Cross-Border Mergers and Acquisitions:

Analysis and Valuation

Courage is not the absence of fear. It is doing the thing you fear

the most.

—Rick Warren

Course Layout: M&A & Other Restructuring Activities

Part IV: Deal Structuring &

Financing

Part II: M&A Process

Part I: M&A Environment

Payment & Legal

Considerations

Public Company Valuation

Financial Modeling

Techniques

M&A Integration

Business & Acquisition

Plans

Search through Closing

Activities

Part V: Alternative Strategies

Accounting & Tax

Considerations

Business Alliances

Divestitures, Spin-Offs & Carve-Outs

Bankruptcy & Liquidation

Regulatory Considerations

Motivations for M&A

Part III: M&A Valuation & Modeling

Takeover Tactics and Defenses

Financing Strategies

Private CompanyValuation

Cross-BorderTransactions

Learning Objectives

• Primary Learning Objective: To provide students with an understanding of how to analyze and value cross-border M&As

• Secondary Learning Objectives: To provide students with an understanding of– Motives for international expansion– Common international market entry strategies– Planning and implementing cross-border transactions

in developed countries– Planning and implementing cross-border transactions

in emerging countries. – Valuing cross-border transactions– Empirical studies of financial returns to international

diversification

Globally Integrated Versus Segmented Capital Markets

• Globally integrated capital markets provide foreigners with unfettered access to local capital markets and local residents to foreign capital markets.

• Segmented capital markets – Exhibit different bond and equity prices in different

geographic areas for identical assets in terms of risk and maturity.

– Arise when investors are unable to move capital from one market to another due to capital controls or a preference for local market investments

Developed Versus Emerging Countries

• Developed countries: Characterized by– Significant/sustainable per capita GDP growth;– Globally integrated capital markets;– Well-defined legal system;– Transparent financial statements;– Currency convertibility; and– Stable government.

• Emerging countries: Characterized by – A lack of many of the characteristics of developed

countries

Motives for International Expansion

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

Common Market Entry Strategies

• Mergers & acquisitions (Offer quick access but often expensive, complex, and beset by cultural issues)

• Greenfield or solo ventures (May offer above average returns but total investment is at risk)

• Alliances and joint ventures (Allows risk/cost sharing & access to other’s resources; may facilitate entry; but must share profits and creates potential competitors)

• Exporting (Cheaper than establishing local operations but still requires local marketing/distribution channels)

• Licensing (Least profitable and risky entry strategy and lack of control could jeopardize brand or trademark)

Discussion Questions

1. What are the differences between segmented and globally integrated capital markets? How do these distinctions affect prices of financial assets of comparable risk and maturity in various countries?

2. Of the various motives for international expansion, which do you believe is the most common and why?

3. Do you believe that some market entry strategies are more suitable for emerging than for developed countries? Explain your answer.

Implementing Cross-Border Transactions in Developed Countries

• Foreign acquirers of U.S. businesses– Acquisition vehicle: Often use C-corporations, LLCs, or partnerships– Form of payment: Most often cash– Form of acquisition: Share acquisitions generally the simplest– Post-merger organization: Centralized organization used to rapidly

realize synergies but decentralized operations used where cultural differences significant

– Tax strategies: • Forward triangular merger common for tax-free asset purchases

and reverse triangular merger common for share acquisitions (latter provides continuity of interests and business enterprise). Both involve acquirer shares as the form of payment.

• Forward triangular cash merger common for taxable transactions

Implementing Cross-Border Transactions in Developed Countries

Cont’d.• Acquisitions by U.S. and Non-U.S acquirers of foreign businesses

– Acquisition vehicle: Corporate-like structures in common law countries; share companies or LLCs in civil law nations

– Form of payment: Generally cash– Form of acquisition: Share acquisitions generally simplest– Post-closing organization: Holding company structure if target to

be operated as independent unit or integrated with acquirer’s existing “in-country” operations

– Tax strategies: Highly complex and vary with local tax and legal jurisdictions

Implementing Cross-Border Transactions in Emerging Countries

• Poses challenges not common to developed countries such as political and economic risks including:– Excessive local government regulation;– Confiscatory tax policies;– Restrictions on cash remittances;– Currency inconvertibility;– Expropriation of foreign assets; – Local corruption; and– Civil war and local insurgencies

• Managing risk through insurance (e.g., OPIC, World Bank), contract options (e.g., puts), and credit default swaps

Valuing Cross-Border Transactions

• Methodology similar to that employed when acquirer and target in same country

• Basic differences between within country and cross-border include the following:– Need to convert target cash flow projections into

acquirer home country currency– Adjusting discount rate for risks uncommon in “within

country” valuations• Currency conversions made using the Interest Rate

Parity theory if data permit and Purchasing Power Parity theory if interest rate information unavailable.

Interest Rate Parity Theory

$1 x ($/€)n = $1 x {(1 + R$n)n/(1 + R€n)n} x ($/€)0

Where ($/€)n = Forward $ exchange rate n periods into the future ($/€)0 = $/Euro spot rate R$n = Interest rate in U.S. R€n = Interest rate in European Union

1€ x (€/$)n = 1€ x {(1 + R€n)n/(1 + R$n)n} x (€/$)0

Where (€/$)n = Forward Euro exchange rate n periods into the future (€/$)0 = Euro/$ spot rate

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

2008 2009 2010Target’s Euro-Denominated €124.5 €130.7 €136.0 FCFF Cash Flows (€ Millions)

Target Country’s Interest Rate (%) 4.50 4.70 5.30U.S. Interest Rate (%) 4.25 4.35 4.55Current Spot Rate ($/€) = 1.2044Projected Spot Rate ($/€) = 1.2015 1.1964 1.1788

Target’s Dollar-Denominated $149.59 $156.37 $160.32 FCFF Cash Flows ($ Millions) Notes: Calculating the projected spot rate using Interest Rate Parity.($/€)2008 = {(1.0425)/(1.0450)} x 1.2044 = 1.2015($/€)2009 = {(1.0435)2/(1.0470)2} x 1.2044 = 1.1964($/€)2010 = {(1.0455)3/(1.0530)3} x 1.2044 = 1.1788

Purchasing Power Parity Theory

($/Peso)n = ((1 + Pus)n/(1 + Pmex)n) x ($/Peso)0

Where ($/Peso)n = Forward $/Peso exchange rate n periods into the future ($/Peso)0 = Spot $/Peso exchange rate Pus = Expected U.S. inflation rate Pmex = Expected Mexican inflation rate

(Peso/$)n = ((1 + Pmex)n/(1 + Pus)n) x (Peso/$)0

Where (Peso/$)n = Forward Peso/$ exchange rate n periods into the future (Peso/$)0 = Spot Peso/$ exchange rate

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

2008 2009 2010Target’s Peso-Denominated P1,050.5 P1,124.7 P1,202.7 FCFF Cash Flows (Millions of Pesos)

Mexican Expected Inflation Rate = 6% U.S. Expected Inflation Rate = 4% Spot Rate ($/Peso) = .0877Projected Spot Rate ($/Peso) .0860 .0844 .0828

Target’s Dollar-Denominated $90.34 $94.92 $99.58 FCFF Cash Flows (Millions of $) Notes: Calculating the projected spot rate using Purchasing Power Parity.($/Peso)2008 = {(1.04)/(1.06)} x .0877 = .0860($/Peso)2009 = {(1.04)2/(1.06)2} x .0877 = .0844($/Peso)2010 = {(1.04)3/(1.06)3} x .0877 = .0828

Estimating Cost of Equity for Developed Countries

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

ke,dev = Rf + ßdevfirm,global (Rm – Rf) + FSP

Where ke,dev = Required return on equity for a firm in a developed country Rf = Local country’s risk-free rate of return if cash flows in local currency or U.S. treasury bond rate if in dollars ßdevfirm,global = Nondiversifiable risk for globally diversified portfolio or well-diversified portfolio highly correlated with the global portfolio (Rm – Rf) = Difference in expected return on global market portfolio, U.S. equity index, or broadly defined index in the local country and the Rf

FSP = Premium small firms must earn to attract investors

Estimating Cost of Equity for Emerging Countries

ke,em = Rf + ßemfirm,global (Rcountry – Rf) + FSP + CRP

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

Estimating the Cost of Debt• For developed countries, the target’s local or the acquirer’s home

country cost of debt.

• For emerging countries, the cost of debt (iemfirm) is as follows:

iemfirm = Rf + CRP + FRP

Where

Rf = Risk free rate (see preceding slide.)

CRP = Specific country risk premium (see preceding slide)

FRP = Firm’s default risk premium (i.e., additional premium for similar

firms rated by credit rating agencies or estimated by comparing

interest coverage ratios used by rating agencies to the firm’s

interest coverage ratios to determine how they would rate the

firm.)

Evaluating Emerging Country Risk Using Scenario Planning

• Risk may be incorporated into the valuation by considering alternative economic scenarios for the emerging country.

• Projected cash flows for alternative scenarios could reflect different GDP growth rates, inflation rates, interest rates, foreign exchange rates, or alternative political conditions.

• If risk is included by calculating a weighted average of alternative scenarios, the discount rate should not be adjusted for specific country risk.

Discussion Questions

1. Discuss the primary differences between valuing target firms’ cash flows in developed versus emerging countries. Be specific.

2. Do you agree or disagree with the many adjustments commonly made to discount rates applied to projected cash flows of target firms in emerging countries? Be specific.

3. In your opinion is it more appropriate to adjust the discount rate for various perceived risks or to introduce risk by utilizing alternative scenarios? Explain your answer.

Things to Remember…• Motives for international expansion vary widely.• There are many alternative strategies to M&A for entering foreign

markets.• Methodology for valuing cross-border transactions is similar to that

employed when both acquirer and target firms are within the same country.

• Basic difference between valuing firms within the same country and those involved in cross-border transactions is that the latter involves converting the target’s projected cash flows form one currency to another. Also, the discount rate for firms in emerging nations may be adjusted for risks not normally found in “within country” transactions.

• For developed countries whose capital markets are globally integrated, a global beta and a global equity premium should be used to calculate the cost of equity.

• For emerging nations whose capital markets are segmented, a local beta and equity premium should be used.