The Country Risk Scenario of Malaysia - Case Study Example

Country risk Executive Summary The fundamental purpose of this report is to conduct a thorough analysis of the country risk scenario of Malaysia. Thereport is directed towards the management of Zeus Plc with the underlying aim of suggesting the company with appropriate financing strategies while they enter the mining industry in Malaysia so as to develop their own mine. The information that have been incorporated within the main body of the report has been retrieved from authentic and valid secondary sources such as Government database, journals, analyst column that encompasses the market in Malaysia. The findings obtained from the research suggests that investing in Malaysia looks like a prospective opportunity for Zeus Plc considering the fact that the value of British pound sterling is considerably stronger than Malaysian ringgit. However investment in this market comes with its fair share of risks associated with the country’s political and economic imbalances. It is with regards to this fact that the company is recommended to adopt a mix of equity, debt capital and grants in order to avoid excessively leveraging in its operations. In addition to that, the company also needs to accumulate a major proportion of the total investment amount from home country so as to pay less tax as well as reduce exposure to a foreign currency. Finally, the company is also suggested to use derivative instruments such as future and forward contracts in order to hedge foreign exchange and interest rate risk. Table of Contents 1. Introduction 4 1.1. Country risk 4 1.2. Type of venture 4 2. Task A 4 3. Task B 6 4. Task C 6 5. Conclusion and recommendation 7 Reference List 8 Appendix 10 1. Introduction 1.1. Country risk Country risk refers to the risk associated with investments made in a foreign nation. Country risk is a compilation of number of risks which include exchange rate risk, sovereign risk and political risk (Gervais, Heaton and Odean, 2011). In other words, country risk can also be defined as the risk of investments being frozen as a consequence of certain governmental policies or actions (Cornett, et al., 2011). The degree of country risk depends largely on certain macro and micro economical factors associated with the country itself. This fact implies that the degree of country risk will always differ from one country to another (Brigham and Houston, 2011). Countries with high risk rating tend to attract lower foreign investments whereas it is the opposite for countries with low risk ratings (Brigham and Ehrhardt, 2013). Till date, the US is considered as the standard for a country with the lowest risk rating and other countries measure their risk with respect to the US benchmark. 1.2. Type of venture Zeus Plc is a mining company based in the UK and is planning to develop a mine in Malaysia in order to extract minerals from the deposits that the company owns at the Tapir River. Provided that company has never operated anywhere outside UK, it will be appropriate for Zeus PLC to enter the Malaysian mining industry through a joint venture strategy. This will allow the company to get access to cheaper source of raw materials as well as labour force. In addition to that, Zeus Plc will also be in a position to assess the mining industry and the Malaysian business environment in general. Not only will that reduce the company’s risk in terms of its investment but it will also allow the managers to protect the company from any form of adverse economical downturns (Brigham and Daves, 2012). A joint venture strategy will help Zeus Plc to get easy access to the distribution networks of the local mining company. It will also enable the managers of Zeus Plc to share the risk as well as the cost associated with the operation. 2. Task A Country risk rating involves the assessment of the risk posed by a country on the basis of several factors such as political risk, economic risk, infrastructure assessments, credit ratings, debt indicators and so on and so forth (Euro money, 2014). The evaluation of a country’s risk rating enables foreign investors to make a learned judgment regarding whether or not to invest in a particular country. Following that if the decision is made in favour of investing in that country, the country risk rating serves as a guidance framework enabling foreign investors to formulate an appropriate financing strategy for making the investment. This evaluation enables companies to assess their exposure to currency risk and thereafter adopt suitable hedging strategies so as to decrease the exposure to such risk. As far as Zeus Plc’s plan to invest $1.5 billion in Malaysia is concerned, making this investment will expose the company to several risk factors. First of all Zeus Plc will be exposed to an extreme degree of political risk given the fact that political dynamics is rated very high in Malaysia. As far as the domestic political risk rating is concerned, Malaysia comes second after Thailand with an average political risk rating of 5.75 (Political & economic risk consultancy ltd, 2011). When this average is broken into several integral factors it shows that the country’s political infrastructure is highly unstable. Malaysia is very highly rated when it comes to the risk of change of administration in the next two years. It is also rated very high in term of the risk of a disorderly political changeover. The governmental policies enacted every year are moderately rated while the government is considered largely ineffective in term of enactment of its policies. Such a weak political environment has a considerable impact on other factors such as exchange rate, interest rate, tax rate, share price of companies and commodity prices (Sarno, Schneider and Wagner, 2012). Enactment of certain corporate tax related legislations could increase Zeus Plc’s tax payments drastically which in turn will deplete its margin of profit. Severe fluctuations in any of these factors could easily decrease the value of investment made by Zeus Plc thereby increasing the company’s project cost (Mancini, Ranaldo and Wrampelmeyer, 2013). Having a higher exposure in a foreign currency will always expose a country to a greater degree of foreign exchange risk. The Malaysian ringgit (MYR) has fluctuated considerably over the last few months which in turn may expose Zeus Plc if they have any exposure to the Malaysian currency (Berk and DeMarzo, 2011). Therefore, an exposure in the amount of millions may even lead to insolvency. According to Oanda (2014), the current conversion rate will give Zeus Plc 5.30 MYR/£ worth of investment. Provided that the British pound is a strong and circulated currency in the world, investment in MYR looks like a prospective investment. However, on the flip side if the value of Malaysian currency starts dipping down abruptly, it will deteriorate the value of investment made by Zeus Plc (Chance and Brooks, 2012). Interest rate risk is another cause of concern for Zeus Plc on whether they should move ahead with their plan to invest in Malaysia for developing the mine. An increase in the rate of interest will amplify the interest expenses of Zeus Plc for the liabilities that they have in their books (Lioui and Maio, 2012). This might deteriorate the company’s profitability by a considerable margin. Moreover, it has to be understood that interest rate fluctuations is one of the consequences of inflation (Solomon and Osu, 2012). Therefore, such abrupt movement in the market will increase the prices of commodity drastically thereby increasing the cost of raw materials that are required to develop the mine (Drehmann, Sorensen and Stringa, 2010). Interest rate risk can also be evaluated on the basis of international fisher effect which suggests that the disparity between the interest rate of two countries is the fundamental determinant of the appreciation and depreciation of one of the country’s currency (Verdelhan, 2010; Bierman Jr and Smidt, 2012). The World Bank (2014) data reports that the real interest rate of Malaysia is 4.7% whereas that of the US is 1.7% (The World bank Group, 2014). As far as the concept of international fisher effect is concerned, the US currency is set to appreciate by 3%. 3. Task B Given the fact that Zeus Plc will be exposed to a relative degree of foreign exchange risk after their investment in Malaysia, the company needs to adopt effective strategies in terms of structuring its finance. However, to be able to do that the sources of finance needs to be identified first (Hodrick, 2014). Firstly Zeus Plc could issue bonds and raise money from the stakeholders, issue shares and raise money from the equity holders/shareholders, access loans from banks and borrow money from the international marketing market (Arnold, 2011). However access to all these options exposes the country to interest rate risk. That is why Zeus Plc has to have a good mix of equity and debt capital (Moles, Parrino and David, 2011). The company has to make sure that their leverage ratio does not extend beyond the threshold (Lins, Servaes and Tamayo, 2011). This is precisely because of the fact that a fluctuation in the rate of interest could significantly increase the value of the liabilities held in the company’s book (Akotey and Abor, 2013). This will amplify the interest expense of the company. Alongside that the augmentation in the rate of interest can render the company incapable of paying off its debt obligations in which case (Alssayah and Krishnamurti, 2013). As far as mitigating the foreign exchange risk is concerned, Zeus Plc should rely on derivatives instruments to hedge foreign exchange risk with the help of forwards and futures contract between British pound and MYR if they believe that the value of the home country currency may depreciate with respect to the value of the foreign country currency (Cornett and Saunders, 2003; Bessis, 2011; McNeil, Frey and Embrechts, 2010). 4. Task C There are ample of opportunities available at the disposal of Zeus Plc that will help them to fund this project efficiently. Zeus Plc should consider making a major proportion of its total investment through funds accessed from the hone country (Reilly and Brown, 2011). This is precisely because of the favourable economic client in the home country as opposed to that in Malaysia. The effectual corporate tax rate in the company’s home country is significantly lower than the tax rate in the foreign country. Consequently, Zeus Plc will be able to realize more profits by accessing funds from the home country. In addition to that Zeus Plc could also avail grant money from the government in its home country as it would not require any sort of repayment. Although grant money comes with several restrictions in term of usage of the money, but it will help the company to keep its expenditures organized through that alongside decreasing liability exposures by a considerable level (Lam, 2014; Rejda, 2011). In that way the company will be able to increase its profit margin by a considerable level after the development of the mine in Malaysia. The value that the company may realize following the conclusion of this project can also be interpreted through utility theory. As far as the theory is concerned, utility measures the degree of satisfaction of a customer towards any goods and services (Brito, de Almeida and Mota, 2010; Dellavigna and Pollet, 2013). Therefore, abiding by this theory, Zeus Plc should use appropriate strategies so as to make sure that the company is protected from adverse economic scenarios such as rising rate of interest, commodity prices and fluctuating exchange rate (Gul and Pesendorfer, 2014). This will help the company to reduce the cost incurred in this project and realize significant profit. These proceeds can thereafter be invested in order to make sure those superior quality products and services are provided to customers and make sure that they serve their utility. 5. Conclusion and recommendation Investment in Malaysia can prove to be immensely profitable for Zeus PLC. However this investment comes with its fair share of risk associated with the country’s economic and political infrastructure. The major risks are posed by rise in interest rate and fluctuations in the exchange rate. In order to make sure that such risks are mitigated Zeus Plc needs to fund its project with a good mix of equity, debt and grant money accumulated from the home country thereby dropping the gearing ratio. The company also needs to use derivate contracts such as futures and forwards in order to hedge interest rate risk and foreign exchange risk. Implementing these strategies will allow Zeus Plc to mitigate the effects of adverse political and economic imbalances that may occur in Malaysia. 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