Cº - Imba International Finance (E) Part 4 Lecture

Bremen
London
 IMBA
   
Marseille
International Master of Business Administration
Moscow
Valencia
Core Module
INTERNATIONAL FINANCE
Part 4 International Investing

AGENDA
Part 1 Global Economics
Part 2 International Accounting
Part 3 Corporate Governance
Part 5 International Financing
Part 6 Global Value Creating Management
Part 7 Current Topics
I MBA
 
2
IMBA International Finance (E) Part 4 Lecture Part 4 International Investing
AGENDA
Chapter 4.1 Foreign Direct Investment Theory & Strategy
Chapter 4.2 Adjusting for Risk in Foreign Investment
Chapter 4.3 Cross-Border Mergers, Acquisitions & Valuation
Chapter 4.4 International Portfolio Theory & Diversification
I MBA
 
3
THE THEORY OF COMPETITIVE ADVANTAGE
The theory of competitive advantage provides a basis
for explaining and justifying international trade in a
model assumed to enjoy free trade, perfect
competition, no uncertainty, costless information and
no government interference
The features of the theory are as follows
• Country A exports goods to unrelated importer in
Country B
• Country A specializes in certain products given
their natural resources
• Country B does the same with different products
I MBA
 
4
THE THEORY OF COMPETITIVE ADVANTAGE
• Because the factors of production cannot be
transported, the benefits of specialization are
realized through international trade
• The terms of trade, the ratio at which quantities
of goods are exchanged, shows the benefits of
excess production
Of course, this is only a theory in today’s world.
No one country specializes in only one product and
the assumptions of the model do not exist in reality
I MBA
 
5
MARKET IMPERFECTIONS:
A RATIONALE FOR THE MNE
MNEs strive to take advantage of imperfections in

national markets
These imperfections for products translate into
market opportunities such as economies of scale,
managerial or technological expertise, financial
strength and product differentiation
I MBA
 
6
MARKET IMPERFECTIONS:
A RATIONALE FOR THE MNE
Firms become multinational for one or several of the following
reasons
• Market seekers: produce in foreign markets either to satisfy
local demand or export to markets other than their own
• Raw material seekers: search for cheaper or more raw
materials outside their own market
• Production efficiency seekers: produce in countries where one
or more of the factors of production are cheaper
• Knowledge seekers: gain access to new technologies or
managerial expertise
• Political safety seekers: establish operations in countries
considered unlikely to expropriate or interfere with private
enterprise
I MBA
 
7
SUSTAINING & TRANSFERRING
COMPETITIVE ADVANTAGE
In order to sustain a competitive advantage it must be

• Firm-specific
• Transferable
• Powerful enough to compensate the firm for the
extra difficulties of operating abroad
I MBA
 
8
SUSTAINING & TRANSFERRING
Some of the competitive advantages enjoyed by MNEs
are
• Economies of scale and scope
• Managerial and marketing expertise
• Advanced technology
• Financial strength
• Differentiated products
• Competitiveness of the their home market
I MBA
 
9
PORTER’S DIAMOND OF NATIONAL
Factor Conditions
Firm strategy, Demand conditions

structure, & rivalry
Related & supporting industries
I MBA
 
10
THE OLI PARADIGM & INTERNATIONALIZATION
The OLI Paradigm (Buckley & Casson, 1976; Dunning

1977) is an attempt to create an overall framework to
explain why MNEs choose FDI rather than serve
foreign markets through alternative modes such as
licensing, joint ventures, strategic alliances,
management contracts and exporting
1. The paradigm states that a firm must first have
some competitive advantage in its home market - “O”
or owner-specific – which can be transferred abroad
I MBA
 
11
2. The firm must also be attracted by specific

characteristics of the foreign market – “L” or location
specific – which will allow the firm to exploit its
competitive advantages in that market
3. The firm will maintain its competitive position by
attempting to control the entire value-chain in its
industry – “I” or internalization
This leads to FDI rather than licensing or outsourcing
I MBA
 
12
Financial strategies are directly related to the OLI

Paradigm in explaining FDI
Strategies can be proactive, controlled in advance by
the management team
Strategies can also be reactive, depend on
discovering market imperfections
I MBA
 
13
I MBA
 
14
WHERE TO INVEST
Two related behavioral theories behind FDI that are
most popular are
• Behavioral approach to FDI
• International network theory
Behavioral Approach – Observation that firms tended
to invest first in countries that were not too far from
their country in psychic terms
• This included cultural, legal, and institutional
environments similar to their own
I MBA
 
15
WHERE TO INVEST
International network theory – As MNEs grow they
eventually become a network, or nodes that operate
either in a centralized hierarchy or a decentralized one
• Each subsidiary competes for funds from the
parent
• It is also a member of an international network
based on its industry
• The firm becomes a transnational firm, one that
is owned by a coalition of investors located in
different countries
I MBA
 
16
HOW TO INVEST ABROAD: MODES OF FDI
Exporting vs. production abroad
• Advantages of exporting are
- None of the unique risks facing FDI, joint
ventures, strategic alliances and licensing
- Political risks are minimal
- Agency costs and evaluating foreign units are
avoided
• Disadvantages are
- Firm is not able to internalize and exploit its
advantages
- Risks losing market to imitators and global
competitors
IMBA International Finance (E) Part 4 Lecture
I MBA
 
Part 4 International Investing 17
Licensing/management contracts versus control of
assets abroad
•Licensing is a popular method for domestic firms to
profit from foreign markets without the need to commit
sizable funds
•Disadvantages of licensing are
- License fees are likely lower than FDI profits
although ROI may be higher
- Possible loss of quality control
- Establishment of potential competitor
- Possible improvement of technology by local license
which then enters firm’s original home market
I MBA
 
18
- Possible loss of opportunity to enter
licensee’s market with FDI later
- Risk that technology will be stolen
- High agency costs
• Management contracts are similar to licensing
insofar as they provide for some cash flow from
foreign source without significant investment or
exposure
• These contracts lessen political risk because
the repatriation of managers is easy
I MBA
 
19
Joint ventures versus wholly owned subsidiary

• A joint venture is a shared ownership in a foreign
business
• This is a viable strategy if the MNE finds the right
local partner
• Some advantages include
- The local partner understands the market
- The local partner can provide competent
management at all levels
- Some host countries require that foreign firms
share ownership with local partner
I MBA
 
20

• Advantages of joint ventures
- The local partner’s contacts & reputation
enhance access to host country’s capital
markets
- The local partner may possess technology
that is appropriate for the local environment
- The public image of a firm that is partially
locally owned may improve its position
I MBA
 
21
Disadvantages of joint ventures
- Political risk is increased if wrong partner is
chosen
- Local and foreign partners have divergent views
on strategy and financing issues
- Transfer pricing creates potential for conflict of
interest
- Financial disclosure between local partner & firm
- Ability of a firm to rationalize production on a
worldwide basis if that would put local partner at
disadvantage
- Valuation of equity shares is difficult
I MBA
 
22
Greenfield investment versus acquisition
• A greenfield investment is establishing a facility
“starting from the ground up”
- Usually require extended periods of physical
construction and organizational development
• Here, a cross-border acquisition may be better
because the physical assets already exist, shorter
time frame and financing exposure
- However, problems with integration, paying too
much for acquisition, post-merger management,
and realization of synergies all exist
I MBA
 
23
Strategic alliances can take several different forms
• First is an exchange of ownership between
two firms
• It can be a defensive strategy against a
takeover
• In addition to exchanging shares, a separate
joint venture can be developed
• Another level of cooperation may be a joint
marketing or servicing agreement
I MBA
 
24
Trident and its
Competitive Advantage Greater Foreign Presence
Change Exploit Existing Competitive

Competitive Advantage Advantage Abroad
Production at Home:
Production Abroad
Exporting
Licensing Control Assets

Management Contract Abroad
Greater
Wholly-Owned
Foreign Joint Venture
Subsidiary
Investment
Greenfield Acquisition of a
Investment Foreign Enterprise
I MBA
 
25
AGENDA
I MBA
 
26
DEFINING RISK
Risks associated with foreign investments are
inherently subjective or qualitative and not
quantitative
Distinguishing risk as either one-sided or two-sided
is one way of applying qualitative and quantitative
measures of risk
One-sided risk only emphasizes the potential for loss
• These risks are typically expropriation risk,
blocked funds, etc.
I MBA
 
27
DEFINING RISK
Two-sided risk carries both loss and gain

• A typical two-sided risk is foreign exchange risk
Risk measurement draws upon two distinct sets

• Measures of risk from the market
• Measures of risk from institutions
I MBA
 
28
DEFINING FOREIGN INVESTMENT RISKS
In order for an MNE to identify, measure, and

manage its foreign investment risk it is useful to
define these risks as being
• Firm-specific
• Country-specific
• Global-specific
I MBA
 
29
Firm-specific are those risks that affect the MNE at
the project or corporate level (e.g. business risk, FX
risk, governance risk)
Country-specific are those risks that also affect the
MNE at the project or corporate level but originate at
the country level (e.g. transfer risk, war risk, nepotism
& corruption)
Global-specific are those risks that affect the MNE at
the project or corporate level but originate at the
global level (e.g. terrorism, anti-globalization,
poverty)
I MBA
 
30
Firm-Specific Country-Specific Global-Specific

Risks Risks Risks
• Business risks • Transfer risk • Terrorism

• Foreign-exchange • War and ethnic strife • Anti-globalization
risks • Nepotism and corruption movement
• Governance risks • Defective economic and • Cyber attacks
social infrastructure
• Poverty
• Macroeconomic
disequilibrium • Environmental
• Sovereign credit risk safety
• Cultural and religious heritage

• Intellectual property rights
I MBA
 
31
MEASURING & MANAGING
FOREIGN INVESTMENT RISKS
Sensitivity Analysis Minimize Assets at Risk
Simulating business plans Minimize equity in subsidiary

Adjusting discount rate Borrow locally
Adjusting cash flows
Diversification Insurance
Plant location Hedging currency risk

Source of debt & equity Risk-sharing agreement
Currency of denomination Country investment agreements
Supply sources Investment guarantees
Sales locations
I MBA
 
32
FIRM-SPECIFIC RISKS: MEASURING &
MANAGING
Firm-Specific Risks: Measurement
Business Foreign Exchange Governance

Risk Risk Risk
• Forecasting errors • Transaction exposure • Goal conflict

• Large & risky projects • Operating exposure • Ownership structure
• Portfolio risk • Accounting exposure • Human resources
Minimize assets
Sensitivity Analysis Diversification Insurance
at risk
Firm-Specific Risks: Management
I MBA
 
33
FIRM-SPECIFIC RISKS:
Business Risks are the risks that actual business
results will be different than the estimates
• Sensitivity analysis: Project viewpoint measurement
- Several “what if” scenarios are estimated
• Sensitivity analysis: Parent viewpoint measurement
- Adjusting discount rates and/or cash flows
- Difficulty in determining which to adjust and by
how much
- Also must consider portfolio risk management
(why does the foreign subsidiary exist?)
I MBA
 
34
Foreign exchange risk
Governance risk is the ability to exercise control over a foreign
subsidiary within a country’s legal and political environment
Negotiating investment agreements
•An investment agreement spells out the rights &
responsibilities of both the foreign firm & the host government
•The agreement should include the following
-Basis on which fund flows such as dividends, royalty fees
and loan repayments may be remitted
-Basis for setting transfer prices
-The right to export to third-country markets
-Obligations to build, or fund social and economic overhead
projects such as schools and hospitals
I MBA
 
35
- Methods of taxation, including rate, type and
means by which rate is determined
- Access to host country capital markets
- Permission for 100% foreign ownership
versus required local partner
- Price controls, if any, applicable to sales in
host country’s markets
- Requirements for local sourcing versus
importation of materials
I MBA
 
36

- Permission to use expatriate managerial
and technical personnel
- Provision for arbitration of disputes
- Provisions for planned divestment,
indicating how the going concern will be
valued (build-to-own or build-to-transfer)
I MBA
 
37
Investment insurance and guarantees: OPIC
• MNEs can sometimes transfer political risk
through an investment insurance agency
• The US investment insurance and guarantee
program is managed by the Overseas Private
Investment Corporation (OPIC)
• It’s stated purpose is to mobilize and facilitate
US private capital and skills in the economic
development of less developed countries
I MBA
 
38
Investment insurance and guarantees: OPIC
• OPIC offers coverage for four separate types of risk
- Inconvertibility: Risk that the investor will not be
able to convert remittances into $
- Expropriation: Risk that the host government will
seize the assets of the US investor without
restitution payments
- War, revolution & insurrection: Covers damages to
physical property of foreign subsidiary
- Business income: Coverage provides
compensation for loss of income due to events
from political violence that directly affect the
company & its assets
I MBA
 
39
OPERATING STRATEGIES
AFTER THE FDI DECISION
Although FDI creates obligations on the part of the
foreign subsidiary and host government, conditions
change and the MNE must be able to adapt
There are several strategies that an MNE can
undertake to anticipate changing conditions or host
government’s future actions and negotiate these
terms
• Local sourcing: Firms may be required to
purchase raw materials from local producers
• Facility location: Facilities may be located to
minimize risk
I MBA
 
40
OPERATING STRATEGIES AFTER FDI DECISION
• Control of transportation: Most important for oil and
pipeline companies
• Control of technology: Control of key patents and
intellectual property
• Control of markets: Common practice in order to
enhance a firm’s bargaining position
• Brand name & trademark control: Gives MNE ability to
operate under a world brand name
• Thin equity base: Foreign subsidiaries can be financed
with a thin equity base and large proportion of local
debt
• Multiple-source borrowing: Firm can borrow from
various banks and countries
I MBA
 
41
COUNTRY-SPECIFIC RISKS
These risks affect all firms, both domestic and foreign

operating within the host country
Most typical risks are
• Transfer risk
• Cultural differences
• Host country protectionism
I MBA
 
42
Country-Specific Risks: Measurement and Management
Transfer Risk Cultural Differences Protectionism
• Blocked funds • Religion • Defense industry

• Macroeconomic • Nepotism and • Agriculture
disequilibrium corruption
• Economic • Intellectual property • Infant industry
infrastructure rights
• Sovereign credit
risk
I MBA
 
43
COUNTRY- SPECIFIC RISKS
Transfer risk are the limitations on the MNE’s ability to
transfer funds into & out of a host country without
restrictions
MNEs can react to potential transfer risk at 3 stages:
• Prior to making the investment, a firm can analyze
the effect of blocked funds
• During operations a firm can attempt to move funds
through a variety of repositioning techniques
• Funds that cannot be moved must be reinvested in
the local country to avoid deterioration in real value
I MBA
 
44
COUNTRY - SPECIFIC RISKS
An MNE has at least 6 strategies for transferring funds
under restrictions:
• Providing alternative conduits for repatriating funds
(Ch. 21)
• Transfer pricing goods & services between
subsidiaries (Ch. 21)
• Leading and lagging payments (Ch. 22)
• Using fronting loans
• Creating unrelated exports
• Obtaining special dispensation
I MBA
 
45
Fronting loans
• A fronting loan is a parent-to-subsidiary loan
channeled through a financial intermediary
• The lending parent deposits the funds in a bank,
let’s say in London
• That bank in turn “loans” this amount to the
borrowing subsidiary
• In essence, the bank “fronts” for the parent
I MBA
 
46
Creating unrelated exports
• Because main reason for stringent exchange
controls is a host country’s ability or inability to earn
hard currency, anything an MNE can do to generate
export sales helps the host country
• Some exports can be created from present
productive capacity or through production of
unrelated products and services for export
Special dispensation
• If the firm is in an important industry for the
development of the host country, it may bargain for a
special dispensation to repatriate some funds
I MBA
 
47
Other country-specific risks that may block funds are

• Host country’s economic infrastructure
• Sovereign credit risk
• War & ethnic strife
I MBA
 
48
Cultural differences
• Differences in allowable ownership structures
• Differences in human resource norms
• Differences in religious heritage
• Nepotism and corruption in the host country
• Protection of intellectual property rights
• Infant industry
- Defense
- Agricultural
I MBA
 
49
GLOBAL-SPECIFIC RISKS
These risks are currently at the forefront for MNEs and include
• Terrorism
• Anti-globalization movement
- The role of international institutions such as the IMF and World Bank
• Environmental concerns
• Poverty
• Cyber attacks
I MBA
 
50
AGENDA
I MBA
 
51
HISTORICAL CROSS-BORDER
M&A ACTIVITY
Cross-Border Mergers & Acquisitions: Developed Countries (billions of US dollars)
I MBA
 
52
HISTORICAL CROSS-BORDER
M&A ACTIVITY
Cross-Border Mergers & Acquisitions: Developing Countries (billions of US dollars)
Africa Asia Latin America West Asia Eastern Europe

70
60
50
40
30
20
10
0
1995 1996 1997 1998 1999 2000
I MBA
 
53
THE DRIVING FORCE FOR
CROSS-BORDER M&A
The main reason for cross-border M&A is to create shareholder value

Public firms’ measure of enhancing shareholder is mainly reflected in their stock
price
• If the MNE’s share price is a combination of earnings and the market’s
opinion of those earnings, the price to earnings multiple, then
management should strive to grow both
I MBA
 
54
THE DRIVING FORCE FOR
CROSS-BORDER M&A
The Goal: Increase the share price of the firm
P
Price = EPS ×
E
Management only
Increasing the share Management, directly
indirectly influences
price means controls through its
the market’s opinion
increasing earnings. efforts the earnings per
of the company’s earnings
share of the firm.
as reflected in the P/E.
So building “value” means growing the firm to grow earnings.

The largest growth potential is global.
I MBA
 
55
CROSS-BORDER M&A DRIVERS
Aside from the desire to grow, MNEs are motivated to undertake M&A activity for
other factors
These drivers are usually both macro in scope, the global competitive environment,
and micro in scope, the variety of industry and firm-level forces and actions driving
firm value
• The primary forces of change in the global competitive environment are
technological change, regulatory change, and capital market change
I MBA
 
56
Other cross-border M&A drivers are

To gain access to strategic proprietary assets
To gain market power and dominance
To achieve synergies in local/global operations across different industries
To become larger and realize benefits of size in competition and negotiation
To diversify and spread risks
To exploit financial opportunities
I MBA
 
57
Cross - Border
M & A activity
Changes in the Global Environment
• Technology New business
• Regulatory frameworks opportunities
• Capital market changes and risks
Firms Undertake M&As to:

• Access strategic proprietary assets
• Gain market power & dominance
Strategic responses by firms • Achieve synergies
to defend and enhance their • Become larger
competitive positions in a • Diversify & spread risks
changing environment. • Exploit financial opportunities
time
Source: UNCTAD, World Development Report 2000: Cross-border Mergers and Acquisitions and Development,
figure V.1., p. 154.
I MBA
 
58
CROSS-BORDER M&A PROCESS
Although most M&A is viewed solely as a process of valuation, there is much more
such as the strategic drivers, which must also be taken into account
The process of acquiring an enterprise has three common elements
• Identification and valuation of the target
• Completion of the ownership change transaction
• Management of the post-acquisition transition
I MBA
 
59
Stage I Stage II Stage III

Strategy
Identification Completion of Management of
& & valuation the ownership the post-acquisition
Management of the target change transition; integration
transaction of business
(the tender) and culture
Financial Rationalization of
Valuation
settlement operations;
Financial &
& integration of
Analysis & negotiation
financial goals;
compensation
Strategy achieving synergies
I MBA
 
60
Stage 1: Identification and Valuation

• This requires a well defined corporate strategy and focus
• Identification of the target market typically precedes the identification of
the target firm
• Valuation comes after identification has taken place
- A variety of techniques can be used
- DCF, multiples, comparables, etc.
I MBA
 
61
Stage 2: Settlement of the Transaction

• This stage includes the approval process from management to
governments to regulatory bodies
• Tender process is gaining the approval of the target company; if no
approval is obtained then acquisition could become a hostile takeover
• Regulatory approval is important for anti-monopolistic threats and
perceptions
- Example: GE and Honeywell being rejected by EUCompensation
settlement is the last act in stage two which is the payment to the
target’s shareholders
• Payment can be in forms from cash to common stock
I MBA
 
62
Stage 3: Post-acquisition Management

• This stage can affect the valuation of the entire deal if the synergies are not
met or the costs of integration become higher than anticipated
• The melding of the two cultures is often the biggest challenge
- Examples: BP and Amoco, Daimler and Chrysler
I MBA
 
63
CORPORATE GOVERNANCE &
SHAREHOLDER RIGHTS
The Tender and shareholder rights

• One issue of contention is the discussion of determining at what point in
the accumulation of shares the bidder is required to make all shareholders
a tender offer
• Theoretically the accumulation of shares should continue until the bidder
has
- The single largest block of shares among shareholders
- Majority control
- All the shares outright
I MBA
 
64
SHAREHOLDER RIGHTS

• The issue of corporate control is regulated by varying countries differently
but typically include the following
• Creeping tenders – the secret accumulation of small blocks of shares in
the private or public market in a preliminary move towards a public bid.
This is prohibited in many countries for the purpose of promoting
disclosure of bids for takeover
• Mandatory offers – many countries require that the bidder make a public
tender to all shareholders when a certain threshold of ownership is
attained. This is intended to extend the opportunity to all shareholders to
sell their shares at the tender price rather than have the bidder pay the
tender price only to those shareholders needed to gain control
I MBA
 
65
SHAREHOLDER RIGHTS

• Timing of takeovers – different time frames apply to takeover bids but
typically this time period is the time the bid must be left open for each
individual tender offer, withdrawal or revision tender. This allows bidders
and targets to consider all possibilities
• Withdrawal rights – most countries allow any security to be withdrawn as
long as bid is open. This protects shareholders against tendering their
shares early at lower prices than may be garnered by waiting for a better
offer
• Market prices during bid – some countries allow the bidder to purchase
shares in the open market during the public tender. Other countries
prohibit this to protect against any potential market manipulation
I MBA
 
66
SHAREHOLDER RIGHTS

• Market sales during bid – this follows the previous regulator point
mentioned
• Limitation of defenses – some countries limit the defensive tactics of the
target; in some countries this is not an explicit law but one implied through
civil trials. This protects shareholders against management taking
defensive measures not in their best interests
• Price integration – most countries require that the highest price paid to any
shareholder be paid to all shareholders tendering their shares. This is
intended to guarantee equitable price offerings yet sometimes becomes
two-tiered in countries that allow front-end and back-end bids
I MBA
 
67
SHAREHOLDER RIGHTS

• Proration of acceptance – most countries require proration when a bid is
made for less than all the shares and more than the maximum is tendered.
Some countries don’t allow a bid to be made for less than all the shares
once the mandatory offer percentage has been reached
• Target responses – many countries require that the Board of Directors of
the target make a public statement regarding their position on the public
tender within a time frame following the tender. This is intended to
disclose the target’s opinions and attitudes towards the tender to existing
shareholders
I MBA
 
68
CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
Anheuser-Busch targets Tsingtao Brewery in China

• In January 2001, Anheuser-Busch (AB) was considering acquiring a
minority interest in China’s Tsingtao brewery
• AB’s key considerations and questions were
- The valuation of Tsingtao’s share price in an illiquid Chinese equity
market
- The percentage of Tsingtao’s total equity that could be purchased
- The terms of settling the transaction
- AB’s prospects of contributing to the management of Tsingtao for a
larger equity stake
- The degree of future compatibility between the two cultures
- The potential for future rationalization of operations
I MBA
 
69
• Having identified the target (Stage I), AB needed to undertake a valuation of

the target (Stage II). Since AB would at best only have a minority interest,
it also needed to assess its prospects for post-acquisition influence in
Tsingtao’s operations (Stage III)
The challenge and the opportunity
• Tsingtao was China’s largest brewer; it operated 43 breweries, 2 malt
plants and 49 distributors covering 15 Chinese provinces
• The Chinese beer market was undergoing consolidation due to high
competitiveness
I MBA
 
70
I MBA
 
71
Tsingtao had grown through acquisitions over the past years and was now
struggling with post-acquisition integration and digestion from the heavy load used
to finance the growth
I MBA
 
72
However, Tsingtao was known for its operational excellence
I MBA
 
73
CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
I MBA
 
74
I MBA
 
75
CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
I MBA
 
76
Valuation of cash flows

• Operating cash flows as recorded on the statement of cash flows is not the
measure of cash flows needed for valuation purposes
• Free cash flows and Net operating profits after-taxes (NOPAT) are needed
for valuation purposes
• Free cash flows = net operating profit after tax (NOPAT), less additions to
working capital, less capital expenditures (capex)
I MBA
 
77
In 2000, Tsingtao’s NOPAT was a positive Rmb430.9 million

Tsintao’s FCF was equal to:
• A NOPAT of 430.9
• Less a reduction in working capital of 133.7
• Less a capital expenditure of 1,330.0,
• For a total of negative Rmb765.4 million
I MBA
 
78
Tsingtao’s DCF valuation requires three critical components for proper calculation
The three critical components for the valuation are
• Expected future free cash flows
• Terminal value
• Risk-adjusted discount rate
I MBA
 
79
Terminal value is critical for DCF analysis because it must capture all the FCF’s for
an indefinite future
Typically terminal value is calculated using a dividend growth model formula
• Here we assume a discount rate (k) of 10%
• and a FCF growth rate (g) of 2%
FCF2000 (1 + g) Rmb591.3(1.02)
Terminal value = = = Rmb7,539.6
k WACC − g 0.10 − 0.02
I MBA
 
80
The discount rate was calculated using CAPM and the following assumptions
• 34% Tax rate
• Pre-tax cost of debt of 8% (after-tax cost of 5.28%)
• Risk free rate of 7%
• Equity risk premium of 6.7%
• Tsingtao’s H-shares beta of 0.80
• Hong Kong stock exchange return of 13.7%
k e = k rf + β (k m − k f ) = 7.0 + 0.80(13.7 − 7.0) = 12.36%
 E    D  
k WACC =   x k e  +   x (1 - t) x k d  = (.667 x12.36%) + (.333x5.28%) = 10.0%
 V    V  
I MBA
 
81
CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
I MBA
 
82
Valuation using multiples

• Multiples such as P/E or Market-to-book can be used as well to compare
the valuation of the target
• P/E ratios are the most widely used for valuation
• Tsingtao’s valuation using P/E ratios would be
Current price in HK$ HK$2.20

P/E = = = 34.4
EPS for 2000 in HK$ HK$0.064
• Tsingtao’s 34.4 × earnings is considerably higher than the Hong Kong exchange’s
average of 12 ×
I MBA
 
83
• The second most widely used multiple is the Market-to-book (MTB) ratio
• This is the measure of the firm’s book value per share relative to its market
price; or the market’s assessment of the employed capital versus what the
capital cost
• Tsingtao's MBT ratio would be
Current price in HK$ HK$2.20

MTB = = = 0.94
Book value per share in HK$ HK$2.35
• According to this, Tsingtao is selling for less than its historical cost of capital invested
I MBA
 
84
I MBA
 
85
AGENDA
I MBA
 
86
INTERNATIONAL DIVERSIFICATION & RISK
Portfolio Risk Reduction

• The risk of a portfolio is measured by the ratio of the variance of the
portfolio’s return relative to the variance of the market return
• This is defined as the beta of the portfolio
• As an investor increases the number of securities, the portfolio’s risk
declines rapidly at first and then asymptotically approaches the level of
systematic risk of the market
• A fully diversified portfolio would have a beta of 1.0
I MBA
 
87
100
Percent Variance of portfolio return
risk = Variance of market return
80
60 Total Risk = Diversifiable Risk + Market Risk

(unsystematic) (systematic)
40 Portfolio of
U.S. stocks
20 Total Systematic
risk risk
1 10 20 30 40 50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the
market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
I MBA
 
88
100
Percent Variance of portfolio return
risk = Variance of market return
80
60
40 Portfolio of
U.S. stocks
20 Portfolio of international stocks
1 10 20 30 40 50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the
market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
I MBA
 
89
FOREIGN EXCHANGE RISK
The foreign exchange risks of a portfolio, whether it be a securities portfolio or the

general portfolio of activities of the MNE, are reduced through diversification
Internationally diversified portfolios are the same in principle because the investor is
attempting to combine assets which are less than perfectly correlated, reducing the
risk of the portfolio
I MBA
 
90
An illustration with Japanese equity

• US investor takes $1,000,000 on 1/1/2002 and invests in stock traded on the
Tokyo Stock Exchange (TSE)
- On 1/1/2002, the spot rate was ¥130/$
• The investor purchases 6,500 shares valued at ¥20,000 for a total
investment of ¥130,000,000
• At the end of the year, the investor sells the shares at a price of ¥25,000 per
share yielding ¥162,500,000
- On 1/1/2003, the spot rate was ¥125/$
• The investor receives a 30% return on investment ($300,000/$1,00,000 =
30%)
I MBA
 
91
An illustration with Japanese equity

• The total return reflects not only the appreciation in stock price but also
the appreciation of the yen
• The formula for the total return is
[(
R $ = 1 + r ¥/$ 1 + r shares,¥ −1 )( )]
Where: ¥130/¥125 = .04 ¥25,000/¥20,000 = .25
R = [(1 +0.400 )(1 +0.250 )] −1 =.300

$
I MBA
 
92
INTERNATIONALIZING THE DOMESTIC PORTFOLIO
Classic portfolio theory assumes that a typical investor is risk-averse

• The typical investor wishes to maximize expected return per unit of
expected risk
An investor may choose from an almost infinite choice of securities
This forms the domestic portfolio opportunity set
The extreme left edge of this set is termed the efficient frontier
• This represents the optimal portfolios of securities that possess the
minimum expected risk per unit of return
• The portfolio with the minimum risk among all those possible is the
minimum risk domestic portfolio
I MBA
 
93
Expected Capital Market

Line (Domestic)
Return
of Portfolio, Rp Optimal domestic
portfolio (DP)
DP
R DP
•
Minimum risk (MRDP )
•
domestic portfolio
MRDP
Domestic portfolio
Rf opportunity set
Expected Risk
DP σ of Portfolio, p
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP,
where the Security Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is MRDP.
I MBA
 
94
If the investor is allowed to choose among an internationally diversified set of

securities, the portfolio set of securities shifts to upward and to the left
This is called the internationally diversified portfolio opportunity set
I MBA
 
95
Expected Capital Market

Line (Domestic)
Return
of Portfolio, Rp
R DP DP
• Internationally diversified
portfolio opportunity set
Domestic portfolio
opportunity set
Rf
Expected Risk
DP σ of Portfolio, p
where the Capital Market Line is tangent to the domestic opportunity set. The domestic portfolio with the minimum risk is designated MRDP.
I MBA
 
96
This new opportunity set allows the investor a new choice for portfolio optimization
The optimal international portfolio (IP) allows the investor to maximize return per
unit of risk more so than would be received with just a domestic portfolio
I MBA
 
97
Optimal CML (International)
Expected
international
Return CML (Domestic)
portfolio
of Portfolio, Rp
•
IP
R IP
R DP DP
•
Internationally diversified
portfolio opportunity set
Domestic portfolio
opportunity set
Rf
Expected Risk
σ IP DP σ of Portfolio, p
where the Security Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is MRDP.
I MBA
 
98
CALCULATING PORTFOLIO RISK AND RETURN
The two-asset model consists of two components

• The expected return of the portfolio
• The expected risk of the portfolio
The expected return is calculated as
E(rA ) = w A E(rA ) + w B E(rB )

Where: A = one asset
B = second asset
w = weights (respectively)
E(r) = expected return of assets
I MBA
 
99
The expected risk is calculated as
σ P = w σ + w σ + 2 w A w Bσ Aσ B ρ AB
2
A
2
A
2
B
2
B
Where: A = first asset

B = second asset
w = weights (respectively)
σ = standard deviation of assets
ρ = correlation coefficient of the two assets
I MBA
 
100
Example of two-asset model
σ P = w 2USσ US
2
+ w GER
2
σ GER
2
+ 2 w US w GERσ USσ GER ρUS/GER
Where: US = US security
GER = German security
wUS = weight of US security – 40%
wGER = weight of German security – 60%
σUS = standard deviation of US security – 15%
ρ = correlation coefficient of the two assets – 0.34
2 2 2 2
0.151 = ( 0.40 ) ( 0.15) + ( 0.60 ) ( 0.20 ) + 2 ( 0.40 )( 0.60 )( 0.15)( 0.20 )( 0.34 )
I MBA
 
101
Example of two-asset model
E(r ) = w US E(rUS ) + w GER E(rGER )

Where: EUS = expected return on US security – 14%
EGER = expected return on German security – 18%
wUS = weight of US security
wUS = weight of German security
E(r) = expected return of portfolio
0.164 = (0.40)(0.14) + (0.60)(0.18)
I MBA
 
102
Expected Portfolio
Return (%)
18
•
17
Maximum
16 • Initial portfolio
(40% US & 60% GER)
return &
maximum risk
•
(100% GER)
Minimum risk combination
15 (70% US & 30% GER)
14
• Domestic only portfolio
(100% US)
13
12
Expected
Portfolio
0 11 12 13 14 15 16 17 18 19 20 Risk ( )
I MBA
 
103
The multiple asset model for portfolio return
N
E(rP ) = Σ w i E(ri )
i =1
I MBA
 
104
The multiple asset model for portfolio risk
N N -1 N
σ P = Σ w σ + Σ Σ w i w jσ iσ j ρ ij
2
i
2
j
i =1 i =1 j=i +1
I MBA
 
105
NATIONAL EQUITY MARKET PERFORMANCE
I MBA
 
106
NATIONAL EQUITY MARKET PERFORMANCE
I MBA
 
107
SHARP AND TREYNOR
PERFORMANCE MEASURES
Investors should not examine returns in isolation but rather the amount of return per
unit risk
To consider both risk and return for portfolio performance there are two main
measures applied
• The Sharpe measure
• The Treynor measure
I MBA
 
108
SHARP AND TREYNOR
The Sharpe measure calculates the average return over and above the risk-free rate
per unit of portfolio risk
Ri − Rf
Sharpe measure =
σi
Where: Ri = average portfolio return
Rf = market return
σ = risk of the portfolio
I MBA
 
109
SHARP AND TREYNOR
The Treynor measure is similar to Sharpe’s measure except that it measures return
over the portfolio’s beta
The measures are similar dependant upon the diversification of the portfolio
• If the portfolio is poorly diversified, the Treynor will show a high ranking
and vice versa for the Sharpe measure
Ri −Rf
Treynor measure =
βi
Where: Ri = average portfolio return
Rf = market return
β = beta of the portfolio
I MBA
 
110
SHARP AND TREYNOR
Example:
- Hong Kong average return was 1.5%
- Assume risk free rate of 5%
- Standard deviation is 9.61%
0.015 − 0.0042
Sharpe measure = = 0.113
0.0961
I MBA
 
111
SHARP AND TREYNOR
Example:
- Hong Kong average return was 1.5%
- Assume risk free rate of 5%
- beta is 1.09
0.015 − 0.0042
Treynor measure = = 0.0100
1.09
I MBA
 
112
SHARP AND TREYNOR
For each unit of risk the Hong Kong market rewarded an investor with a monthly
excess return of 0.113%
The Treynor measure for Hong Kong was the second highest among the global
markets and the Sharpe measure was eighth
This indicates that the Hong Kong market portfolio was not very well diversified from
the world market perspective
I MBA
 
113
ARE MARKETS INCREASINGLY INTEGRATED?
I MBA
 
114
THE INTERNATIONAL CAPM
Recall that CAPM is
k e = k rf + β (k m − k f )
The difference for the international CAPM is that the beta calculation would be
relevant for the equity market for analysis instead of the domestic market
σj
βi = ρjm
σm
Where: β = beta of the security
ρ = correlation coefficient of the market and the security
σ = standard deviation of return
I MBA
 
115
THE INTERNATIONAL CAPM
I MBA
 
116

Cº - Imba International Finance (E) Part 4 Lecture

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cº - Imba International Finance (E) Part 4 Lecture

Uploaded by

Copyright:

Available Formats

Bremen

Part 4 International Investing

Part 1 Global Economics

Part 2 International Accounting

Part 3 Corporate Governance

Part 4 International Investing

Part 5 International Financing

Part 6 Global Value Creating Management

Part 7 Current Topics

Part 4 International Investing

Chapter 4.1 Foreign Direct Investment Theory & Strategy

Chapter 4.2 Adjusting for Risk in Foreign Investment

Chapter 4.3 Cross-Border Mergers, Acquisitions & Valuation

Chapter 4.4 International Portfolio Theory & Diversification

MNEs strive to take advantage of imperfections in

In order to sustain a competitive advantage it must be

Firm strategy, Demand conditions

Related & supporting industries

The OLI Paradigm (Buckley & Casson, 1976; Dunning

2. The firm must also be attracted by specific

Financial strategies are directly related to the OLI

Joint ventures versus wholly owned subsidiary

Joint ventures versus wholly owned subsidiary

Change Exploit Existing Competitive

Licensing Control Assets

Part 4 International Investing

Chapter 4.1 Foreign Direct Investment Theory & Strategy

Chapter 4.2 Adjusting for Risk in Foreign Investment

Chapter 4.3 Cross-Border Mergers, Acquisitions & Valuation

Chapter 4.4 International Portfolio Theory & Diversification

Two-sided risk carries both loss and gain

Risk measurement draws upon two distinct sets

In order for an MNE to identify, measure, and

Firm-Specific Country-Specific Global-Specific

• Business risks • Transfer risk • Terrorism

• Cultural and religious heritage

Sensitivity Analysis Minimize Assets at Risk

Simulating business plans Minimize equity in subsidiary

Plant location Hedging currency risk

Business Foreign Exchange Governance

• Forecasting errors • Transaction exposure • Goal conflict

Firm-Specific Risks: Management

Negotiating investment agreements

These risks affect all firms, both domestic and foreign

Country-Specific Risks: Measurement and Management

Transfer Risk Cultural Differences Protectionism

• Blocked funds • Religion • Defense industry

Other country-specific risks that may block funds are

Part 4 International Investing

Chapter 4.1 Foreign Direct Investment Theory & Strategy

Chapter 4.2 Adjusting for Risk in Foreign Investment

Chapter 4.3 Cross-Border Mergers, Acquisitions & Valuation

Chapter 4.4 International Portfolio Theory & Diversification

Cross-Border Mergers & Acquisitions: Developing Countries (billions of US dollars)

Africa Asia Latin America West Asia Eastern Europe

The main reason for cross-border M&A is to create shareholder value

The Goal: Increase the share price of the firm

So building “value” means growing the firm to grow earnings.

Other cross-border M&A drivers are

Firms Undertake M&As to:

Stage I Stage II Stage III

Stage 1: Identification and Valuation