International Investing Prof Ian Giddy New York University

International Investing Prof. Ian Giddy New York University

International Capital Budgeting Strategic FDI decision vs. project appraisal l NPV, IRR, NTV, APV l Analyzing the cash flows: l u. Tax and repatriation u. Subsidies, including low-cost finance u. Inflation and exchange rate changes u. Whose cash flow? u. Blocked funds l Special risks & risk analysis in ICB Copyright © 1996 Ian H. Giddy International Investing 2

Foreign Direct Investment Why FDI? The theories l Sources of competitive advantage l Tactical choices l uexport vs. foreign production ulicensing vs. FDI l Ownership policy uwholly-owned l vs jv Modes of entry ude Copyright © 1996 Ian H. Giddy novo vs. Acquisition International Investing 3

Nature of FDI Q: Why? A: Ownership-specific advantages of the firm Q: How? A: Internationalization of markets implies FDI Q: Where? A: Location-specific advantages of host country Copyright © 1996 Ian H. Giddy International Investing 4

Conditions for FDI 1. Expected returns exceed the next best alternative (relative return for risk) 2. Foreign investor has competitive advantage relative to host country rivals (monopolistic advantage) 3. FDI more profitable than exporting (locationspecific advantage) 4. FDI more profitable than unaffiliated foreign production 5. Special advantage of foreign investor exceeds costs and risks of owning and managing a foreign operation Copyright © 1996 Ian H. Giddy International Investing 5

FDI Theories l Economic/financial Expected return differential u Currency premium u Diversification benefits u l Behavioral u l Defensive action in oligopolistic market Monopolistic advantage Firm-specific advantage overcomes inherent disadvantage of operating abroad u Product life cycle u l Internalization u l Markets vs heirarchies Eclectic u Mon. Adv. , Internalization & location specific advantage Copyright © 1996 Ian H. Giddy International Investing 6

A Case: Connor Vila Real Connor Peripherals is a U. S. manufacturer of compact, resilient hard drives for laptop and desktop PC's. Connor sells drives to PC manufacturers worldwide. Because of certain incentives and low labor costs, Connor is considering shifting a substantial proportion of its production to Vila Real, Portugal. 1. What might be the advantages of locating production in Portugal? 2. What risks might Connor face? Base your answer on FDI theory. Copyright © 1996 Ian H. Giddy International Investing 7

Connor Vila Real A. Alternatives? B. Advantages u Incentives u Lower costs of production u Portuguese market/EU market C. Risks u Quality control u On time delivery u Customer responsiveness & interaction suffer? u Production disruptions u Exchange risk u Political risk Copyright © 1996 Ian H. Giddy International Investing 8

Capital Budgeting Proposals Copyright © 1996 Ian H. Giddy International Investing 9

International Capital Budgeting u The Capital Budgeting Decision Process u The Relevant Cash Flows u Initial u Operating u Terminal u Exchange and Political Risk Factors u Capital Budgeting Techniques u Payback u NPV u IRR u Approaches Copyright © 1996 Ian H. Giddy for Dealing with Risk International Investing 10

International Capital Budgeting And Long-Term Investments l l l Direct Foreign Investment (FDI) involves the transfer of capital, managerial, and technical assets to a foreign country Two additional factors must be considered: u. Exchange rate fluctuations u. Political/jurisdictional risks and barriers Firms can protect themselves against exchange rate fluctuations using udebt and/or derivatives upricing. Copyright © 1996 Ian H. Giddy International Investing 11

Hangzhou Power Project Key elements: n Cash flow analysis n Understanding risks and returns of the financing techniques n Valuation INVESTORS INTERMEDIARIES SPONSORS Copyright © 1996 Ian H. Giddy International Investing 12

Hanel: Net Income Net Revenues, 000 RMB (Baseline assumptions) Copyright © 1996 Ian H. Giddy International Investing 13

The Relevant Cash Flows l l l Relevant Cash Flows include: u. The incremental after-tax cash outflow (investment) for the project u. The resulting subsequent cash inflows associated with the project Incremental Cash Flows are the additional cash flows directly attributable to the proposed project Can be expressed in host currency, then result translated into home currency Copyright © 1996 Ian H. Giddy International Investing 14

Cash Flow Components Terminal Cash Flow $25, 000 Operating Cash Flows $4, 000 $5, 000 $6, 000 $7, 000 $8, 000 $9, 000 $10, 000 0 1 2 3 4 5 6 7 8 9 10 Time (Years) $50, 000 Copyright © 1996 Ian H. Giddy Initial Investment International Investing 15

Finding the Initial Investment l The initial investment u. Initial investment is determined by subtracting all cash inflows occurring at time zero from all the cash outflows occurring at time zero l Installed cost of new asset u. Outflows to be considered include: q Cost of the new asset q Installation costs Copyright © 1996 Ian H. Giddy International Investing 16

Finding the Operating Cash Inflows The income statement format for calculating operating cash inflows is: - Revenue Expenses (Excluding Depreciation) = - Profits Before Depreciation and Taxes Depreciation = - Net Profits Before Taxes = + Net Profits After Taxes Depreciation = Operating Cash Inflows Copyright © 1996 Ian H. Giddy International Investing 17

Finding the Terminal Cash Flow The Terminal Cash Flow is an after-tax cash flow from the termination and liquidation of a project at the end of its expected useful life l To lend closure to the analysis, the firm must end up where it started, i. e. without the asset. l Copyright © 1996 Ian H. Giddy International Investing 18

Hanel: Cash Flow from Operations Net Operating Cash Flows, 000 RMB (Baseline assumptions) Copyright © 1996 Ian H. Giddy International Investing 19

Interpreting the Cash Flows: NPV n NPV = CFt (1 + k)t i=1 - II = Present Value of Cash Inflows - Initial Investment Copyright © 1996 Ian H. Giddy International Investing 20

IRR is calculated by solving: t=1 n CFt (1 + IRR)t = II PV of Cash Inflows = Initial Investment Copyright © 1996 Ian H. Giddy International Investing 22

Adjusted Present Value in International Capital Budgeting APV = - Initial costs + Present value of operating cash flows + Present value of tax shield + Present value of financing subsidies What rate should be used to discount cash flows in APV? Copyright © 1996 Ian H. Giddy International Investing 23

Inflation and Devaluation l Currency treatment of cash flows? REAL NOMINAL DOMESTIC FOREIGN l Also: Evaluate local or only repatriated cash flows? Copyright © 1996 Ian H. Giddy International Investing 24

Blocked Funds Local cash flows Repatriated cash flows Copyright © 1996 Ian H. Giddy Projected cash flows, reinvested at local rate of return International Investing 25

Imperial Power Spain 1. Domestic sales volume & foreign sales volume (from price changes & elasticities) 2. X projected prices = peseta revenues 3. From units sold get variable costs 4. Other costs; taxable income; income & withholding taxes 5. Project cash flows, incl. Depr. , W. C. , T. V. , int. after tax 6. Dollars 7. Royalties 8. U. S. Taxes 9. Discount to present at 16% 10. Discuss assumptions Copyright © 1996 Ian H. Giddy International Investing 26

Imperial Power Spain Copyright © 1996 Ian H. Giddy International Investing 27

Cost Calculations Copyright © 1996 Ian H. Giddy International Investing 28

Pro-Forma Income Statement Copyright © 1996 Ian H. Giddy International Investing 29

Project Cash Flow Analysis Copyright © 1996 Ian H. Giddy International Investing 30

Parent Cash Flow Analysis Copyright © 1996 Ian H. Giddy International Investing 31

Adjusting for Risk Scenario, sensitivity and simulation l Certainty equivalent l Adjusting the discount rate l Risk and the CAPM l Copyright © 1996 Ian H. Giddy International Investing 34

Sensitivity and Scenario Analysis An approach that attempts to capture the variability of cash inflows and NPV's Sensitivity Analysis uses a number of possible values for a given variable to assess its impact on return, as measured by NPV Scenario Analysis is similar to sensitivity analysis but allows for simultaneous changes in a number of variables Copyright © 1996 Ian H. Giddy International Investing 36

Simulation l l l Simulation is a statistically-based approach using probability distributions and random numbers to estimate risky outcomes Use computer to simulate virtually every inflow and outflow variable and determine the resulting NPV's After a thousand or so simulations the decision maker has a good idea of not only the expected value of the return on a project, but also the dispersion: the probability of achieving a given return. Copyright © 1996 Ian H. Giddy International Investing 37

Risk Adjustment Techniques Certainty Equivalents (CE's) adjust cash inflows to determine the percentage of estimated inflows that investors would be satisfied to receive for certain in exchange for those that are possible each year NPV when CE's are used is calculated as: t x CFt n NPV = t CFt RF = -II (1 + RF = Certainty Equivalent factor in year t (0 < t < 1) = Relevant cash inflow in year t = Risk-free rate of return t =1 Copyright © 1996 Ian H. Giddy )t International Investing 39

Risk-Adjustment Techniques Risk-Adjusted Discount Rates (RADR's) adjust for risk by changing the discount rate -- raising it for higher risk and lowering it for lower risk RADR's are calculated as n NPV = t =1 l CFt (1 + RADR)t - II The use of RADRs is closely linked to the capital asset pricing model (CAPM) Copyright © 1996 Ian H. Giddy International Investing 42

RADR and CAPM Recall that total risk = nondiversifiable risk + diversifiable risk Beta is a measure of nondiversifiable risk and kj = RF + j (km-R F) (CAPM) If we assume that real corporate assets are traded in efficient markets, CAPM can be modified as follows: k. Project j = RF + j Project (km-RF) where: j Project is the relationship between the project's expected return and the market's expected return Copyright © 1996 Ian H. Giddy International Investing 43

RADR and CAPM k SML Accept Reject km RF 0 Copyright © 1996 Ian H. Giddy 1. 0 Beta International Investing 44

Portfolio Effects The value of the firm is generally not affected by diversification l The market for real corporate assets is inefficient, therefore total risk is most relevant l Copyright © 1996 Ian H. Giddy International Investing 47

Risk-Adjusted Investment Cutoff Rates COUNTRY ARGENTINA AUSTRALIA BELGIUM BRAZIL CANADA FRANCE GERMANY GREECE INDIA INDONESIA ITALY JAPAN MALAYSIA MEXICO Copyright © 1996 Ian H. Giddy CUTOFF RATE 17% 10 10 14 10 12 10 17 20 17 14 14 12 17 COUNTRY CUTOFF RATE NETHERLANDS 10 NEW ZEALAND 10 NIGERIA 20 PHILIPPINES 17 PORTUGAL 14 PUERTO RICO 12 SINGAPORE 12 SOUTH AFRICA 12 SOUTH KOREA 20 SPAIN 14 TAIWAN 17 THAILAND 20 UNITED KINGDOM 12 UNITED STATES 10 VENEZUELA 17 International Investing 50

Government Subsidized Financing i = normal cost of debt i* = subsidized cost l Then subsidy equals F(i-i*), where f is the amount of debt subsidized. l A. Adjusting project's cost of capital l B. Adjusting project net cash flows Which is correct? Depends on reinvestment assumption. Copyright © 1996 Ian H. Giddy International Investing 51

Financing Decisions u Capital Structure u Firm Financing Needs u Short Term Debt u Long Term Debt u Equity u Hybrid Securities Copyright © 1996 Ian H. Giddy International Investing 52

Financing Choices Copyright © 1996 Ian H. Giddy International Investing 53

Bond Credit Risk Copyright © 1996 Ian H. Giddy International Investing 54

Valuation of Common Stock Book Value Per Share l Liquidation Value Per Share l Price/Earnings (P/E) Multiples l Capital Asset Pricing Model (expected return and nondiversifiable risk) l Risk-Adjusted Net Present Value l Copyright © 1996 Ian H. Giddy International Investing 55

Financing Choices Copyright © 1996 Ian H. Giddy International Investing 56

Mergers and Acquisitions l Mergers l Acquisitions l Divestitures Concept: Is a division or firm worth more within the company, or outside it? Copyright © 1996 Ian H. Giddy International Investing 62

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 1996 Ian H. Giddy RISK MGT MEASUREMENT DEBT EQUITY TOOLS International Investing 63

The Market for Corporate Control l l M&A&D situations often arise from conflicts: Owner vs manager ("agency problems" Build vs buy ("internalization") Agency problems arise when owners' interests and managers' interests diverge. Resolving agency problems requires Monitoring & intervention, or u Setting incentives, or u Constraining, as in bond covenants u l l Resolving principal-agent conflicts is costly Hence market price may differ from potential value of a corporation Copyright © 1996 Ian H. Giddy International Investing 64

“Internalization”: Is an activity best done within the company, or outside it? Issue: why are certain economic activities conducted within firms rather than between firms? l As a rule, it is more costly to build than to buy— markets make better decisions than bureaucrats l Hence there must be some good reason, some synergy, that makes an activity better if done within a firm l Eg: the production of proprietary information l Often, these synergies are illusory Copyright © 1996 Ian H. Giddy International Investing 65

Goals of Acquisitions Rationale: Firm A should merge with Firm B if [Value of AB > Value of A + Value of B + Cost of transaction] l Synergy l Gain market power l Discipline l Taxes l Financing Copyright © 1996 Ian H. Giddy International Investing 66

Do Acquisitions Benefit Shareholders? Successful Bids Technique Target Bidders Tender offer Merger Proxy contest 30% 20% 8% 4% 0 na n Note: Abnormal price changes are price changes adjusted to eliminate the effects of marketwide price changes Copyright © 1996 Ian H. Giddy International Investing 67

Do Acquisitions Benefit Shareholders? Unsuccessful Bids Technique Target Bidders Tender offer Merger Proxy contest -3% 8% -1% -5% na Copyright © 1996 Ian H. Giddy International Investing 68

Goal of Acquisitions and Mergers l Increase size - easy! l Increase market value - much harder! Copyright © 1996 Ian H. Giddy International Investing 69

Fallacies of Acquisitions Size (shareholders would rather have their money back, eg Credit Lyonnais) l Downstream/upstream integration (internal transfer at nonmarket prices, eg Dow/Conoco, Aramco/Texaco) l Diversification into unrelated industries (Kodak/Sterling Drug) l Copyright © 1996 Ian H. Giddy International Investing 70

Success Rates For Cross-Border Mergers And Acquisitions Copyright © 1996 Ian H. Giddy International Investing 71

Success Rates For Cross-Border Alliances Copyright © 1996 Ian H. Giddy International Investing 72

What's It Worth? Valuation Methods l Book value approach l Market value approach l Ratios (like P/E ratio) l Break-up value l Cash flow value Copyright © 1996 Ian H. Giddy International Investing 73

How Much Should We Pay? Applying the discounted cash flow approach, we need to know: 1. The incremental cash flows to be generated from the acquisition, adjusted for debt servicing and taxes 2. The rate at which to discount the cash flows (required rate of return) 3. The deadweight costs of making the acquisition (investment banks' fees, etc) Copyright © 1996 Ian H. Giddy International Investing 74

Framework for evaluating the value of an Acquisition Standalone value of acquirer (premerger) Standalone value of target (without any takeover premium) Value of Transaction Combined Synergies Costs Value of acquirer if it does not acquire target Value of target to acquirer Price paid including premium Net value gained from acquisition Adapted from: W. Pursche, “Building Better Bids: Synergies and Acquisition prices”, Chief Financial Officcer USA (1988): 63 -64 Copyright © 1996 Ian H. Giddy International Investing 75

Framework For Assessing Restructuring Opportunities Current perceptions gap Current Market Value 1 Maximum restructuring opportunity Company value as is 2 Strategic and operating opportunities 5 Restructuring Framework Potential value with internal improvements Copyright © 1996 Ian H. Giddy Financial engineering opportunities 4 3 Disposal/ Acquisition opportunities Optimal restructured value Potential value with internal and external improvements International Investing 76

Using The Restructuring Framework $ Millions of Value Copyright © 1996 Ian H. Giddy International Investing 77

The Cost of Capital Required rate of return on equity, RE, may be computed from the Capital Asset Pricing Model (CAPM): RE = RF + Beta (RM - RF) where RF = risk-free rate Beta= nondiversifiable risk factor, and RM = return on the market. In short, the discount factor should reflect the riskiness of the acquisition. Copyright © 1996 Ian H. Giddy International Investing 78

Application l l Fakawi Navigation plans to acquire Feng-Shui Compass Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields. Fakawi expects to divest the target in year 6 for $100 million. The Treasury note rate is 6%, and the S&P return is 16%. Fakawi's advisors estimate that Feng. Shui has a beta of 1. 3. For this advice they are charging 2% of the acquisition price. What is the maximum price that Fakawi should offer for Feng-Shui? Copyright © 1996 Ian H. Giddy International Investing 79

Reasons Why Many Acquisitions Fail To Generate Value Destruction Deal price not based on cash flow value Copyright © 1996 Ian H. Giddy International Investing 80

Reasons Why Many Acquisitions Fail To Generate Value Over optimistic market assessments Value Destruction Deal price not based on cash flow value Copyright © 1996 Ian H. Giddy International Investing 81

Reasons Why Many Acquisitions Fail To Generate Value Overestimating synergies Over optimistic market assessments Value Destruction Deal price not based on cash flow value Copyright © 1996 Ian H. Giddy International Investing 82

Reasons Why Many Acquisitions Fail To Generate Value Overestimating synergies Over optimistic market assessments Value Destruction Poor post-merger integration Deal price not based on cash flow value Copyright © 1996 Ian H. Giddy International Investing 83

Typical Losing Pattern For Mergers l l l Candidates are screened on basis of industry and company growth and returns One or two candidates are rejected on basis of objective DCF analysis Frustration sets in; pressures build to do a deal; DCF analysis is tainted by unrealistic expectations of synergies Deal is consummated at large premium Postacquisition experience reveals expected synergies are illusory Company’s returns are reduced and stock price falls Copyright © 1996 Ian H. Giddy International Investing 84

Divestitures Divestiture: the sale of a segment of a company to a third party l Spin-offs—a pro-rata distribution by a company of all its shares in a subsidiary to all its own shareholders l Equity carve-outs—some of a subsidiary' shares are offered for sale to the general public l Split-offs—some, but not all, parent-company shareholders receive the subsidiary's shares in return for which they must relinquish their shares in the parent company l Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist. Copyright © 1996 Ian H. Giddy International Investing 85

Divestitures Add Value Shareholders of the selling firm seem to gain, depending on the fraction sold: l Total value created by divestititures between 1981 and 1986 = $27. 6 billion. l % of the firm sold 0 -10% 10 -50% 50%+ Copyright © 1996 Ian H. Giddy Announcement effect 0 +2. 5% +8% International Investing 86

Strategic Alliances: An Alternative to Acquisition l l "A strategic alliance is a collaborative agreement between two or more companies, which contribute resources to a common endeavor of potentially important competitive consequences, while maintaining their individuality. " Example with internal emphasis: Sunkyong with GTE, Vodaphone & Hutchinson Whampoa for cellular system Example with external emphasis: Santander with Royal Bank of Scotland for European market in financial services Driving forces: Complementary resources - gain strategic resources u Similar capabilities - gain economies or market power u Copyright © 1996 Ian H. Giddy International Investing 87

Forms of Strategic Alliance l Many linkages are options for future development of relationships POTENTIAL FOR CONTROL ACQUISITION MERGER WITH FULL INTEGRATION JOINT VENTURE JOINT PROJECTS INFORMAL ALLIANCE SPECIFIC DISTRIBUTION OR SUPPLY AGREEMENT IRREVERSIBILITY OF COMMITMENT Copyright © 1996 Ian H. Giddy International Investing 88

Pitfalls and Problems Linkage may not offer access to partner's resources (JP Morgan-Espirito Santo) l Disagreement on contribution (Euroclear-Cedel) l Partners competing in one another's market (Credit Lyonnias-Commerzbank) l Linkage may exclude other options for expansion into a product or market l Clash of cultures; cross-purpose marketing (Credit Suisse-First Boston) Key predictor of stability is asset specificity and irreversibility of commitment. l Copyright © 1996 Ian H. Giddy International Investing 89

Geographic Overlap Helps Mergers And Acquisitions. . . 6 Failure for acquirer 92 Success for acquirer Copyright © 1996 Ian H. Giddy 94 8 Minimal geographic overlap (sample of 12) Moderate or high geographic overlap (sample of 16) International Investing 90

. . . But It Hinders Alliances Copyright © 1996 Ian H. Giddy International Investing 91

Mergers and Acquisitions: Summary l Mergers & Acquisitions l Divestitures l Strategic Alliances Concept: Is a business worth more within our company, or outside it? Copyright © 1996 Ian H. Giddy International Investing 92