442 CORPORATE STRATEGY AND FOREIGN DIRECT INVESTMENT
3It is fair to assume that Toyota and Ford are automobile manufacturers that desire to benefit from economies of scale. Suppose that Toyota decides to establish distribution dealerships in foreign countries, while Ford decides to establish manufacturing subsidiaries in foreign countries. Which company is more likely to benefit from economies of scale? Which company has less to lose if the venture fails?
4What are the distinct alternatives available to companies for their foreign investment?
5What is the major difference in mergers and corporate governance between the USA and Japan?
6Discuss some reasons for the recent decline of foreign direct investment in developing markets.
7Explain why mergers are often more difficult to evaluate than the establishment of new production facilities.
8What are the factors affecting international acquisitions?
Problems
1GM is analyzing the acquisition of a British company for $1 million. The British company has expected cash flows of $90,000 per year. The synergistic benefits of the merger will add $10,000 per year to cash flow. Finally, the British company has a $50,000 tax loss carryforward that can be used immediately by GM. GM is subject to a 40 percent tax rate and has a 10 percent cost of capital. Should GM acquire this British company?
2The cost of debt (10 percent), the cost of equity (15 percent), the tax rate (50 percent), and annual earnings after taxes ($10,000) are the same for a domestic firm and a multinational company. The firm’s target debt ratio (optimum capital structure) is 20 percent, while the company’s target debt ratio is 50 percent.
(a)Determine the weighted average costs of capital for these two enterprises.
(b)Determine the market values of the two enterprises.
3Assume that the worldwide profit breakdown for Ford is 85 percent in the USA, 5 percent in Japan, and 10 percent in the rest of the world. On the other hand, the worldwide profit breakdown for Toyota is 40 percent in Japan, 35 percent in the USA, and 25 percent in the rest of the world. Earnings per share are $5 in the USA, $8 in Japan, and $10 in the rest of the world for both companies.
(a)What are the weighted average earnings per share of Ford and Toyota?
(b)Which company is likely to have the international competitive advantage?
4We will assume that IBM is analyzing the acquisition of a privately held French company. The French company is more similar to Low Tech (LT) than any other company whose stock is traded in the public market. To establish a fair market price for the French company, IBM has compiled the statistics presented in the following table. Estimate the market value of
CASE PROBLEM 17
443
the French company (FM) in the following three ways: (a) the price–earnings ratio, (b) market value/book value, and (c) the dividend growth model.
Variables
French company
Low Tech
Earnings per share
$
2.00
$
4.00
Dividend per share in year 1
$
1.50
$
2.00
Annual dividend growth rate
0.04
0.04
Price per share
?
$40.00
Book value per share
$16.00
$20.00
Cost of equity
?
0.14
Number of shares outstanding
1 million
1.2 million
REFERENCES
BenDaniel, D. J. and A. H. Rosenbloom, eds., The Handbook of International Mergers and Acquisitions, Englewood Cliffs, NJ: Prentice Hall, 1990, pp. 1–24.
Ferdows, K., “Making the Most of Foreign Factories,” Harvard Business Review, Mar./Apr. 1997, pp. 74–88.
King, A. M., “Merger Accounting Magic May Disappear,” Strategic Finance, Jan. 2000, pp. 39–43.
Lehner, U. C., “Money Hungry,” The Wall Street Journal, Sept. 18, 1997, pp. R1, R4.
Newman, L. R., “Strategic Choices,” in D. J. BenDaniel and A. H. Rosenbloom, eds., The Handbook of International Mergers and Acquisi-
tions, Englewood Cliffs, NJ: Prentice Hall, 1990, pp. 1–24.
Solnik, B. and D. McLeavey, International Investment, New York: Addison Wesley, 2003, ch. 9: The Case for International Diversification.
Spindle, B., “Japanese Companies Speed Up Sales of Cross-Holdings,” The Wall Street Journal, Mar. 7, 2000, p. A18.
The World Bank, Global Development Finance, Washington, DC: The World Bank, 2003.
The World Bank, Global Economic Prospects, Washington, DC: The World Bank, 2003.
Case Problem 17: BP’s Acquisition of Amoco
On December 31, 1998, British Petroleum PLC (BP) bought Amoco Corp., the fourth-largest US oil company, for $52.41 billion in stock, then the largest industrial merger in history. This deal surpassed the $40.5 billion dollar purchase of Chrysler Corp. by Germany’s Daimler-Benz AG, completed in November 1998. The combined company, named BP Amoco, would remain the world’s third-largest oil company, but the deal would make it a bigger rival to the number one, Royal Dutch/Shell, and the number two, Exxon Corp., in size and scope (see figure 17.7): $108 billion in annual revenue, 14.8 billion barrels in oil and gas reserves, 1.9 million barrels of daily oil production, $6.4 billion in annual profit, $132 billion in market value, and 100,000
444 CORPORATE STRATEGY AND FOREIGN DIRECT INVESTMENT
Moving Up the Ranks
Reserves1 vs. market capitalization2
The supermajors
$200
inbillions
Exxon
RD Shell Group
150
BP Amoco
capitalization,
100
BP3
Chevron
Mobil
50
Enron
Texaco
Market
Corp. Elf
Amoco
Phillips
Total
D
0
5,000
10,000
15,000
20,000
0
Oil/NGL/Gas reserves, in millions of barrels equivalent
1Excluding affiliates.1997 data
2AS of July 24, 1998; on combined basis for BP Amoco
3Includes associated undertaking (Abu Dhabi)
Note: Worldwide publicly traded companies included
Source: Annual report for BP and Amoco: Petrompanies for the remainder, Datastream
Figure 17.7 Major oil companies: their reserves and market capitalization
Source: BP Amoco.
employees. Amoco shareholders received a 0.66 BP American depository receipt for each share of Amoco. This price represents a premium of about 15 percent to the value of Amoco before the merger. BP used the pooling-of-interest accounting treatment in acquiring Amoco instead of the purchase-of-asset accounting treatment.
“The potential for cost-cutting and improving efficiencies is enormous,” said analyst Fadel Gheit at Fahne-Stock & Co. “There will be no weakness in the new company, which will have the two top international players looking over their shoulders.”
By combining operations, BP Amoco contended that it would cut $2 billion in annual costs from its operations by the end of the year 2000, boost its annual pretax profits by a few hundred million dollars in the next 2 years, and reduce the cost of capital substantially. This combined company failed to increase its earnings in 1999, but the merger boosted shareholder value substantially through December 1999.
BP had already demonstrated that it knows how to hold down costs, most notably during a big reorganization that took place in the early 1990s, when it slashed its payroll deeply. Now, led by Chief Executive John Brown, BP was expected to apply some of the same discipline to Amoco, whose performance on the cost-cutting front had lagged. But, just as important, there was also the potential for substantial growth. The combined company’s revenues would enable it to finance more development itself, keep costs down, and help win more victories at auctions of oil reserves.
CASE PROBLEM 17
445
Analysts stated that the assets of these two companies complimented each other. BP brought a huge worldwide exploration and production operation to the company, plus a strong European retail network. As for Amoco, it was the largest natural gas producer in North America and had a large US gasoline marketing network. Both companies had petrochemicals operations that would become among the largest in some areas. Both also operated in the niche area of solar energy and would pose a challenge to that market’s leader, Germany’s Siemens AG.
More specifically, BP Amoco Chairman John Brown said that beyond the projected $2 billion in savings, he expected additional savings and growth opportunities. He pointed to such areas as Azerbaijan, the oil-rich Central Asian nation where both companies are major players. Other synergies would include deeper-water exploration and production, where BP would bring its expertise to Amoco’s fields in the Gulf of Mexico. Similarly, the deal could combine Amoco’s lower development costs with BP’s cheaper exploration costs.
Since BP announced its proposed acquisition of Amoco in August 1998, a wave of merger activity has hit the oil industry. These more recent acquisitions include Exxon’s agreement to buy Mobile for $75 billion, BP Amoco’s proposed merger with Arco for $25 billion, the agreement by France’s Total SA to buy Belgium’s Petrofina SA for $15 billion, and proposed alliances among national oil companies of Brazil, Mexico, Saudi Arabia, and Venezuela. Why have all these oil mergers and alliances happened in recent years? First, the most successful companies, such as BP and Exxon, had already slashed costs. When costs have been cut to the bone, merger remains a route to higher profits. Second, advances in drilling and other oil technologies have enabled oil companies to discover previously untapped oil fields. In addition, these new technologies have allowed hundreds of players to produce ever larger amounts of petroleum at ever lower costs.
Case Questions
1Explain how BP Amoco could cut $2 billion in costs and boost annual pretax profits by a few hundred million dollars for the first 2 years.
2Explain how this merger could reduce its cost of capital substantially.
3Why did BP treat its merger with Amoco as a pooling transaction rather than a purchase transaction?
4Explain how the BP–Amoco merger could boost its shareholder wealth as reflected by its stock price. According to the case, the combined company did not earn more money after the merger, but its stock price increased. How do you explain this apparent conflict between earnings and stock price?
5Briefly explain American depository receipts. The last closing price per share for Amoco stock was about $52. What was the closing price of BP American depository receipts (ADRs) on its last trading day?
446 CORPORATE STRATEGY AND FOREIGN DIRECT INVESTMENT
6Some websites, such as www.dbc.com and www.quicken.com, provide many pieces of information about publicly held companies for investors. Use several websites of your choice to compare some key financial statistics of BP Amoco with those of its major competitors.
Sources: B. Bahree, “Big Oil Mapped Mergers Before Turmoil,” The Wall Street Journal, Dec. 9, 1998, p. A17; R. Frank and S. Liesman, “While BP Prepares New US Acquisition, Amoco Counts Scars,” The Wall Street Journal, Mar. 31, 1999, pp. A1, A8; G. Steinmetz, C. Goldsmith, and S. Lipin, “BP to Acquire Amoco in Huge Deal Spurred by Low Energy Prices,” The Wall Street Journal, Aug. 12, 1998, pp. A1, A8; and BP Amoco Annual Report, 1998 and 1999.
CHAPTER 18
International Capital
Budgeting Decisions
Opening Case 18: External Factors Affecting Foreign
Project Analysis
Foreign-exchange rates, interest rates, and inflation are three external factors that affect multinational companies (MNCs) and their markets. Changes in these three factors stem from several sources, such as economic conditions, government policies, monetary systems, and political risks. Each factor is a significant external variable that affects areas such as policy decisions, strategic planning, profit planning, and budget control. To minimize the possible negative impact of these factors, MNCs must establish and implement policies and practices that recognize and respond to their influences.
These three factors – exchange rates, interest rates, and inflation – affect sales budgets, expense budgets, capital budgeting, and cash budgets. However, they are particularly useful when evaluating international capital budgeting alternatives. Foreign-exchange rates have the most significant effect on the capital budgeting process. A foreign investment project will be affected by exchange rate fluctuations during the life of the project, but these fluctuations are difficult to forecast. There are methods of hedging against exchange rate risks, but most hedging techniques are used to cover short-term positions.
The cost of capital is used as a cutoff point to accept or reject a proposed project. Because the cost of capital is the weighted average cost of debt and equity, interest rates play a key role in a capital expenditure analysis. Most components of project cash flows – revenues, variable costs, and fixed costs – are likely to rise in line with inflation, but local price controls may not permit internal price adjustments. A capital expenditure analysis requires price projections for the entire life of the project. In some
448 INTERNATIONAL CAPITAL BUDGETING DECISIONS
countries, the inflation rate may exceed 100 percent during a 3-year period, a condition known as hyperinflation. These and other factors related to inflation make the capital budgeting process extremely difficult.
Source: Paul V. Mannino and Ken Milani, “Budgeting for an International Business,” Management Accounting, Feb. 1992, pp. 36–41.
The basic principles of analysis are the same for foreign and domestic investment projects. However, a foreign investment decision results from a complex process, which differs, in many aspects, from the domestic investment decision.
Relevant cash flows are the dividends and royalties that would be repatriated by each subsidiary to a parent firm. Because these net cash flows must be converted into the currency of a parent company, they are subject to future exchange rate changes. Moreover, foreign investment projects are subject to political risks such as exchange controls and discrimination. Normally, the cost of capital for a foreign project is higher than that for a similar domestic project. Certainly, this higher risk comes from two major sources, political risk and exchange risk.
This chapter is composed of four major sections. The first section describes the entire process of planning capital expenditures in foreign countries beyond 1 year. The second section examines how international diversification can reduce the overall riskiness of a company. The third section compares capital budgeting theory with capital budgeting practice. The fourth section covers political risk analysis.
18.1 The Foreign Investment Decision-Making Process
The foreign investment decision-making process involves the entire process of planning capital expenditures in foreign countries beyond 1 year. The 1-year time frame is arbitrary, but a 1-year boundary is rather widely accepted. There are many steps and elements in this process. Each element is a subsystem of the capital budgeting system. Thus, the foreign investment decisionmaking process may be viewed as an integral unit of many elements that are interrelated. Here we assume that the entire foreign investment decision-making process consists of 11 phases: (1) the decision to search for foreign investment, (2) an assessment of the political climate in the host country, (3) an examination of the company’s overall strategy, (4) cash flow analysis, (5) the required rate of return, (6) economic evaluation, (7) selection, (8) risk analysis, (9) implementation, (10) expenditure control, and (11) post-audit.
18.1.1The search for foreign investment
The availability of good investment opportunities sets the foundation for a successful investment program. Hence, a system should be established to stimulate ideas for capital expenditures abroad and to identify good investment opportunities. Moreover, good investment opportuni-
THE FOREIGN INVESTMENT DECISION-MAKING PROCESS
449
ties come from hard thinking, careful planning, and, frequently, large outlays for research and development.
The first phase in the foreign investment decision-making process is an analysis of the forces that lead some company officials to focus on the possibilities of foreign investment. If a company recognizes foreign investment as a legitimate program, its search for foreign investment opportunities will start. The economic and political forces in the host countries are largely responsible for the expansion of foreign investment. Many companies also desire foreign investment to seek new markets, raw materials, and production efficiency. Chapter 2 described these and other motives for foreign investment in detail.
It is not easy to pinpoint one motive for a decision to invest abroad in any particular case or to find out exactly who initiated a foreign project. The decision to search for foreign investment comes at the end of a series of events, and it is a combination of several motivating forces and activities of different persons. Typically, the decision to look abroad depends on the interaction of many forces. Considerations such as profit opportunities, tax policy, and diversification strategies are economic variables that may affect a decision to look overseas. In addition, environmental forces, organizational factors, and a drive by some high-ranking officials inside a company could be major forces leading a company to look abroad.
18.1.2The political climate
Political risks may exist for the domestic investment. Price controls may be established or lifted, some regulated industries may be deregulated, or quotas and tariffs on cheap imported components may be imposed. Certainly, there are more political risks in foreign investment. For one thing, at least two national governments become involved in a foreign investment project – that of the home country of the parent company and that of the host country of the subsidiary. The goals of the two countries may differ; laws may change; rights to repatriate capital may be modified; and, in an extreme situation, assets may be seized by a host government without adequate compensation.
One major concern of MNCs is the possibility that the political climate of a host country may deteriorate. The multinational financial manager must analyze the political environment of the proposed host country and determine whether the economic environment would be receptive to the proposed project. In general, projects designed to reduce the country’s need for imports and thus save foreign exchange are given the highest priority by the host government.
Political actions, such as exchange controls and discrimination, adversely affect company operations. Thus, the analyst should emphasize such factors as the host government’s attitudes toward foreign investment, the desire of the host country for national rather than foreign control, and its political stability. The analyst should also determine whether adequate and prompt compensation is guaranteed if a host country nationalizes alien assets in the public interest.
18.1.3The company’s overall strategy
If the initial screening of the political climate is favorable, the MNCs can move on to the next stage of the decision-making process. The analyst then assesses the usefulness of each alternative within the company’s overall strategy to determine how foreign operations may perpetuate current
450 INTERNATIONAL CAPITAL BUDGETING DECISIONS
strengths or offset weaknesses. This approach allows a company to reduce alternatives to a manageable number. At this stage, the company must check whether the project conflicts with company goals, policies, and resources. The analyst must also evaluate whether the company has the experience to handle the project and how the project could be integrated into existing projects.
The company’s overall strategy consists of objectives, policies, and resources. In capital expenditure analysis, there are objectives to be attained and policies designed to achieve these objectives. If a particular set of policies is not consistent with the stated objectives, either the policies or the objectives should be revised. The company must also have resources necessary to carry out its policies. If resources are not available, they must be acquired, or the policies and/or the objectives must be revised.
THE COMPANY GOAL The primary goal of the MNC is to maximize its stock price. The market price of the firm’s stock reflects the market’s evaluation of its prospective earnings stream over time and the riskiness of this stream. Thus, the company must attempt to accept projects whose profits are higher and whose risks are lower.
COMPANY POLICY If the company has carefully established policies to achieve its goal, it can overcome the threat of competitors and use its oligopolistic advantages. The company should systematically evaluate individual entry strategies in foreign markets, continuously audit the effectiveness of current entry modes, and use appropriate evaluation criteria.
COMPANY RESOURCES Resources are assets that enable the company to carry out its objectives and policies; they include marketing skills, management time and expertise, capital resources, technological capabilities, and strong brand names.
18.1.4Cash flow analysis
The fourth stage of the screening process involves a standard cash flow analysis. The after-tax cash outflows and inflows directly associated with each project must be estimated to evaluate capital investment alternatives. An MNC must forecast its expected expenditures for the proposed project. Ordinarily, it obtains these forecasts from data of similar ventures. A company may also make forecasts by such techniques as the percent-of-sale method or a linear regression analysis. An important difference in the application of cash flow analysis for foreign investment is that a company must make two sets of cash flow analyses, one for the project itself and one for the parent company.
THE DEMAND FORECAST The first step in analyzing cash flows for any investment proposal is a forecast of demand. These estimates of usage are highly correlated with historical demand, population, income, alternative sources of products, competition, the feasibility of serving nearby markets, and general economic conditions.
There are a number of reasons for emphasizing market size in the investment decision-making process. First, the expected market size can be used as an indication of profit possibilities for the proposed investment project. Second, small markets tend to have high uncertainty. If a market
THE FOREIGN INVESTMENT DECISION-MAKING PROCESS
451
is small, the MNC has little or no leeway in case of an erroneous estimate. Third, small markets are not worth the effort. Because management is one of scarce resources in a company, the proposed project should be large enough to support management time on project analysis.
DUTIES AND TAXES Because foreign investment cuts across national boundaries, a unique set of tax laws and import duties may be applicable. An MNC must review the tax structure of the host country. In this analysis, the evaluator would include the definition of a taxable entity, statutory tax rates, tax treaties, treatment of dual taxation, and tax incentive programs. The MNC should also know whether the host government imposes customs duties on imported production equipment and materials not obtainable from local sources.
FOREIGN-EXCHANGE RATES AND RESTRICTIONS Another important feature of foreign investment analysis is that project inflows available to the investor are subject to foreign-exchange rates and restrictions. When the host country has a stable exchange rate, no problems are presented. However, if the exchange rate is expected to change or allowed to float, cash flow analysis becomes more complicated, because the analyst must forecast the exchange rate that may be applicable to convert cash flows into hard currencies.
It is equally important to recognize that many host governments have various exchange control regulations. Under these regulations, permission may be required to buy foreign exchange with local currency for payment of loan interest, management fees, royalties, and most other billings for services provided by foreign suppliers. Processing applications for permission to purchase foreign exchange may take a long time. Moreover, the granting of permission to buy foreign exchange does not guarantee that a related foreign exchange will be available in time, because commercial banks can allocate only such amounts as are made available by a central bank.
Many factors affect the blockage of funds to nonresidents. They include an expected shortage of foreign exchange, a long-run deficiency of the foreign exchange, and certain types of domestic political pressures. If all funds are blocked in perpetuity, the value of a project is zero to the parent company. However, in actuality funds are likely to be only partially blocked, because MNCs have many ways to remove blocked funds. These methods include transfer price adjustments, loan repayments, royalty adjustments, and fee adjustments. Furthermore, most host countries limit the amount of fund transfers to nonresidents or block the transfer of funds only on a temporary basis. Nevertheless, MNCs must analyze the effect of blocked funds on project return. It is critical that an analyst determines the amount of blocked funds, their reinvestment return, and ways in which funds can be transferred under the host country’s law.
PROJECT VERSUS PARENT CASH FLOWS To determine after-tax profits from a proposed project, the MNC must develop a demand forecast, forecast its expected expenditures, and review the tax structure of the host country. The estimated sales, less estimated expenses, plus noncash outlays such as depreciation, gives the cash inflows from operations.
Typically, an MNC desires to maximize the utility of project cash flows on a worldwide basis. The MNC must value only those cash flows that can be repatriated, because only these funds can be used for investment in new ventures, for payment of dividends and debt obligations, and for reinvestment in other subsidiaries. Project cash flows would have little value if they could not be used for these alternatives.
