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and Acquisitions:
Analysis and Valuation
Cross-Border Mergers,
Acquisitions, and Valuation
• Although there are many pieces to the puzzle of
building shareholder value, ultimately it comes
down to growth.
• An increasingly popular route to “going global” in
search of new markets, resources, productive
advantages, and other elements of competition
and profit is through cross-border mergers and
acquisitions.
Cross-Border Mergers,
Acquisitions, and Valuation
• 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.
• An enterprise’s potential value is a combination
of the intended strategic plan and the expected
operational effectiveness to be implemented
post-acquisition.
Globally Integrated Versus
Segmented Capital Markets
• Globally integrated capital markets provide foreigners
with unfettered access to local capital markets and local
residents to foreign capital markets.
• Segmented capital markets
– Exhibit different bond and equity prices in different
geographic areas for identical assets in terms of risk
and maturity.
– Arise when investors are unable to move capital from
one market to another due to capital controls or a
preference for local market investments
Developed Versus Emerging Countries
• Developed countries: Characterized by
– Significant/sustainable per capita GDP growth;
– Globally integrated capital markets;
– Well-defined legal system;
– Transparent financial statements;
– Currency convertibility; and
– Stable government.
• Emerging countries: Characterized by
– A lack of many of the characteristics of developed
countries
Motives for
International Expansion
• Geographic and industrial diversification
• Accelerating growth
• Industry consolidation
• Utilization of lower raw material and labor costs
• Leveraging intangible assets
• Minimizing tax liabilities
• Avoiding entry barriers
• Avoiding fluctuating exchange rates
• Following customers
Common Market Entry Strategies
• Mergers & acquisitions (Offer quick access but often
expensive, complex, and beset by cultural issues)
• Greenfield or solo ventures (May offer above average
returns but total investment is at risk)
• A form of foreign direct investment where a parent company builds its
operations in a foreign country from the ground up. In addition to the construction
of new production facilities, these projects can also include the building of new
distribution hubs, offices and living quarters.
P
Price = EPS x E
time
Source: UNCTAD, World Development Report 2000: Cross-border Mergers and Acquisitions
and Development, figure V.1., p. 154.
Cross-Border Mergers
and Acquisitions
• The drivers of M&A activity are both macro in scope
(the global competitive environment) and micro in
scope (the variety of industry and firm-level forces
and actions driving individual firm value).
• The primary forces of change in the global
competitive environment – technological change,
regulatory change, and capital markets change –
create new business opportunities for MNEs.
Cross-Border Mergers and
Acquisitions
• MNEs undertake cross-border M&A for a variety of reasons.
• The drivers are strategic responses by MNEs to defend and
enhance their global competitiveness by:
– Gaining access to strategic proprietary assets
– Gaining market power and dominance
– Achieving synergies in local/global operations 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
Cross-Border Mergers and Acquisitions
• As opposed to a greenfield investment, a cross-border
acquisition has a number of significant advantages.
– First, it is quicker (shortening the time required to gain a
presence and facilitate competitive entry into the market).
– Second, acquisition may be a cost-effective way of gaining
competitive advantages such as technology, brand names,
and/or logistic/distribution capabilities while eliminating a
local competitor.
– Third, specific to cross-border acquisitions, international
economic, political, and foreign exchange conditions may
result in market imperfections, allowing target firms to be
undervalued.
Cross-Border Mergers and
Acquisitions
• Cross-border acquisitions are not, however, without their
pitfalls.
– There are still problems with paying too much or suffering excessive
financing costs.
– Melding corporate cultures can also be traumatic.
– In addition, management of the post-acquisition process is
extremely difficult to do successfully.
– Internationally, additional difficulties arise from host governments
intervening in pricing, financing, employment guarantees, market
segmentation, and general nationalism and favoritism.
The Cross-Border Acquisition
Strategy
• The process of acquiring an enterprise
anywhere in the world has three common
elements:
– Identification and valuation of the target
– Completion of the ownership change
transaction (the tender)
– Management of the post-acquisition transition
The Cross-Border Acquisition Process
Stage I Stage II Stage III
1 RFCn
n 0
Where:
(LC/FC)n = Forward LC exchange rate n periods into the future
(LC/FC)0 = LC/FC spot rate
RLCn = Interest Rate in Home Country
RFCn = Interest rate in foreign (Host) country
1 RFCn
1FC x ( FC / LC ) n 1FC x
x FC / LC
n
1 RLCn
n 0
Where:
(FC/LC)n = Forward FC exchange rate n periods into the future
(FC/LC)0 = FC/LC spot rate
Interest Rate Parity Theory – Example
USD Vs Euro
$1 x ($/€)n = $1 x {(1 + R$n)n/(1 + R€n)n} x ($/€)0
Where (€/$)n = Forward Euro exchange rate n periods into the future
(€/$)0 = Euro/$ spot rate
Converting Euro-Denominated into Dollar-Denominated
Free Cash Flows to the Firm Using Interest Rate Parity Theory
1 PF n
( FC / LC ) n x x ( FC / LC ) 0
n
1 PL
Where:
(FC/LC)n = Forward FC/LC exchange rate n periods into the future
(FC/LC)0 = Spot FC/LC exchange rate
Purchasing Power Parity Theory – Example
USD Vs Mexican Peso
($/Peso)n = ((1 + Pus)n/(1 + Pmex)n) x ($/Peso)0
Where ($/Peso)n = Forward $/Peso exchange rate n periods into the future
($/Peso)0 = Spot $/Peso exchange rate
Pus = Expected U.S. inflation rate
Pmex = Expected Mexican inflation rate
Where (Peso/$)n = Forward Peso/$ exchange rate n periods into the future
(Peso/$)0 = Spot Peso/$ exchange rate
Converting Peso-Denominated Into Dollar Denominated
Free Cash Flows to the Firm Using Purchasing Power Parity Theory
Notes: Calculating the projected spot rate using Purchasing Power Parity.
($/Peso)2008 = {(1.04)/(1.06)} x .0877 = .0860
($/Peso)2009 = {(1.04)2/(1.06)2} x .0877 = .0844
($/Peso)2010 = {(1.04)3/(1.06)3} x .0877 = .0828
Estimating Cost of Equity for Developed Countries
Developed countries exhibit little differences in cost of equity
because of globally integrated capital markets. Therefore, the Global
CAPM can be written as follows:
ke,dev = Rf + ßdevfirm,global (Rm – Rf) + FSP
Where
ke,dev = Required return on equity for a firm in a developed
country
Rf = Local country’s risk-free rate of return if cash flows in
local currency or U.S. treasury bond rate if in dollars
ßdevfirm,global = Nondiversifiable risk for globally diversified portfolio or
well-diversified portfolio highly correlated with the global
portfolio
(Rm – Rf) = Difference in expected return on global market
portfolio, U.S. equity index, or broadly defined index in
the local country and the Rf
FSP = Premium small firms must earn to attract investors
Estimating Cost of Equity for Emerging Countries
ke,em = Rf + ßemfirm,global (Rcountry – Rf) + FSP + CRP
where
Rf = Local risk free rate or U.S. treasury bond rate converted
to a local nominal rate if cash flows are in the local
currency; if cash flows in dollars, the U.S. treasury
rate
(Rcountry – Rf) = Difference between expected return on a broadly defined
equity index in the local country or in a similar country
and the risk free rate.
ßemfirm,global = Emerging country firm’s global beta
CRP = Specific country risk premium expressed as difference
between the local country’s (or a similar country’s)
government bond rate and the U.S. treasury bond rate of
the same maturity.
FSP = Premium small firms must earn to attract investors
Estimating the Cost of Debt
• For developed countries, the target’s local or the acquirer’s home
country cost of debt.
• For emerging countries, the cost of debt (iemfirm) is as follows:
iemfirm = Rf + CRP + FRP
Where
Rf = Risk free rate (see preceding slide.)
CRP = Specific country risk premium (see preceding slide)
FRP = Firm’s default risk premium (i.e., additional premium for similar
firms rated by credit rating agencies or estimated by comparing
interest coverage ratios used by rating agencies to the firm’s
interest coverage ratios to determine how they would rate the
firm.)
Evaluating Emerging Country Risk
Using Scenario Planning
• Risk may be incorporated into the valuation by
considering alternative economic scenarios for the
emerging country.
• Projected cash flows for alternative scenarios could
reflect different GDP growth rates, inflation rates, interest
rates, foreign exchange rates, or alternative political
conditions.
• If risk is included by calculating a weighted average of
alternative scenarios, the discount rate should not be
adjusted for specific country risk.
Things to Remember…
• Motives for international expansion vary widely.
• There are many alternative strategies to M&A for entering foreign
markets.
• Methodology for valuing cross-border transactions is similar to that
employed when both acquirer and target firms are within the same
country.
• Basic difference between valuing firms within the same country and
those involved in cross-border transactions is that the latter involves
converting the target’s projected cash flows form one currency to
another. Also, the discount rate for firms in emerging nations may be
adjusted for risks not normally found in “within country” transactions.
• For developed countries whose capital markets are globally
integrated, a global beta and a global equity premium should be
used to calculate the cost of equity.
• For emerging nations whose capital markets are segmented, a local
beta and equity premium should be used.
Discussion Questions
1. What are the differences between segmented and globally integrated
capital markets? How do these distinctions affect prices of financial assets
of comparable risk and maturity in various countries?
2. Of the various motives for international expansion, which do you believe is
the most common and why?
3. Do you believe that some market entry strategies are more suitable for
emerging than for developed countries? Explain your answer.
4. Discuss the primary differences between valuing target firms’ cash flows
in developed versus emerging countries. Be specific.
5. Do you agree or disagree with the many adjustments commonly made to
discount rates applied to projected cash flows of target firms in emerging
countries? Be specific.
6. In your opinion is it more appropriate to adjust the discount rate for various
perceived risks or to introduce risk by utilizing alternative scenarios?
Explain your answer.