international investing prof. ian giddy new york university

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International Investing Prof. Ian Giddy New York University

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Page 1: International Investing Prof. Ian Giddy New York University

International Investing

Prof. Ian Giddy

New York University

Page 2: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 2

International Capital Budgeting

Strategic FDI decision vs. project appraisal NPV, IRR, NTV, APV Analyzing the cash flows:

Tax and repatriationSubsidies, including low-cost financeInflation and exchange rate changesWhose cash flow?Blocked funds

Special risks & risk analysis in ICB

Page 3: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 3

Foreign Direct Investment

Why FDI? The theories Sources of competitive advantage Tactical choices

export vs. foreign productionlicensing vs. FDI

Ownership policywholly-owned vs jv

Modes of entryde novo vs. Acquisition

Page 4: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 4

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

Page 5: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 5

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 (location-specific 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

Page 6: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 6

FDI Theories

Economic/financial Expected return differential Currency premium Diversification benefits

Behavioral Defensive action in oligopolistic market

Monopolistic advantage Firm-specific advantage overcomes inherent disadvantage

of operating abroad Product life cycle

Internalization Markets vs heirarchies

Eclectic Mon. Adv., Internalization & location specific advantage

Page 7: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 7

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.

Page 8: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 8

Connor Vila Real

A. Alternatives?

B. Advantages IncentivesLower costs of productionPortuguese market/EU market

C. RisksQuality controlOn time deliveryCustomer responsiveness & interaction suffer?Production disruptionsExchange riskPolitical risk

Page 9: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 9

Capital Budgeting Proposals

BOARD OF DIRECTORS

MANAGEMENTCOMMITTEE

INVESTMENTADVISORYCOMMITTEE

TREASURER'SDEPARTMENT

LOCAL AFFILIATE

GUIDELINES

PROJECTPROPOSAL

Page 10: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 10

International Capital Budgeting

The Capital Budgeting Decision Process The Relevant Cash Flows

Initial Operating Terminal

Exchange and Political Risk Factors Capital Budgeting Techniques

Payback NPV IRR

Approaches for Dealing with Risk

Page 11: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 11

International Capital Budgeting And Long-Term Investments

Direct Foreign Investment (FDI) involves the transfer of capital, managerial, and technical assets to a foreign country

Two additional factors must be considered:Exchange rate fluctuations Political/jurisdictional risks and barriers

Firms can protect themselves against exchange rate fluctuations using debt and/or derivativespricing.

Page 12: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 12

Hangzhou Power Project

INVESTORSINVESTORS

INTERMEDIARIESINTERMEDIARIES

SPONSORSSPONSORS

Key elements: Cash flow

analysis Understanding

risks and returns of the financing techniques

Valuation

Page 13: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 13

Hanel: Net Income

-5000

0

5000

10000

15000

20000

25000

30000

35000

40000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Net Revenues, 000 RMB

(Baseline assumptions)

Page 14: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 14

The Relevant Cash Flows

Relevant Cash Flows include:The incremental after-tax cash outflow

(investment) for the projectThe 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

Page 15: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 15

Cash Flow Components

$50,000

$4,000 $5,000 $6,000 $7,000 $7,000 $8,000 $8,000 $8,000 $9,000 $10,000

0 1 2 3 4 5 6 7 8 9 10

Operating Cash Flows

Terminal Cash Flow $25,000

Time (Years)

Initial Investment

Page 16: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 16

Finding the Initial Investment

The initial investment Initial investment is determined by

subtracting all cash inflows occurring at time zero from all the cash outflows occurring at time zero

Installed cost of new assetOutflows to be considered include:

Cost of the new assetInstallation costs

Page 17: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 17

The income statement format for calculating operating cash inflows is:

Revenue- Expenses (Excluding Depreciation)

= Profits Before Depreciation and Taxes- Depreciation

= Net Profits Before Taxes- Taxes

= Net Profits After Taxes+ Depreciation

= Operating Cash Inflows

Finding the Operating Cash Inflows

Page 18: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 18

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

To lend closure to the analysis, the firm must end up where it started, i.e. without the asset.

Finding the Terminal Cash Flow

Page 19: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 19

Hanel: Cash Flow from Operations

0

5000

10000

15000

20000

25000

30000

35000

40000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Net Operating Cash Flows, 000 RMB

(Baseline assumptions)

Page 20: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 20

Interpreting the Cash Flows: NPV

n

NPV = i=1

= Present Value of Cash Inflows - Initial Investment

CFt (1 + k)t - II

Page 21: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 22

IRR is calculated by solving:

n t = 1

PV of Cash Inflows = Initial Investment

CFt (1 + IRR)t = II

Page 22: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 23

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?

Page 23: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 24

Inflation and Devaluation

Currency treatment of cash flows?

REAL NOMINAL

DOMESTIC

FOREIGN

Also: Evaluate local or only repatriated cash flows?

Page 24: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 25

Blocked Funds

Local cash flows

Repatriated cash flowsProjected cash flows,

reinvested at local

rate of return

Page 25: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 26

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

Page 26: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 27

Imperial Power SpainTABLE 1 TO TAL SALES VO LUM E AND REVENUE

1979 1980

Dom estic Sales 1. Units budgeted to be sold 50000 60000 2. Unit sales price (15% p.a. increase) x 1,300 x 1,495 3. Dom estic sales revenue (Ptas 000) 65000 89700

Export Sales 4. Pta. unit price in Spain (line 2) 1300 1495 5. Forecast Exchange rate, Pta./FF 16.67 17.5 6. Unit price in French francs 77.98 85.43 7. Change in franc price over prior year 9.55% 8. Less allowable 5% annual inflation -5.00% 9. Relative price change over prior year1 4.55%10. Resulting volum e change (tim es -1.5) -6.82%11. Prior year sales volum e 15000012. Increase for 10% growth 1500013. Volum e before price effect 16500014. Tim es elasticity factor (line 10)2 x 0.931815. Units budgeted to be sold 150000 15374716. Tim es unit price (in pesetas) x 1,300 x 1,49517. Export sales revenue (Ptas. 000) 195000 229852

Calculation of Sales Volum e18. Dom estic Volum e (line 1) 50000 6000019. Export Volum e (line 15) 150000 15374720. Total Unit Volum e 200000 213747

Page 27: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 28

Cost Calculations

EXHIBIT 2 CO ST CALCULATIO NS1979 1980

Calculation of per-unit cost of im ported m aterial (Note: 20% of Ptas. 840 = Ptas. 168

21. O riginal dollar unit cost (Ptas. 168/70) $2.40 $2.4022. Adjusted to U.S. inflation rate (tim es 1.05n) x 1.0000 x 1.050023. Inflated dollar unit cost 2.4 2.5224. Exchange rate (year begin) 70 7025. Peseta unit cost of im ported m aterial 168 176.4

Calculation of peseta interest expense

26. Dollar interest paid (10% x $600,000) $60,000 $60,00027. Exchange rate (year end) 70 8528. Peseta interest expense (000) 4200 5100

Calculation of peseta royalty expense

29. Dollar royalties paid $30,000 $30,00030. Exchange rate (year end) 70 8531. Peseta royalty expense (000) 2100 2550

Page 28: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 29

Pro-Forma Income StatementTABLE 3 PRO -FO RM A INCO M E STATEM ENTS (Pta 000)

1979 1980

Revenue from Sales32. Dom estic sales revenue (line 3) 65000 8970033. Export sales revenue (line 17) 195000 22985234. Total revenue 260000 319552

Expenses35. Im port m aterial/unit (line 25) 168 176.436. Dom estic m aterial/unit (840)(0.4)(1.15)n 336 386.437. Labor/unit (840)(0.4)(1.15)n 336 386.438. Total unit variable costs 840 949.239. Tim es unit sales volum e (line 20) x 200,000 x 213,747

40. Total variable costs (Ptas 000) 168000 20288941. M anufacturing overhead (x 1.15n) 75000 8625042. Depreciation (10% of cost) 7000 700043. Interest (line 28) 4200 510044. Royalties (line 31) 2100 255045. Total expenses 256300 303789

Profit & Dividend Calculation46. Net incom e before tax 3700 1576347. Less 30% incom e tax 1110 472948. Net incom e after tax 2590 1103449. Less 10% dividend tax 259 110350. Dividend paid to IPC (US) 2331 9931

Dollar equivalents on above51. Year-end exchange rate 70 8552. Net incom e before incom e tax ($) 52857 18544753. Incom e & Dividend taxes paid 19557 6861254. Dividend paid to IPC (US) 33300 116835

Page 29: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 30

Project Cash Flow Analysis

TABLE 4 PRO JECT CASH FLO W S (Pta 000)1978 1979 1980

Cash Inflows55. Net incom e after tax (line 48) -- 2590 1103456. Depreciation (line 42) -- 7000 700057. Interest after tax (line 28 x 0.7) -- 2940 357058. Recapture of working capital3 -- -- --59. Net term inal value4 -- -- --60. Total cash inflow 12530 21604

Cash O utflows61. Net working capital 77000 -- --62. Equipm ent 70000 -- --63. Total outflows 147000 -- --

Cash Flow Analysis64. Net cash flows -147000 12530 2160465. 16% present value factor 1 0.8621 0.743266. Present value of each cash flow -147000 10802 1605667. Cum ulative net present value -147000 -136198 -120142

68. Approxim ate internal rate of return = 46%

Page 30: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 31

Parent Cash Flow Analysis

TABLE 5 PARENT CASH FLO W ANALYSIS (US$)1978 1979 1980

Cash Inflows69. Dividends from IPC-Spain (line 54) -- 33300 11683570. Royalty receipts from IPC-Spain (line 29) -- 30000 3000071. Net term inal value5 -- -- --72. Total cash inflow -- 63300 146835

Cash O utflows73. Parent equity investm ent 1500000 -- --74. Pre-tax incom e, IPC-Spain (line 52) -- 52857 18544775. U.S. taxes at 50% -- 26428 9272376. Less credit for Spanish taxes (line 53) -- 19557 6861277. U.S. taxes payable on dividend incom e -- 6871 2411178. U.S. taxes payable on royalty incom e -- 15000 1500079. Total outflow 1500000 21871 39111

Cash Flow Analysis80. Net cash flow -1500000 41429 10772481. 16% value factor 1 0.8621 0.743282. Present value of each cash flow -1500000 35716 8006083. Cum ulative net present value -1500000 -1464284 -1384224

84. Approx. internal rate of return =27%

Page 31: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 34

Adjusting for Risk

Scenario, sensitivity and simulation Certainty equivalent Adjusting the discount rate Risk and the CAPM

Page 32: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 36

Sensitivity andScenario 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

Page 33: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 37

Simulation

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.

Page 34: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 39

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: n NPV = = - I I

t =1 (1 + RF)t t = Certainty Equivalent factor in year t (0 < t < 1)

CFt = Relevant cash inflow in year t

RF= Risk-free rate of return

t x CFt

Page 35: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 42

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

The use of RADRs is closely linked to the capital asset pricing model (CAPM)

- II CFt

(1 + RADR)t

Page 36: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 43

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:

kProject j = RF + j Project (km-RF)

where:

j Project is the relationship between the project's expected return and the market's expected return

Page 37: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 44

RADR and CAPM

SML

AcceptReject

k

km

RF

0

1.0Beta

Page 38: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 47

Portfolio Effects

The value of the firm is generally not affected by diversification

The market for real corporate assets is inefficient, therefore total risk is most relevant

Page 39: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 50

Risk-Adjusted Investment Cutoff Rates

COUNTRY CUTOFF RATE

ARGENTINA 17%

AUSTRALIA 10

BELGIUM 10

BRAZIL 14

CANADA 10

FRANCE 12

GERMANY 10

GREECE 17

INDIA 20

INDONESIA 17

ITALY 14

JAPAN 14

MALAYSIA 12

MEXICO 17

COUNTRY CUTOFF RATE

NETHERLANDS 10

NEW ZEALAND 10

NIGERIA 20

PHILIPPINES17

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

Page 40: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 51

Government Subsidized Financing

i = normal cost of debt

i* = subsidized cost Then subsidy equals F(i-i*), where f is the

amount of debt subsidized. A. Adjusting project's cost of capital B. Adjusting project net cash flows

Which is correct? Depends on reinvestment assumption.

Page 41: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 52

Financing Decisions

Capital Structure Firm Financing Needs Short Term Debt Long Term Debt Equity Hybrid Securities

Page 42: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 53

THEFIRM

DEBT

EQUITY

SHORTTERM

LONGTERM

BANK LOANSREVOLVERS,

EUROCREDITS

COMMERCIALPAPER

TERM LOANS

PREFERRED STOCK

BONDS

LEASINGCOMMON

HYBRIDS

CONVERTS WARRANTSRIGHTS

BONDS

Financing Choices

Page 43: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 54

Bond Credit Risk

Moody’sStandard &Poor’s Interpretation

AaaAa

AAAAA

High-quality debt instruments

ABaa

ABBB

Strong to adequate ability topay principal and interest

BaBCaaCaC

BBBCCCCCC

Ability to pay interest andprincipal speculative

D In default

Page 44: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 55

Book Value Per Share Liquidation Value Per Share Price/Earnings (P/E) Multiples Capital Asset Pricing Model (expected

return and nondiversifiable risk) Risk-Adjusted Net Present Value

Valuation of Common Stock

Page 45: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 56

THEFIRM

DEBT

EQUITY

SHORTTERM

LONGTERM

BANK LOANSREVOLVERS,

EUROCREDITS

COMMERCIALPAPER

TERM LOANS

PREFERRED STOCK

BONDS

LEASINGCOMMON

HYBRIDS

CONVERTS WARRANTSRIGHTS

BONDS

Financing Choices

Page 46: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 62

Mergers and Acquisitions

Mergers Acquisitions Divestitures

Concept: Is a division or firm worth more within the company, or outside it?

Page 47: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 63

Corporate Finance

CORPORATE FINANCE

DECISONS

CORPORATE FINANCE

DECISONS

INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT

Page 48: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 64

The Market for Corporate Control

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 Setting incentives, or Constraining, as in bond covenants

Resolving principal-agent conflicts is costly Hence market price may differ from potential value of a

corporation

Page 49: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 65

“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?

As a rule, it is more costly to build than to buy—markets make better decisions than bureaucrats

Hence there must be some good reason, some synergy, that makes an activity better if done within a firm

Eg: the production of proprietary information Often, these synergies are illusory

Page 50: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 66

Goals of Acquisitions

Rationale: Firm A should merge with Firm B if

[Value of AB > Value of A + Value of B + Cost of transaction]

Synergy Gain market power Discipline Taxes Financing

Page 51: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 67

Do Acquisitions Benefit Shareholders?Successful Bids

Technique Target Bidders

Tender offer 30% 4%

Merger 20% 0

Proxy contest 8% na

Note: Abnormal price changes are price changes adjusted to eliminate the effects of marketwide price changes

Page 52: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 68

Do Acquisitions Benefit Shareholders?Unsuccessful Bids

Technique Target Bidders

Tender offer -3% -1%

Merger -3% -5%

Proxy contest 8% na

Page 53: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 69

Goal of Acquisitions and Mergers

Increase size - easy! Increase market value - much

harder!

Page 54: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 70

Fallacies of Acquisitions

Size (shareholders would rather have their money back, eg Credit Lyonnais)

Downstream/upstream integration (internal transfer at nonmarket prices, eg Dow/Conoco, Aramco/Texaco)

Diversification into unrelated industries (Kodak/Sterling Drug)

Page 55: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 71

Success Rates For Cross-Border Mergers And Acquisitions

Success43%

Failure57%

100%=28

Page 56: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 72

Success Rates For Cross-Border Alliances

Success55%

Failure27%

Undecided18%

100%=45

Page 57: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 73

What's It Worth?

Valuation Methods Book value approach Market value approach Ratios (like P/E ratio) Break-up value Cash flow value

Page 58: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 74

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)

Page 59: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 75

Framework for evaluating the value of an Acquisition

Value ofacquirer ifit does not

acquiretarget

Value of target

to acquirer

Price paidincludingpremium

Net value

gainedfrom

acquisition

Adapted from: W. Pursche, “Building Better Bids: Synergies and Acquisition \prices”, Chief Financial Officcer USA (1988):63-64

Stand-alone

value ofacquirer

(pre-merger)

Stand-alone

value oftarget

(withoutany

takeoverpremium)

Value ofSynergies

TransactionCosts

CombinedValue

Page 60: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 76

Framework For Assessing Restructuring Opportunities

Restructuring Framework

1

2

CurrentMarketValue

3

Optimal restructuredvalue

Potential value withinternaland externalimprovements

Potentialvalue withinternalimprovements

Companyvalue as is

Maximum restructuringopportunity

Financialengineeringopportunities

4

Disposal/Acquisitionopportunities

Strategicand operatingopportunities

Currentperceptionsgap

5

Page 61: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 77

Using The Restructuring Framework$ Millions of Value

RestructuringFramework

1

2

CurrentMarketValue

3

Optimalrestructuredvalue

Potentialvalue withinternaland externalimprovements

Potentialvalue withinternalimprovements

Companyvalue as is

Maximumrestructuringopportunity

Financialengineeringopportunities

4

Disposal/Acquisitionopportunities

Strategicand operatingopportunities

Currentperceptionsgap

5

$ 25

$ 975

$ 350

$ 1,325

$ 300

$ 1,625

$ 100

$ 1,725

$ 725

$1,000

Increase D/E

Page 62: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 78

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.

Page 63: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 79

Application

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?

Page 64: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 80

Reasons Why Many Acquisitions Fail To Generate Value

Value

Destruction

Deal price not based on cash flow value

Page 65: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 81

Reasons Why Many Acquisitions Fail To Generate Value

Value

Destruction

Over optimisticmarketassessments

Deal price not based on cash flow value

Page 66: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 82

Reasons Why Many Acquisitions Fail To Generate Value

Value

Destruction

Over optimisticmarketassessments

Overestimatingsynergies

Deal price not based on cash flow value

Page 67: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 83

Reasons Why Many Acquisitions Fail To Generate Value

Value

Destruction

Over optimisticmarketassessments

Poorpost-mergerintegration

Overestimatingsynergies

Deal price not based on cash flow value

Page 68: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 84

Typical Losing Pattern For Mergers

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

Page 69: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 85

Divestitures

Divestiture: the sale of a segment of a company to a third party

Spin-offs—a pro-rata distribution by a company of all its shares in a subsidiary to all its own shareholders

Equity carve-outs—some of a subsidiary' shares are offered for sale to the general public

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

Split-ups—all of the parent company's subsidiaries are spun off and the parent company ceases to exist.

Page 70: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 86

Divestitures Add Value

Shareholders of the selling firm seem to gain, depending on the fraction sold:

Total value created by divestititures between 1981 and 1986 = $27.6 billion.

% of the firm sold Announcement effect

0-10%10-50%50%+

0+2.5%+8%

Page 71: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 87

Strategic Alliances:An Alternative to Acquisition "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 Similar capabilities - gain economies or market power

Page 72: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 88

Forms of Strategic Alliance

Many linkages are options for future development of relationships

IRREVERSIBILITY OF COMMITMENT

POTENTIAL

FOR CONTROL

INFORMAL

ALLIANCE

JOINT

PROJECTS

JOINT

VENTURE

MERGER

WITH FULL

INTEGRATION

ACQUISITION

SPECIFIC

DISTRIBUTION

OR SUPPLY

AGREEMENT

Page 73: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 89

Pitfalls and Problems

Linkage may not offer access to partner's resources (JP Morgan-Espirito Santo)

Disagreement on contribution (Euroclear-Cedel) Partners competing in one another's market

(Credit Lyonnias-Commerzbank) Linkage may exclude other options for expansion

into a product or market Clash of cultures; cross-purpose marketing (Credit

Suisse-First Boston)

Key predictor of stability is asset specificity and irreversibility of commitment.

Page 74: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 90

Geographic Overlap Helps Mergers And Acquisitions...

8

9492

6

Minimalgeographic

overlap (sampleof 12)

Moderate orhigh geographicoverlap (sample

of 16)

Failure foracquirer

Success foracquirer

Page 75: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 91

...But It Hinders Alliances

62

25

14

38

2437

Minimalgeographic

overlap(sample of 37)

Moderate orhigh

geographicoverlap

Failure for both partners

Mixed Results

Success for both partners

Page 76: International Investing Prof. Ian Giddy New York University

Copyright ©1996 Ian H. Giddy International Investing 92

Mergers and Acquisitions: Summary

Mergers & Acquisitions Divestitures Strategic Alliances

Concept: Is a business worth more within our company, or outside it?