ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 8: International investment and financing decisions

The project is financially viable, subject to an assessment of the project risk, if the

NPV at Stage 2 is positive.

Example

A company is considering an investment in another country, by setting up a foreign

subsidiary. The investment would cost 20 million foreign currency units (CUs).

At current prices, the cash flows from the project in the other country are expected

to be as follows, before allowing for tax:

Year CUs

0 (20.0) million

1 8.0 million

2 10.0 million

3 8.0 million

Taxation in the foreign country is at 50%, and is payable in the year following the

year in which the taxable profits occur.

In addition, in Year 1 of the project, the foreign government will refund 50% of the

cost of the investment as a tax allowance. This will be refunded in the form of a cash

payment to the company’s subsidiary.

Other information:

 The rate of inflation in the foreign country is expected to be 10% each year.

 The equity beta for the new project will be 1.80.

 The company is all-equity financed, and would finance the new project with

equity.

 The risk-free rate of return is 10% and the market return is 15%, in the foreign

country.

 The company’s own cost of capital is 11%.

 Due to foreign exchange control regulations, the company will not be permitted

to withdraw its surplus cash from the country in dividends until the end of Year

3. At the end of Year 3, the dividends paid from the foreign subsidiary to the

parent company will be the total cash profits from the project, less the net tax

payments.

 The company will also have to spend $200,000 in its own country at the start of

the project on legal fees and set-up costs. The tax rate in the company’s own

country is 30%.

 The expected rate of inflation in the company’s own country over the next three

years is expected to be 6% each year.

 The current rate of exchange is $1 = 4 Currency Units.

Required

Calculate the NPV of the investment, and recommend whether it should be

undertaken.

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Answer

Step 1: Calculate the NPV of the cash flows in the foreign country

The project is all-equity financed. The cost of capital for the project can therefore be

calculated directly from the CAPM, using a beta factor of 1.80.

Cost of equity = 10% + 1.80 (15% – 10%) = 19%.

The cash flows for the project in the other country must now be estimated. The cash

flow estimates should allow for both taxation at 50% and annual inflation at 10%.

The tax cash flows are one year in arrears of the profits or losses that give rise to

them.

The following cash flow estimates are all in millions of CUs:

Year 0 1 2 3 4

Cash flows before tax and inflation

(20.00)

8.00

10.00

8.00

Cash flows allowing for inflation at 10%

(20.00)

8.80

12.10

10.65

Tax at 50%

10.00

(4.40)

(6.05) (5.33)

Net cash flows

(20.00)

18.80

7.70

4.60 (5.33)

The NPV of the project within the foreign country can now be calculated, using a

discount rate of 19%.

Year

Cash flow

Discount

factor at 19%

CUs (millions)

0 (20.00) 1.000

(20.00)

1 18.80 0.840

15.79

2 7.70 0.706

5.44

3 4.60 0.593

2.73

4 (5.33) 0.499

(2.66)

NPV

+ 1.30

The investment would have a positive NPV on the basis of the cash flows in the

foreign country.

Step 2

Calculate the NPV of the investment for the parent company, by calculating the cash

flows to the parent from the investment and discounting these at the parent’s

(WACC).

To do this, an estimate is needed of the future exchange rate in the years when the

cash flows from the foreign investment will be received.

Year

Cash flow in

CUs

Estimated

exchange rate

(see working)

Cash flow

in $

CUs $

0 Capital expenditure (20,000,000)

4.0 (5,000,000)

0 Other expenditure: legal fees, set-up costs

(200,000)

1 Tax relief on Year 0 spending at 30%

60,000

3 Dividends from foreign subsidiary:

Cash profits (8.8 + 12.1 + 10.65)

31,550,000

Net tax ((10.0) + 4.4 + 6.05 + 5.33)

(5,780,000)

Dividend

25,770,000

4.47 5,770,000

Chapter 8: International investment and financing decisions

Working

Using the PPP theory formula shown earlier, the estimated exchange rate at the end

of Year 3 =

$1 = 4CUs × (1.10)

/(1.06)

$1 = 4 × 1.331/1.191

$1 = 4.47.

At this exchange rate, the dividend of 25.77 million CUs will be exchanged into:

25.77 million/4.47 = $5.77 million.

These cash flows should be discounted at the parent company’s WACC to arrive at

an NPV for the project.

The parent company’s WACC is 11%.

Year

Cash flow

Discount

factor at 11%

$ million

0 (5.20) 1.000

(5.20)

1 0.06 0.901

0.05

3 5.77 0.731

4.22

NPV

(0.93)

The NPV is negative; therefore the project should not be undertaken. The negative

NPV has been caused by:

 the delay until Year 3 in being able to repatriate the investment profits in the

form of dividend payments

 the falling value of the foreign Currency Units between Year 0 and Year 3.

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International sources of finance

 Currency borrowing to reduce the currency risk in capital investments

 Local capital markets for borrowing

4 International sources of finance

4.1 Currency borrowing to reduce the currency risk in capital investments

International capital investment is similar in many respects to capital investment in

a company’s own country, although there are some extra risks. As explained earlier,

a major additional risk is the currency risk. Changes in the value of a foreign

currency relative to the investing company’s currency could have a significant effect

on a project NPV.

One way of reducing currency risk is to borrow in the currency of the investment to

finance some or all of a proposed international project. Borrowing in the currency of

the investment reduces risk in two ways.

 It reduces the translation risk. By borrowing in the currency of the investment,

the parent company is able to match assets in a foreign currency with liabilities

in the same currency. To the extent that the assets and liabilities are matched in

value, any movement in the exchange rate will have an equal effect on the

translated value of the assets and liabilities. For example, if a company invests in

a project costing 20 million foreign currency units, and borrows 20 million

foreign currency units to finance the project, assets and liabilities in the foreign

currency are matched, and translation risk is eliminated.

 It also reduces the transaction risk. This is because when a company borrows in

a foreign currency, it must pay interest and repay the loan in the same currency.

It will use cash flows from the project to make the payments. In doing so, it is

able to match some of its receipts in the foreign currency with payments in the

same currency. To the extent that receipts and payments in the same foreign

currency can be matched, transaction risk is eliminated

4.2 Local capital markets for borrowing

The ability of a company to borrow in the currency of an international investment

depends on:

 whether there is a large and active local capital market, and

 if there is a large capital market for the foreign currency, whether the company is

able to borrow in that market.

An international company might be able to borrow in the local currency from a

bank, possibly through its foreign subsidiary. It is much less likely that the foreign

country will have a well-developed corporate bond market for issuing bonds in the

local currency. The international bond markets are also inappropriate for borrowing

in any currency except the major international currencies (mostly the US dollar and

the euro).

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CHAPTER

Mergers and acquisitions

Contents

1 Mergers and takeovers: strategic and regulatory

issues

2 Valuation for mergers and acquisitions: book

value plus and market relative models

3 Valuation for mergers and acquisitions: cash flow

models

4 Shareholder value added (SVA) method of

valuation

5 Economic value added (EVA) and market value

added (MVA) valuation models

6 Other aspects of valuation

7 Financing acquisitions and mergers

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Mergers and takeovers: strategic and regulatory issues

 The distinction between acquisitions and mergers

 The objective of a merger or takeover

 Criteria for choosing an acquisition target

 Synergy

 The high failure rate of acquisitions

 The regulatory framework for acquisitions

 Defences against a hostile takeover bid

 Will shareholders in the target company accept an offer for their shares?

1 Mergers and takeovers: strategic and regulatory

issues

1.1 The distinction between acquisitions and mergers

A company with a growth strategy might seek to grow by means of a merger or

acquisition. Mergers and acquisitions involve the amalgamation of two companies.

 Typically, one company acquires the other and becomes the parent company.

The second company becomes a subsidiary within the group.

 Occasionally, a new parent company might be created, and the two merging

companies become subsidiaries of the new parent company.

A merger is an amalgamation of two companies of approximately equal size. In a

takeover, a larger company usually acquires a majority of the share capital in a

smaller ‘target’ company. In practice, business combinations are usually an

acquisition of one company by another.

However the financial management issues are broadly the same for mergers as for

acquisitions.

1.2 The objective of a merger or takeover

The objective of a takeover should be consistent with the overall objectives of the

company making the takeover, which should be to increase the wealth of its

shareholders. Similarly, the objective of a merger should be to satisfy the objectives

of both companies – to increase the wealth of the shareholders of both companies. It

is not always obvious, however, how a merger or takeover might add value and

create wealth for shareholders.

More specifically, the purpose of an acquisition or a merger is to grow the company.

In an acquisition, the acquiring company takes over the business of the target

company – its net assets, its other resources, its sales and markets and (hopefully) its

profits.

Chapter 9: Mergers and acquisitions

Alternatives to acquisitions

A company that is pursuing an expansion strategy might consider alternative

expansion strategies. The main alternatives are:

 growth through internal development of the business

 growth by means of a joint venture.

A comparison of growth by acquisition and internal growth

Compared to growth through internal development, growth by acquisition has

several advantages.

 By far the most important advantage of an acquisition is that growth is achieved

much more quickly. By making an acquisition, a company immediately gets

bigger. If the target for acquisition has been selected well, the company should

be able to move towards its strategic goals more quickly than if it tried to grow

internally.

 It is often argued that when a target company is acquired, it should be possible

to achieve ‘synergies’ and add value by increasing the combined profits of the

two companies. Synergy is explained in more detail later.

 When a company is trying to grow its business in another country, acquisition

might be better than internal growth, because the company will acquire skilled

employees who already understand the business, the country, its laws and

culture and its language.

 Unless a company acquires available target businesses, its competitors might

acquire them instead and the strategic threat from the enlarged competitor

might increase.

There are several reasons, however, why growth through internal development

might be preferred to growth by acquisition.

 There is a high risk that the price paid for an acquisition will be too high, and the

financial return from buying an over-valued company will be low.

 Many acquisitions are failures. This means that an acquisition strategy is a high-

risk strategy. The reasons why acquisitions often fail are explained later.

 With a strategy of internal growth, the company’s management should be able

to plan and control the development of the business more effectively, because

the practical problems associated with acquisitions do not arise. The practical

problems include difficulties with employees in the acquired company and the

management time needed to combine the systems of the two companies after the

acquisition.

 An acquisition is not usually ‘ideal’ and there will be some features of the target

company that the acquirer might not want to buy. After the acquisition, the

acquiring company might want to sell off unwanted parts of the business. This

can be a time-consuming process, and the prices obtained from selling off these

operations and assets might be low.

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A comparison of growth by acquisition and growth by joint venture

An opportunity might arise to grow the business by forming a joint venture with

one or more other entities. Growth through joint ventures has some advantages

over growth through acquisition.

 When a company wants to enter the market in a foreign country, there might be

a risk that an acquisition will create a hostile response from the government of

the country concerned and from the customers of the target company. There

might even be legal restrictions on the maximum percentage of shares in a

domestic company that a foreign investor is allowed to acquire. These

difficulties might be avoided by setting up a joint venture with a local company.

 Joint ventures should involve a lower capital investment, because the setup costs

will be shared with the joint venture partner. The business risks and (in a foreign

country) political risks are also shared.

 A joint venture partner might bring skills and expertise to the venture that the

company does not have. The companies in a joint venture might therefore

complement each other, and improve the prospects for success of the venture.

Joint ventures also have disadvantages, compared with an acquisition.

 The joint venture partners might have different strategic objectives, and might

want different end-results from the business venture. This might eventually lead

to a conflict of interests and disagreement between the partners.

 With an acquisition, the acquirer obtains management control of the target

business. In a joint venture, control is shared with the other partner or partners.

 At some stage in the future, it is likely that one joint venture partner will want to

buy-out the other, if the venture is a success. For the company selling its share of

the business to the other partner, the joint venture will not have been successful

in achieving long-term growth in the business, only a short-term financial

return.

1.3 Criteria for choosing an acquisition target

The choice of acquisition targets might be based on any of the following criteria:

 Strategic aims and objectives. An acquisition target is usually selected because

acquiring the target would help the acquiring company to achieve its strategic

targets. For example, a company might be seeking to grow the business by

expanding its product range for its existing markets, or moving into new

geographical markets. Acquiring a suitable business would enable a company to

expand its product range or move into new geographical markets. Some

companies have pursued a strategy of buying up a large number of small

companies in a fragmented market, with the intention of becoming the largest

company and market leader.

 Cost and relative size. Although there are occasional examples of small

companies acquiring much larger ones in a ‘reverse takeover’, target companies

are usually selected because they are affordable.

 Opportunity and availability. In many cases, targets for acquisition are selected

because of circumstances. An opportunity to acquire a particular company

Chapter 9: Mergers and acquisitions

might arise, and the acquiring company might decide to take the opportunity

whilst it is available.

 Potential synergy. Acquisition targets might possibly be selected because they

provide an opportunity to increase total profits through improvements in

efficiency. One reason for the success of private equity funds in acquiring target

companies has been their ability to achieve additional efficiencies and economies

that the previous company management had been unable to do. A strategy of

private equity funds might be to look for target companies that they consider

under-valued, with the intention of improving their operations and creating

extra value.

1.4 Synergy

Synergy is sometimes called the ‘2 + 2 = 5’ effect. It is the concept that the combined

sum of two separate entities after a merger or acquisition will be worth more than

their sum as two separate entities. When two separate entities come together into a

single entity, opportunities might arise for increasing profits.

Synergies might be divided into three categories:

 Revenue synergies

 Cost synergies

 Financial synergies.

Revenue synergies

Revenue synergies are increases in total sales revenue following a merger or

acquisition, by increasing total combined market share. For example, if Company A

has annual sales revenue of $500 million acquires Company B which has annual

sales revenue of $200 million, the combined revenue of the two companies after the

merger might be, say, $750 million.

It is unusual for revenue synergies to occur, but they might occur in the following

circumstances:

 The acquisition or merger creates an enlarged company that is able to promote

its brand more effectively, and market share increases because customers are

attracted by the new brand image.

 The acquisition or merger creates an enlarged company that is able to bid for

large contracts, such as contracts to supply the government, which the two

companies were unable to do before they combined due to their smaller size.

Cost synergies

Cost synergies are reductions in costs as a consequence of a merger or takeover.

They might arise because it is possible to improve efficiency. For example, it might

be possible to reduce the size and cost of administrative departments by combining

the administrative functions of the two companies. It is not unusual for takeovers to

result in staff redundancies, partly for this reason.

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Cost synergies might also be possible by combining other activities, such as

combining warehouse facilities.

Experience has shown, however, that companies often have difficulty in achieving

planned cost synergies after a takeover, because combining the activities of the two

companies after the takeover is often a long and complex process.

Financial synergies

A larger (combined) company or group might be able to raise finance in a cheaper

way. The enlarged company might have access to financial markets, such as the

bond market, that the two individuals companies could not access before the

takeover, due to their smaller size.

The larger company might also be seen as a lower credit risk, so that it is able to

borrow from banks at a lower rate of interest.

1.5 The high failure rate of acquisitions

Many acquisitions fail, and do not provide the value for shareholders that was

expected when the acquisition was made. There are several reasons for failure.

 The purchase price paid for an acquisition is often too high.

 The expected synergies do not occur.

 There are serious problems with integrating the acquired company into the new

group.

- Employees in the acquired company might find it difficult to accept the

different culture of the acquiring company, and a new set of policies and

procedures. The loss of staff might be high, and valuable knowledge and

expertise might be lost.

- There might be problems with establishing effective management control

in the acquired company. Control systems might have to be reviewed and

changed.

 Senior management in the acquiring company might not give the acquired

company sufficient time and attention to make the acquisition operationally and

financially successful.

 Competitors might react to an acquisition with a new competitive strategy of

their own. Increased competition might drive down the profits for all

participants in the market.

1.6 The regulatory framework for acquisitions

The regulatory framework for mergers and acquisitions varies between countries.

In the UK, listed companies are required to obtain shareholder approval for major

acquisitions or a merger, and subject to the requirements of competition law

mergers or acquisitions do not need government approval and are not prohibited by

law. This means for example that UK regulations do not restrict the ability of non-

UK companies to acquire UK companies.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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