Why should the discount rate not be adjusted for political risk?

Question

What will be an ideal response?

Answer 1

Consider a multinational corporation with a shareholder base that is globally diversified. In this case, the discount rate should reflect only international, systematic risks. Chapter 13 showed that systematic risks are typically related to how an MNC's return in a particular country covaries with the world market return. If the risk of loss from political risk does not covary with the world market return, no adjustment to the discount rate is necessary. Positive covariation between the cash flows from the project and the world market return increases the required global discount rate. Consequently, unless political risk, which adversely affects the MNC's investment returns, is systematically high when the world market return is low, political risk should not enter the calculation of the discount rate. Instead, the company's cash flows should be adjusted for the presence of political risk.
To fully understand this argument, suppose a company takes out an insurance policy against political risk and that the policy covers all contingencies and has no deductible. In this case, a company would simply compute its expected cash flows as if there were no political risk and then subtract the insurance premium it must pay each year from the cash flows of the project. The cash flows would then be discounted at the usual discount rate. While it is possible to purchase political risk insurance, it is seldom the case that an investment can be fully insured. If a company chooses not to purchase political risk insurance, it must incorporate into its forecasts of future cash flows how they might be affected by various political risks, such as expropriation, unexpected taxation, and so forth.