Description
This is a presentation explains about the various approaches which can be taken while valuing international acquisition.
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Managers evaluating an international acquisition need to address 2 questions Should the acquisition be evaluated from the perspective of managers in the country in which the firm is located or that of parent company? Should the cash flows be adjusted downwards or the discount rate be raised to account for differential political and economic risks?
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An international acquisition can be evaluated in two stages. In the first stage, firm is evaluated from the subsidiary’s perspective. In the second stage, the amount and timing of profits repatriated (after paying taxes) to the parent company is estimated. It is common practice to make ad-hoc adjustments to cash flows or discount rates. For instance, if a company were to use 15% discount rate for a domestic acquisition, it might raise it to 20 % for foreign acquisition.
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Some academics suggest that it is better to adjust cash flows to account for risks (and not discount rate) because international risks are unsystematic in nature and hence diversifiable.
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Forecast foreign currency cash flows using host country tax rate and inflation rate. Estimate foreign currency discount rate using project (target firm) specific capital structure and beta. Calculate PV of the free cash flows in foreign currency. Convert to home currency using spot exchange rate.
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?
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Forecast foreign currency cash flows using host country tax rate and inflation rate. Forecast future exchange rates using parity relationships and convert cash flows to home currency Estimate home currency discount rate using project specific capital structure and beta. Calculate PV in home currency.
?
?
?
The effect of international risk can be incorporated by charging a premium for political and economic risk against each year’s cash flows. That is, incorporate the cost of buying an insurance to cover political risk from an agency like Overseas Private Investment Corporation or the Lloyd’s of London and the cost of covering economic risk by a forward cover in the currency market. Another approach is to estimate the probability of expropriation and the expected value (mean) of cash flows.
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Once the cash flow in the host country’s currency is estimated, probabilities are attached to different exchange rates (between local currency and home currency) forecasted by the analyst to translate cash flows into home currency.
?
?
?
?
Whether or not the discount rate for a foreign project should be adjusted depends on how one views international risk. Modern finance theory suggests that only systematic risk of a project matters as unsystematic risk can be diversified away. A multinational, due to its global focus, can diversify country specific risk as long as cash flows from these counties are not perfectly positively correlated. The standard measure of systematic risk is beta, which measures the sensitivity of asset returns to market returns.
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?
?
What is the appropriate proxy for the market portfolio in case of multinational investment? Is it the portfolio in country of operation or that in the home country? Or may be a global portfolio? The cost of equity estimate depends on the company’s beta, which could be estimated using the home country index or some global index.
?
?
?
CAPM is appropriate if the portfolio returns can be completely characterized by the mean and standard deviation. A large number of studies have shown that emerging market returns are non normal and hence cannot be described by mean and variance TN example of Mexico
?
? ? ?
?
If the Mexican returns were generated from a normal distribution, we would not expect so many negative returns of that magnitude. Thailand is similar to Mexico with some extreme negative observations. The same is true of many other countries. Emerging market returns are not only higher than returns from developed markets but also far more volatile due to economic shocks, military coups and such other factors. In addition, the mean and variance of returns change over time.
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?
?
In many emerging countries, the stock markets lack depth. Typically, a handful of companies account for more than half the market capitalization. So the stock market index would be a poor proxy for market portfolio which is supposed to represent the portfolio of all risky assets held by the marginal investor.
?
? ?
?
A recent study of emerging market returns suggests that there is no relation between expected returns and beta measured with respect to the world market portfolio Further, according to CAPM, expected return is a function of beta. The beta is measured by analyzing the way the equity returns covary with a benchmark return. In many countries beta cannot be estimated because the equity market does not exist!
?
?
?
One can estimate the beta of the company, if there is a stock market, by regressing stock returns against an international index such as the Morgan Stanley Capital International Emerging market index. The risk premium for a company in a non-US country could be expressed as Risk premium = base premium for a mature market + country premium
?
?
?
Cost of equity = Rf + ? (base premium for mature market like US) + Country premium. Where Rf = T – bond rate, a proxy for risk free rate, base premium is the geometric average premium (i.e., Rm – Rf) earned by stocks over bonds over a long period of time, 6.1 % in case of U.S. The country premium is added on the assumption that country risk cannot be diversified due to cross market correlation.
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Put differently, a major portion of the country risk is systematic. The equity risk premium of a country is a function of country default risk and the volatility of equity market relative to the country bond market.
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?
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Country equity risk premium = Country default spread * [?equity /? country bond] The country risk can be measured by the credit rating given by international credit rating agencies like Standard & Poor and Moody’s These agencies publish default spread over T- bond rate and spread over corporate bonds with similar rating in US.
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Where ?equity is the standard deviation of returns on the country’s stock market index and ? country bond is the standard deviation of country bond prices
?
?
?
The cost of equity estimate depends on the company’s beta, which could be estimated using the home country index or some global index. The choice depends on the investment opportunity set facing the company’s investors. If investors are assumed to be internationally diversified the returns on a global portfolio would be a better benchmark for assessing the cost of equity.
?
?
As long as there are benefits from international diversification, a portion of what seems to be systematic risk in a domestic context may be diversifiable country risk at a global level. If markets are completely integrated there would be no benefit from international diversification.
?
? ?
?
Although the tendency of markets to move together has increased in the recent years, the correlation is still less than 1. So there are still risk reducing opportunities. An estimate of cost of capital based on local CAPM is based on the assumption that each market is segmented from the rest of the world. Using a global CAPM would give more realistic estimates of expected returns for international firms.
?
?
?
?
The Global CAPM expressed in dollars states that E(R$) = Rf$ + ?g$ [Global Risk premium in dollar] ?g$ = global beta in US dollars measured by regressing monthly data for Infosys and, say, MSCI Emerging Markets Data processing & Reproduction Index Rf$ = risk free rate in dollars
?
?
Global risk premium = [return on the global portfolio in US dollar – dollar risk free rate The dollar rate might be used to discount dollar free cash flows to estimate the value of equity.
doc_204970447.pptx
This is a presentation explains about the various approaches which can be taken while valuing international acquisition.
?
?
?
Managers evaluating an international acquisition need to address 2 questions Should the acquisition be evaluated from the perspective of managers in the country in which the firm is located or that of parent company? Should the cash flows be adjusted downwards or the discount rate be raised to account for differential political and economic risks?
? ? ?
? ?
An international acquisition can be evaluated in two stages. In the first stage, firm is evaluated from the subsidiary’s perspective. In the second stage, the amount and timing of profits repatriated (after paying taxes) to the parent company is estimated. It is common practice to make ad-hoc adjustments to cash flows or discount rates. For instance, if a company were to use 15% discount rate for a domestic acquisition, it might raise it to 20 % for foreign acquisition.
?
Some academics suggest that it is better to adjust cash flows to account for risks (and not discount rate) because international risks are unsystematic in nature and hence diversifiable.
?
?
?
?
Forecast foreign currency cash flows using host country tax rate and inflation rate. Estimate foreign currency discount rate using project (target firm) specific capital structure and beta. Calculate PV of the free cash flows in foreign currency. Convert to home currency using spot exchange rate.
?
?
?
?
Forecast foreign currency cash flows using host country tax rate and inflation rate. Forecast future exchange rates using parity relationships and convert cash flows to home currency Estimate home currency discount rate using project specific capital structure and beta. Calculate PV in home currency.
?
?
?
The effect of international risk can be incorporated by charging a premium for political and economic risk against each year’s cash flows. That is, incorporate the cost of buying an insurance to cover political risk from an agency like Overseas Private Investment Corporation or the Lloyd’s of London and the cost of covering economic risk by a forward cover in the currency market. Another approach is to estimate the probability of expropriation and the expected value (mean) of cash flows.
?
Once the cash flow in the host country’s currency is estimated, probabilities are attached to different exchange rates (between local currency and home currency) forecasted by the analyst to translate cash flows into home currency.
?
?
?
?
Whether or not the discount rate for a foreign project should be adjusted depends on how one views international risk. Modern finance theory suggests that only systematic risk of a project matters as unsystematic risk can be diversified away. A multinational, due to its global focus, can diversify country specific risk as long as cash flows from these counties are not perfectly positively correlated. The standard measure of systematic risk is beta, which measures the sensitivity of asset returns to market returns.
?
?
?
What is the appropriate proxy for the market portfolio in case of multinational investment? Is it the portfolio in country of operation or that in the home country? Or may be a global portfolio? The cost of equity estimate depends on the company’s beta, which could be estimated using the home country index or some global index.
?
?
?
CAPM is appropriate if the portfolio returns can be completely characterized by the mean and standard deviation. A large number of studies have shown that emerging market returns are non normal and hence cannot be described by mean and variance TN example of Mexico
?
? ? ?
?
If the Mexican returns were generated from a normal distribution, we would not expect so many negative returns of that magnitude. Thailand is similar to Mexico with some extreme negative observations. The same is true of many other countries. Emerging market returns are not only higher than returns from developed markets but also far more volatile due to economic shocks, military coups and such other factors. In addition, the mean and variance of returns change over time.
?
?
?
In many emerging countries, the stock markets lack depth. Typically, a handful of companies account for more than half the market capitalization. So the stock market index would be a poor proxy for market portfolio which is supposed to represent the portfolio of all risky assets held by the marginal investor.
?
? ?
?
A recent study of emerging market returns suggests that there is no relation between expected returns and beta measured with respect to the world market portfolio Further, according to CAPM, expected return is a function of beta. The beta is measured by analyzing the way the equity returns covary with a benchmark return. In many countries beta cannot be estimated because the equity market does not exist!
?
?
?
One can estimate the beta of the company, if there is a stock market, by regressing stock returns against an international index such as the Morgan Stanley Capital International Emerging market index. The risk premium for a company in a non-US country could be expressed as Risk premium = base premium for a mature market + country premium
?
?
?
Cost of equity = Rf + ? (base premium for mature market like US) + Country premium. Where Rf = T – bond rate, a proxy for risk free rate, base premium is the geometric average premium (i.e., Rm – Rf) earned by stocks over bonds over a long period of time, 6.1 % in case of U.S. The country premium is added on the assumption that country risk cannot be diversified due to cross market correlation.
?
?
Put differently, a major portion of the country risk is systematic. The equity risk premium of a country is a function of country default risk and the volatility of equity market relative to the country bond market.
?
?
?
Country equity risk premium = Country default spread * [?equity /? country bond] The country risk can be measured by the credit rating given by international credit rating agencies like Standard & Poor and Moody’s These agencies publish default spread over T- bond rate and spread over corporate bonds with similar rating in US.
?
Where ?equity is the standard deviation of returns on the country’s stock market index and ? country bond is the standard deviation of country bond prices
?
?
?
The cost of equity estimate depends on the company’s beta, which could be estimated using the home country index or some global index. The choice depends on the investment opportunity set facing the company’s investors. If investors are assumed to be internationally diversified the returns on a global portfolio would be a better benchmark for assessing the cost of equity.
?
?
As long as there are benefits from international diversification, a portion of what seems to be systematic risk in a domestic context may be diversifiable country risk at a global level. If markets are completely integrated there would be no benefit from international diversification.
?
? ?
?
Although the tendency of markets to move together has increased in the recent years, the correlation is still less than 1. So there are still risk reducing opportunities. An estimate of cost of capital based on local CAPM is based on the assumption that each market is segmented from the rest of the world. Using a global CAPM would give more realistic estimates of expected returns for international firms.
?
?
?
?
The Global CAPM expressed in dollars states that E(R$) = Rf$ + ?g$ [Global Risk premium in dollar] ?g$ = global beta in US dollars measured by regressing monthly data for Infosys and, say, MSCI Emerging Markets Data processing & Reproduction Index Rf$ = risk free rate in dollars
?
?
Global risk premium = [return on the global portfolio in US dollar – dollar risk free rate The dollar rate might be used to discount dollar free cash flows to estimate the value of equity.
doc_204970447.pptx