## **Learning Outcomes**

After reading this article, you will be able to explain when and why the cost of capital should be adjusted for country and project-specific risk in international investments. You will distinguish between business risk, financial risk, and country risk, and calculate project-specific discount rates using betas. You will also apply techniques to appraise projects with multi-currency cash flows, considering country risk premiums and selecting appropriate risk-adjusted discount rates for the ACCA Advanced Financial Management exam.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand how to apply the cost of capital to global investment decisions and adjust for country risk. Focus your revision on these syllabus outcomes:

- Explain when a project-specific or risk-adjusted discount rate should be used in place of group WACC
- Calculate project-specific cost of equity and cost of capital using beta estimation and re-gearing
- Assess how country risk premiums are determined and incorporated into discount rates
- Appraise projects with multi-currency free cash flows, including estimating future exchange rates
- Evaluate the financial and strategic impact of country risk and multi-currency considerations on project appraisal

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is a country risk premium, and why is it added to project discount rates in international investment appraisal?
2. How does a project's business risk profile affect the discount rate used in its NPV calculation?
3. When appraising a multi-currency project, what is the primary method for converting foreign currency cash flows to the home currency?
4. Explain briefly how asset betas are used in determining a project-specific discount rate.

## **Introduction**

In multinational companies, investment appraisal is complicated by differences in risk across projects and countries. Simply discounting foreign project cash flows at the parent company's group-wide weighted average cost of capital (WACC) fails to account for variations in business activities, financial structure, and country-specific risk. Instead, financial managers must identify when, and how, to use project-specific discount rates, factoring in country risk premiums and multi-currency cash flows.

This article provides a clear approach for ACCA candidates on adjusting the cost of capital for international projects, covering the adjustment for business and country risk, and the practical methods for multi-currency NPV calculations.

## **PROJECT-SPECIFIC COST OF CAPITAL: RISK ADJUSTMENT**

When evaluating an investment, the risk profile of the project may differ significantly from the company’s current business operations and capital structure. In these cases, using the group WACC as the discount rate can misstate the project's true value.

> **Key Term: project-specific discount rate**  
> A rate of return that reflects the unique business and financial risk of a particular investment project; used when the project’s risk profile differs from the main operations of the company.

To determine the correct project-specific rate, two main types of risk must be considered:

1. **Business risk**: The degree of uncertainty regarding cash flows from project operations.
2. **Financial risk**: The risk created by the financial structure (debt/equity) used to fund the project.

When the business risk or financial structure of a new project differs materially from that of the firm's core activities, a risk-adjusted rate must be calculated. This is achieved using beta estimation.

> **Key Term: beta**  
> A measure of an asset’s systematic risk relative to the overall market; used to calculate expected returns in the CAPM framework.

### Calculating a Project-Specific Beta

1. **Obtain a proxy equity beta** for a company engaged primarily in the same type of business as the project.
2. **De-gear** the equity beta to obtain the asset (unlevered) beta, removing the effect of capital structure.
3. **Re-gear** the asset beta to reflect the target/project capital structure, capturing the financial risk intended for the project.
4. **Apply the Capital Asset Pricing Model** (CAPM) using the project beta, risk-free rate, and relevant market risk premium.

> **Key Term: asset beta**  
> A company’s beta assuming it is all-equity financed; measures only business risk.
>
> **Key Term: country risk premium**  
> An extra return added to the risk-free rate or market risk premium to account for additional political, economic, or regulatory risks in a specific country.

### **Worked Example 1.1**

A UK engineering firm, with a current equity beta of 1.1 and gearing of 40% debt to 60% equity, is considering a project in a foreign country's food sector. Quoted food sector companies in the target country have an average equity beta of 1.4 and gearing of 20% debt to 80% equity. The firm's planned capital structure for the project matches its group structure. The risk-free rate is 4%, the market risk premium is 6%, and an additional country risk premium of 2% is considered appropriate.

Calculate the project-specific cost of equity for the appraisal.

> **Answer:**  
> Step 1: **De-gear sector beta** (food sector proxy, geared at 20:80):  
> Asset beta = 1.4 × (0.8 / [0.8 + 0.2 × (1 - 0.3)]) = 1.4 × (0.8 / 0.94) ≈ 1.19  
> Step 2: **Re-gear for project structure** (40:60 gearing):  
> Project equity beta = 1.19 × ([0.6 + 0.4 × (1 - 0.3)] / 0.6) = 1.19 × (0.88 / 0.6) ≈ 1.75  
> Step 3: **Apply CAPM including the country risk premium**:  
> Cost of equity = 4% + 2% + 1.75 × 6% = 4% + 2% + 10.5% = 16.5%

### **Exam Warning**

Be careful to use market values—not book values—of debt and equity when calculating gearing for beta adjustment. Using the wrong figures can materially distort your result.

## **COUNTRY RISK PREMIUMS IN OVERSEAS PROJECTS**

Standard discount rates based on developed market risk may understate the true required return for high-risk countries. These countries might have unstable political environments, undeveloped capital markets, or volatile economies, all of which demand extra compensation for risk.

A country risk premium is used to bridge this gap. It is typically estimated by:

- Taking sovereign bond yield spreads versus a developed market’s government bonds
- Analysing country credit ratings and adding an estimated spread to the market risk premium

The country risk premium is then:

- Added to the risk-free rate
- Or added directly to the required return calculated via CAPM

Projects exposed to significant country risk require this adjustment to avoid overestimating project value.

### **Worked Example 1.2**

A multinational is considering building a plant in a country whose government bonds yield 6% above US Treasuries. The local sector asset beta is 1.2. The market risk premium is 5%. Calculate the minimum appropriate discount rate for the project, ignoring tax/gross adjustments for simplicity.

> **Answer:**  
> Minimum discount rate = risk-free rate + country risk premium + (asset beta × market risk premium).  
> Assuming a US risk-free rate of 3%, discount rate = 3% + 6% + (1.2 × 5%) = 3% + 6% + 6% = 15%.

## **MULTI-CURRENCY PROJECT APPRAISAL**

International projects usually generate cash flows in different currencies. Standard practice is to:

- Forecast future cash flows in each currency
- Forecast relevant exchange rates (often using purchasing power parity or forward curves)
- Translate future foreign currency cash flows into the home currency at forecast exchange rates
- Discount all cash flows using the home currency risk-adjusted rate (including all relevant risk premiums)

> **Key Term: purchasing power parity**  
> An economic theory stating that exchange rates adjust over time so that identical goods cost the same in different countries, allowing for inflation differentials.

### **Worked Example 1.3**

A UK parent expects project inflows of €1m in year 1 and €1.05m in year 2. UK inflation is 3%, Eurozone inflation is 1%, and today’s spot rate is €1.20/£1. Using purchasing power parity, estimate year-1 and year-2 exchange rates and the GBP value of the inflows.

> **Answer:**  
> Year 1 rate: €1.20 × (1.01/1.03) = €1.177/£1  
> Year 2 rate: €1.177 × (1.01/1.03) = €1.155/£1  
> Year 1 inflow in GBP: €1m / 1.177 ≈ £849,000  
> Year 2 inflow in GBP: €1.05m / 1.155 ≈ £909,000

## **Summary**

Project appraisal in an international context requires careful adjustment of the discount rate for business risk, financial structure, and the specific country risk premium. When multi-currency cash flows are involved, reliable forecasts of exchange rates and consistent currency conversion in the NPV calculation are essential. Using group WACC without specific risk adjustment can lead to flawed investment decisions. Correct identification and quantification of risk ensure more accurate project valuations.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- When and why to use project-specific discount rates instead of group WACC
- How to calculate project-specific betas and cost of equity/debt
- The concept and application of country risk premiums in discount rates
- Approaches for incorporating multi-currency cash flows into NPV analysis
- The importance of using market value gearing in all risk adjustments
- Typical methods for forecasting and applying exchange rates in multinational projects

## **Key Terms and Concepts**

- project-specific discount rate
- beta
- asset beta
- country risk premium
- purchasing power parity

Cost of capital and project-specific rates - Country risk premiums and multi-currency projects