Introduction. Valuation of Assets. Capital Budgeting in Global Markets

Transcription

1 Capital Budgeting in Global Markets Spring 2008 Introduction Capital markets and investment opportunities ave become increasingly global over te past 25 years. As firms (and individuals) are increasingly able to diversify teir operations (investments) across countries. Tis leads to te questions: How do corporate and country caracteristics influence te value of projects in different countries? Wic caracteristics are important and ow do tey influence te tecniques we use to value tese projects? Valuation of Assets Te concept of future prospects and particularly of continued growt in te future invites te application of formulas out of iger matematics to establis te present value of te favored issue. But te combination of precise formulas wit igly imprecise assumptions can be used to establis, or rater justify, practically any value one wises, owever ig, for a really outstanding issue. Benjamin Graam Wat does tis mean for te valuation of assets? Valuation is part art and part science Useful to ave several perspectives. Eac will ave different strengts and weaknesses wic sould be acknowledged and leveraged.

2 Valuation Tecniques: Review Discounted cas flow (DCF) approaces: Dividend discount models (DDM s) Free cas flow models (FCF s) Relative / multiples valuation approaces: Determine market value of a firm based on financial ratios or oter caracteristics of comparable firms. Value based on similar transactions. Valuation of separate parts / Break-up value Determine te value of all subsidiaries separately and add togeter. Valuing Cross-Border Investments One of te most common and intuitive ways to value a project is by discounting te future expected casflows generated by te project. Can generally forecast casflows but comparable transactions are not always available, especially in emerging markets. Similar to te DCF analysis from te core Finance course. To extend tis to international problems tere are some extra tings we need to consider: Coice of currency for te FCF s Coice of country for cost of capital (discount rate) Special international risks: political risk, etc. Option value of setting up a project in a different country Cost of Capital Te minimum required rate of return on a capital investment for te investor/firm to be willing to undertake te project : te expected return tat is just sufficient to compensate all investors for te risk of te project. sometimes referred to as te required rate of return or te urdle rate. Te basic principle is: any project tat can provide an expected return greater tan te cost of capital required by its investors sould be undertaken. any positive NPV project sould be undertaken.

3 Some Preliminary Issues Te true cost of capital cannot be observed directly It is frequently estimated by analyzing te required returns on publicly traded financial securities for firms or projects wit similar risk caracteristics. Te estimated cost of capital sould make sense! Investors require iger returns on assets wose cas flow generating ability is more uncertain. It is a long-run caracteristic of te firm so it sould be stable over time. Only include compensation for risks consistently faced by te firm. Oter factors sould be allowed to influence expected casflow estimates. Wat about country and political risk? (i.e., Cina? Russia? US?) Relationsip between Risk and Return Required or Expected Rate of Return Risk Free Rate Risk Premium Risk Local versus Foreign It appears logical to use te local cost of capital (te cost of capital for te ome market of te project). A Frenc cost of capital for a project located in France Te key question is: wo are te investors supplying te capital for te project and wat are te returns tat tey require on te capital tey are providing? Te cost of capital sould be calculated using te required returns for te actual suppliers of capital (bot debt and equity).

4 Weigted Average Cost of Capital (WACC) Wat is te cost of capital for all of a firm s investors? Since te government pays part of te interest expense, te after-tax cost of capital is: k c = ( D / V ) * k d * (1-t) + ( E / V ) * k e k d = cost of debt D = value of debt k e = cost of equity E = value of equity k c = overall cost of capital Value of firm = D + E t = firm s marginal tax rate Capital Structure: Local vs Global Localized capital structures are better because: Addresses criticisms tat te foreign affiliate is insensitive to local market conditions. Helps management evaluate performance relative to oter firms in te same market. Forces te local firm to allocate capital efficiently by not insulating tem from local forces. Localized capital structures are worse because: Loss of teir competitive advantage from teir better access to global capital markets. Harder to interpret consolidated financial statements. Te affiliates debt ratio does not reflect true default risk due to te guarantees it as from te parent firm. Wat Do We Do? Te target capital structure for te project is te mix of financing (in market values) it would maintain as a stand alone entity. May need local comparables or even comparables from anoter country to determine tis. Its actual capital structure may deviate from tis for tax purposes, to deal wit political risk or oter types of risk. Expected tax effects of te actual capital structure sould be incorporated into te expected casflows to te parent. Putting tis in te discount rate would be double counting.

5 Cost of Debt (k d ) Matc wit term of projects (generally long-term). Use current (wat te firm would pay today) as opposed to past interest rates: If te corresponding corporate rates can not be found, take government rates and add a risk premium based on: istoric spread or premium for issuer spread required given te bond rating, if available Wat risks does te bond rating capture? Wat risks does it not consider? Cost of Equity (k e ) Problem: we cannot observe current required equity returns directly. We can only observe current equity prices and past equity returns. Tis is an even greater problem in te international environment, because market data may not be readily available and/or reliable. Two Basic Approaces: 1. Estimate te expected (internal rate of) return to owning te company s stock using te dividend discount model (DDM). 2. Estimate te market s required return on te firm s equity using a risk pricing model suc as te CAPM. Note: in an efficient market te required and expected returns sould be te same. Cost of Equity: Te CAPM Approac Te return te firm s investors require on teir investment based on te risk tey face relative to te most relevant market index. Te CAPM relates te cost of equity for an individual asset to tat asset s beta. Formally: k e = r f + β E(R m -R f ) were: k e r f = required rate of return on equity = risk-free rate β = beta of stock (risk relative to market) E(R m -R f ) = expected market risk premium

6 CAPM: Grapically Slope = (E(R m ) - R f ) Required or Expected Risk Premium, Rate of Return, E(R i ) β i (E(R m ) - R f ) Risk Free Rate, r f Risk, β i How Is Beta Measured or Estimated? Regression of observed excess returns for security i, R i,t - R f,t, against te excess return on a market index, R m,t -R f,t : (R i,t -R f,t, ) = α i + β i (MRP,t ) + ε i,t were β i is te slope or regression coefficient, and α i is te intercept tat represents te sample abnormal return. Te R 2 from te regression is an indication of te degree of correlation between te market and te asset. Tis can be done using Excel or anoter statistical program or Bloomberg and oter sources do tis automatically. Te CAPM: Inputs and Outputs β -beta Beta for an asset of similar risk to te market portfolio = 1.0. Typical range of betas: If you cannot measure tis for a firm, use te beta of comparable firms. Be consistent wit capital structure assumptions - may need to unlever / relever te beta. r f - risk free rate Current yield on intermediate or long-term government bonds (Wat does tis capture?) E(R m -r f ) - expected market risk premium Historic average of difference between te return on te market (e.g. S&P/TSX) and long-term government bonds 4-6% for most developed countries if no better data available (wat about for less-developed countries?)

7 Wic Casflows to Forecast? Usually easier to forecast FCF s in te local currency Can take te local market conditions into consideration (e.g. inflation, regulation, ) Casflows earned abroad may be ard to repatriate. Regardless of wen te earnings will be repatriated, we sould use earned casflows since tese are te funds tat can be invested by te firm. An as is valuation uses existing market prices as forecasts. Ultimately, owever, we are interested in te value of te project wit transfer pricing, royalties, subsidies, taxes etc. At te end of te process, we sould perform sensitivity analysis on economic risks, political risks, learning and te impact of oter international risks/opportunities on casflows. Casflows and Cost of Capital Te appropriate discount rate can be eiter: A domestic currency rate if expected future casflows are in te domestic currency, or A foreign currency rate if expected future casflows are converted into te foreign currency. Coice of currency depends on te ability to accurately forecast eac type of casflow and convert tem back to te firm s ome currency. Generally better to use te foreign currency for tese forecasts because it is easier to explicitly include forecasted inflation, excange rates, etc. in tese estimates. Be clear and consistent! Converting Cost of Capital Wat do we do if we can not compute te costs of capital in te required markets? E.g., Wat if te equity and/or bond markets are under-developed or tere are no local comparables? We can convert estimates made in te ome market to approximate te foreign values. A Frenc WACC (or cost of debt or cost of equity) can be converted to a Canadian WACC (or vice-versa) using interest rate parity: (1 + k Canada ) = (1 + k France ) {(1 + r Canada )/(1 + r France )} Intuition: if Canada or te Canadian dollar is riskier tan France or te Euro, te interest rates sould be iger in Canada so te cost of capital in Canada will be iger tan in France.

8 Free Cas Flows to te Firm (FCF) Wat exactly are tese casflows? FCFs represent cas flows upon wic all stakeolders ave a claim. Tey are te casflows we expect to ave generated by te assets of te firm in te future. Basically, free cas flows to te firm equal: FCF = EBIT (1 - tax rate) + Depreciation and amortization - Capital Expenditures - Increase in Working Capital Forecasting Free Casflows Te value of te assets is te net present value (NPV) of all of te expected future operating free cas flows (actually EV). Once we ave forecasts for tese, tey are discounted at te firm s cost of capital: NPV = FCF 1 + FCF k c (1+k c ) 2 If te growt rate is constant into te future (i.e., terminal value): FCF NPV = 1 k c -g Or combination of te two: forecast period and terminal value. NPV for FCF in Different Currencies Suppose we are considering a firm wit a sequence of forecasted free cas flows to te firm (revenues) in Yen: FCF 1, FCF 2, FCF 3,, FCF n in Yen. Wat is te present value of tis cas stream in Canadian dollars?

9 Metod 1: Discount te yen cas flows using te yen discount rate. Tis gives us a present value in yen. Convert te result into today s dollars using te spot dollar/yen excange rate. PV in Yen NPV = S[FCF 1 /(1+k c,yen ) + FCF 2 /(1+ k c,yen ) FCF n /(1+ k c,yen ) n ] Metod 2: Use forward contracts (interest rate parity) to determine te expected future dollar/yen excange rate at te different points in time at wic cas flows are received. Compute te present value of te edged into dollars cas flows using te dollar discount rate. FCF in $ NPV = [F 1 FCF 1 ]/(1+ k c,cad ) + [F 2 FCF 2 ]/(1+ k c,cad ) [F n FCF n ]/(1+ k c,cad ) n Metod 3: Assume relative PPP olds, so use te inflation differential to predict excange rates: Example: Inflation in Japan is expected to be 2% per year Inflation in Canada is expected to be 3% per year We expect te Yen to appreciate against te Canadian dollar by [(1+0.03)/(1+0.02) 1] = 1 percent per year. Compute te present value of te expected dollar casflows (determined wit PPP) using te dollar discount rate: NPV = [P 1 FCF 1 ]/(1+ k c,cad ) + [P 2 FCF 2 ]/(1+ k c,cad ) [P n FCF n ]/(1+ k c,cad ) n FCF in $

10 Final Stage of DCF Valuation Adjustments to casflows may need to be made for non-diversifiable risks suc as political risks. Te casflows are expected casflows and tis may need to be considered. Political risk insurance is available to elp deal wit some of tese and te premium can be deducted from te casflows. We need to consider te impact tat tax breaks and subsidies may ave on te casflows to te project as well as to te parent company. We need to consider te potential cannibalization by te new project and te possible option value of doing oter, subsequent projects in tis country. Sensitivity or scenario analysis to determine te impact of different assumptions and risks on our results. Relative Valuation Approaces Expected value of te equity of a company (on a per sare basis) is equal to P/E multiple times expected earnings: P 0 = P/E multiple x EPS 1 Tis multiple usually comes from comparable firms or is based on comparable transactions. Preferably witin te same country or a country wit similar caracteristics. Different countries value assets differently and ave different accounting standards. Valuation: Te Process Value of synergy and oter gains to bidder Transaction Costs Min. bid Standalone target value Value of target wit synergies Max. Bid

11 Valuation: Example LSE soars as Nasdaq makes bid (Reuters Marc 13, 2006) altoug te offer from Nasdaq undervalues te potential synergies from any deal, tere will be increasing pressure from LSE sareolders to seal a deal at a sligtly iger price. Nasdaq plans to use synergies to elp justify te price it is offering to pay for te LSE and still as scope to raise its offer if necessary, sources close to te matter said on Monday. Wile Macquarie's plan was to use te LSE's stable cas flow, Nasdaq plans to take advantage of its similar business model to boost te efficiency of a joint excange and justify its iger bid Valuation: Best Practices DCF is te dominant valuation tecnique. WACC is te dominant discount rate. For WACC: weigts based on market not book values CAPM used to estimate cost of equity betas obtained from publised sources risk-free rate to matc stream of cas flows (eg, L-T) istorical equity risk premium of 6% or lower monitor canges at least annually Source: Best Practices in Estimating te Cost of Capital: Survey and Syntesis, R. Bruner, K. Eades, R. Harris and R. Higgins, Financial Practice and Education, Spring/Summer 1998, pp Summary 1) & I) Forecast foreign currency FCF s use expected inflation rates, marginal tax rate include a terminal value II) Forecast FX rates - parity conditions convert foreign FCF s to domestic 2) Determine foreign WACC III) Determine ome country WACC use project specific capital structure use project specific cap struc use project specific beta use project specific beta incorporate systematic risks incorporate systematic risks 3) Calculate PV in foreign currency IV) Calculate PV in domestic currency 4) Convert to domestic currency at spot rate