Issues in Cross Border Valuation

I.

Financial Statement Analysis (different standards) - While accounting standards continue to converge, differences continue to abound. Consequently, the seller should confirm that their financial statements have been prepared in accordance with Financial Accounting standard board (if in the US), International Accounting Standards Board (Europe and elsewhere). Tax strategies (Repatriation Risk) - The risk of repatriation has to do with an investors inability to take their profits outside of the country. This risk can manifest itself in several ways including capital controls limiting hard currency transactions and tax policies that make repatriation uneconomical. Three common structures include the tax-free reorganization, taxable purchase, and hybrid transaction, which may result in a transaction which is taxable to some target shareholders but not to others. 1 Adjusting the discount rate for risks - In todays investment world, many investors use a simplified approach to adjusting their valuations to incorporate the political risks noted in the previous section. Rather than explicitly factoring in the risks into the expected cash flows, they tend to value these businesses using the discounted cash flow (DCF) approach with an appropriate discount rate that accounts for political risk. They use the following formula to calculate the discount rate:
Ka = Rf of US T-Bond + (Beta x Market Risk Premium) + Sovereign Spread
1

II.

III.

The formula merely adds in a sovereign spread to the commonly-used CAPM approach. The sovereign spread is the difference in risk free rates between the US Treasury bond and a government bond of the emerging market that is denominated in dollars. 1
IV.

Deciding on the spot and future exchange rate - Generally, target firm cash flows are projected and then converted to the acquirers home currency. This requires estimating exchange rates between the acquirers and targets currency. Future spot exchange rates are estimated using either relative interest rates (i.e., interest rate parity theory) in each country or relative rates of expected inflation (i.e., purchasing power parity theory). Since interest rate information is often limited, the purchasing power parity approach may be most appropriate when the target firm is in an emerging nation.

V.

Adjust cost of equity for specific econo-political risks - Developed economies show little differences in the cost of equity or capital due to the high level of integration of their capital markets in the global capital market. Consequently, either the acquirers or the targets cost of equity (adjusted for firm size) may be employed to discount future cash flows when both firms are located developed countries. In emerging countries, capital markets often are segmented such that investments are made primarily in a particular country. This implies that the local countrys equity premium differs from the global equity premium, reflecting the local countrys non-diversifiable risk. Non-diversifiable risk when capital markets are segmented is measured by estimating the emerging country firms global beta as the product of the firms country beta times the emerging countrys global beta. The countrys equity risk premium is estimated using the prospective method implied by the constant growth model, which relates the target firms country stock index or for a similar country to the dividend yield plus the expected earnings growth rate. The firms cost of equity may be adjusted for specific political/economic risk by adding the difference between the yield on the countrys government bonds and the U.S treasury bond of the same maturity. Additional adjustments could include liquidity risk and firm size. 1 Performing sensitivity analysis - Once the NPV is calculated, a sensitivity analysis should be performed to determine how changes in key assumptions affect NPV. It is important to remember that a NPV is a best guess estimate of project value and does not say anything about the variance around this best guess. The assumptions made when constructing the pro forma projections should be analyzed to measure their effect on NPV. Special notes should be given to dramatic shifts in currency exchange rates, country risk premiums, relative business risk, and probability weighted scenarios.2 Financing considerations - Cross-border transactions are most often financed with debt. Sources of financing include capital markets in the acquirers home market, the targets local country, or in a third country. It is important to understand the debt that is being used to fund the transaction (if any), and the possible fluctuations in its value down the line.

VI.

VII.