, H. (2019). Theories of foreign direct investment (FDI)
and the significance of human capital.
Clark, E. (2018). Political Risk in Hong Kong and Taiwan:
Pricing the China Factor. In Evaluating Country Risks for
International Investments: Tools, Techniques and
Applications (pp. 203-219).
Country Risk Retrievd from
https://www.exportfinance.gov.au/resources-news/country-
profiles/asia/india/country-
risk/#:~:text=India's%20political%20risk%20is%20low,and%20
undermine%20the%20economic%20recovery.
Deligonul, S. Z. (2020). Multinational country risk: Exposure to
asset holding risk and operating risk in international
business. Journal of World Business, 55(2), 101041.
Espinoza, D., Morris, J., Baroud, H., Bisogno, M., Cifuentes,
A., Gentzoglanis, A., ... & Vahedifard, F. (2020). The role of
traditional discounted cash flows in the tragedy of the horizon:
another inconvenient truth. Mitigation and Adaptation
Strategies for Global Change, 25(4), 643-660.
Giambona, E., Graham, J. R., & Harvey, C. R. (2017). The
management of political risk. Journal of International Business
Studies, 48(4), 523-533.
Guo, S. Y., & Zheng, M. (2020). Political Risk and Corporate
Tax Behavior: Firm-Level Evidence. Michael, Political Risk and
Corporate Tax Behavior: Firm-Level Evidence (December 30,
2020).
Muzir, E., Kizil, C., & Ceylan, B. (2021). Role of International
Trade Competitive Advantage and Corporate Governance
Quality in Predicting Equity Returns: Static and Conditional
Model Proposals for an Emerging Market. Journal of Risk and
Financial Management, 14(3), 125.
Paul, J., & Singh, G. (2017). The 45 years of foreign direct
investment research: Approaches, advances and analytical
areas. The World Economy, 40(11), 2512-2527.
Rafat, M., & Farahani, M. (2019). The country risks and foreign

15. direct investment (FDI). Iranian Economic Review, 23(1), 235-
260.
COUNTRY RISK INCORPORATING INTO CAPITAL
BUDGETING
1
Foreign Direct
Investment
is an
investment
that a
multinational
c
orporation
makes in a host
country where they act as
a
parent company and ha
ve con
trol and earn
a
private
return.
T
he
collaboration

16. between companies,
the
cross
-
border partners
hip ca
n
facilitate
long
-
term
bu
siness
solutions
.
F
oreign firms
through geographic di
versi
fication can
safeguard themselves from
supply chain
disruption
an
d can enhance the economic
pro
s
p
ects
of both host country and parent
country. One

17. of the perplexing issues faced in international business lies
within the political and
financial
risk in
project investment. Political risk can be defined as the risk
which affects the cash
flow of any company dealing in international business and
investment which is affected by a
change in government action.
A subject matter of paradox gets its exp
osure whe
n several authors
and scholars vouch for the way capital budgeting is explained
and practiced. The general
observation in a corporate finance world is the increase in the
value of shareholders with NPV
being positive. The project cash flow can be
forecaste
d followed by discounting method at a
discounting rate to reflect the price that the capital market is
charging for the risk in cash flow;
hence the derivation for NPV (
Guo & Zheng,2020).
The investors only consider the systematic
risk of the proj
ect while
ignoring the imperfection that is captured in the capital market
in the
case of capital budgeting. It is also believed that that
quantification of the political risk is a
difficult task even for investors.
In this paper, we will explore the coun

18. try's risk
in a broader aspect and incorporate it with
the concepts of capital budgeting. It will also contain empirical
evidence of FDI for an Australian
company, AUF, investing in a software development business in
India. The aim is to investigate
the co
untry
-
spec
ific political
and financial
risk
associated
with
India
and its effect on the capital
budgeting decision
-
making process
. To ensure optimality, the key decision
-
makers often use a
COUNTRY RISK INCORPORATING INTO CAPITAL
BUDGETING 1
Foreign Direct Investment is an investment that a multinational
corporation makes in a host
country where they act as a parent company and have control
and earn a private return. The
collaboration between companies, the cross-border partnership
can facilitate long-term business
solutions. Foreign firms through geographic diversification can
safeguard themselves from
supply chain disruption and can enhance the economic prospects

19. of both host country and parent
country. One of the perplexing issues faced in international
business lies within the political and
financial risk in project investment. Political risk can be defined
as the risk which affects the cash
flow of any company dealing in international business and
investment which is affected by a
change in government action. A subject matter of paradox gets
its exposure when several authors
and scholars vouch for the way capital budgeting is explained
and practiced. The general
observation in a corporate finance world is the increase in the
value of shareholders with NPV
being positive. The project cash flow can be forecasted
followed by discounting method at a
discounting rate to reflect the price that the capital market is
charging for the risk in cash flow;
hence the derivation for NPV (Guo & Zheng,2020). The
investors only consider the systematic
risk of the project while ignoring the imperfection that is
captured in the capital market in the
case of capital budgeting. It is also believed that that
quantification of the political risk is a
difficult task even for investors.
In this paper, we will explore the country's risk in a broader
aspect and incorporate it with
the concepts of capital budgeting. It will also contain empirical
evidence of FDI for an Australian
company, AUF, investing in a software development business in
India. The aim is to investigate
the country-specific political and financial risk associated with
India and its effect on the capital
budgeting decision-making process. To ensure optimality, the
key decision-makers often use a