Cross-Border Mergers

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.

• Alliances and joint ventures (Allows risk/cost sharing &

access to other’s resources; may facilitate entry; but
must share profits and creates potential competitors)
• Exporting (Cheaper than establishing local operations
but still requires local marketing/distribution channels)
• Licensing (Least profitable and risky entry strategy and
lack of control could jeopardize brand or trademark)
 Cross-Border Mergers
and Acquisitions
• The true motivation for cross-border mergers and
acquisitions is a traditional one: to build shareholder
value.
• The following exhibit justifies this global expansion as
a result of the following:
– Publicly traded MNEs live and die, in the eyes of the
shareholders, by their share price
– If the MNE’s share price is a combination of the earnings of
the firm and the market’s opinion of those earnings and the
price-to-earnings multiple, management must strive to grow
both
 Cross-Border Mergers
and Acquisitions
– Management’s problem is that it does not directly influence
the market’s opinion of its earnings
– Although management’s responsibility is to increase the P/E
ratio, this is a difficult, indirect, and long-term process of
communication and promise fulfillment
– However, management does control EPS and often must
look outward to build value
– The global marketplace can offer greater growth potential
when compared to struggling within a domestic market for
market share and profits
Building Shareholder Value Means Building Earnings

The Goal: Increase the share price of the firm

P
Price = EPS x E

Increasing the share Management, directly Management only

price means controls through its indirectly influences
increasing earnings. efforts the earnings per the market’s opinion
share of the firm. of the company’s earnings
as reflected in the P/E.

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

The largest growth potential is global.
 Cross-Border Mergers
and Acquisitions
• In addition to the desire to grow, MNEs are motivated
to undertake cross-border mergers and acquisitions
by a number of other factors.
• The United Nations Conference on Trade and
Development (UNCTAD), has summarized the M&A
drivers in the following exhibit.
 Driving Forces Behind Cross Border M&A
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:

Strategic responses by firms
to defend and enhance their
competitive positions in a
changing environment.
• Access strategic proprietary assets
• Gain market power & dominance
• Achieve synergies
• Become larger
• Diversify & spread risks
• Exploit financial opportunities

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

Identification Completion of Management of

Strategy
& valuation the ownership the post-acquisition
&
of the target change transition; integration
Management transaction of business
(the tender) and culture

Financial Valuation Financial Rationalization of

& settlement operations;
Analysis &
negotiation & integration of
Strategy compensation financial goals;
achieving synergies
 The Cross-Border Acquisition
Strategy
• Stage I – Involves the identification task for firms that
have promising market opportunities and may be
amenable to suitors in addition to valuation using
traditional (DCF) and multiples (earnings and cash flows)
analysis.
• Stage II – Requires gaining the approval of the target
company (target company management support),
regulatory approval and the appropriate compensation
settlement for target shareholders.
• Stage III – This critical process requires the realization of
the motivations for the transaction itself and can be
extremely difficult for a variety of reasons.
 Corporate Governance and
Shareholder Rights
• One of the most controversial issues in shareholder
rights is at what point in the accumulation of shares is
the bidder required to make all shareholders a tender
offer.
• While every country possesses a different set of rules
and regulations for the transfer of control, the market
for corporate control has been the subject of
enormous debate in recent years.
• There are many elements involved in the regulation of
cross-border takeovers.
 Cross-Border Valuation
• Illustrative case: The potential acquisition of Tsingtao
brewery Company, Ltd., China
– In January 2001, Anheuser Busch (AB) was considering
acquiring a larger minority interest in Tsingtao Brewery
Company Ltd., China
– AB had originally acquired a 5% equity interest in 1993 when
Tsingtao had first been partly privatized
– Since AB had already identified the target (Phase I), it would
only need to value the target’s shares (Phase II) and to
assess its prospects for post acquisition influence on
Tsingtao’s operations
 Cross-Border Valuation
• In 1999, negotiations had broken down between AB and Tsingtao
because Tsingtao would not offer AB a voice in its operations.
• However, by 2001, Tsingtao needed an equity infusion to grow its
business.
• Key questions for AB were:
– The valuation of Tsingtao shares in an illiquid Chinese market
– The percentage of Tsingtao’s total equity to be purchased
– The terms of the transaction
– The prospects for AB to contribute management skills to Tsingtao
– The degree of future compatibility between the two corporate
cultures
– The potential for future rationalization of operations
 Cross-Border Valuation
• As a fundamental metric in the determination of
value, free cash flow (FCF) is a critical input in
the valuation of any enterprise.
FCF = NOPAT + D&A – Δ in NWC – CAPEX
• Where:
– NOPAT = net operating profit after tax
– D&A = depreciation and amortization
– NWC = net working capital
– CAPEX = capital expenditures
 Cross-Border Valuation
• Analyzing Tsingtao’s FCF for 2000 showed a healthy operating cash
flow (OCF) but a negative FCF due to enormous capital
expenditures.
• For valuation purposes, this (and previous years) detailed financial
data was utilized in forecasting expected future free cash flows (in
this example in local currency).
• These free cash flows were valued using a risk-adjusted discount
rate; in this methodology the Tsingtao (local currency) WACC is
used.
• In addition, the terminal value of the firm, beyond the FCF projection
period, was also added to the value of the FCF to determine the
entity value.
• Equity value is determined by subtracting the PV of debt capital.
 Cross-Border Valuation
• In addition to the DCF exercise, a multiples analysis is
performed by analyzing (in this case):
– Price/Earnings Ratio (P/E) - an indication of what the market
is willing to pay for a currency unit of earnings
– Market/Book Ratio (M/B) - provides some measure of the
market’s assessment of the employed capital per share
versus what the capital cost
– Other multiples – including (in this case) price/sales or
entity/enterprise value to EBTIDA (business earnings)
 Implementing Cross-Border
Transactions in Emerging Countries
• Poses challenges not common to developed countries
such as political and economic risks including:
– Excessive local government regulation;
– Confiscatory tax policies;
– Restrictions on cash remittances;
– Currency inconvertibility;
– Expropriation of foreign assets;
– Local corruption; and
– Civil war and local insurgencies
• Managing risk through insurance (e.g., World Bank),
contract options (e.g., puts), and credit default swaps
 Valuing Cross-Border Transactions
• Methodology similar to that employed when acquirer and
target in same country
• Basic differences between within country and cross-
border include the following:
– Need to convert target cash flow projections into
acquirer home country currency
– Adjusting discount rate for risks uncommon in “within
country” valuations
• Currency conversions made using the Interest Rate
Parity theory if data permit and Purchasing Power Parity
theory if interest rate information unavailable.
 Interest Rate Parity Theory

 1  RLCn
LC1 x ( LC / FC ) n  LC1 x 
  x LC / FC 
n



 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 $ exchange rate n periods into the future

($/€)0 = $/Euro spot rate
R$n = Interest rate in U.S.
R€n = Interest rate in European Union

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

2008 2009 2010

Target’s Euro-Denominated €124.5 €130.7 €136.0
FCFF Cash Flows (€ Millions)

Target Country’s Interest Rate (%) 4.50 4.70 5.30

U.S. Interest Rate (%) 4.25 4.35 4.55
Current Spot Rate ($/€) = 1.2044
Projected Spot Rate ($/€) = 1.2015 1.1964 1.1788

Target’s Dollar-Denominated $149.59 $156.37 $160.32

FCFF Cash Flows ($ Millions)
Notes: Calculating the projected spot rate using Interest Rate Parity.
($/€)2008 = {(1.0425)/(1.0450)} x 1.2044 = 1.2015
($/€)2009 = {(1.0435)2/(1.0470)2} x 1.2044 = 1.1964
($/€)2010 = {(1.0455)3/(1.0530)3} x 1.2044 = 1.1788
 Purchasing Power Parity Theory
 1  PL n 
LC / FC n   
n 
x LC / FC 0
 1  PF  
Where:
(LC/FC)n = Forward LC/FC exchange rate n periods into the future
(LC/FC)0 = Spot LC/FC exchange rate
PL = Expected Home country inflation rate
PF = Expected Host country inflation rate

 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

(Peso/$)n = ((1 + Pmex)n/(1 + Pus)n) x (Peso/$)0

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

2008 2009 2010

Target’s Peso-Denominated P1,050.5 P1,124.7 P1,202.7
FCFF Cash Flows (Millions of Pesos)

Mexican Expected Inflation Rate = 6%

U.S. Expected Inflation Rate = 4%
Spot Rate ($/Peso) = .0877
Projected Spot Rate ($/Peso) .0860 .0844 .0828

Target’s Dollar-Denominated $90.34 $94.92 $99.58

FCFF Cash Flows (Millions of $)

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.