Multinational capital budgeting questions and answers

CHAPTER 18 Multinational Capital Budgeting and Cross-Border Acquisitions

When it comes to finances, remember that there are no withholding taxes on the wages of sin.

—Mae West (1892–1980), Mae West on Sex, Health and ESP, 1975.

LEARNING OBJECTIVES

■ Extend the domestic capital budgeting analysis to evaluate a greenfield foreign project

■ Distinguish between the project viewpoint and the parent viewpoint of a potential foreign investment

■ Adjust the capital budgeting analysis of a foreign project for risk

■ Examine the use of project finance to fund and evaluate large global projects

■ Introduce the principles of cross-border mergers and acquisitions

This chapter describes in detail the issues and principles related to the investment in real productive assets in foreign countries, generally referred to as multinational capital budgeting . The chapter first describes the complexities of budgeting for a foreign project. Second, we describe the insights gained by valuing a project from both the project’s viewpoint and the parent’s viewpoint using an illustrative case involving an investment by Cemex of Mexico in Indonesia. This illustrative case also explores real option analysis . Next, the use of project financing today is discussed, and the final section describes the stages involved in affecting cross-border acquisitions. The chapter concludes with the Mini-Case, Elan and Royalty Pharma, about a hostile takeover (acquisition) attempt that played out in the summer of 2013.

Although the original decision to undertake an investment in a particular foreign country may be determined by a mix of strategic, behavioral, and economic factors, the specific project should be justified—as should all reinvestment decisions—by traditional financial analysis. For example, a production efficiency opportunity may exist for a U.S. firm to invest abroad, but the type of plant, mix of labor and capital, kinds of equipment, method of financing, and other project variables must be analyzed with traditional discounted cash flow analysis. The firm must also consider the impact of the proposed foreign project on consolidated earnings, cash flows from subsidiaries in other countries, and on the market value of the parent firm.

Multinational capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting—with a few very important differences. The basic steps are as follows:

■ Identify the initial capital invested or put at risk.

■ Estimate cash flows to be derived from the project over time, including an estimate of the terminal or salvage value of the investment.

■ Identify the appropriate discount rate for determining the present value of the expected cash flows.

■ Use traditional capital budgeting methods, such as net present value (NPV) and internal rate of return (IRR), to assess and rank potential projects.

Complexities of Budgeting for a Foreign Project

Capital budgeting for a foreign project is considerably more complex than the domestic case. Two broad categories of factor contribute to this greater complexity, cash flows and managerial expectations.

Cash Flows

■ Parent cash flows must be distinguished from project cash flows. Each of these two types of flows contributes to a different view of value.

■ Parent cash flows often depend on the form of financing. Thus, we cannot clearly separate cash flows from financing decisions, as we can in domestic capital budgeting.

■ Additional cash flows generated by a new investment in one foreign subsidiary may be in part or in whole taken away from another subsidiary, with the net result that the project is favorable from a single subsidiary’s point of view but contributes nothing to worldwide cash flows.

■ The parent must explicitly recognize remittance of funds because of differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in the way financial markets and institutions function.

■ An array of nonfinancial payments can generate cash flows from subsidiaries to the parent, including payment of license fees and payments for imports from the parent.

Management Expectations

■ Managers must anticipate differing rates of national inflation because of their potential to cause changes in competitive position, and thus changes in cash flows over a period of time.

■ Managers must keep the possibility of unanticipated foreign exchange rate changes in mind because of possible direct effects on the value of local cash flows, as well as indirect effects on the competitive position of the foreign subsidiary.

■ Use of segmented national capital markets may create an opportunity for financial gains or may lead to additional financial costs.

■ Use of host-government subsidized loans complicates both capital structure and the parent’s ability to determine an appropriate weighted average cost of capital for discounting purposes.

■ Managers must evaluate political risk because political events can drastically reduce the value or availability of expected cash flows.

■ Terminal value is more difficult to estimate because potential purchasers from the host, parent, or third countries, or from the private or public sector, may have widely divergent perspectives on the value to them of acquiring the project.

Since the same theoretical capital budgeting framework is used to choose among competing foreign and domestic projects, it is critical that we have a common standard. Thus, all foreign complexities must be quantified as modifications to either expected cash flow or the rate of discount. Although in practice many firms make such modifications arbitrarily, readily available information, theoretical deduction, or just plain common sense can be used to make less arbitrary and more reasonable choices.

Project versus Parent Valuation

Consider a foreign direct investment like that illustrated in Exhibit 18.1. A U.S. multinational invests capital in a foreign project in a foreign country, the results of which—if they occur—are generated over time. Similar to any investment, domestically or internationally, the return on the investment is based on the outcomes to the parent company. Given that the initial investment is in the parent’s own or home currency, the U.S. dollar as shown here, then those returns over time need to be denominated in that same currency for evaluation purposes.

EXHIBIT 18.1 Multinational Capital Budgeting: Project and Parent Viewpoints

A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect the firm’s many interest groups. However, since most of a project’s cash flows to its parent or sister subsidiaries are financial cash flows rather than operating cash flows, the parent viewpoint violates a cardinal concept of capital budgeting, namely, that financial cash flows should not be mixed with operating cash flows. Often the difference is not important because the two are almost identical, but in some instances a sharp divergence in these cash flows will exist. For example, funds that are permanently blocked from repatriation, or “forcibly reinvested,” are not available for dividends to the stockholders or for repayment of parent debt. Therefore, shareholders will not perceive the blocked earnings as contributing to the value of the firm, and creditors will not count on them in calculating interest coverage ratios and other metrics of debt service capability.

Evaluation of a project from the local viewpoint—the project viewpoint—serves a number of useful purposes as well. In evaluating a foreign project’s performance relative to the potential of a competing project in the same host country, we must pay attention to the project’s local return. Almost any project should at least be able to earn a cash return equal to the yield available on host government bonds with a maturity equal to the project’s economic life, if a free market exists for such bonds. Host-government bonds ordinarily reflect the local risk-free rate of return, including a premium equal to the expected rate of inflation. If a project cannot earn more than such a bond yield, the parent firm should buy host government bonds rather than invest in a riskier project.

Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project. If they are unable to earn superior returns on foreign projects, their stockholders would be better off buying shares in local firms, where possible, and letting those companies carry out the local projects. Apart from these theoretical arguments, surveys over the past 40 years show that in practice MNEs continue to evaluate foreign investments from both the parent and project viewpoint.

The attention paid to project returns in various surveys may reflect emphasis on maximizing reported earnings per share as a corporate financial goal of publicly traded companies. It is not clear that privately held firms place the same emphasis on consolidated results, given that few public investors ever see their financial results. Consolidation practices, including translation as described in Chapter 11, remeasure foreign project cash flows, earnings, and assets as if they are “returned” to the parent company. And as long as foreign earnings are not blocked, they can be consolidated with the earnings of both the remaining subsidiaries and the parent.1 Even in the case of temporarily blocked funds, some of the most mature MNEs do not necessarily eliminate a project from financial consideration. They take a very long-run view of world business opportunities.

If reinvestment opportunities in the country where funds are blocked are at least equal to the parent firm’s required rate of return (after adjusting for anticipated exchange rate changes), temporary blockage of transfer may have little practical effect on the capital budgeting outcome, because future project cash flows will be increased by the returns on forced reinvestment. Since large multinationals hold a portfolio of domestic and foreign projects, corporate liquidity is not impaired if a few projects have blocked funds; alternate sources of funds are available to meet all planned uses of funds. Furthermore, a long-run historical perspective on blocked funds does indeed lend support to the belief that funds are almost never permanently blocked. However, waiting for the release of such funds can be frustrating, and sometimes the blocked funds lose value while blocked because of inflation or unexpected exchange rate deterioration, even though they have been reinvested in the host country to protect at least part of their value in real terms.

1U.S. firms must consolidate foreign subsidiaries that are over 50% owned. If a firm is owned between 20% and 49% by a parent, it is called an affiliate . Affiliates are consolidated with the parent owner on a pro rata basis. Subsidiaries less than 20% owned are normally carried as unconsolidated investments.

In conclusion, most firms appear to evaluate foreign projects from both parent and project viewpoints. The parent’s viewpoint gives results closer to the traditional meaning of net present value in capital budgeting theoretically, but as we will demonstrate, possibly not in practice. Project valuation provides a closer approximation of the effect on consolidated earnings per share, which all surveys indicate is of major concern to practicing managers. To illustrate the foreign complexities of multinational capital budgeting, we analyze a hypothetical market-seeking foreign direct investment by Cemex in Indonesia.

Illustrative Case: Cemex Enters Indonesia2

Cementos Mexicanos, Cemex, is considering the construction of a cement manufacturing facility on the Indonesian island of Sumatra. The project, Semen Indonesia (the Indonesian word for “cement” is semen), would be a wholly owned greenfield investment with a total installed capacity of 20 million metric tonnes per year (mmt/y). Although that is large by Asian production standards, Cemex believes that its latest cement manufacturing technology would be most efficiently utilized with a production facility of this scale.

Cemex has three driving reasons for the project: (1) the firm wishes to initiate a productive presence of its own in Southeast Asia, a relatively new market for Cemex; (2) the long-term prospects for Asian infrastructure development and growth appear very good over the longer term; and (3) there are positive prospects for Indonesia to act as a produce-for-export site as a result of the depreciation of the Indonesian rupiah (IDR or Rp) in recent years.

Cemex, the world’s third-largest cement manufacturer, is an MNE headquartered in an emerging market but competing in a global arena. The firm competes in the global marketplace for both market share and capital. The international cement market, like markets in other commodities such as oil, is a dollar-based market. For this reason, and for comparisons against its major competitors in both Germany and Switzerland, Cemex considers the U.S. dollar its functional currency.

Cemex’s shares are listed in both Mexico City and New York (OTC: CMXSY). The firm has successfully raised capital—both debt and equity—outside Mexico in U.S. dollars. Its investor base is increasingly global, with the U.S. share turnover rising rapidly as a percentage of total trading. As a result, its cost and availability of capital are internationalized and dominated by U.S. dollar investors. Ultimately, the Semen Indonesia project will be evaluated—in both cash flows and capital cost—in U.S. dollars.

Overview

The first step in analyzing Cemex’s potential investment in Indonesia is to construct a set of pro forma financial statements for Semen Indonesia, all in Indonesian rupiah (IDR). The next step is to create two capital budgets, the project viewpoint and parent viewpoint. Semen Indonesia will take only one year to build the plant, with actual operations commencing in year 1. The Indonesian government has only recently deregulated the heavier industries to allow foreign ownership.

All of the following analysis is conducted assuming that purchasing power parity (PPP) holds for the rupiah to dollar exchange rate for the life of the Indonesian project. This is a standard financial assumption made by Cemex for its foreign investments. Thus, if we assume an initial spot rate of Rp10,000/$, and Indonesian and U.S. inflation rates of 30% and 3% per annum, respectively, for the life of the project, forecasted spot exchange rates follow the usual PPP calculation. For example, the forecasted exchange rate for year 1 of the project would be as follows:

2Cemex is a real company. However, the greenfield investment described here is hypothetical.

The financial statements shown in Exhibits 18.2 through 18.5 are based on these assumptions.

Capital Investment.

Although the cost of building new cement manufacturing capacity anywhere in the industrial countries is now estimated at roughly $150/tonne of installed capacity, Cemex believed that it could build a state-of-the-art production and shipment facility in Sumatra at roughly $110/tonne (see Exhibit 18.2). Assuming a 20 million metric ton per year (mmt/y) capacity, and a year 0 average exchange rate of Rp10,000/$, this cost will constitute an investment of Rp22 trillion ($2.2 billion). This figure includes an investment of Rp17.6 trillion in plant and equipment, giving rise to an annual depreciation charge of Rp1.76 trillion if we assume a 10-year straight-line depreciation schedule. The relatively short depreciation schedule is one of the policies of the Indonesian tax authorities meant to attract foreign investment.

Financing.

This massive investment would be financed with 50% equity, all from Cemex, and 50% debt—75% from Cemex and 25% from a bank consortium arranged by the Indonesian government. Cemex’s own U.S. dollar-based weighted average cost of capital (WACC) was currently estimated at 11.98%. The WACC for the project itself on a local Indonesian level in rupiah terms was estimated at 33.257%. The details of this calculation are discussed later in this chapter.

The cost of the U.S. dollar-denominated loan is stated in rupiah terms assuming purchasing power parity and U.S. dollar and Indonesian inflation rates of 3% and 30% per annum, respectively, throughout the subject period. The explicit debt structures, including repayment schedules, are presented in Exhibit 18.3. The loan arranged by the Indonesian government, part of the government’s economic development incentive program, is an eight-year loan, in rupiah, at 35% annual interest, fully amortizing. The interest payments are fully deductible against corporate tax liabilities.

The majority of the debt, however, is being provided by the parent company, Cemex. After raising the capital from its financing subsidiary, Cemex will re-lend the capital to Semen Indonesia. The loan is denominated in U.S. dollars, five years maturity, with an annual interest rate of 10%. Because the debt will have to be repaid from the rupiah earnings of the Indonesian enterprise, the pro forma financial statements are constructed so that the expected costs of servicing the dollar debt are included in the firm’s pro forma income statement. The dollar loan, if the rupiah follows the purchasing power parity forecast, will have an effective interest expense in rupiah terms of 38.835% before taxes. We find this rate by determining the internal rate of return of repaying the dollar loan in full in rupiah (see Exhibit 18.3).

The loan by Cemex to the Indonesian subsidiary is denominated in U.S. dollars. Therefore, the loan will have to be repaid in U.S. dollars, not rupiah. At the time of the loan agreement, the spot exchange rate is Rp10,000/$. This is the assumption used in calculating the “scheduled” repaying of principal and interest in rupiah. The rupiah, however, is expected to depreciate in line with purchasing power parity. As it is repaid, the “actual” exchange rate will therefore give rise to a foreign exchange loss as it takes more and more rupiah to acquire U.S. dollars for debt service, both principal and interest. The foreign exchange losses on this debt service will be recognized on the Indonesian income statement.

Revenues.

Given the current existing cement manufacturing in Indonesia, and its currently depressed state as a result of the Asian crisis, all sales are based on export. The 20 mmt/y facility is expected to operate at only 40% capacity (producing 8 million metric tonnes). Cement produced will be sold in the export market at $58/tonne (delivered). Note also that, at least for the conservative baseline analysis, we assume no increase in the price received over time.

EXHIBIT 18.2 Investment and Financing of the Semen Indonesia Project (in 000s)

EXHIBIT 18.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses

Costs.

The cash costs of cement manufacturing (labor, materials, power, etc.) are estimated at Rp115,000 per tonne for year 1, rising at about the rate of inflation, 30% per year. Additional production costs of Rp20,000 per tonne for year 1 are also assumed to rise at the rate of inflation. As a result of all production being exported, loading costs of $2.00/tonne and shipping of $10.00/tonne must also be included. Note that these costs are originally stated in U.S. dollars, and for the purposes of Semen Indonesia’s income statement, they must be converted to rupiah terms. This is the case because both shiploading and shipping costs are international services governed by contracts denominated in dollars. As a result, they are expected to rise over time only at the U.S. dollar rate of inflation (3%).

EXHIBIT 18.4 Semen Indonesia’s Pro Forma Income Statement (millions of rupiah)

Semen Indonesia’s pro forma income statement is illustrated in Exhibit 18.4. This is the typical financial statement measurement of the profitability of any business, whether domestic or international. The baseline analysis assumes a capacity utilization rate of only 40% (year 1), 50% (year 2), and 60% in the following years. Management believes this is necessary since existing in-country cement manufacturers are averaging only 40% of capacity at this time.

Tax credits resulting from current period losses are carried forward toward next year’s tax liabilities. Dividends are not distributed in the first year of operations as a result of losses, and are distributed at a 50% rate in years 2–5.

Additional expenses in the pro forma financial analysis include license fees paid by the subsidiary to the parent company of 2.0% of sales, and general and administrative expenses for Indonesian operations of 8.0% per year (and growing an additional 1% per year). Foreign exchange gains and losses are those related to the servicing of the U.S. dollar-denominated debt provided by the parent and are drawn from the bottom of Exhibit 18.3. In summary, the subsidiary operation is expected to begin turning an accounting profit in its fourth year of operations, with profits rising as capacity utilization increases over time.

The loan by Cemex to the Indonesian subsidiary is denominated in U.S. dollars. Therefore, the loan will have to be repaid in U.S. dollars, not rupiah. At the time of the loan agreement, the spot exchange rate is Rp10,000/$. This is the assumption used in calculating the “scheduled” repaying of principal and interest in rupiah. The rupiah, however, is expected to depreciate in line with purchasing power parity. As it is repaid, the “actual” exchange rate will therefore give rise to a foreign exchange loss as it takes more and more rupiah to acquire U.S. dollars for debt service, both principal and interest. The foreign exchange losses on this debt service will be recognized on the Indonesian income statement.

Tax credits resulting from current period losses are carried forward toward next year’s tax liabilities. Dividends are not distributed in the first year of operations as a result of losses, and are distributed at a 50% rate in years 2000–2003. All calculations are exact, but may appear not to add due to reported decimal places. The tax payment for year 3 is zero, and year 4 is less than 30%, as a result of tax loss carry-forwards from previous years.

Project Viewpoint Capital Budget

The capital budget for the Semen Indonesia project from a project viewpoint is shown in Exhibit 18.5. We find the net cash flow, free cash flow as it is often labeled, by summing EBITDA (earnings before interest, taxes, depreciation, and amortization), recalculated taxes, changes in net working capital (the sum of the net additions to receivables, inventories, and payables necessary to support sales growth), and capital investment.

Note that EBIT, not EBT, is used in the capital budget, which contains both depreciation and interest expense. Depreciation and amortization are noncash expenses of the firm and therefore contribute positive cash flow. Because the capital budget creates cash flows that will be discounted to present value with a discount rate, and the discount rate includes the cost of debt—interest—we do not wish to subtract interest twice. Therefore, taxes are recalculated on the basis of EBIT.3 The firm’s cost of capital used in discounting also includes the deductibility of debt interest in its calculation.

The initial investment of Rp22 trillion is the total capital invested to support these earnings. Although receivables average 50 to 55 days sales outstanding (DSO) and inventories average 65 to 70 DSO, payables and trade credit are also relatively long at 114 DSO in the Indonesian cement industry. Semen Indonesia expects to add approximately 15 net DSO to its investment with sales growth. The remaining elements to complete the project viewpoint’s capital budget are the terminal value (discussed below) and the discount rate of 33.257% (the firm’s weighted average cost of capital).

3This highlights the distinction between an income statement and a capital budget. The project’s income statement shows losses the first two years of operations as a result of interest expenses and forecast foreign exchange losses, so it is not expected to pay taxes. But the capital budget, constructed on the basis of EBIT, before these financing and foreign exchange expenses, calculates a positive tax payment.

EXHIBIT 18.5 Semen Indonesia Capital Budget: Project Viewpoint (millions of rupiah)

Terminal Value.

The terminal value (TV) of the project represents the continuing value of the cement manufacturing facility in the years after year 5, the last year of the detailed pro forma financial analysis shown in Exhibit 18.5. This value, like all asset values according to financial theory, is the present value of all future free cash flows that the asset is expected to yield. We calculate the TV as the present value of a perpetual net operating cash flow (NOCF) generated in the fifth year by Semen Indonesia, the growth rate assumed for that net operating cash flow (g), and the firm’s weighted average cost of capital (kWACC):

or Rp21,274,102 trillion. The assumption that g = 0, that is, that net operating cash flows will not grow past year 5 is probably not true, but it is a prudent assumption for Cemex to make when estimating future cash flows. (If Semen Indonesia’s business was to continue to grow inline with the Indonesian economy, g may well be 1% or 2%.) The results of the capital budget from the project viewpoint indicate a negative net present value (NPV) and an internal rate of return (IRR) of only 19.1 % compared to the 33.257% cost of capital. These are the returns the project would yield to a local or Indonesian investor in Indonesian rupiah. The project, from this viewpoint, is not acceptable.

Repatriating Cash Flows to Cemex

Exhibit 18.6 now collects all incremental earnings to Cemex from the prospective investment project in Indonesia. As described in the section, Project versus Parent Valuation, a foreign investor’s assessment of a project’s returns depends on the actual cash flows that are returned to it in its own currency via actual potential cash flow channels. For Cemex, this means that the investment must be analyzed in terms of the actual likely U.S. dollar cash inflows and outflows associated with the investment over the life of the project, after-tax, discounted at its appropriate cost of capital.

EXHIBIT 18.6 Semen Indonesia’s Remittance of Income to Parent Company (millions of rupiah and US$)

The parent viewpoint capital budget is constructed in two steps:

1. First, we isolate the individual cash flows, cash flows by channel, adjusted for any withholding taxes imposed by the Indonesian government and converted to U.S. dollars. (Statutory withholding taxes on international transfers are set by bilateral tax treaties, but individual firms may negotiate lower rates with governmental tax authorities. In the case of Semen Indonesia, dividends will be charged a 15% withholding tax, 10% on interest payments, and 5% license fees.) Mexico does not tax repatriated earnings since they have already been taxed in Indonesia. (The U.S. does levy a contingent tax on repatriated earnings of foreign source income, as discussed in Chapter 16.)

2. The second step, the actual parent viewpoint capital budget, combines these U.S. dollar after-tax cash flows with the initial investment to determine the net present value of the proposed Semen Indonesia subsidiary in the eyes (and pocketbook) of Cemex. This is illustrated in Exhibit 18.6, which shows all incremental earnings to Cemex from the prospective investment project. A specific peculiarity of this parent viewpoint capital budget is that only the capital invested into the project by Cemex itself, $1,925 million, is included in the initial investment (the $1,100 million in equity and the $825 million loan). The Indonesian debt of Rp2.75 billion ($275 million) is not included in the Cemex parent viewpoint capital budget.

Parent Viewpoint Capital Budget

Finally, all cash flow estimates are now constructed to form the parent viewpoint’s capital budget, detailed in the bottom of Exhibit 18.6. The cash flows generated by Semen Indonesia from its Indonesian operations, dividends, license fees, debt service, and terminal value are now valued in U.S. dollar terms after-tax.

In order to evaluate the project’s cash flows that are returned to the parent company, Cemex must discount these at the corporate cost of capital. Remembering that Cemex considers its functional currency to be the U.S. dollar, it calculates its cost of capital in U.S. dollars. As described in Chapter 13, the customary weighted average cost of capital formula is as follows:

where ke is the risk-adjusted cost of equity, kd is the before-tax cost of debt, t is the marginal tax rate, E is the market value of the firm’s equity, D is the market value of the firm’s debt, and V is the total market value of the firm’s securities (E + D).

ke = krf + (km − krf)βCemex = 6.00% + (13.00% − 6.00%)1.5 = 16.50%

Cemex’s cost of equity is calculated using the capital asset pricing model (CAPM):

This assumes the risk-adjusted cost of equity (ke) is based on the risk-free rate of interest (krf), as measured by the U.S. Treasury intermediate bond yield of 6.00%, the expected rate of return in U.S. equity markets (km) is 13.00%, and the measure of Cemex’s individual risk relative to the market (βCemex) is 1.5. The result is a cost of equity—required rate of return on equity investment in Cemex—of 16.50%.

The investment will be funded internally by the parent company, roughly in the same debt/equity proportions as the consolidated firm, 40% debt (D/V) and 60% equity (E/V). The current cost of debt for Cemex is 8.00%, and the effective tax rate is 35%. The cost of equity, when combined with the other components, results in a weighted average cost of capital for Cemex of

= (16.50%)(.60) + (8.00%)(1 − .35)(.40) = 11.98%

Cemex customarily uses this weighted average cost of capital of 11.98% to discount prospective investment cash flows for project ranking purposes. The Indonesian investment poses a variety of risks, however, which the typical domestic investment does not.

If Cemex were undertaking an investment of the same relative degree of risk as the firm itself, a simple discount rate of 11.980% might be adequate. Cemex, however, generally requires new investments to yield an additional 3% over the cost of capital for domestic investments, and 6% more for international projects (these are company-required spreads, and will differ dramatically across companies). The discount rate for Semen Indonesia’s cash flows repatriated to Cemex will therefore be discounted at 11.98% + 6.00%, or 17.98%. The project’s baseline analysis indicates a negative NPV with an IRR of 7.21%, which means that it is an unacceptable investment from the parent’s viewpoint.

Most corporations require that new investments more than cover the cost of the capital employed in their undertaking. It is therefore not unusual for the firm to require a hurdle rate of 3% to 6% above its cost of capital in order to identify potential investments that will literally add value to stockholder wealth. An NPV of zero means the investment is “acceptable,” but NPV values that exceed zero are literally the present value of wealth that is expected to be added to the value of the firm and its shareholders. For foreign projects, as discussed previously, we must adjust for agency costs and foreign exchange risks and costs.

Sensitivity Analysis: Project Viewpoint

So far, the project investigation team has used a set of “most likely” assumptions to forecast rates of return. It is now time to subject the most likely outcome to sensitivity analyses. The same probabilistic techniques are available to test the sensitivity of results to political and foreign exchange risks as are used to test sensitivity to business and financial risks. Many decision makers feel more uncomfortable about the necessity to guess probabilities for unfamiliar political and foreign exchange events than they do about guessing their own more familiar business or financial risks. Therefore, it is more common to test sensitivity to political and foreign exchange risk by simulating what would happen to net present value and earnings under a variety of “what if” scenarios.

Political Risk.

What if Indonesia imposes controls on the payment of dividends or license fees to Cemex? The impact of blocked funds on the rate of return from Cemex’s perspective would depend on when the blockage occurs, what reinvestment opportunities exist for the blocked funds in Indonesia, and when the blocked funds would eventually be released to Cemex. We could simulate various scenarios for blocked funds and rerun the cash flow analysis in Exhibit 18.6 to estimate the effect on Cemex’s rate of return.

What if Indonesia should expropriate Semen Indonesia? The effect of expropriation would depend on the following factors:

1. When the expropriation occurs, in terms of number of years after the business began operation

2. How much compensation the Indonesian government will pay, and how long after expropriation the payment will be made

3. How much debt is still outstanding to Indonesian lenders, and whether the parent, Cemex, will have to pay this debt because of its parental guarantee

4. The tax consequences of the expropriation

5. Whether the future cash flows are foregone

Many expropriations eventually result in some form of compensation to the former owners. This compensation can come from a negotiated settlement with the host government or from payment of political risk insurance by the parent government. Negotiating a settlement takes time, and the eventual compensation is sometimes paid in installments over a further period of time. Thus, the present value of the compensation is often much lower than its nominal value. Furthermore, most settlements are based on book value of the firm at the time of expropriation rather than the firm’s market value.

The tax consequences of expropriation would depend on the timing and amount of capital loss recognized by Mexico. This loss would usually be based on the uncompensated book value of the Indonesian investment. The problem is that there is often some doubt as to when a write-off is appropriate for tax purposes, particularly if negotiations for a settlement drag on. In some ways, a nice clear expropriation without hope of compensation, such as occurred in Cuba in the early 1960s, is preferred to a slow “bleeding death” in protracted negotiations. The former leads to an earlier use of the tax shield and a one-shot write-off against earnings, whereas the latter tends to depress earnings for years, as legal and other costs continue and no tax shelter is achieved.

Foreign Exchange Risk.

The project investigation team assumed that the Indonesian rupiah would depreciate versus the U.S. dollar at the purchasing power parity “rate” (approximately 20.767% per year in the baseline analysis).

What if the rate of rupiah depreciation were greater? Although this event would make the assumed cash flows to Cemex worth less in dollars, operating exposure analysis would be necessary to determine whether the cheaper rupiah made Semen Indonesia more competitive. For example, since Semen Indonesia’s exports to Taiwan are denominated in U.S. dollars, a weakening of the rupiah versus the dollar could result in greater rupiah earnings from those export sales. This serves to somewhat offset the imported components that Semen Indonesia purchases from the parent company that are also denominated in U.S. dollars. Semen Indonesia is representative of firms today that have both cash inflows and outflows denominated in foreign currencies, providing a partial natural hedge against currency movements.

What if the rupiah should appreciate against the dollar? The same kind of economic exposure analysis is needed. In this particular case, we might guess that the effect would be positive on both local sales in Indonesia and the value in dollars of dividends and license fees paid to Cemex by Semen Indonesia. Note, however, that an appreciation of the rupiah might lead to more competition within Indonesia from firms in other countries with now lower cost structures, lessening Semen Indonesia’s sales.

Sometimes foreign exchange risk and political risks were inseparable, as was the case of Venezuela in 2015 as examined in Global Finance in Practice 18.1 .

Other Sensitivity Variables.

The project rate of return to Cemex would also be sensitive to a change in the assumed terminal value, the capacity utilization rate, the size of the license fee paid by Semen Indonesia, the size of the initial project cost, the amount of working capital financed locally, and the tax rates in Indonesia and Mexico. Since some of these variables are within control of Cemex, it is still possible that the Semen Indonesia project could be improved in its value to the firm and become acceptable.

Sensitivity Analysis: Parent Viewpoint Measurement

When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in two ways, adjusting the discount rates or adjusting the cash flows.

GLOBAL FINANCE IN PRACTICE 18.1 Venezuelan Currency and Capital Controls Force Devaluation of Business

The Venezuelan government’s restrictions on access to hard currency have now lasted more than 12 years, and foreign corporate interests have had enough. Throughout 2014 and into 2015 many international investors in Venezuela struggled to run and value their businesses.

Air Canada suspended all flights to Venezuela in March 2014, citing concern over its ability to assure passenger safety in light of ongoing civil protest in the country. Air Canada was also due millions of dollars in back payments for services rendered. International airlines in total claimed that they were owed more than $2 billion in backpayments. Other companies like Avon and Merck wrote down their investments in Venezuela as a result of the continuing fall in the market value of the Venezuelan bolivar. Manufacturing companies like GM continued to struggle to even operate, as restricted access to hard currency prevented them from purchasing critical inputs and components for their products. Factories stopped, layoffs followed.

In February 2015 the Venezuelan government announced once again a “new” currency exchange system. The new system was little different, however, from the old three-tiered system in effect. There is the official exchange rate of roughly 6.3 bolivars to the U.S. dollar. But outside of food and medical purchases, few companies had access to this rate. The second- or middle-tier rate, called SICAD 1, a rate that was offered to select companies, was 12 bolivars. The third-tier rate, SICAD 2, theoretically open to all who needed it, was hovering around 52. A fourth, the black market rate, was trading at 190 bolivars per dollar.

Regardless of the next exchange rate system or next devaluation, multinational firms from all over the world continued to write down their Venezuelan investments. This included Coca Cola (U.S.), Telefonica (Spain) and drugmaker Bayer (Germany). So what was the value of investing or doing business in Venezuela tomorrow?

Adjusting Discount Rates.

The first method is to treat all foreign risk as a single problem, by adjusting the discount rate applicable to foreign projects relative to the rate used for domestic projects to reflect the greater foreign exchange risk, political risk, agency costs, asymmetric information, and other uncertainties perceived in foreign operations. However, adjusting the discount rate applied to a foreign project’s cash flow to reflect these uncertainties does not penalize net present value in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time. Combining all risks into a single discount rate may thus cause us to discard much information about the uncertainties of the future.

In the case of foreign exchange risk, changes in exchange rates have a potential effect on future cash flows because of operating exposure. The direction of the effect, however, can either decrease or increase net cash inflows, depending on where the products are sold and where inputs are sourced. To increase the discount rate applicable to a foreign project on the assumption that the foreign currency might depreciate more than expected, is to ignore the possible favorable effect of a foreign currency depreciation on the project’s competitive position. Increased sales volume might more than offset a lower value of the local currency. Such an increase in the discount rate also ignores the possibility that the foreign currency may appreciate (two-sided risk).

Adjusting Cash Flows.

In the second method, we incorporate foreign risks in adjustments to forecasted cash flows of the project. The discount rate for the foreign project is risk-adjusted only for overall business and financial risk, in the same manner as for domestic projects. Simulation-based assessment utilizes scenario development to estimate cash flows to the parent arising from the project over time under different alternative economic futures.

Certainty regarding the quantity and timing of cash flows in a prospective foreign investment is, to quote Shakespeare, “the stuff that dreams are made of.” Due to the complexity of economic forces at work in major investment projects, it is paramount that the analyst understand the subjectivity of the forecast cash flows. Humility in analysis is a valuable trait.

Shortcomings of Each.

In many cases, however, neither adjusting the discount rate nor adjusting cash flows is optimal. For example, political uncertainties are a threat to the entire investment, not just the annual cash flows. Potential loss depends partly on the terminal value of the unrecovered parent investment, which will vary depending on how the project was financed, whether political risk insurance was obtained, and what investment horizon is contemplated. Furthermore, if the political climate were expected to be unfavorable in the near future, any investment would probably be unacceptable. Political uncertainty usually relates to possible adverse events that might occur in the more distant future, but that cannot be foreseen at the present. Adjusting the discount rate for political risk thus penalizes early cash flows too heavily while not penalizing distant cash flows enough.

Repercussions to the Investor.

Apart from anticipated political and foreign exchange risks, MNEs sometimes worry that taking on foreign projects may increase the firm’s overall cost of capital because of investors’ perceptions of foreign risk. This worry seemed reasonable if a firm had significant investments in Iraq, Iran, Russia, Serbia, or Afghanistan in recent years. However, the argument loses persuasiveness when applied to diversified foreign investments with a heavy balance in the industrial countries of Canada, Western Europe, Australia, Latin America, and Asia where, in fact, the bulk of FDI is located. These countries have a reputation for treating foreign investments by consistent standards, and empirical evidence confirms that a foreign presence in these countries may not increase the cost of capital. In fact, some studies indicate that required returns on foreign projects may even be lower than those for domestic projects.

MNE Practices.

Surveys of MNEs over the past 35 years have shown that about half of them adjust the discount rate and half adjust the cash flows. One recent survey indicated a rising use of adjusting discount rates over adjusting cash flows. However, the survey also indicated an increasing use of multifactor methods—discount rate adjustment, cash flow adjustment, real options analysis, and qualitative criteria—in evaluating foreign investments.4

Portfolio Risk Measurement

The field of finance has distinguished two different definitions of risk: (1) the risk of the individual security (standard deviation of expected return) and (2) the risk of the individual security as a component of a portfolio ( beta ). A foreign investment undertaken in order to enter a local or regional market—market seeking—will have returns that are more or less correlated with those of the local market. A portfolio-based assessment of the investment’s prospects would then seem appropriate. A foreign investment motivated by resource-seeking or production-seeking objectives may yield returns related to the products or services and markets of the parent company or units located somewhere else in the world and have little to do with local markets. Cemex’s proposed investment in Semen Indonesia is both market-seeking and production-seeking (for export). The decision about which approach is to be used in evaluating prospective foreign investments may be the single most important analytical decision that the MNE makes. An investment’s acceptability may change dramatically across criteria.

4Tom Keck, Eric Levengood, and Al Longield, “Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital,” Journal of Applied Corporate Finance, Vol. 11, No. 3, Fall 1998, pp. 82–99.

For comparisons within the local host country, we should overlook a project’s actual financing or parent-influenced debt capacity, since these would probably be different for local investors than they are for a multinational owner. In addition, the risks of the project to local investors might differ from those perceived by a foreign multinational owner because of the opportunities an MNE has to take advantage of market imperfections. Moreover, the local project may be only one out of an internationally diversified portfolio of projects for the multinational owner; if undertaken by local investors it might have to stand alone without international diversification. Since diversification reduces risk, the MNE can require a lower rate of return than is required by local investors.

Thus, the discount rate used locally must be a hypothetical rate based on a judgment as to what independent local investors would probably demand were they to own the business. Consequently, application of the local discount rate to local cash flows provides only a rough measure of the value of the project as a stand-alone local venture, rather than an absolute valuation.

Real Option Analysis

The discounted cash flow (DCF) approach used in the valuation of Semen Indonesia—and capital budgeting and valuation in general—has long had its critics. Investments that have long lives, cash flow returns in later years, or higher levels of risk than those typical of the firm’s current business activities are often rejected by traditional DCF financial analysis. More importantly, when MNEs evaluate competitive projects, traditional discounted cash flow analysis is typically unable to capture the strategic options that an individual investment option may offer. This has led to the development of real option analysis. Real option analysis is the application of option theory to capital budgeting decisions.

Real options present a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. It is particularly useful when analyzing investment projects that will follow very different value paths at decision points in time where management decisions are made regarding project pursuit. This wide range of potential outcomes is at the heart of real option theory. These wide ranges of value are volatilities, the basic element of option pricing theory described previously.

Real option valuation also allows us to analyze a number of managerial decisions, which in practice characterize many major capital investment projects:

■ The option to defer

■ The option to abandon

■ The option to alter capacity

■ The option to start up or shut down (switching)

Real option analysis treats cash flows in terms of future value in a positive sense, whereas DCF treats future cash flows negatively (on a discounted basis). Real option analysis is a particularly powerful device when addressing potential investment projects with extremely long life spans or investments that do not commence until future dates. Real option analysis acknowledges the way information is gathered over time to support decision-making. Management learns from both active (searching it out) and passive (observing market conditions) knowledge-gathering and then uses this knowledge to make better decisions.

Project Financing

One of the more unique structures used in international finance is project finance, which refers to the arrangement of financing for long-term capital projects, large in scale, long in life, and generally high in risk. This is a very general definition, however, because there are many different forms and structures that fall under this generic heading.

Project finance is not new. Examples of project finance go back centuries, and include many famous early international businesses such as the Dutch East India Company and the British East India Company. These entrepreneurial importers financed their trade ventures to Asia on a voyage-by-voyage basis, with each voyage’s financing being like venture capital-investors would be repaid when the shipper returned and the fruits of the Asian marketplace were sold at the docks to Mediterranean and European merchants. If all went well, the individual shareholders of the voyage were paid in full.

Project finance is used widely today in the development of large-scale infrastructure projects in China, India, and many other 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. Equity is a small component of project financing for two reasons: first, the simple scale of the investment project often precludes a single investor or even a collection of private investors from being able to fund it; second, many of these projects involve subjects traditionally funded by governments—such as electrical power generation, dam building, highway construction, energy exploration, production, and distribution.

This level of debt, however, places an enormous burden on cash flow for debt service. Therefore, project financing usually requires a number of additional levels of risk reduction. The lenders involved in these investments must feel secure that they will be repaid; bankers are not by nature entrepreneurs, and do not enjoy entrepreneurial returns from project finance. Project finance has a number of basic properties that are critical to its success.

Separability of the Project from Its Investors

The project is established as an individual legal entity, separate from the legal and financial responsibilities of its individual investors. This not only serves to protect the assets of equity investors, but also it provides a controlled platform upon which creditors can evaluate the risks associated with the singular project, the ability of the project’s cash flows to service debt, and to rest assured that the debt service payments will be automatically allocated by and from the project itself (and not from a decision by management within an MNE).

Long-Lived and Capital-Intensive Singular Projects

Not only must the individual project be separable and large in proportion to the financial resources of its owners, but also its business line must be singular in its construction, operation, and size (capacity). The size is set at inception, and is seldom, if ever, changed over the project’s life.

Cash Flow Predictability from Third Party Commitments

An oil field or electric power plant produces a homogeneous commodity product that can produce predictable cash flows if third party commitments to take and pay can be established. In addition to revenue predictability, nonfinancial costs of production need to be controlled over time, usually through long-term supplier contracts with price adjustment clauses based on inflation. The predictability of net cash inflows to long-term contracts eliminates much of the individual project’s business risk, allowing the financial structure to be heavily debt-financed and still be safe from financial distress.

The predictability of the project’s revenue stream is essential in securing project financing. Typical contract provisions that are intended to assure adequate cash flow normally include the following clauses: quantity and quality of the project’s output; a pricing formula that enhances the predictability of adequate margin to cover operating costs and debt service payments; a clear statement of the circumstances that permit significant changes in the contract, such as force majeure or adverse business conditions.

Finite Projects with Finite Lives

Even with a longer-term investment, it is critical that the project have a definite ending point at which all debt and equity has been repaid. Because the project is a stand-alone investment in which its cash flows go directly to the servicing of its capital structure and not to reinvestment for growth or other investment alternatives, investors of all kinds need assurances that the project’s returns will be attained in a finite period. There is no capital appreciation, only cash flow.

Examples of project finance include some of the largest individual investments undertaken in the past three decades, such as British Petroleum’s financing of its interest in the North Sea, and the Trans-Alaska Pipeline. The Trans-Alaska Pipeline was a joint venture between Standard Oil of Ohio, Atlantic Richfield, Exxon, British Petroleum, Mobil Oil, Philips Petroleum, Union Oil, and Amerada Hess. Each of these projects was at or above $1 billion, and represented capital expenditures that no single firm would or could attempt to finance. Yet, through a joint venture arrangement, the higher than normal risk absorbed by the capital employed could be managed.

Cross-Border Mergers and Acquisitions

The drivers of M&A activity, summarized in Exhibit 18.7, are both macro in scope—the global competitive environment—and micro in scope—the variety of industry and firm-level forces and actions driving individual firm value. The primary forces of change in the global competitive environment—technological change, regulatory change, and capital market change—create new business opportunities for MNEs, which they pursue aggressively.

But the global competitive environment is really just the playing field, the ground upon which the individual players compete. MNEs undertake cross-border mergers and acquisitions for a variety of reasons. As shown in Exhibit 18.7, the drivers are strategic responses by MNEs to defend and enhance their global competitiveness.

As opposed to greenfield investment, a cross-border acquisition has a number of significant advantages. First and foremost, it is quicker. Greenfield investment frequently requires extended periods of physical construction and organizational development. By acquiring an existing firm, the MNE shortens the time required to gain a presence and facilitate competitive entry into the market. Second, acquisition may be a cost-effective way of gaining competitive advantages, such as technology, brand names valued in the target market, and logistical and distribution advantages, while simultaneously eliminating a local competitor. Third, specific to cross-border acquisitions, international economic, political, and foreign exchange conditions may result in market imperfections, allowing target firms to be undervalued.

Cross-border acquisitions are not, however, without their pitfalls. As with all acquisitions—domestic or cross-border—there are problems of paying too much or suffering excessive financing costs. Melding corporate cultures can be traumatic. Managing the post-acquisition process is frequently characterized by downsizing to gain economies of scale and scope in overhead functions. This results in nonproductive impacts on the firm as individuals attempt to save their own jobs. Internationally, additional difficulties arise from host governments intervening in pricing, financing, employment guarantees, market segmentation, and general nationalism and favoritism. In fact, the ability to successfully complete cross-border acquisitions may itself be a test of competency of the MNE when entering emerging markets.

EXHIBIT 18.7 Driving Forces Behind Cross-Border Acquisition

The Cross-Border Acquisition Process

Although the field of finance has sometimes viewed acquisition as mainly an issue of valuation, it is a much more complex and rich process than simply determining what price to pay. As depicted in Exhibit 18.8, the process begins with the strategic drivers discussed in the previous section.

The process of acquiring an enterprise anywhere in the world has three common elements: (1) identification and valuation of the target, (2) execution of the acquisition offer and purchase—the tender , and (3) management of the post-acquisition transition.

Stage 1: Identification and Valuation.

Identification of potential acquisition targets requires a well-defined corporate strategy and focus.

The identification of the target market typically precedes the identification of the target firm. Entering a highly developed market offers the widest choice of publicly traded firms with relatively well-defined markets and publicly disclosed financial and operational data. In this case, the tender offer is made publicly, although target company management may openly recommend that its shareholders reject the offer. If enough shareholders take the offer, the acquiring company may gain sufficient ownership influence or control to change management. During this rather confrontational process, it is up to the board of the target company to continue to take actions consistent with protecting the rights of shareholders. The board may need to provide rather strong oversight of management during this process to ensure that the acts of management are consistent with protecting and building shareholder value.

Once identification has been completed, the process of valuing the target begins. A variety of valuation techniques are widely used in global business today, each with its own merits. In addition to the fundamental methodologies of discounted cash flow (DCF) and multiples (earnings and cash flows), there are also industry-specific measures that focus on the most significant elements of value in business lines. The completion of various alternative valuations for the target firm aids not only in gaining a more complete picture of what price must be paid to complete the transaction, but also in determining whether the price is attractive.

EXHIBIT 18.8 The Cross-Border Acquisition Process

Stage 2: Execution of the Acquisition.

Once an acquisition target has been identified and valued, the process of gaining approval from management and ownership of the target, getting approvals from government regulatory bodies, and finally determining method of compensation—the complete execution of the acquisition strategy—can be time-consuming and complex.

Gaining the approval of the target company has been the highlight of some of the most famous acquisitions in business history. The critical distinction here is whether the acquisition is supported or not by the target company’s management.

Although there is probably no “typical transaction,” many acquisitions flow relatively smoothly through a friendly process. The acquiring firm will approach the management of the target company and attempt to convince them of the business logic of the acquisition. (Gaining their support is sometimes difficult, but assuring target company management that it will not be replaced is often quite convincing!) If the target’s management is supportive, management may then recommend to stockholders that they accept the offer of the acquiring company. One problem that occasionally surfaces at this stage is that influential shareholders may object to the offer, either in principle or based on price, and may therefore feel that management is not taking appropriate steps to protect and build their shareholder value.

The process takes on a very different dynamic when the acquisition is not supported by the target company management—the so-called hostile takeover. The acquiring company may choose to pursue the acquisition without the target’s support, and instead go directly to the target shareholders. In this case, the tender offer is made publicly, although target company management may openly recommend that its shareholders reject the offer. If enough shareholders take the offer, the acquiring company may gain sufficient ownership influence or control to change management. During this rather confrontational process, it is up to the board of the target company to continue to take actions consistent with protecting the rights of shareholders. As in Stage 1, the board may need to provide rather strong oversight of management during this process to ensure that the acts of management are consistent with protecting and building shareholder value.

Regulatory approval alone may prove to be a major hurdle in the execution of the deal. An acquisition may be subject to significant regulatory approval if it involves a company in an industry considered fundamental to national security or if there is concern over major concentration and anticompetitive results from consolidation.

The proposed acquisition of Honeywell International (itself the result of a merger of Honeywell U.S. and Allied-Signal U.S.) by General Electric (U.S.) in 2001 was something of a watershed event in the field of regulatory approval. General Electric’s acquisition of Honeywell had been approved by management, ownership, and U.S. regulatory bodies when it then sought approval within the European Union. Jack Welch, the charismatic chief executive officer and president of GE did not anticipate the degree of opposition that the merger would face from EU authorities. After a continuing series of demands by the EU that specific businesses within the combined companies be sold off to reduce anticompetitive effects, Welch withdrew the request for acquisition approval, arguing that the liquidations would destroy most of the value-enhancing benefits of the acquisition. The acquisition was canceled. This case may have far-reaching effects on cross-border M&A for years to come, as the power of regulatory authorities within strong economic zones like the EU to block the combination of two MNEs may foretell a change in regulatory strength and breadth.

The last act within this second stage of cross-border acquisition, compensation settlement, is the payment to shareholders of the target company. Shareholders of the target company are typically paid either in shares of the acquiring company or in cash. If a share exchange occurs, the exchange is generally defined by some ratio of acquiring company shares to target company shares (say, two shares of acquirer in exchange for three shares of target), and the stockholder is typically not taxed—the shares of ownership are simply replaced by other shares in a nontaxable transaction.

If cash is paid to the target company shareholder, it is the same as if the shareholder sold the shares on the open market, resulting in a capital gain or loss (a gain, it is hoped, in the case of an acquisition) with tax liabilities. Because of the tax ramifications, shareholders are typically more receptive to share exchanges so that they may choose whether and when tax liabilities will arise.

A variety of factors go into the determination of the type of settlement. The availability of cash, the size of the acquisition, the friendliness of the takeover, and the relative valuations of both acquiring firm and target firm affect the decision. One of the most destructive forces that sometimes arises at this stage is regulatory delay and its impact on the share prices of the two firms. If regulatory body approval drags out over time, the possibility of a drop in share price increases and can change the attractiveness of the share swap.

Stage 3: Post-Acquisition Management.

Although the headlines and flash of investment banking activities are typically focused on the valuation and bidding process in an acquisition transaction, post-transaction management is probably the most critical of the three stages in determining an acquisition’s success or failure. An acquiring firm can pay too little or too much, but if the post transaction is not managed effectively, the entire return on the investment is squandered. Post-acquisition management is the stage in which the motivations for the transaction must be realized—motivations such as more effective management, synergies arising from the new combination, or the injection of capital at a cost and availability previously out of the reach of the acquisition target, must be effectively implemented after the transaction. The biggest problem, however, is nearly always melding corporate cultures.

The clash of corporate cultures and personalities pose both the biggest risk and the biggest potential gain from cross-border mergers and acquisitions. Although not readily measurable as are price/earnings ratios or share price premiums, in the end, the value is either gained or lost in the hearts and minds of the stakeholders.

EXHIBIT 18.9 Currency Risks in Cross-Border Acquisitions

Currency Risks in Cross-Border Acquisitions

The pursuit and execution of a cross-border acquisition poses a number of challenging foreign currency risks and exposures for an MNE. As illustrated by Exhibit 18.9, the nature of the currency exposure related to any specific cross-border acquisition evolves as the bidding and negotiating process itself evolves across the bidding, financing, transaction (settlement), and operating stages. The assorted risks, both in the timing and information related to the various stages of a cross-border acquisition, make the management of the currency exposures difficult. As illustrated in Exhibit 18.9, the uncertainty related to the multitude of stages declines over time as stages are completed and contracts and agreements reached.

The initial bid, if denominated in a foreign currency, creates a contingent foreign currency exposure for the bidder. This contingent exposure grows in certainty of occurrence over time as negotiations continue, regulatory requests and approvals are gained, and competitive bidders emerge. Although a variety of hedging strategies might be employed, the use of a purchased currency call option is the simplest. The option’s notional principal would be for the estimated purchase price, but the maturity, for the sake of conservatism, might possibly be significantly longer than probably needed to allow for extended bidding, regulatory, and negotiation delays.

Once the bidder has successfully won the acquisition, the exposure evolves from a contingent exposure to a transaction exposure . Although a variety of uncertainties remain as to the exact timing of the transaction settlement, the certainty over the occurrence of the currency exposure is largely eliminated. Some combination of forward contracts and purchased currency options may then be used to manage the currency risks associated with the completion of the cross-border acquisition.

Once consummated, the currency risks and exposures of the cross-border acquisition, now a property and foreign subsidiary of the MNE, changes from being a transaction-based cash flow exposure to the MNE to part of its multinational structure and therefore part of its operating exposure from that time forward. Time, as is always the case involving currency exposure management in multinational business, is the greatest challenge to the MNE, as illustrated by Global Finance in Practice 18.2 .

GLOBAL FINANCE IN PRACTICE 18.2 Statoil of Norway’s Acquisition of Esso of Sweden

Statoil’s acquisition of Svenska Esso (Exxon’s wholly owned subsidiary operating in Sweden) in 1986 was one of the more uniquely challenging cross-border acquisitions ever completed. First, Statoil was the national oil company of Norway, and therefore a government-owned and operated business bidding for a private company in another country. Second, if completed, the acquisition’s financing as proposed would increase the financial obligations of Svenska Esso (debt levels and therefore debt service), reducing the company’s tax liabilities to Sweden for many years to come. The proposed cross-border transaction was characterized as a value transfer from the Swedish government to the Norwegian government.

As a result of the extended period of bidding, negotiation, and regulatory approvals, the currency risk of the transaction was both large and extensive. Statoil, being a Norwegian oil company, was a Norwegian kroner (NOK)-based company with the U.S. dollar as its functional currency as a result of the global oil industry being dollar-denominated. Svenska Esso, although Swedish by incorporation, was the wholly owned subsidiary of a U.S.-based MNE, Exxon, and the final bid and cash settlement on the sale was therefore U.S. dollar-denominated.

On March 26, 1985, Statoil and Exxon agreed upon the sale of Svenska Esso for $260 million, or NOK2.47 billion at the current exchange rate of NOK9.50/$. (This was by all modern standards the weakest the Norwegian krone had ever been against the dollar, and many currency analysts believed the dollar to be significantly overvalued at the time.) The sale could not be consummated without the approval of the Swedish government. That approval process—eventually requiring the approval of Swedish Prime Minister Olaf Palme—took nine months. Because Statoil considered the U.S. dollar as its true operating currency, it chose not to hedge the purchase price currency exposure. At the time of settlement the krone had appreciated to NOK7.65/$, final acquisition cost in Norwegian kroner of NOK1.989 billion. Statoil saved nearly 20% on the purchase price, NOK0.481 billion, as a result of not hedging.

SUMMARY POINTS

■ Parent cash flows must be distinguished from project cash flows. Each of these two types of flows contributes to a different view of value.

■ Parent cash flows often depend on the form of financing. Thus, cash flows cannot be clearly separated from financing decisions, as is done in domestic capital budgeting.

■ Remittance of funds to the parent 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.

■ When a foreign project is analyzed from the project’s point of view, risk analysis focuses on the use of sensitivities, as well as consideration of foreign exchange and political risks associated with the project’s execution over time.

■ When a foreign project is analyzed from the parent’s point of view, the additional risk that stems from its “foreign” location can be measured in at least two ways, adjusting the discount rates or adjusting the cash flows.

■ Real option analysis is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based 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.

■ The process of acquiring an enterprise anywhere in the world has three common elements: (1) identification and valuation of the target; (2) completion of the ownership change transaction (the tender); and (3) the management of the post-acquisition transition.

■ Cross-border mergers, acquisitions, 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 of enterprise valuation combines elements of strategy, management, and finance.

MINI-CASE Elan and Royalty Pharma5

We lived a long time with Elan (ELN). We always appreciated its science and scientists, and, at times, we hated its former management, or whoever caused it to turn from ascending towards becoming a citadel of sciences, especially neurosciences, into an almost bankrupt firm with less everything valuable in it than what was necessary for its survival. What saved it at the time was the emergence of Tysabri, for multiple sclerosis, which we knew it was second to none in treatment of relapsing remitting multiple sclerosis. We were certain that this drug, like Aaron’s cane, would swallow up all magicians’ staffs.

—“Biogen Idec Pays Elan $3.25 Billion for Tysabri: Do We Leave, Or Stay?,” Seeking Alpha, February 6, 2013.

Elan’s shareholders (Elan Corporation, NYSE: ELN) were faced with a difficult choice. Elan’s management had made four proposals to shareholders in an attempt to defend itself against a hostile takeover from Royalty Pharma (U.S.), a privately held company. If shareholders voted in favor of any of the four initiatives, it would kill Royalty Pharma’s offer. That would allow Elan to stay independent and remain under the control of a management team that had not sparked confidence in recent years. All votes had to be filed by midnight June 16, 2013.

The Players

Elan Corporation was a global biopharmaceutical company headquartered in Dublin, Ireland. Elan focused on the discovery, development and marketing of therapeutic products in neurology including Alzheimer’s disease and Parkinson’s disease and autoimmune diseases such as multiple sclerosis and Crohn’s disease. But over time the company had spun-out, sold-off, or closed most of its business activities. By the spring of 2013, Elan was a company of only two assets: a large pile of cash and a perpetual royalty stream on a leading therapeutic for multiple sclerosis called Tysabri, which it had co-developed with Biogen.

5Copyright © 2014 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only.

The solution to Elan’s problem was the sale of its interest in Tysabri to its partner Biogen. In February 2013 Elan sold its 50% rights in Tysabri to Biogen in return for $3.29 billion in cash and a perpetual royalty stream on Tysabri. Whereas previously Elan earned returns on only its 50% share of Tysabri, the royalty agreement was based on 100% of the asset. The royalty was a step-up rate structure on worldwide sales of 12% in year 1, 18% all subsequent years, plus 25% on all global sales above $2 billion.

The ink had barely dried on Elan’s sale agreement in February 2013 when it was approached by a private U.S. firm, Royalty Pharma, about the possible purchase of Elan for $11 per share. Elan acknowledged the proposal publicly, and stated it would consider the proposal along with other strategic options.

Royalty Pharma (RP) is a privately held company (owned by private equity interests) that acquires royalty interests in marketed or late-stage pharmaceutical products. Its business allows the owners of these intellectual products to monetize their interests in order to pursue additional business development opportunities. RP accepts the risk that the price they paid for the asset interest will actually accrue over time. RP owns royalty rights; it does not operate or market.

In March 2013, possibly tired of waiting, RP issued a statement directly to Elan shareholders to encourage them to vote for the proposed acquisition of Elan for $11 per share. At that time, Elan issued a response to RP’s statement that characterized the Royalty Pharma proposal as “conditional and opportunistic.”

Elan’s Defense

Elan’s leadership was now under considerable pressure by shareholders to explain why shareholders should not tender their shares to Royalty Pharma. In May, Elan began to detail a collection of initiatives to redefine the company. Going forward, Elan described a series of four complex strategic initiatives that it would pursue to grow and diversify the firm beyond its current two-asset portfolio. Because the company was currently in the offer period of a proposed acquisition, Irish securities laws required that all four of Elan’s proposals be approved by shareholders. But from the beginning that appeared difficult given public perception that the initiatives were purely defensive.

Royalty Pharma responded publicly with a letter to Elan’s stockholders questioning whether Elan’s leadership was really acting in the best interests of the shareholders. It then increased its tender offer to $12.50/share plus a Contingent Value Right (CVR). The CVR was a conditional element where all shareholders would receive an additional amount per share in the future—up to an additional $2.50 per share—if Tysabri’s future sales reached specific milestone targets. Royalty Pharma’s CVR offer required Tysabri sales to hit $2.6 billion by 2015 and $3.1 billion by 2017. Royalty Pharma also made it very clear that if shareholders were to approve any of the Elan’s four management proposals, the acquisition offer would lapse.

The Value Debate

Elan, as of May 2013, consisted of $1.787 billion in cash, the Tysabri royalty stream, a few remaining prospective pipeline products, and between $100 and $200 million in annual expenses associated with its business. Elan’s leadership wanted to use its cash and its annual royalty earnings to build a new business. Royalty Pharma just wanted to buy Elan, take the cash and royalty stream assets, and shut Elan down.

The valuation debate on Elan revolved around the value of the Tysabri royalty stream. That meant predicting what actual sales were likely to be in the coming decade. Exhibit A presents Royalty Pharma’s synopsis of the sales debate, noting that Elan’s claims on value have been selectively high, while Royal Pharma has based its latest offer on the Street Consensus numbers.

Predicting royalty earnings on biotechnology products is not all that different than predicting the sales of any product. Pricing, competition, regulation, government policy, changing demographics and conditions—all could change future global sales. That said, there were several more distinct factors of concern.

First, Tysabri was scheduled to go off-patent in 2020 (original patent filing was in 2000). The Street Consensus forecast, the one advocated by Royalty Pharma, predicted Tysabri global sales to peak in that year at $2.74 billion. Sales would slide, but continue, in the following years. Second, competitive products were already entering the market. In the spring, Biogen had finally received FDA approval on an oral treatment for relapsing-remitting forms of multiple sclerosis. It was only one of several new treatments coming to the market. Royalty Pharma had pointed to declining new patient adds over the past two quarters as evidence that aggressive future sales forecasts for Tysabri may be unrealistic—already.

For these and other reasons Royalty Pharma had argued that a conservative sales forecast was critically important for investors to use when deciding whether or not to go with management or Royalty Pharma’s offer. Royalty Pharma’s valuation, presented in Exhibit B, used this sales forecast for its baseline analysis. Royalty Pharma’s valuation of Elan was based on the following critical assumptions:

EXHIBIT A Forecasts of Tysabri’s Worldwide Sales

Source: “Royalty Pharma’s Response to Elan’s Tysabri Valuation,” Royalty Pharma, May 31, 2013, p. 4.

■ Tysabri’s worldwide sales, the top-line of the valuation, were based on the Street Consensus.

■ Elan’s operating expenses would remain relatively flat, rising at 1% to 2% per year, from $75 million in 2013.

■ Elan’s net operating losses and Irish incorporation would reduce effective taxes to 1% per year through 2017, rising to Ireland’s still relatively low corporate tax rate of 12.5% per year afterward.

■ The discount rate would be 7.5% per year up until going off-patent in 2017, and rising to 10% after that.

■ Perpetuity value (terminal value) would be based on year 2024’s income, discounted at 12%, and assuming an annual growth rate of either −2% or −4% as Tysabri’s sales slide into the future.

■ There were 518 million shares outstanding as of May 29, 2013, according to Elan’s most recent communications.

■ Elan’s cash total was $1.787 billion, according to Elan’s most recent communications.

The result was a base valuation of $10.49 or $10.17 per share, depending on the terminal value decline assumption. As typical of most valuations, the top-line total sales was the single largest driver for all future projected cash flows. The shares outstanding assumption, 518 million shares, reflected the results of a large share repurchase program that Elan had pursued right up to mid-May of 2013. Note that Royalty Pharma expressly decomposed its total valuation into three pieces: (1) the under patent period, (2) the post-patent period, and (3) the perpetuity value. In Royalty Pharma’s opinion, the post-patent period represented a significantly higher risk period for actual Tysabri sales.

Market Valuation

Despite the debate over Elan’s value, as a publicly traded company, the market made its opinion known every single trading day. On the day prior to receiving the first indication of interest from Royalty Pharma, Elan was trading at $11 per share. (In the days that follow, the market is factoring in what it thinks the effective offer price is from a suitor like Royalty Pharma and the probability of the acquisition occurring.) Elan’s share price history for 2013 is shown in Exhibit C.

EXHIBIT B Valuing Elan: Prospective Royalties on Tysabri Plus Cash

EXHIBIT C Elan’s Share Price (January 1–June 16, 2013)

Elan’s management had made their case to shareholders. The collection of initiatives that Elan’s leadership wished to pursue had to be approved, however, by shareholders. The Extraordinary General Meeting (EGM) of shareholders would be held on Monday, June 17th. At that meeting the results of the shareholder vote (all votes were due by the previous Friday) would be announced.

In the days leading up to the EGM, the battle had become very public, and in the words of one journalist, “quite chippy.” In a Financial Times editorial, one former Elan board member, Jack Schuler, wrote “I have no confidence that Kelly Martin [Elan’s CEO] or the other Elan board members will act in the interests of shareholders. I hope the Elan shareholders realise that their only option is to sell the company to the highest bidder.” Elan’s current non-executive chairman then responded: “I note that Elan’s share price has trebled since Mr. Schuler’s departure. The board and management team remain wholly focused on continued value creation and will continue to act in the best interests of our shareholders.”

Shareholders had to decide—quickly.

Mini-Case Questions

1. Using the sales forecasts for Tysabri presented in Exhibit A, and using the discounted cash flow model presented in Exhibit B, what do you think Elan is worth?

2. What other considerations do you think should be included in the valuation of Elan?

3. What would be your recommendation to shareholders—to approve management’s proposals killing RP’s offer—or say “no” to the proposals, probably prompting the acceptance of RP’s offer?

QUESTIONS

These questions are available in MyFinanceLab.

1. Capital Budgeting Theoretical Framework. Capital budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting. What are the basic steps in domestic capital budgeting?

2. Foreign Complexities. Capital budgeting for a foreign project is considerably more complex than the domestic case. What are the factors that add complexity?

3. Project versus Parent Valuation. Why should a foreign project be evaluated both from a project and parent viewpoint?

4. Viewpoint and NPV. Which viewpoint, project or parent, gives results closer to the traditional meaning of net present value in capital budgeting?

5. Viewpoint and Consolidated Earnings. Which viewpoint gives results closer to the effect on consolidated earnings per share?

6. Operating and Financing Cash Flows. Capital projects provide both operating cash flows and financial cash flows. Why are operating cash flows preferred for domestic capital budgeting but financial cash flows given major consideration in international projects?

7. Risk-Adjusted Return. Should the anticipated internal rate of return (IRR) for a proposed foreign project be compared to (a) alternative home country proposals, (b) returns earned by local companies in the same industry and/or risk class, or (c) both? Justify your answer.

8. Blocked Cash Flows. In the evaluation of a potential foreign investment, how should a multinational firm evaluate cash flows in the host foreign country that are blocked from being repatriated to the firm’s home country?

9. Host Country Inflation. How should an MNE factor host country inflation into its evaluation of an investment proposal?

10. Cost of Equity. A foreign subsidiary does not have an independent cost of capital. However, in order to estimate the discount rate for a comparable host-country firm, the analyst should try to calculate a hypothetical cost of capital. How is this done?

11. Viewpoint Cash Flows. What are the differences in the cash flows used in a project point of view analysis and a parent point of view analysis?

12. Foreign Exchange Risk and Capital Budgeting. How is foreign exchange risk sensitivity factored into the capital budgeting analysis of a foreign project?

13. Expropriation Risk. How is expropriation risk factored into the capital budgeting analysis of a foreign project?

14. Real Option Analysis. What is real option analysis? How is it a better method of making investment decisions than traditional capital budgeting analysis?

15. M&A Business Drivers. What are the primary driving forces that motivate cross-border mergers and acquisitions?

16. Three Stages of Cross-Border Acquisitions. What are the three stages of a cross-border acquisition? What are the core financial elements integral to each stage?

17. Currency Risks in Cross-Border Acquisitions. What are the currency risks that arise in the process of making a cross-border acquisition?

18. Contingent Currency Exposure. What are the largest contingent currency exposures that arise in the process of pursuing and executing a cross-border acquisition?

PROBLEMS

These problems are available in MyFinanceLab.

1. Carambola de Honduras. Slinger Wayne, a U.S.-based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 13 million Honduran lempiras (Lp) next year (2012), and that this free cash flow will continue to grow at a constant rate of 8.0% per annum indefinitely.

A private equity firm like Slinger Wayne, however, is not interested in owning a company for long, and plans to sell Carambola at the end of three years for approximately 10 times Carambola’s free cash flow in that year. The current spot exchange rate is Lp14.80/$, but the Honduran inflation rate is expected to remain at a relatively high rate of 16.0% per annum compared to the U.S. dollar inflation rate of only 2.0% per annum. Slinger Wayne expects to earn at least a 20% annual rate of return on international investments like Carambola.

a. What is Carambola worth if the Honduran lempira were to remain fixed over the three year investment period?

b. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity?

2. Finisterra, S.A. Finisterra, S.A., located in the state of Baja California, Mexico, manufactures frozen Mexican food that is popular in the states of California and Arizona (U.S.). In order to be closer to its U.S. market, Finisterra is considering moving some of its manufacturing operations to southern California. Operations in California would begin in year 1 and have the following attributes:

Assumptions

Value

Sales price per unit, year 1 (US$)

$5.00

Sales price increase, per year

3.00%

Initial sales volume, year 1, units

1,000,000

Sales volume increase, per year

10.00%

Production costs per unit, year 1

$4.00

Production cost per unit increase, per year

4.00%

General and administrative expenses

per year

$100,000

Depreciation expenses per year

$ 80,000

Finisterra’s WACC (pesos)

16.00%

Terminal value discount rate

20.00%

The operations in California will pay 80% of its accounting profit to Finisterra as an annual cash dividend. Mexican taxes are calculated on grossed up dividends from foreign countries, with a credit for host-country taxes already paid. What is the maximum U.S. dollar price Finisterra should offer in year 1 for the investment?

3. Grenouille Properties. Grenouille Properties (U.S.) expects to receive cash dividends from a French joint venture over the coming three years. The first dividend, to be paid December 31, 2011, is expected to be €720,000. The dividend is then expected to grow 10.0% per year over the following two years. The current exchange rate (December 30, 2010) is $1.3603/€. Grenouille’s weighted average cost of capital is 12%.

a. What is the present value of the expected euro dividend stream if the euro is expected to appreciate 4.00% per annum against the dollar?

b. What is the present value of the expected dividend stream if the euro were to depreciate 3.00% per annum against the dollar?

4. Natural Mosaic. Natural Mosaic Company (U.S.) is considering investing Rs50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years, the subsidiary would be sold to Indian investors for Rs100,000,000. A pro forma income statement for the Indian operation predicts the generation of Rs7,000,000 of annual cash flow, is listed in the following table.

Sales revenue

30,000,000

Less cash operating expenses

(17,000,000)

Gross income

13,000,000

Less depreciation expenses

(1,000,000)

Earnings before interest and taxes

12,000,000

Less Indian taxes at 50%

(6,000,000)

Net income

6,000,000

Add back depreciation

1,000,000

Annual cash flow

7,000,000

The initial investment will be made on December 31, 2011, and cash flows will occur on December 31st of each succeeding year. Annual cash dividends to Philadelphia Composite from India will equal 75% of accounting income.

The U.S. corporate tax rate is 40% and the Indian corporate tax rate is 50%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Natural Mosaic will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Natural Mosaic uses a weighted average cost of capital of 14% on domestic investments, but will add six percentage points for the Indian investment because of perceived greater risk. Natural Mosaic forecasts the rupee/dollar exchange rate for December 31st on the next six years are listed below.

R$/$

2011

50

2012

54

2013

58

2014

62

2015

66

2016

70

What is the net present value and internal rate of return on this investment?

5. Doohicky Devices. Doohickey Devices, Inc., manufactures design components for personal computers. Until the present, manufacturing has been subcontracted to other companies, but for reasons of quality control Doohicky has decided to manufacture itself in Asia. Analysis has narrowed the choice to two possibilities, Penang, Malaysia, and Manila, the Philippines. At the moment only the summary of expected, after-tax, cash flows displayed at the bottom of this page is available. Although most operating outflows would be in Malaysian ringgit or Philippine pesos, some additional U.S. dollar cash outflows would be necessary, as shown in the table at the top of the next page.

The Malaysia ringgit currently trades at RM3.80/$ and the Philippine peso trades at Ps50.00/$. Doohicky expects the Malaysian ringgit to appreciate 2.0% per year against the dollar, and the Philippine peso to depreciate 5.0% per year against the dollar. If the weighted average cost of capital for Doohicky Devices is 14.0%, which project looks most promising?

Problem 5.

Doohicky in Penang (after-tax)

2012

2013

2014

2015

2016

2017

Net ringgit cash flows

(26,000)

8,000

6,800

7,400

9,200

10,000

Dollar cash outflows

−

(100)

(120)

(150)

(150)

−

Doohicky in Manila (after-tax)

Net peso cash flows

(560,000)

190,000

180,000

200,000

210,000

200,000

Dollar cash outflows

−

(100)

(200)

(300)

(400)

−

Problem 6.

Assumptions

0

1

2

3

Original investment (Czech korunas, K)

250,000,000

Spot exchange rate (K/$)

32.50

30.00

27.50

25.00

Unit demand

700,000

900,000

1,000,000

Unit sales price

$10.00

$10.30

$10.60

Fixed cash operating expenses

$1,000,000

$1,030,000

$1,060,000

Depreciation

$500,000

$500,000

$500,000

Investment in working capital (K)

100,000,000

6. Wenceslas Refining Company. Privately owned Wenceslas Refining Company is considering investing in the Czech Republic so as to have a refinery source closer to its European customers. The original investment in Czech korunas would amount to K250 million, or $5,000,000 at the current spot rate of K32.50/$, all in fixed assets, which will be depreciated over 10 years by the straight-line method. An additional K100,000,000 will be needed for working capital.

For capital budgeting purposes, Wenceslas assumes sale as a going concern at the end of the third year at a price, after all taxes, equal to the net book value of fixed assets alone (not including working capital). All free cash flow will be repatriated to the United States as soon as possible. In evaluating the venture, the U.S. dollar forecasts are shown in the table above.

Variable manufacturing costs are expected to be 50% of sales. No additional funds need be invested in the U.S. subsidiary during the period under consideration. The Czech Republic imposes no restrictions on repatriation of any funds of any sort. The Czech corporate tax rate is 25% and the United States rate is 40%. Both countries allow a tax credit for taxes paid in other countries. Wenceslas uses 18% as its weighted average cost of capital, and its objective is to maximize present value. Is the investment attractive to Wenceslas Refining?