Chapter 17

Cross-Border Mergers and Acquisitions

Analysis and Valuation

Courage is not the absence of fear. It is doing the thing you fear the most.

— Rick Warren

Inside M&A: inbev buys an american icon for $52 billion

For many Americans, Budweiser is synonymous with American beer, and American beer is synonymous with Anheuser-Busch. Ownership of the American icon changed hands on July 14, 2008, when beer giant Anheuser-Busch agreed to be acquired by Belgian brewer InBev for $52 billion in an all-cash deal. The combined firms would have annual revenue of about $36 billion and control about 25% of the global beer market and 40% of the U.S. market. The purchase is the largest in a wave of consolidations in the global beer industry, reflecting an attempt to offset rising commodity costs by achieving greater scale and purchasing power. While expecting to generate annual cost savings of about $1.5 billion, InBev stated publicly that the transaction is more about the two firms being complementary rather than overlapping.

The announcement marked a reversal from AB's position the previous week when it said publicly that the InBev offer undervalued the firm and subsequently sued InBev for “misleading statements” it had allegedly made about the strength of its financing. To court public support, AB publicized its history as a major benefactor in its hometown area (St. Louis, Missouri). The firm also argued that its own long-term business plan would create more shareholder value than the proposed deal. AB also investigated the possibility of acquiring the half of Grupo Modelo, the Mexican brewer of Corona beer, that it did not already own to make the transaction too expensive for InBev.

While it publicly professed to want a friendly transaction, InBev wasted no time in turning up the heat. The firm launched a campaign to remove Anheuser's board and replace it with its own slate of candidates, including a Busch family member. However, AB was under substantial pressure from major investors to agree to the deal, since the firm's stock had been lackluster during the preceding several years. In an effort to gain additional shareholder support, InBev raised its initial $65 bid to $70. To eliminate concerns over its ability to finance the deal, InBev agreed to fully document its credit sources rather than rely on the more traditional but less certain credit commitment letters.

In an effort to placate AB's board, management, and the myriad politicians who railed against the proposed transaction, InBev agreed to name the new firm Anheuser-Busch InBev and keep Budweiser as the new firm's flagship brand and St. Louis as its North American headquarters. In addition, AB would be given two seats on the board, including August A. Busch IV, AB's CEO and patriarch of the firm's founding family. InBev also announced that AB's 12 U.S. breweries would remain open.

By the end of 2010, the combined firms seemed to be progressing well, with the debt accumulated as a result of the takeover being paid off faster than planned. Earnings per share exceeded investor expectations. The sluggish growth in the U.S. market was offset by increased sales in Latin America. Challenges remain, however, since AB Inbev still must demonstrate that it can restore growth in the United States.1

Chapter overview

There are as many motives as there are strategies for international expansion. This chapter addresses common motives for international expansion, as well as the advantages and disadvantages of a variety of international market entry strategies. However, the focus in this chapter is on M&A as a market entry or expansion mode because cross-border M&As comprise on average one-fourth of all global transactions and more than one-half of direct foreign investment annually.² Moreover, foreign direct investment has replaced international trade as the driving force behind global integration of product markets. Given its focus on M&As, this chapter also addresses the challenges of M&A deal structures, financing, valuation, and execution in both developed and emerging countries. Finally, the chapter summarizes empirical studies investigating the actual benefits to both target and acquiring company shareholders of international diversification.

A chapter review (including practice questions with answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.

Distinguishing between developed and emerging economies

Throughout the chapter, the term local country refers to the target's country of residence, while home country refers to the acquirer's country of residence. Developed countries are those having significant and sustainable per capita economic growth, globally integrated capital markets, a well-defined legal system, transparent financial statements, currency convertibility, and a stable government. According to the World Bank, emerging countries have a growth rate in per capita gross domestic product significantly below that of developed countries. Note that while many emerging countries show annual gross domestic product (GDP) growth well in excess of that of developed countries, their per capita GDP growth rate, generally considered a better measure of economic well-being, is usually much lower.

Table 17.1 provides examples of developed and emerging economies as defined by Morgan Stanley Capital International. Other organizations, such as the Organization for Economic Cooperation and Development and the United Nations, include a somewhat different mix of countries. Despite definitional differences, Brazil, Russia, India, and China make everyone's list of emerging nations. These four countries (often grouped together under the acronym BRIC) constitute about four-fifths of the total GDP of emerging countries.³

Table 17.1. Examples of Developed and Emerging Economies

Source: Morgan Stanley Capital International (www.msci.com).

Globally integrated versus segmented capital markets

The world's economies have become more interdependent since WWII due to expanding international trade. As restrictions to foreign investment have been removed, country financial markets also have displayed similar interdependence or integration such that fluctuations in financial returns in one country's equity markets impact returns in other countries' equity markets. Between 1960 and 1990, the correlation among equity market financial returns for seven large developed countries increased, reflecting the emergence of a global capital market.⁴ Furthermore, the correlation between equity market returns in emerging economies compared to global financial market returns has increased following the liberalization of their stock markets.⁵

However, in contrast to earlier studies, there does not seem to have been an increase in the upward trend in correlation among financial returns for 23 developed countries between 1980 and 2003 (Table 17.2).⁶ The major exception is the correlation among equity market returns in European countries. However, the correlation appears to be highly sensitive to the time period examined. For example, the correlation between the performance of U.S. and European stocks increased from less than 30% in the 1970s to 90% for the five-year period ending in 2006.⁷

Table 17.2. Long-Term Movements in Country Financial Return Correlations between 1980 and 2003

Country Grouping	Average Correlation
All Countries	0.37
G7	0.37
Europe	0.54
Far East	0.30
U.S. versus Far East	0.27
U.S. versus Europe	0.39
U.S. versus All Other Countries	0.35

Source: Bekaert, Hodrick, and Zhang (2009).

Globally integrated capital markets provide foreigners with unfettered access to local capital markets and local residents with access to foreign capital markets. Factors contributing to the integration of global capital markets include the reduction in trade barriers, removal of capital controls, the harmonization of tax laws, floating exchange rates, and the free convertibility of currencies. Improving accounting standards and corporate governance also encourage cross-border capital flows. Transaction costs associated with foreign investment portfolios have also fallen because of advances in information technology and competition. Consequently, multinational corporations can more easily raise funds in both domestic and foreign capital markets. This increase in competition among lenders and investors has resulted in a reduction in the cost of capital for such firms.

Unlike globally integrated capital markets, segmented capital markets exhibit different bond and equity prices in different geographic areas for identical assets in terms of risk and maturity. Arbitrage should drive the prices in different markets to be the same, since investors sell those assets that are overvalued to buy those that are undervalued. Segmentation arises when investors are unable to move capital from one market to another due to capital controls or simply because they prefer to invest in their local markets. Segmentation or local bias may arise because of investors having better information about local rather than more remote firms.⁸

Investors in segmented markets bear a higher level of risk by holding a disproportionately large share of their investments in their local market as opposed to the level of risk if they invested in a globally diversified portfolio. Reflecting this higher level of risk, investors and lenders in such markets require a higher rate of return to local market investments than if investing in a globally diversified portfolio of stocks. Therefore, the cost of capital for firms in segmented markets without easy access to global markets often is higher than the global cost of capital.

There is evidence that capital markets in some countries may be segmented to the extent that local factors are more important in determining cash flows, access to capital, and share prices of small firms than of large firms.⁹ Consequently, the share price of a major French retailer like Carrefour may trade very much like the giant U.S. retailer Wal-Mart. However, the stock of a small French retail discount chain, affected more by factors in its local market segment, may trade differently from either Carrefour or Wal-Mart and exhibit a much higher cost of capital.

Motives for international expansion

The reasons firms expand internationally include the desire to achieve geographic diversification, accelerate growth, consolidate industries, utilize natural resources and lower labor costs elsewhere, and leverage intangible assets. Other motives include minimizing tax liabilities, avoiding entry barriers, fluctuating exchange rates, and following customers into foreign markets. Each of these is discussed in the following sections.

Geographic and Industrial Diversification

Firms may diversify by investing in different industries in the same country, the same industries in different countries, or different industries in different countries. Firms investing in industries or countries whose economic cycles are not highly correlated may lower the overall volatility in their consolidated earnings and cash flows. By increasing earnings and cash flow predictability, such firms may reduce their cost of capital.¹⁰

Accelerating Growth

Foreign markets represent an opportunity for domestic firms to grow. Large firms experiencing slower growth in their domestic markets have a greater likelihood of making foreign acquisitions, particularly in rapidly growing emerging markets.¹¹ U.S. firms have historically invested in potentially higher-growth foreign markets. Similarly, the United States represents a large, growing, and politically stable market. Consequently, foreign firms have increased their exports to and direct investment (including M&As) in the United States. For example, facing increasingly saturated home markets, many European telecommunications companies, such as Vodafone and Spain's Telefonica, set their sights on emerging markets to fuel future expansion.¹²

Reflecting the increasing cost of bringing drugs to market and the loss of patent protection on high-revenue-generating drugs, the global healthcare industry has been undergoing consolidation during much of the last decade. As part of the ongoing trend, chemical and drug manufacturer Merck acquired Millipore, a manufacturer of products to help develop and process drugs, in 2010.

Although headquartered in the United States, Millipore does about 40% of its business in Europe. The deal enabled Merck to diversify into the higher-growth and higher-margin biologics business to help offset declining margins in its chemical business.

That same year, Spanish bank Banco Bilbao Vizcaya Argentaria (BBVA) acquired a 24.9% stake in Turkey's largest bank, Turkiye Garanti Bankasi (Garanti), giving it access to a market that is growing much faster than its own domestic market. The price paid represented a 10 percent discount to Garanti's average closing price, reflecting BBVA's less than controlling interest. Also in 2010, China's Geely Automotive acquired Ford Motor Company's Volvo subsidiary in an attempt to substantially increase its international sales (see Case Study 17.1).

Case Study 17.1

Ford Sells Volvo to Geely in China's Biggest Overseas Auto Deal

Despite a domestic car market in which car sales exceeded the U.S. market for the first time in 2009, Chinese auto manufacturers moved aggressively to expand their international sales. In an effort to do so, Zhejiang Geely Holding Company, China's second largest non-government-owned car manufacturer, acquired Ford's money-losing Volvo operation in mid-2010 for $1.8 billion. The purchase price consisted of a $200 million note and $1.6 billion in cash.

Geely sees this acquisition as a way of moving from being a maker of low-priced cars affordable in the Chinese mass market to selling luxury cars and penetrating the European car market. Geely has publicly stated that it hopes to have one-half of its revenue coming from international sales by 2015. With 2,500 dealerships in more than 100 countries, acquiring Volvo is seen as a significant first step in achieving this goal.

As part of the agreement, Ford will continue to sell Volvo engines and other components and to provide engineering and technology support for an unspecified period of time. Geely intends to maintain car production in Sweden and to build another factory in China within the next several years.

Discussion Questions

1. With the world's largest and fastest-growing domestic car market, why do you believe Chinese carmakers are interested in expanding internationally?

2. What factors are likely to motivate Geely and other Chinese carmakers to ensure strict enforcement of intellectual property laws?

Industry Consolidation

Excess capacity in many industries often drives M&A activity, as firms strive to achieve greater economies of scale and scope as well as pricing power with customers and suppliers. The highly active consolidation in recent years in the metals industries (e.g., steel, nickel, and copper) represents an excellent example of this global trend. Global consolidation has also been common in such industries as financial services, media, oil and gas, telecommunications, and pharmaceuticals.

Once industries become more concentrated, smaller competitors often are compelled to merge, thereby accelerating the pace of consolidation. In late 2006, midsize European drug maker Merck KGaA agreed to buy Swiss biotechnology company Serono SA for $11 billion, and Germany's Alana AF said it would sell its comparatively low-market-share pharmaceutical business to Danish drug manufacturer Nycomed for $5 billion. Smaller drug companies found it difficult to compete with behemoths Pfizer Inc. and GlaxoSmithKline PLC, which have much larger research budgets and sales forces. Midsize firms also are more likely to be reliant on a few drugs for the bulk of their revenue, which makes them highly vulnerable to generic copies of their drugs.

Consolidation also results from buyers seeking to exploit what are believed to be undervalued assets. In late 2010, Canadian banks Toronto-Dominion and Bank of Montreal, largely unscathed by the global financial crisis, acquired U.S. consumer lenders Chrysler Financial for $6.3 billion and Wisconsin-based Marshall & Ilsley for $4.1 billion, respectively, to increase their market share in the consumer loan market.

Utilization of Lower Raw Material and Labor Costs

Emerging markets may be particularly attractive, since they often represent low labor costs, access to inexpensive raw materials, and low levels of regulation.13 Thus, shifting production overseas represents an opportunity to significantly reduce operating expenses and become more competitive in global markets. The salutary impact of lower labor costs often is overstated because worker productivity in emerging countries tends to be significantly lower than in more developed countries.

Leveraging Intangible Assets

Firms with significant expertise, brands, patents, copyrights, and proprietary technologies seek to grow by exploiting these advantages in emerging markets. Foreign buyers may seek to acquire firms with intellectual property so that they can employ such assets in their own domestic markets.¹⁴ Firms with a reputation for superior products in their home markets might find that they can successfully apply this reputation in foreign markets (e.g., Coke, Pepsi, and McDonald's).¹⁵ Firms seeking to leverage their capabilities are likely to acquire controlling interests in foreign firms.¹⁶ However, as Wal-Mart discovered, sometimes even a widely recognized brand name is insufficient to overcome the challenges of foreign markets (see Case Study 17.3).

Minimizing Tax Liabilities

Firms in high-tax countries may shift production and reported profits by building or acquiring operations in countries with more favorable tax laws. Evidence supporting the notion that such strategies are common is mixed.¹⁷

Avoiding Entry Barriers

Quotas and tariffs on imports imposed by governments to protect domestic industries often encourage foreign direct investment. Foreign firms may acquire existing facilities or start new operations in the country imposing the quotas and tariffs to circumvent such measures.

Fluctuating Exchange Rates

Changes in currency values can have a significant impact on where and when foreign direct investments are made. Appreciating foreign currencies relative to the dollar reduce the overall cost of investing in the United States. The impact of exchange rates on cross-border transactions has been substantiated in a number of studies.¹⁸

Following Customers

Often suppliers are encouraged to invest abroad to better satisfy the immediate needs of their customers. For example, auto parts suppliers worldwide have set up operations next to large auto manufacturing companies in China. By doing so, parts suppliers were able to reduce costs and make parts available as needed by the auto companies.

Common international market entry strategies

The method of market entry chosen by a firm reflects the firm's risk tolerance, perceived risk, competitive conditions, and overall resources. Common entry strategies include greenfield or solo ventures, mergers and acquisitions, joint ventures, export, and licensing. The literature discussing the reasons why a firm chooses one strategy over another is extensive. Figure 17.1 summarizes the factors influencing the choice of entry strategy.

Figure 17.1 Alternative market-entry strategies.

M&As can provide quick access to a new market; however, they are subject to many of the same problems associated with domestic M&As. They often are very expensive, complex to negotiate, subject to myriad regulatory requirements, and sometimes beset by intractable cultural issues. The challenges of implementing cross-border transactions are compounded by substantial cultural differences and frequently by local country political and regulatory considerations.

In a greenfield or solo venture, a foreign firm starts a new business in the local country, enabling the firm to control technology, production, marketing, and product distribution. Studies show that firms with significant intangible assets (e.g., proprietary know-how) are frequently able to earn above-average returns, which can be leveraged in a greenfield or start-up venture.¹⁹ However, the firm's total investment is at risk, and the need to hire local residents ensures that the firm is able to face the challenges associated with managing a culturally diverse employee base.

Joint ventures allow firms to share the risks and costs of international expansion, develop new capabilities, and gain access to important resources.²⁰ Most strategic alliances are with a local firm that understands the competitive conditions, legal and social norms, and cultural standards of the country. Local firms may be interested in alliances to gain access to the technology, brand recognition, and innovative products of the foreign firm. Despite these benefits, many alliances fail due to conflict between partners (see Chapter 14).

Alliances tend to produce higher financial returns if the partners have an equity interest.²¹ In contrast to earlier studies showing increasing use of alliances and joint ventures in entering foreign markets, more recent studies show a decline in the frequency of such activity. Factors contributing to this decline include lower coordination costs between domestic and foreign operations due to easier communication; reduced transportation costs; and integration of global financial markets.

Exporting does not require the expense of establishing local operations. However, exporters must establish some means of marketing and distributing their products at the local level. The disadvantages of exporting include high transportation costs, exchange rate fluctuations, and possible tariffs placed on imports into the local country. Moreover, the exporter has limited control over the marketing and distribution of its products in the local market. Recent studies show that firms exhibiting relatively low productivity (a proxy for cash flow) are more likely to enter foreign markets by exporting than via acquisition or investing in greenfield operations.²²

Licensing allows a firm to purchase the right to manufacture and sell another firm's products within a specific country or set of countries. The licensor is normally paid a royalty on each unit sold. The licensee takes the risks and makes the investments in facilities for manufacturing, marketing, and distribution of goods and services. Consequently, licensing is possibly the least costly form of international expansion. Therefore, licensing is an increasingly popular entry mode for smaller firms with insufficient capital and limited brand recognition.²³ Disadvantages include the lack of control over the manufacture and marketing of the firm's products in other countries. The risk may be high if the firm's brand or trademark is put in jeopardy. Furthermore, licensing often is the least profitable entry strategy because the profits must be shared between the licensor and licensee. Finally, the licensee may learn the technology and sell a similar competitive product after the license expires.

Structuring cross-border transactions

Acquisition vehicles, forms of payment and acquisition, and tax strategies are discussed in detail elsewhere in this book. This section discusses those aspects of deal structuring most pertinent to cross-border transactions.

Acquisition Vehicles

Non-U.S. firms seeking to acquire U.S. companies often use C corporations, limited liability companies, or partnerships to acquire the shares or assets of U.S. targets. C corporations are relatively easy to organize quickly, since all states permit such structures and no prior government approval is required. There is no limitation on non-U.S. persons or entities acting as shareholders in U.S. corporations, except for certain regulated industries. A limited liability company is attractive for joint ventures in which the target would be owned by two or more unrelated parties, corporations, or nonresident investors. While not traded on public stock exchanges, LLC shares can be sold freely to members. This facilitates the parent firm operating the acquired firm as a subsidiary or JV. A partnership may have advantages for investors from certain countries (e.g., Germany), where income earned from a U.S. partnership is not subject to taxation. A holding company structure enables a foreign parent to offset gains from one subsidiary with losses generated by another, serves as a platform for future acquisitions, and provides the parent with additional legal protection in the event of lawsuits.

U.S. companies acquiring businesses outside the United States encounter obstacles atypical of domestic acquisitions. These include investment and exchange control approvals, tax clearances, clearances under local competition (i.e., antitrust) laws, and unusual due diligence problems. Other problems involve the necessity of agreeing on an allocation of the purchase price among assets located in various jurisdictions and compliance with local law relating to the documentation necessary to complete the transaction. Much of what follows also applies to non-U.S. firms acquiring foreign firms.

The laws governing foreign firms have an important impact on the choice of acquisition vehicle, since the buyer must organize a local company to hold acquired shares or assets in a way that is consistent with local country law. In common-law countries (e.g., the United Kingdom, Canada, Australia, India, Pakistan, Hong Kong, Singapore, and other former British colonies), the acquisition vehicle will be a corporation-like structure. Corporations in the United Kingdom and other commonwealth countries are similar to those in the United States. In civil law countries (which include Western Europe, South America, Japan, and Korea), the acquisition will be in the form of a share company or limited liability company. Civil law is synonymous with codified law, continental law, or the Napoleonic Code. Practiced in some Middle Eastern Muslim countries and some countries in Southeast Asia (e.g., Indonesia and Malaysia), Islamic law is based on the Koran.

In the European Union, there is no overarching law or EU directive requiring a specific corporate form. Rather, corporate law is the responsibility of each member nation. In many civil law countries, smaller enterprises often use a limited liability company, while larger enterprises, particularly those with public shareholders, are referred to as share companies. The rules applicable to limited liability companies tend to be flexible and are particularly useful for wholly-owned subsidiaries. In contrast, share companies are subject to numerous restrictions and applicable securities laws. However, their shares trade freely on public exchanges.

Share companies tend to be more heavily regulated than U.S. corporations. Share companies must register with the commercial registrar in the location of their principal place of business. Bureaucratic delays from several weeks to several months between the filing of the appropriate documents and the organization of the company may occur. Most civil law countries require that there be more than one shareholder. Usually there is no limitation on foreigners acting as shareholders.

Limited liability companies outside the United States are generally subject to fewer restrictions than share companies. A limited liability company typically is required to have more than one quota holder (i.e., investor). In general, either domestic or foreign corporations or individuals may be quota holders in the LLC.²⁴

Form of Payment

U.S. target shareholders most often receive cash rather than shares in cross-border transactions.²⁵ Shares and other securities require registration with the Securities and Exchange Commission and compliance with all local securities (including state) laws if they are resold in the United States. Acquirer shares often are less attractive to potential targets because of the absence of a liquid market for resale or because the acquirer is not widely recognized by the target firm's shareholders.

Form of Acquisition

While a foreign buyer may acquire shares or assets directly, share acquisitions are generally the simplest form of acquisition. Share acquisitions result in all assets and liabilities of the target firm, on or off the balance sheet, transferred to the acquirer by “rule of law.” Asset purchases result in the transference of all or some of the assets of the target firm to the acquirer (see Chapter 11).

For acquisitions outside the United States, share acquisitions are the simplest mechanism for conveying ownership, since licenses, permits, franchises, contracts, and leases generally transfer to the buyer, without the need to get approval from licensors, permit holders, and the like, unless otherwise stipulated in the contract. The major disadvantage of a share purchase is that all the target's known and unknown liabilities transfer to the buyer. When the target is in a foreign country, full disclosure of liabilities is often limited, and some target assets transfer encumbered by tax liens or other associated liabilities.

While asset sales generally make sense in acquiring a single line of business, they often are more complicated in foreign countries when the local law requires that the target firm's employees automatically become the acquirer's employees with the sale of the assets. Mergers are not legal or practical in all countries, often due to the requirement that minority shareholders must assent to the will of the majority vote.

Tax Strategies

A common strategy used by foreign companies buying U.S. firms is the tax-free reorganization, or merger, in which target shareholders receive mostly acquirer stock in exchange for substantially all of the target's assets or shares. The target firm merges with a U.S. subsidiary of the foreign acquirer in a statutory merger under state laws. To qualify as a U.S. corporation for tax purposes, the foreign firm must own at least 80% of the stock of the domestic subsidiary. As such, the transaction can qualify as a type A tax-free reorganization (see Chapter 12). Target company shareholders receive voting or nonvoting stock of the foreign acquirer in exchange for their stock in the target firm.

Another form of deal structure is the taxable purchase, which involves the acquisition by one company of the shares or assets of another, usually in exchange for cash or debt. Such a transaction is called taxable because the target firm's shareholders recognize a taxable gain or loss on the exchange. The forward triangular merger in cash is the most common form of taxable transaction. The target company merges with a U.S. subsidiary of the foreign acquirer, with shareholders of the target firm receiving acquirer shares as well as cash, although cash is the predominate form of payment. This structure is useful when the foreign acquirer is willing to issue some shares and some target company shareholders want shares, while others want cash.

Hybrid transactions represent a third form of transaction used in cross-border transactions. This type of structure affords the U.S. target corporation and its shareholders tax-free treatment, while avoiding the issuance of shares of the foreign acquirer. In general, a hybrid transaction may be taxable to some target shareholders and tax free to others. To structure hybrid transactions, some target company shareholders may exchange their common shares for a nonvoting preferred stock, while the foreign acquirer or its U.S. subsidiary buys the remaining common stock for cash. This transaction is tax free to target company shareholders taking preferred stock and taxable to those selling their shares for cash.²⁶

Financing cross-border transactions

Debt is most often used to finance cross-border transactions. The proceeds of the debt financing may be used either to purchase the target's outstanding shares for cash or to repurchase acquirer shares issued to target shareholders to minimize potential earnings dilution. Sources of financing exist in capital markets in the acquirer's home, the target's local country, or in some third country. Domestic capital sources available to cross-border acquirers include banks willing to provide bridge financing and lines of credit, bond markets, and equity markets.

Debt Markets

Eurobonds represent a common form of financing for cross-border transactions. Eurobonds are debt instruments expressed in terms of U.S. dollars or other currencies and sold to investors outside the country in whose currency they are denominated. A typical Eurobond transaction could be a dollar-denominated bond issued by a French firm through an underwriting group. The underwriting group could comprise the overseas affiliate of a New York commercial bank, a German commercial bank, and a consortium of London banks. Bonds issued by foreign firms and governments in local markets have existed for many years. Such bonds are issued in another country's domestic bond market, denominated in its currency, and subject to that country's regulations. Bonds of a non-U.S. issuer registered with the SEC for sale in the U.S. public bond markets are called yankee bonds. Similarly, a U.S. company issuing a bond in Japan would be issuing a “samurai” bond.

Equity Markets

The American depository receipt (ADR) market evolved as a means of enabling foreign firms to raise funds in the U.S. equity markets. ADRs represent the receipt for the shares of a foreign-based corporation held in a U.S. bank. Such receipts entitle the holder to all dividends and capital gains. American depositary shares (ADS) are shares issued under a deposit agreement representing the underlying common share, which trades in the issuer's market. The acronyms ADS and ADR often are used interchangeably. The Euroequity market reflects equity issues by a foreign firm tapping a larger investor base than the firm's home equity market.

If the acquirer is not well known in the target's home market, target shareholders may be able to sell the shares only at a discount in their home market. In this instance, the buyer may have to issue shares in its home market or possibly to the international equities market and use the proceeds to acquire the target for cash. Alternatively, the acquirer may issue shares in the target's market to create a resale market for target shareholders or offer target shareholders the opportunity to sell the shares in the buyer's home market through an investment banker.

Sovereign Funds

Sovereign wealth funds (SWFs) are government-backed or -sponsored investment funds whose primary function is to invest accumulated reserves of foreign currencies. For years, such funds, in countries that had accumulated huge quantities of dollars, would reinvest in U.S. Treasury securities. However, in recent years, such funds have become more sophisticated, increasingly taking equity positions in foreign firms and diversifying their currency holdings. Collectively, the sovereign funds control about $3.4 trillion in assets.²⁷ The biggest shift in recent years has been the funds' willingness to make high-profile investments in public companies. For the most part, the sovereign funds appear to be long-term, sophisticated investors. In addition to providing a source of capital, sovereign wealth funds, as politically connected large investors, may contribute to the value of a firm in which they invest by providing access to the SWF's home market and to government-related contracts.²⁸

Planning and implementing cross-border transactions in emerging countries

Entering emerging economies poses a host of new challenges not generally encountered in developed countries, which include a range of political and economic risks.

Political and Economic Risks

It is difficult to differentiate between political and economic risks, since they are often highly interrelated. Examples of political and economic risks include excessive local government regulation, confiscatory tax policies, restrictions on cash remittances, currency inconvertibility, restrictive employment policies, outright expropriation of assets of foreign firms, civil war or local insurgencies, and corruption. Another, sometimes overlooked, challenge is the failure of the legal system in an emerging country to honor contracts.²⁹

Many of these risks result in gyrating exchange rates, which heighten the level of risk associated with foreign direct investment in an emerging country. Unanticipated changes in exchange rates can influence substantially the competitiveness of goods produced in the local market for export to the global marketplace. Furthermore, changes in exchange rates alter the value of assets invested in the local country and earnings repatriated from the local operations to the parent corporation in the home country. Not surprisingly, the degree of economic and political freedom correlates positively with foreign direct investment. When they believe that their property rights are going to respected and relatively few restrictions are placed on managing investments and repatriating earnings, foreigners are more inclined to invest directly in the local country.³⁰

Recent developments also highlight the importance of rising nationalism and protectionism amid the global economic slowdown in recent years. Australian mining giant BHP Billiton abandoned its effort to acquire Canadian fertilizer producer Potash Corporation in 2010. Regulatory authorities blocked the takeover amidst public furor over the potential loss of control of the nation's natural resources. The reaction was somewhat unusual for Canada, a traditionally free-trade supporter.

Sources of Information for Assessing Political and Economic Risk

Information sources include consultants in the local country, joint venture partners, a local legal counsel, or appropriate government agency, such as the U.S. Department of State. Other sources of information include the major credit rating agencies such as Standard & Poor's, Moody's, and Fitch IBCA. Trade magazines, such as Euromoney and Institutional Investor, provide overall country risk ratings updated semiannually. The Economic Intelligence Unit also provides numerical risk scores for individual countries. The International Country Risk Guide, published by the Political Risk Services Group, offers overall numerical risk scores for individual countries, as well as separate scores for political, financial, and economic risks.

Using Insurance to Manage Risk

The decision to buy political risk insurance depends on the size of the investment and the perceived level of risk. Parties have a variety of sources from which to choose. For instance, the export credit agency in a variety of countries such as Export Import Bank (United States), SACE (Italy), Hermes (Germany), and so forth, may offer coverage for companies based within their jurisdictions. The Overseas Private Investment Corporation is available to firms based in the United States, while the World Bank's Multilateral Investment Guarantee Agency is available to all firms. These government and quasi-governmental insurers are the only substantial providers of war and political violence coverage.

Using Options and Contract Language to Manage Risk

In emerging countries, where financial statements may be haphazard and gaining access to the information necessary to adequately assess risk is limited, it may be impossible to perform an adequate due diligence. Under these circumstances, acquirers may protect themselves by including a put option in the agreement of purchase and sale. Such an option enables the buyer to require the seller to repurchase shares from the buyer at a predetermined price under certain circumstances. Alternatively, the agreement could include a clause requiring a purchase price adjustment. For example, in late 2005, the Royal Bank of Scotland purchased shares in the Bank of China. If subsequent to closing there were material restatements to the Bank of China's financial statements, the purchase price would have been adjusted in the Royal Bank's favor.

Valuing cross-border transactions

The methodology for valuing cross-border transactions using discounted-cash-flow analysis is similar to that employed when both the acquiring and target firms are within the same country. The basic differences between within-country and cross-border valuation methods is that the latter involves converting cash flows from one currency to another and adjusting the discount rate for risks not generally found when the acquirer and target firms are within the same country.

Converting Foreign Target Cash Flows to Acquirer Domestic Cash Flows

Cash flows of the target firm can be expressed in its own currency including expected inflation (i.e., nominal terms), its own currency without inflation (i.e., real terms), or the acquirer's currency. Real cash-flow valuation adjusts all cash flows for inflation and uses real discount rates. Normally, M&A practitioners utilize nominal cash flows except when inflation rates are high. Under these circumstances, real cash flows are preferable. Real cash flows are determined by dividing the nominal cash flows by the country's gross domestic product deflator or some other broad measure of inflation. Future real cash flows are estimated by dividing future nominal cash flows by the current GDP deflator, increased by the expected rate of inflation. Real discount rates are determined by subtracting the expected rate of inflation from nominal discount rates. Nominal or real cash flows should give the same NPVs if the expected rate of inflation used to convert future cash flows to real terms is the same inflation rate used to estimate the real discount rate.

Inflation in the target country may affect the various components of the target firm's cash flows differently. For example, how the inventory component of working capital is affected by inflation reflects in part how sensitive certain raw materials and the like are to inflation and how such inventory is recorded (i.e., LIFO or FIFO basis). Moreover, straight-line depreciation may not adequately account for the true replacement cost of equipment in an inflationary environment. Since conversion of the various components of cash flow from local to home country currency may result in unnecessary distortions, it is advisable to project the target's cash flows in terms in its own currency, then convert the cash flows into the acquirer's currency. This requires estimating future exchange rates between the target (local) and acquirer's (home) currency.

Interest rates and expected inflation in one country versus another affect exchange rates between the two countries. The current rate at which one currency can be exchanged for another is called the spot exchange rate. Consequently, the translation to the acquirer's currency can be achieved by using future spot exchange rates estimated either from relative interest rates (the interest rate parity theory) in each country or from the relative rates of expected inflation (the purchasing power parity theory).³¹

When Target Firms Are in Developed (Globally Integrated) Capital Market Countries

For developed countries, such as those in Western Europe, the interest rate parity theory provides a useful framework for estimating forward currency exchange rates (i.e., future spot exchange rates). To illustrate this process, consider a U.S. acquirer's valuation of a firm in the European Union (EU), with projected cash flows expressed in terms of euros. The target's cash flows can be converted into dollars by using a forecast of future dollar-to-euro spot rates. The interest rate parity theory relates forward or future spot exchange rates to differences in interest rates between two countries adjusted by the spot rate. Therefore, dollar/euro exchange rate ($/€) _n (i.e., the future or forward exchange rate), n periods into the future, is expected to appreciate (depreciate) according to the following relationship:

(17.1)

Similarly, the euro-to-dollar exchange rate (€/$) _n , n periods into the future, would be expected to appreciate (depreciate) according to the following relationship:

(17.2)

Note that ($/€)₀ and (€/$)₀ represent the spot rate for the dollar-to-euro and euro-to-dollar exchange rates, respectively; R _$n and R _€n represent the interest rate in the United States and the European Union, respectively. Equations (17.1) and (17.2) imply that if U.S. interest rates rise relative to those in the European Union, investors will buy dollars with euros at the current spot rate and sell dollars for euros in the forward or futures market to offset the risk of exchange rate changes n periods into the future. By doing so, investors avoid the potential loss of the value of their investment expressed in terms of dollars when they wish to convert their dollar holdings back into euros. In this way, the equality in these two equations is maintained. Exhibit 17.1 illustrates how to convert a target company's nominal free cash flows to the firm (FCFF) expressed in euros (i.e., the local country or target's currency) to those expressed in dollars (i.e., home country or acquirer's currency).

Exhibit 17.1 Converting Euro-Denominated into Dollar-Denominated Free Cash Flows to the Firm Using the Interest Rate Parity Theory

Note: Calculating the projected spot rate using Eq. (17.1):

When Target Firms Are in Emerging (Segmented) Capital Market Countries

Cash flows are converted as before using the interest rate parity theory or the purchasing power parity theory. The latter is used if there is insufficient information about interest rates in the emerging market. The purchasing power parity theory states that one currency appreciates (depreciates) with respect to another currency according to the expected relative rates of inflation between the two countries. To illustrate, the dollar/Mexican peso exchange rate, ($/Peso) _n , and the Mexican peso/dollar exchange rate, (Peso/$) _n , n periods from now (i.e., future exchange rates), is expected to change according to the following relationships:

(17.3)

and

(17.4)

where P _us and P _mex are the expected inflation rates in the United States and Mexico, respectively, and ($/Peso)₀ and (Peso/$)₀ are the dollar-to-peso and peso-to-dollar spot exchange rates, respectively. If future U.S. inflation is expected to rise faster than the Mexican inflation rate, the forward dollar-to-peso exchange rate—that is, future spot rates shown by Eq. (17.4)—would depreciate as U.S. citizens sell dollars for pesos to buy relatively cheaper Mexican products. See Exhibit 17.2 for an illustration of how this might work in practice.

Exhibit 17.2 Converting Peso-Denominated into Dollar-Denominated Free Cash Flows to the Firm Using the Purchasing Power Parity Theory

Note: Calculating the projected spot rate using Eq. (17.3):

Selecting the Correct Marginal Tax Rate

If the acquirer's country makes foreign income exempt from further taxation once taxed in the foreign country, the correct tax rate would be the marginal tax rate in the foreign country because that is where taxes are paid. Otherwise, the correct tax rate should be the acquirer's country rate if it is higher than the target's country rate and taxes paid in a foreign country are deductible from the taxes owed by the acquirer in its home country. The acquirer must still pay taxes owed in the country in which it resides in excess of any credits received for foreign taxes paid.

Estimating the Cost of Capital in Cross-Border Transactions

While almost three-fourths of U.S. corporate chief financial officers surveyed use the capital asset pricing model to calculate the cost of equity, there is considerable disagreement in how to calculate the cost of equity in cross-border transactions.³² To the extent a consensus exists, the basic capital asset pricing model or a multifactor model (e.g., CAPM plus a factor to adjust for the size of the firm, etc.) should be used in developed countries with liquid capital markets.

For emerging countries, the estimation of the cost of equity is more complex. There are at least 12 separate approaches to estimating the international cost of equity.³³ Each method endeavors to incorporate adjustments to the discount rate to account for potential capital market segmentation and specific country risks. Still other approaches attempt to incorporate the risk of investing in emerging countries, not by adjusting the discount rate but by adjusting projected cash flows. In either case, the adjustments often appear arbitrary.

Developed economies seem to exhibit little differences in the cost of equity, due to the relatively high integration of their capital markets with the global capital market. Thus, adjusting the cost of equity for specific country risk does not seem to make any significant difference.³⁴ However, for emerging market countries, the existence of segmented capital markets, political instability, limited liquidity, currency fluctuations, and currency inconvertibility seems to make adjusting the target firm's cost of equity for these factors (to the extent practical) desirable.³⁵

The following discussion incorporates the basic elements of valuing cross-border transactions, distinguishing between the different adjustments made when investing in developed and emerging countries. Nonetheless, considerable debate continues in this area.

Estimating the Cost of Equity in Developed (Globally Integrated) Countries

What follows is a discussion of how to adjust the basic CAPM formulation for valuing cross-border transactions where the target is located in a developed country. The discussion is very similar to the capital asset pricing model formulation (CAPM) outlined in Chapter 7, except for the use of either national or globally diversified stock market indices in estimating beta and calculating the equity market risk premium.

Estimating the risk-free rate of return (developed countries)

For developed countries, the risk-free rate generally is the local country's government (i.e., sovereign) bond rate whenever the projected cash flows for the target firm are expressed in local currency. However, the debt crises in a number of developed countries in 2010 and 2011 suggest that in such situations alternative measures of risk-free measures should be used.³⁶ The risk-free rate is the U.S. Treasury bond rate if projected cash flows are in terms of dollars.

Adjusting CAPM for risk (developed countries)

The equity premium, reflecting the difference between the return on a well-diversified portfolio and the risk-free return, is the incremental return required to induce investors to buy stock. The use of a well-diversified portfolio eliminates risk specific to a business or so-called diversifiable risk. The firm's β is a measure of nondiversifiable risk. In a world in which capital markets are fully integrated, equity investors hold globally diversified portfolios. When measured in the same currency, the equity premium is the same for all investors because each security's β is estimated by regressing its historical financial returns, or those of a comparable firm, against the returns on a globally diversified equity index.

Alternatively, an analyst could use a well-diversified country index that is highly correlated with the global index. In the United States, an example of a well-diversified portfolio is the Standard & Poor's 500 stock index (S&P 500); in the global capital markets, the Morgan Stanley Capital International World Index (MSCI) is commonly used as a proxy for a well-diversified global equity portfolio. Thus, the equity premium may be estimated on a well-diversified portfolio of U.S. equities, on another developed country's equity portfolio, or on a global equity portfolio.

Adjusting CAPM for firm size

As noted in Chapter 7, studies show that the capital asset pricing model should be adjusted for the size of the firm. The size factor serves as a proxy for factors such as smaller firms being subject to higher default risk and generally being less liquid than large capitalization firms.³⁷ See Table 7.1 in Chapter 7 for estimates of the amount of the adjustment to the cost of equity to correct for firm size, as measured by market value.

Global CAPM formulation (developed countries)

In globally integrated markets, nondiversifiable or systematic market risk is defined relative to the rest of the world. Therefore, an asset has systematic risk only to the extent that the performance of the asset correlates with the overall world economy. When using a global equity index, the resulting CAPM often is called the global or international capital asset pricing model. If the risk associated with the target firm is similar to that faced by the acquirer, the acquirer's cost of equity may be used to discount the target's cash flows.

The global capital asset pricing model for the target firm may be expressed as follows:

(17.5)

where

k_{e ,dev} = required return on equity for a firm operating in a developed country.

R_f = local country's risk-free financial rate of return if cash flows are measured in the local country's currency or in the U.S. Treasury bond rate if in dollars.

(R_m – R_f ) = difference between the expected return on the global market portfolio (i.e., MSCI), U.S. equity index (S&P 500), or a broadly defined index in the target's local country and R_f . This difference is the equity premium, which should be approximately the same when expressed in the same currency for countries with globally integrated capital markets.

β_{devfirm,global} = measure of nondiversifiable risk with respect to a globally diversified equity portfolio or a well-diversified country portfolio highly correlated with the global index. Alternatively, β_{devfirm,global} may be estimated indirectly as illustrated in Eq. (17.7).

FSP = firm size premium reflecting the additional return smaller firms must earn relative to larger firms to attract investors.

An analyst may wish to value the target's future cash flows in both the local and home currencies. The Fisher effect allows the analyst to convert a nominal cost of equity from one currency to another. Assuming the expected inflation rates in the two countries are accurate, the real cost of equity should be the same in either country.

Applying the fisher effect

The so-called Fisher effect states that nominal interest rates can be expressed as the sum of the real interest rate (i.e., interest rates excluding inflation) and the anticipated rate of inflation. The Fisher effect can be shown for the United States and Mexico as follows:

If real interest rates are constant among all countries, nominal interest rates among countries will vary only by the difference in the anticipated inflation rates. Therefore,

(17.6)

where

i _us and i _mex = nominal interest rates in the United States and Mexico, respectively

r _us and r _mex = real interest rates in the United States and Mexico, respectively

P _us and P _mex = anticipated inflation rates in the United States and Mexico, respectively

If the analyst knows the Mexican interest rate and the anticipated inflation rates in Mexico and the United States, solving Eq. (17.6) provides an estimate of the U.S. interest rate (i.e., i _us = [(1 + i _mex) × (1 + P _us)/(1 + P _mex)] – 1). Exhibit 17.3 illustrates how the cost of equity estimated in one currency is converted easily to another using Eq. (17.6). Although the historical equity premium in the United States is used in calculating the cost of equity, the historical U.K. or MSCI premium also could have been employed.

Exhibit 17.3 Calculating the Target Firm's Cost of Equity in Both Home and Local Currency

Acquirer, a U.S. multinational firm, is interested in purchasing Target, a small U.K.-based competitor, with a market value of £550 million, or about $1 billion. The current risk-free rate of return for U.K. ten-year government bonds is 4.2%. The anticipated inflation rates in the United States and the United Kingdom are 3% and 4%, respectively. The expected size premium is estimated at 1.2%. The historical equity risk premium in the United States is 5.5%.^a Acquirer estimates Target's β to be 0.8, by regressing Target's historical financial returns against the S&P 500. What is the cost of equity (k_{e ,uk}) that should be used to discount Target's projected cash flows when they are expressed in terms of British pounds (i.e., local currency)? What is the cost of equity (k_{e ,us}) that should be used to discount Target's projected cash flows when they are expressed in terms of U.S. dollars (i.e., home currency)?^b

Estimating the Cost of Equity in Emerging (Segmented) Capital Market Countries

If the individual country's capital markets are segmented, the global capital asset pricing model must be adjusted to reflect the tendency of investors in individual countries to hold local country rather than globally diversified equity portfolios. Consequently, equity premiums differ among countries, reflecting the nondiversifiable risk associated with each country's equity market index. What follows is a discussion of how to adjust the basic CAPM formulation for valuing cross-border transactions where the target is located in an emerging country.

Estimating the risk-free rate of return (emerging countries)

For emerging economies, data limitations often preclude using the local country's government bond rate as the risk-free rate. If the target firm's cash flows are in terms of local currency, the U.S. Treasury bond rate often is used to estimate the risk-free rate. To create a local nominal interest rate, the Treasury bond rate should be adjusted (using the Fisher effect) for the difference in the anticipated inflation rates in the two countries. See Eq. (17.6) to determine how to make this adjustment.

Adjusting CAPM for risk (emerging countries)

An analyst can determine if a country's equity market is likely to be segmented from the global equity market if the β derived by regressing returns in the foreign market with returns on the global equity market is significantly different from 1. This implies that the local country's equity premium differs from the global equity premium, reflecting the local country's nondiversifiable risk.

Nondiversifiable risk for a firm operating primarily in its emerging country's home market, whose capital market is segmented, is measured mainly with respect to the country's equity market index (β _{emfirm,country}) and to a lesser extent with respect to a globally diversified equity portfolio (β _{country,global}). The emerging country firm's global beta (β _{emfirm,global}) can be adjusted to reflect the relationship with the global capital market as follows:

(17.7)

The value of β _{emfirm,country} is estimated by regressing historical returns for the local firm against returns for the country's equity index. In the absence of sufficient information, β_{emfirm,country} may be estimated by using the beta for a similar local firm or a similar foreign firm. The value of β _{country,global} can be estimated by regressing the financial returns for the local country index (or for the index in a similar country) against the historical financial returns for a global index. Alternatively, a more direct approach is to regress the local firm's historical returns against the financial returns for a globally diversified portfolio of stocks to estimate β _{emfirm,global}. Furthermore, the β between a similar local or foreign firm and the global index could be used for this purpose.

Due to the absence of historical data in many emerging economies, the equity risk premium often is estimated using the “prospective method” implied in the constant growth valuation model. As shown in Eq. (7.14) in Chapter 7, this formulation provides an estimate of the present value of dividends growing at a constant rate in perpetuity. This method requires that the dividends paid in the current period (d ₀) are grown at a constant rate of growth (g) such that d ₁ equals d ₀(1 + g).

Assuming the stock market values stocks correctly and we know the present value of a broadly defined index in the target firm's country (P _country) or in a similar country, dividends paid annually on this index in the next period (d ₁), and the expected dividend growth (g), we can estimate the expected return (R _country) on the stock index as follows:

(17.8)

From Eq. (17.8), the equity risk premium for the local country's equity market is R _country – R_f , where R_f is the local country's risk-free rate of return. Exhibit 17.4 illustrates how to calculate the cost of equity for a firm in an emerging country in the absence of perceived significant country or political risk not captured in the beta or equity risk premium. Note that the local country's risk-free rate of return is estimated using the U.S. Treasury bond rate adjusted for the expected inflation in the local country relative to the United States. This converts the U.S. Treasury bond rate into a local country nominal interest rate.

Exhibit 17.4 Calculating the Target Firm's Cost of Equity for Firms in Emerging Countries

Assume next year's dividend yield on an emerging country's stock market is 5% and that earnings for the companies in the stock market index are expected to grow by 6% annually in the foreseeable future. The country's global beta (β _{country,global}) is 1.1. The U.S Treasury bond rate is 4%, and the expected inflation rate in the emerging country is 4% compared to 3% in the United States. Estimate the country's risk-free rate (R_f ), the return on a diversified portfolio of equities in the emerging country (R _country), and the country's equity risk premium (R _country – R_f ). What is the cost of equity in the local currency for a local firm (k_{e ,em}) whose country beta (β _{emfirm,country}) is 1.3?

Solution

Adjusting the CAPM for country or political risk

Recall that a country's equity premium reflects systematic risk (i.e., factors affecting all firms). However, the country's equity premium may not capture all the events that could jeopardize a firm's ability to operate. For example, political instability could result in a government that assumes an antiforeigner business stance, resulting in potential nationalization, limits on repatriation of earnings, capital controls, the levying of confiscatory or discriminatory taxes, and the like. Such factors could increase significantly the firm's likelihood of default. Unless the analyst includes the risk of default by the firm in projecting a local firm's cash flows, the expected cash-flow stream will be overstated to the extent that it does not reflect the costs of financial distress (e.g., higher borrowing costs).

If the U.S. Treasury bond rate is used as the risk-free rate in calculating the CAPM, adding a country risk premium to the basic CAPM estimate is appropriate. The country risk premium (CRP) often is measured as the difference between the yield on the country's sovereign or government bonds and the U.S. Treasury bond rate of the same maturity.38 The difference or “spread” is the additional risk premium that investors demand for holding the emerging country's debt rather than U.S. Treasury bonds.

A country risk premium should not be added to the cost of equity if the risk-free rate is the country's sovereign or government bond rate, since the effects of specific country or political risk have already been reflected. Standard & Poor's (www.standardardandpoors.com), Moody's Investors Service (www.moodys.com), and Fitch IBCA (www.fitchibca.com) provide sovereign bond spreads. In practice, the sovereign bond spread is computed from a bond with the same maturity as the U.S. benchmark Treasury bond used to compute the risk-free rate for the calculation of the cost of equity. The U.S. benchmark rate usually is the ten-year Treasury bond rate.

Global CAPM formulation (emerging countries)

To estimate the cost of equity for a firm in an emerging economy (k_{e ,em}), Eq. (17.5) can be modified for specific country risk as follows:

(17.9)

where

R_f = local risk-free rate or the U.S. Treasury bond rate converted to a local nominal rate if cash flows are in the local currency (see Eq. (17.6)) or to the U.S. Treasury bond rate if cash flows are in dollars

(R _country – R_f ) = difference between expected return on a well-diversified equity index in the local country or a similar country and the risk-free rate

β _{emfirm,global} = emerging country firm's global beta (see Eq. (17.7))

FSP = firm size premium reflecting the additional return that smaller firms must earn relative to larger firms to attract investors

CRP = specific country risk premium, expressed as the difference between the local country's (or a similar country's) government bond rate and the U.S. Treasury bond rate of the same maturity. Add to the CAPM estimate only if the U.S. Treasury bond rate is employed as a proxy for the local country's risk-free rate.

Estimating the Local Firm's Cost of Debt in Emerging Markets

The cost of debt for an emerging market firm (i _emfirm) should be adjusted for default risk due to events related to the country and those specific to the firm. When a local corporate bond rate is not available, the cost of debt for a specific local firm may be estimated by using an interest rate in the home country (i _home) that reflects a level of creditworthiness comparable to the firm in the emerging country. The country risk premium is added to the appropriate home country interest rate to reflect the impact of such factors as political instability on i _emfirm. Therefore, the cost of debt can be expressed as follows:

(17.10)

Most firms in emerging markets are not rated. Therefore, to determine which home country interest rate to select, it is necessary to assign a credit rating to the local firm. This “synthetic” credit rating may be obtained by comparing financial ratios for the target firm to those used by U.S. rating agencies. The estimate of the unrated firm's credit rating may be obtained by comparing interest coverage ratios used by Standard & Poor's to the firm's interest coverage ratio to determine how S&P would rate the firm. Exhibit 17.5 illustrates how to calculate the cost of emerging market debt.

Exhibit 17.5 Estimating the Cost of Debt in Emerging Market Countries

Assume that a firm in an emerging market has annual operating income before interest and taxes of $550 million and annual interest expenses of $18 million. This implies an interest coverage ratio of 30.6 (i.e., $550 ÷ $18). For Standard & Poor's, this corresponds to an AAA rating. According to S&P, default spreads for AAA firms are 0.85 currently. The current interest rate on U.S. triple A–rated bonds is 6.0%. Assume further that the country's government bond rate is 10.3% and that the U.S. Treasury bond rate is 5%. Assume that the firm's marginal tax rate is 0.4. What is the firm's cost of debt before and after tax?

Solution

Exhibit 17.6 illustrates the calculation of WACC in cross-border transactions. Note the adjustments made to the estimate of the cost of equity for firm size and country risk. Note also the adjustment made to the local borrowing cost for country risk. The risk-free rate of return is the U.S. Treasury bond rate converted to a local nominal rate of interest.

Exhibit 17.6 Estimating the Weighted Average Cost of Capital in Cross-Border Transactions

Acquirer Inc., a U.S.-based corporation, wants to purchase Target Inc. Acquirer's management believes that the country in which Target is located is segmented from global capital markets because the beta estimated by regressing the financial returns on the country's stock market with those of a global index is significantly different from one.

Assumptions: The current U.S. Treasury bond rate (R _us) is 5%. The expected inflation rate in the target's country is 6% annually as compared to 3% in the United States. The country's risk premium (CRP) provided by Standard & Poor's is estimated to be 2%. Based on Target's interest coverage ratio, its credit rating is estimated to be AA. The current interest rate on AA-rated U.S. corporate bonds is 6.25%. Acquirer Inc. receives a tax credit for taxes paid in a foreign country. Since its marginal tax rate is higher than Target's, Acquirer's marginal tax rate of 0.4 is used in calculating WACC. Acquirer's pretax cost of debt is 6%. The firm's total capitalization consists only of common equity and debt. Acquirer's projected debt–to–total capital ratio is 0.3.

Target's beta and the country beta are estimated to be 1.3 and 0.7, respectively. The equity premium is estimated to be 6% based on the spread between the prospective return on the country's equity index and the estimated risk-free rate of return. Given Target Inc.'s current market capitalization of $3 billion, the firm's size premium (FSP) is estimated at 1.0 (see Table 7.1 in Chapter 7). What is the appropriate weighted average cost of capital Acquirer should use to discount target's projected annual cash flows expressed in its own local currency?

Solution:

^aNote that the expression {[(1 + 0.05) × (1 + 0.06)/(1 + 0.03)] – 1} × 100 represents the conversion of the U.S. Treasury bond rate to a local nominal rate of interest using Eq. (17.6). Also note that 1.3 × 0.7 results in the estimation of the target's global beta, as indicated in Eq. (17.7).

Table 17.3 summarizes the methods commonly used for valuing cross-border transactions involving firms in developed and emerging countries. The WACC calculation assumes that the firm uses only common equity and debt financing. Note that the country risk premium is added to both the cost of equity and the after-tax cost of debt in calculating the WACC for a target firm in an emerging country if the U.S. Treasury bond rate is used as the risk-free rate of return. The analyst should avoid adding the country risk premium to the cost of equity if the risk-free rate used to estimate the cost of equity is the local country's government bond rate. References to home and local countries in Table 17.3 refer to the acquirer's and the target's countries, respectively.

Table 17.3. Common Methodologies for Valuing Cross-Border Transactions

Developed Countries (Integrated Capital Markets)	Emerging Countries (Segmented Capital Markets)
Step 1. Project and Convert Cash Flows a.Project target's cash flows in the country's local currency. b.Convert local cash flows into acquirer's home currency, employing forward exchange rates that are projected using the interest rate parity theory. Step 2. Adjust Discount Rates k e,dev = Rf + β devfirm,global a (Rm – Rf ) + FSP i = cost of debtc WACC = ke We + i(1 – t) ×Wd	Step 1. Project and Convert Cash Flows a. Project target's cash flows in the country's local currency. b. Convert local cash flows into acquirer's home currency using forward exchange rates. Project exchange rates using purchasing power parity theory if there are few reliable data on interest rates available. Step 2. Adjust Discount Rates k e,em = Rf + β emfirm,global a (R country – Rf )b + FSP + CRP i local = i home + CRP WACC = ke We + i local (1 – t) × Wd
a. Rf is the long-term government bond rate in the home country. b. β devfirm,global is nondiversifiable risk associated with a well-diversified global, U.S., or local country equity index. c. Rm is the return on a well-diversified U.S., local, or global equity index. d. FSP is the firm size premium. e. t is the appropriate marginal tax rate. f. We is the acquirer's target equity–to–total capital ratio, and Wd is 1 – We .	a. Rf is the long-term government bond rate in the local country or the U.S. Treasury bond rate converted to a local nominal rate if cash flows in local currency or if cash flows in dollars, the U.S. Treasury bond rate. Note that if local risk-free rate is used, do not add CRP. b. β emfirm,global is nondiversifiable risk associated with target's local country β and local country's global β. c. R country is the return on a diversified local equity index or a similar country's index. d. CRP is the country risk premium. e. i home is the home country cost of debt. f. i local is the local country cost of debt .

^a β may be estimated directly for firms whose business is heavily dependent on exports or operating in either developing or emerging countries by directly regressing the firm's historical financial returns against returns on a well-diversified global equity index. For firms operating primarily in their home markets, β may be estimated indirectly by using Eq. (17.7).

^b (R _country – R_f) also could be the equity premium for well-diversified U.S. or global indices if the degree of local segmentation is believed to be small.

^c For developed countries, either the home or local country cost of debt may be used. There is no need to add a country risk premium as would be the case in estimating a local emerging country's cost of debt.

Evaluating Risk Using Scenario Planning

Many emerging countries have few publicly traded firms and even fewer M&A transactions to serve as guides in valuing companies. Furthermore, with countries like China and India growing at or near double-digit rates, the future may be too dynamic to rely on discounted cash flows. Projecting cash flows beyond three years may be pure guesswork.

As an alternative to making seemingly arbitrary adjustments to the target firm's cost of capital, the acquirer may incorporate risk into the valuation by considering alternative economic scenarios for the emerging country. The variables that define these alternative scenarios could include GDP growth, inflation rates, interest rates, and foreign exchange rates. Each of these variables can be used to project cash flows using regression analysis (see the file entitled “Primer on Cash Flow Forecasting” on this book's companion site). The scenarios may also be built on alternative industry or political conditions. For example, a best-case scenario can be based on projected cash flows, assuming the emerging market's economy grows at a moderate real growth rate of 2% per annum for the next five years. Alternative scenarios could assume a one- to two-year recession. A third scenario could assume a dramatic devaluation of the country's currency. The NPVs are weighted by subjectively determined probabilities. The actual valuation of the target firm reflects the expected value of the three scenarios. Note that if a scenario approach is used to incorporate risk in the valuation, there is no need to modify the discount rate for perceived political and economic risk in the local country. See Chapter 8 for a more detailed discussion and illustration of scenario planning in the context of a decision tree framework.

While building risk into the projected cash flows is equivalent to adjusting the discount rate in applying the discounted-cash-flow method, it also appears to be subject to making arbitrary or highly subjective adjustments. What are the appropriate scenarios to be simulated? How many such scenarios are needed to adequately incorporate risk into the projections? What is the likelihood of each scenario occurring? The primary advantage of adopting a scenario approach is that it forces the analyst to evaluate a wider range of possible outcomes. The major disadvantages are the substantial additional effort required and the degree of subjectivity in estimating probabilities.

Empirical studies of financial returns to international diversification

Cross-border M&A transactions may contribute to higher average risk-adjusted financial returns for acquiring firms and improved corporate governance for target firms in emerging markets. These and other issues are addressed next.

International Diversification May Contribute to Higher Financial Returns

Empirical studies suggest that international diversification may increase financial returns by reducing risk if economies are relatively uncorrelated.³⁹ Higher financial returns from international diversification may also be due to economies of scale and scope, geographic location advantages associated with being nearer customers, increasing the size of the firm's served market, and learning new technologies.⁴⁰ Controversy continues as to whether returns are higher for multinational companies that diversify across countries⁴¹ or across industries.⁴² In either case, selecting an appropriate country remains very important. Buyers of targets in segmented markets realize larger abnormal returns than if they were to buy firms in globally integrated countries, since targets in segmented markets benefit from the acquirer's lower cost of capital.⁴³

Foreign Buyers of U.S. Firms Tend to Pay Higher Premiums than U.S. Buyers

Foreign bidders have historically paid higher premiums to acquire U.S. firms than domestic acquirers of U.S. firms due to more favorable foreign currency exchange rates, which contributed to lower overall purchase prices when expressed in terms of foreign currency.⁴⁴ Between 1990 and 2007, the premium paid by foreign buyers of U.S. firms over those paid by U.S. acquirers averaged about 4 percentage points. The continued higher premiums paid by foreign buyers may reflect their efforts to preempt U.S. buyers, U.S. target firm shareholders' lack of familiarity with foreign acquirers, and concern that the transaction would not be consummated due to political (e.g., Unocal and CNOOC) and economic considerations (i.e., lack of financial resources).

Returns for Cross-Border Transactions Consistent with Domestic Results

Shareholders of target firms in cross-border transactions receive substantial abnormal returns. Such returns for shareholders of U.S. targets of foreign buyers range from about 23%⁴⁵ to about 40%.⁴⁶ Abnormal returns to shareholders of U.S. and non-U.S. buyers of foreign firms are about zero to slightly negative.⁴⁷

In comparing returns in cross-border transactions to domestic deals, researchers have found that U.S. acquirers realize stock returns for cross-border transactions as much as 1% lower than for U.S. deals.⁴⁸ This may be attributable to increased competition for attractive foreign targets and reduced gains from diversification into formerly segmented markets due to increasingly global integration. Studies of U.K. and Canadian targets acquired by U.S. firms also found that bidders buying foreign targets underperform those acquiring domestic firms.⁴⁹ In contrast, acquirer returns increase on average by 1.65 to 3.1% when the targets are in emerging markets. This improvement is attributable to the achievement of control (e.g., enabling the protection of intellectual property), the elimination of minority shareholders, and the encouragement of investment in the target by the parent.⁵⁰

Good Corporate Governance Supports Cross-Border M&A Activity

Higher firm valuations are often found in countries with better shareholder protections.⁵¹ This is especially true in emerging countries, where firms have a single dominant investor.⁵² Inflows of foreign investment are highest in countries that enforce laws requiring firms to disclose information and provide good shareholder protections. This finding underscores the importance of countries having in place legal systems that actively enforce contracts and prevailing securities laws.⁵³

M&A activity is substantially larger in countries with better accounting standards and shareholder safeguards. Moreover, researchers have found that targets in cross-border deals are typically from countries with poorer investor protection than the acquirer's country. The transference of corporate governance practices through cross-border mergers may improve shareholder safeguards and, in turn, financial returns to target firm shareholders. Target firms in weaker corporate governance countries relative to the acquirer often adopt the better practices because of a change in the country of incorporation of the firm. When the bidder is from a country with stronger governance practices and gains full control of a target firm in a country with weaker governance practices, part of the total synergy value of the takeover may result from imposing the stricter practices of the bidder on the target firm.⁵⁴

Foreign firms that invest less in corporate governance than a comparable U.S. firm have a lower market value than the U.S. firm.⁵⁵ This may be attributable to the characteristics of the country (e.g., legal system, extent of enforcement of exiting laws). The underinvestment is greatest in countries in which it is in the best interests of the controlling shareholders, who often can obtain benefits at the expense of minority shareholders. Efforts to increase minority shareholder protection can increase the attractiveness of the firm's shares to a broader array of investors.

Foreign Institutional Ownership May Promote Cross-Border M&A Activity

Foreign institutional ownership in acquiring and target firms may promote cross-border transactions and increase corporate governance in developing countries. Cross-border transactions are more likely to be characterized by significant foreign institutional ownership intent on facilitating a change in corporate control in firms located in countries characterized by weak corporate governance or legal institutions and protections (see Ferreira et al., 2010). The foreign institutional investors facilitate change of control transactions by serving as brokers or intermediaries between bidding and target firms and by resolving information asymmetry problems by supplying information not publicly available. In doing so, the institutional investors hope to raise the value of their investments.

Some things to remember

The motives for international corporate expansion include a desire to accelerate growth, achieve geographic diversification, consolidate industries, and exploit natural resources and lower labor costs available elsewhere. Other motives include applying a firm's brand name or intellectual property in new markets, minimizing tax liabilities, following customers into foreign markets, as well as avoiding such entry barriers as tariffs and import barriers. Alternative strategies for entering foreign markets include exporting, licensing, alliances or joint ventures, solo ventures or greenfield operations (i.e., establishing new wholly-owned subsidiaries), and mergers and acquisitions.

The methodology for valuing cross-border transactions is quite similar to that employed when both the acquiring and target firms are within the same country. The methodology involves projecting the target firm's cash flows and converting these future cash flows to current or present values using an appropriate discount rate. The basic differences between within-country and cross-border valuation methods is that the latter involves converting cash flows from one currency to another and adjusting the discount rate for risks not generally found when the acquirer and target firms are within the same country.

Discussion Questions

17.1 Find a recent example of a cross-border merger or acquisition in the business section of a newspaper. Discuss the motives for the transaction. What challenges would the acquirer experience in managing and integrating the target firm? Be specific.

17.2 Classify the countries of the acquirer and target in a recent cross-border merger or acquisition as developed or emerging. Identify the criteria you use to classify the countries. How might your classification of the target firm's country affect the way you analyze the target firm?

17.3 Describe the circumstances under which a firm may find a merger or acquisition a more favorable market entry strategy than a joint venture with a firm in the local country.

17.4 Discuss some of the options commonly used to finance international transactions. If you were the chief financial officer of the acquiring firm, what factors would you consider in determining how to finance a transaction?

17.5 Compare and contrast laws that might affect acquisitions by a foreign firm in the United States. In the European Union.

17.6 Discuss the circumstances under which a non-U.S. buyer may choose a U.S. corporate structure as its acquisition vehicle. A limited liability company. A partnership.

17.7 Which factors influence the selection of which tax rate to use (i.e., the target's or the acquirer's) in calculating the weighted-average cost of capital in cross-border transactions?

17.8 Discuss adjustments commonly made in estimating the cost of debt in emerging countries.

17.9 Find an example of a recent cross-border transaction in the business section of a newspaper. Discuss the challenges an analyst might face in valuing the target firm.

17.10 Discuss the various types of adjustments for risk that might be made to the global CAPM before valuing a target firm in an emerging country. Be specific.

17.11 Do you see the growth in sovereign wealth funds as important sources of capital to the M&A market or as a threat to the sovereignty of the countries in which they invest? Explain your answer.

17.12 What are the primary factors contributing to the increasing integration of the global capital markets? Be specific.

17.13 Give examples of economic and political risk that you could reasonably expect to encounter in acquiring a firm in an emerging economy. Be specific.

17.14 During the 1980s and 1990s, changes in the S&P 500 (a broadly diversified index of U.S. stocks) were about 50% correlated with the MSCI EAFE Index (a broadly diversified index of European and other major industrialized countries' stock markets). In recent years, the correlation has increased to more than 90%. Why? If an analyst wishes to calculate the cost of equity, which index should he or she use in estimating the equity risk premium?

17.15 Comment on the following statement: “The conditions for foreign buyers interested in U.S. targets could not be more auspicious. The dollar is weak, M&A financing is harder to come by for financial sponsors (private equity firms), and many strategic buyers in the United States are hard-pressed to make acquisitions at a time when earnings targets are being missed.”

Answers to these Chapter Discussion Questions are found in the Online Instructor's Manual for instructors using this book.

Chapter business cases

Case Study 17.2

Overcoming Political Risk in Cross-Border Transactions: China's CNOOC Invests in Chesapeake Energy

Cross-border transactions often are subject to considerable political risk. In emerging countries, this may reflect the potential for expropriation of property or disruption of commerce due to a breakdown in civil order. However, as Chinese efforts to secure energy supplies in recent years have shown, foreign firms have to be highly sensitive to political and cultural issues in any host country, developed or otherwise.

In addition to a desire to satisfy future energy needs, the Chinese government has been under pressure to tap its domestic shale gas deposits, due to the clean burning nature of such fuels, to reduce its dependence on coal, the nation's primary source of power. However, China does not currently have the technology for recovering gas and oil from shale. In an effort to gain access to the needed technology and to U.S. shale gas and oil reserves, China National Offshore Oil Corporation Ltd. in October 2010 agreed to invest up to $2.16 billion in selected reserves of U.S. oil and gas producer Chesapeake Energy Corp. Chesapeake is a leader in shale extraction technologies and an owner of substantial oil and gas shale reserves, principally in the southwestern United States.

The deal grants CNOOC the option of buying up to a third of any other fields Chesapeake acquires in the general proximity of the fields the firm currently owns. The terms of the deal call for CNOOC to pay Chesapeake $1.08 billion for a one-third stake in a South Texas oil and gas field. CNOOC could spend an additional $1.08 billion to cover 75% of the costs of developing the 600,000 acres included in this field. Chesapeake will be the operator of the JV project in Texas, handling all leasing and drilling operations, as well as selling the oil and gas production. The project is expected to produce as much as 500,000 barrels of oil daily within the next decade, about 2.5% of the current U.S. daily oil consumption.

Having been forced in 2005 to withdraw what appeared to be a winning bid for U.S. oil company Unocal, CNOOC stayed out of the U.S. energy market until 2010. The firm's new strategy includes becoming a significant partner in joint ventures to develop largely untapped reserves. The investment had significant appeal to U.S. interests because it represented an opportunity to develop nontraditional sources of energy while creating thousands of domestic jobs and millions of dollars in tax revenue. This investment was particularly well timed, as it coincided with a nearly double-digit U.S. jobless rate; yawning federal, state, and local budget deficits; and an ongoing national desire for energy independence. The deal makes sense for debt-laden Chesapeake, since it lacked the financial resources to develop its shale reserves.

In contrast to the Chesapeake transaction, CNOOC tried to take control of Unocal, triggering what may be the most politicized takeover battle in U.S. history. Chevron, a large U.S. oil and gas firm, had made an all-stock $16 billion offer (subsequently raised to $16.5 billion) for Unocal, which was later trumped by an all-cash $18.5 billion bid by CNOOC. About three-fourths of CNOOC's all-cash offer was financed through below-market-rate loans provided by its primary shareholder: the Chinese government.

China National Offshore Oil Corporation's all-cash offer sparked instant opposition from members of Congress, who demanded a lengthy review and introduced legislation to place even more hurdles in CNOOC's way. Hoping to allay fears, CNOOC offered to sell Unocal's U.S. assets and promised to retain all of Unocal's workers, something Chevron was not prone to do. U.S. lawmakers expressed concern that Unocal's oil drilling technology might have military applications and that CNOOC's ownership structure (i.e., 70% owned by the Chinese government) would enable the firm to secure low-cost financing that was unavailable to Chevron.

The final blow to CNOOC's bid was an amendment to an energy bill passed in July requiring the Departments of Energy, Defense, and Homeland Security to spend four months studying the proposed takeover before granting federal approval.

Perhaps somewhat naively, the Chinese government viewed the low-cost loans as a way to “recycle” a portion of the huge accumulation of dollars it was experiencing. While the Chinese remained largely silent through the political maelstrom, CNOOC's management appeared to be greatly surprised and embarrassed by the public criticism in the United States about the proposed takeover of a major U.S. company. Up to that point, the only other major U.S. firm acquired by a Chinese firm was the 2004 acquisition of IBM's personal computer business by Lenovo, the largest PC manufacturer in China.

Many foreign firms desirous of learning how to tap shale deposits from U.S. firms like Chesapeake and to gain access to such reserves have invested in U.S. projects, providing a much-needed cash infusion. In mid-2010, Indian conglomerate Reliance Industries acquired a 45% stake in Pioneer Natural Resources Company's Texas natural gas assets and has negotiated deals totaling $2 billion for minority stakes in projects in the eastern United States. Norwegian oil producer Statoil announced in late 2010 that it would team up with Norwegian oil producer Talisman Energy to buy $1.3 billion worth of assets in the Eagle Ford fields, the same shale deposit being developed by Chesapeake and CNOOC.

Discussion Questions

1. Do you believe that countries should permit foreign ownership of vital scarce natural resources? Explain your answer.

2. What real options (see Chapter 8) might be implicit in CNOOC's investment in Chesapeake? Be specific.

3. To what extent does the Chesapeake transaction represent the benefits of free global trade and capital movements? In what way might it reflect the limitations of free trade?

4. Compare and contrast the Chesapeake and Unocal transactions. Be specific.

5. Describe some of the ways in which CNOOC could protect its rights as a minority investor in the joint venture project with Chesapeake. Be specific.

Answers to these questions are found in the Online Instructor's Manual available for instructors using this book.

Case Study 17.3

Wal-Mart's International Strategy Illustrates the Challenges and the Potential of Global Expansion

With more than one-fifth of its nearly $450 billion fiscal 2010 revenue coming from its international operations, mega-retailer Wal-Mart would appear to be well on its way to diversifying its business from the more mature U.S. market to faster-growing emerging markets. With the announcement in late 2010 of its controlling interest in South African retailer Massmart Holdings, more than one-half of all Wal-Mart stores are now located outside of the United States (Table 17.4).

Table 17.4. Global Distribution of Wal-Mart Stores

Country	Number of Stores
United States	4,400
Mexico	1,578
Brazil	452
Japan	414
United Kingdom	379
Canada	321
China	298
South Africa	288a
Chile	264
Costa Rica	172
Guatemala	170
El Salvador	77
Nicaragua	57
Honduras	55
Argentina	52
India	3
Total	8,980

Source: Wal-Mart.

^a A small number of these stores are located elsewhere within the region.

Massmart gives Wal-Mart entry into sub-Saharan Africa, a region that to date has been largely ignored by the firm's primary international competitors, France's Carrefour SA, Germany's Metro AG, and the United Kingdom's Tesco PLC. South Africa has embraced shopping malls for years, and an increasingly affluent middle class has emerged since the demise of apartheid. South Africa also has relatively little regulatory oversight. Furthermore, there is an established infrastructure of roads, ports, and warehouses, as well as an effective banking and telecommunications system. While the country has a relatively small population of 50 million, it provides access to the entire region. However, the country is not without challenges, including well-organized and sometimes violent labor unions, a high crime rate, and a 25% unemployment rate.

Wal-Mart's past missteps have taught it to make adequate allowances for significant cultural differences. With respect to Massmart Holdings, there appears to be no plans to rebrand the chain early on. The first sign of change customers will see will be the introduction of new products, including private label goods and the sale of more food in the stores. Wal-Mart also has publicly committed to honoring current union agreements and to working constructively with the unions in the future. Current Massmart management also will remain in place.

Its decision to buy less than 100% of Massmart's outstanding shares reflected a desire by institutional investors in Massmart to retain exposure to the region and by the South African government to continue to have Massmart listed on the South African stock exchange. As one of the nation's largest companies, it provides significant name recognition for investors and a sense of national pride. Wal-Mart has a history of structuring its international operations to meet the demands of each region. For example, Wal-Mart owns 100 percent of its Asda operations in the United Kingdom and 68 percent of Wal-Mart de Mexico.

The year 2006 marked the most significant retrenchment for Wal-Mart since it undertook its international expansion in the early 1990s in an effort to rejuvenate sales growth. Wal-Mart admitted defeat in its long-standing effort to penetrate successfully the German retail market. On July 30, 2006, the behemoth announced that it was selling its operations in Germany to German retailer Metro AG. Wal-Mart, which had been trying to make its German stores profitable for eight years, announced a pretax loss on the sale of $1 billion. Wal-Mart had previously announced in May 2006 that it would sell its 16 stores in South Korea.

Wal-Mart apparently underestimated the ferocity of German competitors, the frugality of German shoppers, and the extent to which regulations, cultural differences, and labor unions would impede its ability to apply in Germany what had worked so well in the United States. German discount retailers offer very low prices, and German shoppers have shown they can be very demanding. Germany's shoppers are accustomed to buying based primarily on price. They are willing to split their shopping activities among various retailers, which blunts the effectiveness of the “superstores” offering one location for all of a shopper's needs. Employees filed a lawsuit against the retailer's policy forbidding romantic relationships between employees and supervisors. Accustomed to putting their own groceries in shopping bags, German shoppers were alienated by clerks who bagged groceries. Moreover, German regulations limited Wal-Mart's ability to offer extended and weekend hours, as well as to sell merchandise below cost in an effort to lure consumers with so-called loss leaders. Strong unions also limited the firm's ability to contain operating costs.

Wal-Mart also experienced a loss of executives when it acquired several German retailers whose headquarters were located in different cities. When Wal-Mart consolidated the two headquarters in one city, many executives left rather than relocate. Perhaps reflecting this “brain drain,” Wal-Mart's German operations had four presidents in eight years. Wal-Mart has not been alone in finding the German discount market challenging. Nestlé SA and Unilever are among the large multinational retailers that had to change the way they do business in Germany. France's Carrefour SA, Wal-Mart's largest competitor worldwide, diligently avoided Germany.

After opening its first store in mainland China in 1996, the firm had to face the daunting challenge of the country's bureaucracy and a distribution system largely closed to foreign firms. In India, Wal-Mart is still waiting for the government to ease restrictions on foreign firms wanting to enter the retail sector, which is currently populated with numerous small merchants.

Discussion Questions

1. Wal-Mart's missteps in Germany may represent an example of the limitations of introducing what works in one market (i.e., so-called best practices) into another. To what extent do you believe that Wal-Mart's failure represented a strategic error? To what extent did the firm's lack of success represent an implementation error?

2. In what ways does the Massmart acquisition reflect lessons learned by Wal-Mart from its previous international market entries? Be specific.

3. Given the challenges of international market entry and the probable substantial delay in experiencing a return on investment, do you believe that Wal-Mart should slow its pace of international expansion or even avoid it altogether? Explain your answer

4. In your judgment, what criteria should Wal-Mart employ in selecting other foreign markets to enter? Be specific.

Answers to these questions are found in the Online Instructor's Manual available to instructors using this book.

¹ Schultes, 2010

² Hopkins, 2008; Kang and Johansson, 2001; Letto-Gillies, Meschi, and Simonetti, 2001; Chen and Findlay, 2002

³ The Economist, 2006b

⁴ Longin and Solnik, 1995

⁵ Bekaert and Harvey, 2000

⁶ Bekaert, Hodrick, and Zhang, 2009

⁷ Blackman, 2006

⁸ Kang, 2008

⁹ Eun, Huang, and Lai, 2007

¹⁰ Numerous studies show that diversified international firms often exhibit a lower cost of capital than firms whose investments are not well diversified (Chan, Karolyi, and Stulz, 1992; Stulz 1995a, 1995b; Stulz and Wasserfallen, 1995; and Seth, Song, and Petit, 2002).

¹¹ Graham, Martey, and Yawson, 2008

¹² The number of cell phone subscribers in Europe has been increasing at a tepid 6 to 8% pace as compared to 34% in the Middle East and 55% per annum in Africa (Bryan-Low, 2005).

¹³ Dunning, 1988

¹⁴ Eun, Kolodny, and Scherage, 1996; Morck and Yeung, 1991

¹⁵ Caves, 1982

¹⁶ Ferreira and Tallman, 2005

¹⁷ Servaes and Zenner (1994) found a positive correlation between cross-border mergers and differences in tax laws. However, Manzon, Sharp, and Travlos (1994) and Dewenter (1995) found little correlation.

¹⁸ Georgopoulos, 2008; Feliciano and Lipsey, 2002; Vasconcellos and Kish, 1998; Harris and Ravenscraft, 1991; Vasconcellos, Madura, and Kish, 1990

¹⁹ Brouthers and Brouthers, 2000

²⁰ Zahra and Elhagrasey, 1994

²¹ Pan, Li, and Tse, 1999

²² Raff, Ryan, and Staehler, 2008

²³ Hitt and Ireland, 2000

²⁴ For an excellent discussion of alternative corporate structures in common and civil law countries, see Truitt (2006).

²⁵ Ceneboyan, Papaiaoannou, and Travlos, 1991

²⁶ For an excellent discussion of the different tax laws in various countries, see PriceWaterhouseCoopers (2006).

²⁷ Teslik, 2010

²⁸ Sojli and Tham, 2010

²⁹ Khanna, Palepu, and Sinha, 2005

³⁰ Bengoa and Sanchez-Robles (2003) and Berggren and Jordahl (2005) demonstrate a strong positive relationship between foreign direct investment and the Heritage Foundation's Freedom Index. This index contains about 50 variables divided into 10 categories, measuring various aspects of economic and political freedoms.

³¹ For a detailed discussion of the interest rate parity and purchasing power parity theories, see Shapiro (2005).

³² Graham and Harvey, 2001

³³ Harvey, 2005

³⁴ Koedijk and Van Dijk, 2000; Koedijk et al., 2002; Mishra and O'Brien, 2001; Bodnar, Dumas, and Marston, 2003

³⁵ Bodnar et al. (2003) argue that in addition to the risk-free rate of return, the firm's cost of equity should be adjusted for such factors as the risk arising from variation in returns on a global stock market, country-specific stock market risk, and industry-specific risk. Other factors include exchange rate, political, and liquidity risk. Unfortunately, the substantial amount of information needed to estimate the adjustments required in such extensive multifactor models usually makes this approach impractical.

³⁶ Note that the debt crises in Greece and other developed countries in 2010 and 2011 suggest that in some instances the interest rate on the debt of a large corporation within the local country or the U.S. Treasury bond rate may be more appropriate to use as a risk-free rate. The Treasury bond rate should be adjusted (using the Fisher effect) for the difference in the anticipated inflation rates in the two countries. This converts the Treasury bond rate into a local country nominal interest rate.

³⁷ Berk, 1995

^a The U.S. equity premium or the U.K. equity premium could have been used, since equity markets in either country are highly correlated.

^b The real rate of return is the same in the United Kingdom (r _uk) and the United States (r _us). r _uk = 9.8% – 4.0% = 5.8%, and r _us = 8.8% – 3.0% = 5.8%.

³⁸ Increasingly, country risk is measured by adding the country's credit default swap spread to the U.S. Treasury interest rate.

³⁹ Delos and Beamish, 1999; Tang and Tikoo, 1999; Madura and Whyte, 1990

⁴⁰ Zahra, Ireland, and Hitt, 2000; Caves, 1982

⁴¹ Isakov and Sonney, 2002

⁴² Diermeier and Solnik, 2001

⁴³ Francis, Hasan, and Sun, 2008

⁴⁴ Harris and Ravenscraft, 1991

⁴⁵ Kuipers, Miller, and Patel, 2003

⁴⁶ Seth, Song, and Pettit, 2000; Eun, Kolodny, Scherage, 1996; Servaes and Zenner, 1994; Harris and Ravenscraft, 1991

⁴⁷ Kuipers et al., 2003; Seth et al., 2000; Eckbo and Thorburn, 2000; Markides and Oyon, 1998; Cakici and Tandon, 1996

⁴⁸ Moeller and Schlingemann, 2002

⁴⁹ Chatterjee and Aw (2004) for U.K. and Eckbo and Thorburn (2000) for Canadian targets.

⁵⁰ Chari, Ouimet, and Tesar, 2004

⁵¹ La Porta, Lopez-De-Silanes, and Shleifer, 2002; Lemmons and Lins, 2003; Peng, Lee, and Lang, 2005

⁵² Young et al., 2008

⁵³ Leuz, Lins, and Warnock, 2004

⁵⁴ Rossi and Volpin, 2004; Bris and Cabolis, 2004; Martynova and Renneboog, 2008b

⁵⁵ Aggarwal et al., 2007