Fundamentals of Multinational Finance Sixth Edition Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Learning Objectives • Extend the domestic capital budgeting analysis to evaluate a greenfield foreign project • Distinguish between the project viewpoint and the parent viewpoint when analyzing a potential foreign investment • Adjust the capital budgeting analysis of a foreign project for risk • Introduce the use of real option analysis as a complement to DCF analysis • Examine the use of project finance to fund and evaluate large global projects • Introduce the principles of cross-border mergers and acquisitions Multinational Capital Budgeting • Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic decisions – as well as reinvestment decisions – it should be justified by traditional financial analysis. • As domestic capital budgeting, focuses on the cash inflows and outflows associated with the investment projects • Follows same framework as domestic budgeting – Identify initial capital invested – Estimate cash inflows, including a terminal value or salvage value of investment – Identify appropriate discount rate for PV calculation – Apply traditional NPV or IRR analysis Complexities of Budgeting for a Foreign Project • Several factors make budgeting for a foreign project more complex – Parent cash flows must be distinguished from project – Parent cash flows often depend on the form of financing – Consider externalities on other subsidiaries – Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints – Cash flows to parent in form of licensing fees, royalty payments, etc. – Anticipate differing rates of national inflation – Segmented national capital markets may create opportunity for financial gain or additional costs – Host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC – Evaluate political risk – Terminal value is more difficult to estimate Project versus Parent Valuation • Most firms evaluate foreign projects from both parent and project viewpoints • Parent’s viewpoint – closer to traditional NPV analysis – Analyzes investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments • Project viewpoint provides closer approximation of effect on consolidated EPS Illustrative Case: Cemex Enters Indonesia • Cementos Mexicanos (Cemex) is considering construction of plant in Indonesia (Semen Indonesia) as a wholly owned greenfield project • Cemex is listed on both US and Mexican markets but most of its capital is US dollar denominated so evaluation of project is in US dollars Exhibit 18.1: Multination Capital Budgeting: Project and Parent Viewpoints Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Illustrative Case: Cemex Enters Indonesia • Financial assumptions –Capital Investment – cost to build plant estimated at $150/tonne but Cemex believes it can build the plant at a cost of $110/tonne ▪ Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is estimated at Rp22 trillion as Cemex wants 20 mln/ton/yr plant capacity. This cost includes Rp 17.6 trillion investment in PP&E ▪ Straight line 10-year depreciation on equipment value of Rp17.6 trillion will be 1.76 trillion/year –Financing – plant would be financed with 50% equity (all from Cemex) and 50% debt ▪ Debt is broken down, with Cemex providing 75% and a bank consortium providing the remaining 25% ▪ Cemex’s WACC (in US dollars) is 11.98% ▪ For the local project (in rupiah) the WACC is 33.257% Exhibit 18.2: Investment and Financing of the Semen Indonesia Project (in 000s unless o.w. noted) Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Illustrative Case: Cemex Enters Indonesia • Financial assumptions – Revenues – plant will operate at 40% capacity producing 8 million tonnes/year sold at $58/tonne (keeping same price overtime) – Costs –Cost per ton/yr is estimated at Rp115,000 or $11.5 (production, materials, power) (rising at the annual rate of Rp inflation of 30%) –Addition production costs at Rp20,000 per ton/yr (also rising with inflation of 30%) –Loading costs of $2.00/tonne; shipping costs of $10/tonne (governed by international contracts; denominated in $; rising with U.S inflation of 3%) Exhibit 18.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses Exhibit 18.4 Semen Indonesia’s Pro Forma Income Statement (millions of rupiah) Note: license fees are 2% of sales; SGA expense is 8% of sales and rising 1%/yr Illustrative Case: Cemex Enters Indonesia • Project Viewpoint Capital Budget – Semen Indonesia’s free cash flows are found by looking at EBIT, not EBT, and adding DA after tax is subtracted (as DA is non-cash expense and contributes positively to CFs) – Therefore, taxes are re-calculated based on EBIT – Terminal value is calculated as a perpetual net operating cash flow after year 5 Terminal Value = NOCF5 (1 + g) 7,075,059(1 + 0) = = Rp21,274,1 02 102 k WACC − g 0.33257 − 0 Exhibit 18.5 Semen Indonesia Capital Budget: Project Viewpoint (millions of rupiah) Exhibit 18.6 Semen Indonesia’s Remittance of Income to Parent Company (millions of rupiah and US$) Note: dividends are charged 15% tax 10% on interest payments 5% license fees Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Illustrative Case: Cemex Enters Indonesia • Parent Viewpoint Capital Budget – Cash flows constructed from parent’s viewpoint – Use Cemex cost of capital (11.98%) and not the project’s – However, Cemex requires an additional 6% for international projects, thus the discount rate will be 17.98% – This yields an NPV of -$903.9 million (IRR –1.12%) which is unacceptable from the parent’s viewpoint Illustrative Case: Cemex Enters Indonesia Sensitivity Analysis Project Viewpoint Measurement – Political risk – biggest risk is blocked funds or expropriation ▪ Analysis should build in these scenarios and answer questions such as how, when, how much, etc. – Foreign exchange risk ▪ Analysis should also consider appreciation or depreciation of the US dollar Parent Viewpoint Measurement – The additional risk that stems from its “foreign” location can be measured in at least two ways ▪ Adjusting the discount rates ▪ Adjusting the cash flows Illustrative Case: Cemex Enters Indonesia • Adjusting discount rates – To reflect the greater foreign exchange risk, political risk, agency costs, asymmetric information and other uncertainties – Does not penalize NPV in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time • Adjusting cash flows – Incorporates foreign risks in adjustments to forecasted project CFs – The discount rate for the foreign project is risk-adjusted only for overall business and financial risk, similarly as for domestic projects – Forecasting cash flows is extremely subjective • Shortcomings – often, neither is optimal ▪ Political uncertainties are a threat to the entire investment, not just CFs ▪ MNEs worry that taking on foreign projects may increase the firm’s overall cost of capital due to investor’s perceptions of foreign risk Illustrative Case: Cemex Enters Indonesia Real Option Analysis – DCF analysis cannot capture the value of the strategic options – Real option analysis includes the valuation of the project with future choices such as ▪ The option to defer ▪ The option to abandon ▪ The option to alter capacity ▪ The option to start up or shut down (switching) – Treats cash flows in terms of future value in a positive sense whereas DCF treats future cash flows negatively (on a discounted basis) – Acknowledges the way in
formation is gathered over time (active and passive) to improve decisions – The valuation of real options is similar to equity options Project Financing • Project finance is the arrangement of financing for long-term capital projects, large in scale, long in life, and generally high in risk. • The following four basic properties are critical to the success of project financing: – 1. Separability of a project from its investors – 2. Long-lived and capital-intensive singular projects – 3. Cash flow predictability from third party commitments – 4. Finite projects with finite lives Exhibit 18.7: Driving Forces Behind Cross-Border Mergers and Acquisitions Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Cross-Border Mergers and Acquisitions M&A vs. Greenfield Investments Advantages – M&A is quicker – Acquisition may be a cost-effective way of gaining competitive advantages – technology, brand names valued in the target market, logistical/distribution advantages, while simultaneously eliminating a local competitor – Market imperfections, allowing target firms to be undervalued Disadvantages – Paying too much – Melding corporate cultures can be traumatic – Downsizing to gain economies of scale and scope in overhead functions may have nonproductive impacts on the firm – Host government intervention Exhibit 18.8: the Cross-Border Acquisition Process Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Cross-Border Mergers and Acquisitions: Stages • 1a. Identification – First the target market followed by the target firm • 1b. Valuation – DCF analysis; Multiples; Industry-specific measures • 2. Execution – may be very time-consuming, requiring approval from management, target ownership, regulatory bodies, and final determination of methods of compensation – Friendly takeover – Hostile takeover – Regulatory bodies in each country may have different requirements – Compensation usually via stock and/or cash • 3. Post-acquisition management – the most critical step of the M&A process – determines if investors view it as (un)successful Currency Risks in Cross-Border Acquisitions • Currency Risks vary with timing of the takeover process and with amount of available information • A contingent foreign currency exposure is created with the initial bid, thus hedging is usually part of the process • Once the bid is accepted the exposure evolves into a transaction exposure Summary of Learning Objectives • The proposed greenfield investment in Indonesia by Cemex was analyzed within the traditional capital budgeting framework (base case) • The foreign complications were introduced to the analysis, including foreign exchange and political risks • Parent cash flows must be distinguished from project cash flows. Each of these two types of flows contributes to a different view of value Summary of Learning Objectives • Parent cash flows often depend on the form of financing. Thus, cash flows cannot be clearly separated from financing decisions, as in domestic capital budgeting • Remittance of funds must be explicitly recognized because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in how financial markets and institutions function Summary of Learning Objectives • Cash flows from subsidiaries to parent can include payment of license fees etc. • From the project’s point of view, risk analysis focuses on the use of sensitivities, considering foreign exchange and political risks associated with the project’s execution over time • From the parent’s point of view, the additional risk from the “foreign” location can be measured adjusting the discount rates or adjusting the cash flows Summary of Learning Objectives • Real option analysis, a different way of thinking, is a cross between decision-tree analysis and pure optionbased valuation – It allows us to evaluate the option to defer, the option to abandon, the option to alter size or capacity, and the option to start up or shut down a project • Project finance is used widely today in the development of large-scale infrastructure projects in many emerging markets. Although each individual project has unique characteristics, most are highly leveraged transactions, with debt making up more than 60% of the total financing Summary of Learning Objectives • The process of acquiring an enterprise anywhere in the world has three common elements: – Identification and valuation of the target; – Execution (the tender); and – Management of the post-acquisition transition • The settlement stage of a cross-border M&A requires gaining the approval and cooperation of management, shareholders, and eventually regulatory authorities • Cross-border M&A and strategic alliances, all face similar challenges: They must value the target enterprise on the basis of its projected performance in its market. This process combines elements of strategy, management, and finance Fundamentals of Multinational Finance Sixth Edition Chapter 14 Funding the Multinational Firm Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Learning Objectives • Design a strategy to source equity and debt globally • Analyze the motivations and goals of a firm for – cross-listing its shares on foreign equity markets –issuing new equity shares on foreign equity markets • Understand the many barriers to penetrate effectively foreign equity markets • Examine the various financial instruments which can be used to source equity in the global equity markets Designing a Strategy to Source Capital Globally • To gain access to global capital markets a firm must begin by designing a strategy that will ultimately attract international investors • It would require – restructuring of the firm – improving the quality and level of its disclosure – making its accounting/reporting standards more transparent to potential foreign investors • Management must agree upon a long-run financial objective and then choose among various alternative paths to get there • Investment bankers can help navigate the various institutional requirements and barriers that must be satisfied to source equity globally Designing a Strategy to Source Capital Globally • Most firms raise capital in their own domestic market • However, most firms that have only raised capital in their domestic market are not well known enough to attract foreign investors. • Incremental steps to bridge this gap include – conducting an international bond offering and/or – cross-listing equity shares on more highly liquid foreign stock exchanges. Exhibit 14.1: Alternative Paths to Globalize the Cost and Availability of Capital Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Optimal Financial Structure • A firm’s optimal financial structure is a mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk • If the business risk of new projects differs from the risk of existing projects, a new optimal mix would recognize tradeoffs between business and financial risks Exhibit 14.2: the Cost of Capital and Financial Structure Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved Optimal Financial Structure & The MNE • The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNE – 1. – 2. – 3. – 4. Availability of capital International diversification of cash flows Foreign exchange risk Expectation of international portfolio investors Optimal Financial Structure & The MNE • 1. Availability of capital – Lowers the cost of capital – Permits MNEs to maintain a desired debt ratio – Allows MNEs to operate competitively even if their domestic market is illiquid and segmented • 2. International diversification of cash flows – Reduces risk – Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates Optimal Financial Structure & The MNE •
3. Foreign exchange risk & cost of debt – When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency – This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value ( k = 1+ k $ d Sfr d ) x (1 + s)− 1 Where kd$ = Cost of borrowing for US firm in home country kdSfr = Cost of borrowing for US firm in Swiss francs s = Percentage change in spot rate Optimal Financial Structure & The MNE • 4. Expectations of International Portfolio Investors – The key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors – If firms want to attract and maintain international portfolio investors, they must follow the norms of financial structures Raising Equity Globally • Initial Public Offering (IPO) – the first public issue of a firm’s equity shares. – First a prospectus is published – The IPO typically represents 15% to 25% of ownership – Later issues by the firm are considered “seasoned offerings” – With public issuance of shares comes greater public disclosure • Euroequity Issue – an IPO on multiple exchanges in multiple countries at the same time. – The “Euro” market – international securities issues originating and being sold anywhere in the world – The euroequity seeks to raise more capital in its issuance by reaching as many different investors as possible Raising Equity Globally • Directed public share issue is one that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country – Might not be denominated in the currency of the target market – Shares might be cross-listed in the target market • Depositary receipts – negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank – Global Depositary Receipts (GDRs) – outside the US – American Depositary Receipts (ADRs) – traded in the U.S. and denominated in USD – each ADR represents a multiple of the underlying foreign share Raising Equity Globally • Private Placement Under SEC Rule 144A – Sale of securities to a small set of qualified institutional buyers (QIB), traditionally insurance companies and investment companies – Investors typically follow “buy and hold” strategy – Rule 144A allows QIB to trade privately placed securities without holding period restrictions and without SEC registration • Private Equity Funds – Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets – Then invest these funds in mature, family-owned firms located in emerging markets • Strategic Alliances – Normally followed by firms that expect to gain synergies from one or more joint efforts Foreign Equity Listing & Issuance • Objectives of cross-listing and selling on foreign stock exchanges: – – – – Improve the liquidity of its existing and new shares Overcome mispricing in a segmented and illiquid home market Increase visibility and political acceptance Establish a secondary market for shares used for acquisitions or to compensate local management and employees in foreign subsidiaries Raising Debt Globally • These markets offer a variety of – maturities – repayment structures – currencies of denomination – sources of funding – pri …
