General Electric – Risk & Cost of Capital

1. General Electric – Risk & Cost of Capital

2. Aspects of a deal Target Identifi- cation Strategy Approach Target Negotiation Risk & Cost of capital Valuation Deal Structure Due Diligence Incorporating risk in valuation is key

3. GE’s approach to risk - two fold • Mitigate • Hedge transactions…currency, commodities • Transactions backed by guarantees…corporate guarantee, LOC, parent guarantee • Back to back agreements • Government approvals…country risk • Deal covenants • GE Management • Incorporate • Higher cost of capital • Adjust cash flows

4. Why is cost of capital important? • Objective • Proxy for risk • Reduces value of investment…faster pay back • Should mirror cost of obtaining funds and certainty and timing of recovery • Uses • Purchase/ building of industrial facility • Acquisitions/ investments • Long term contracts

5. Computation of cost of capital • Cost of capital is - • WACC or Discount rate • Base rate usually anchored on US • Base rate adjusted for risk- • Currency • Industry • Expropriation • Demand • Regulatory risk • Environment reg. Not all risks result in adjustment to cost of capital

6. Risk and cost of capital Examples Risk Treatment People/ Management Financial Environment Cost of capital adjusted Cost of capital adjusted unless agreement reached Cash flows adjusted Cost of capital not adjusted Usually hedged..cost of capital not adjusted Cost of capital adjusted Cost of capital adjusted more so if local borrowing Cost of capital adjusted Cost of capital & cash flows adjusted Cost of capital & cash flows adjusted • No freedom to rationalize people • Trade unions • Cost of severance • Quality of management • Currency exposure • Inflation/ devaluation • Funding • Interest rates • Health and safety issues • Country/ industry environment exposure

7. Risk and cost of capital Examples Risk Treatment Country Project/ investment related risks Cost of capital adjusted Cost of capital not adjusted unless risk very high Cost of capital adjusted Cost of capital not adjusted Cost of capital not adjusted Cost of capital adjusted Cost of capital adjusted Cost of capital adjusted Cost of capital not adjusted unless exposure very high Cost of capital adjusted Cost of capital not adjusted…usually cash flows Cost of capital not adjusted…unless risk quantifiable • Political Instability • Regulatory reforms/ policies • Economic instability • Corruption • Supply interruption • Technology • Market risk – sell-side • Barriers to entry • Force Majure • Weak Exit Strategy • Tax exposure • Possibility of Unscheduled events/ delays

8. Risk & Cost of Capital – Tools and Internal Process

9. Due Diligence Process • Objective • To provide enough information to measure and assess risk in deals and investment • Internal and external parties involved - GE Audit Staff, KPMG • Process usually covers the following risks: • People/ Management • Project/ investment related risks • Environment, Health and Safety • End result • Information on risks…risks usually quantified • Incorporation of risks and adjustment of cost of capital by Deal team • Process more art than science

10. Due Diligence Process

11. Due Diligence Process

12. Due Diligence Process – EHS web-page

13. Country risks…GE Capital Risk Management • Objective • To provide enough information to measure and assess country risk in deals and investment • Process usually covers the following : • Risk assessment by GE’s economists and risk management team • Comments of in-country teams incorporated • Internal analysis verified with external reports • End result • Information on country risks…risks usually quantified • Cost of capital adjusted by Deal team • Process highly scientific

14. Country risks: Web page

15. Country risks: Sample analysis

16. Country risk: GE legal web-page

17. Financial risks…GE Treasury • Objective • To provide enough information to measure and assess financial risk in deals and investment • Involvement of corporate and business treasury teams • Process usually covers the following : • Risk assessment by GE’s economists and treasurers • Internal analysis verified with external reports • Hedging instruments identified • Optimal capital structure identified • End result • Information on currency risks…risks usually hedged • Cost of capital adjusted by Deal team for funding, local borrowing • Process mix of art and science

18. Currency risks – GE Treasury web-page

19. Easy way out…. Target Company Information: M&A News: Current Borrowing Cost and WACC: Links to sources of basic information regarding a company Recent GE acquisitions in the news GE’s current borrowing cost and WACC used for modeling acquisitions Companies would centralize information…not to reinvent the wheel

20. Business case – GE Lighting acquisition of Tungsram

21. Deal Basics • Strategic consideration • Rapid Market share • Low cost position • Access to new product lines • Access to distribution channels • Facts • Acquirer: GE Lighting • Tungsram Company, Hungary • 12 factories, 18K employees • Low cost but low quality producer • Annual sales: $300MM • Valuation Assumptions • 2% growth • Cost of Capital – 14% • Reduction in overhead costs..10% workforce reduction • 20% Hungarian tax • Material efficiency..10% over 5 years • Deal Structure • Huge country risk • Cash deal - $ 160MM • Reduced exposure by limiting investment to 50% + 1 share • DCRR: 19.1% • Payback: 8.6 years

22. Cost of capital - adjustments Overall weighted cost of capital 14%