Capital budgeting, political risk and prudence.

In this paper we consider the problem of project evaluation in internationally integrated cross border capital budgeting with political risk. The framework is multi-risk where the first risk is associated with the volatility of the investment's outcome and the second risk is political and is modeled as white noise associated with one or more of the possible investment outcomes. Using the concept of prudence, we show that for utility functions with positive absolute prudence, otherwise equivalent investments can be ranked according to which possible outcomes are affected by the political risk factor. In fact, the effect of political risk is inversely related to the level of the investment's outcome. This gives rise to what we call the "good times" rule, which states that political risk associated with good times (superior outcomes) is preferred to political risk associated with bad times (inferior outcomes). The better the outcome the less onerous is the political risk.