General Electric – Risk & Cost of Capital

Aspects of a deal Risk & Cost of capital Negotiation Strategy Deal Structure Approach Target Identifi- cation Valuation Due Diligence Incorporating risk in valuation is key

GE’s approach to risk - two fold Mitigate – Hedge transactions…currency, commodities – Transactions backed by guarantees…corporate guarantee, LOC, parent guarantee – Back to back agreements – Government approvals…country risk – Deal covenants – GE Management Incorporate – Higher cost of capital – Adjust cash flows

Why is cost of capital important? Objective – Proxy for risk – Reduces value of investment…faster pay back – Should mirror cost of obtaining funds and certainty and timing of recovery Uses – Purchase/ building of industrial facility – Acquisitions/ investments – Long term contracts

Computation of cost of capital Cost of capital is - – WACC or Discount rate – Base rate usually anchored on US Base rate adjusted for risk- – Currency – Industry – Expropriation – Demand – Regulatory risk – Environment reg. Not all risks result in adjustment to cost of capital

Risk and cost of capital People/ Management Financial Environment  No freedom to rationalize people  Trade unions  Cost of severance  Quality of management  Currency exposure  Inflation/ devaluation  Funding  Interest rates  Health and safety issues  Country/ industry environment exposure Cost of capital adjusted unless agreement reached Cash flows adjusted Cost of capital not adjusted Usually hedged..cost of capital not adjusted Cost of capital adjusted more so if local borrowing Cost of capital adjusted Cost of capital & cash flows adjusted Risk Examples Treatment

Risk and cost of capital Country Project/ investment related risks Risk Examples Treatment  Political Instability  Regulatory reforms/ policies  Economic instability  Corruption  Supply interruption  Technology  Market risk – sell-side  Barriers to entry  Force Majure  Weak Exit Strategy  Tax exposure  Possibility of Unscheduled events/ delays Cost of capital adjusted Cost of capital not adjusted unless risk very high Cost of capital adjusted Cost of capital not adjusted Cost of capital adjusted Cost of capital not adjusted unless exposure very high Cost of capital adjusted Cost of capital not adjusted…usually cash flows Cost of capital not adjusted…unless risk quantifiable

Risk & Cost of Capital – Tools and Internal Process

Due Diligence Process Objective – To provide enough information to measure and assess risk in deals and investment – Internal and external parties involved - GE Audit Staff, KPMG Process usually covers the following risks: – People/ Management – Project/ investment related risks – Environment, Health and Safety End result – Information on risks…risks usually quantified – Incorporation of risks and adjustment of cost of capital by Deal team – Process more art than science

Due Diligence Process

Due Diligence Process – EHS web-page

Country risks…GE Capital Risk Management Objective – To provide enough information to measure and assess country risk in deals and investment Process usually covers the following : – Risk assessment by GE’s economists and risk management team – Comments of in-country teams incorporated – Internal analysis verified with external reports End result – Information on country risks…risks usually quantified – Cost of capital adjusted by Deal team – Process highly scientific

Country risks: Web page

Country risks: Sample analysis

Country risk: GE legal web-page

Financial risks…GE Treasury Objective – To provide enough information to measure and assess financial risk in deals and investment – Involvement of corporate and business treasury teams Process usually covers the following : – Risk assessment by GE’s economists and treasurers – Internal analysis verified with external reports – Hedging instruments identified – Optimal capital structure identified End result – Information on currency risks…risks usually hedged – Cost of capital adjusted by Deal team for funding, local borrowing – Process mix of art and science

Currency risks – GE Treasury web-page

Easy way out…. Target Company Information: M&A News: Current Borrowing Cost and WACC: Links to sources of basic information regarding a company Recent GE acquisitions in the news GE’s current borrowing cost and WACC used for modeling acquisitions Companies would centralize information…not to reinvent the wheel

Business case – GE Lighting acquisition of Tungsram

Deal Basics Facts Acquirer: GE Lighting Tungsram Company, Hungary 12 factories, 18K employees Low cost but low quality producer Annual sales: $300MM Deal Structure Huge country risk Cash deal - $ 160MM Reduced exposure by limiting investment to 50% + 1 share DCRR: 19.1% Payback: 8.6 years Strategic consideration Rapid Market share Low cost position Access to new product lines Access to distribution channels Valuation Assumptions 2% growth Cost of Capital – 14% Reduction in overhead costs..10% workforce reduction 20% Hungarian tax Material efficiency..10% over 5 years

Cost of capital - adjustments Overall weighted cost of capital 14%