Discount rate Argumentative Essay

Given that the project is located in Argentina, a 10% percent discount rate is not the appropriate rate for valuing the project. 10% discount rate is the capital cost for similar U.S based projects. When the project is located in countries other than the U.S., a different discount rate should be used in compensate for different country risks. U.S is the most developed country in the world with well established political, economic and financial system.

Political environment is relatively stable, and chances of economic or financial crisis are low compared to other nations, especial developing nations. If the project is located in Argentina, we should take Argentina’s country risks into account when determining what discount rate should be used. Normally, discount rate in Argentina should be higher than that in the U.S due to higher country risks in Argentina. Country risks consist of three different types of risks, political risks, financial risks and economics risks.

During the past decade, political environment in Argentina has been relatively stable, the democratic government remained in power for 12 years and no expropriation had been reported for the previous 50 years. Although the political system seem to be stable in Argentina, political risks of Argentina is still relatively high compared to political risks in the U.S. Economics prosperous and stability is key to political stability, governments will lose power and credits if economy of the country shrinks and national income decreases.

Economic instability is a major concern for foreign companies when considering launching a project in Argentina. During 1980s, Argentina witnessed series hyperinflation, stagflation and huge fiscal deficits. National income decreased by a large amount and unemployment rate increased dramatically. Although situation in Argentina has been improving since late 1980s, the probability of having another hyperinflation period remains at a significant level. Economic instability in turn contributes to political instability; therefore, political and economic risks increase cost of capital for projects located in Argentina.

Financial risks, or precisely, currency risks, are the major country risks when considering locating projects in Argentina. Between 1970s and 1995, Argentina had experienced at least 9 major currency crises including the Tequila Crisis that happened recently. During currency crises, the Peso loss credibility and people in Argentina started selling Argentina Peso and buying USD since they expected that Argentina Peso is losing value and they will get nothing if they keep Peso instead of USD.

This will make Peso depreciate even further. Dow Argentina receives Peso in Argentina and converts Peso into USD. If Peso depreciates a lot, the company will suffer great loss. The convertibility law ties Peso to USD at an exchange rate of 1:1 to store value of Argentina Peso. This is not a perfect solution since pegging Argentina Peso to USD requires huge foreign reserve, Peso will lose its credit if the central bank of Argentina fails to maintain adequate amount of foreign reserve.

In conclusion, discount rate of projects located in Argentina should be high than similar U.S based projects in compensate for higher country risk in Argentina. From historical data, Argentine yields equal to U.S yields plus Argentine country risk premium. According to EMBI Index, Argentine country risk premium at the end of 1995 is about 11%, thus, discount rate for Dow is equal to cost of capital for similar U.S based projects plus Argentine country risk premium. That is 10%+11%=21% Using discount rate of 21% for projects in Argentina that developed in question 6 along with discount cash flow method, we can find the value of the project if the project is located in Argentina. The total value of the project using 21% discount rate is 514.4088 million USD. Value for stage 1, stage 2 and stage 3 are 290.9129 million, 153.7234 and 69.7725 million, respectively. Detailed comparison is as follows:

The total value of the project in Argentina is about one fourth that of the project if the project is located in the U.S. Value of the project decreases significantly because country risks in Argentina is higher than in the U.S. Higher country risk is incorporated in higher discount rate, and thus present value of cash flow decreases. Value of the project in stage 1 given the project is located in U.S is 714.391 million, and value of the project in stage 1 if the project is located in Argentina is 290.9129 million.

The project value decreases by more than a half if the project is located in Argentina. Percentage decrease in value in stage 1 is less than percentage decrease in value for the whole project, since majority value of stage 1 is from early years of stage 1. And country risks are generally lower in the short run than in the long run in that probability of unexpected events is larger in the long run; therefore, value of stage 1 decrease less than value of the whole project.

This is also true for stage 2, where value of project is 168.5178 million if the project is located in Argentina and value of stage 2 is 363.4208 million if it is located in the U.S. Value of stage 3 is only 69.7225 million if it is in Argentina, a significant decrease comparing to value of stage 3 if it is located in the U.S. Value of stage 3 is 903.3546 million if it is in the U.S. This is because the majority value of stage 3 comes from terminal value. The further the cash flow is from today, the more likely that there are events that will reduce value of cash flow to the company, for example, a currency crisis that depreciates value of Peso will reduce value of cash flow to Dow. In other words, country risks of Argentina are higher in the long run than in the short run. Value of stage 3 mainly comes from distant cash flows, and country risks affect these cash flow the most; therefore, value of stage 3 decreases significantly.