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The CaseTaiwan Semiconductor Manufacturing Company

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John Kim had just been appointed as the fund manager for Bank of Korea’s newly unveiled Emerging Markets Technology Fund. The management of the Bank had high expectations for both John and the Fund, considering the lack of performance by the two other funds managed by the Investment Management Division (IMD), which was based in New York City. With worldwide mutual fund returns dwindling, management was hoping that strong returns by the Technology Fund would help the Bank garner larger institutional investors.

John had been a high performer in IMD for some time. Having earned his MBA degree at the prestigious Leonard N. Stern School of Business at New York University, he had accepted a position as a Research Associate upon graduation. As an associate, John had a history of identifying and analyzing undervalued companies in the emerging markets sectors. His work had been instrumental in the investment strategy of fund managers in the IMD division. But because the two previous funds were devoted more towards stable growth industries, his analyses had not been maximized. The Bank hoped to leverage his exceptional skills through the new fund, which would focus on Technology and Biotechnology companies publicly traded in Emerging Market Countries. Though other Technology Funds managed by other financial institutions had not faired well since the year 2000, management had different expectations for this Fund primarily due to John’s history of comprehensive analysis. Though he would have a small staff under his authority, it was understood that John would have an influential role in the due diligence process prior to investment.

Over the years, John had been intrigued by the Taiwan Semiconductor Manufacturing Company (TSMC), which was traded on the Taiwanese Stock Exchange (TW: 2330) and the New York Stock Exchange (NYSE: TSM) as an American Depository Receipt (Stock Chart: Appendix A). It was widely known that TSMC was one of the leaders in the manufacturing and testing of integrated circuits. Due to the technology bubble in early 2000, the Company’s stock price had been depressed both on the Taiwanese and New York markets. Though he was aware that most research analysts had rated the Company as a “Buy”, he could not comprehend why the price per share had been less than half of its February 2000 high of NT $111.10. He figured that the price depression was due to investor caution regarding technology equity and the worldwide economic conditions rather than the Company’s operations itself. Regardless of consolidation by competitors and decreased demand, the Company continued to hold a dominant share of the market. Furthermore, John had read in the Wall Street Journal that the Company had been approved for foreign direct investment in Shanghai, China in the form of a manufacturing facility, which would surely decrease tariff constraints and lower the Company’s Cost of Goods Sold margin when operational.

John therefore intended to study the Company in more detail. He would perform valuation analyses to confirm his premonition that TSMC was indeed undervalued. He was interested in the Shanghai manufacturing facilities’ implications on operations and cash flows. With an initial capital base of $1 billion allotted to him by the Bank, he hoped to hold a large position in the Company, which would be the basis upon which he would build the Fund.

Overview of TSMC:Taiwan Semiconductor Manufacturing Company (TSMC) is the leading dedicated integrated circuit (IC) foundry. The Company manufactures chips used across the entire IC application spectrum, including microprocessors, graphics chips, wireless IC communications platforms and programmable logic devices. The Company offers a broad spectrum of processes, such as logic, mixed-signal/RF (radio frequency), embedded memory, color image sensor and high-voltage process technologies. These processes are transferred to volume production, where they are used as platforms for computing, graphics, communications (network and wireless), industrial and consumer electronics applications. TSMC has developed a service organization featuring sophisticated design services, mask making and wafer probing capabilities, as well as third-party alliances that match the Company and its customers with developers of electronic design automation tools, libraries, intellectual property cores and assembly and testing services. The Company’s major customers include ATI, Altera, Broadcom, Nvidia, Marvell, Motorola, Texas Instruments, and VIA.

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TSMC currently operates seven large wafer fabrication plants and three joint-ventures, with a Yr. 2002 expected manufacturing capacity of 3.9 million 8-inch wafers.1 The revenue breakdown, classified in terms of IC technology and application, is as follows:

1 Merrill Lynch Research Report, Dated March 17, 2003.

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Source: Company’s Year 2001 20F Statement, Filed With US SEC.

Though the Company is based in Asia, much of its revenues come from other parts of the world, with a negligible portion coming from Mainland China, as per conversations with TSMC’s investor relations personnel.

Source: Company’s Year 2001 20F Statement, Filed With US SEC.

The Company also boasts a dominant percentage of the integrated circuits market relative to its competitors, the largest of whom are United Microelectronics (UMC) and Chartered Semiconductor, both of whom are listed on the New York Stock Exchange.

Source: Company Website

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The Company’s audited financial statements, constructed in accordance with US General Accepted Accounting Principles (GAAP) can be seen in Appendix B, along with a summary of recent press releases issued by the Company.

Integrated Circuits Industry:An integrated circuit (IC), sometimes called a microchip, is a semiconductor wafer on which tiny resistors, capacitors, and transistors are fabricated upon. Integrated circuits are used for a variety of devices, including microprocessors, audio and video equipment, and automobiles.

In the current environment, chip foundries continue to suffer from the excesses of the late 1990’s. With excess capacity and pricing pressure, no recovery seems in sight. Asia-based foundries supply chips to the PC, consumer, and communications sectors. In fact, many PC makers have scaled back orders in order to purge the excess inventory from last year’s sluggish back-to-school and Christmas seasons. One pocket of strength is the wireless communications sector as demand for wireless LAN chips is still high. Since it is difficult to determine when the demand will pick up, S&P suggests investors and speculators to avoid foundry stocks.

According to industry observers, excess capacity is likely to persist and may even get worse, keeping capacity utilization rates significantly below average. For the first quarter of this year, TSMC expects only 60% of its facilities to be running, compared with 61% in the fourth quarter of 2002 and 79% in the third. United Microelectronics Corp (UMC), also based in Taiwan, expects capacity utilization of only 60% in the first quarter of this year, compared with 64% in the fourth quarter of 2002. Furthermore, both companies have slashed their 2003 capital budgeting plans. TSMC indicated it will invest between US$ 1 billion and US$ 1.5 billion, down from US$ 1.65 billion in 2002. UMC will cut its budget to US$ 500 million from US$ 800 million.2

However, there does seem to be light at the end of the tunnel. TSMC recently said that it remains confident in the long-term development of the global wafer foundry industry. The world's biggest contract chipmaker sees a recovery for the industry starting from the second quarter of this year, 2003.

Shanghai Manufacturing Facility:John had completed an extensive, follow-up research analysis on the article he had read in the Wall Street Journal. TSMC had been granted the manufacturing facility and has been making preparation for construction by China and Taiwan. Though the respective countries have been rivals since the creation of an independent Taiwan, back-channels have always remained open between the two countries. Over the past decade, there has been significant capital inflow into China from Taiwan. Various businesses from the Island have invested US $50 Billion across the strait, often through third country entities to avoid legal and political hurdles. In fact, towns up the Pearl River Delta have been nicknamed “Little Taipeis”.

The Taiwanese Government has granted permission for high-tech companies to legally and directly invest in China, which will directly benefit the Company. The facility will not be devoted primarily to its Chinese operations, for Mainland sales is currently minimal, at best. China offers the ability to manufacture more cost-effectively through its surplus of low-cost labor. Current tariffs on semiconductor imports will be reduced from a rate of 17% for imports to 3% for chips manufactured locally. Unlike some existing foundries, the facility will be a wholly owned subsidiary, rather than a joint venture with the Chinese government. The Company will solely hold intellectual property rights and will be able to operate more efficiently and effectively through its autonomy. Furthermore, the Company would secure the first-movers advantage and would benefit considerably relative to its competitors (United Microelectronics (UMC), ProMOS Technologies and Powerchip Semiconductor have indicated interest in direct investment in China).

2 PlanetAnalog.

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After much research, John had discovered the cost structure for the new manufacturing facility. The total cost of the facility will be US $898 million, with the funds coming from the following sources:

US $371 million will be taken from the Company’s cash balance; US $418 million will be provided by financial institutions in the form of debt; and US $109 million will come from retained earnings.

Investment Environment:As a seasoned professional in regards to capital investment in the emerging markets, John has some reservations in regards to the political, economical and social environment of both countries. He is quite aware that Taiwan is possibly one of the most open and free economies in Asia, but is unsure of the intricacies of investment in the country. John is unsure of the implications of a large investment in a national company and whether the economy is liquid enough to handle a position of great magnitude (capital controls, inefficiencies, etc.). As a fund manager, he must be able to buy and sell positions readily to maximize returns for investors. He is likewise skeptical of China; though the country has become a more open economy over the past decade, as evident in its membership to the World Trade Organization (WTO), there is much uncertainty in regards to the intentions of the Communist government. He commissions his chief economist to analyze the respective countries on a macro- level so that he may make a more informed decision. (See Appendices E – G For Economic Data). The report is attached below.

Taiwan – Macroeconomics:Asian Financial Crisis and the 1990s -The past decade had been a period filled with achievements for Taiwan. Politically, it transformed from an authoritarian government into a true democracy; economically, Taiwan has prospered into a US $258 billion economy. Taiwan has established itself as the world’s twelfth largest trading power, and currently has a multi-billion dollar annual trading relationship with the United States, Japan, Germany, Korea, France and a number of other countries. In addition, Taiwan is a producer of advanced manufactured products, including semiconductors (TSMC, UMC), computers (Acer, Quanta, Asustek), and steel (China Steel). Like most Asian countries, Taiwan could not avoid the effects brought by the Asian Financial Crisis in the mid-1990s. However, the country fared well during this period of turmoil, and its economic performance was fairly stable relative to other Asian countries, such as Thailand and Indonesia. Most countries saw their respective stock indices slip at least 16%; however, Taiwan witnessed an increase in its stock index (Taiwan Weighted Index) by 9.97% during this period. Aggregately, share prices and currency only dipped approximately 4.71% in Taiwan, compared to 95.62% in Indonesia and 69.42% in South Korea. This phenomenon was considered a direct contribution to the region’s stability, and was a result of several underlying factors. Taiwan’s economy had robust fundamentals, such as its persistent surpluses on both trade account and balance of payments. In 1996, Taiwan ran a surplus of US$ 11 billion, or 4.7% of GDP on current account, though in 1997 it declined to US$ 5.1 billion, or 2.3% of GDP. Moreover, the country has never relied excessively on foreign capital for economic development (see chart below). The savings rate has steadily declined from a peak of 38.5% in 1987 to 24.4% 1997, but remained higher than the investment rate. Public external debt was very limited, less than US$ 100 million at the end of 1997. Moreover, Taiwan's foreign exchange reserves have been ahead of most countries for many years. Another important factor is that Taiwan’s financial institutions have been known for their soundness and prudence. Banks’ exposure to risk has been effectively kept in check with good governance and cautious loan approvals. In addition, foreign capitals flowing into Taiwan are mostly for direct investment in production activities, and less into the stock market or real estate (see chart below).

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Sources: Taiwan Institute of Economic Research

Accession Into The World Trade Organization (WTO) -Being a strong candidate for WTO membership, Taiwan’s GDP stands at an impressive US $258 Billion, positioning the country as the world’s 13th largest economy. Taiwan is also the world’s 12th largest trading power. In 1998, the country’s international trade totaled more than US $216 Billion; import from all sources was worth US $105 billion. More importantly, from the perspective of the WTO and its trading partners, Taiwan has proven itself a responsible trading power. In the last decade, the country has greatly liberalized its trading system; tariffs and non-tariff measures (NTMs) have come down and protection of intellectual property has improved to a level consistent with other developed countries. There are still areas in Taiwan’s trading regime which could be improved, but the economy is already more open than that of most of its Asian neighbors. Unlike the People’s Republic of China (PRC) and many current members of the WTO, Taiwan’s trading regime is already in compliance with the provisions of the WTO.

Upon accession into the WTO on January 1st, 2002, Taiwan agreed to undertake a series of additional trade-liberalizing measures that will open billions of dollars in new trade opportunities annually for its trading partners. Taiwan’s largest trading partners, such as the United States and Japan, are currently enjoying a substantial share of these new opportunities, but the country is a diversified trader that

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maintains substantial trade relationships with many countries. These trade partners, along with countries not currently trading with Taiwan, will likely enjoy additional export opportunities.

Current Economy -Taiwan has a dynamic capitalist economy with gradually decreasing guidance of investment and foreign trade by government authorities. In keeping with this trend, some large government-owned banks and industrial firms are being privatized. Real growth in GDP has averaged about 8% during the past three decades. Exports have provided the primary impetus for industrialization, and the trade surplus is substantial, while foreign reserves are the world's third largest. Agriculture contributes 2% to GDP, down from 35% in 1952. Traditional labor-intensive industries are steadily being moved offshore and replaced with more capital- and technology-intensive industries. Taiwan has become a major investor in China, Thailand, Indonesia, the Philippines, Malaysia, and Vietnam; 50,000 Taiwanese businesses are established in China. Because of its conservative financial approach and its entrepreneurial strengths, Taiwan suffered little compared with many of its neighbors from the Asian financial crisis in 1998-99. The global economic downturn, however, combined with poor policy coordination by the new administration and increasing bad debts in the banking system, pushed Taiwan into recession in 2001, the first whole year of negative growth since 1947. Unemployment also reached a level not seen since the 1970’s oil crisis.

Financial Environment -For the past decade, Taiwan has successfully taken steps to liberalize its economy and improve its investment environment in order to continue its successful goals as a member nation of the WTO and is developing the island into an Asia-Pacific regional operations center. Cross-strait tension in 1996 and East Asian financial turmoil since the middle of 1997 have not deterred foreign investors from coming to Taiwan, as foreign firms investing in Taiwan are generally accorded national treatment, and trade-related capital flows are basically unrestricted. Most export-performance and local-content requirements have been removed, while foreign-ownership limits remain although they have been substantially loosened. Portfolio investment has been opened to both institutional and individual foreign investors, but foreign investors are still subject to both restrictions on investment funds and limits to ownership. Taiwan has a comprehensive legal system that protects foreign investments and property rights and ensures fair competition.

Taiwan – Political Condition:Government -Taiwan’s government is a multiparty-democratic regime headed by an elected president with a unicameral legislature. Since 1912, Taiwan has been controlled by the country’s strongest and oldest party, the KMT (Nationalist Party); however, with Mr. Chen Shui-bian’s victory in 2000 as the second largest party’s presidential candidate, the DPP (Democratic Progressive Party) has taken over the government. Not surprisingly, with the Party’s original policy platform calling for the establishment of an independent Republic of Taiwan, China has been opposing the DPP and is more reluctant to negotiate with the current government. It was widely feared in Taiwan that the often-tense cross-Strait relationship would become even more difficult if ever the main opposition DPP were to win power. So it was to the relief of many that the election in 2000 was not accompanied by a crisis in cross-Strait relations. That said, modern Taiwan’s first non-KMT government hardly got off to a smooth start—in the second half of 2000 the island suffered from an unprecedented degree of domestic political instability. This was partly related to the DPP’s lack of experience in possessing national executive power, but was also because the Legislative Yuan (parliament) remained under the control of the KMT. However, the political instability has since settled, particularly after the KMT was clearly defeated in the December 2001 legislative election. But a return to the stability of the past is not expected—although the DPP is now the largest party in the Legislative Yuan, it still does not enjoy a majority.

Security Risk -Mainland China presents the largest security threat to the country. Although the military threat posed by China is real, most people believe that a full-scale cross-Strait confrontation is not expected to erupt. China views Taiwan as a renegade province, and its “unification” has been publicly regarded with great importance, not just by the leadership in Beijing, but also by many people in China. The Chinese

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authorities have refused to rule out using force to achieve this goal, traditionally saying that they would attack only if provoked by a foreign force invading Taiwan, or if Taiwan indefinitely rejected reunification. China’s seriousness is evident as it retains missiles aimed at the Island and has built up and armed its navy. In the run-up to Taiwan’s first direct presidential election in 1996, China undertook extensive military exercises in the Taiwan Strait, even firing (unarmed) missiles just 40 km off Taiwan’s main port of Kaohsiung. To defend itself, Taiwan has a well-armed military and may be able to rely on support from the US in the event of a Mainland attack. Under the terms of the Taiwan Relations Act (TRA) of 1979, which forms the basis for Taiwan-US relations, any military action, boycott or embargo against the country would be considered “of grave concern to the US”.

Investment In China -Although the government did announce in March of 2003 that it would allow local semiconductor companies to invest in the Mainland, the liberalization was cautious. Officials have said that they will approve only three such applications before 2005, with production limited to eight-inch wafer fabs, the industry standard. Furthermore, firms wishing to establish facilities on the Mainland must show that they have been producing more advanced 12-inch wafers in Taiwan for at least six months.

China – Macroeconomics:The Chinese economic momentum over the past decade may be unequalled as compared to other developing countries in the world. Though the Asian Currency Crisis in the mid-1990s and the current global economic stagnancy have had its devastating effects, China continues to grow at robust rates due to the commendable efforts of the political institutions. The past decade has seen the aggressive use of fiscal and monetary policies, reform of stringent regulations, privatization of previously state-owned entities (SOEs) and increased emphasis on foreign direct investment to abate much of the effects of various worldwide shocks. The recent entrance into the World Trade Organization (WTO) has continued to shape the country from its pre-1990s protectionism. Though exchange rate risk and deflation is still a major concern, the country has faired well relative to its neighbors and is forecasting continued economic growth in the foreseeable future. Nevertheless, one must not conclude China as a free economy just yet, for the government continues to exercise considerable control over private enterprises.

Asian Crisis and the 1990s -The dampening of the Asian economies in the mid-1990s could be attributed towards the currency crisis that had stretched across the continent. Deflation and exchange rate risk in the form of appreciation relative to other currencies prevailed. For China, reduced competition and demand for products in favor of other Asian countries resulted in plant closures and widespread layoffs and a high unemployment rate. Output and income decreased, resulting in a change from pre-Crisis trade deficit to surplus primarily due to the unwillingness of the public to purchase goods. The government severely reduced insurance benefits (education, health and retirement expenses), resulting in a need for personal savings, placing more stress on consumption. The real interest rate rose from –4.8% (1995) to 7.2% (1998), as there was increased capital outflow to the more developed countries. Investment in China was precluded and there was a demand for an increased market premium to compensate for the considerable economic risk. Furthermore, with large liabilities in the form of foreign-denominated debt, domestic firms and institutions defaulted on payments, placing more burden on the rough conditions.

But China emerged relatively unscathed (though it was hit hard) as compared to its neighbors due to the various policies that the government enacted. It was decided that currency risk would be reduced through parity with the US dollar via monetary policy (notice stability in chart below). Foreign currency reserves were employed to combat currency appreciation. Though there was a decrease in the growth of the country’s reserves at the time, China’s robust treasury provided the necessary means towards currency control. Much like the United States in the early portion of the 21st century, the Chinese officials decreased the interest rates to exert spending. Minimum wages and the salaries of public sector workers were increased. As part of its fiscal stimulus and soft budget policy, there was increased spending by the government through infrastructure development (roads, telecommunications, etc.). But government consumption began to preclude private investment; though the soft budget policy was adopted to fuel spending, it ironically increased the country’s real interest rates.

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Exchange Rate Fluctuation(RMB Per Unit Of Currency)

99.25

99.50

99.75

100.00

100.25

1997 1998 1999 2000 2001

US Dollar HK Dollar

Source: National Bureau of Statistics, China Statistical Yearbook 2002.

The Chinese government soon realized that privatization and foreign direct investment could be the answer to their economic woes. There was an increased emphasis on reform and a mobilization of previously public entities towards the private domain, with foreign direct investment increasing tremendously through the mid-1990s due to the authorization of wholly-owned foreign enterprises in the manufacturing sector, with much of the capital influx coming from Taiwan (see charts below for foreign investment in China). Initially, foreign investment was limited to Special Economic Zones (SPZs). The cities within these SPZs were vested with the authority to approve projects valued up to US$ 30 million, with the state department reserving the discretionary power to approve investments exceeding the threshold. The long-term plan of the Chinese was to sell off all, or a portion, of SOEs to the public, with the Communist Party restricting sales of certain industries posing “national security” issues, such as telecommunications and mass media. The government established special preferences for projects involving high technology and export-oriented investments (transportation, communications, energy, metallurgy, construction materials, machinery, chemicals, pharmaceuticals, medical equipment and electronics, etc.). The housing market was liberalized and the private ownership of property was sanctioned. The Party retained the ability to approve economic policies and management appointments of financial institutions and enterprises.

To encourage investment, the governments provided tax rebates and incentives, essentially creating a two-tiered corporate tax system benefiting the foreign companies over domestic enterprises. The foreign investments were also rewarded for reinvestment of profits with 40% refunds paid on its share of income taxes if such profits were reinvested for at least 5 years; special preference entities were able to collect full rebates. Due to the government’s concentration on attracting the manufacturing sector, China has become oversaturated and possesses excess capacities in certain industries, leaving the country relatively underdeveloped in the service sector. But the country has gained competitive dominance in manufacturing. Due to poor infrastructure and controls, investment tailed off in the latter 1990s, only to be revived again by the return potential due to China’s entrance into the World Trade Organization, the relaxing of administrative barriers, and the ability to invest in previously restricted areas. But there still remains continued opportunities for privatization; of the 171,256 industrial enterprises with sales in excess of RMB 5 million (US $600,000) registered in 2001, 46,767 are inflicted with some state intervention either through complete or partial ownership.

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Source: The Economist

Accession Into The World Trade Organization (WTO) -Negotiations for China’s entrance into the WTO solidified in 1999. The US-China Bilateral Market Access Agreement on November 15, 1999 was a landmark treaty that opened the previously protectionist economy. This event is quite crucial towards the further development of the Chinese economy, for with the introduction of the rule of law in the multiple trade agreements between member countries, there could be further liberalization of the economy.

Through the WTO, trade restrictions in the form of import quotas and tariffs have been reduced. The prohibitive value-added tariff (VAT) is an additional tax levied towards domestic and foreign companies engaged in the import-export, production, distribution or retail activities. At the current time, the general VAT rate stands at 17%, with necessities (such as agriculture and utilities) taxed at 13%. Small business (typically enterprises with production sales of less than RMB 1 million or annual wholesale/retail sales of less than RMB 1.8 million) are subject to a 6% VAT rate, but unlike the larger business, may not be entitled to tax credits on such payments. There is hope that the VAT rate could be lowered even further through discourse and engagements with other nations, enabling increased trade. With a reduction of protectionist and monopoly-sustaining policies, China could continue to be a dominant competitor in the international markets, thereby benefiting the people.

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Current Situation -The global economic downturn of the 21st century continues to plague China, with demand for domestic products still low. Deflation carried from 2001 into 2002. The ever increasing income gap between urban and rural workers pressures consumption and investment. To sustain growth and job creation, monetary policy continues to control interest rates at reasonable levels. But with strong present and future growth, estimated conservatively at 8-13%, interest rates should be kept constant at current levels. In July 2001, the government civil servant wage was increased for a fourth time. As of June 2002, foreign reserves are estimated to be at US $242.8 billion, enabling the government to minimize exchange rate risk.

Continued soft budget fiscal policies, led by government spending on infrastructure, capital construction, education, social security and pension payouts, has been the primary means for fiscal stimulus over the past 5 years. But with decreased governmental revenue from reductions in corporate taxes, tariffs and stamp duty, there is an increasing strain on the ability for the government to spend. Debt has become the most effective capital raising instrument. Treasury bonds valued at RMB 592.9 billion and “special bonds” valued at RMB 140 billion have been issued. As of June 2002, external debt reached US $139 billion, of which 31% was designated as short term liabilities, presenting further liquidity issues.

To encourage more foreign investment, the government is taking on corporate governance and mergers & acquisitions regulation reforms. The Chinese Association of Certified Public Accountants is developing greater controls in the accounting industry to raise the quality of service and instill confidence in figures reported by the companies. Even the banking industry is changing structure with the June 2002 regulations enacted to facilitate joint ventures in fund management. BNP Paribas Peregrine has already set up China’s second joint venture investment bank, and such combinations are expected to continue. With the abundance of both skilled and unskilled labor (unemployment rate at a functional 10-15%), there remains huge potentials for profit and growth in China.

China – Political Condition:Chinese Government -China has had a Marxist-style party-state for the past 54 years. It has been controlled by the Chinese Communist Party since the inception of The People’s Republic of China in 1949. Though it remains a communist country, it has adopted free-market economic reforms since 1978, which transformed the economic structure of the country and raised the living standards of the people. The National People’s Congress (legislature) is the state organ that passes laws, treaties, nominates the executive officers, and approves the constitution. The 2,989 members are replaced every five years and they are elected by lower-level people’s congress. In the past they have voted against appointees to top leadership and have registered protest votes against reports of the procurator-general mainly due to corruption. China also has the Chinese People’s Political Conference which is a powerless forum that provides consultation between ruling parties and other social and political organizations. Taiwan forms part of this entity but as mentioned before it is powerless. The State Council, or the cabinet, is elected by the NPC.

In recent years China has moved toward opening trade with Taiwan. In 1993, China began to move towards improving cross-strait relationships by promulgating the procedures for the administration of small-volume exchange of goods between the Mainland and Taiwan, which was a big step given that trade had not occurred between the two for 20 years. In 1997 Deng Xiaoping died, leaving Jiang Zemin as the new head of China. His government was moving forward towards China’s acceptance into the WTO but the bombing of the Chinese Embassy in Belgrade by NATO stopped this progress. In 2001 the NPC revealed an economic plan with acceptance into the WTO as its main goal and achieved this in December of 2001. In 2002 Jiang retired and Hu Jintao, who is the first senior Chinese official to visit the Pentagon, has assumed office.

Many specialists believe that Taiwan will, in some form, be united with China. Despite a tense war of nerves being waged between the two governments, some sort of adjustment seems inevitable. According to even Taiwanese executives and local residents, from a macroeconomic point of view Taiwan cannot afford being outside of China. Economically and culturally, the merger is already occurring.

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China – Social Condition:People -China has the largest population in the world, which is considered to be its greatest asset. However, the government has pursued a rigorous ‘one-child policy’ in order to decelerate the population growth to an economically manageable level. And this has caused China’s population to age fast—25% of the world’s population on pension is expected to live in China by 2020. Additionally, the income disparity between the urban and the rural population is increasing rapidly, despite the government’s effort to hamper such disparity.

Education -In year 2000, the number of illiterate people had fallen to 85 million, or 6.7% of the total population, down from 180 million (15.9%) in 1990. Though there are great strides toward establishing higher education, the supply of teachers and other academic personnel is far behind the demand, mainly due to funding shortages, as illustrated by China’s diminished spending on education which hovers around 2.55% of its GDP. In contrast, an average developing country spends about 4.1% of its GDP on education.

Health - Like income disparity, health conditions vary greatly between urban and rural areas. In the rural areas, this poses a serious threat as no more than 10% of the people have access to public medical facility. Though the conditions are much better in urban areas, only half of urban population is covered by health insurance systems. Recently, reported cases of AIDS/HIV infections have been rising rapidly due to lack of public awareness in the dangers of using contaminated blood.

Infrastructure -China’s infrastructure is in the middle of a very rapid transition. There is a great deal of effort in expanding the railway, the highway, and the waterway. According to the 10th five-year plan, a further 200,000 kilometers of roads will be built, which will connect 93% of villages across China. Additionally, China’s telecoms sector is booming—China now boasts more subscribers for cable television (100 million) and mobile phones (145.2 million at end-2001) than the US. By as early as 2010, all urban households will have access to broadband multimedia.

Natural Resources -Despite its enormous land mass, there is a severe scarcity of arable land. The availability of cropland per capita remains below the world average, due to the loss of land to urban construction needs. However, China ranks top in world production of certain minerals, including phosphate, tungsten, molybdenum and titanium. The country is also the world’s largest producer of coal.

Considerations:Having received an extensive report on the macro-environment of China and Taiwan, John focuses his attention on the valuation analyses for TSMC. Because of his many responsibilities as the fund manager, he calls into his office his financial analysts. John prefers to have much information before his final decision; therefore, he asks his analysts to perform as many analytical procedures at their disposal. In addition to determining the intrinsic value of the Company on a stand-alone basis, John would like to assess the Company’s value relative to competitors in the integrated circuits market. Because the financials have been constructed with US GAAP, the integrity of the figures should not be an issue. He intends to use the analysis in making an informed decision on whether to invest in the Company.

However, he warns his analysts not to make the assumption that he would purchase equity in the Company based on pure numbers. Though John is bullish on TSMC, unlike his peer fund managers, he values alternative investment strategies. He indicates that he is willing to purchase derivatives, in the form of call options, to hedge the risk of purchasing the Company’s equity shares in an uncertain and volatile economic and capital market. John considers the current market value of July options too high, rationalizing that the uncertain markets have led interested investors to purchase option rather than the equity shares.

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Appendices:

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Appendix A – Stock Chart:

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Appendix B – Financial Statements:Consolidated Balance Sheet (In $NT millions) -

Year Ended December 31,1999 2000 2001

CURRENT ASSETS:Cash and Cash Equivalents 29,517.7 38,840.2 37,556.3 Pledged time deposits 3,161.0 - - Short-term investments 965.4 2,351.6 1,398.1 Receivables - net 13,322.0 27,055.5 16,452.2 Receivable from related parties 340.9 948.7 494.7 Inventories - net 7,104.0 12,785.7 9,828.3 Deferred income tax assets - net 2,616.6 8,178.0 2,350.1 Prepaid expenses and other current assets 2,630.0 3,034.6 2,721.4 Total Current Assets 59,657.6 93,194.3 70,801.1

Long-term investments 16,164.7 9,814.3 11,599.2 Property, plant and equipment - net 150,059.9 244,747.9 251,287.6 Goodwill - 11,531.0 11,437.6

OTHER ASSETS:Rental Assets - 625.6 - Deferred income tax assets - net 7,006.7 6,629.8 16,245.8 Deferred charges - net 2,380.8 3,335.7 3,769.8 Refundable deposits 59.4 979.1 784.1 Assests leased to others - - 555.1 Miscellaneous 106.4 28.3 37.4 Total Other Assets 9,553.3 11,598.5 21,392.2

TOTAL ASSETS 235,435.5 370,886.0 366,517.7

Year Ended December 31,

1999 2000 2001CURRENT LIABILITIES:

Short-term bank loans 5,026.6 3,833.8 6,269.2 Commercial paper payable 94.8 - - Accounts payable 3,273.9 8,507.8 1,397.9 Payable to related parties 1,036.4 2,606.3 1,048.3 Income tax payable 155.1 3.3 - Payables to contractors and equipment suppliers 12,593.7 25,550.3 12,867.2 Current portion of long-term liabilities 1.0 51.1 5,000.0 Accrued expenses and other current liabilities 4,208.9 6,872.4 6,746.4 Total Current Liabilities 26,390.4 47,425.0 33,329.0

LONG-TERM LIABILITIES:Long-term bank loans 22,743.5 23,339.4 22,399.3 Long-term bonds payable 20,000.0 29,000.0 24,000.0 Total Long-term liabilities 42,743.5 52,339.4 46,399.3

OTHER LIABILITIES:Accrued pension cost 1,013.8 1,511.3 1,856.6 Deferred gain on sale - leaseback - 434.2 268.2 Lease obligation payable 4.4 3.3 Guarantee deposits 5,188.7 7,097.4 7,212.7 Others - - 141.5 Total Other Liabilities 6,206.9 9,046.2 9,479.0

TOTAL LIABILITIES 75,340.8 108,810.6 89,207.3

MINORITY INTEREST IN SUBSIDIARIES 7,524.2 321.7 120.2

SHAREHOLDERS' EQUITY:Capital Stock - $10 par value

Issued Preferred - 13,000.0 13,000.0 Issued Common 85,208.8 116,893.7 168,325.6

Suscribed Capital 13,118.0 - - Capital Surplus 23,951.4 57,089.0 57,128.4 Retained Earnings 31,382.4 75,121.0 37,507.5 Unrealized loss on long-term investments - (71.6) - Cumulative translation adjustments (1,090.1) (278.4) 1,228.7 Total Shareholders' Equity 152,570.5 261,753.7 277,190.2

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY 235,435.5 370,886.0 366,517.7

17

Consolidated Income Statement (In $NT millions) -

Year Ended December 31,1998 1999 2000 2001

NET SALES 50,524.5 76,305.1 166,197.6 125,884.9 COST OF SALES 33,009.3 46,237.4 89,681.7 92,228.1 GROSS PROFIT 17,515.2 30,067.7 76,515.9 33,656.8

OPERATING EXPENSESResearch and development 2,314.0 3,090.8 5,131.5 10,649.0 General and administrative 2,128.2 2,845.3 7,408.1 7,939.9 Marketing 767.5 1,861.6 2,681.6 2,290.1 Total Operating Expenses 5,209.7 7,797.7 15,221.2 20,879.0

INCOME FROM OPERATIONS 12,305.5 22,270.0 61,294.7 12,777.8

NON-OPERATING INCOMEGain on sales of short-term investments - net 11.9 48.6 1,060.9 1,619.1 Interest 1,111.9 1,114.5 1,679.7 1,486.7 Royalty Income - - - 1,301.6 Insurance compensation - net - 184.6 1,623.8 860.8 Premium income-net 8.3 63.8 640.5 234.7 Gain on sales of long-term investments - net 781.6 67.8 15.1 105.4 Technical service income - - 138.5 55.1 Gain on sales of property, plant, and equipment 3.3 4.0 62.9 52.4 Reversal of allowance for losses on shoter-term investment - net - 140.1 0.7 - Foreign exchange gain - net - - 828.0 - Other 59.6 58.9 177.8 759.8 Total Non-Operating Income 1,976.6 1,682.3 6,227.9 6,475.6

NON-OPERATING EXPENSESInvestments loss recognized by equity method - net 1,400.0 288.5 187.2 3,959.0 Interest 1,191.7 2,417.0 2,717.0 3,144.1 Foreign exchange loss - net 259.5 119.1 - 695.6 Loss on sales of property, plant, and equipment 4.4 164.4 114.7 235.6 Amortization of issuance costs of bonds 143.7 114.8 32.7 12.5 Premium expenses - net - 86.8 108.1 - Permanent loss on long-term investments 5.8 31.6 - - Provision for loss in short-term investments 121.9 - - - Other 99.9 101.8 461.4 420.1 Total Non-Operating Expenses 3,226.9 3,324.0 3,621.1 8,466.9

INCOME BEFORE INCOME TAX 11,055.2 20,628.3 63,901.5 10,786.5 INCOME TAX BENEFIT 2,318.4 2,382.8 1,167.9 3,740.7 INCOME BEFORE MINORITY INTEREST 13,373.6 23,011.1 65,069.4 14,527.2

MINORITY INTEREST IN LOSS (INCOME) OF SUBSIDIARIES 1,015.6 515.9 36.8 (44.0)

NET INCOME 14,389.2 23,527.0 65,106.2 14,483.2

EARNINGS PER SHARE 1.35 2.21 5.71 0.86 EARNINGS PER EQUIVALENT ADS 6.75 11.04 28.55 4.17

WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING 10,656.0 10,656.0 11,400.9 16,832.6 WEIGHTED AVERAGE NUMBER OF EQUIVALENT ADS OUTSTANDING 2,131.2 2,131.2 2,280.2 3,473.2

18

Consolidated Cash Flows Statement (In $NT millions) -

Year Ended December 31,1998 1999 2000 2001

CASH FLOWS FROM OPERATING ACTIVITIES:Net Income 14,389.2 23,527.0 65,106.2 14,483.2 Adjustments To Reconcile Net Income To Cash:

Depreciation and amortization 15,522.0 25,197.9 41,446.1 55,323.0 Deferred income tax (3,007.9) (2,481.8) (956.1) (3,788.1) Investment loss recognized by equity method - net 1,400.0 288.5 187.2 3,959.0 Gain on sale of long term investments (781.6) (67.8) (15.1) (105.4) Loss on sale of properties - net 1.1 160.4 51.8 183.2 Reversal of provision for losses on short-term investments - net - - - (13.2) Permanent loss on long term investments 5.8 31.6 - - Accretion in redemption value of bonds 875.8 585.6 - - Accrued pension cost 264.3 260.4 370.3 345.3 Allowance for doubtful receivables (10.0) 148.6 524.5 153.8 Allowance for sales returns and others (93.2) 402.1 1,679.3 123.3 Transfer property into expenses - 39.1 - - Minority interest in loss of subsidiaries (1,015.6) (515.9) (36.8) 44.0

Changes In Operating Assets and Liabilities:Short-term investments (124.8) 5,049.7 (1,373.6) - Forward exchange contract receivable - - (113.7) 49.5 Receivables 1,640.5 (6,391.8) (15,428.2) 10,326.2 Receivables from related parties 215.6 (273.2) (737.1) 454.0 Inventories 537.5 (2,765.2) (4,033.8) 2,957.4 Prepaid expenses and other current liabilities 221.8 (1,278.1) 352.0 202.3 Accounts payables (929.0) 985.9 3,170.7 (7,109.9) Payables to related parties (46.8) 878.4 2,334.2 (1,558.0) Income tax payable 746.8 (622.3) (151.8) - Forward exchange contract payable - 6.1 (987.6) 218.1 Accrued expenses and other current liabilities 318.4 2,137.2 2,024.1 (430.0)

Net Cash Provided By Operating Activities 30,129.9 45,302.4 93,412.6 75,817.7

19

Consolidated Cash Flows Statement – Con’t (In $NT millions) -

Year Ended December 31,

1998 1999 2000 2001

CASH FLOWS FROM INVESTING ACTIVITIES:Decrease (Increase) in short-term investments - - - 117.1 Acquisitions Of:

Long-term investments (1,555.8) (10,057.9) (2,107.3) (5,120.6) Properties (55,780.5) (51,459.1) (103,761.9) (70,201.2)

Proceeds From Sales Of:Long-term investments 1,523.5 150.0 49.4 559.1 Properties 3.5 413.1 364.9 301.4

Decrease (Increase) in restricted cash (7.3) 7.2 - - Decrease (Increase) in pledge time deposits (209.6) (2,290.0) 3,161.7 - Increase in deferred charges (1,187.5) (1,179.3) (1,793.2) (1,805.2) Decrease (Increase) In refundable deposits (9.7) 61.4 (915.6) 195.0 Decrease (Increase) in other assets - miscellaneous (0.8) 13.5 77.4 (9.1) Decrease in minority interest in subsidiaries (86.6) (1,660.8) (15,386.9) (249.2) Increase in goodwill (1,019.2) Cash of TASMC as of July 1, 2000 - - 736.6 - Net Cash Used In Investing Activites (57,310.8) (66,001.9) (119,574.9) (77,231.9)

CASH FLOWS FROM FINANCING ACTIVITIESProceeds From Issuance Of:

Short-term bank borrowings 2,109.2 2,917.4 - 2,435.4 Commercial paper 98.2 - - - Long-term bonds 9,772.5 9,450.6 9,000.0 - Long-term bank borrowings 6,903.8 7,997.6 - - Capital Stock 530.0 20,618.0 39,204.5 -

Payments On:Short-term bank borrowings - - (8,592.8) - Commercial paper - - (4,241.0) - Short-term notes - (253.4) - - Long-term bank borrowings - - (2,648.9) (940.1)

Increase (Decrease) in guarantee deposits and other liabilities (2,318.9) (1,010.4) 2,977.9 75.0 Issuance costs of financing (78.3) (63.3) (118.3) (47.7) Cash dividends paid on preferred shares - - - (41.1) Bonus to directors and supervisors (161.6) (138.1) (215.1) (584.3) Net Cash Provided By Financing Activites 16,854.9 39,518.4 35,366.3 897.2

Effects Of Changes In Foreign Exchange Rate (657.6) (173.1) 118.5 (766.9)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (10,983.6) 18,645.8 9,322.5 (1,283.9) BEGINNING BALANCE - CASH AND CASH EQUIVALENTS 21,855.5 10,871.9 29,517.7 38,840.2 ENDING BALANCE - CASH AND CASH EQUIVALENTS 10,871.9 29,517.7 38,840.2 37,556.3

20

Appendix C – Company Press Release Summary

February 13, 2003: Taiwan Semiconductor January Sales Rise 9 PercentTaiwan Semiconductor, the world’s largest supplier of made-to-order computer chips, said that sales rose 9% in January to NT$ 13,130 million from a year earlier.

February 13, 2003: Altera Boosts Taiwan Semiconductor OrdersAltera Corp., the world’s second-largest designer of programmable chips for other companies, has boosted orders at Taiwan Semiconductor Manufacturing Company. In 2000, Altera was one of Taiwan Semiconductor’s biggest customers. In making the announcement, Altera said it would resume orders with the chipmaker at levels comparable to 2000.

February 8, 2003: Taiwan Semiconductor Gives Gov't China Project PlansTaiwan Semiconductor has given Taiwan’s government information about its plans to invest in a plant in China. The Ministry of Economic Affairs will examine the information before giving final approval. If approved, it would allow Taiwan Semiconductor to build a plant in Shanghai, China. The company will borrow $418 million from Chinese banks to finance the $898 million plant. The Chairman of Taiwan Semiconductor said that production at the plant would not start until the end of 2004 at the earliest. Taiwan has restricted certain technological investment in China on fears it may lose part of this business to its political rival.

February 6, 2003: Taiwan Semiconductor, United Micro SlideTaiwan Semiconductor said that demand may not improve in the first three months of 2003 as “CEO’s of technology companies are being very conservative about 2003”. Also, the company said that capacity utilization would be 60% in the first quarter of 2003 compared to 61% in fourth quarter of 2002 and 79% in the third quarter. In addition, fourth-quarter income fell because of new equipment costs and lower demand.

January 28, 2003: Fujitsu, Taiwan Semiconductor See No Improvement in Chip DemandTaiwan Semiconductor expects the average selling price of chips to drop 7% in the first quarter of 2003 compared to the fourth quarter of 2002.

January 23, 2003: Taiwan Semiconductor Shares Rise on Approval of China ProjectThe Taiwanese Government gave Taiwan Semiconductor preliminary approval for its investment in China. If approved, Taiwan Semiconductor would be the first Taiwan Chipmaker to open a factory in China.

January 9, 2003: Taiwan Semiconductor Begins Work on 1st China PlantTaiwan Semiconductor has begun construction on its first plant in China because it expects approval from the Taiwanese Government.

December 28, 2002: Taiwan Semiconductor to Offer Stock OptionsTaiwan Semiconductor will eliminate is bonus-only incentive system for one that offer bonuses as well as stock options.

December 12, 2002: Taiwan Semiconductor’s China Plant Nod May Be DelayedTaiwan Semiconductor planned to win approval for its plant this year but that goal may be delayed as officials reviewing the application have asked for more information.

November 30, 2002: Taiwan Semiconductor Sees Capacity GlutTaiwan Semiconductor said that even if chip demand increases in 2003, it wouldn’t be able to absorb excess worldwide capacity.

21

November 22, 2002: Taiwan Semiconductor Sharply raises Q4 Wafer Shipment/Capacity Forecast on Increased DemandTaiwan Semiconductor said that it now expects wafer shipment in the fourth quarter to be equal to third-quarter levels, as compared to previous guidance of a 10-14 percent sequential fall. It also expects capacity utilization to be closer to 60% as opposed to its guidance of low to mid 50%.

October 22, 2002: Taiwan Semiconductor Third Quarter ReportNet Sales for the third-quarter reached NT $39,835 million, a 47.9% increase over the third-quarter of 2001. Net income was NT $3,160 million or NT$ .16 per share, a 155.5% increase over the same period a year ago.

September 9, 2002: Taiwan Semiconductor Files Application for IC Fab Facility in Mainland ChinaTaiwan Semiconductor filed an application with the Investment Committee of Taiwan’s Ministry of Economic Affairs for approval for an investment project in Mainland China. August 6, 2002: Taiwan Semiconductor Board of Directors Approves Capital Appropriation for 90nm Copper ProcessesTaiwan Semiconductor’s Board of Directors approved appropriation of capital for the increase of capacity for one of its processes. In addition, even with this appropriation, the Company does not expect capital expenditures to exceed US$ 2 billion for the year 2002. July 25, 2002: Taiwan Semiconductor Second Quarter ReportTaiwan Semiconductor reported second quarter revenues of NT$ 44,182 million and net income of NT$ 9,130 million or NT$ .49. For the first six-months of 2002, net income per share was NT$ .84. Also, during the second quarter operating margin increased to 27.1% from 22.9% in the first quarter. In addition, capacity utilization increased to 85% due to an increase in demand from 67% in the first quarter.

June 6, 2002: Taiwan Semiconductor Announces Limited Stock Dividend Details for its Common Shares and ADSsThe Company announced a 10% stock dividend for both its TSE-listed Common Shares and for its NYSE- listed American Depositary Shares.

May 7, 2002: Taiwan Semiconductor’s Board of Directors Approves Capital Appropriation for ProjectsThe Board of Directors approved expenditures of NT$ 69,275 million to expand capacity for several of its processes. The board also approved the investment of US$ 20 million in Extreme Ultra Violet LLC, a consortium led by AMD, IBM, Infineon Technologies, Intel, Micron Technologies and Motorola.

April 25, 2002: Taiwan Semiconductor First Quarter Report 2002The Company announced revenues of NT$ 35,790 million and net income of NT$ 6,588 or NT$.39. The company also said that it expects earnings and orders to exceed the levels achieved in he first quarter of 2002.

January 25, 2002: Taiwan Semiconductor Fourth Quarter Report 2001Revenues for the fourth quarter of 2001 reached NT$ 33,130 million and net income was NT$ 4514 million or NT$ .26 per share. For fiscal year 2001, net sales totaled NT$125,888 million and net income totaled NT$ 14,483 million or NT $.83 per share for 2001. Capacity utilization reached 50% in the fourth quarter from 41% in the third. These results slightly exceeded the Company’s own expectations for 2001.

January 3, 2002: Taiwan Semiconductor Named Best Managed Company between 2001 and 2002 by AsiaMoney Magazine Taiwan Semiconductor was named the best-managed company from 1991 to 2001 by AsiaMoney Magazine. It was also ranked number one by fund managers in the same category.

22

October 26, 2001: Taiwan Semiconductor 2001 Third Quarter ReportSales for the third quarter of 2001 reached NT$ 26,940 million and net income totaled NT $1,237 million or NT$ .06 per share.

October 10, 2001: Taiwan Semiconductor Appoints Sheldon Wu to Liaison Office in Mainland ChinaTaiwan Semiconductor has said that the liaison will be responsible for exploring and building relationships with vendors and suppliers on the mainland. July 26, 2001: Taiwan Semiconductor 2001 Second Quarter ReportRevenues for the second quarter reached NT$ 26,298 million and net income totaled NT $312 million or NT$ .01 per share.

23

Appendix D – Service Provided To Customers:

Source: Company’s Year 2001 20F Statement, Filed With US SEC.

24

Appendix E – Country GDP Growth

Taiwan's GDP Growth

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Perc

enta

ge

China's GDP Growth

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Perc

enta

ge

Sources: Mellon Economics.

25

Appendix F – Taiwan Economic Summary

26

Appendix G – China Economic Summary

27

Appendix H – Supplementary Material

Additional Press Releases Analyst Reports