The standard method of incorporating political risk into the calculation of cost of capital is flawed, according to a new paper. The authors offer an alternative procedure to more accurately reflect political risk in a net present value (NPV) analysis.
Double counting: The paper, “Political Risk and International Valuation,” is by Geert Bekaert (Columbia Business School), Campbell R. Harvey (Duke University), Christian T. Lundblad (University of North Carolina), and Stephan Siegel (University of Washington). The authors explain: “One popular approach [to measure the impact of political risk] is to assume that the sovereign yield spread captures political risk and to augment the project discount rate by this spread. We show that this approach is flawed. While the sovereign spread is influenced by political risk, it also reflects other risks that are likely included in the valuation analysis—leading to the double counting of risks. We propose to use ‘political risk spreads’ to undo the double counting in the evaluation of international investment projects.”
This paper is posted on the website of the Social Science Research Network, where you’ll find all kinds of interesting research being done related to business valuation. Economics and finance are considered to be social sciences, so they fall under the realm of SSRN.
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