Transcript IFM12 - New York University

International Investing
Prof. Ian Giddy
New York University
International Capital Budgeting
Strategic FDI decision vs. project
appraisal
 NPV, IRR, NTV, APV
 Analyzing the cash flows:

Tax
and repatriation
Subsidies, including low-cost finance
Inflation and exchange rate changes
Whose cash flow?
Blocked funds

Special risks & risk analysis in ICB
Copyright ©1996 Ian H. Giddy
International Investing 2
Foreign Direct Investment
Why FDI? The theories
 Sources of competitive advantage
 Tactical choices

export
vs. foreign production
licensing vs. FDI

Ownership policy
wholly-owned

vs jv
Modes of entry
de
Copyright ©1996 Ian H. Giddy
novo vs. Acquisition
International Investing 3
Nature of FDI
Q: Why?
A: Ownership-specific advantages of the firm
Q: How?
A: Internationalization of markets implies FDI
Q: Where?
A: Location-specific advantages of host
country
Copyright ©1996 Ian H. Giddy
International Investing 4
Conditions for FDI
1. Expected returns exceed the next best
alternative (relative return for risk)
2. Foreign investor has competitive advantage
relative to host country rivals (monopolistic
advantage)
3. FDI more profitable than exporting (locationspecific advantage)
4. FDI more profitable than unaffiliated foreign
production
5. Special advantage of foreign investor exceeds
costs and risks of owning and managing a
foreign operation
Copyright ©1996 Ian H. Giddy
International Investing 5
FDI Theories

Economic/financial




Behavioral



Firm-specific advantage overcomes inherent
disadvantage of operating abroad
Product life cycle
Internalization


Defensive action in oligopolistic market
Monopolistic advantage


Expected return differential
Currency premium
Diversification benefits
Markets vs heirarchies
Eclectic

Mon. Adv., Internalization & location specific advantage
Copyright ©1996 Ian H. Giddy
International Investing 6
A Case: Connor Vila Real
Connor Peripherals is a U.S. manufacturer of
compact, resilient hard drives for laptop and
desktop PC's. Connor sells drives to PC
manufacturers worldwide. Because of certain
incentives and low labor costs, Connor is
considering shifting a substantial proportion of
its production to Vila Real, Portugal.
1. What might be the advantages of
locating production in Portugal?
2. What risks might Connor face?
Base your answer on FDI theory.
Copyright ©1996 Ian H. Giddy
International Investing 7
Connor Vila Real
A. Alternatives?
B. Advantages
 Incentives
 Lower
costs of production
 Portuguese market/EU market
C. Risks
 Quality
control
 On time delivery
 Customer responsiveness & interaction suffer?
 Production disruptions
 Exchange risk
 Political risk
Copyright ©1996 Ian H. Giddy
International Investing 8
Capital Budgeting Proposals
BOARD OF DIRECTORS
GUIDELINES
MANAGEMENT
COMMITTEE
INVESTMENT
ADVISORY
COMMITTEE
TREASURER'S
DEPARTMENT
LOCAL AFFILIATE
Copyright ©1996 Ian H. Giddy
PROJECT
PROPOSAL
International Investing 9
International Capital Budgeting
 The
Capital Budgeting Decision Process
 The Relevant Cash Flows
 Initial
 Operating
 Terminal
 Exchange
and Political Risk Factors
 Capital Budgeting Techniques
 Payback
 NPV
 IRR
 Approaches
Copyright ©1996 Ian H. Giddy
for Dealing with Risk
International Investing 10
International Capital Budgeting And
Long-Term Investments



Direct Foreign Investment (FDI) involves the
transfer of capital, managerial, and technical
assets to a foreign country
Two additional factors must be considered:
Exchange rate fluctuations
Political/jurisdictional risks and barriers
Firms can protect themselves against
exchange rate fluctuations using
debt and/or derivatives
pricing.
Copyright ©1996 Ian H. Giddy
International Investing 11
Hangzhou Power Project
Key elements:
 Cash flow analysis
 Understanding risks
and returns of the
financing techniques
 Valuation
INVESTORS
INTERMEDIARIES
SPONSORS
Copyright ©1996 Ian H. Giddy
International Investing 12
Hanel: Net Income
Net Revenues, 000 RMB
(Baseline assumptions)
40000
35000
30000
25000
20000
15000
10000
5000
0
-5000
1
Copyright ©1996 Ian H. Giddy
2
3
4
5
6
7
8
9
10
11 12
13
14 15
16 17
18
19 20
International Investing 13
The Relevant Cash Flows



Relevant Cash Flows include:
The incremental after-tax cash outflow
(investment) for the project
The resulting subsequent cash inflows
associated with the project
Incremental Cash Flows are the additional cash
flows directly attributable to the proposed project
Can be expressed in host currency, then result
translated into home currency
Copyright ©1996 Ian H. Giddy
International Investing 14
Cash Flow Components
Terminal Cash Flow
$25,000
Operating Cash Flows
$4,000 $5,000 $6,000 $7,000 $7,000 $8,000 $8,000 $8,000 $9,000 $10,000
0
1
2
3
4
5
6
7
8
9
10
Time (Years)
$50,000
Copyright ©1996 Ian H. Giddy
Initial Investment
International Investing 15
Finding the Initial Investment

The initial investment
Initial
investment is determined by
subtracting all cash inflows occurring at time
zero from all the cash outflows occurring at
time zero

Installed cost of new asset
Outflows
to be considered include:
 Cost of the new asset
 Installation costs
Copyright ©1996 Ian H. Giddy
International Investing 16
Finding the Operating Cash Inflows
The income statement format for calculating
operating cash inflows is:
-
Revenue
Expenses (Excluding Depreciation)
=
-
Profits Before Depreciation and Taxes
Depreciation
=
-
Net Profits Before Taxes
Taxes
=
+
Net Profits After Taxes
Depreciation
=
Operating Cash Inflows
Copyright ©1996 Ian H. Giddy
International Investing 17
Finding the Terminal Cash Flow
The Terminal Cash Flow is an after-tax
cash flow from the termination and
liquidation of a project at the end of its
expected useful life
 To lend closure to the analysis, the firm
must end up where it started, i.e. without
the asset.

Copyright ©1996 Ian H. Giddy
International Investing 18
Hanel: Cash Flow from Operations
Net Operating Cash Flows, 000 RMB
(Baseline assumptions)
40000
35000
30000
25000
20000
15000
10000
5000
0
1
Copyright ©1996 Ian H. Giddy
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21
International Investing 19
Interpreting the Cash Flows: NPV
CFt
(1 + k)t - II
i=1
n
NPV =
= Present Value of Cash Inflows - Initial
Investment
Copyright ©1996 Ian H. Giddy
International Investing 20
IRR is calculated by solving:

t=1
n
CFt
(1 + IRR)t
= II
PV of Cash Inflows = Initial Investment
Copyright ©1996 Ian H. Giddy
International Investing 22
Adjusted Present Value in International
Capital Budgeting
APV =
- Initial costs
+ Present value of operating cash flows
+ Present value of tax shield
+ Present value of financing subsidies
What rate should be used to discount cash
flows in APV?
Copyright ©1996 Ian H. Giddy
International Investing 23
Inflation and Devaluation

Currency treatment of cash flows?
REAL
NOMINAL
DOMESTIC
FOREIGN

Also: Evaluate local or only repatriated
cash flows?
Copyright ©1996 Ian H. Giddy
International Investing 24
Blocked Funds
Local cash flows
Repatriated cash flows
Copyright ©1996 Ian H. Giddy
Projected cash flows,
reinvested at local
rate of return
International Investing 25
Imperial Power Spain
1. Domestic sales volume & foreign sales volume (from
price changes & elasticities)
2. X projected prices = peseta revenues
3. From units sold get variable costs
4. Other costs; taxable income; income & withholding
taxes
5. Project cash flows, incl. Depr., W.C., T.V., int. after tax
6. Dollars
7. Royalties
8. U.S. Taxes
9. Discount to present at 16%
10.Discuss assumptions
Copyright ©1996 Ian H. Giddy
International Investing 26
Imperial Power Spain
TABLE 1
TOTAL SALES VOLUME AND REVENUE
1979
Domestic Sales
1. Units budgeted to be sold
2. Unit sales price (15% p.a. increase)
3. Domestic sales revenue (Ptas 000)
Export Sales
4. Pta. unit price in Spain (line 2)
5. Forecast Exchange rate, Pta./FF
6. Unit price in French francs
7. Change in franc price over prior year
8. Less allowable 5% annual inflation
9. Relative price change over prior year1
10. Resulting volume change (times -1.5)
11. Prior year sales volume
12. Increase for 10% growth
13. Volume before price effect
14. Times elasticity factor (line 10)2
15. Units budgeted to be sold
16. Times unit price (in pesetas)
17. Export sales revenue (Ptas. 000)
Calculation of Sales Volume
18. Domestic Volume (line 1)
19. Export Volume (line 15)
20. Total Unit Volume
Copyright ©1996 Ian H. Giddy
1980
50000
60000
x 1,300
x 1,495
65000
89700
1300
16.67
77.98
1495
17.5
85.43
9.55%
-5.00%
4.55%
-6.82%
150000
15000
165000
x 0.9318
150000
153747
x 1,300
x 1,495
195000
229852
50000
150000
200000
60000
153747
213747
International Investing 27
Cost Calculations
EXHIBIT 2
COST CALCULATIONS
1979
1980
Calculation of per-unit cost of imported material
(Note: 20% of Ptas. 840 = Ptas. 168
21.
22.
23.
24.
25.
Original dollar unit cost (Ptas. 168/70)
Adjusted to U.S. inflation rate (times 1.05n)
Inflated dollar unit cost
Exchange rate (year begin)
Peseta unit cost of imported material
$2.40
$2.40
x 1.0000
x 1.0500
2.4
2.52
70
70
168
176.4
Calculation of peseta interest expense
26. Dollar interest paid (10% x $600,000)
27. Exchange rate (year end)
28. Peseta interest expense (000)
$60,000
70
4200
$60,000
85
5100
$30,000
70
2100
$30,000
85
2550
Calculation of peseta royalty expense
29. Dollar royalties paid
30. Exchange rate (year end)
31. Peseta royalty expense (000)
Copyright ©1996 Ian H. Giddy
International Investing 28
Pro-Forma Income Statement
TABLE 3
PRO-FORMA INCOME STATEMENTS (Pta 000)
Revenue from Sales
32. Domestic sales revenue (line 3)
33. Export sales revenue (line 17)
34. Total revenue
Expenses
35. Import material/unit (line 25)
36. Domestic material/unit (840)(0.4)(1.15)n
37. Labor/unit (840)(0.4)(1.15)n
38. Total unit variable costs
39. Times unit sales volume (line 20)
40.
41.
42.
43.
44.
45.
Total variable costs (Ptas 000)
Manufacturing overhead (x 1.15n)
Depreciation (10% of cost)
Interest (line 28)
Royalties (line 31)
Total expenses
Profit & Dividend Calculation
46. Net income before tax
47. Less 30% income tax
48. Net income after tax
49. Less 10% dividend tax
50. Dividend paid to IPC (US)
Dollar equivalents on above
51. Year-end exchange rate
52. Net income before income tax ($)
53. Income & Dividend taxes paid
54. Dividend paid to IPC (US)
Copyright ©1996 Ian H. Giddy
1979
1980
65000
195000
260000
89700
229852
319552
168
176.4
336
386.4
336
386.4
840
949.2
x 200,000 x 213,747
168000
75000
7000
4200
2100
256300
202889
86250
7000
5100
2550
303789
3700
1110
2590
259
2331
15763
4729
11034
1103
9931
70
52857
19557
33300
85
185447
68612
116835
International Investing 29
Project Cash Flow Analysis
TABLE 4
PROJECT CASH FLOW S (Pta 000)
1978
Cash Inflows
55. Net income after tax (line 48)
56. Depreciation (line 42)
57. Interest after tax (line 28 x 0.7)
58. Recapture of working capital3
59. Net terminal value4
60. Total cash inflow
Cash Outflows
61. Net working capital
62. Equipment
63. Total outflows
Cash Flow Analysis
64. Net cash flows
65. 16% present value factor
66. Present value of each cash flow
67. Cumulative net present value
------
1979
1980
2590
7000
2940
11034
7000
3570
--
---
-12530
77000 -70000 -147000 --
-147000
1
-147000
-147000
21604
----
12530
0.8621
10802
-136198
21604
0.7432
16056
-120142
68. Approximate internal rate
of return = 46%
Copyright ©1996 Ian H. Giddy
International Investing 30
Parent Cash Flow Analysis
TABLE 5
PARENT CASH FLOW ANALYSIS (US$)
1978
Cash Inflows
69. Dividends from IPC-Spain (line 54)
70. Royalty receipts from IPC-Spain (line 29)
71. Net terminal value5
72. Total cash inflow
Cash Outflows
73. Parent equity investment
74. Pre-tax income, IPC-Spain (line 52)
75. U.S. taxes at 50%
76. Less credit for Spanish taxes (line 53)
77. U.S. taxes payable on dividend income
78. U.S. taxes payable on royalty income
79. Total outflow
Cash Flow Analysis
80. Net cash flow
81. 16% value factor
82. Present value of each cash flow
83. Cumulative net present value
-----
1979
1980
33300
30000
-63300
116835
30000
-146835
1500000 -------
--
1500000
52857
26428
19557
6871
15000
21871
185447
92723
68612
24111
15000
39111
-1500000
1
-1500000
-1500000
41429
0.8621
35716
-1464284
107724
0.7432
80060
-1384224
84. Approx. internal rate of return =27%
Copyright ©1996 Ian H. Giddy
International Investing 31
Adjusting for Risk
Scenario, sensitivity and simulation
 Certainty equivalent
 Adjusting the discount rate
 Risk and the CAPM

Copyright ©1996 Ian H. Giddy
International Investing 34
Sensitivity and
Scenario Analysis
An approach that attempts to capture the variability
of cash inflows and NPV's
Sensitivity Analysis uses a number of possible
values for a given variable to assess its impact on
return, as measured by NPV
Scenario Analysis is similar to sensitivity analysis
but allows for simultaneous changes in a number
of variables
Copyright ©1996 Ian H. Giddy
International Investing 36
Simulation



Simulation is a statistically-based approach
using probability distributions and random
numbers to estimate risky outcomes
Use computer to simulate virtually every inflow
and outflow variable and determine the resulting
NPV's
After a thousand or so simulations the decision
maker has a good idea of not only the expected
value of the return on a project, but also the
dispersion: the probability of achieving a given
return.
Copyright ©1996 Ian H. Giddy
International Investing 37
Risk Adjustment Techniques
Certainty Equivalents (CE's) adjust cash inflows to determine
the percentage of estimated inflows that investors would
be satisfied to receive for certain in exchange for those
that are possible each year
NPV when CE's are used is calculated as:
 t x CFt
n
NPV =

= -II
(1 + RF)t
= Certainty Equivalent factor in year t (0 < t < 1)
= Relevant cash inflow in year t
= Risk-free rate of return
t =1
t
CFt
RF
Copyright ©1996 Ian H. Giddy
International Investing 39
Risk-Adjustment Techniques
Risk-Adjusted Discount Rates (RADR's) adjust for
risk by changing the discount rate -- raising it for
higher risk and lowering it for lower risk
RADR's are calculated as
n
NPV =

t =1

CFt
(1 + RADR)t
- II
The use of RADRs is closely linked to the capital
asset pricing model (CAPM)
Copyright ©1996 Ian H. Giddy
International Investing 42
RADR and CAPM
Recall that
total risk = nondiversifiable risk + diversifiable risk
Beta is a measure of nondiversifiable risk and
kj = RF + j (km-R F)
(CAPM)
If we assume that real corporate assets are traded in efficient
markets, CAPM can be modified as follows:
kProject j = RF + j Project (km-RF)
where:
j Project is the relationship between the project's expected
return and the market's expected return
Copyright ©1996 Ian H. Giddy
International Investing 43
RADR and CAPM
k
SML
Accept
Reject
km
RF
0
Copyright ©1996 Ian H. Giddy
1.0
Beta
International Investing 44
Portfolio Effects
The value of the firm is generally not
affected by diversification
 The market for real corporate assets is
inefficient, therefore total risk is most
relevant

Copyright ©1996 Ian H. Giddy
International Investing 47
Risk-Adjusted Investment Cutoff Rates
COUNTRY
ARGENTINA
AUSTRALIA
BELGIUM
BRAZIL
CANADA
FRANCE
GERMANY
GREECE
INDIA
INDONESIA
ITALY
JAPAN
MALAYSIA
MEXICO
Copyright ©1996 Ian H. Giddy
CUTOFF RATE
17%
10
10
14
10
12
10
17
20
17
14
14
12
17
COUNTRY
CUTOFF RATE
NETHERLANDS
10
NEW ZEALAND
10
NIGERIA
20
PHILIPPINES
17
PORTUGAL
14
PUERTO RICO
12
SINGAPORE
12
SOUTH AFRICA
12
SOUTH KOREA
20
SPAIN
14
TAIWAN
17
THAILAND
20
UNITED KINGDOM 12
UNITED STATES 10
VENEZUELA
17
International Investing 50
Government Subsidized Financing
i = normal cost of debt
i* = subsidized cost
 Then subsidy equals F(i-i*), where f is the
amount of debt subsidized.
 A. Adjusting project's cost of capital
 B. Adjusting project net cash flows
Which is correct? Depends on reinvestment
assumption.
Copyright ©1996 Ian H. Giddy
International Investing 51
Financing Decisions
 Capital
Structure
 Firm Financing Needs
 Short Term Debt
 Long Term Debt
 Equity
 Hybrid Securities
Copyright ©1996 Ian H. Giddy
International Investing 52
Financing Choices
SHORT
TERM
COMMERCIAL
PAPER
DEBT
THE
FIRM
BANK LOANS
REVOLVERS,
EUROCREDITS
LONG
TERM
TERM LOANS
BONDS
EQUITY
COMMON
HYBRIDS
CONVERTS
Copyright ©1996 Ian H. Giddy
RIGHTS
LEASING
PREFERRED STOCK
WARRANTS
International Investing 53
Bond Credit Risk
Standard &
Moody’s Poor’s
Interpretation
Aaa
Aa
AAA
AA
High-quality debt instruments
A
Baa
A
BBB
Strong to adequate ability to
pay principal and interest
Ba
B
Caa
Ca
C
BB
B
CCC
CC
C
D
Ability to pay interest and
principal speculative
Copyright ©1996 Ian H. Giddy
In default
International Investing 54
Valuation of Common Stock
Book Value Per Share
 Liquidation Value Per Share
 Price/Earnings (P/E) Multiples
 Capital Asset Pricing Model (expected
return and nondiversifiable risk)
 Risk-Adjusted Net Present Value

Copyright ©1996 Ian H. Giddy
International Investing 55
Financing Choices
SHORT
TERM
COMMERCIAL
PAPER
DEBT
THE
FIRM
BANK LOANS
REVOLVERS,
EUROCREDITS
LONG
TERM
TERM LOANS
BONDS
EQUITY
COMMON
HYBRIDS
CONVERTS
Copyright ©1996 Ian H. Giddy
RIGHTS
LEASING
PREFERRED STOCK
WARRANTS
International Investing 56
Mergers and Acquisitions
 Mergers
 Acquisitions
 Divestitures
Concept: Is a division or firm worth more
within the company, or outside it?
Copyright ©1996 Ian H. Giddy
International Investing 62
Corporate Finance
CORPORATE FINANCE
DECISONS
INVESTMENT
FINANCING
PORTFOLIO
RISK MGT
MEASUREMENT
CAPITAL
DEBT
M&A
Copyright ©1996 Ian H. Giddy
EQUITY
TOOLS
International Investing 63
The Market for Corporate Control




M&A&D situations often arise from conflicts:
Owner vs manager ("agency problems"
Build vs buy ("internalization")
Agency problems arise when owners' interests and
managers' interests diverge. Resolving agency
problems requires





Monitoring & intervention, or
Setting incentives, or
Constraining, as in bond covenants
Resolving principal-agent conflicts is costly
Hence market price may differ from potential value of a
corporation
Copyright ©1996 Ian H. Giddy
International Investing 64
“Internalization”: Is an activity best
done within the company, or outside it?
Issue: why are certain economic activities
conducted within firms rather than between
firms?
 As a rule, it is more costly to build than to buy—
markets make better decisions than
bureaucrats
 Hence there must be some good reason, some
synergy, that makes an activity better if done
within a firm
 Eg: the production of proprietary information
 Often, these synergies are illusory
Copyright ©1996 Ian H. Giddy
International Investing 65
Goals of Acquisitions
Rationale: Firm A should merge with Firm B if
[Value of AB > Value of A + Value of B + Cost
of transaction]
 Synergy
 Gain market power
 Discipline
 Taxes
 Financing
Copyright ©1996 Ian H. Giddy
International Investing 66
Do Acquisitions Benefit Shareholders?
Successful Bids
Technique
Target
Bidders
Tender offer
Merger
Proxy contest
30%
20%
8%
4%
0
na

Note: Abnormal price changes are price changes adjusted to
eliminate the effects of marketwide price changes
Copyright ©1996 Ian H. Giddy
International Investing 67
Do Acquisitions Benefit Shareholders?
Unsuccessful Bids
Technique
Target
Bidders
Tender offer
Merger
Proxy contest
-3%
-3%
8%
-1%
-5%
na
Copyright ©1996 Ian H. Giddy
International Investing 68
Goal of Acquisitions and Mergers
 Increase
size - easy!
 Increase market value - much
harder!
Copyright ©1996 Ian H. Giddy
International Investing 69
Fallacies of Acquisitions
Size (shareholders would rather have
their money back, eg Credit Lyonnais)
 Downstream/upstream integration
(internal transfer at nonmarket prices, eg
Dow/Conoco, Aramco/Texaco)
 Diversification into unrelated industries
(Kodak/Sterling Drug)

Copyright ©1996 Ian H. Giddy
International Investing 70
Success Rates For Cross-Border
Mergers And Acquisitions
100%=28
Success
43%
Failure
57%
Copyright ©1996 Ian H. Giddy
International Investing 71
Success Rates For Cross-Border
Alliances
100%=45
Undecided
18%
Success
55%
Failure
27%
Copyright ©1996 Ian H. Giddy
International Investing 72
What's It Worth?
Valuation Methods
 Book value approach
 Market value approach
 Ratios (like P/E ratio)
 Break-up value
 Cash flow value
Copyright ©1996 Ian H. Giddy
International Investing 73
How Much Should We Pay?
Applying the discounted cash flow
approach, we need to know:
1.The incremental cash flows to be
generated from the acquisition, adjusted
for debt servicing and taxes
2.The rate at which to discount the cash
flows (required rate of return)
3.The deadweight costs of making the
acquisition (investment banks' fees, etc)
Copyright ©1996 Ian H. Giddy
International Investing 74
Framework for evaluating the value of
an Acquisition
Standalone
value of
acquirer
(premerger)
Standalone
value of
target
(without
any
takeover
premium)
Value of Transaction Combined
Synergies
Costs
Value
Value of
acquirer if
it does not
acquire
target
Value of
target
to acquirer
Price paid
including
premium
Net
value
gained
from
acquisition
Adapted from: W. Pursche, “Building Better Bids: Synergies and Acquisition \prices”, Chief Financial Officcer USA (1988):63-64
Copyright ©1996 Ian H. Giddy
International Investing 75
Framework For Assessing
Restructuring Opportunities
Current
perceptions
gap
Current
Market
Value
1
Maximum
restructuring
opportunity
Company
value as is 2
Strategic
and operating
opportunities
5
Restructuring
Framework
Potential
value with
internal
improvements
Copyright ©1996 Ian H. Giddy
Financial
engineering
opportunities
4
3
Disposal/
Acquisition
opportunities
Optimal
restructured
value
Potential
value with
internal
and external
improvements
International Investing 76
Using The Restructuring Framework
$ Millions of Value
$1,000
$ 25
$ 975
$ 350
Current
perceptions
gap
Company
value as is
Current
Market
Value
1
2
Maximum
restructuring
opportunity
5
Restructuring
Framework
Strategic
and operating
opportunities
$ 725
$ 1,725
Optimal
restructured
value
Financial
engineering
opportunities
$ 100
Increase D/E
4
3
Potential
value with
internal
improvements
Disposal/
Acquisition
opportunities
$ 1,325
Potential
value with
internal
and external
improvements
$ 1,625
$ 300
Copyright ©1996 Ian H. Giddy
International Investing 77
The Cost of Capital
Required rate of return on equity, RE, may
be computed from the Capital Asset
Pricing Model (CAPM):
RE = RF + Beta (RM - RF)
where RF = risk-free rate
Beta= nondiversifiable risk factor, and
RM = return on the market.
In short, the discount factor should reflect
the riskiness of the acquisition.
Copyright ©1996 Ian H. Giddy
International Investing 78
Application


Fakawi Navigation plans to acquire Feng-Shui
Compass Co. This would result in $25 million of
incremental operating revenues in each of the first 5
years, and in $15 million of additional debt servicing
costs per annum, as well as $5 million in tax shields.
Fakawi expects to divest the target in year 6 for $100
million. The Treasury note rate is 6%, and the S&P
return is 16%. Fakawi's advisors estimate that FengShui has a beta of 1.3. For this advice they are
charging 2% of the acquisition price.
What is the maximum price that Fakawi should offer for
Feng-Shui?
Copyright ©1996 Ian H. Giddy
International Investing 79
Reasons Why Many Acquisitions Fail
To Generate Value
Value
Destruction
Deal price not based on
cash flow value
Copyright ©1996 Ian H. Giddy
International Investing 80
Reasons Why Many Acquisitions Fail
To Generate Value
Over
optimistic
market
assessments
Value
Destruction
Deal price not based on
cash flow value
Copyright ©1996 Ian H. Giddy
International Investing 81
Reasons Why Many Acquisitions Fail
To Generate Value
Overestimating
synergies
Over
optimistic
market
assessments
Value
Destruction
Deal price not based on
cash flow value
Copyright ©1996 Ian H. Giddy
International Investing 82
Reasons Why Many Acquisitions Fail
To Generate Value
Overestimating
synergies
Over
optimistic
market
assessments
Value
Destruction
Poor
post-merger
integration
Deal price not based on
cash flow value
Copyright ©1996 Ian H. Giddy
International Investing 83
Typical Losing Pattern For Mergers






Candidates are screened on basis of
industry and company growth and
returns
One or two candidates are rejected on
basis of objective DCF analysis
Frustration sets in; pressures build to do
a deal; DCF analysis is tainted by
unrealistic expectations of synergies
Deal is consummated at large premium
Postacquisition experience reveals
expected synergies are illusory
Company’s returns are reduced and
stock price falls
Copyright ©1996 Ian H. Giddy
International Investing 84
Divestitures
Divestiture: the sale of a segment of a company to a
third party
 Spin-offs—a pro-rata distribution by a company of all
its shares in a subsidiary to all its own shareholders
 Equity carve-outs—some of a subsidiary' shares are
offered for sale to the general public
 Split-offs—some, but not all, parent-company
shareholders receive the subsidiary's shares in return
for which they must relinquish their shares in the
parent company
 Split-ups—all of the parent company's subsidiaries
are spun off and the parent company ceases to exist.
Copyright ©1996 Ian H. Giddy
International Investing 85
Divestitures Add Value
Shareholders of the selling firm seem to
gain, depending on the fraction sold:
 Total value created by divestititures
between 1981 and 1986 = $27.6 billion.

% of the firm sold
0-10%
10-50%
50%+
Copyright ©1996 Ian H. Giddy
Announcement effect
0
+2.5%
+8%
International Investing 86
Strategic Alliances:
An Alternative to Acquisition




"A strategic alliance is a collaborative agreement
between two or more companies, which contribute
resources to a common endeavor of potentially
important competitive consequences, while
maintaining their individuality."
Example with internal emphasis: Sunkyong with GTE,
Vodaphone & Hutchinson Whampoa for cellular
system
Example with external emphasis: Santander with
Royal Bank of Scotland for European market in
financial services
Driving forces:


Complementary resources - gain strategic resources
Similar capabilities - gain economies or market power
Copyright ©1996 Ian H. Giddy
International Investing 87
Forms of Strategic Alliance

Many linkages are options for future
development of relationships
POTENTIAL
FOR CONTROL
ACQUISITION
MERGER
WITH FULL
INTEGRATION
JOINT
VENTURE
JOINT
PROJECTS
INFORMAL
ALLIANCE
SPECIFIC
DISTRIBUTION
OR SUPPLY
AGREEMENT
IRREVERSIBILITY OF COMMITMENT
Copyright ©1996 Ian H. Giddy
International Investing 88
Pitfalls and Problems
Linkage may not offer access to partner's
resources (JP Morgan-Espirito Santo)
 Disagreement on contribution (Euroclear-Cedel)
 Partners competing in one another's market
(Credit Lyonnias-Commerzbank)
 Linkage may exclude other options for expansion
into a product or market
 Clash of cultures; cross-purpose marketing (Credit
Suisse-First Boston)
Key predictor of stability is asset specificity and
irreversibility of commitment.

Copyright ©1996 Ian H. Giddy
International Investing 89
Geographic Overlap Helps Mergers
And Acquisitions...
6
Failure for
acquirer
92
94
Success for
acquirer
8
Minimal
geographic
overlap (sample
of 12)
Copyright ©1996 Ian H. Giddy
Moderate or
high geographic
overlap (sample
of 16)
International Investing 90
...But It Hinders Alliances
Failure for
both
partners
24
Mixed
Results
14
Success
for both
partners
37
38
62
25
Minimal
geographic
overlap
(sample of 37)
Copyright ©1996 Ian H. Giddy
Moderate or
high
geographic
overlap
International Investing 91
Mergers and Acquisitions: Summary
 Mergers
& Acquisitions
 Divestitures
 Strategic Alliances
Concept: Is a business worth more
within our company, or outside it?
Copyright ©1996 Ian H. Giddy
International Investing 92