Core Module

INTERNATIONAL FINANCE
Part 4 International Investing


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Bre
Lon
Mars
Mos
Vale
men
don
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cow
ncia
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AGENDA

Global Economics

International Accounting
Corporate Governance
International Investing
International Financing
Global Value Creating Management
Current Topics

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7
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AGENDA

Part 4

Chapter 4.1

Chapter 4.2

Chapter 4.3

Chapter 4.4
International Investing

Foreign Direct Investment Theory & Strategy

Adjusting for Risk in Foreign Investment
Cross-Border Mergers, Acquisitions & Valuation
International Portfolio Theory & Diversification
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THE THEORY OF COMPETITIVE ADVANTAGE
THE THEORY OF COMPETITIVE ADVANTAGE

The theory of competitive advantage provides a basis
The theory of competitive advantage provides a basis
for explaining and justifying international trade in a
for explaining and justifying international trade in a
model assumed
model assumed
to enjoy
to enjoy
free trade, perfect
free trade, perfect
competition, no uncertainty, costless information and
competition, no uncertainty, costless information and
no government interference
no government interference

The
The
features of the theory
features of the theory
are as follows
are as follows

Country A exports goods to unrelated importer in
Country A exports goods to unrelated importer in
Country B
Country B

Country A specializes in certain products given
Country A specializes in certain products given
their natural resources
their natural resources

Country B does the same with different products
Country B does the same with different products
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THE THEORY OF COMPETITIVE ADVANTAGE
THE THEORY OF COMPETITIVE ADVANTAGE

Because the
Because the
factors of production cannot be
factors of production cannot be
transported
transported
, the benefits of specialization are
, the benefits of specialization are
realized through international trade
realized through international trade

The
The
terms of trade
terms of trade
, the ratio at which quantities
, the ratio at which quantities
of goods are exchanged, shows the benefits of
of goods are exchanged, shows the benefits of
excess production
excess production

Of course,
Of course,
this is only a theory
this is only a theory
in today’s world
in today’s world
.
.
No one country specializes in only one product and
No one country specializes in only one product and
the assumptions of the model do not exist in reality
the assumptions of the model do not exist in reality
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MARKET IMPERFECTIONS:
MARKET IMPERFECTIONS:
A RATIONALE FOR THE MNE
A RATIONALE FOR THE MNE

MNEs strive
MNEs strive
to take advantage of imperfections
to take advantage of imperfections
in
in
national markets
national markets

These imperfections for products
These imperfections for products
translate into
translate into
market opportunities
market opportunities
such as economies of scale,
such as economies of scale,
managerial or technological expertise, financial
managerial or technological expertise, financial
strength and product differentiation
strength and product differentiation
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MARKET IMPERFECTIONS:
MARKET IMPERFECTIONS:
A RATIONALE FOR THE MNE
A RATIONALE FOR THE MNE

Firms become multinational for Firms become multinational for one or several of the following one or several of the following
reasons reasons

Market seekers: Market seekers: produce in foreign markets either to satisfy produce in foreign markets either to satisfy
local demand or export to markets other than their own local demand or export to markets other than their own

Raw material seekers: Raw material seekers: search for cheaper or more raw search for cheaper or more raw
materials outside their own market materials outside their own market

Production efficiency seekers: Production efficiency seekers: produce in countries where one produce in countries where one
or more of the factors of production are cheaper or more of the factors of production are cheaper

Knowledge seekers Knowledge seekers: gain access to new technologies or : gain access to new technologies or
managerial expertise managerial expertise

Political safety seekers: Political safety seekers: establish operations in countries establish operations in countries
considered unlikely to expropriate or interfere with private considered unlikely to expropriate or interfere with private
enterprise enterprise
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SUSTAINING & TRANSFERRING
SUSTAINING & TRANSFERRING
COMPETITIVE ADVANTAGE
COMPETITIVE ADVANTAGE

In order
In order
to sustain a competitive advantage
to sustain a competitive advantage
it must be
it must be

Firm-
Firm-
specific
specific

Transferable
Transferable

Powerful enough
Powerful enough
to compensate the firm for the
to compensate the firm for the
extra difficulties of operating abroad
extra difficulties of operating abroad
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SUSTAINING & TRANSFERRING
SUSTAINING & TRANSFERRING
COMPETITIVE ADVANTAGE
COMPETITIVE ADVANTAGE

Some of the
Some of the
competitive advantages
competitive advantages
enjoyed by MNEs
enjoyed by MNEs
are
are

Economies of scale
Economies of scale
and
and
scope
scope

Managerial and marketing expertise
Managerial and marketing expertise

Advanced technology
Advanced technology

Financial strength
Financial strength

Differentiated products
Differentiated products

Competitiveness
Competitiveness
of the their home market
of the their home market
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PORTER’S DIAMOND
PORTER’S DIAMOND
OF NATIONAL
OF NATIONAL
COMPETITIVE ADVANTAGE
COMPETITIVE ADVANTAGE
Factor Conditions Factor Conditions
Related & supporting industries Related & supporting industries
Demand conditions Demand conditions
Firm strategy, Firm strategy,
structure, & rivalry structure, & rivalry
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THE OLI PARADIGM & INTERNATIONALIZATION
THE OLI PARADIGM & INTERNATIONALIZATION

The
The
OLI Paradigm
OLI Paradigm
(Buckley & Casson, 1976; Dunning
(Buckley & Casson, 1976; Dunning
1977) is an attempt to create an overall framework
1977) is an attempt to create an overall framework
to
to
explain why MNEs choose FDI rather than
explain why MNEs choose FDI rather than
serve
serve
foreign markets through alternative modes such as
foreign markets through alternative modes such as
licensing, joint ventures, strategic alliances,
licensing, joint ventures, strategic alliances,
management contracts and exporting
management contracts and exporting

1. The paradigm states that
1. The paradigm states that
a firm must first have
a firm must first have
some competitive advantage in its home market
some competitive advantage in its home market
-
-
“O”
“O”
or owner-specific –
or owner-specific –
which can be transferred abroad
which can be transferred abroad
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THE OLI PARADIGM & INTERNATIONALIZATION
THE OLI PARADIGM & INTERNATIONALIZATION

2. The firm must also be attracted by specific
2. The firm must also be attracted by specific
characteristics of the foreign market
characteristics of the foreign market


“L” or location
“L” or location
specific –
specific –
which will allow the firm to exploit its
which will allow the firm to exploit its
competitive advantages in that market
competitive advantages in that market

3. The firm will maintain its competitive position by
3. The firm will maintain its competitive position by
attempting to
attempting to
control the entire value-chain in its
control the entire value-chain in its
industry
industry


“I” or internalization
“I” or internalization


This leads to FDI rather than licensing or outsourcing
This leads to FDI rather than licensing or outsourcing
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THE OLI PARADIGM & INTERNATIONALIZATION
THE OLI PARADIGM & INTERNATIONALIZATION

Financial strategies are directly related to the OLI
Financial strategies are directly related to the OLI
Paradigm in explaining FDI
Paradigm in explaining FDI

Strategies can be proactive, controlled in advance by
Strategies can be proactive, controlled in advance by
the management team
the management team

Strategies can also be reactive, depend on
Strategies can also be reactive, depend on
discovering market imperfections
discovering market imperfections
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THE OLI PARADIGM & INTERNATIONALIZATION
THE OLI PARADIGM & INTERNATIONALIZATION
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WHERE TO INVEST
WHERE TO INVEST

Two related behavioral theories behind FDI that are
Two related behavioral theories behind FDI that are
most popular are
most popular are

Behavioral approach to FDI
Behavioral approach to FDI

International network theory
International network theory

Behavioral Approach – Observation that firms tended
Behavioral Approach – Observation that firms tended
to invest first in countries that were not too far from
to invest first in countries that were not too far from
their country in psychic terms
their country in psychic terms

This included cultural, legal, and institutional
This included cultural, legal, and institutional
environments similar to their own
environments similar to their own
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WHERE TO INVEST
WHERE TO INVEST

International network theory – As MNEs grow they
International network theory – As MNEs grow they
eventually become a network, or nodes that operate
eventually become a network, or nodes that operate
either in a centralized hierarchy or a decentralized one
either in a centralized hierarchy or a decentralized one

Each subsidiary competes for funds from the
Each subsidiary competes for funds from the
parent
parent

It is also a member of an international network
It is also a member of an international network
based on its industry
based on its industry

The firm becomes a transnational firm, one that
The firm becomes a transnational firm, one that
is owned by a coalition of investors located in
is owned by a coalition of investors located in
different countries
different countries
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Exporting vs. production abroad
Exporting vs. production abroad

Advantages of exporting are
Advantages of exporting are
-
None of the unique risks facing FDI, joint
None of the unique risks facing FDI, joint
ventures, strategic alliances and licensing
ventures, strategic alliances and licensing
-
Political risks are minimal
Political risks are minimal
-
Agency costs and evaluating foreign units are
Agency costs and evaluating foreign units are
avoided
avoided

Disadvantages are
Disadvantages are
-
Firm is not able to internalize and exploit its
Firm is not able to internalize and exploit its
advantages
advantages
-
Risks losing market to imitators and global
Risks losing market to imitators and global
competitors
competitors
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

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
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI
-
Possible loss of opportunity to enter
Possible loss of opportunity to enter
licensee’s market with FDI later
licensee’s market with FDI later
-
Risk that technology will be stolen
Risk that technology will be stolen
-
High agency costs
High agency costs

Management contracts are similar to licensing
Management contracts are similar to licensing
insofar as they provide for some cash flow from
insofar as they provide for some cash flow from
foreign source without significant investment or
foreign source without significant investment or
exposure
exposure

These contracts lessen political risk because
These contracts lessen political risk because
the repatriation of managers is easy
the repatriation of managers is easy
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Joint ventures versus wholly owned subsidiary
Joint ventures versus wholly owned subsidiary

A joint venture is a shared ownership in a foreign
A joint venture is a shared ownership in a foreign
business
business

This is a viable strategy if the MNE finds the right
This is a viable strategy if the MNE finds the right
local partner
local partner

Some advantages include
Some advantages include
-
The local partner understands the market
The local partner understands the market
-
The local partner can provide competent
The local partner can provide competent
management at all levels
management at all levels
-
Some host countries require that foreign firms
Some host countries require that foreign firms
share ownership with local partner
share ownership with local partner
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Joint ventures versus wholly owned subsidiary
Joint ventures versus wholly owned subsidiary

Advantages of joint ventures
Advantages of joint ventures
-
The local partner’s contacts & reputation
The local partner’s contacts & reputation
enhance access to host country’s capital
enhance access to host country’s capital
markets
markets
-
The local partner may possess technology
The local partner may possess technology
that is appropriate for the local environment
that is appropriate for the local environment
-
The public image of a firm that is partially
The public image of a firm that is partially
locally owned may improve its position
locally owned may improve its position
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Joint ventures versus wholly owned subsidiary
Joint ventures versus wholly owned subsidiary
Disadvantages of joint ventures
Disadvantages of joint ventures
-
Political risk is increased if wrong partner is
Political risk is increased if wrong partner is
chosen
chosen
-
Local and foreign partners have divergent views
Local and foreign partners have divergent views
on strategy and financing issues
on strategy and financing issues
-
Transfer pricing creates potential for conflict of
Transfer pricing creates potential for conflict of
interest
interest
-
Financial disclosure between local partner & firm
Financial disclosure between local partner & firm
-
Ability of a firm to rationalize production on a
Ability of a firm to rationalize production on a
worldwide basis if that would put local partner at
worldwide basis if that would put local partner at
disadvantage
disadvantage
-
Valuation of equity shares is difficult
Valuation of equity shares is difficult
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Greenfield investment versus acquisition
Greenfield investment versus acquisition

A greenfield investment is establishing a facility
A greenfield investment is establishing a facility
“starting from the ground up”
“starting from the ground up”
-
Usually require extended periods of physical
Usually require extended periods of physical
construction and organizational development
construction and organizational development

Here, a cross-border acquisition may be better
Here, a cross-border acquisition may be better
because the physical assets already exist, shorter
because the physical assets already exist, shorter
time frame and financing exposure
time frame and financing exposure
-
However, problems with integration, paying too
However, problems with integration, paying too
much for acquisition, post-merger management,
much for acquisition, post-merger management,
and realization of synergies all exist
and realization of synergies all exist
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HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI

Strategic alliances can take several different forms
Strategic alliances can take several different forms

First is an exchange of ownership between
First is an exchange of ownership between
two firms
two firms

It can be a defensive strategy against a
It can be a defensive strategy against a
takeover
takeover

In addition to exchanging shares, a separate
In addition to exchanging shares, a separate
joint venture can be developed
joint venture can be developed

Another level of cooperation may be a joint
Another level of cooperation may be a joint
marketing or servicing agreement
marketing or servicing agreement
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Trident and its
Competitive Advantage
Exploit Existing Competitive
Advantage Abroad
Change
Competitive Advantage
Licensing
Management Contract
Control Assets
Abroad
Acquisition of a
Foreign Enterprise
Greenfield
Investment
Production at Home:
Exporting
Production Abroad
Joint Venture
Wholly-Owned
Subsidiary
Greater Foreign Presence Greater Foreign Presence
Greater Greater
Foreign Foreign
Investment Investment
HOW TO INVEST ABROAD: MODES OF FDI
HOW TO INVEST ABROAD: MODES OF FDI
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AGENDA

Part 4

Chapter 4.1

Chapter 4.2

Chapter 4.3

Chapter 4.4
International Investing

Foreign Direct Investment Theory & Strategy

Adjusting for Risk in Foreign Investment
Cross-Border Mergers, Acquisitions & Valuation
International Portfolio Theory & Diversification
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DEFINING RISK
DEFINING RISK

Risks associated with foreign investments are
Risks associated with foreign investments are
inherently subjective or qualitative and not
inherently subjective or qualitative and not
quantitative
quantitative

Distinguishing risk as either one-sided or two-sided
Distinguishing risk as either one-sided or two-sided
is one way of applying qualitative and quantitative
is one way of applying qualitative and quantitative
measures of risk
measures of risk

One-sided risk only emphasizes the potential for loss
One-sided risk only emphasizes the potential for loss

These risks are typically expropriation risk,
These risks are typically expropriation risk,
blocked funds, etc.
blocked funds, etc.
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DEFINING RISK
DEFINING RISK

Two-sided risk carries both loss and gain
Two-sided risk carries both loss and gain

A typical two-sided risk is foreign exchange risk
A typical two-sided risk is foreign exchange risk

Risk measurement draws upon two distinct sets
Risk measurement draws upon two distinct sets

Measures of risk from the market
Measures of risk from the market

Measures of risk from institutions
Measures of risk from institutions
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DEFINING FOREIGN INVESTMENT RISKS
DEFINING FOREIGN INVESTMENT RISKS

In order for an MNE to identify, measure, and
In order for an MNE to identify, measure, and
manage its foreign investment risk it is useful to
manage its foreign investment risk it is useful to
define these risks as being
define these risks as being

Firm-specific
Firm-specific

Country-specific
Country-specific

Global-specific
Global-specific
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DEFINING FOREIGN INVESTMENT RISKS
DEFINING FOREIGN INVESTMENT RISKS
Firm-specific are those risks that affect the MNE at
Firm-specific are those risks that affect the MNE at
the project or corporate level (e.g. business risk, FX
the project or corporate level (e.g. business risk, FX
risk, governance risk)
risk, governance risk)

Country-specific are those risks that also affect the
Country-specific are those risks that also affect the
MNE at the project or corporate level but originate at
MNE at the project or corporate level but originate at
the country level (e.g. transfer risk, war risk, nepotism
the country level (e.g. transfer risk, war risk, nepotism
& corruption)
& corruption)

Global-specific are those risks that affect the MNE at
Global-specific are those risks that affect the MNE at
the project or corporate level but originate at the
the project or corporate level but originate at the
global level (e.g. terrorism, anti-globalization,
global level (e.g. terrorism, anti-globalization,
poverty)
poverty)
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DEFINING FOREIGN INVESTMENT RISKS
DEFINING FOREIGN INVESTMENT RISKS
Firm-Specific
Risks
• Business risks
• Foreign-exchange
risks
• Governance risks
Country-Specific
Risks
• Transfer risk
• War and ethnic strife
• Nepotism and corruption
• Defective economic and
social infrastructure
• Macroeconomic
disequilibrium
• Sovereign credit risk
• Cultural and religious heritage
• Intellectual property rights
Global-Specific
Risks
• Terrorism
• Anti-globalization
movement
• Cyber attacks
• Poverty
• Environmental
safety
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MEASURING & MANAGING
MEASURING & MANAGING
FOREIGN INVESTMENT RISKS
FOREIGN INVESTMENT RISKS
Sensitivity Analysis Minimize Assets at Risk
Diversification Insurance
Simulating business plans Minimize equity in subsidiary
Adjusting discount rate Borrow locally
Adjusting cash flows
Plant location Hedging currency risk
Source of debt & equity Risk-sharing agreement
Currency of denomination Country investment agreements
Supply sources Investment guarantees
Sales locations
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FIRM-SPECIFIC RISKS: MEASURING &
FIRM-SPECIFIC RISKS: MEASURING &
MANAGING
MANAGING
Firm-Specific Risks: Measurement
Firm-Specific Risks: Management
Foreign Exchange
Risk
Governance
Risk
Business
Risk
• Forecasting errors
• Large & risky projects
• Portfolio risk
• Goal conflict
• Ownership structure
• Human resources
• Transaction exposure
• Operating exposure
• Accounting exposure
Sensitivity Analysis Diversification
Minimize assets
at risk
Insurance
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Business Risks
Business Risks
are the risks that actual business
are the risks that actual business
results will be different than the estimates
results will be different than the estimates

Sensitivity analysis: Project viewpoint measurement
Sensitivity analysis: Project viewpoint measurement
-
Several “what if” scenarios are estimated
Several “what if” scenarios are estimated

Sensitivity analysis: Parent viewpoint measurement
Sensitivity analysis: Parent viewpoint measurement
-
Adjusting discount rates and/or cash flows
Adjusting discount rates and/or cash flows
-
Difficulty in determining which to adjust and by
Difficulty in determining which to adjust and by
how much
how much
-
Also must consider portfolio risk management
Also must consider portfolio risk management
(why does the foreign subsidiary exist?)
(why does the foreign subsidiary exist?)
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Foreign exchange risk Foreign exchange risk

Governance risk Governance risk is the ability to exercise control over a foreign is the ability to exercise control over a foreign
subsidiary within a country’s legal and political environment subsidiary within a country’s legal and political environment

Negotiating investment agreements Negotiating investment agreements

An investment agreement spells out the rights & An investment agreement spells out the rights &
responsibilities of both the foreign firm & the host government responsibilities of both the foreign firm & the host government

The agreement should include the following The agreement should include the following
-
Basis on which fund flows such as dividends, royalty fees Basis on which fund flows such as dividends, royalty fees
and loan repayments may be remitted and loan repayments may be remitted
-
Basis for setting transfer prices Basis for setting transfer prices
-
The right to export to third-country markets The right to export to third-country markets
-
Obligations to build, or fund social and economic overhead Obligations to build, or fund social and economic overhead
projects such as schools and hospitals projects such as schools and hospitals
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Negotiating investment agreements
Negotiating investment agreements
-
Methods of taxation, including rate, type and
Methods of taxation, including rate, type and
means by which rate is determined
means by which rate is determined
-
Access to host country capital markets
Access to host country capital markets
-
Permission for 100% foreign ownership
Permission for 100% foreign ownership
versus required local partner
versus required local partner
-
Price controls, if any, applicable to sales in
Price controls, if any, applicable to sales in
host country’s markets
host country’s markets
-
Requirements for local sourcing versus
Requirements for local sourcing versus
importation of materials
importation of materials
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Negotiating investment agreements
Negotiating investment agreements
-
Permission to use expatriate managerial
Permission to use expatriate managerial
and technical personnel
and technical personnel
-
Provision for arbitration of disputes
Provision for arbitration of disputes
-
Provisions for planned divestment,
Provisions for planned divestment,
indicating how the going concern will be
indicating how the going concern will be
valued (build-to-own or build-to-transfer)
valued (build-to-own or build-to-transfer)
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Investment insurance and guarantees: OPIC
Investment insurance and guarantees: OPIC

MNEs can sometimes transfer political risk
MNEs can sometimes transfer political risk
through an investment insurance agency
through an investment insurance agency

The US investment insurance and guarantee
The US investment insurance and guarantee
program is managed by the Overseas Private
program is managed by the Overseas Private
Investment Corporation (OPIC)
Investment Corporation (OPIC)

It’s stated purpose is to mobilize and facilitate
It’s stated purpose is to mobilize and facilitate
US private capital and skills in the economic
US private capital and skills in the economic
development of less developed countries
development of less developed countries
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FIRM-SPECIFIC RISKS:
FIRM-SPECIFIC RISKS:
MEASURING & MANAGING
MEASURING & MANAGING

Investment insurance and guarantees: OPIC
Investment insurance and guarantees: OPIC

OPIC offers coverage for four separate types of risk
OPIC offers coverage for four separate types of risk
-
Inconvertibility: R
Inconvertibility: R
isk that the investor will not be
isk that the investor will not be
able to convert remittances into $
able to convert remittances into $
-
Expropriation: R
Expropriation: R
isk that the host government will
isk that the host government will
seize the assets of the US investor without
seize the assets of the US investor without
restitution payments
restitution payments
-
War, revolution & insurrection: C
War, revolution & insurrection: C
overs damages to
overs damages to
physical property of foreign subsidiary
physical property of foreign subsidiary
-
Business income: C
Business income: C
overage provides
overage provides
compensation for loss of income due to events
compensation for loss of income due to events
from political violence that directly affect the
from political violence that directly affect the
company & its assets
company & its assets
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OPERATING STRATEGIES
OPERATING STRATEGIES
AFTER THE FDI DECISION
AFTER THE FDI DECISION

Although FDI creates obligations on the part of the
Although FDI creates obligations on the part of the
foreign subsidiary and host government, conditions
foreign subsidiary and host government, conditions
change and the MNE must be able to adapt
change and the MNE must be able to adapt

There are several strategies that an MNE can
There are several strategies that an MNE can
undertake to anticipate changing conditions or host
undertake to anticipate changing conditions or host
government’s future actions and negotiate these
government’s future actions and negotiate these
terms
terms

Local sourcing
Local sourcing
: Firms may be required to
: Firms may be required to
purchase raw materials from local producers
purchase raw materials from local producers

Facility location
Facility location
: Facilities may be located to
: Facilities may be located to
minimize risk
minimize risk
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OPERATING STRATEGIES AFTER FDI DECISION
OPERATING STRATEGIES AFTER FDI DECISION

Control of transportation
Control of transportation
: Most important for oil and
: Most important for oil and
pipeline companies
pipeline companies

Control of technology
Control of technology
: Control of key patents and
: Control of key patents and
intellectual property
intellectual property

Control of markets
Control of markets
: Common practice in order to
: Common practice in order to
enhance a firm’s bargaining position
enhance a firm’s bargaining position

Brand name & trademark control
Brand name & trademark control
: Gives MNE ability to
: Gives MNE ability to
operate under a world brand name
operate under a world brand name

Thin equity base
Thin equity base
: Foreign subsidiaries can be financed
: Foreign subsidiaries can be financed
with a thin equity base and large proportion of local
with a thin equity base and large proportion of local
debt
debt

Multiple-source borrowing
Multiple-source borrowing
: Firm can borrow from
: Firm can borrow from
various banks and countries
various banks and countries
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COUNTRY-SPECIFIC RISKS
COUNTRY-SPECIFIC RISKS

These risks affect all firms, both domestic and foreign
These risks affect all firms, both domestic and foreign
operating within the host country
operating within the host country

Most typical risks are
Most typical risks are

Transfer risk
Transfer risk

Cultural differences
Cultural differences

Host country protectionism
Host country protectionism
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COUNTRY-SPECIFIC RISKS
COUNTRY-SPECIFIC RISKS
Country-Specific Risks: Measurement and Management Country-Specific Risks: Measurement and Management
Transfer Risk Transfer Risk
• • Blocked funds Blocked funds
• • Macroeconomic Macroeconomic
disequilibrium disequilibrium
• • Economic Economic
infrastructure infrastructure
• • Sovereign credit Sovereign credit
risk risk
Cultural Differences Cultural Differences
• • Religion Religion
• • Nepotism and Nepotism and
corruption corruption
• • Intellectual property Intellectual property
rights rights
Protectionism Protectionism
• • Defense industry Defense industry
• • Agriculture Agriculture
• • Infant industry Infant industry
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COUNTRY- SPECIFIC RISKS
COUNTRY- SPECIFIC RISKS

Transfer risk
Transfer risk
are the limitations on the MNE’s ability to
are the limitations on the MNE’s ability to
transfer funds into & out of a host country without
transfer funds into & out of a host country without
restrictions
restrictions

MNEs can react to potential transfer risk at 3 stages:
MNEs can react to potential transfer risk at 3 stages:

Prior to making the investment, a firm can analyze
Prior to making the investment, a firm can analyze
the effect of
the effect of
blocked funds
blocked funds

During operations a firm can
During operations a firm can
attempt to move funds
attempt to move funds

through a variety of repositioning techniques
through a variety of repositioning techniques

Funds that cannot be moved
Funds that cannot be moved
must be reinvested in
must be reinvested in
the local country to avoid deterioration in real value
the local country to avoid deterioration in real value
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COUNTRY - SPECIFIC RISKS
COUNTRY - SPECIFIC RISKS

An MNE has at least 6
An MNE has at least 6
strategies for transferring funds
strategies for transferring funds
under restrictions:
under restrictions:

Providing alternative conduits for repatriating funds
Providing alternative conduits for repatriating funds
(Ch. 21)
(Ch. 21)

Transfer pricing goods & services between
Transfer pricing goods & services between
subsidiaries (Ch. 21)
subsidiaries (Ch. 21)

Leading and lagging payments (Ch. 22)
Leading and lagging payments (Ch. 22)

Using fronting loans
Using fronting loans

Creating unrelated exports
Creating unrelated exports

Obtaining special dispensation
Obtaining special dispensation
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COUNTRY - SPECIFIC RISKS
COUNTRY - SPECIFIC RISKS

Fronting loans
Fronting loans

A fronting loan is a parent-to-subsidiary loan
A fronting loan is a parent-to-subsidiary loan
channeled through a financial intermediary
channeled through a financial intermediary

The lending parent deposits the funds in a bank,
The lending parent deposits the funds in a bank,
let’s say in London
let’s say in London

That bank in turn “loans” this amount to the
That bank in turn “loans” this amount to the
borrowing subsidiary
borrowing subsidiary

In essence, the bank “fronts” for the parent
In essence, the bank “fronts” for the parent
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COUNTRY - SPECIFIC RISKS
COUNTRY - SPECIFIC RISKS

Creating unrelated exports
Creating unrelated exports

Because main reason for stringent exchange
Because main reason for stringent exchange
controls is a host country’s ability or inability to earn
controls is a host country’s ability or inability to earn
hard currency, anything an MNE can do to generate
hard currency, anything an MNE can do to generate
export sales helps the host country
export sales helps the host country

Some exports can be created from present
Some exports can be created from present
productive capacity or through production of
productive capacity or through production of
unrelated products and services for export
unrelated products and services for export

Special dispensation
Special dispensation

If the firm is in an important industry for the
If the firm is in an important industry for the
development of the host country, it may bargain for a
development of the host country, it may bargain for a
special dispensation to repatriate some funds
special dispensation to repatriate some funds
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COUNTRY-SPECIFIC RISKS
COUNTRY-SPECIFIC RISKS

Other country-specific risks that may block funds are
• Host country’s economic infrastructure
• Sovereign credit risk
• War & ethnic strife
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COUNTRY-SPECIFIC RISKS
COUNTRY-SPECIFIC RISKS

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
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GLOBAL-SPECIFIC RISKS
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
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AGENDA

Part 4

Chapter 4.1

Chapter 4.2

Chapter 4.3

Chapter 4.4
International Investing

Foreign Direct Investment Theory & Strategy

Adjusting for Risk in Foreign Investment
Cross-Border Mergers, Acquisitions & Valuation
International Portfolio Theory & Diversification
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HISTORICAL CROSS-BORDER
HISTORICAL CROSS-BORDER
M&A ACTIVITY
M&A ACTIVITY
Cross-Border Mergers & Acquisitions: Developed Countries (billions of US dollars)
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HISTORICAL CROSS-BORDER
M&A ACTIVITY
0
10
20
30
40
50
60
70
1995 1996 1997 1998 1999 2000
Africa Asia Latin America West Asia Eastern Europe
Cross-Border Mergers & Acquisitions: Developing Countries (billions of US dollars)
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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
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THE DRIVING FORCE FOR
CROSS-BORDER M&A
Price = EPS ×
P
E
Management, directly
controls through its
efforts the earnings per
share of the firm.
Management only
indirectly influences
the market’s opinion
of the company’s earnings
as reflected in the P/E.
Increasing the share
price means
increasing earnings.
The Goal: Increase the share price of the firm
So building “value” means growing the firm to grow earnings.
The largest growth potential is global.
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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
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CROSS-BORDER M&A DRIVERS

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
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CROSS-BORDER M&A DRIVERS
Cross - Border
M & A activity
time
Source: UNCTAD, World Development Report 2000: Cross-border Mergers and Acquisitions and Development,
figure V.1., p. 154.
Firms Undertake M&As to: Firms Undertake M&As to:
• Access strategic proprietary assets
• Gain market power & dominance
• Achieve synergies
• Become larger
• Diversify & spread risks
• Exploit financial opportunities
Strategic responses by firms Strategic responses by firms
to defend and enhance their to defend and enhance their
competitive positions in a competitive positions in a
changing environment. changing environment.
Changes in the Global Environment Changes in the Global Environment
• Technology
• Regulatory frameworks
• Capital market changes
New business
opportunities
and risks
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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
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CROSS-BORDER M&A PROCESS
Identification
& valuation
of the target
Valuation
&
negotiation
Management of
the post-acquisition
transition; integration
of business
and culture
Rationalization of
operations;
integration of
financial goals;
achieving synergies
Completion of
the ownership
change
transaction
(the tender)
Financial
settlement
&
compensation
Strategy
&
Management
Financial
Analysis &
Strategy
Stage III Stage III Stage II Stage II Stage I Stage I
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CROSS-BORDER M&A PROCESS

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.
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CROSS-BORDER M&A PROCESS

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
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CROSS-BORDER M&A PROCESS

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
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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
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CORPORATE GOVERNANCE &
SHAREHOLDER RIGHTS

The Tender and 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
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CORPORATE GOVERNANCE &
SHAREHOLDER RIGHTS

The Tender and 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
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CORPORATE GOVERNANCE &
SHAREHOLDER RIGHTS

The Tender and 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
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CORPORATE GOVERNANCE &
SHAREHOLDER RIGHTS

The Tender and 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
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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
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
• 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
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

However, Tsingtao was known for its operational excellence
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CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
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CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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)
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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%
Rmb7,539.6
02 . 0 10 . 0
) 02 . 1 ( 3 . 591 Rmb
g k
g) 1 ( FCF
value Terminal
WACC
2000
·

·

+
·
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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%
% 36 . 12 ) 0 . 7 7 . 13 ( 80 . 0 0 . 7 ) k k ( k k
f m rf e
· − + · − + · β
10.0% %) (.333x5.28 x12.36%) 667 (. k x t) - (1 x
V
D
k x
V
E
k
d e WACC
· + ·
]
]
]

,
`

.
|
+
]
]
]

,
`

.
|
·
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CROSS-BORDER
VALUATION:
TSINGTAO BREWERY
COMPANY
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY

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
4 . 34
HK$0.064
HK$2.20
HK$ in 2000 for EPS
HK$ in price Current
P/E · · ·
• Tsingtao’s 34.4 × earnings is considerably higher than the Hong Kong exchange’s
average of 12 ×
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
• 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
94 . 0
HK$2.35
HK$2.20
HK$ in share per Book value
HK$ in price Current
MTB · · ·
• According to this, Tsingtao is selling for less than its historical cost of capital invested
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CROSS-BORDER VALUATION:
TSINGTAO BREWERY COMPANY
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AGENDA

Part 4

Chapter 4.1

Chapter 4.2

Chapter 4.3

Chapter 4.4
International Investing

Foreign Direct Investment Theory & Strategy

Adjusting for Risk in Foreign Investment
Cross-Border Mergers, Acquisitions & Valuation
International Portfolio Theory & Diversification
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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
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INTERNATIONAL DIVERSIFICATION & RISK
Portfolio of
U.S. stocks
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.
Systematic
risk
Total
risk
Total Risk = Diversifiable Risk + Market Risk
(unsystematic) (systematic)
Percent
risk
=
Variance of portfolio return
Variance of market return
20
40
60
80
Number of stocks in portfolio
10 20 30 40 50 1
100
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INTERNATIONAL DIVERSIFICATION & RISK
Portfolio of international stocks
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.
Percent
risk
=
Variance of portfolio return
Variance of market return
20
40
60
80
Number of stocks in portfolio
10 20 30 40 50 1
100
Portfolio of
U.S. stocks
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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
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FOREIGN EXCHANGE RISK

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%)
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FOREIGN EXCHANGE RISK

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
( )( ) [ ] 1 r 1 r 1 R
shares,¥ ¥/$ $
− + + ·
( )( ) [ ] 300 . 1 250 . 0 1 400 . 0 1 R
$
· − + + ·
Where: ¥130/¥125 = .04 ¥25,000/¥20,000 = .25
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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
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INTERNATIONALIZING THE DOMESTIC PORTFOLIO
Expected
Return
of Portfolio, R
p
Expected Risk
of Portfolio,
p
Domestic portfolio
opportunity set
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 MR
DP
.
R
f
Capital Market
Line (Domestic)

σ
DP
R
DP

Minimum risk (MR
DP
)
domestic portfolio
MR
DP
DP
Optimal domestic
portfolio (DP)
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INTERNATIONALIZING THE DOMESTIC PORTFOLIO

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
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INTERNATIONALIZING THE DOMESTIC PORTFOLIO
Expected
Return
of Portfolio, R
p
Expected Risk
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 Capital Market Line is tangent to the domestic opportunity set. The domestic portfolio with the minimum risk is designated MR
DP
.
R
f
Capital Market
Line (Domestic)

σ
DP
R
DP
Domestic portfolio
opportunity set
DP
Internationally diversified
portfolio opportunity set
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INTERNATIONALIZING THE DOMESTIC PORTFOLIO

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
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INTERNATIONALIZING THE DOMESTIC PORTFOLIO
Expected
Return
of Portfolio, R
p
Expected Risk
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 MR
DP
.
R
f
CML (Domestic)

σ
DP
R
DP
Domestic portfolio
opportunity set
DP
Internationally diversified
portfolio opportunity set
R
IP

σ
IP
IP
Optimal
international
portfolio
CML (International)
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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(r w ) E(r w ) E(r
B B A A A
+ ·
Where: A = one asset
B = second asset
w = weights (respectively)
E(r) = expected return of assets
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CALCULATING PORTFOLIO RISK AND RETURN

The expected risk is calculated as
AB B A B A
2
B
2
B
2
A
2
A P
w w 2 w w ρ σ σ σ σ σ + + ·
Where: A = first asset
B = second asset
w = weights (respectively)
σ = standard deviation of assets
ρ = correlation coefficient of the two assets
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CALCULATING PORTFOLIO RISK AND RETURN

Example of two-asset model
US/GER GER US GER US
2
GER
2
GER
2
US
2
US P
w w 2 w w ρ σ σ σ σ σ + + ·
Where: US = US security
GER = German security
w
US
= weight of US security – 40%
w
GER
= weight of German security – 60%
σ
US
= standard deviation of US security – 15%
ρ = correlation coefficient of the two assets – 0.34
) 34 . 0 )( 20 . 0 )( 15 . 0 )( 60 . 0 )( 40 . 0 ( 2
2
) 20 . 0 (
2
) 60 . 0 (
2
) 15 . 0 (
2
) 40 . 0 ( 151 . 0 + + ·
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CALCULATING PORTFOLIO RISK AND RETURN

Example of two-asset model
) E(r w ) E(r w ) E(r
GER GER US US
+ ·
Where: E
US
= expected return on US security – 14%
E
GER
= expected return on German security – 18%
w
US
= weight of US security
w
US
= weight of German security
E(r) = expected return of portfolio
) 18 . 0 )( 60 . 0 ( ) 14 . 0 )( 40 . 0 ( 164 . 0 + ·
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CALCULATING PORTFOLIO RISK AND RETURN
11 12 13 0 14 15 16 17 18 19 20
Expected
Portfolio
Risk ( )
Expected Portfolio
Return (%)
12
13
14
15
16
17
18

Maximum
return &
maximum risk
(100% GER)

Minimum risk combination
(70% US & 30% GER)

Domestic only portfolio
(100% US)

Initial portfolio
(40% US & 60% GER)
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CALCULATING PORTFOLIO RISK AND RETURN

The multiple asset model for portfolio return
) E(r w ) E(r
i i
N
1 i
P
·
Σ ·
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CALCULATING PORTFOLIO RISK AND RETURN

The multiple asset model for portfolio risk
ij j i j i
N
1 i j
1 - N
1 i
2
j
2
i
N
1 i
P
w w w ρ σ σ σ σ
+ · · ·
Σ Σ + Σ ·
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NATIONAL EQUITY MARKET PERFORMANCE
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NATIONAL EQUITY MARKET PERFORMANCE
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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
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SHARP AND TREYNOR
PERFORMANCE MEASURES

The Sharpe measure calculates the average return over and above the risk-free rate
per unit of portfolio risk
i
f
i
R R
measure Sharpe
σ

·
Where: R
i
= average portfolio return
R
f
= market return
σ = risk of the portfolio
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SHARP AND TREYNOR
PERFORMANCE MEASURES

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
i
f
i
R R
measure Treynor
β

·
Where: R
i
= average portfolio return
R
f
= market return
β = beta of the portfolio
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SHARP AND TREYNOR
PERFORMANCE MEASURES

Example:
- Hong Kong average return was 1.5%
- Assume risk free rate of 5%
- Standard deviation is 9.61%
113 . 0
0.0961
0042 . 0 015 . 0
measure Sharpe ·

·
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SHARP AND TREYNOR
PERFORMANCE MEASURES

Example:
- Hong Kong average return was 1.5%
- Assume risk free rate of 5%
- beta is 1.09
0100 . 0
1.09
0042 . 0 015 . 0
measure Treynor ·

·
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SHARP AND TREYNOR
PERFORMANCE MEASURES

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
114 IMBA International Finance (E) Part 4 Lecture Part 4 International Investing

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International Master of Business Administration
ARE MARKETS INCREASINGLY INTEGRATED?
115 IMBA International Finance (E) Part 4 Lecture Part 4 International Investing

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International Master of Business Administration
THE INTERNATIONAL CAPM

Recall that CAPM is

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
) k k ( k k
f m rf e
− + · β
m
j
jm i
σ
σ
ρ β ·
Where: β = beta of the security
ρ = correlation coefficient of the market and the security
σ = standard deviation of return
116 IMBA International Finance (E) Part 4 Lecture Part 4 International Investing

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International Master of Business Administration

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International Master of Business Administration

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International Master of Business Administration
THE INTERNATIONAL CAPM