Determining a correlation between the value & location of an asset is what makes asset assessment so challenging. Assessing country risk provides an accurate picture of how operating an asset in this or that country can impact it politically, economically & financially. By and large, asset valuation is a complicated procedure & if we consider the fact that asset valuation is used for companies established abroad, it gets even more complicated.
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Country Risk Explained
Country risk plays an important role in damage assessment. The dilemma everybody is facing nowadays is whether assets’ value should be determined by taking into consideration a country where their value is generated or not. So, what determines companies’ value? The thing is, assets’ value can only be impacted by risks that the owners of companies are unable to diversify. Putting it differently, if some risks may be offset by investing in several assets, they may be substantially lessened & not be ultimately related to the assets’ value.
According to this principle, diversifying investments between several countries can help reduce risks associated with the influence of a particular country, thus preventing them from affecting assets’ assessment. However, there’s a downside: there won’t be any diversification of investors depending on a country, which is why country risk is going will still be a major factor. Diversification of investors can be an option, but diversification of country risks may be a big challenge, since it can communicate between countries, particularly when it comes to sudden recessions.
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Determining assets’ value through the DFC method includes applying a DR to their projected cash flows. The idea behind is to determine their current value. 2 factors impact the DR:
- monetary value in terms of time: current flows cost more
- risks: cash flows which will be safer later on will have a bigger value than unsafe ones
Hence, if generating cash flows in a particular country involves more risks, the DR is going to be a reflection of those risks through CRP. This growth of the DR can be perceived as:
- a return on investment in a particular country
- an adjustment of projected cash flows which doesn’t represent incremental risks
- combination of the two
If perceived in the second sense, the CPR on the DR becomes a way of transforming optimistic projections about cash flows into expected ones. Putting it differently, this is just another a way of obtaining projections about cash flows through the DCF method.
Since forecasting different scenarios arising from them can represent a big challenge, the generally accepted way of valuing risk-prone assets consists in adding an accretion to the DR.
To take into consideration country risks, evaluators sometimes decrease their projections with regard to cash flows & add a CPR to the DR. However, if cash flows get reduced due to country risks, adding a CRP which includes those risks in the DR will result in their doubling & lead to an overvalued DR & an undervalued asset.
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How DR is Affected by Country-Specific Risks
Determining country-specific risks may be done in 2 ways:
- by comparing the yield of securities a particular country issues with that of a reference country. If the difference is substantial, then the country’s government will be unlikely to fulfill its obligations & investors won’t be able recover their funds in case of default.
- by comparing the volatility of a country’s market with that of a reference country.
High concentration markets often have more volatility than diversified ones. If it is too high, it companies or industries’ risks, and not the country-specific risks or risks relating to assets under assessment are considered.
Another problem arises when there’s a substantial difference between inflation in a given country & that of a reference country. Therefore, the only way of determining both markets’ volatility will be by using an identical currency.
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Other Methods of Valuing Assets
It’s always worth considering which assets & shares can be compared. To be compared, assets must have identical risks & growth. This is frequently determined by the size of a particular company or industry, however, assets with not too different country risk will need to be carefully filtered out.
Things to Be Kept in Mind When Assessing Damages
Risks related to countries & assets aren’t always the same thing. Assets which do not depend on the capital or labor of a country tend to be less affected by any economic or political changes in it than assets which utilize these resources. If there’s a risk of a country’s government defaulting on its debts only shows how the country’s conditions influence the financial situation of its government. Although conditions like these also impact local companies, private enterprises get exposed to a plethora of risks unrelated to the government’s defaulting on its obligations.
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