International Value Creation

1. DRAFT International Value Creation Campbell R. Harvey Duke University and National Bureau of Economic Research

2. International Value1. Setting • A critical component in implementing EVA in international context is knowing the appropriate hurdle rates. • Each country has its own risk characteristics which need to be taken into account.

3. International Value1. Setting • Unfortunately, there is widespread disagreement over approaches to international valuation • Different methods provide sharply different hurdle rates in international context

4. International Value1. Setting • Disagreement comes at a bad time with growth in global investment

5. International Value2. Goals • Motivation • Defining Country Risk • Methods of Calculating Hurdle Rates • Implementing the International Cost of Capital • Country Risk and EVA

6. International Value3. Motivation • Dramatic internationalization of world • Economic integration through increased trade. • Financial integration through liberalization of capital markets

7. International Value3. Motivation (Exports+Imports)/GDP Developed Countries

8. International Value3. Motivation (Exports+Imports)/GDP Emerging Countries

9. International Value3. Motivation Value of US Acquisitions of Foreign Firms Number of US Acquisitions of Foreign Firms Number USD Billions Data through 1997.

10. International Value3. Motivation Value of Foreign Acquisitions of US Firms Number of Foreign Acquisitions of US Firms Number USD Billions Data through 1997.

11. International Value3. Motivation Value of German Acquisitions of US Firms Number of German Acquisitions of US Firms Number USD Billions Data through 1997.

12. International Value3. Motivation Value of US Acquisitions of German Firms Number of US Acquisitions of German Firms Number USD Billions Data through 1997.

13. International Value4. Motivation Advantages • A broader selection of company targets • Access to growth and innovation in new markets • Lower operating costs • Labor • Purchased materials • Reduced taxes in selected markets • Reduced borrowing costs • Investment incentives • Reduced risk: Diversification among less correlated markets

14. International Value4. Motivation Advantages Diversification argument somewhat controversial • Traditional view is that shareholders can do their own diversification. • Modern view is that diversification reduces the volatility of a company’s cash flows and gives it the flexibility to pursue the most profitable projects • That is, if a company was not diversified, a negative current cash flow might exclude it from investing in high value projects (because the cost of debt and equity financing is high)

15. International Value4. Motivation Correlations of World Returns and Developed Markets Data through June 1998

16. International Value4. Motivation Correlations of World Equity Returns and Emerging Markets Data through June 1998

17. International Value4. Motivation Disadvantages • Increased operating cost expectations • Taxes, tariffs and quotas • Transportation/shipping costs • Infrastructure costs • Organizational costs • Increased or different risk expectations • Lack of information • Different equity return premiums • Currency fluctuations • Liquidity risk • Sovereign risk (e.g. expropriation and restrictions on repatriation of capital)

18. International Value4. Motivation Investment of $100 in three Korean companies

19. International Value5. Valuation Approaches Many common methods

20. International Value5. Valuation Approaches Ratios often not comparable across countries MSCI data as of June 1998

21. International Value6. Global DCF Analysis • DCF can be used to calculate business plan, capital investment, and acquisition values • The same factors affect value around the globe • Cash flows • Timing • Risk

22. International Value6. Global DCF Analysis Applying DCF to international opportunities requires adjustments to each component of value Value Cash Flow Timing Risk • Currency Translation • Accounting Adjustments • Taxes • Liquidity • Repatriation Limits • Systematic • Currency • Information • Sovereign/Credit Risk

23. Multistep process to apply DCF analysis to international opportunities International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for specific risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value Reflect systematic risks Calculate cash flows for international investment

24. International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value

25. International Value6. Global DCF Analysis Unpredictable: Hyper-Inflationary Economy Predictable:Low to Moderate Inflation Economy Forecast “real” cash flows (backout or exclude inflation) Forecast “nominal” cash flows(include inflation) Discount cash flows with the “real”economic valuation rate Discount cash flows with the “nominal” economic valuation rate

26. International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value

27. International Value6. Global DCF Analysis Forecast cash flows in local currency • Financial data is most often collected in local currency • It has more relevance to the local management • It facilitates reflecting local inflation in revenues and costs • It makes calculation of taxes, repatriation limits and currency exposure easier • Conversion to US dollars is easier, simpler, and less prone to error when done at the end of the local currency analysis • Works best in moderate to low inflation countries

28. International Value6. Global DCF Analysis When valuing global opportunities only include cash flows that can be remitted to the parent • Governments sometimes set limits on cash out flows from their countries • The amount of cash flow • The types of cash flows (e.g. dividends, profits and transfer costs) • When they can be taken out (e.g. none for five years) • If repatriation is uncertain, estimate the probability of repatriation and calculate the expected value of future cash flows • If delayed, cash flows should be included at the time they become available to shareholders • However, if valuing for sale, include all cash flows, compute NPV, and then estimate what can be remitted

29. International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value

30. Devaluation/ Revaluation Risk that a drop in the value of a firm's currency will reduce the firm's value Country Systematic  Liquidity The risk that the owners might not be able to sell assets when desired Specific  Currency The risk that volatility in currency exchange rates causes a target's value to fluctuate Specific  Inflation The risk that inflation will rise unexpectedly, reducing the present value of future international cash flows Country Systematic  Interest Rate The risk that interest rates will rise unexpectedly, reducing the present value of future international cash flows Country Systematic  Information The risk that limited or biased information might lead you to over value a target company Specific  International Value6. Global DCF Analysis International Risks Where to Reflect Risk Description Risk Type Cash Flow Economic Valuation Rate Sovereign: country credit rating Risk that a country's government might take actions that reduce the value of a firm to its current owners (e.g. expropriation, tax hikes) Country Systematic 

31. International Value6. Global DCF Analysis International specific risks can be incorporated into expected cash flows using scenario analysis Steps for Scenario Analysis • Identify risks and estimate their probabilities of occurrence • Estimate when they are most likely to occur • Identify the impact of each risk on expected cash flows • Calculate expected value of cash flows by weighting the cash flows in each scenario by the probability the scenario occurs Note: The same should be done for NOPAT when calculating residual value using the perpetuity method

32. Year 1 Year 2 Year 3 Year 4 $37 $50 $68 $83 Base Case Cash Flows $ Millions Currency Risk Information Liquidity -10% 0% 0% -10% 1% 0% -10% 1% -5% -10% 1% -5% Total Adjustments -10% -9% -14% -14% Adjusted Cash Flows ($M) $33 $46 $58 $72 International Value6. Global DCF Analysis Incorporating information, currency transaction and liquidity risks into “Global-Co’s”cash flows forecast EXAMPLE Risk Information Risks Estimated Probability Estimated Cash Flow Impact Probability Adjustment Estimated Timing Currency Risk 100% -10% -10% Immediate Information (i.e. market acceptance) 20% +5% 1% 2 years 3 years Liquidity 5% -100% -5% Sample Cash Flow Adjustment

33. International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value

34. Future cash flows can be translated using exchange rate forecasts based on parity relationships International Value6. Global DCF Analysis Example: Converting Forecast Peso Cash Flows into US$ Cash Flows Year 1 Year 2 Year 3 Year 4 US$ Inflation* 1.4 1.4 1.4 1.4 Mexican Peso Inflation* 15.3 15.3 15.3 15.3 1 + i US$ 1 + i Peso 0.8794 0.7733 0.6801 0.5981 Spot US$/Peso Rate 0.1177 0.1177 0.1177 0.1177 Forward US$/Peso Rate0.1035 0.0910 0.0801 0.0704 (Parity Factor x Spot Rate) Parity Factor = Peso Cash Flows 320 500 730 1020 US$ Cash Flows 33 46 58 72 *For calculation simplicity, same inflation rates were used each year

35. International Value6. Global DCF Analysis When applied correctly, forecasting in US$ or local currency results in the same shareholder value independent of the choice of currency Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3% US Cost of Capital 10.0% Mexican Cost of Capital 25.1% Spot Rate (US$/Peso) 0.1177 US Dollar Forecast Peso Forecast Year1 Year2 Year3 Year4 Year1 Year2 Year3 Year4 Forward Rates 0.1035 0.0910 0.0801 0.0704 Cash Flows 320 Cash Flows 33 500 730 1,020 46 58 72 Residual Value Residual Value 4,067 286 Discount Factor Discount Factor 0.7995 0.6392 0.5110 0.4086 0.9091 0.8264 0.7513 0.6830 Present Value Present Value 30 256 320 373 2,078 38 44 245 Cumulative PV Peso 3,027 Cumulative PV $356 Equivalent at 0.1177 US$/Peso spot exchange rate

36. Cumulative PV $556 Cumulative PV $356 International Value6. Global DCF Analysis Applying today’s spot rate to the forecast grosslyoverstates the value if projected local inflation exceeds US inflation -- in this example by 56%! Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3% US Cost of Capital 10.0% Mexican Cost of Capital 25.1% Spot Rate (US$/Peso) 0.1177 US Dollar Forecast(incorrectly using Today’s Spot Rate) US Dollar Forecast(using Forward Rates) Year1 Year1 Year2 Year3 Year4 Year2 Year3 Year4 Spot Rate 0.1177 Forward Rates 0.1035 0.1177 0.1177 0.1177 0.0910 0.0801 0.0704 Cash Flows 38 Cash Flows 33 59 86 120 46 58 72 Residual Value Residual Value 478 286 Discount Factor Discount Factor 0.9091 0.8264 0.7513 0.6830 0.9091 0.8264 0.7513 0.6830 Present Value Present Value 34 49 65 409 30 38 44 245 Cumulative PV $556 Cumulative PV $356

37. International Value6. Global DCF Analysis Forward RatesUsed to bring cash flows to U.S. dollarsDetermined by differences in interest rates

38. International Value6. Global DCF Analysis Forward RatesCovered Interest Rate Parity is enforced by arbitrage.

39. International Value6. Global DCF Analysis Forward RatesExample.Suppose a German 12-month T-bill yield is 8% and the U.S.12-month T-bill yield is 4%.Does it make sense for the U.S. investor to invest in the higher yielding German T-bill?

40. International Value6. Global DCF Analysis Forward RatesAnswer: NoIf you invest in the German T-bill, you will take on some currency risk. Suppose you invested 100m DM and at the end of the year you will receive 108m DM.To hedge this risk, you will sell forward 108m DM today. The forward rate will guarantee that you lock in a 4% return - which is no different than buying the U.S. T-bill!

41. International Value6. Global DCF Analysis Forward RatesRates are readily available for the major currencies from major banks and trading houses.Example: Bloomberg screen for $/DM

42. International Value6. Global DCF Analysis

43. International Value6. Global DCF Analysis Forward RatesIf no quoted forward rates:Use forward rate equation and interest rates to backout forward rates.If no quoted interest rates:Use inflation forecasts and add real economic growth forecast tocreate nominal interest rates.

44. International Value6. Global DCF Analysis Step 1 Step 2 Step 3 Step 4 Step 5 Determine “nominal” or “real” forecast basis Forecast local currency cash flows Adjust cash flows for risks Translate into U.S. cash flows using forward rates Compute discount rate adjust residual value, calculate present value

45. International Value7. Economic Valuation Rate Many different approaches: • Identical Cost of Capital (all locations) • World CAPM or Multifactor Model (Sharpe-Ross) • Segmented/Integrated (Bekaert-Harvey) • Bayesian (Ibbotson Associates) • Country Risk Rating (Erb-Harvey-Viskanta) • CAPM with Skewness (Harvey-Siddique)

46. International Value7. Economic Valuation Rate • Goldman-integrated sovereign yield spread model • Goldman-segmented • Goldman-EHV hybrid • CSFB volatility ratio model • CSFB-EHV hybrid

47. International Value7. Economic Valuation Rate Identical Cost of Capital • Ignores the fact that shareholders require different expected returns for different risks

48. International Value7. Economic Valuation Rate Identical Cost of Capital • Risky investments get evaluated with too low of a discount rate (and look better than they should) • Less risky investments get evaluated with too high of a discount rate (and look worse than they are) • Hence, method destroys value • Avoid

49. International Value7. Economic Valuation Rate World CAPM • Sharpe’s Capital Asset Pricing Model is the mainstay of economic valuation • Simple formula • Intuition is that required rate of return depends on how the investment contributes to the volatility of a well diversified portfolio

50. International Value7. Economic Valuation Rate World CAPM • Expected discount rate (in U.S. dollars) on investment that has average in a country = riskfree + bixworld risk premium • Beta is measured relative to a “world” portfolio • OK for developed markets if we allow risk to change through time (Harvey 1991)