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Issues in Cross Border Valuation

I. Financial Statement Analysis (different standards) - While

accounting standards continue to converge, differences continue to

abound. Consequently, the seller should confirm that their financial

statements have been prepared in accordance with Financial Accounting

standard board (if in the US), International Accounting Standards Board

(Europe and elsewhere).

II. Tax strategies (Repatriation Risk) - The risk of repatriation has to dowith an investors inability to take their profits outside of the country. Thisrisk can manifest itself in several ways including capital controls limitinghard currency transactions and tax policies that make repatriationuneconomical. Three common structures include the tax-freereorganization, taxable purchase, and hybrid transaction, which may result

in a transaction which is taxable to some target shareholders but not toothers. 1

III. Adjusting the discount rate for risks - In todays investment world,

many investors use a simplified approach to adjusting their valuations to

incorporate the political risks noted in the previous section. Rather than

explicitly factoring in the risks into the expected cash flows, they tend to

value these businesses using the discounted cash flow (DCF) approach with

an appropriate discount rate that accounts for political risk. They use the

following formula to calculate the discount rate:

Ka = Rfof US T-Bond + (Beta x Market Risk Premium) + Sovereign Spread 1

The formula merely adds in a sovereign spread to the commonly-used

CAPM approach. The sovereign spread is the difference in risk free rates

between the US Treasury bond and a government bond of the emerging

market that is denominated in dollars. 1

IV. Deciding on the spot and future exchange rate - Generally, targetfirm cash flows are projected and then converted to the acquirers homecurrency. This requires estimating exchange rates between the acquirersand targets currency. Future spot exchange rates are estimated usingeither relative interest rates (i.e., interest rate parity theory) in eachcountry or relative rates of expected inflation (i.e., purchasing power paritytheory). Since interest rate information is often limited, the purchasingpower parity approach may be most appropriate when the target firm is inan emerging nation.

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V. Adjust cost of equity for specific econo-political risks - Developedeconomies show little differences in the cost of equity or capital due to thehigh level of integration of their capital markets in the global capitalmarket. Consequently, either the acquirers or the targets cost of equity(adjusted for firm size) may be employed to discount future cash flows

when both firms are located developed countries. In emerging countries,capital markets often are segmented such that investments are madeprimarily in a particular country. This implies that the local countrys equitypremium differs from the global equity premium, reflecting the localcountrys non-diversifiable risk. Non-diversifiable risk when capital marketsare segmented is measured by estimating the emerging country firmsglobal beta as the product of the firms country beta times the emergingcountrys global beta. The countrys equity risk premium is estimated usingthe prospective method implied by the constant growth model, whichrelates the target firms country stock index or for a similar country to thedividend yield plus the expected earnings growth rate. The firms cost of

equity may be adjusted for specific political/economic risk by adding thedifference between the yield on the countrys government bonds and theU.S treasury bond of the same maturity. Additional adjustments couldinclude liquidity risk and firm size. 1

VI. Performing sensitivity analysis - Once the NPV is calculated, a

sensitivity analysis should be performed to determine how changes in key

assumptions affect NPV. It is important to remember that a NPV is a best

guess estimate of project value and does not say anything about the

variance around this best guess. The assumptions made when constructing

the pro forma projections should be analyzed to measure their effect onNPV. Special notes should be given to dramatic shifts in currency exchange

rates, country risk premiums, relative business risk, and probability

weighted scenarios.2

VII. Financing considerations - Cross-border transactions are most often

financed with debt. Sources of financing include capital markets in the

acquirers home market, the targets local country, or in a third country. It

is important to understand the debt that is being used to fund the

transaction (if any), and the possible fluctuations in its value down the line.