Question

In some countries, the expropriation (seizure) of foreign investments is a common practice. If you were considering an investment in one of those countries, would the use of the payback period criterion seem more reasonable than it otherwise might? Why or why not? Can explain in a bit more detail please.

Answer 1

There had been empirical evidences and studies that have shown that the choice of capital budgeting decision is indeed impacted by the perceived level of political risk. While analyzing the capital investment decisions in the countries where political risk is high, multi-national companies have shown preference towards use of otherwise neglected Payback Period more than the traditional NPV or IRR methods.

The reasons for the same can be seen below:

1. In countries where the risk of expropriation is quite high, the return of capital takes precedence of return on capital. Companies are now concerned with the return of investment more than any incremental return on the investment. How quickly the investment capital is recouped, becomes the primary criterion for selection of project. Payback period is a precise measure of how quickly a project returns the capital back. Hence, payback period definitely finds a preference over rest of the methods of capital budgeting.
2. In countries with high political risks and uncertainty, the assessment of riskiness of the cash flows is quite complex and complicated. Since the assessment and quantification of risks involved is difficult, managers are not able to figure out the appropriate discount rate for investment decisions. Hence, NPV, IRR or profitability index methods can't be applied properly in the absence of a discount rate. Payback period becomes the automatic choice of the managers.
3. In politically risky countries, where expropriation risk is high, the life of the project itself is very uncertain. This limits the applicability of NPV, IRR or Profitability Index methods. In the absence of any other method, Payback period method becomes the automatic choice.

Finance Managers therefore rely upon shorter payback period as an investment criterion while evaluating investments in countries with high political risks.