CROSS-BORDER VALUATION ISSUES. Ninfa Borth Altadonna Jeff Fosler Susan Hua Shawn Kennedy Brian Limurti Alex Santibanez Valuation and Corporate Combinations Finance 668. 25 Sat. , Dec. 4, 2010 Contents I. Executive Summary3 II. Summary of Key Terms & Concepts3 III. Discuss various Valuation Implications and Applicability to MNC’s ; global capital markets13 IV. Discuss DCF Methods (Multiple analyses in US or Foreign comparables)18 V. Discuss a Short Example23
VI. Real World Company Case Study 1:25 VII. Real World Company Case Study 2:27 VIII. Conclusion28 I. Executive Summary There are many important facets to assessing cross-border valuation issues in the context of mergers and acquisitions. It is important that the investor gain a strong understanding of a companies’ culture, its management and its employees. Additionally, there are nuances involved in managing assets, capabilities, and operational plans as well as in information reporting and sharing.
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These are issues that are prevalent in evaluating any business, but particularly for any organization engaged in extensive operations or investments across national borders or located in foreign environments. To help us gain a better understanding of the complexities involved in creating a successful global firm topical areas such as Political Risk, Foreign Currency and Accounting Principles to among others, this paper will discuss areas that apply to multinational corporations and the global capital market, including important and.
We will examine how companies can craft an attractive cross border investment strategy by taking into consideration the particular areas that are unique to the global business arena. Additionally, we will compare differences between domestic and foreign Discounted Cash Flow (DCF), which will be reviewed with a further understanding on variables that can bring further valuation issues to the forefront when engaging in the constant and evolving challenges in the global markets.
We will conclude with real life illustrations, examining two cases studies: one involving political risk valuation for a Brazilian Corporation and the other case involving the valuation of businesses between a U. S. and U. K. company. II. Summary of Key Terms & Concepts GENERAL GLOBAL FINANCE MANAGEMENT TERMS/CONCEPTS Interest Rate Parity (IRP) is an important equilibrium position of globalized financial markets. It requires that national and international interest rates for the same types of loans in the same currency be equal.
Otherwise, arbitragers will simultaneously borrow in one market and lend in another, making tremendous profits. These profits are often much greater than could be attained from merchandise and services trade. Purchase Power Parity (PPP) describes the relationship between currency exchange rate and price levels in two countries. The exchange rate in two countries is positively related to the price level in foreign country and negatively related to price level in home country. “Spot” Exchange Rate is the rate prevailing for purchases or a sale affected at the time the rate is quoted. Forward” Rate is the exchange rate in which a contract can be signed at the same time to buy or sell foreign exchange in the future (hence, forward rate). Arbitrage is the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices. Fisher Equation is simply the nominal rate of interest = real rate of interest + inflation. HOW BORDERS AFFECT M&A VALUATION Inflation is a rise in most prices ??? a rise in the average price level of the economy.
Country Comparison:??Inflation rate (consumer prices) * *This entry furnishes the annual percent change in consumer prices compared with the previous year’s consumer prices. Chart created from https://www. cia. gov/library/publications/the-world-factbook/rankorder/2092rank. html; obvious issues are that the estimates vary from country to country so it may be difficult, inaccurate if the analyst does not have the most updated information. Exchange Rate is the rate at which one currency may be converted into another.
The exchange rate is used when simply converting one currency to another (such as for the purposes of travel to another country), or for engaging in speculation or trading in the foreign exchange market. There are a wide variety of factors which influence the exchange rate, such as interest rates, inflation, and the state of politics and the economy in each country. Tax Rates ??? The percent of income paid as tax, or the percent of the value of a good, service or asset paid as tax. *Created from following source: http://www. business. nsw. gov. u/aboutnsw/climate/A14_corp_tax_rates. htm 1 The effective tax rate for foreign companies with income less than INR 10 million is 41. 2% (40% basic corporate tax plus education cess of 3% on tax); otherwise it is 42. 23% (40%, plus surcharge of 2. 5% of the tax, plus education cess of 3% on tax and surcharge). The effective tax rate for domestic companies having income less than INR 10 million is 30. 9% (30% basic corporate tax plus education cess of 3% on tax), otherwise it is 33. 99% (30% plus surcharge of 10% of the tax, plus education cess of 3% on tax and surcharge).
A Minimum Alternate Tax (MAT) is levied at 10% of the adjusted profits of companies where tax liability is less than 10% of book profit. 2 The corporate tax rate is 30% (22% on the first JPY 8 million for companies with paid-in capital of JPY 100 million or less). In addition, there is a special local corporate tax (national tax), a business tax (a local tax which is deductible from taxable income) and prefectural and municipal inhabitant taxes (also local tax), which vary depending on the locality, the amount of paid-in capital of the company, etc. The rate shown (40. 9%) is the illustrative effective rate that applies for a company in Tokyo with paid-in capital of more than JPY 100 million after taking into account a deduction for business tax. Size based business tax is also levied on a company with paid-in capital of more than JPY 100 million, so the overall tax rate for such companies can be higher than 40. 69%. For small and medium sized companies with paid-in capital of JPY 100 million or less, the effective tax rate in Tokyo is 42. 05% with no size based business tax imposed. 3 The federal corporate income tax is applied on a sliding scale.
The marginal federal corporate income tax rate on the highest income bracket of corporations (US$18. 33 million for 2009) is 35%. State and local governments may also impose income taxes at rates ranging from less than 1% to 12% (top marginal rates average approximately 7. 5%). A corporation may deduct its state and local income tax expense when computing its federal taxable income, generally resulting in a net effective rate of approximately 40%. The effective rate may vary significantly, depending on the locality in which a corporation conducts business.
The United States also has a parallel alternative minimum tax (AMT) system, which is generally characterized by a lower tax rate (20%) but a broader tax base. 4 For fiscal years ending after 1 January 2007, the corporate tax rate is 33. 3%. An additional social security levy of 3. 3% is applied to companies where income taxable at the standard rate exceeds 2. 289 million Euros. This additional levy of 3. 3% is calculated on the basis of the reference amount of corporate income tax less 763,000 Euros. Small companies (those which have a turnover of up to 7. 3 million Euros, and where individuals hold at least 75% of the share capital, or which are owned by companies meeting the same conditions) are subject to a corporate tax rate of 15% on the taxable profit up to 38,120 Euros and the standard rate on remaining profits, and are exempt from the 3. 3% contribution. 5 Corporations and resident foreign corporations are subject to the 2% minimum corporate income tax (MCIT) starting in their fourth year of operation. The MCIT is based on gross income and is paid in lieu of the 30% corporate tax on net income whenever it is greater than the latter. The corporate income tax rate is 30% but may temporarily be reduced to 20% or 25% for certain Thai companies that are listed on the Stock Exchange of Thailand or the Market for Alternative Investment prior to 31 December 2009. For small and medium enterprises with paid-up capital of less than THB 5 million, a rate of 0% applies on the first THB 150,000 of net taxable profits, 15% on THB 150,001 to THB 1 million of net taxable profits, 25% on net profit of over THB 1 million but not exceeding THB 3 million, and a 30% rate applies for net profit over THB 3 million. The rate includes corporate income tax at 15% plus a solidarity surcharge of 0. 825% (5. 5% of the corporate income tax). In addition, a local trade tax, which ranges from 7% to 17. 15% depending on the location, is levied (around 14-16% on average). This trade tax is not deductible as a business expense from 2008 onwards. 8 A flat rate of 28% applies from 2009. Public companies that satisfy a minimum listing requirement of 40% and some other conditions are entitled to a tax discount of 5% off the standard rate, giving them an effective tax rate of 23% in 2009.
Small enterprises with an annual turnover of not more than IDR 50 billion are entitled to a tax discount of 50% of the standard rate for taxable income of up to IDR 4. 8 billion. Territorial Tax System is where taxation depends on where the income is earned. Worldwide Tax Credit System ??? Under such a system, the buyers company recognizes taxes paid in a foreign country as a credit against taxes liability at home. Thus, if the buyer’s tax rate is higher than the target’s, the buyer will receive a credit and still be liable at home for the balance. Timing of Cash Remittance is the movement of cash and resources.
There are a few concerns in this area which include (1) financial management, more specifically, when costs occur in the manufacturer’s country but profits are received in another country, (2) risks of transfer of money may incur small or even red-line returns and (3) it could affect when taxes need to get paid. Political Risk are those risks that are principally the result of forces external to the industry, and which involve some sort of government action or occasionally, inaction. Country Credit Spread (aka, Political Risk Premiums) is measured by rate-of-return differentials between U.
S. government bonds and U. S. dollar denominated sovereign bonds of the same tenor. Market Segmentation divides markets into submarkets (synonym: market segments, target groups), within which consumer behavior proves to be more homogenous than among those submarkets. Some of the factors include: * Foreign Exchange Controls * Controls on Investment by foreigners * High and Variable Inflation * Lack of High-quality regulatory and accounting framework * Lack of control funds or cross-listed securities that provides benchmarks for arbitrage * Small Size of Market Poor credit ratings or absence of credit ratings Corporate Governance refers to the relationship that exists between the different participants, and defining the direction and performance of a corporate firm. The following bodies are the main actors in corporate governance: (a) The CEO, i. e. the management (b) The board of directors (c) The Shareholders International Accounting Standards Board (IASC) – An independent, privately funded body responsible for establishing and improving international accounting standards. It superseded the International Accounting Standards Committee (IASC) in 2001.
According to the mission statement of the IASB, its objectives are: ??? to develop, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards that require high-quality, transparent, and comparable information in financial statements and other financial reporting, thereby helping participants in the world’s capital markets and other users make economic decisions; ??? to promote the use and rigorous application of those standards; ??? to bring about convergence of national accounting standards with International Accounting Standards and International Financial Reporting Standards.
The IASB has no authority to require compliance with its accounting standards. However, many countries (including the USA and member states of the EU) now require that statements of publicly traded companies are prepared in accordance with IASB standards. The organization is based in London. Encyclopedia. com. Accounting Principles, in terms of global accounting principles, different territories vary on their restrictions. International Financial Reporting Standards (IFRS) are principles-based Standards, Interpretations and the Framework (1989) adopted by the International Accounting Standards Board (IASB).
Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS was issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and SICs. The IASB has continued to develop standards calling the new standards IFRS. Below are some specific examples on how arts of the world are trying to accommodate the accounting principles: Australia: The Australian Accounting Standards Board (AASB) has issued ‘Australian equivalents to IFRS’ (A-IFRS), numbering IFRS standards as AASB 1???8 and IAS standards as AASB 101???141. Australian equivalents to SIC and IFRIC Interpretations have also been issued, along with a number of ‘domestic’ standards and interpretations. These pronouncements replaced previous Australian generally accepted accounting principles with effect from annual reporting periods beginning on or after 1 January 2005 (i. . 30 June 2006 was the first report prepared under IFRS-equivalent standards for June year ends). To this end, Australia, along with Europe and a few other countries, was one of the initial adopters of IFRS for domestic purposes (in the developed world). It must be acknowledged; however, that IFRS and primarily IAS have been part and parcel of accounting standard package in the developing world for many years since the relevant accounting bodies were more open to adoption of international standards for many reasons including that of capability.
Canada: The use of IFRS will be required for Canadian publicly accountable profit-oriented enterprises for financial periods beginning on or after 1 January 2011. This includes public companies and other “profit-oriented enterprises that are responsible to large or diverse groups of shareholders. ” European Union: All listed EU companies have been required to use IFRS since 2005.
In order to be approved for use in the EU, standards must be endorsed by the Accounting Regulatory Committee (ARC), which includes representatives of member state governments and is advised by a group of accounting experts known as the European Financial Reporting Advisory Group. As a result IFRS as applied in the EU may differ from that used elsewhere. Hong Kong: Starting in 2005, Hong Kong Financial Reporting Standards (HKFRS) are identical to International Financial Reporting Standards. While Hong Kong had adopted many of the earlier IAS as Hong Kong standards, some had not been adopted, including IAS 32 and IAS 39.
And all of the December 2003 improvements and new and revised IFRS issued in 2004 and 2005 will take effect in Hong Kong beginning in 2005. Implementing Hong Kong Financial Reporting Standards: The challenge for 2005 (August 2005) sets out a summary of each standard and interpretation, the key changes it makes to accounting in Hong Kong, the most significant implications of its adoption, and related anticipated future developments. There is one Hong Kong standard and several Hong Kong interpretations that do not have counterparts in IFRS. Also there are several minor wording differences between HKFRS and IFRS.
India: The Institute of Chartered Accountants of India (ICAI) has announced that IFRS will be mandatory in India for financial statements for the periods beginning on or after 1 April 2011. This will be done by revising existing accounting standards to make them compatible with IFRS. Reserve Bank of India has stated that financial statements of banks need to be IFRS-compliant for periods beginning on or after 1 April 2011. Japan: The Accounting Standards Board of Japan has agreed to resolve all inconsistencies between the current JP-GAAP and IFRS wholly by 2011.
Pakistan: All listed companies must follow all issued IAS/IFRS except the following: IAS 39 and IAS 40: Implementation of these standards has been held in abeyance by State Bank of Pakistan for Banks and DFIs IFRS-1: Effective for the annual periods beginning on or after January 1, 2004. This IFRS is being considered for adoption for all companies other than banks and DFIs. IFRS-9: Under consideration of the relevant Committee of the Institute (ICAP). This IFRS will be effective for the annual periods beginning on or after 1 January 2013.
Russia: The government of Russia has been implementing a program to harmonize its national accounting standards with IFRS since 1998. Since then twenty new accounting standards were issued by the Ministry of Finance of the Russian Federation aiming to align accounting practices with IFRS. Despite these efforts essential differences between national accounting standards and IFRS remain. Since 2004 all commercial banks have been obliged to prepare financial statements in accordance with both national accounting standards and IFRS. Full transition to IFRS is delayed and is expected to take place from 2011.
Singapore: In Singapore the Accounting Standards Committee (ASC) is in charge of standard setting. Singapore closely models its Financial Reporting Standards (FRS) according to the IFRS, with appropriate changes made to suit the Singapore context. Before a standard is enacted, consultations with the IASB are made to ensure consistency of core principles. South Africa: All companies listed on the Johannesburg Stock Exchange have been required to comply with the requirements of International Financial Reporting Standards since 1 January 2005. The IFRS for SMEs may be pplied by ‘limited interest companies’, as defined in the South African Corporate Laws Amendment Act of 2006 (that is, they are not ‘widely held’), if they do not have public accountability (that is, not listed and not a financial institution). Alternatively, the company may choose to apply full South African Statements of GAAP or IFRS. Turkey: Turkish Accounting Standards Board translated IFRS into Turkish in 2006. Since 2006 Turkish companies listed in Istanbul Stock Exchange are required to prepare IFRS reports. Wikipedia. com Retrieved on September 26, 2010: http://en. wikipedia. rg/wiki/International_Financial_Reporting_Standards Cultural and Social Issues – Differences in national culture, customer preferences, business practices, and institutional forces, such as government regulations, can hinder firms from fully realizing their strategic objectives. Uncertainty and information asymmetry in foreign markets make it difficult for firms to adjust and learn from both the local market and target firm (Kogut and Singh, 1988; Zaheer, 1995). Differences in the national cultures largely imply different individual values, risk propensity, acceptance of uncertainty, etc. while differences in corporate cultures suggest different organizational routines, managerial practices and styles, communication systems, etc. COMPARING TWO DCF VALUATION APPROACHES ??? This may be approached in two ways: 1. Convert local currency flows into dollars using forward exchange rates, and discount cash flows at a dollar rate. 2. Forecast in local currency and discount at a local WACC. ADJUSTING CASH FLOW SECTION In regards to Tax Rate Assumption and Inflation Rate Assumptions there should be uniformity in the procedures.
Nominal Cash Flow is cash flow in terms of currency, without adjustment for inflation. Real Cash Flow refers to the cash flows purchasing power. World Beta measures the sensitivity of a national market to world market movements. Integrated Markets is where capital should flow across borders in order to insure that the price of risk (i. e. , the compensation investors receive for bearing risk) is equalized across assets. Conversely, if capital controls or other forces prevent free movement of capital across borders, then it is likely that different economies will demand different levels of compensation of risk.
AN OVERVIEW OF COST OF EQUITY MODELS FOR CROSS-BORDER INVESTING 1- Asset pricing is globally integrated and the information environment is strong 2- Asset pricing is segmented and the information environment is strong 3- Asset pricing is assumed to be globally integrated though the information environment is weak 4- Asset pricing is segmented and the information environment is weak Multifactor Model factors include the following risks: World stock-market price risk ??? the classic CAPM says that this is the only systematic source of risk (. . . ).
The fundamental source of this dimension of risk is the fluctuation in worldwide business activity. Country stock-market price risk arises from variations in the price of a country’s equity market portfolio. Logically, this would capture all risk exposure in a country’s business sector. MSCI reports the daily performance of various country indexes each day. Industry price risk arises from variations in the price of the industry’s global equity market portfolio. For instance, the global automobile portfolio would consist of the equities of all automobiles manufacturer’s, regardless of their location.
Exchange rate risk results from the fluctuations in the relative values of foreign currencies against each other when they are bought and sold on international financial markets. Political risk is the unwanted consequence of political activities that will have an effect on the value of the firm. Liquidity risk is the risk of loss arising from an inability to quickly realize asset value or obtain funding and can be damaging if not properly considered or actively managed. Lack of liquidity can lead to large losses in asset/liability portfolios and off balance sheet activities and in extreme cases can trigger financial distress and insolvency.
Capital Asset Pricing Model (CAPM) has only one systematic risk factor ??? the risk of the overall movement of the market. This risk factor is referred to as the market risk. So, in the CAPM, the “market risk” and “systematic risk” are used interchangeably. International CAPM (ICAPM) tries to incorporate aspects that could influence asset pricing in an international context. Those could be exchange rates, transaction costs, barriers to foreign investment and different consumption tastes across countries.
Basis Points is defined as 1/100 of 1%, and is used to note changes in the rates of financial instruments. Basis points, or bps for short, are most commonly used in quoting interest rate and yield changes. III. Discuss various Valuation Implications and applicability to MNC’s & global capital markets When determining values of acquiring foreign businesses, it is crucially important to consider not only the models we use for domestic valuations, but also the characteristics that are unique to foreign transactions and how those characteristics add additional complexity and risk.
Among the complexities inherent in cross-border valuations are the need to factor-in the foreign country’s anticipated inflation levels and any anticipated fluctuations in their currency value. Additionally, investors must taking into consideration the country’s accounting principles, their tax laws and their rules on remittance of cash generated from an enterprise. Furthermore, the risk of instability or hostile actions by the foreign government’s political leadership are crucially important for the acquirer to consider. We will examine these issues (and how to mitigate them in valuation models) in the following sections. i.
Inflation Considerations ii. iii. The way in which a country conducts its monetary and fiscal policies can have a tremendous effect on that country’s inflation rate. High levels of direct intervention in money supply can cause inflation to increase at a substantial rate, which will eventually erode the purchasing power of income generated there. When valuing the returns of an investment in a business enterprise in a foreign country, one must factor that inflation risk into valuation models, as inflation rates will have an effect on any forecasted cash flows and discount rates used to value an investment in the foreign country.
It is therefore important to decide whether you will use nominal or real cash flows in your valuations, and to ensure that you are consistent with your choice in all related variables within your valuation model. One should seek to avoid the “money illusion” (Bruner, 2004, p. 350) or the false higher returns that can come from higher nominal cash flows caused by the inclusion of inflation versus the lower, real numbers. This is because nominal cash flow will be always appear greater than real cash flow due to inflation rates embedded in nominal cash flows.
It is therefore important to use the appropriate discount rate when valuing nominal or real cash flows. For example, if real cash flows are discounted using the nominal cost of capital, then the NPV estimate will be too low. Thus, nominal cash flows should be discounted with the cost of capital that includes an appropriate risk premium for inflation. * * iv. Foreign Currency Considerations v. vi. Additional implications of the interest rate effects discussed above are the effects that inflation variance between the domestic and foreign currencies will have on the exchange rates between the two countries.
If you are using discounted cash flows for example, and have chosen to convert the foreign cash flows to US dollars, there are additional factors that must be considered for your model to arrive at the most accurate valuation estimation possible. Since currency exchange rates are in a constant state of flux, and since the DCF model is based on forecasted future cash flows, it is important to use currency conversions based on forward exchange rates. The forward rate equation is: * * *
If markets act rationally, the theories of IRP (Interest rate parity) and purchasing power parity (PPP) show that forward rates can be useful in making estimations. Since GDP growth and inflation are important drivers of foreign-exchange rates, foreign-exchange rates need to reflect inflation in the long run in the valuation model because of purchasing-power parity (James 83). Valuation variances inherent in exchange rates can render one country’s firms cheaper to buyers from another country (Bruner107). Thus, it is crucial to incorporate the proper risk in cash flows. Often, emerging arkets experience restraint in capital flows that are linked with large real exchange rate depreciations (Bleaney 632), and this will affect the valuation of cash flow items such as revenue, expense, working capital, capital spending and debt instruments. Tax Rates and Implications When developing valuation models for analyzing potential returns in a foreign business investment, it is inappropriate to develop your model with the assumption of a consistent tax rate between the domestic country and the foreign country without evaluating the marginal rates of both countries.
Both forecasted cash flow and the discount rate can be distorted by choosing an inconsistent tax rate. By changing the tax rate, a valuation’s WACC can significantly be affected. This will have direct impact on the projected future cash flows that can greatly under/overvalue a company and affect the price paid in a merger or acquisition. Recent trends suggest that countries are moving more and more toward a consistent, singular rate in order to do more cross-border business, but there are still large variances among the global business communities.
For these reasons, it is important to select a marginal tax rate that corresponds with the country in which the cash flows are generated, as these cash flows will be taxed according to the country the business generating those flows resides in on top of any other applicable taxes from the acquiring company’s domestic government. After all, the total cumulative effect of all taxes will reduce the cash flows realized, and will have a huge effect on the overall NPV of the cross-border business investment. Timing on Remittance of Cash
Some foreign countries exhibit controls and limits on the timing and amount of capital and cash that is allowed to leave a country’s borders. As cash flow is controlled and limited, this will have a direct affect on projected cash flow in any given period in the future. Therefore, it is important that the valuation of a foreign investment is modified to reflect the timing of the cash received to the parent company rather than simply forecasting the operating cash flows. To be consistent, a valuation model should consider the financial management, repatriation risk, and the timing of taxes paid in a foreign company.
By implementing base-case assumptions, a valuation model can reveal different scenarios to adjust and calculate various present values of future cash flows if a foreign company were inclined to implement stringent capital controls in a given period that would limit the cash flow from being delivered to the parent “home” company. For example, in 1998, Malaysia imposed stringent capital controls that prevented outside investors from transferring their money overseas in order to maintain liquidity in the local market (Kaplan 6).
Accounting Principles There are large variances between accounting principles among the global business community. US companies, when valuing foreign firms, may find it beneficial to convert the foreign assets and liabilities into a GAAP equivalent before making final estimations on the return potential of any foreign business investments. There are several approaches that are taken throughout the world, and some of the notable examples of cross-border variations are: * * Cash * * Expense and Investment * Pension Accounting * * Inflation Accounting (Bruner, 2004, pg. 353) Some of the notable examples of different regional approaches are listed below: * * Anglo-American Dutch * * Continental Europe * * South American * * Mixed Economies * * Islamic * * International Accounting Standards Committee (IASC) * * (Bruner, 2004, pg 353) Political Risk The US has been relatively stable as a nation (politically and fiscally) for the past 50 years.
However, the same cannot be said for the rest of the world. Many nations and regions have undergone significant changes in that time, and those changes can carry with them a “political risk”, to businesses that are located in less stable countries. There are challenges in determining the effect of a country’s political risk, and those are often exacerbated by a lack of information available on foreign companies. Furthermore, measuring political risk is very subjective; the extent varies greatly across emerging markets.
Before valuing political risk, acquirers need to examine dangers such as expropriation and regulatory risk. When valuing a cross-border investment, one must take into consideration the overall political environment of the country or region. For example, an investment in a stable country like Canada could be evaluated with a low political risk level. However, and investment located in an unstable country like Darfur would be very risky. The government could appropriate some or all of your returns and assets at any moment, possibly resulting in a total loss on your investment.
For these reasons, it is important to factor in the level of political risk involved. You do this by creating additional variables in your discounted cash flow analysis. Naturally, when there is a risk of destabilization, default, or war, the required rate of return investors will demand from investment in that country will increase substantially. Failing to incorporate the different variables for political risks, your model valuation could produce inflated cash flows which will over value the targeted foreign company.
One approach to adjusting valuation for political risk is using the discount cash flow approach with an appropriate discount rate that accounts for political risk (Patel 4). However, measuring political risk remains complex and imperfect. There are few independent sources that can provide a better measure of political risk in an emerging market such as the sovereign spread, Euromoney Country Risk Rating, Economist Intelligence Unit, Institutional Investor Country Risk Rating, and the International Country Risk Guide. Two methods can be used to adjusting the discounted cash flow valuation that accounts for political risk.
The acquiring firm can adjust the cash flows of the target firm by underestimating the target firm’s expected cash flow, thus providing a more conservative estimate. Another approach that could be considered would be to adjust the discount rate for the target’s firm’s cash flow that appropriately reflects the level of political risk in the foreign country. In any case, it is important that the acquirer firm construct various scenarios based on the different macroeconomic factors that will affect the performance of the foreign target firm (Patel 8).
IV. Discuss DCF Methods (Multiple analyses in US or Foreign comparables) * * Now that we have discussed some of the many risks and considerations to factor into the valuation of cross border acquisition targets, we will now look at some of the nuances one should consider in their valuation models when contemplating an international investment. First, we will look at the appropriate discount rate to use. a. On the domestic side of business, the aftertax Cost of Debt is calculated by the following: equation: Where Tax Rate) is the percentage rate that the firm is taxed depending the domestic nation’s tax laws and the size of the firm. (Rate of Debt Financing) is the percentage rate that firms pay on their debt from lenders. A common method of determining the Cost of Equity () on the domestic side is to use Capital Asset Pricing Model (CAPM) equation, which is defined as: Where (Risk-free rate) is the determined to be the value of long-term U. S. Treasury bond yield. (Beta of asset i) is the measured covariance of asset i stock’s returns and the market returns divided by the variance of returns on the market.
The value of beta used for the domestic calculations is a U. S. beta. (Equity market risk premium) is the difference between the expected return on the market and the risk-free rate. The Weighted Average Cost of Capital (WACC) is defined domestically use the equation: Where (Equity-value Ratio) is the amount of equity divided by the total amount of financing within the firm. (Dept-value Ratio) is the amount of debt divided by the total amount of financing within the firm. Ross, Stephen A. , Westerfield, Randolph W. , and Jaffe, Jeffrey (2010) Corporate Finance.
New York, NY: McGraw-Hill/Irwin b. (i)Typically, most corporations make investment decisions in terms of the home currency. By doing this, the corporation can directly compare a few investment proposals by directors and also ease the process of financial planning and reporting. Thus, there are two ways by which analysts derive a U. S. dollar NPV from foreign country free cash flows: 1. The dominant approach to project evaluation is to discount expected-after-tax project cash flows (after converting the foreign currency flows to dollars) by the dollar weighted average cost of- capital.
The formula looks like this: Essentially, there are two elements in this formula that we need to look at: a. Foreign Currency rate * Since the NPV formula requires that future cash flows be converted from foreign to home currency before discounting them, we need to know which foreign exchange rates we should be using. Typically, most financial advisers and institutions offer two-year forecasts, and beyond that, we need to use the interest rate parity formula (which considers long-term future inflation rates in the two currencies). * b. Estimation of WACC Estimating the dollar WACC must reflect not only the systematic risk (beta), but also we need to incorporate the equity market risk and political risk of the country. Ways to estimate those risks are: * Business risk could be priced using CAPM and cost of debt for comparable firms in the United States. When the home and foreign countries are very similar in terms of risk, the calculation of business risk is all we need to estimate WACC. * Country Risk could be estimated as the yield difference between U. S. Treasuries and yield dollar denominated foreign government bonds.
The end result is a DCF value denominated in U. S. dollars. * 2. The second approach is to discount foreign cash flows using a foreign WACC, and then translate the foreign DCF into a dollar DCF using the spot exchange rate. However, a major drawback to this method is that betas are not estimated for many stocks in emerging markets, so often the only way to estimate Beta accurately is to obtain quality and reliable market data of the country (which might not be available in developing countries). b. (ii) Cross border mergers and acquisitions are playing an important role in the growth of international production.
Generally, the basic merger or acquisition is the same worldwide; however, undertaking a cross-border transaction is more complex than those conducted ”in market” because of the multiple political and country risks involved. Country risks are defined as challenges that occur due to the multiple variations in business across countries. Those variations are: inflation, foreign currency exchange rates, tax rates, and social/cultural issues. On the other hand, political risks are defined as the extent to which local governments intervene in the working of markets and firms.
Examples of government interventions include regulation, punitive tax policies, restrictions on cash transfers and employment policies among others. Some ways to mitigate foreign investment risks are: 1. Adjust the discount Rate: * Adjusting the discount rate also means estimating a precise weighted average cost of capital (WACC). Typically, cost of debt, tax rate, and capital structure are identifiable elements. Thus, the most important part to investigate is the cost of equity. A few ways to estimate cost of equity are: * Use a discount rate for a stream of cash consistent with the risk of that stream in the foreign country. Use a discount rate based on the target’s stock prices or prices of comparable firms. * 2. Adjust the Beta: Test for market segmentation to see if the beta of a foreign country index versus the global equity market index is materially different from 1. 0. Plainly, country betas can vary dramatically with differences in local volatility and correlation. And if capital market segmentation exists, global CAPM must be used to estimate cost of equity. Three elements to consider in global CAPM: Ke = Rf (US)+ Country Credit Spread+(Bx foreign. B US/Foreign). Rm US ??? Rf US) * Country credit spread (political risk premium) measured by rate of return differentials between U. S. government bonds and U. S. dollar denominated sovereign bonds of the same tenor * Bx foreign = Beta of asset X estimated against the foreign country equity market index * B US/Foreign = Country beta of the foreign country equity market index relative to the US equity market index 3. Adjust the cash flow An alternative approach for taking into account country risk is to incorporate it in your model for the cash flows, and then discount those cash flows at the developed market usual discount rate.
In practical terms, managers can develop a number of scenarios about the future cash flows, employing a number of assumptions, and then weight each scenario with a probability based on the managers’ knowledge or even instinct. This approach could work because: * Investors can diversify many company-specific risks. The use of a country equity risk premium in the discount rate can account for some of the diversifiable risks as well, overstating the needed discount. * Logically, by applying a different discount to the same cash flows forecast, managers aren’t required to think about what the whole risk analysis was.
Instead, we should require managers to make explicit risk scenarios and assign probabilities. These tasks would push managers to gain better understanding of the operations and investment characteristics of the target’s home country. In the end, managers will make better investment decisions, and investors will benefit handsomely. c. Compare and Contrast Domestic vs. International The table below compares and summarizes some of the differences that exist between Domestic and International valuations, and the implications that the investor should consider in their models. Domestic| International| * Cost Of Equity| * Acquirer Cost of Equity doesn’t change even if the acquired company had lower/higher cost of equity | * If market segmentation exists, cost of Equity would increase/decrease depending upon the global CAPM calculation| * Valuation| * Free cash flows are discounted by cost of capital (WACC) to obtain economic present value of assets| * 2 approaches: * Free cash flows are discounted by cost of capital (WACC).
However, foreign exchange rate and equity market risks are included in the calculation * Discount foreign cash flows using a foreign WACC, and then translate the foreign DCF into a dollar DCF using the spot exchange rate| * Adjusting Risk * | * Typically there are no political risk and country risk in the cost of capital calculation | * 3 ways * Adjust the discount rate * Adjust the Beta * Adjust the cash flow * | d. Cost basis is a major concern when it comes to determining values in multiple foreign comparables of across borders mergers and acquisitions.
The costs of political risk, inflation and deflation, foreign exchange rates, tax rates and capital market segmentation can become very large if they are not considered in the valuation of the merger or acquisition. It can be difficult to calculate definitive numbers when accessing such variables as political risk and capital market segmentation for across borders mergers and acquisitions. However, research, history, and educated estimates of the quantifiable values of those factors make the cost basis calculations possible.
For multiple analysis in cross border transactions, it makes the most sense to compare and contrast data dealing with multiple foreign comparables. Since the merger or acquisition will be taking place in a foreign market this method will allow for the greatest clarity and understanding of what will be the associated costs and expenses, along with expected work environment and workforce production. Using multiple analyses of multiple foreign comparables will allow for the necessary determination of an accurate DCF of a cross border mergers or acquisition. V. Discuss a Short Example In this short example of a cross-border merger, specifically of a foreign company merging with a US company, we’ll discuss the valuation implications as well as touch on nonfinancial repercussions of the Daimler and Chrysler unification. The DaimlerChrysler AG merger took place in the 1990’s and the intent was to bring two successful and companies (Daimler-Benz and Chrysler) together to create one of the largest automobile companies in the world. The marriage between the two would bring increased asset and resources, not to mention an increase in market share.
Below are excerpts from International Review of Financial Analysis (IFRA) on the “Valuation Creation and Challenges of an International Transaction – The DaimlerChrysler Merger. ” “Daimler-Benz retained Goldman Sachs and Chrysler hired CSFB to act as their financial advisors. In determining the exchange ratio, Goldman Sachs and CSFB considered several valuation techniques, including discounted cash-flow techniques, P/E multiples, and comparable company analysis (based on equity analyst price targets).
Financial advisors reviewed publicly available business and financial information related to the merging companies as well as the financial forecasts provided by Daimler and Chrysler. ” “CSFB reviewed the stock price performance of the merging companies and compared them with the performance of other U. S. and European auto manufacturers. The high, low and average share prices were considered, and CSFB concluded that the proposed exchange ratio for the DaimlerChrysler shares represented a premium for the Chrysler shareholders ranging from 15 to 37%.
CSFB also reviewed the equity analysts’ price targets from selected investment research reports. The exchange ratio represented a premium of 16% over the mean target prices. ” “To estimate the present value of stand-alone Chrysler, a discounted (unlevered) free-cash flow analysis was performed for the years 1998-2002. The analysis defines unlevered free-cash flows as unlevered net income plus depreciation plus amortization less capital expenditures less investment working capital.
CSFB also performed a similar analysis for every business segment of Daimler-Benz and observed that the exchange rate represented a premium of approximately 14 to 16% over the ratios of discounted cash-flow-evaluations. ” “Operating and stock market data were used to analyze Chrysler relative to peer companies (General Motors Corporation and Ford Motor Company). The EPS (earnings per share) multiples for the selected companies ranged from 8. 0 to 9. 5. Correspondingly, CSFB performed a similar analysis for every business segment of Daimler-Benz.
Based on the EPS analysis, the exchange ratio represented a discount of approximately 17% under to a premium of 15% over the ratios of comparable companies’ equity valuations. ” In addition to the wide variance in valuation, there were other nonfinancial implications that ultimately lead to the failure of this merger included strategic ineffectiveness and lack of preparation. In addition, there were differences in the culture, not only on the management level but also amongst the employees. This could also have led to difficulty in running the operations efficiently.
Clearly, with the volatile mix of German control and American creative vision, this was certainly a fragile business to run. More specifically, the appointment of a German appointee raised eyebrows when this seemed to be an “equal???merger. ” However, after that event, many believed it to be otherwise and some had strong thoughts that the Germans were exercising their strength on the Americans. These feelings around escalated further after the demise of the Plymouth brand as that seemed to further insinuated that the Chrysler group was vanishing slowly. VI. Real World Company Case Study 1: A case involving political risk: Milagrol Ltda. Brazil) In December of 2006, U. S. ‘s Peterson Valve Company offered to purchase Milagrol Ltda. , a Brazilian manufacturer of faucets, showers, and other bathroom fittings. Both companies believed there were advantages to combining efforts. Milagrol needed capital to support research and development endeavors, and Peterson was interested in diversifying its operations globally and gaining access to manufacturing processes that would be costly to develop on their own Peterson’s management was not looking for a bargain price and would only be satisfied with capturing value created by the synergies resulting from greater information transfer.
Peterson therefore wished to offer Milagrol a price consistent with the expected value of the company given its operations in Brazil and exports to neighboring countries. The substantive challenge for Peterson was in determining how to value Milagrol given the many possible pitfalls inherent in the cross-border nature of the deal. The following describes some of the other factors that Peterson needed to consider in their valuation of Milagrol. Valuation Challenges Cash Flows
Even though forecasting operating cash flows of Milagrol was a relatively easy task due to its predictable cost structure, and the ease in determining investments in working capital and manufacturing capacity (plant and equipment), there was difficulty in planning for inflation as Brazil faced high degrees of inflation that were often difficult to anticipate. For this reason, Peterson obtained a forecast of inflation for the coming five years from Econo-Metrics, a reputable international economic forecasting group.
The real demand changes and inflation forecasts were combined with data on costs to provide a forecast of free cash flows that Peterson was more confident with. Terminal Value Regarding an estimation of a terminal value for any valuation of Milagrol as a company, an EBIT multiple (enterprise value to EBIT) of somewhere between five and six would be appropriate for U. S. companies in this industry. An alternative valuation could be based on long run growth expectations.
Based on its analysis of the industry and Brazilian inflation prospects over the long run, Peterson believed a long-term nominal growth rate of 18% was appropriate for projects in Brazil. This estimate assumed long-run inflation would average about 15% and that Milagrol would grow at slightly more than the inflation rate. Exchange Rate One major challenge Peterson faced was how to handle exchange rates. Clearly, any valuation would have to result in a U. S. dollar-denominated valuation even though operating cash flows were denominated in Brazilian real. There were two ways Peterson could handle the valuation: 1.
Convert future real-denominated cash flows into dollar cash flows at an estimated future exchange rate and then applied an appropriate dollar discount rate to those cash flows to obtain a dollar valuation. 2. Convert the appropriate dollar discount rate to an equivalent real discount rate and discount the real-denominated cash flows and then convert the real valuation to a dollar valuation at the current spot rate. Overall, the first method was preferred because it was quite explicit about assumptions for exchange rates, which are often a subject of discussion, further analysis, and concern for Peterson.
While an exchange rate forecast could have been obtained from inflation rates, as an added measure Peterson also obtained an exchange-rate forecast from Econo-Metrics. Peterson was concerned about the possible effects of government policies on exchange rates. Any impact of government policies on inflation would be expected to affect exchange rates. More directly, however, was the fear that recent concerns about economic growth would induce the government to devalue its currency. In fact, some economists at the time expected a real devaluation (beyond what would be justified by inflation) of about 10% in each of the next two years.
Any devaluation of the real, certainly, would attenuate the value of Milagrol to Peterson. On this point, Peterson’s management differed with the Econo-Metrics forecast it had obtained. Whereas Peterson felt a devaluation was likely (probably a 30% chance), the Econo-Metrics forecast showed the Brazillian government was unlikely to take such an action. They placed the odds no higher than 10%. Peterson decided to factor-in its own prediction of a 30% chance of the real devaluing in the valuation analysis. Discount Rate
Another challenge was establishing a discount rate for the analysis. Following standard practice at Peterson, the appropriate discount rate they typically chose was the average cost of capital of a sample of firms in the same industry as the project or acquisition being evaluated. Such a set had been identified for the Milagrol acquisition, and the cost of capital in dollars was determined to be 12%. What concerned Peterson was whether this rate needed some further adjustment to reflect the additional political risks in Brazil.
A common practice in this regard was to use the spread between the yield on a dollar-denominated U. S. government security and the yield on a dollar-denominated (not real-denominated) Brazilian government security. This “sovereign spread” would be added to any discount rate to reflect risks unique to the Brazilian government. The current sovereign spread for Brazil at the time was 1. 95%, thus Peterson used 13. 95% as a discount rate used in the valuation analysis for Milagrol. VII. Real World Company Case Study 2:
A case involving valuation of businesses located in two different countries: The Yell Group In April of 2001, two global private equity firms, Apax Partners and Hicks, Muse, Tate & Furst, needed to value Yell Group’s businesses located in the U. K and the U. S. to determine what to bid for the company, and perhaps close the largest-ever European LBO by a financial buyer. Yell businesses consisted of two main assets: BT Yellow Pages, the market-leading classified directory business in the United Kingdom; and Yellow Book USA, the market-leading independent publisher of business directories in the United States.
The Yell cross-border valuation case study includes areas of examination such as businesses located in different markets and different growth rates among the businesses, thus resulting in diverse cash flow characteristics. We will look at these factors in more detail below. Valuation Challenges Growth Rates and Future Cash Flow BT Yellow Pages BT Yellow Pages was a series of annual, regional, classified directories that listed the name, address, and telephone number of substantially all business telephone subscribers in the United Kingdom. That represented nearly 85% of the U. K. lassified directories advertising revenues. Because yellow pages advertising expenditures tended to be more stable than other forms of media advertising and did not fluctuate widely with economic cycles, BT’s revenues have been growing steadily in the past 10 years. Around the same time as the LBO, however, the U. K. ‘s Office of Fair Trading (OFT) was reviewing BT Yellow Pages’ leading position in the classified directories advertising services market. The OFT was expected to recommend the imposition of a limit on the annual increase in rates for advertising, thereby affecting BT Yellow Pages’ valuation.
It was critical to understand how much value was dependent on such regulatory imposition. Yellow Book USA The U. S. yellow pages market was a $13 billion industry that had been growing at a steady 4%???5% per year. Yellow Book was the market-leading independent publisher of yellow pages directories in the United States. The company’s growth had been fueled by expansion efforts such as launching new directories into contiguous markets and launching wide area books into cities without an independence presence. Yellow Book’s overall growth plans were ambitious.
Although the Apax/Hicks Muse team was confident that some organic growth could be achieved in the next few years, they thought that an aggressive strategy of new product launches would have to complement organic growth in order to achieve management projections on the revenue side. The team expected EBITDA margins to increase as the portfolio matured. In their experience very low margins were achieved in the first year of operations for new launches, while margins could improve significantly and almost match margins on organic sales right from the second year of operations.
Accordingly, in order to roll the two very different types of markets together for the true valuation in terms of revenue, the team thought it important to segregate organic revenues from new launch revenues using two different EBITDA’s. This approach resulted in a more nuanced treatment of the Yellow Book USA’s operating income due to its unique growth rate. VIII. Conclusion While cross-border mergers and acquisitions have several features in common with domestic mergers and acquisitions, they have exceptional and significant distinctions.
A company in one country evaluating a company or a foreign project in another country can present many challenges, whether they are planning to integrate horizontally or vertically. There are many sources of risk to assess, which include stock-market price, industry price, and country and political risks. A firm must make estimations on opportunity free cash flows just as in a domestic project, but selecting a suitable discount rate is no easy task because of the unpredictable elements in a cross-border merger.
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