Assignment 3

( CHOOSE : JP Morgan & Chase as my chosen comapny, so this assignment suppose to fit JP Morgan & chase comapny.) Forums / Week 6 Forum / Financing the MNC

Requirements: Based on the company that you will review in your final paper, identify examples of concepts and issues presented in Chapters 14 (optimal financial structure) and 18 (project finance), and discuss how these are involved or addressed.

Instructions: Your initial response should be no less than 450-words with at least one scholarly journal reference (dictionary-type websites are excluded)**.

Enclosed please find a soft copy of the chapters 14 and 18 of this book ( Eiteman, D.  Stonehill,A. & Moffett, M(2016). Multinational Business Finance,  14th Edition. Pearson Learning Solutions. VitalBook file.)- course FINC620. Use them when necessary 

CHAPTER 14     Raising Equity and Debt Globally

Do what you will, the capital is at hazard. All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.

—Prudent Man Rule, Justice Samuel Putnam, 1830.

LEARNING OBJECTIVES

■ Design a strategy to source capital equity globally

■ Examine the potential differences in the optimal financial structure of the multinational firm compared to that of the domestic firm

■ Describe the various financial instruments that can be used to source equity in the global equity markets

■ Understand the different forms of foreign listings—depositary receipts—in U.S. markets

■ Analyze the unique role private placement enjoys in raising global capital

■ Evaluate the different goals and considerations relevant to a firm pursuing foreign equity listing and issuance

■ Explore the different structures that can be used to source debt globally

Chapter 13 analyzed why gaining access to global capital markets should lower a firm’s cost of capital, increase its access to capital, and improve the liquidity of its shares by overcoming market segmentation. A firm pursuing this lofty goal, particularly a firm from a segmented or emerging market, must first design a financial strategy that will attract international investors. This involves choosing among alternative paths to access global capital markets.

This chapter focuses on firms that reside in less liquid, segmented, or emerging markets. They are the ones that need to tap liquid and unsegmented markets in order to attain the global cost and availability of capital. Firms resident in large and highly industrialized countries already have access to their own domestic, liquid, and unsegmented markets. Although they too source equity and debt abroad, it is unlikely to have as significant an impact on their cost and availability of capital. In fact, for these firms, sourcing funds abroad is often motivated solely by the need to fund large foreign acquisitions rather than to fund existing operations.

This chapter begins with the design of a financial strategy to source both equity and debt globally. It then analyzes the optimal financial structure for an MNE and its subsidiaries, one that minimizes its cost of capital. We then explore the alternative paths that a firm may follow in raising capital in global markets. The chapter concludes with the Mini-Case, Petrobrás of Brazil and the Cost of Capital, which examines how the international markets discriminate in their treatment of multinational firms by home and industry.

Designing a Strategy to Source Capital Globally

Designing a capital sourcing strategy requires management to agree upon a long-run financial objective and then choose among the various alternative paths to get there. Exhibit 14.1 is a visual presentation of alternative paths to the ultimate objective of attaining a global cost and availability of capital.

EXHIBIT 14.1         Alternative Paths to Globalize the Cost and Availability of Capital

Source: Oxelhiem, Stonehill, Randøy, Vikkula, Dullum, and Modén, Corporate Strategies in Internationalizing the Cost of Capital, Copenhagen: Copenhagen Business School Press, 1998, p. 119.

Normally, the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm. Investment bankers are in touch with the potential foreign investors and their current requirements. They can also help navigate the various institutional requirements and barriers that must be satisfied. Their services include advising if, when, and where a cross-listing should be initiated. They usually prepare the required prospectus if an equity or debt issue is desired, help to price the issue, and maintain an aftermarket to prevent the share price from falling below its initial price.

Most firms raise their initial capital in their own domestic market (see Exhibit 14.1). Next, they are tempted to skip all the intermediate steps and drop to the bottom line, a euroequity issue in global markets. This is the time when a good investment bank advisor will offer a “reality check.” Most firms that have only raised capital in their own domestic market are not sufficiently well known to attract foreign investors. Remember from Chapter 12 that Novo was advised by its investment bankers to start with a convertible eurobond issue and simultaneously cross-list their shares and their bonds in London. This was despite the fact that Novo had an outstanding track record of financial and business performance.

Exhibit 14.1 shows that most firms should start sourcing abroad with an international bond issue. It could be placed on a less prestigious foreign market. This could be followed by an international bond issue in a target market or in the eurobond market. The next step might be to cross-list and issue equity in one of the less prestigious markets in order to attract the attention of international investors. The next step could then be to cross-list shares on a highly liquid prestigious foreign stock exchange such as London (LSE), NYSE, Euronext, or NASDAQ. The ultimate step would be to place a directed equity issue in a prestigious target market or a euroequity issue in global equity markets.

Optimal Financial Structure

After many years of debate, finance theorists now agree that there is an optimal financial structure for a firm, and practically, they agree on how it is determined. The great debate between the so-called traditionalists and the Modigliani and Miller school of thought has ended in compromise:

When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk.

If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.

Exhibit 14.2 illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio, defined as total debt divided by total assets at market values, increases, the after-tax weighted average cost of capital (k_WACC) decreases because of the heavier weight of low-cost debt [k_d (1 − t)] compared to high-cost equity (k_e). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 − t).

Partly offsetting the favorable effect of more debt, is an increase in the cost of equity (k_e), because investors perceive greater financial risk. Nevertheless, the after-tax weighted average cost of capital (k_WACC) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, thereby increasing the weighted average cost of capital. The low point on the resulting U-shaped cost of capital curve, 14% in Exhibit 14.2, defines the debt ratio range in which the cost of capital is minimized.

Most theorists believe that the low point is actually a rather broad flat area encompassing a wide range of debt ratios, 30% to 60% in Exhibit 14.2, where little difference exists in the cost of capital. They also generally agree that, at least in the United States, the range of the flat area and the location of a particular firm’s debt ratio within that range are determined by such variables as (1) the industry in which it competes; (2) volatility of its sales and operating income; and (3) the collateral value of its assets.

EXHIBIT 14.2         The Cost of Capital and Financial Structure

Optimal Financial Structure and the Multinational

The domestic theory of optimal financial structures needs to be modified by four more variables in order to accommodate the case of the multinational enterprise. These variables are (1) availability of capital; (2) diversification of cash flows; (3) foreign exchange risk; and (4) expectations of international portfolio investors.¹

Availability of Capital

Chapter 13 demonstrated that access to capital in global markets allows an MNE to lower its cost of equity and debt compared with most domestic firms. It also permits an MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, a multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms because they do not have access to the national equity or debt markets. They must either rely on internally generated funds or borrow for the short and medium terms from commercial banks.

Multinational firms domiciled in countries that have illiquid capital markets are in almost the same situation as small domestic firms unless they have gained a global cost and availability of capital. They must rely on internally generated funds and bank borrowing. If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital. This is equivalent to saying that their marginal cost of capital is increasing at higher budget levels.

¹An excellent recent study on the practical dimensions of optimal capital structure can be found in “An Empirical Model of Optimal Capital Structure,” Jules H. Binsbergen, John R. Graham, and Jie Yang, Journal of Applied Corporate Finance, Vol. 23, No. 4, Fall 2011, pp. 34–59.

Diversification of Cash Flows

As explained in Chapter 13, the theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios because their cash flows are diversified internationally. The probability of a firm’s covering fixed charges under varying conditions in product, financial, and foreign exchange markets should increase if the variability of its cash flows is minimized.

By diversifying cash flows internationally, the MNE might be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally. Returns are not perfectly correlated between countries. In contrast, a domestic German firm, for example, would not enjoy the benefit of international cash flow diversification. Instead, it would need to rely entirely on its own net cash inflow from domestic operations. Perceived financial risk for the German firm would be greater than for a multinational firm because the variability of its German domestic cash flows could not be offset by positive cash flows elsewhere in the world.

As discussed in Chapter 13, the diversification argument has been challenged by empirical research findings that MNEs in the United States actually have lower debt ratios than their domestic counterparts. The agency costs of debt were higher for the MNEs, as were political risks, foreign exchange risks, and asymmetric information.

Foreign Exchange Risk and the Cost of Debt

When a firm issues foreign currency-denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses.

For example, if a U.S.-based firm borrows SF1,500,000 for one year at 5.00% interest, and during the year the Swiss franc appreciates from an initial rate of SF1.5000/$ to SF1.4400/$, what is the dollar cost of this debt ? The dollar proceeds of the initial borrowing are calculated at the current spot rate of SF1.5000/$:

At the end of one year the U.S.-based firm is responsible for repaying the SF1,500,000 principal plus 5.00% interest, or a total of SF1,575,000. This repayment, however, must be made at an ending spot rate of SF1.4400/$:

The actual dollar cost of the loan’s repayment is not the nominal 5.00% paid in Swiss franc interest, but 9.375%:

The dollar cost is higher than expected due to appreciation of the Swiss franc against the U.S. dollar. This total home-currency cost is actually the result of the combined percentage cost of debt and percentage change in the foreign currency’s value. We can find the total cost of borrowing Swiss francs by a U.S.-dollar based firm, , by multiplying one plus the Swiss franc interest expense, , by one plus the percentage change in the SF/$ exchange rate, s:

where  = 5.00% and s = 4.1667%. The percentage change in the value of the Swiss franc versus the U.S. dollar, when the home currency is the U.S. dollar, is

The total expense, combining the nominal interest rate and the percentage change in the exchange rate, is

The total percentage cost of capital is 9.375%, not simply the foreign currency interest payment of 5%. The after-tax cost of this Swiss franc denominated debt, when the U.S. income tax rate is 34%, is

The firm would report the added 4.1667% cost of this debt in terms of U.S. dollars as a foreign exchange transaction loss, and it would be deductible for tax purposes.

Expectations of International Portfolio Investors

Chapter 13 highlighted the fact that the key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors. Those investors’ expectations for a firm’s debt ratio and overall financial structures are based on global norms that have developed over the past 30 years. Because a large proportion of international portfolio investors and based in the most liquid and unsegmented capital markets, such as the United States and the United Kingdom, their expectations tend to predominate and override individual national norms. Therefore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt global norms that are close to the U.S. and U.K. norms. Debt ratios up to 60% appear to be acceptable. Higher debt ratios are more difficult to sell to international portfolio investors.

Raising Equity Globally

Once a multinational firm has established its financial strategy and considered its desired and target capital structure, it then proceeds to raise capital outside of its domestic market—both debt and equity—using a variety of capital raising paths and instruments.

Exhibit 14.3 describes three key critical elements to understanding the issues that any firm must confront when seeking to raise equity capital. Although the business press does not often make a clear distinction, there is a fundamental distinction between an equity issuance and an equity listing. A firm seeking to raise equity capital is ultimately in search of an issuance—the IPO or SPO described in Exhibit 14.3. This generates cash proceeds to be used for funding and executing the business. But often issuances must be preceded by listings, in which the shares are traded on an exchange and, therefore, in a specific country market, gaining name recognition, visibility, and hopefully preparing the market for an issuance.

That said, an issuance need not be public. A firm, public or private, can place an issue with private investors, a private placement. (Note that private placement may refer to either equity or debt.) Private placements can take a variety of different forms, and the intent of investors may be passive (e.g., Rule 144A investors) or active (e.g., private equity, where the investor intends to control and change the firm).

EXHIBIT 14.3         Equity Avenues, Activities, and Attributes

Publicly traded companies, in addition to raising equity capital, are also in pursuit of greater market visibility and reaching ever-larger potential investor audiences. The expectation is that the growing investor audience will result in higher share prices over time—increasing the returns to owners. Privately held companies are more singular in their objective: to raise greater quantities of equity at the lowest possible cost—privately. As discussed in Chapter 4, ownership trends in the industrialized markets have tended toward more private ownership, while many multinational firms from emerging market countries have shown growing interest in going public.

Exhibit 14.4 provides an overview of the four major equity alternatives available to multinational firms today. A firm wishing to raise equity capital outside of its home market may take a public pathway or a private one. The public pathway includes a directed public share issue or a euroequity issue. Alternatively, and one that has been used with greater frequency over the past decade, is a private pathway—private placements, private equity, or a private share sale under strategic alliance.

Initial Public Offering (IPO)

A private firm initiates public ownership of the company through an initial public offering, or IPO. Most IPOs begin with the organization of an underwriting and syndication group comprised of investment banking service providers. This group then assists the company in preparing the regulatory filings and disclosures required, depending on the country and stock exchange the firm is using. The firm will, in the months preceding the IPO date, publish a prospectus. The prospectus will provide a description of the company’s history, business, operating and financing results, associated business, financial or political risks, and the company’s business plan for the future, all to aid prospective buyers in their assessment of the firm.

EXHIBIT 14.4      Equity Alternatives in the Global Market

The initial issuance of shares by a company typically represents somewhere between 15% and 25% of the ownership in the firm (although a number in recent years have been as little as 6% to 8%). The company may follow the IPO with additional share sales called seasoned offerings or follow-on offerings (FOs) in which more of the firm’s ownership is sold in the public market. The total shares or proportion of shares traded in the public market is often referred to as the public float or free float.

Once a firm has “gone public,” it is open to a considerably higher level of public scrutiny. This scrutiny arises from the detailed public disclosures and financial filings it must make periodically as required by government security regulators and individual stock exchanges. This continuous disclosure is not trivial in either cost or competitive implications. Public firm financial disclosures can be seen as divulging a tremendous amount of information that customers, suppliers, partners, and competitors may use in their relationship with the firm. Private firms have a distinct competitive advantage in this arena.²

An added distinction about the publicly traded firm’s shares is that they only raise capital for the firm upon issuance. Although the daily rise and fall of share prices drives the returns to the owners of those shares, that daily price movement does not change the capital of the company.

²A publicly traded firm like Walmart will produce hundreds of pages of operational details, financial results, and management discussion on a quarterly basis. That is in comparison to large private firms like Cargill or Koch, where finding a full single page of financial results would be an achievement.

Euroequity Issue

A euroequity or euroequity issue is an initial public offering on multiple exchanges in multiple countries at the same time. Almost all euroequity issues are underwritten by an international syndicate. The term “euro” in this context does not imply that the issuers or investors are located in Europe, nor does it mean the shares are denominated in euros. It is a generic term for international securities issues originating and being sold anywhere in the world. The euroequity seeks to raise more capital in its issuance by reaching as many different investors as possible. Two examples of high-profile euroequity issues would be those of British Telecommunications and the famous Italian luxury goods producer, Gucci.

The largest and most spectacular issues have been made in conjunction with a wave of privatizations of state-owned enterprises (SOEs). The Thatcher government in the United Kingdom created the model when it privatized British Telecom in December 1984. That issue was so large that it was necessary and desirable to sell tranches to foreign investors in addition to the sale to domestic investors. (A tranche is an allocation of shares, typically to underwriters that are expected to sell to investors in their designated geographic markets.) The objective is both to raise the funds and to ensure post-issue worldwide liquidity.

Euroequity privatization issues have been particularly popular with international portfolio investors because most of the firms are very large, with excellent credit ratings and profitable quasi-government monopolies at the time of privatization. The British privatization model has been so successful that numerous others have followed like the Deutsche Telecom initial public offering of $13 billion in 1996.

State-owned enterprises (SOEs)—government-owned firms from emerging markets—have successfully implemented large-scale privatization programs with these foreign tranches. Telefonos de Mexico, the giant Mexican telephone company, completed a $2 billion euroequity issue in 1991 and has continued to have an extremely liquid listing on the NYSE.

One of the largest euroequity offerings by a firm resident in an illiquid market was the 1993 sale of $3 billion in shares by YPF Sociedad Anónima, Argentina’s state-owned oil company. About 75% of its shares were placed in tranches outside of Argentina, with 46% in the United States alone. Its underwriting syndicate represented a virtual “who’s who” of the world’s leading investment banks.

Directed Public Share Issues

A directed public share issue or directed issue is defined as one that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country. The issue may or may not be denominated in the currency of the target market and is typically combined with a cross-listing on a stock exchange in the target market.³

A directed issue might be motivated by a need to fund acquisitions or major capital investments in a target foreign market. This is an especially important source of equity for firms that reside in smaller capital markets and that have outgrown that market.

Nycomed, a small but well-respected Norwegian pharmaceutical firm, was an example of this type of motivation for a directed issue combined with cross-listing. Its commercial strategy for growth was to leverage its sophisticated knowledge of certain market niches and technologies within the pharmaceutical field by acquiring other promising firms—primarily firms in Europe and the United States—that possessed relevant technologies, personnel, or market niches. The acquisitions were paid for partly with cash and partly with shares. The company funded its acquisition strategy by selling two directed issues abroad. In 1989 it cross-listed on the London Stock Exchange (LSE) and raised $100 million in equity from foreign investors. Nycomed followed its LSE listing and issuance with a cross-listing and issuance on the NYSE, raising another $75 million from U.S. investors. Global Finance in Practice 14.1 offers another example of a directed issue, in this case, a publicly traded firm in Sweden and Norway issuing a euroequity to partially fund the development of a recent oil property acquisition.

³The share issue by Novo in 1981 (Chapter 12) was a good example of a successful directed share issue that both improved the liquidity of Novo’s shares and lowered its cost of capital.

GLOBAL FINANCE IN PRACTICE 14.1     The Planned Directed Equity Issue of PA Resources of Sweden

One example of the use of directed public share issues was the 2005 issuance of PA Resources (PAR.ST), a Swedish oil and gas reserve acquisition and development firm. First listed on the Oslo, Norway, stock exchange in 2001, PAR announced in 2005 a potential private placement of up to 7 million shares that were specifically directed at Norwegian and international investors (non-U.S. investors). The proceeds of the issuance were expected to partially fund the development of recent oil and gas reserve acquisitions made by the company in the North Sea and Tunisia.

The directed issue was reportedly heavily oversubscribed following the announcement. Like many directed issuances outside the United States the offer expressly stated that the securities would not be offered or sold in the U.S., as the issue had not and would not be registered in the U.S. under the U.S. Securities Act of 1933.

Depositary Receipts

Depositary receipts (DRs) are negotiable certificates issued by a bank to represent the underlying shares of stock that are held in trust at a foreign custodian bank. Global depositary receipts (GDRs) refer to certificates traded outside of the United States, and American depositary receipts (ADRs) refer to certificates traded in the United States and denominated in U.S. dollars. For a company that is incorporated outside the United States and that wants to be listed on a U.S. stock exchange, the primary way of doing so is through an ADR program. For a company incorporated anywhere in the world that wants to be listed in any foreign market, this is done via a GDR program.

ADRs are sold, registered, and transferred in the U.S. in the same manner as any share of stock, with each ADR representing either a multiple or portion of the underlying foreign share. This multiple/portion allows ADRs to carry a price per share appropriate for the U.S. market (typically under $20 per share), even if the price of the foreign share is inappropriate when converted to U.S. dollars directly. A number of ADRs, like the ADR of Telefonos de Mexico (TelMex) of Mexico shown in Exhibit 14.5, have been some of the most active shares on U.S. exchanges for many years.

The first ADR program was created for a British company, Selfridges Provincial Stores Limited, a famous British retailer, in 1927. Created by J.P. Morgan, the shares were listed on the New York Curb Exchange, which in later years was transformed into the American Stock Exchange. As with many financial innovations, depositary receipts were created to defeat a regulatory restriction. In this case, the British government had prohibited British companies from registering their shares on foreign markets without British transfer agents. Depositary receipts, in essence, create a synthetic share abroad, and therefore do not require actual registration of shares outside Britain.

EXHIBIT 14.5         TelMex’s American Depositary Receipt (Sample)

ADR Mechanics

Exhibit 14.6 illustrates the issuance process of a DR program, in this case a U.S.-based investor purchasing shares in a publicly traded Brazilian company—an American depositary receipt or ADR program:

1. The U.S. investor instructs his broker to make a purchase of shares in the publicly traded Brazilian company.
2. The U.S. broker contacts a local broker in Brazil (either through the broker’s international offices or directly), placing the order.
3. The Brazilian broker purchases the desired ordinary shares and delivers them to a custodian bank in Brazil.
4. The U.S. broker converts the U.S. dollars received from the investor into Brazilian reais to pay the Brazilian broker for the shares purchased.
5. On the same day that the shares are delivered to the Brazilian custodian bank, the custodian notifies the U.S. depositary bank of their deposit.
6. Upon notification, the U.S. depositary bank issues and delivers DRs for the Brazilian company shares to the U.S. broker.
7. The U.S. broker then delivers the DRs to the U.S. investor.

EXHIBIT 14.6      The Structural Execution of ADRs

Source: Based on Depositary Receipts Reference Guide, JPMorgan, 2005, p. 33.

The DRs are now held and tradable like any other common stock in the United States. In addition to the process just described, it is possible for the U.S. broker to obtain the DRs for the U.S. investor by purchasing existing DRs, not requiring a new issuance. Exhibit 14.6 also describes the alternative process mechanics of a sale or cancellation of ADRs.

Once the ADRs are created, they are tradable in the U.S. market like any other U.S. security. ADRs can be sold to other U.S. investors by simply transferring them from the existing ADR holder (the seller) to another DR holder (the buyer). This is termed intra-market trading. This transaction would be settled in the same manner as any other U.S. transaction, with settlement in U.S. dollars on the third business day after the trade date and typically using the depository trust company (DTC). Intra-market trading accounts for nearly 95% of all DR trading today.

ADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and U.S. prices of any given share the same after adjusting for transfer costs. For example, investor demand in one market will cause a price rise there, which will cause an arbitrage rise in the price on the other market even when investors there are not as bullish on the stock.

ADRs convey certain technical advantages to U.S. shareholders. Dividends paid by a foreign firm are passed to its custodial bank and then to the bank that issued the ADR. The issuing bank exchanges the foreign currency dividends for U.S. dollars and sends the dollar dividend to the ADR holders. ADRs are in registered form, rather than in bearer form. Transfer of ownership occurs in the United States in accordance with U.S. laws and procedures. Normally, trading costs are lower than when buying or selling the underlying shares in their home market, and settlement is faster. Withholding taxes is simpler because it is handled by the depositary bank.

ADR Program Structures

The previous section described the issuance of a DR (an ADR in this case) on a Brazilian company’s shares resulting from the desire of a U.S.-based investor to buy shares in a Brazilian company. But DR programs can also be viewed from the perspective of the Brazilian company—as part of its financial strategy to reach investors in the United States.

ADR programs differ in whether they are sponsored and in their certification level. Sponsored ADRs are created at the request of a foreign firm wanting its shares listed or traded in the United States. The firm applies to the U.S. SEC and a U.S. bank for registration and issuance of ADRs. The foreign firm pays all costs of creating such sponsored ADRs. If a foreign firm does not seek to have its shares listed in the United States but U.S. investors are interested, a U.S. securities firm may initiate creation of the ADRs—an unsponsored ADR program. Unsponsored ADRs are still required by the SEC to obtain approval of the firms whose shares are to be listed. Unsponsored programs represent a relatively small portion of all DR programs.

The second dimension of ADR differentiation is certification level, described in detail in Exhibit 14.7. The three general levels of commitment are distinguished by degree of disclosure, listing alternatives, whether they may be used to raise capital (issue new shares), and the time typically taken to implement the programs. (SEC Rule 144A programs are described in detail later in this chapter.)

Level I (over-the-counter or pink sheets) DR Programs.

Level I programs are the easiest and fastest programs to execute. A Level I program allows the foreign securities to be purchased and held by U.S. investors without being registered with the SEC. It is the least costly approach but might have a minimal favorable impact on liquidity.

Level II DR Programs.

Level II applies to firms that want to list existing shares on a U.S. stock exchange. They must meet the full registration requirements of the SEC and the rules of the specific exchange. This also means reconciling their financial accounts with those used under U.S. GAAP, raising the cost considerably.

EXHIBIT 14.7    American Depositary Receipt (ADR) Programs by Level

Level III DR Programs.

Level III applies to the sale of a new equity issued in the United States—raising equity capital. It requires full registration with the SEC and an elaborate stock prospectus. This is the most expensive alternative, but is the most fruitful for foreign firms wishing to raise capital in the world’s largest capital markets and possibly generate greater returns for all shareholders.

DR Markets Today: Who, What, and Where

The rapid growth in emerging markets in recent years has been partly a result of the ability of companies from these countries to both list their shares and issue new shares on global equity markets. Their desire to access greater pools of affordable capital, as well as the desire for many of their owners to monetize existing value, has led to an influx of emerging market companies into the DR market.

The Who.

The Who of global DR programs today is a mix of major multinationals from all over the world, but in recent years participation has shifted back toward industrial country companies. For example, in 2013 the largest issues came from established multinationals like BP, Vodafone, Royal Dutch Shell, and Nestlé, but also included Lukoil and Gazprom of Russia and Taiwan Semiconductor Manufacturing of Taiwan. The oil and gas sector was clearly the largest in both 2012 and 2013, but followed closely by pharmaceutical and telecommunications firms. It’s also important to note that in recent years, as illustrated by Exhibit 14.8, the market has clearly been in decline.

The What.

The What of the global DR market today is a fairly even split between IPO and follow-on offerings or FOs (additional offerings of equity shares post-IPO). It does appear that IPOs continue to make up the majority of DR equity-raising activity.

EXHIBIT 14.8    Equity Capital Raised Through Depositary Receipts

Source: “Depositary Receipts, Year in Review 2013,” JPMorgan, p. 5. Data derived by JPMorgan from other depositary banks, Bloomberg, and stock exchanges, 2014.

The Where.

Given the dominance of emerging market companies in DR markets today, it is not surprising that the Where of the DR market is dominated by New York and London. By the end of 2013 there were more than 2,300 sponsored DR programs from more than 86 countries. Of those 2,300, just over half were U.S. programs (ADRs), with the remainder being GDR programs split between the London and Luxembourg stock exchanges.

Even more important than the number of programs participating in the DR markets is the capital that has been raised by companies via DR programs globally. Exhibit 14.8 distinguishes between equity capital raised through initial equity share offerings (IPOs) and seasoned offerings (follow-on). The DR market has periodically proved very fruitful as an avenue for raising capital. It is also obvious which years have been better for equity issuances—years like 2000 and 2006–2007.

Global Registered Shares (GRS)

A global registered share (GRS) is a share of equity that is traded across borders and markets without conversion, where one share on the home exchange equals one share on the foreign exchange. The identical share is listed on different stock exchanges, but listed in the currency of the exchange. GRSs can theoretically be traded “with the sun”—following markets as they open and close around the globe and around the clock. The shares are traded electronically, eliminating the specialized forms and depositaries required by share issuances like DRs.

The differences between GRSs and GDRs can be seen in the following example. Assume a German multinational has shares listed on the Frankfurt Stock Exchange, and those shares are currently trading at €4.00 per share. If the current spot rate is $1.20/€, those same shares would be listed on the NYSE at $4.80 per share.

€4.00 × $1.20/€ = $4.80

This would be a standard GRS. But $4.80 per share is an extremely low share price for the NYSE and the U.S. equity market.

If, however, the German firm’s shares were listed in New York as ADRs, they would be converted to a value that was strategically priced for the target market—the United States. Strategic pricing in the U.S. means having share prices that are generally between $10 and $20 per share, a price range long-thought to maximize buyer interest and liquidity. The ADR would then be constructed so that each ADR represented four shares in the company on the home market, or:

$4.80 × 4 = $19.20 per share

Does this distinction matter? Clearly the GRS is much more similar to ordinary shares than depositary receipts, and it allows easier comparison and analysis. But if target pricing is important in key markets like that of the U.S., then the ADR offers better opportunities for a foreign firm to gain greater presence and activity.⁴

There are two fundamental arguments used by proponents of GRSs over ADRs, both based on pure forces of globalization:

1. Investors and markets alike will continue to grow in their desire for securities, which are increasingly identical across markets—taking on the characteristics of commodity—like securities, changing only by the currency of denomination of the local exchange.

⁴GRSs are not a new innovation, as they are identical to the structure used for cross-border trading of Canadian equities in the United States for many years. More than 70 Canadian firms are listed on the NYSE-Euronext. Of course, one could argue that has been facilitated by near-parity of the U.S. and Canadian dollar for years as well.

2. Regulations governing security trading across country markets will continue to converge toward a common set of global principles, eliminating the need for securities customized for local market attributes or requirements.

Other potential distinctions include the possibility of retaining all voting rights (GRSs do, by definition, while some ADRs may not) and the general principle that ADRs are designed for one singular cultural and legal environment—the United States. All argument aside, at least to date, the GRS has not replaced the ADR or GDR.

Private Placement

Raising equity through private placement is increasingly common across the globe. Publicly traded and private firms alike raise private equity capital on occasion. A private placement is the sale of a security to a small set of qualified institutional buyers. The investors are traditionally insurance companies and investment companies. Since the securities are not registered for sale to the public, investors have typically followed a “buy and hold” policy. In the case of debt, terms are often custom designed on a negotiated basis. Private placement markets now exist in most countries.

SEC Rule 144A

In 1990, the SEC approved Rule 144A. It permits qualified institutional buyers (QIBs) to trade privately placed securities without the previous holding period restrictions and without requiring SEC registration.

A QIB is an entity (except a bank or a savings and loan) that owns and invests on a discretionary basis $100 million in securities of non-affiliates. Banks and savings and loans must meet this test but also must have a minimum net worth of $25 million. The SEC has estimated that about 4,000 QIBs exist, mainly investment advisors, investment companies, insurance companies, pension funds, and charitable institutions. Simultaneously, the SEC modified its regulations to permit foreign issuers to tap the U.S. private placement market through an SEC Rule 144A issue, also without SEC registration. A trading system called PORTAL was established to support the distribution of primary issues and to create a liquid secondary market for these issues.

Since SEC registration has been identified as the main barrier to foreign firms wishing to raise funds in the United States, SEC Rule 144A placements are proving attractive to foreign issuers of both equity and debt securities. Atlas Copco, the Swedish multinational engineering firm, was the first foreign firm to take advantage of SEC Rule 144A. It raised $49 million in the United States through an ADR equity placement as part of its larger $214 million euroequity issue in 1990. Since then, several billion dollars have been raised each year by foreign issuers with private equity placements in the United States. However, it does not appear that such placements have a favorable effect on either liquidity or stock price.

Private Equity Funds

Private equity funds are usually limited partnerships of institutional and wealthy investors, such as college endowment funds, that raise capital in the most liquid capital markets. They are best known for buying control of publicly owned firms, taking them private, improving management, and then reselling them after one to three years. They are resold in a variety of ways including selling the firms to other firms, to other private equity funds, or by taking them public once again. The private equity funds themselves are frequently very large, but may also utilize a large amount of debt to fund their takeovers. These “alternatives” as they are called, demand fees of 2% of assets plus 20% of profits. Equity funds have had some highly visible successes.

Many mature family-owned firms resident in emerging markets are unlikely to qualify for a global cost and availability of capital even if they follow the strategy suggested in this chapter. Although they might be consistently profitable and growing, they are still too small, too invisible to foreign investors, lacking in managerial depth, and unable to fund the up-front costs of a globalization strategy. For these firms, private equity funds may be a solution.

Private equity funds differ from traditional venture capital funds. The latter usually operate mainly in highly developed countries. They typically invest in start-up firms with the goal of exiting the investment with an initial public offering (IPO) placed in those same highly liquid markets. Very little venture capital is available in emerging markets, partly because it would be difficult to exit with an IPO in an illiquid market. The same exiting problem faces the private equity funds, but they appear to have a longer time horizon. They invest in already mature and profitable companies. They are content with growing companies through better management and mergers with other firms.

Foreign Equity Listing and Issuance

According to the alternative equity pathways in the global market illustrated earlier in Exhibit 14.1, a firm needs to choose one or more stock market on which to cross-list its shares and sell new equity. Just where to go depends mainly on the firm’s specific motives and the willingness of the host stock market to accept the firm. By cross-listing and selling its shares on a foreign exchange, a firm typically tries to accomplish one or more of the following objectives:

■ Improve the liquidity of its shares and support a liquid secondary market for new equity issues in foreign markets

■ Increase its share price by overcoming mispricing in a segmented and illiquid home capital market

■ Increase the firm’s visibility and acceptance to its customers, suppliers, creditors, and host governments

■ Establish a liquid secondary market for shares used to acquire other firms in the host market and to compensate local management and employees of foreign subsidiaries⁵

Improving Liquidity

Quite often foreign investors have acquired a firm’s shares through normal brokerage channels, even though the shares are not listed in the investor’s home market or are not traded in the investor’s preferred currency. Cross-listing is a way to encourage such investors to continue to hold and trade these shares, thus marginally improving secondary market liquidity. This is usually done through ADRs.

Firms domiciled in countries with small illiquid capital markets often outgrow those markets and are forced to raise new equity abroad. Listing on a stock exchange in the market in which these funds are to be raised is typically required by the underwriters to ensure post-issue liquidity in the shares.

The first section of this chapter suggested that firms start by cross-listing in a less liquid market, followed by an equity issue in that market (see Exhibit 14.1). In order to maximize liquidity, however, the firm ideally should cross-list and issue equity in a more liquid market and eventually offer a global equity issue.

⁵A recent example of this trading expansion opportunity is Kosmos Energy. Following the company’s IPO in the United States in May 2011 (NYSE: KOS), the company listed its shares on the Ghanaian Stock Exchange. Ghana was the country in which the oil company had made its major discoveries and generated nearly all of its income.

In order to maximize liquidity, it is desirable to cross-list and/or sell equity in the most liquid markets. Stock markets have, however, been subject to two major forces in recent years, which are changing their very behavior and liquidity—demutualization and diversification.

Demutualization is the ongoing process by which the small controlling seat owners on a number of exchanges have been giving up their exclusive powers. As a result, the actual ownership of the exchanges has become increasingly public. Diversification represents the growing diversity of both products (derivatives, currencies, etc.) and foreign companies/shares being listed. This has increased the activities and profitability of many exchanges while simultaneously offering a more global mix for reduced cost and increased service.

Stock Exchanges.

With respect to stock exchanges, New York and London are clearly the most liquid. The recent merger of the New York Stock Exchange (NYSE) and Euronext, which itself was a merger of stock exchanges in Amsterdam, Brussels, and Paris, has extended the NYSE’s lead over both the NASDAQ (New York) and the London Stock Exchange (LSE). Tokyo has declined a bit over the past 20 years in terms of trading value globally, as many foreign firms chose to delist from the Tokyo exchange. Few foreign firms remain cross-listed now in Tokyo. Deutsche Börse (Germany) has a fairly liquid market for domestic shares but a much lower level of liquidity for trading foreign shares. On the other hand, it is an appropriate target market for firms resident in the European Union, especially those that have adopted the euro. It is also used as a supplementary cross-listing location for firms that are already cross-listed on the LSE, NYSE, or NASDAQ.

Why are New York and London so dominant? They offer what global financial firms are looking for: plenty of skilled people, ready access to capital, good infrastructure, attractive regulatory and tax environments, and low levels of corruption. Location and the use of English, increasingly acknowledged as the language of global finance, are also important factors.

Electronic Trading.

Most exchanges have moved heavily into electronic trading in recent years. In fact, the U.S. stock market is now a network of 50 different venues connected by an electronic system of published quotes and sales prices. This shift to electronic trading has had broad-reaching effects. For example, the role of the specialist on the floor of the NYSE has been greatly reduced with a corresponding reduction in employment by specialist firms. Specialists are no longer responsible for ensuring an orderly movement for their stocks, but they are still important in making more liquid markets for the less-traded shares. The same fate has reduced the importance of market makers on the London Stock Exchange (LSE).

Electronic trading has allowed hedge funds and other high-frequency traders to dominate the market. High-frequency traders now account for 60% of daily volumes. Conversely, volume controlled by the NYSE fell from 80% in 2005 to 25% in 2010. Trades are executed immediately by computer. Spreads between buy and sell orders are now in decimal points as low as a penny a share instead of an eighth of a point. Liquidity has greatly increased but so has the risk of unexpected swings in prices. For example, on May 6, 2010, the Dow Jones Average fell 9.2% at one point but eventually recovered by the end of the day. During that single day of trading, nineteen billion shares were bought and sold.

Promoting Shares and Share Prices

Although cross-listing and equity issuance can occur together, their impacts are separable and significant in and of themselves.

Cross-Listing.

Does merely cross-listing on a foreign stock exchange have a favorable impact on share prices? It depends on the degree to which markets are segmented.

If a firm’s home capital market is segmented, the firm could theoretically benefit by cross-listing in a foreign market if that market values the firm or its industry more than does the home market. This was certainly the situation experienced by Novo when it listed on the NYSE in 1981 (see Chapter 12). However, most capital markets are becoming more integrated with global markets. Even emerging markets are less segmented than they were just a few years ago.

Equity Issuance.

It is well known that the combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross-listing alone. This occurs because the new issue creates an instantly enlarged shareholder base. Marketing efforts by the underwriters prior to the issue engender higher levels of visibility. Post-issue efforts by the underwriters to support at least the initial offering price also reduce investor risk.

Increasing Visibility and Political Acceptance

MNEs list in markets where they have substantial physical operations. Commercial objectives are to enhance corporate image, advertise trademarks and products, get better local press coverage, and become more familiar with the local financial community in order to raise working capital locally.

Political objectives might include the need to meet local ownership requirements for a multinational firm’s foreign joint venture. Local ownership of the parent firm’s shares might provide a forum for publicizing the firm’s activities and how they support the host country.

Establish Liquid Secondary Markets

The establishment of a local liquid market for the firm’s equity may aid in financing acquisitions and in the creation of stock-based management compensation programs for subsidiaries.

Funding Growth by Acquisitions.

Firms that follow a strategy of growth by acquisition are always looking for creative alternatives to cash for funding these acquisitions. Offering their shares as partial payment is considerably more attractive if those shares have a liquid secondary market. In that case, the target’s shareholders have an easy way to convert their acquired shares to cash if they prefer cash to a share swap. However, a share swap is often attractive as a tax-free exchange.

Compensating Management and Employees.

If an MNE wishes to use stock options and share purchase compensation plans as a component of the compensation scheme for local management and employees, local listing on a liquid secondary market would enhance the perceived value of such plans. It should reduce transaction and foreign exchange costs for the local beneficiaries.

Barriers to Cross-Listing and Selling Equity Abroad

Although a firm may decide to cross-list and/or sell equity abroad, certain barriers exist. The most serious barriers are the future commitment to providing full and transparent disclosure of operating results and balance sheets as well as a continuous program of investor relations.

The Commitment to Disclosure and Investor Relations.

A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program. For firms resident in the Anglo-American markets, listing abroad might not appear to be much of a barrier. For example, the SEC’s disclosure rules for listing in the United States are so stringent and costly that any other market’s rules are mere child’s play. Reversing the logic, however, non-U.S. firms must consider disclosure requirements carefully before cross-listing in the United States. Not only are the disclosure requirements breathtaking, timely quarterly information is also required by U.S. regulators and investors. As a result, the foreign firm must maintain a costly continuous investor relations program for its U.S. shareholders, including frequent “road shows” and the time-consuming personal involvement of top management.

Disclosure Is a Double-Edged Sword.

The U.S. school of thought presumes that the worldwide trend toward more comprehensive, more transparent, and more standardized financial disclosure of operating results and financial positions will have the desirable effect of lowering the cost of equity capital. As we observed in 2002 and 2008, lack of full and accurate disclosure and poor transparency contributed to the U.S. stock market decline as investors fled to safer securities such as U.S. government bonds. This action increased the equity cost of capital for all firms.

The opposing school of thought—the other edge of the sword—is that the U.S. level of required disclosure is an onerous, costly burden. It discourages many potential listers, and thereby narrows the choice of securities available to U.S. investors at reasonable transaction costs.

Raising Debt Globally

The international debt markets offer the borrower a variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments.

Exhibit 14.9 provides an overview of the three basic categories described in the following sections, along with their primary components as issued or traded in the international debt markets today. As shown in the exhibit, the three major sources of debt funding on the international markets are the international bank loans and syndicated credits, euronote market, and international bond market.

EXHIBIT 14.9         International Debt Markets and Instruments

Bank Loans and Syndications

International Bank Loans.

International bank loans have traditionally been sourced in the eurocurrency loan markets. Eurodollar bank loans are also called “eurodollar credits” or simply “eurocredits.” The latter title is broader because it encompasses nondollar loans in the eurocurrency loan market. The key factor attracting both depositors and borrowers to the eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%.

Eurocredits.

Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. The basic borrowing interest rate for eurocredits has long been tied to the London Interbank Offered Rate (LIBOR), which is the deposit rate applicable to interbank loans within London. Eurocredits are lent for both short- and medium-term maturities, with maturities for six months or less regarded as routine. Most eurocredits are for a fixed term with no provision for early repayment.

Syndicated Credits.

The syndication of loans has enabled banks to spread the risk of large loans among a number of banks. Syndication is particularly important because many large MNEs need credit in excess of a single bank’s loan limit. A syndicated bank credit is arranged by a lead bank on behalf of its client. Before finalizing the loan agreement, the lead bank seeks the participation of a group of banks, with each participant providing a portion of the total funds needed. The lead bank will work with the borrower to determine the amount of the total credit, the floating-rate base and spread over the base rate, maturity, and fee structure for managing the participating banks. There are two elements to the periodic expenses of the syndicated credit:

1. Actual interest expense of the loan, normally stated as a spread in basis points over a variable-rate base such as LIBOR
2. Commitment fees paid on any unused portions of the credit—the spread paid over LIBOR by the borrower is considered the risk premium, reflecting the general business and financial risk applicable to the borrower’s repayment capability

Euronote Market

The euronote market is the collective term used to describe short- to medium-term debt instruments sourced in the eurocurrency markets. Although a multitude of differentiated financial products exists, they can be divided into two major groups—underwritten facilities and nonunderwritten facilities. Underwritten facilities are used for the sale of euronotes in a number of different forms. Nonunderwritten facilities are used for the sale and distribution of euro-commercial paper (ECP) and euro medium-term notes (EMTNs).

Euronotes and Euronote Facilities.

A major development in international money markets was the establishment of underwriting facilities for the sale of short-term, negotiable, promissory notes—euronotes. Among the facilities for their issuance were revolving underwriting facilities (rufs), note issuance facilities (nifs), and standby note issuance facilities (snifs). These facilities were provided by international investment and commercial banks. The euronote was a substantially cheaper source of short-term funds than were syndicated loans because the securitized and underwritten form allowed the ready establishment of liquid secondary markets, allowing the notes to be placed directly with the investing public. The banks received substantial fees initially for their underwriting and placement services.

Eurocommercial Paper (ECP).

Eurocommercial paper (ECP), like commercial paper issued in domestic markets around the world, is a short-term debt obligation (nonunderwritten) of a corporation or bank. Maturities are typically one, three, and six months. The paper is sold normally at a discount or occasionally with a stated coupon. Although the market is capable of supporting issues in any major currency, over 90% of issues outstanding are denominated in U.S. dollars.

Euro Medium-Term Notes (EMTNs).

The euro medium-term note (EMTN) market effectively bridges the maturity gap between ECP and the longer-term and less flexible international bond. Although many of these notes were initially underwritten, most EMTNs are now nonunderwritten.

The rapid initial growth of the EMTN market followed directly on the heels of the same basic instrument that began in the U.S. domestic market when the U.S. SEC instituted SEC Rule #415, allowing companies to obtain shelf registrations for debt issues. Once such a registration was obtained, the corporation could issue notes on a continuous basis without the need to obtain new registrations for each additional issue. This, in turn, allowed a firm to sell short- and medium-term notes through a much cheaper and more flexible issuance facility than ordinary bonds.

The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity, coupon structures, and rates being comparable. The EMTN’s typical maturities range from as little as nine months to a maximum of 10 years. Coupons are typically paid semiannually, and coupon rates are comparable to similar bond issues. The EMTN does, however, have three unique characteristics: (1) the EMTN is a facility, allowing continuous issuance over a period of time, unlike a bond issue that is essentially sold all at once; (2) because EMTNs are sold continuously, in order to make debt service (coupon redemption) manageable, coupons are paid on set calendar dates regardless of the date of issuance; (3) EMTNs are issued in relatively small denominations, from $2 million to $5 million, making medium-term debt acquisition much more flexible than the large minimums customarily needed in the international bond markets.

International Bond Market

The international bond market sports a rich array of innovative instruments created by imaginative investment bankers who are unfettered by the usual controls and regulations governing domestic capital markets. Indeed, the international bond market rivals the international banking market in terms of the quantity and cost of funds provided to international borrowers. All international bonds fall within two generic classifications, eurobonds and foreign bonds. The distinction between categories is based on whether the borrower is a domestic or a foreign resident, and whether the issue is denominated in the local currency or a foreign currency.

Eurobonds.

A Eurobond is underwritten by an international syndicate of banks and other securities firms, and is sold exclusively in countries other than the country in whose currency the issue is denominated. For example, a bond issued by a firm resident in the United States, denominated in U.S. dollars, and sold to investors in Europe and Japan (but not to investors in the United States), is a eurobond.

Eurobonds are issued by MNEs, large domestic corporations, sovereign governments, governmental enterprises, and international institutions. They are offered simultaneously in a number of different national capital markets, but not in the capital market or to residents of the country in whose currency the bond is denominated. Almost all eurobonds are in bearer form with call provisions (the ability of the issuer to call the bond in prior to maturity) and sinking funds (required accumulations of funds by the firms to assure repayment of the obligation).

The syndicate that offers a new issue of eurobonds might be composed of underwriters from a number of countries, including European banks, foreign branches of U.S. banks, banks from offshore financial centers, investment and merchant banks, and nonbank securities firms. There are three types of eurobond issues:

■       The Straight Fixed-Rate Issue. The straight fixed-rate issue is structured like most domestic bonds, with a fixed coupon, set maturity date, and full principal repayment upon final maturity. Coupons are normally paid annually, rather than semiannually, primarily because the bonds are bearer bonds and annual coupon redemption is more convenient for the holders.

■       The Floating-Rate Note. The floating-rate note (FRN) normally pays a semiannual coupon that is determined using a variable-rate base. A typical coupon would be set at some fixed spread over LIBOR. This structure, like most variable-rate interest-bearing instruments, was designed to allow investors to shift more of the interest-rate risk of a financial investment to the borrower. Although many FRNs have fixed maturities, in recent years many issues are perpetuities, with no principal repayment, taking on the characteristics of equity.

■       The Equity-Related Issue. The equity-related international bond resembles the straight fixed-rate issue in practically all price and payment characteristics, with the added feature that it is convertible to stock prior to maturity at a specified price per share (or alternatively, number of shares per bond). The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature.

Foreign Bonds.

A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country. The issuer, however, is from another country. A bond issued by a firm resident in Sweden, denominated in U.S. dollars, and sold in the United States to U.S. investors by U.S. investment bankers, is a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the United States are Yankee bonds; foreign bonds sold in Japan are Samurai bonds; and foreign bonds sold in the United Kingdom are Bulldogs.

Unique Characteristics of Eurobond Markets

Although the eurobond market evolved at about the same time as the eurodollar market, the two markets exist for different reasons, and each could exist independently of the other. The eurobond market owes its existence to several unique factors: the absence of regulatory interference, less stringent disclosure practices, favorable tax treatment, and ratings.

Absence of Regulatory Interference.

National governments often impose tight controls on foreign issuers of securities denominated in the local currency and sold within their national boundaries. However, governments in general have less stringent limitations for securities denominated in foreign currencies and sold within their markets to holders of those foreign currencies. In effect, eurobond sales fall outside the regulatory domain of any single nation.

Less Stringent Disclosure.

Disclosure requirements in the eurobond market are much less stringent than those of the U.S. Securities and Exchange Commission (SEC) for sales within the United States. U.S. firms often find that the registration costs of a eurobond offering are less than those of a domestic issue and that less time is needed to bring a new issue to market. Non-U.S. firms often prefer eurodollar bonds over bonds sold within the United States because they do not wish to undergo the costs and disclosure needed to register with the SEC. However, the SEC has relaxed disclosure requirements for certain private placements (Rule #144A), which has improved the attractiveness of the U.S. domestic bond and equity markets.

Favorable Tax Treatment.

Eurobonds offer tax anonymity and flexibility. Interest paid on eurobonds is generally not subject to an income withholding tax. As one might expect, eurobond interest is not always reported to tax authorities. Eurobonds are usually issued in bearer form, meaning that the name and country of residence of the owner is not on the certificate. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at a banking institution listed on the issue as a paying agent. European investors are accustomed to the privacy provided by bearer bonds and are very reluctant to purchase registered bonds, which require holders to reveal their names before they receive interest. It follows, then, that bearer bond status is often tied to tax avoidance.

Access to debt capital is obviously impacted by everything from the legal and tax environments to basic societal norms. Indeed, even religion plays a part in the use and availability of debt capital. Global Finance in Practice 14.2 illustrates one area rarely seen by Westerners, Islamic finance.

GLOBAL FINANCE IN PRACTICE 14.2   Islamic Finance

Muslims, the followers of Islam, now make up roughly one-fourth of the world’s population. The countries of the world that are predominantly Muslim create roughly 10% of global GDP and comprise a large share of the emerging marketplace. Islamic law speaks to many dimensions of the individual and organizational behaviors for its practitioners—including business. Islamic finance, the specific area of our interest, imposes a number of restrictions on Muslims, which have a dramatic impact on the funding and structure of Muslim businesses.

The Islamic form of finance is as old as the religion of Islam itself. The basis for all Islamic finance lies in the principles of the Sharia, or Islamic Law, which is taken from the Qur’an. Observance of these principles precipitates restrictions on business and finance practices as follows:

■    Making money from money is not permissible

■    Earning interest is prohibited

■    Profit and loss should be shared

■    Speculation (gambling) is prohibited

■    Investments should support only halal activities

For the conduct of business, the key to understanding the Sharia prohibition on earning interest is to understand that profitability from traditional Western investments arises from the returns associated with carrying risk. For example, a traditional Western bank may extend a loan to a business. It is agreed that the bank will receive its principal and interest in return regardless of the ultimate profitability of the business (the borrower). In fact, the debt is paid off before returns to equity occur. Similarly, an individual who deposits money in a Western bank will receive interest earnings on that deposit regardless of the profitability of the bank and of the bank’s associated investments.

Under Sharia law, however, an Islamic bank cannot pay interest to depositors. Therefore, the depositors in an Islamic bank are, in effect, shareholders (much like credit unions in the West), and the returns they receive are a function of the profitability of the bank’s investments. Their returns cannot be fixed or guaranteed, because that would break the principle of profit and loss being shared.

Recently, however, a number of Islamic banking institutions have opened in Europe and North America. A Muslim now can enter into a sequence of purchases that allows him to purchase a home without departing from Islamic principles. The buyer selects the property, which is then purchased by an Islamic bank. The bank in turn resells the house to the prospective buyer at a higher price. The buyer is allowed to pay off the purchase over a series of years. Although the difference in purchase prices is, by Western thinking, implicit interest, this structure does conform to Sharia law. Unfortunately, in both the United States and the United Kingdom, this “implicit interest” is not a tax-deductible expense for the homeowner as interest would be.

Ratings.

Rating agencies, such as Moody’s and Standard and Poor’s (S&P), provide ratings for selected international bonds for a fee. Moody’s ratings for international bonds imply the same creditworthiness as for domestic bonds of U.S. issuers. Moody’s limits its evaluation to the issuer’s ability to obtain the necessary currency to repay the issue according to the original terms of the bond. The agency excludes any assessment of risk to the investor caused by changing exchange rates.

Moody’s rates international bonds at the request of the issuer. Based on supporting financial statements and other material obtained from the issuer, it makes a preliminary rating and then informs the issuer who has an opportunity to comment. After Moody’s determines its final rating, the issuer may decide not to have the rating published. Consequently, a disproportionately large number of published international ratings fall into the highest categories, since issuers that receive a lower rating do not allow publication.

Purchasers of eurobonds do not rely only on bond-rating services or on detailed analyses of financial statements. The general reputation of the issuing corporation and its underwriters has been a major factor in obtaining favorable terms. For this reason, larger and better-known MNEs, state enterprises, and sovereign governments are able to obtain the lowest interest rates. Firms whose names are better known to the general public, possibly because they manufacture consumer goods, are often believed to have an advantage over equally qualified firms whose products are less widely known.

SUMMARY POINTS

■ Designing a capital sourcing strategy requires management to design a long-run financial strategy. The firm must then choose among the various alternative paths to achieve its goals, including where to cross-list its shares, and where to issue new equity, and in what form.

■ A multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms.

■ By diversifying cash flows internationally, the MNE may be able to achieve the same kind of reduction in cash flow variability that portfolio investors receive from diversifying their portfolios internationally.

■ When a firm issues foreign currency-denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses.

■ There is a variety of different equity pathways that firms may choose between when pursuing global sources of equity, including euroequity issues, direct foreign issuances, depositary receipt programs, and private placements.

■ Depositary receipt programs, either American or global, provide an extremely effective way for firms from outside of the established industrial country markets to improve the liquidity of their existing shares, or issue new shares.

■ Private placement is a growing segment of the market, allowing firms from emerging markets to raise capital in the largest of capital markets with limited disclosure and cost.

■ The international debt markets offer the borrower a variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments.

■ Eurocurrency markets serve two valuable purposes: (1) eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity, and (2) the eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.

MINI-CASE   Petrobrás of Brazil and the Cost of Capital⁶

The national oil company of Brazil, Petrobrás, suffered from an ailment common in emerging markets—a high and uncompetitive cost of capital. Despite being widely considered the global leader in deepwater technology (the ability to drill and develop oil and gas fields more than a mile below the ocean’s surface), unless it could devise a strategy to lower its cost of capital, it would be unable to exploit its true organizational competitive advantage.

Many market analysts argued that the Brazilian company should follow the strategy employed by a number of Mexican companies and buy its way out of its dilemma. If Petrobrás were to acquire one of the many independent North American oil and gas companies, it might transform itself from being wholly “Brazilian” to partially “American” in the eyes of capital markets, and possibly lower its weighted average cost of capital (WACC) to between 6% and 8%.

Petróleo Brasileiro S.A. (Petrobrás) was an integrated oil and gas company founded in 1954 by the Brazilian government as the national oil company of Brazil. The company was listed publicly in São Paulo in 1997 and on the New York Stock Exchange (NYSE: PBR) in 2000. Despite the equity listings, the Brazilian government continued to be the controlling shareholder, with 33% of the total capital and 55% of the voting shares. As the national oil company of Brazil, the company’s singular purpose was the reduction of Brazil’s dependency on imported oil. A side effect of this focus, however, had been a lack of international diversification. Many of the company’s critics argued that being both Brazilian and undiversified internationally resulted in an uncompetitive cost of capital.

Need for Diversification

Petrobrás in 2002 was the largest company in Brazil, and the largest publicly traded oil company in Latin America. It was not, however, international in its operations. This inherent lack of international diversification was apparent to international investors, who assigned the company the same country risk factors and premiums they did to all other Brazilian companies. The result was a cost of capital in 2002, as seen in Exhibit A, that was 6% higher than the other firms shown.

Petrobrás embarked on a globalization strategy, with several major transactions heading up the process. In December 2001, Repsol-YPF of Argentina and Petrobrás concluded an exchange of operating assets valued at $500 million. In the exchange, Petrobrás received 99% interest in the Eg3 S.A. service station chain, while Repsol-YPF gained a 30% stake in a refinery, a 10% stake in an offshore oil field, and a fuel resale right to 230 service stations in Brazil. The agreement included an eight-year guarantee against currency risks.

In October 2002, Petrobrás purchased Perez Companc (Pecom) of Argentina. Pecom had quickly come into play following the Argentine financial crisis in January 2002. Although Pecom had significant international reserves and production capability, the combined forces of a devalued Argentine peso, a largely dollar-denominated debt portfolio, and a multitude of Argentine government regulations that hindered its ability to hold and leverage hard currency resources, the company had moved quickly to find a buyer to refund its financial structure. Petrobrás took advantage of the opportunity. Pecom’s ownership had been split between its original controlling family owners and their foundation, 58.6%, and public flotation of the remaining 41.4%. Petrobrás had purchased the controlling interest, the full 58.6% interest, outright from the family.

Over the next three years, Petrobrás focused on restructuring much of its debt (and the debt it had acquired via the Pecom acquisition) and investing in its own growth. But progress toward revitalizing its financial structure came slowly, and by 2005 there was renewed discussion of a new equity issuance to increase the firm’s equity capital.⁷ But at what cost? What was the company’s cost of capital?

⁶Copyright © 2008 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management.

⁷By 2005, the company’s financial strategy was showing significant diversification. Total corporate funding was well-balanced: bonds, $4 billion; BNDES (bonds issued under the auspices of a Brazilian economic development agency), $3 billion; project finance, $5 billion; other, $4 billion.

EXHIBIT A Petrobrás’ Uncompetitive Cost of Capital

Source: MorganStanley Research, January 18, 2002, p. 5.

Country Risk

Exhibit A presented the cost of capital of a number of major oil and gas companies across the world, including Petrobrás in 2002. This comparison could occur only if all capital costs were calculated in a common currency, in this case, the U.S. dollar. The global oil and gas markets had long been considered “dollar-denominated,” and any company operating in these markets, regardless of where it actually operated in the world, was considered to have the dollar as its functional currency. Once that company listed its shares in a U.S. equity market, the dollarization of its capital costs became even more accepted.

But what was the cost of capital—in dollar terms—for a Brazilian business? Brazil has a long history of bouts with high inflation, economic instability, and currency devaluations and depreciations (depending on the regime de jure). One of the leading indicators of the global market’s opinion of Brazilian country risk was the sovereign spread, the additional yield or cost of dollar funds that the Brazilian government had to pay on global markets over and above that which the U.S. Treasury paid to borrow dollar funds. As illustrated in Exhibit B, the Brazilian sovereign spread had been both high and volatile over the past decade.⁸ The spread was sometimes as low as 400 basis points (4.0%), as in recent years, or as high as 2,400 basis points (24%), during the 2002 financial crisis in which the real was first devalued then floated. And that was merely the cost of debt for the government of Brazil. How was this sovereign spread reflected in the cost of debt and equity for a Brazilian company like Petrobrás?

One approach to the estimation of Petrobrás’ cost of debt in U.S. dollar terms (k_d^$ was to build it up: the government of Brazil’s cost of dollar funds adjusted for a private corporate credit spread.

If the U.S. Treasury risk-free rate was estimated using the Treasury 10-year bond rate (yield), a base rate in August 2005 could be 4.0%. The Brazilian sovereign spread, as seen in Exhibit B, appeared to be 400 basis points, or an additional 4.0%. Even if Petrobrás’ credit spread was only 1.0%, the company’s current cost of dollar debt would be 9%. This cost was clearly higher than the cost of debt for most of the world’s oil majors who were probably paying only 5% on average for debt in late 2005.

⁸The measure of sovereign spread presented in Exhibit B is that calculated by JPMorgan in its Emerging Market Bond Index Plus (EMBI+) index. This is the most widely used measure of country risk by practitioners.

EXHIBIT B The Brazilian Sovereign Spread

Source: JPMorgan’s EMBI+ Spread, as quoted by Latin Focus, www.latin-focus.com/latinfocus/countries/brazilbisprd.htm, August 2005.

Petrobrás’ cost of equity would be similarly affected by the country risk-adjusted risk-free rate of interest. Using a simple expression of the Capital Asset Pricing Model (CAPM) to estimate the company’s cost of equity capital in dollar terms :

This calculation assumed the same risk-free rate as used in the cost of debt previously, with a beta (NYSE basis) of 1.10 and a market risk premium of 5.500%. Even with these relatively conservative assumptions (many would argue that the company’s beta was actually higher or lower, and that the market risk premium was 6.0% or higher), the company’s cost of equity was 14%.

Assuming a long-term target capital structure of one-third debt and two-thirds equity, and an effective corporate tax rate of 28% (after special tax concessions, surcharges, and incentives for the Brazilian oil and gas industry), Petrobrás’ WACC was estimated at a little over 11.5%:

WACC = (0.333 × 9.000% × 0.72) + (0.667 × 14.050%) = 11.529%.

So, after all of the efforts to internationally diversify the firm and internationalize its cost of capital, why was Petrobrás’ cost of capital still so much higher than its global counterparts? Not only was the company’s weighted average cost of capital high compared to other major global players, this was the same high cost of capital used as the basic discount rate in evaluating many potential investments and acquisitions.

A number of the investment banking firms that covered Petrobrás noted that the company’s share price had shown a very high correlation with the EMBI + sovereign spread for Brazil (shown in Exhibit B), hovering around 0.84 for a number of years. Similarly, Petrobrás’ share price was also historically correlated—inversely—with the Brazilian reais/U.S. dollar exchange rate. This correlation had averaged −0.88 over the 2000–2004 period. Finally, the question of whether Petrobrás was considered an oil company or a Brazilian company was also somewhat in question:

Petrobrás’ stock performance appears more highly correlated to the Brazilian equity market and credit spreads based on historical trading patterns, suggesting that one’s view on the direction of the broad Brazilian market is important in making an investment decision on the company. If the historical trend were to hold, an improvement in Brazilian risk perception should provide a fillip to Petrobrás’ share price performance.

—“Petrobrás: A Diamond in the Rough,”

JPMorgan Latin American Equity Research,

June 18, 2004, pp. 26–27.

Mini-Case Questions

1. Why do you think Petrobrás’ cost of capital is so high? Are there better ways, or other ways, of calculating its weighted average cost of capital?
2. Does this method of using the sovereign spread also compensate for currency risk?
3. The final quote on “one’s view on the direction of the broad Brazilian market” suggests that potential investors consider the relative attractiveness of Brazil in their investment decision. How does this perception show up in the calculation of the company’s cost of capital?
4. Is the cost of capital really a relevant factor in the competitiveness and strategy of a company like Petrobrás? Does the corporate cost of capital really affect competitiveness?

QUESTIONS

These questions are available in MyFinanceLab.

1. Equity Sourcing Strategy. Why does the strategic path to sourcing equity start with debt?
2. Optimal Financial Structure. If the cost of debt is less than the cost of equity, why doesn’t the firm’s cost of capital continue to decrease with the use of more and more debt?
3. Multinationals and Cash Flow Diversification. How does the multinational’s ability to diversify its cash flows alter its ability to use greater amounts of debt?
4. Foreign Currency-Denominated Debt. How does borrowing in a foreign currency change the risk associated with debt?
5. Three Keys to Global Equity. What are the three key elements related to raising equity capital in the global marketplace?
6. Global Equity Alternatives. What are the alternative structures available for raising equity capital on the global market?
7. Directed Public Issues. What is a directed public issue? What is the purpose of this kind of international equity issuance?
8. Depositary Receipts. What is a depositary receipt? Give examples of equity shares listed and issued in foreign equity markets in this form?
9. GDRs, ADRs, and GRSs. What is the difference between a GDR, ADR, and GRS? How are these differences significant?
10. Sponsored and Unsponsored. ADRs and GDRs can be sponsored or unsponsored. What does this mean and will it matter to investors purchasing the shares?
11. ADR Levels. Distinguish between the three levels of commitment for ADRs traded in the United States.
12. IPOs and FOs. What is the significance of IPOs versus FOs?
13. Foreign Equity Listing and Issuance. Give five reasons why a firm might cross-list and sell its shares on a very liquid stock exchange.
14. Cross-Listing Abroad. What are the main reasons for firms to cross-list abroad?
15. Barriers to Cross-Listing. What are the main barriers to cross-listing abroad?
16. Private Placement. What is a private placement? What are the comparative pros and cons of private placement versus a pubic issue?
17. Private Equity. What is private equity and how do private equity funds differ from traditional venture capital firms?
18. Bank Loans versus Securitized Debt. For multinational corporations, what is the advantage of securitized debt instruments sold on a market versus bank borrowing?
19. International Debt Instruments. What are the primary alternative instruments available for raising debt on the international marketplace?
20. Eurobond versus Foreign Bonds. What is the difference between a eurobond and a foreign bond and why do two types of international bonds exist?
21. Funding Foreign Subsidiaries. What are the primary methods of funding foreign subsidiaries, and how do host government concerns affect those choices?
22. Local Norms. Should foreign subsidiaries of multinational firms conform to the capital structure norms of the host country or to the norms of their parent’s country?
23. Internal Financing of Foreign Subsidiaries. What is the difference between “internal” financing and “external” financing for a subsidiary?
24. External Financing of Foreign Subsidiaries. What are the primary alternatives for the external financing of a foreign subsidiary?

PROBLEMS

These problems are available in MyFinanceLab.

1. Copper Mountain Group (U.S.). The Copper Mountain Group, a private equity firm headquartered in Boulder, Colorado, borrows £5,000,000 for one year at 7.375% interest.
2. What is the dollar cost of this debt if the pound depreciates from $2.0260/£ to $1.9460/£ over the year?
3. What is the dollar cost of this debt if the pound appreciates from $2.0260/£ to $2.1640/£ over the year?
4. Foreign Exchange Risk and the Cost of Borrowing Swiss Francs. The chapter demonstrated that a firm borrowing in a foreign currency could potentially end up paying a very different effective rate of interest than what it expected. Using the same baseline values of a debt principal of SF1.5 million, a one year period, an initial spot rate of SF1.5000/$, a 5.000% cost of debt, and a 34% tax rate, what is the effective cost of debt for one year for a U.S. dollar-based company if the exchange rate at the end of the period was:
5. SF1.5000/$
6. SF1.4400/$
7. SF1.3860/$
8. SF1.6240/$
9. McDougan Associates (U.S.). McDougan Associates, a U.S.-based investment partnership, borrows €80,000,000 at a time when the exchange rate is $1.3460/€. The entire principal is to be repaid in three years, and interest is 6.250% per annum, paid annually in euros. The euro is expected to depreciate vis-à-vis the dollar at 3% per annum. What is the effective cost of this loan for McDougan?
10. 4. Morning Star Air (China). Morning Star Air, headquartered in Kunming, China, needs US$25,000,000 for one year to finance working capital. The airline has two alternatives for borrowing:
11. Borrow US$25,000,000 in Eurodollars in London at 7.250% per annum
12. Borrow HK$39,000,000 in Hong Kong at 7.00% per annum, and exchange these Hong Kong dollars at the present exchange rate of HK$7.8/US$ for U.S. dollars.

At what ending exchange rate would Morning Star Air be indifferent between borrowing U.S. dollars and borrowing Hong Kong dollars?

5. Pantheon Capital, S.A. If Pantheon Capital, S.A. is raising funds via a euro-medium-term note with the following characteristics, how much in dollars will Pantheon receive for each $1,000 note sold?

Coupon rate: 8.00% payable semiannually on June 30 and December 31

Date of issuance: February 28, 2011

Maturity: August 31, 2011

6. Westminster Insurance Company. Westminster Insurance Company plans to sell $2,000,000 of eurocommercial paper with a 60-day maturity and discounted to yield 4.60% per annum. What will be the immediate proceeds to Westminster Insurance?
7. Sunrise Manufacturing, Inc. Sunrise Manufacturing, Inc., a U.S. multinational company, has the following debt components in its consolidated capital section. Sunrise’s finance staff estimates their cost of equity to be 20%. Current exchange rates are also listed below. Income taxes are 30% around the world after allowing for credits. Calculate Sunrise’s weighted average cost of capital. Are any assumptions implicit in your calculation?

Assumption

Value

Tax rate

30.00%

10-year eurobonds (euros)

6,000,000

20-year yen bonds (yen)

750,000,000

Spot rate ($/euro)

1.2400

Spot rate ($/pound)

1.8600

Spot rate (yen/$)

109.00

8. 8. Petrol Ibérico. Petrol Ibérico, a European gas company, is borrowing US$650,000,000 via a syndicated eurocredit for six years at 80 basis points over LIBOR. LIBOR for the loan will be reset every six months. The funds will be provided by a syndicate of eight leading investment bankers, which will charge up-front fees totaling 1.2% of the principal amount. What is the effective interest cost for the first year if LIBOR is 4.00% for the first six months and 4.20% for the second six months.
9. Adamantine Architectonics. Adamantine Architectonics consists of a U.S. parent and wholly owned subsidiaries in Malaysia (A-Malaysia) and Mexico (A-Mexico). Selected portions of their non-consolidated balance sheets, translated into U.S. dollars, are shown in the table below. What are the debt and equity proportions in Adamantine’s consolidated balance sheet?

A-Malaysia (accounts in ringgits)

A-Mexico (accounts in pesos)

Long-term debt

RM11,400,000

Long-term debt

PS20,000,000

Shareholders’ equity

RM15,200,000

Shareholders’ equity

PS60,000,000

Adamantine Architectonics

(Nonconsolidated Balance Sheet—Selected Items Only)

Investment in subsidiaries

 

Parent long-term debt

$12,000,000

In A-Malaysia

$4,000,000

Common stock

5,000,000

In A-Mexico

6,000,000

Retained earnings

20,000,000

Current exchange rates:

Malaysia

RM3.80/$

 

 

Mexico

PS10/$

 

 

Petrobrás of Brazil: Estimating its Weighted Average Cost of Capital

Petrobrás Petróleo Brasileiro S.A. or Petrobras is the national oil company of Brazil. It is publicly traded, but the government of Brazil holds the controlling share. It is the largest company in the Southern Hemisphere by market capitalization and the largest in all of Latin America. As an oil company, the primary product of its production has a price set on global markets—the price of oil—and much of its business is conducted the global currency of oil, the U.S. dollar. Problems 10–15 examine a variety of different financial institutions’ attempts to estimate the company’s cost of capital.

10. JPMorgan. JPMorgan’s Latin American Equity Research department produced the following WACC calculation for Petrobrás of Brazil versus Lukoil of Russia in their June 18, 2004, report. Evaluate the methodology and assumptions used in the calculation. Assume a 28% tax rate for both companies.

 

Petrobrás

Lukoil

Risk-free rate

4.8%

4.8%

Sovereign risk

7.0%

3.0%

Equity risk premium

4.5%

5.7%

Market cost of equity

16.3%

13.5%

Beta (relevered)

0.87

1.04

Cost of debt

8.4%

6.8%

Debt/capital ratio

0.333

0.475

WACC

14.7%

12.3%

11. UNIBANCO. UNIBANCO estimated the weighted average cost of capital for Petrobrás to be 13.2% in Brazilian reais in August of 2004. Evaluate the methodology and assumptions used in the calculation.

Risk-free rate

4.5%

Beta

0.99

Market premium

6.0%

Country risk premium

5.5%

Cost of equity (US$)

15.9%

Cost of debt (after-tax)

5.7%

Tax rate

34%

Debt/total capital

40%

WACC (R$)

13.2%

12. Citigroup SmithBarney (Dollar). Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrás in its coverage. That DCF analysis requires the use of a discount rate, which they base on the company’s weighted average cost of capital. Evaluate the methodology and assumptions used in the 2003 Actual and 2004 Estimates of Petrobrás’ WACC shown in the table on the next page.

Problem 12.

 

July 28, 2005

March 8, 2005

Capital Cost Components

2003A

2004E

2003A

2004E

Risk-free rate

9.400%

9.400%

9.000%

9.000%

Levered beta

1.07

1.09

1.08

1.10

Risk premium

5.500%

5.500%

5.500%

5.500%

Cost of equity

15.285%

15.395%

14.940%

15.050%

Cost of debt

8.400%

8.400%

9.000%

9.000%

Tax rate

28.500%

27.100%

28.500%

27.100%

Cost of debt, after-tax

6.006%

6.124%

6.435%

6.561%

Debt/capital ratio

32.700%

32.400%

32.700%

32.400%

Equity/capital ratio

67.300%

67.600%

67.300%

67.600%

WACC

12.20%

12.30%

12.10%

12.30%

13. Citigroup SmithBarney (Reais). In a report dated June 17, 2003, Citigroup SmithBarney calculated a WACC for Petrobrás denominated in Brazilian reais (R$). Evaluate the methodology and assumptions used in this cost of capital calculation.

Risk-free rate (Brazilian C-Bond)

9.90%

Petrobrás levered beta

1.40

Market risk premium

5.50%

Cost of equity

17.60%

Cost of debt

10.00%

Brazilian corporate tax rate

34.00%

Long-term debt ratio (% of capital)

50.60%

WACC (R$)

12.00%

14. BBVA Investment Bank. BBVA utilized a rather innovative approach to dealing with both country and currency risk in their December 20, 2004, report on Petrobrás. Evaluate the methodology and assumptions used in this cost of capital calculation.

Cost of Capital Component

2003 Estimate

2004 Estimate

U.S. 10-year risk-free rate (in US$)

4.10%

4.40%

Country risk premium (in US$)

6.00%

4.00%

Petrobrás premium “adjustment”

1.00%

1.00%

Petrobrás risk-free rate (in US$)

9.10%

7.40%

Market risk premium (in US$)

6.00%

6.00%

Petrobrás beta

0.80

0.80

Cost of equity (in US$)

13.90%

12.20%

Projected 10-year currency devaluation

2.50%

2.50%

Cost of equity (in R$)

16.75%

14.44%

Petrobrás cost of debt after-tax (in R$)

5.50%

5.50%

Long-term equity ratio (% of capital)

69%

72%

Long-term debt ratio (% of capital)

31%

28%

WACC (in R$)

13.30%

12.00%

15. Petrobrás’ WACC Comparison. The various estimates of the cost of capital for Petrobrás of Brazil appear to be very different, but are they? Reorganize your answers to Problems 10–14 into those costs of capital that are in U.S. dollars versus Brazilian reais. Use the estimates for 2004 as the basis of comparison.
16. Grupo Modelo S.A.B. de C.V. Grupo Modelo, a brewery out of Mexico that exports such well-known varieties as Corona, Modelo, and Pacifico, is Mexican by incorporation. However, the company evaluates all business results, including financing costs, in U.S. dollars. The company needs to borrow $10,000,000 or the foreign currency equivalent for four years. For all issues, interest is payable once per year, at the end of the year. Available alternatives are as follows:
17. Sell Japanese yen bonds at par yielding 3% per annum. The current exchange rate is ¥106/$, and the yen is expected to strengthen against the dollar by 2% per annum.
18. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is $1.1960/€, and the euro is expected to weaken against the dollar by 2% per annum.
19. Sell U.S. dollar bonds at par yielding 5% per annum.

Which course of action do you recommend Grupo Modelo take and why?

INTERNET EXERCISES

1. Global Equities. Bloomberg provides extensive coverage of the global equity markets 24 hours a day. Using the Bloomberg site listed here, note how different the performance indices are on the same equity markets at the same point in time all around the world.

Bloomberg

www.bloomberg.com/markets/stocks/world-indexes/

2. JPMorgan and Bank of New York Mellon. JPMorgan and Bank of New York Mellon provide up to the minute performance of American Depositary Receipts in the U.S. marketplace. The site highlights the high-performing equities of the day.
3. Prepare a briefing for senior management in your firm encouraging them to consider internationally diversifying the firm’s liquid asset portfolio with ADRs.
4. Identify whether the ADR program level (I, II, III, 144A) has any significance to which securities you believe the firm should consider.

JPMorgan ADRs

www.adr.com

Bank of New York Mellon

www.adrbnymellon.com

3. London Stock Exchange. The London Stock Exchange (LSE) lists many different global depositary receipts among its active equities. Use the LSE’s Internet site to track the performance of the largest GDRs active today.

London Stock Exchange

www.londonstockexchange.com/traders-and-brokers/security-types/gdrs/gdrs.htm

CHAPTER 14 APPENDIX Financial Structure of Foreign Subsidiaries

If we accept the theory that minimizing the cost of capital for a given level of business risk and capital budget is an objective that should be implemented from the perspective of the consolidated MNE, then the financial structure of each subsidiary is relevant only to the extent that it affects this overall goal. In other words, an individual subsidiary does not really have an independent cost of capital. Therefore, its financial structure should not be based on the objective of minimizing its cost of capital.

Financial structure norms for firms vary widely from one country to another but vary less for firms domiciled in the same country. This statement is the conclusion of a long line of empirical studies that have investigated the question of what factors drive financial structure. Most of these international studies concluded that country-specific environmental variables are key determinants of debt ratios. These variables include historical development, taxation, corporate governance, bank influence, existence of a viable corporate bond market, attitude toward risk, government regulation, availability of capital, and agency costs, to name a few.

Local Norms

Within the constraint of minimizing its consolidated worldwide cost of capital, should an MNE take differing country debt ratio norms into consideration when determining its desired debt ratio for foreign subsidiaries? For definition purposes the debt considered here should include only funds borrowed from sources outside the MNE. This debt would include local and foreign currency loans as well as eurocurrency loans.

The reason for this definition is that parent loans to foreign subsidiaries are often regarded as equivalent to equity investment both by host country and by investing firms. A parent loan is usually subordinated to other debt and does not create the same threat of insolvency as an external loan. Furthermore, the choice of debt or equity investment is often considered arbitrary (by some) and subject to negotiation between host country and parent firm.

The main advantages of a finance structure for foreign subsidiaries that conforms to local debt norms are as follows:

■ A localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high a proportion of debt (judged by local standards), often resulting in the accusation that they are not contributing a fair share of risk capital to the host country.

■ A localized financial structure helps management evaluate return on equity investment relative to local competitors in the same industry.

■ In economies where interest rates are relatively high because of a scarcity of capital, the high cost of local funds reminds management that return on assets needs to exceed the local price of capital.

The main disadvantages of localized financial structures are as follows:

■ An MNE is expected to have a comparative advantage over local firms in overcoming imperfections in national capital markets through better availability of capital and the ability to diversify risk.

■ If each foreign subsidiary of an MNE localizes its financial structure, the resulting consolidated balance sheet might show a financial structure that does not conform to any particular country’s norm.

■ The debt ratio of a foreign subsidiary is only cosmetic, because lenders ultimately look to the parent and its consolidated worldwide cash flow as the source of repayment.

In our opinion, a compromise position is possible. Both multinational and domestic firms should try to minimize their overall weighted average cost of capital for a given level of business risk and capital budget, as finance theory suggests. However, if debt is available to a foreign subsidiary at equal cost to that which could be raised elsewhere, after adjusting for foreign exchange risk, then localizing the foreign subsidiary’s financial structure should incur no cost penalty and would also enjoy the advantages listed above.

Financing the Foreign Subsidiary

In addition to choosing an appropriate financial structure for foreign subsidiaries, financial managers of multinational firms need to choose among alternative sources of funds—internal and external to the multinational—with which to finance foreign subsidiaries.

Ideally, the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk. The firm should choose internal sources in order to minimize worldwide taxes and political risk, while ensuring that managerial motivation in the foreign subsidiaries is geared toward minimizing the firm’s consolidated worldwide cost of capital, rather than the subsidiary’s cost of capital.

Internal Sources of Funding

Exhibit 14A.1 provides an overview of the internal sources of financing for foreign subsidiaries. In general, although a minimum amount of equity capital from the parent company is required, multinationals often strive to minimize the amount of equity in foreign subsidiaries in order to limit risks of losing that capital. Equity investment can take the form of either cash or real goods (machinery, equipment, inventory, etc.).

While debt is the preferable form of subsidiary financing, access to local host country debt is limited in the early stages of a foreign subsidiary’s life. Without a history of proven operational capability and debt service capability, the foreign subsidiary may need to acquire its debt from the parent company or from unrelated parties with a parental guarantee (after operations have been initiated). Once the operational and financial capabilities of the subsidiary have been established, it may then actually enjoy preferred access to debt locally.

EXHIBIT 14A.1      Internal Financing of the Foreign Subsidiary

External Sources of Funding

Exhibit 14A.2 provides an overview of the sources of foreign subsidiary financing external to the MNE. The sources are first decomposed into three categories: (1) debt from the parent’s country; (2) debt from countries outside the parent’s country; and (3) local equity.

Debt acquired from external parties in the parent’s country reflects the lenders’ familiarity with and confidence in the parent company itself, although the parent is in this case not providing explicit guarantees for the repayment of the debt. Local currency debt is particularly valuable to the foreign subsidiary that has substantial local currency cash inflows arising from its business activities. In the case of some emerging markets, however, local currency debt is in short supply for all borrowers, local or foreign.

EXHIBIT 14A.2      External Financing of the Foreign Subsidiary

(Eiteman 384)

Eiteman, David K., Arthur Stonehill, Michael Moffett. Multinational Business Finance, 14th Edition. Pearson Learning Solutions, 2016. VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

PLACE YOUR ORDER NOW

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 (k_WACC):

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 k_e is the risk-adjusted cost of equity, k_d 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).

k_e = k_rf + (k_m − k_rf)β_Cemex = 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 (k_e) is based on the risk-free rate of interest (k_rf), as measured by the U.S. Treasury intermediate bond yield of 6.00%, the expected rate of return in U.S. equity markets (k_m) is 13.00%, and the measure of Cemex’s individual risk relative to the market (β_Cemex) 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. 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.

1. What is Carambola worth if the Honduran lempira were to remain fixed over the three year investment period?
2. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity?
3. 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%.
4. 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?
5. What is the present value of the expected dividend stream if the euro were to depreciate 3.00% per annum against the dollar?
6. 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?

Hermosa Beach Components (U.S.)

Use the following information and assumptions to answer Problems 7–10.

Hermosa Beach Components, Inc., of California exports 24,000 sets of low-density light bulbs per year to Argentina under an import license that expires in five years. In Argentina, the bulbs are sold for the Argentine peso equivalent of $60 per set. Direct manufacturing costs in the United States and shipping together amount to $40 per set. The market for this type of bulb in Argentina is stable, neither growing nor shrinking, and Hermosa holds the major portion of the market.

The Argentine government has invited Hermosa to open a manufacturing plant so imported bulbs can be replaced by local production. If Hermosa makes the investment, it will operate the plant for five years and then sell the building and equipment to Argentine investors at net book value at the time of sale plus the value of any net working capital. (Net working capital is the amount of current assets less any portion financed by local debt.) Hermosa will be allowed to repatriate all net income and depreciation funds to the United States each year. Hermosa traditionally evaluates all foreign investments in U.S. dollar terms.

■          Investment. Hermosa’s anticipated cash outlay in U.S. dollars in 2012 would be as follows:

Building and equipment

$1,000,000

Net working capital

1,000,000

Total investment

$2,000,000

All investment outlays will be made in 2012, and all operating cash flows will occur at the end of years 2013 through 2017.

■          Depreciation and Investment Recovery. Building and equipment will be depreciated over five years on a straight-line basis. At the end of the fifth year, the $1,000,000 of net working capital may also be repatriated to the United States, as may the remaining net book value of the plant.

■          Sales Price of Bulbs. Locally manufactured bulbs will be sold for the Argentine peso equivalent of $60 per set.

■          Operating Expenses per Set of Bulbs. Material purchases are as follows:

Materials purchased in Argentina (U.S. dollar equivalent)

$20 per set

Materials imported from Hermosa Beach-USA

10 per set

Total variable costs

$30 per set

■          Transfer Prices. The $10 transfer price per set for raw material sold by the parent consists of $5 of direct and indirect costs incurred in the United States on their manufacture, creating $5 of pre-tax profit to Hermosa Beach.

■          Taxes. The corporate income tax rate is 40% in both Argentina and the United States (combined federal and state/province). There are no capital gains taxes on the future sale of the Argentine subsidiary, either in Argentina or the United States.

■          Discount Rate. Hermosa Components uses a 15% discount rate to evaluate all domestic and foreign projects.

7. Hermosa Components: Baseline Analysis. Evaluate the proposed investment in Argentina by Hermosa Components (U.S.). Hermosa’s management wishes the baseline analysis to be performed in U.S. dollars (and implicitly also assumes the exchange rate remains fixed throughout the life of the project). Create a project viewpoint capital budget and a parent viewpoint capital budget. What do you conclude from your analysis?
8. Hermosa Components: Revenue Growth Scenario. As a result of their analysis in Problem 7, Hermosa wishes to explore the implications of being able to grow sales volume by 4% per year. Argentine inflation is expected to average 5% per year, so sales price and material cost increases of 7% and 6% per year, respectively, are thought reasonable. Although material costs in Argentina are expected to rise, U.S.-based costs are not expected to change over the five-year period. Evaluate this scenario for both the project and parent viewpoints. Is the project under this revenue growth scenario acceptable?
9. Hermosa Components: Revenue Growth and Sales Price Scenario. In addition to the assumptions employed in Problem 8, Hermosa now wishes to evaluate the prospect of being able to sell the Argentine subsidiary at the end of year 5 at a multiple of the business’ earnings in that year. Hermosa believes that a multiple of six is a conservative estimate of the market value of the firm at that time. Evaluate the project and parent viewpoint capital budgets.
10. Hermosa Components: Revenue Growth, Sales Price, and Currency Risk Scenario. Melinda Deane, a new analyst at Hermosa and a recent MBA graduate, believes that it is a fundamental error to evaluate the Argentine project’s prospective earnings and cash flows in dollars, rather than first estimating their Argentine peso (Ps) value and then converting cash flow returns to the United States in dollars. She believes the correct method is to use the end-of-year spot rate in 2012 of Ps3.50/$ and assume it will change in relation to purchasing power. (She is assuming U.S. inflation to be 1% per annum and Argentine inflation to be 5% per annum). She also believes that Hermosa should use a risk-adjusted discount rate in Argentina that reflects Argentine capital costs (20% is her estimate) and a risk-adjusted discount rate for the parent viewpoint capital budget (18%) on the assumption that international projects in a risky currency environment should require a higher expected return than other lower-risk projects. How do these assumptions and changes alter Hermosa’s perspective on the proposed investment?

INTERNET EXERCISES

1. Capital Projects and the EBRD. The European Bank for Reconstruction and Development (EBRD) was established to foster market-oriented business development in the former Soviet Bloc. Use the EBRD Web site to determine which projects and companies EBRD is currently undertaking.

European Bank for Reconstruction and Development

www.ebrd.com

2. Emerging Markets: China. Long-term investment projects such as electrical power generation require a thorough understanding of all attributes of doing business in that country. China is currently the focus of investment and market penetration strategies of multinational firms worldwide. Using the Web (you might start with the Web sites listed below), build a database on doing business in China, and prepare an update of many of the factors discussed in this chapter.

Ministry of Foreign Trade and Economic Cooperation, PRC

english.mofcom.gov.cn

China Investment Trust and Investment Corporation

www.citic.com/wps/portal/ enlimited

ChinaNet Investment Pages

www.chinanet-online.com

3. BeyondBrics: The Financial Times’ Emerging Market Hub. Check the FT’s blog on emerging markets for the latest debates and guest editorials.

Financial Times Blog on Emerging Markets

blogs.ft.com/beyond-brics/

(Eiteman 510)

Eiteman, David K., Arthur Stonehill, Michael Moffett. Multinational Business Finance, 14th Edition. Pearson Learning Solutions, 2016. VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

PLACE YOUR ORDER NOW