Cross-Border Mergers and Acquisitions: Analysis and Valuation

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Cross-Border Mergers and Acquisitions Analysis
and Valuation
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Courage is not the absence of fear. It is doing
the thing you fear the most.

Rick
Warren
3
Cross-Border Transactions
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Learning Objectives

• Primary Learning Objective To provide students
  with an understanding of how to analyze and value
  cross-border MAs
• Secondary Learning Objectives To provide
  students with an understanding of
• Motives for international expansion
• Common international market entry strategies
• Planning and implementing cross-border
  transactions in developed countries
• Planning and implementing cross-border
  transactions in emerging countries.
• Valuing cross-border transactions
• Empirical studies of financial returns to
  international diversification

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Globally Integrated Versus Segmented Capital
Markets

• Globally integrated capital markets provide
  foreigners with unfettered access to local
  capital markets and local residents to foreign
  capital markets.
• Segmented capital markets
• Exhibit different bond and equity prices in
  different geographic areas for identical assets
  in terms of risk and maturity.
• Arise when investors are unable to move capital
  from one market to another due to capital
  controls or a preference for local market
  investments

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Developed Versus Emerging Countries

• Developed countries Characterized by
• Significant/sustainable per capita GDP growth
• Globally integrated capital markets
• Well-defined legal system
• Transparent financial statements
• Currency convertibility and
• Stable government.
• Emerging countries Characterized by
• A lack of many of the characteristics of
  developed countries

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Motives for International Expansion

• Geographic and industrial diversification
• Accelerating growth
• Industry consolidation
• Utilization of lower raw material and labor costs
• Leveraging intangible assets
• Minimizing tax liabilities
• Avoiding entry barriers
• Avoiding fluctuating exchange rates
• Following customers

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Common Market Entry Strategies

• Mergers acquisitions (Offer quick access but
  often expensive, complex, and beset by cultural
  issues)
• Greenfield or solo ventures (May offer above
  average returns but total investment is at risk)
• Alliances and joint ventures (Allows risk/cost
  sharing access to others resources may
  facilitate entry but must share profits and
  creates potential competitors)
• Exporting (Cheaper than establishing local
  operations but still requires local
  marketing/distribution channels)
• Licensing (Least profitable and risky entry
  strategy and lack of control could jeopardize
  brand or trademark)

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Discussion Questions

1. What are the differences between segmented and
   globally integrated capital markets? How do these
   distinctions affect prices of financial assets of
   comparable risk and maturity in various
   countries?
2. Of the various motives for international
   expansion, which do you believe is the most
   common and why?
3. Do you believe that some market entry strategies
   are more suitable for emerging than for developed
   countries? Explain your answer.

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Implementing Cross-Border Transactions in
Developed Countries

• Foreign acquirers of U.S. businesses
• Acquisition vehicle Often use C-corporations,
  LLCs, or partnerships
• Form of payment Most often cash
• Form of acquisition Share acquisitions generally
  the simplest
• Post-merger organization Centralized
  organization used to rapidly realize synergies
  but decentralized operations used where cultural
  differences significant
• Tax strategies
• Forward triangular merger common for tax-free
  asset purchases and reverse triangular merger
  common for share acquisitions (latter provides
  continuity of interests and business enterprise).
  Both involve acquirer shares as the form of
  payment.
• Forward triangular cash merger common for taxable
  transactions

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Implementing Cross-Border Transactions in
Developed Countries Contd.

• Acquisitions by U.S. and Non-U.S acquirers of
  foreign businesses
• Acquisition vehicle Corporate-like structures in
  common law countries share companies or LLCs in
  civil law nations
• Form of payment Generally cash
• Form of acquisition Share acquisitions generally
  simplest
• Post-closing organization Holding company
  structure if target to be operated as independent
  unit or integrated with acquirers existing
  in-country operations
• Tax strategies Highly complex and vary with
  local tax and legal jurisdictions

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Implementing Cross-Border Transactions in
Emerging Countries

• Poses challenges not common to developed
  countries such as political and economic risks
  including
• Excessive local government regulation
• Confiscatory tax policies
• Restrictions on cash remittances
• Currency inconvertibility
• Expropriation of foreign assets
• Local corruption and
• Civil war and local insurgencies
• Managing risk through insurance (e.g., OPIC,
  World Bank), contract options (e.g., puts), and
  credit default swaps

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Valuing Cross-Border Transactions

• Methodology similar to that employed when
  acquirer and target in same country
• Basic differences between within country and
  cross-border include the following
• Need to convert target cash flow projections into
  acquirer home country currency
• Adjusting discount rate for risks uncommon in
  within country valuations
• Currency conversions made using the Interest Rate
  Parity theory if data permit and Purchasing Power
  Parity theory if interest rate information
  unavailable.

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Interest Rate Parity Theory
1 x (/)n 1 x (1 Rn)n/(1 Rn)n x
(/)0 Where (/)n Forward exchange rate
n periods into the future (/)0
/Euro spot rate Rn Interest
rate in U.S. Rn Interest rate
in European Union
1 x (/)n 1 x (1 Rn)n/(1 Rn)n x
(/)0 Where (/)n Forward Euro exchange
rate n periods into the future (/)0
Euro/ spot rate

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Converting Euro-Denominated into
Dollar-Denominated Free Cash Flows to the Firm
Using Interest Rate Parity Theory

2008 2009
2010 Targets Euro-Denominated
124.5 130.7
136.0 FCFF Cash Flows ( Millions) Target
Countrys Interest Rate () 4.50
4.70
5.30 U.S. Interest Rate ()
4.25 4.35
4.55 Current Spot Rate (/)
1.2044 Projected Spot Rate (/)
1.2015 1.1964
1.1788 Targets Dollar-Denominated
149.59 156.37
160.32 FCFF Cash Flows ( Millions)
Notes Calculating the projected spot rate
using Interest Rate Parity. (/)2008
(1.0425)/(1.0450) x 1.2044
1.2015 (/)2009 (1.0435)2/(1.0470)2 x 1.2044
1.1964 (/)2010 (1.0455)3/(1.0530)3 x
1.2044 1.1788
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Purchasing Power Parity Theory
(/Peso)n ((1 Pus)n/(1 Pmex)n) x (/Peso)0
Where (/Peso)n Forward /Peso exchange rate
n periods into the future (/Peso)0
Spot /Peso exchange rate Pus
Expected U.S. inflation rate Pmex
Expected Mexican inflation rate

(Peso/)n ((1 Pmex)n/(1 Pus)n) x (Peso/)0
Where (Peso/)n Forward Peso/ exchange rate
n periods into the future (Peso/)0
Spot Peso/ exchange rate

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Converting Peso-Denominated Into Dollar
Denominated Free Cash Flows to the Firm Using
Purchasing Power Parity Theory

2008 2009
2010 Targets Peso-Denominated
P1,050.5 P1,124.7 P1,202.7
FCFF Cash Flows (Millions of Pesos) Mexican
Expected Inflation Rate 6 U.S.
Expected Inflation Rate 4
Spot Rate (/Peso) .0877 Projected Spot Rate
(/Peso) .0860
.0844 .0828 Targets
Dollar-Denominated
90.34 94.92 99.58
FCFF Cash Flows (Millions of ) Notes
Calculating the projected spot rate using
Purchasing Power Parity. (/Peso)2008
(1.04)/(1.06) x .0877 .0860 (/Peso)2009
(1.04)2/(1.06)2 x .0877 .0844 (/Peso)2010
(1.04)3/(1.06)3 x .0877 .0828
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Estimating Cost of Equity for Developed Countries

• Developed countries exhibit little
  differences in cost of equity because of globally
  integrated capital markets. Therefore, the Global
  CAPM can be written as follows

ke,dev Rf ßdevfirm,global (Rm Rf)
FSP Where ke,dev
Required return on equity for a firm in a
developed country
Rf Local countrys
risk-free rate of return if cash flows in
local currency or U.S.
treasury bond rate if in dollars
ßdevfirm,global Nondiversifiable risk for
globally diversified portfolio or
well-diversified portfolio highly
correlated with the global
portfolio (Rm Rf)
Difference in expected return on global market
portfolio, U.S.
equity index, or broadly defined index in
the local country and the
Rf FSP Premium small firms
must earn to attract investors

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Estimating Cost of Equity for Emerging Countries

• ke,em Rf ßemfirm,global (Rcountry Rf) FSP
  CRP
• where
• Rf Local risk free rate or
  U.S. treasury bond rate converted
• to a local nominal
  rate if cash flows are in the local
• currency if cash
  flows in dollars, the U.S. treasury
• rate
• (Rcountry Rf) Difference between expected
  return on a broadly defined
• equity index in the
  local country or in a similar country
• and the risk free
  rate.
• ßemfirm,global Emerging country firms
  global beta
• CRP Specific country risk
  premium expressed as difference
• between the local
  countrys (or a similar countrys)
• government bond rate
  and the U.S. treasury bond rate of
• the same maturity.
• FSP Premium small firms must
  earn to attract investors

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Estimating the Cost of Debt

• For developed countries, the targets local or
  the acquirers home country cost of debt.
• For emerging countries, the cost of debt
  (iemfirm) is as follows
• iemfirm Rf CRP FRP
• Where
• Rf Risk free rate (see preceding slide.)
• CRP Specific country risk premium (see
  preceding slide)
• FRP Firms default risk premium (i.e.,
  additional premium for similar
• firms rated by credit rating agencies
  or estimated by comparing
• interest coverage ratios used by
  rating agencies to the firms
• interest coverage ratios to determine
  how they would rate the
• firm.)

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Evaluating Emerging Country Risk Using Scenario
Planning

• Risk may be incorporated into the valuation by
  considering alternative economic scenarios for
  the emerging country.
• Projected cash flows for alternative scenarios
  could reflect different GDP growth rates,
  inflation rates, interest rates, foreign exchange
  rates, or alternative political conditions.
• If risk is included by calculating a weighted
  average of alternative scenarios, the discount
  rate should not be adjusted for specific country
  risk.

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Discussion Questions

• 1. Discuss the primary differences between
  valuing target firms cash flows in developed
  versus emerging countries. Be specific.
• 2. Do you agree or disagree with the many
  adjustments commonly made to discount rates
  applied to projected cash flows of target firms
  in emerging countries? Be specific.
• 3. In your opinion is it more appropriate to
  adjust the discount rate for various perceived
  risks or to introduce risk by utilizing
  alternative scenarios? Explain your answer.

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Things to Remember

• Motives for international expansion vary widely.
• There are many alternative strategies to MA for
  entering foreign markets.
• Methodology for valuing cross-border transactions
  is similar to that employed when both acquirer
  and target firms are within the same country.
• Basic difference between valuing firms within the
  same country and those involved in cross-border
  transactions is that the latter involves
  converting the targets projected cash flows form
  one currency to another. Also, the discount rate
  for firms in emerging nations may be adjusted for
  risks not normally found in within country
  transactions.
• For developed countries whose capital markets are
  globally integrated, a global beta and a global
  equity premium should be used to calculate the
  cost of equity.
• For emerging nations whose capital markets are
  segmented, a local beta and equity premium should
  be used.