Multinational Capital Budgeting and Cross-Border Acquisitions Chapter 16 Multinational Capital Budgeting and Cross-Border Acquisitions

Multinational Capital Budgeting and Cross-Border Acquisitions Learning Objectives Extend the domestic capital budgeting analysis to evaluate a Greenfield foreign project Distinguish between the project viewpoint & the parent viewpoint when analyzing a potential foreign investment Adjust the capital budgeting analysis of a foreign project for risk Introduce the use of real option analysis as a complement to DCF analysis Examine the use of project finance to fund and evaluate large global projects Introduce the principles of cross-border mergers and acquisitions

Complexities of Budgeting for a Foreign Project Like domestic capital budgeting, this focuses on the cash inflows and outflows associated with prospective long-term investment projects Capital budgeting follows same framework as domestic budgeting Identify initial capital invested or put at risk Estimate cash inflows, including a terminal value or salvage value of investment Identify appropriate discount rate for PV calculation Apply traditional NPV or IRR analysis

Complexities of Budgeting for a Foreign Project Several factors make budgeting for a foreign project more complex Parent cash flows must be distinguished from project Parent cash flows often depend on the form of financing, thus cannot clearly separate cash flows from financing Additional cash flows from new investment may in part or in whole take away from another subsidiary; thus as stand alone may provide cash flows but overall adds no value to entire organization Parent must recognize remittances from foreign investment because of differing tax systems, legal and political constraints

Complexities of Budgeting for a Foreign Project An array of non-financial payments can generate cash flows to parent in form of licensing fees, royalty payments, etc. Managers must anticipate differing rates of national inflation which can affect differing cash flows Use of segmented national capital markets may create opportunity for financial gain or additional costs Use of host government subsidies complicates capital structure and parent’s ability to determine appropriate WACC Managers must evaluate political risk Terminal value is more difficult to estimate because potential purchasers have widely divergent views

Project versus Parent Valuation Most firms evaluate foreign projects from both parent and project viewpoints The parent’s viewpoint analyses investment’s cash flows as operating cash flows instead of financing due to remittance of royalty or licensing fees and interest payments The parent’s viewpoint gives results closer to traditional NPV capital budgeting analysis Project valuation provides closer approximation of effect on consolidated EPS

Illustration: Cemex Enters Indonesia Cementos Mexicanos (Cemex) is considering construction of plant in Indonesia (Semen Indonesia) as a Greenfield project Cemex is listed on both US and Mexican markets but most of its capital is US dollar denominated so evaluation of project is in US dollars

Exhibit 16.1 A Road-Map to the Construction of Semen Indonesia’s Capital Budget

Illustration: Cemex Goes Abroad Financial assumptions Capital Investment – cost to build plant estimated at $150/tonne but Cemex believes it can build the plant at a cost of $110/tonne Assuming exchange rate of Rp10,000/$ and a 20 year life, cost is estimated at Rp22 trillion With straight line depreciation on equipment values at Rp17.6 trillion costing 1.76 trillion per year

Illustration: Cemex Goes Abroad Financial assumptions Financing – plant would be financed with 50% equity (all from Cemex) and 50% debt Debt is broken down, with Cemex providing 75% and a bank consortium providing the remaining 25% Cemex’s WACC (in US dollars) is 11.98% For the local project (in rupiah) the WACC is 33.257%

Exhibit 16.2 Investment and Financing of the Semen Indonesia Project (all values in 000s unless otherwise noted)

Illustration: Cemex Goes Abroad Financial assumptions Revenues – sales are based on export and the plant will operate at 40% capacity producing 8 million tonnes per year Cement will be sold in export market at $58/tonne Costs – cost per ton is estimated at Rp115,000 in 1999 and rising at the rate of inflation (30%) per year For export costs, loading costs of $2.00/tonne and shipping costs of $10/tonne must also be added

Exhibit 16.3 Semen Indonesia’s Debt Service Schedules and Foreign Exchange Gains/Losses

Exhibit 16.4 Semen Indonesia’s Pro Forma Income Statement (millions of rupiah)

Illustration: Cemex Goes Abroad Project Viewpoint Capital Budget Semen Indonesia’s free cash flows are found by looking at EBITDA and not EBT Taxes are calculated based on this amount Terminal value is calculated for the continuing value of the plant after year 5 TV is calculated as a perpetual net operating cash flow after year 5 457

Exhibit 16.5 Semen Indonesia’s Capital Budget: Project Viewpoint (Millions of Rupiah)

Exhibit 16.6 Semen Indonesia's Remittance of Income to Parent Company (millions of rupiah and US$)

Illustration: Cemex Goes Abroad Parent Viewpoint Capital Budget Now cash flows estimates are constructed from parent’s viewpoint Cemex must now use it’s cost of capital and not the project’s Recall that Cemex’s WACC was 11.98% However, Cemex requires an additional yield of 6% for international projects, thus the discount rate will be 17.98% This yields an NPV of -$925.6 million (IRR –1.84%) which is unacceptable from the parent’s viewpoint

Illustration: Cemex Goes Abroad Sensitivity Analysis: Project Viewpoint Measurement Political risk – biggest risk is blocked funds or expropriation Analysis should build in these scenarios and answer questions such as how, when, how much, etc. Foreign exchange risk Analysis should also consider appreciation or depreciation of the US dollar

Illustration: Cemex Goes Abroad 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 at least two ways; Adjusting the discount rates Adjusting the cash flows

Illustration: Cemex Goes Abroad 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 However, adjusting the discount rate applied to a foreign project’s cash flow to reflect these uncertainties does not penalize NPV in proportion either to the actual amount at risk or to possible variations in the nature of that risk over time

Illustration: Cemex Goes Abroad 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 It is important to remember that the process of forecasting cash flows is extremely subjective – humility is key!

Illustration: Cemex Goes Abroad Shortcomings of each In many cases, 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 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 investor’s perceptions of foreign risk; in these cases diversification is a risk mitigant

Illustration: Cemex Goes Abroad Real Option Analysis DCF analysis cannot capture the value of the strategic options, yet real option analysis allows this valuation Real option analysis includes the valuation of the project with future choices such as The option to defer The option to abandon The option to alter capacity The option to start up or shut down (switching)

Illustration: Cemex Goes Abroad Real Option Analysis 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) The valuation of real options and the variables’ volatilities is similar to equity option math

Cross-Border Mergers and Acquisitions Macro- and Microeconomic factors drive cross-border mergers and acquisitions The drivers of M & A activity are: Gaining access to strategic proprietary assets Gaining market power and dominance Achieving synergies in local/global operations and across different industries Becoming larger, and then reaping the benefits of size in competition and negotiation Diversifying and spreading their risks wider Exploiting financial opportunities they may possess and others desire

Exhibit 16.7 Driving Forces Behind Cross Border M&A

Cross-Border Mergers and Acquisitions M & A vs. Greenfield Investments Advantages: M & A is quicker 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 market imperfections, allowing target firms to be undervalued

Cross-Border Mergers and Acquisitions M & A vs. Greenfield Investments Disadvantages: Paying too much Melding corporate cultures can be traumatic Downsizing to gain economies of scale and scope in overhead functions may have nonporductive impacats on the firm Host government intervention

Cross-Border Mergers and Acquisitions 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) management of the post-acquisition transition

Exhibit 16.8 The Cross-Border Acquisition Process

Cross-Border Mergers and Acquisitions Identification – first the target market followed by the target firm Valuation – DCF analysis Multiples Industry-specific measures

Cross-Border Mergers and Acquisitions Settlement – may be very time-consuming needing approval from management, target ownership, regulatory bodies, and final determination of methods of compensation Friendly takeover Hostile takeover Regulatory bodies in each country may have different and/or requirements Compensation usually via stock and/or cash

Cross-Border Mergers and Acquisitions Post-acquisition management probably the mosst critical step of the M & A process Currency Risks vary with timing of the takeover process and with amount of available information A contingent foreign currency exposure is created with the initial bid, thus hedging is usually part of the process Once the bid is accepted the exposure evolves into a transaction exposure

Exhibit 16.9 Currency Risks in Cross-Border Acquisitions

Summary of Learning Objectives The proposed greenfield investment in Indonesia by Cemex was analyzed within the traditional capital budgeting framework (base case) The foreign complications were introduced to the analysis, including foreign exchange and political risks 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

Summary of Learning Objectives 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 Cash flows from subsidiaries to parent can be generated by an array of nonfinancial payments, including payment of license fees and payments for imports from the parent Differing rates of national inflation must be anticipated because of their importance in causing changes in competitive position, and thus in cash flows over a period of time

Summary of Learning Objectives 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

Summary of Learning Objectives Real option valuation 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

Summary of Learning Objectives 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 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

Summary of Learning Objectives The settlement stage of a cross-border merger or acquisition requires gaining the approval and cooperation of management, shareholders, and eventually regulatory authorities 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