Nov 2015 Q1 b.
Ahomka Fruity Ltd (Ahomka), a listed company based in Ghana, produces fresh pineapple juice packaged in bottles and cans. The company has been exporting to Nigeria for many years, earning an annual after-tax contribution of NGN5 million. The company wants to establish a wholly-owned subsidiary in Nigeria to produce and sell its pineapple juice products over there. If a subsidiary is established and operated in Nigeria, Ahomka will cease exporting pineapple juice products to Nigeria. However, Ahomka plans to sell some raw materials and services to the subsidiary for cash.
Acquiring a suitable premises, required plant and equipment, and installing the machinery will take the next two years to complete. Production and sales will commence in the third year and indefinitely.
Capital expenditure is estimated to be NGN10 million at the start of the first year and NGN5 million at the start of the second year. Ahomka will have to make working capital of NGN2 million available at the start of the third year, and this is expected to be increased to NGN2.5 million at the start of the fifth year.
The proposed Nigerian subsidiary will produce the following pre-tax operating cash flows at the end of each of the first three years of production and sales:
The tax rate in Nigeria is 30% and tax is paid in the same year the profit is earned. Capital allowance is granted on capital expenditure at the end of each year of production/sale at the rate of 30% on reducing balance basis.
After the first three years of production and sales, post-tax incremental net operating cash flows will grow at the rate of 4% every year to perpetuity.
Ahomka plans to finance the project entirely with loans raised from Ghana at an after-tax cost of 18%. The maximum post-tax operating cash flows possible will be remitted to the parent company at the end of each year to help pay off the loans. Nigeria does not restrict fund remittance to a parent company outside of Nigeria and there are no taxes on funds remittance.
The Naira- Ghana Cedi exchange rate is currently NGN55.40/GHS. Annual inflation is expected to be 18% in Ghana and 20% in Nigeria.
Required: (Note: Professional marks will be awarded for presentation)
(b) Present a paper to the Board of Directors of Ahomka, which advises on potential risks the company might be exposed to if it proceeds with the Nigerian subsidiary project, and strategies the company could employ to avoid or manage the risks.
(10 marks)
View Solution
Introduction
Foreign operations present additional risks in excess of business risks which are inherent in any business venture whether domestic or foreign. Risks that are associated with foreign operations are collectively referred to as country risk, which is the risk that unexpected changes in the business environment of the host country will affect the value and position of a company. If Ahomka establishes and operates the proposed subsidiary in Nigeria, the company would be exposed to risks that are due to political actions/events (i.e. political risks) and/or risks that are due to economic conditions (i.e. financial risk). A good understanding of the possible political and financial risks is crucial to designing appropriate strategies for avoiding or managing the risks. This paper discusses possible political risks, financial risks, and other risks that could affect the value and position of Ahomka if it proceeds with the establishment and operation of a subsidiary in Nigeria. Ways of dealing with the potential risks are also covered in this paper.
Political risks
The Government of Nigeria may take actions that affect Nigeria’s business environment. Business environmental factors that may be manipulated by the Government of Nigeria to the disadvantage of Ahomka includes:
1. Taxes and tariffs: Tax rules in Nigeria might change to the disadvantage of Ahomka. The current corporate tax rate of 30% could be increased or new taxes, such as profit repatriation tax, might be introduced after Ahomka has established the subsidiary. If these happen, cash flows from the subsidiary will reduce, and the value of Ahomka will fall.
2. Local content and labor regulation: Rules relating to local content might change after Ahomka has established the subsidiary. New rules may demand more local content and/or impose restrictions on the use of expatriate managers. Ahomka’s plan to operate a wholly-owned subsidiary may be threatened by changes in local ownership requirement. If minimum local shareholding is raised, Ahomka will be forced to cede ownership to undesirable local partners or sell significant proportion of its stake in the subsidiary for a lower consideration.
3. Protection of intellectual property: Laws on protection of intellectual property may be nonexistent or weak. Besides, enforcement of such laws may be inefficient. Ahomka might lose profits due to infringements on its intellectual property rights.
4. Protectionism: Protectionist measures such as import quotas, imposition of stringent safety and quality standards, and devaluation of local currency might be employed after the subsidiary has been established. If this happens Ahomka’s plans to sell goods and services to the subsidiary for payments will not yield the expected cash flows.
5. Foreign exchange control: The Nigerian government might interrupt the current floating rate exchange rate regime and directly devalue or revalue the Nigeria naira against the Ghanaian cedi. If the naira is devalued relative to the cedi, import of materials and services from Ghana including those from the parent company will be more expensive to the subsidiary which will restrict intra-group transfers and reduce Ahomka’s value. Moreover, there might be exchange controls with the effect of blocking the flow of foreign exchange into and out of Nigeria. If Ahomka faces a situation of blocked funds after establishing the subsidiary it will not be able to remit the maximum funds possible to pay off loans raised from Ghana to finance the Nigerian operation.
6. Nationalization: Foreign operations face the threat of nationalization particularly when a democratic system of governance is not in place. Nigeria has recorded a sustained democratic system of governance in recent years. However, it history of coup d’états cannot be overlooked. If government falls into the hands of militants, radical changes to the investment and finance environment, including nationalization of foreign interests, may be executed.
7. Tradition of law and order: The tradition of disregard for and poor enforcement of law and order in Nigeria will adversely affect the value and position of Ahomka. Disregard for law and order as well as poor enforcement of laws would mean that employees, suppliers, and credit customers may not perform their contractual obligations. What is more, the subsidiary might suffer vandalism, sabotage, and looting with little or no help from law enforcement agencies.
In addition to the aforementioned business environment factors that could be manipulated by the government to the disadvantage of Ahomka and its subsidiary, there are political environment factors that might present additional risks Ahomka and its Nigerian subsidiary.
8. Civil war: If a civil war explodes in Nigeria, the subsidiary will lose sales as it may not be able to operate and/or customers/distributors will not be able to buy goods. Besides, there may be breakdown of law and order with attendant vices such as vandalism and looting.
9. Corruption: High level of corruption amongst public officials, including regulators, will make it difficult for Ahomka to get services it deserves and on time. If Ahomka decides to pay its way out, that will increase its costs of operation.
10. Racial or ethnic tensions: Racial or ethnic tensions has serious ramifications for human resource, marketing, and plant location decisions. If racial or ethnic tension is rife amongst employees, the company will not be able to operate efficiently.
11. Terrorism: Terrorist activities creates fear and panic amongst the population, including employees and customers. If the issue of Boko Haram is not solved and their activities spreads, operations of the subsidiary could be under threat.
Financial Risks
Ahomka may face financial risks such as currency risk, inflation risk, interest rate risk, and payment delays.
1. Currency risk: The exchange rate between the naira and the cedi is subject to change. If the cedi continues to strengthen against the naira as relative expected inflation rate in Ghana and Nigeria suggests presently, Ahomka will lose as naira cash flows from the subsidiary will convert into lower cedi cash flows. If this happens, it will be difficult for Ahomka to pay off the cedi loans it plans raising to finance the project. Besides, translation losses will reduce the book value of the Ahomka group.
2. Inflation risk: Unexpected changes in Nigeria’s inflation rate could present risks to Ahomka. If inflation in Nigeria increases above the projected 20% and Ahomka is not able to raise output prices high enough to absorb the rise in operating costs, cash flows from the subsidiary will reduce and the NPV from the project will be lower than projected.
3. Interest rate risk: Ahomka will face interest rate risk as it plans to finance the Nigerian operation with loans from Ghana. In the domestic economy, interest rates may fall in the future and that will make the fixed rate cedi loan relatively expensive. The rate of interest in Ghana relative to interest rates in Nigeria may change. Given the exchange rate, reduction in interest rates in Nigeria would make the domestic loan more expensive. What is more, if the pattern of cash flows from the Nigerian subsidiary changes, the fixed rate cedi loan may not be appropriate.
4. Payment delays: Delay in payments from distributors due to default or inefficiency in the funds transfer system will adversely affect the value of Ahomka. If payment culture in Nigeria is not that of prompt payment to suppliers and there are no mandatory interest charges on delayed payments, Ahomka may not receive cash flows timely as projected and this will reduce the NPV of the project.
Agency problems
As a company, there is likely to be agency problems, particularly those between shareholders and managers. However, when a company becomes a multinational, other dimensions of the agency problem arise. As Ahomka operates a subsidiary in Nigeria conflicts might arise between the objectives of head office managers and managers at the subsidiary.
Strategies for avoiding or managing the risks
There are a lot of risk avoidance or management strategies Ahomka could adopt. For the political risks, Ahomka could adopt the following strategies:
- Negotiate for a favourable business environment: Ahomka could negotiate with the Nigerian government and regulators for a favorable business environment before making the investment. Ahomka could negotiate for favourable tax rates and tax holiday, local content rules, cash flow remittances, subsidized financing, and corporate governance environment.
- Structure operations to limit exposure to political risks while optimizing returns: Ahomka could limit the extent of technology transfer to only non-essential parts of the manufacturing process, limit dependence on any single supplier or distributor, establish the Nigerian operation as a joint venture with local investors, or cede shareholding to local investors.
Ahomka could sell goods and services to the subsidiary for payments in case Nigeria imposes restrictions on profit repatriation. Ahomka could also patent its production process and brand names; and then license the subsidiary to use them for royalty payments. This may be an effective way of dealing with blocked funds. - Take political risk insurance: Ahomka can take insurance cover against insurable political risks such as political violence due to revolution, insurrection, civil unrest, terrorism, or war; expropriation or confiscation of assets; and restriction on funds remittance.
For the financial risks, Ahomka could do the following:
- Hedge against currency risk using financial derivatives such as futures and options to make expected cedi cash flows more certain.
- Hedge against interest rate risk using interest rate swap.
On the potential agency problem between managers at the head office and the manager of the subsidiary, Ahomka should align interests using an effective group bonus scheme. Again, the performance evaluation criteria for the subsidiary manager should exclude factors that are rather influenced by head office.
Conclusion
Like any other investment opportunity, an investment opportunity in the multinational business environment would come with its own risks. An attitude of avoiding risks altogether implies missing opportunities to enhance the value of shareholders. Insofar as the risks are managed effectively and efficiently to keep the NPV positive, the Nigerian subsidiary will be an excellent opportunity to increase the value of Ahomka’s shareholders.