Unpacking the Discount Rate: Part II
This is the second of two articles that discuss the use of discount rates in assessing losses in international arbitration. In this article, we explore how “country risk” can affect the value of investments and the approaches taken to incorporate this risk in damages calculations in international arbitration.
Defining “Country Risk”
We explained in Part I of this article that the discount rate applied in a discounted cash flow valuation depends, in part, on the risk attaching to the asset being valued. We also explained that risk has a precise meaning in the context of valuation theory: the variability of future cash flows around anticipated returns. An implication of this definition is that risk includes variability relating to both ‘out performance’ as well as ‘under performance’. This can be contrasted with the use of risk in everyday language, which tends only to be associated with adverse outcomes.
When valuing assets in less developed economic markets, valuers must have regard to both adverse outcomes that are less prevalent in developed economic markets (such as the chance of labour disruption) and increased variability of future cash flows around anticipated returns (for example, more macro-economic volatility). Both types of risk are sometimes referred to, in aggregate, as “country risk”. This can include political risk (higher taxes on profits, expropriation, inability to repatriate profits, etc.), macroeconomic risk (inflation, currency instability, high or unstable interest rates, etc.) and environmental risk (war, labour disruption, natural disaster, etc.).
A potential source of confusion when discussing country risk is that some valuers adjust the discount rate to try to take account of all of these “country risks”, whereas other valuers adjust the discount rate only to take account of risk as commonly understood in valuation theory (variability of future cash flows around anticipated returns). If taking the latter approach, valuers may consider whether it is also necessary to modify cash flow projections to take account of adverse outcomes associated with investments in the relevant country.