DISPARITY IN F OREIGN T ARGET V ALUATIONS

Most MNCs that consider acquiring a specific target will use a somewhat similar process

for valuing the target. Nevertheless, their valuations of the target will vary because of differences in
the following inputs: (1) cash flows to be generated by the target, (2) exchange rate effects on funds
remitted to the MNC’s parent, and (3) the parent’s required rate of return in order to acquire the
target.

Expected Cash Flows of the Foreign Target

The target’s expected future cash flows will vary among any MNCs that would consider
acquiring it because the cash flows to the acquirer will be dependent on the its management or
oversight of the target’s operations. If an MNC can improve the production efficiency of the target
without reducing the target’s production volume, it can improve the target’s cash flows.

Each MNC may have a different plan as to how the target will fit within its structure and how
the target will conduct future operations. The target’s expected cash flows will be influenced by the
way it is utilized. An MNC with production plants in Asia that purchases another Asian production
plant may simply be attempting to increase its market share and production capacity. This MNC’s
cash flows change because of a higher production and sales level. Conversely, an MNC with all of its
production plants in the United States may purchase an Asian production plant to shift its production
where costs are lower. This MNC’s cash flows change because of lower expenses.

Tax laws can create competitive advantages for acquirers based in some countries. Acquirers
based in low-tax countries may be able to generate higher cash flows from acquiring a foreign target
than acquirers in high-tax countries simply because they are subject to lower taxes on the future
earnings remitted by the target (after it is acquired).

Exchange Rate Effects on Remitted Earnings

The valuation of a target can vary among MNCs simply because of differences in the

exchange rate effects on earnings remitted by the foreign target to the MNC’s parent. If

the MNC would require the target to remit most of its earnings shortly after acquiring it,

the target’s value will be partially dependent on the expected exchange rate of the target’s

local currency when the earnings are remitted to the MNC. Conversely, if the MNC

468 Part 4: Long-Term Asset and Liability Management would want the target to reinvest its earnings
to expand operations in the host country, the target’s valuation is more dependent on its local
growth strategy and on exchange rates in the distant future.

Required Return of Acquirer

The valuation of the target could also vary among MNCs because of differences in their

required rate of return from investing funds to acquire the target. If an MNC targets a

successful foreign company and plans to continue the target’s local business in a more

efficient manner, the risk of the business will be relatively low. Therefore, the MNC’s
required return from acquiring the target will be relatively low. Conversely, if an MNC

wants to convert the target into a major exporter, the risk is much higher because the

cash flows from the new exporting business are very uncertain. Thus, the required return

to acquire the target company under these conditions will be relatively high as well.

If potential acquirers are based in different countries, their required rates of return

from a specific target will vary even if they plan to use the target in similar ways. Recall

that an MNC’s required rate of return on any project is dependent on the local risk-free

interest rate (since that influences the cost of funds for that MNC). Therefore, the

required rate of return for MNCs based in countries with relatively high interest rates

such as Brazil and Venezuela may differ from MNCs based in low-interest-rate countries

such as the United States or Japan. The higher required rate of return for MNCs based in

Latin American countries will not necessarily lead to a lower valuation. The target’s currency might
be expected to appreciate substantially against Latin American currencies (since some Latin
American currencies have consistently weakened over time), which would enhance the amount of
cash flows received as a result of remitted funds and could possibly offset the effects of the higher
required rate of return

OTHER C ORPORATE C ONTROL D ECISIONS

Besides acquiring foreign firms, MNCs may also pursue international partial acquisitions,
acquisitions of privatized businesses, and international divestitures.

International Partial Acquisitions

In many cases, an MNC may consider a partial international acquisition of a firm, in

which it purchases part of the existing stock of a foreign firm. A partial international

acquisition requires less funds because only a portion of the foreign target’s shares are

purchased. With this type of investment, the foreign target normally continues operating

and may not experience the employee turnover that commonly occurs after a target’s

ownership changes. Nevertheless, by acquiring a substantial fraction of the shares, the

MNC may have some influence on the target’s management and is in a position to complete
the acquisition in the future. Some MNCs buy substantial stakes in foreign companies to have some
control over their operations. For example, Coca-Cola has purchased stakes in many foreign bottling
companies that bottle its syrup. In this way, it can ensure that the bottling operations meet its
standards.

EXPLANATION; This type of investment is usually considered when the MNC wants to exert some
level of influence over the target firm's management without the need to purchase the entire
company.
Valuation Process When an MNC considers a partial acquisition in which it will purchase sufficient
shares so that it can control the firm, the MNC can conduct its valuation of the target in much the
same way as when it purchases the entire firm. If the MNC buys only a small proportion of the firm’s
shares, however, the MNC cannot restructure the firm’s operations to make it more efficient.
Therefore, its estimates of the firm’s cash flows must be made from the perspective of a passive
investor rather than as a decision maker for the firm.

EXPLANATION; In terms of valuation, if the MNC aims to control the firm in the future, it can conduct
its valuation of the target in the same way as if they were purchasing the entire firm. However, if the
MNC buys only a small proportion of the firm's shares, their estimates of the firm's cash flows must
be made from the perspective of a passive investor rather than as a decision-maker for the firm.
Overall, international partial acquisitions provide MNCs with an opportunity to invest in a foreign
company without investing a significant amount of resources and still having a level of control over
the target's management.

International Acquisitions of Privatized Businesses

In recent years, government-owned businesses in many developing countries in Eastern

Europe and South America have been sold to individuals or corporations. Many MNCs

have capitalized on this wave of so-called privatization by taking control of businesses

that are sold by governments. These businesses may be attractive because of the potential

for MNCs to increase their efficiency.

EXPLANATION; International acquisitions of privatized businesses refer to MNCs purchasing

previously government-owned businesses that have undergone privatization. This type of acquisition
has become popular in recent years in developing countries in Eastern Europe and South America,
where governments sell their businesses to individuals or corporations. MNCs often take advantage
of this opportunity because these businesses have the potential for increased efficiency, which can
result in greater profits. These businesses may also provide access to new markets that were
previously untapped.

Overall, international acquisitions of privatized businesses allow MNCs to expand their

international operations, gain access to new markets, and potentially increase their efficiency and
profitability. As with any acquisition, there may be challenges, but with proper planning and
execution, MNCs can reap the benefits of these opportunities.

Valuation Process An MNC can conduct a valuation of a foreign business that was

owned by the government in a developing country by using capital budgeting analysis, as illustrated
earlier. However, the valuation of such businesses is difficult for the following reasons:

The future cash flows are very uncertain because the businesses were previously

operating in environments of little or no competition. Thus, previous sales volume

figures may not be useful indicators of future sales.

■ Data concerning what businesses are worth are very limited in some countries
because there are not many publicly traded firms in their markets and there is

limited disclosure of prices paid for targets in other acquisitions. Consequently, there

may not be any benchmarks to use when valuing a privatized business.

------This statement means that in some countries, there is limited information available about the
value of businesses because there are not many publicly traded companies in their markets.
Additionally, there may be limited disclosure of the prices that were paid for businesses that were
previously acquired by others. This creates a challenge when valuing a privatized business because
there are no benchmarks available to provide context or comparison. As a result, determining the
value of a privatized business in such countries can be more difficult and require different valuation
methods.

■ Economic conditions in these countries are very uncertain during the transition to a

market-oriented economy.

■ Political conditions tend to be volatile during the transition because government

policies for businesses are sometimes unclear or subject to abrupt changes.

■ If the government retains a portion of the firm’s equity, it may attempt to exert

some control over the firm. Its objectives may be very different from those of the

acquirer, a situation that could lead to conflict.

2 Economic conditions in countries transitioning to a market-oriented economy are uncertain: This

means that when a country is shifting from a government-controlled economy to a market-oriented
one, there may be a lot of uncertainty about how the economy will react. There may be a lack of
established rules, regulations or processes which can lead to erratic changes in the market as
participants test the boundaries. This can create a challenging environment for businesses, including
newly privatized ones, to operate in.

3. Political conditions are often volatile during the transition period: When a country is transitioning
from a state-controlled economy to a market-oriented one, the government's policies for businesses
can be unclear or subject to abrupt changes. This uncertainty often results in volatile political
conditions that can be difficult for businesses to predict or navigate. This can be further exacerbated
by interest groups attempting to influence government decisions. Businesses may face difficulties
adapting to new policies or may be caught off guard by unpredictable changes, which can negatively
affect their operations.

4 Government control and acquirer conflict: If the government retains some control over a newly
privatized business, this can create potential for conflict between the acquirer and government. The
government's objectives may not coincide with those of the acquirer, who may have very different
ideas about how the business should operate or its objectives. This conflict could lead to issues such
as band-aid solutions that may not stimulate long-term growth. Additionally, the government's goals
may not prioritize the growth and profitability of the new privatized business, creating potentially
problematic relationships between the acquirer and the government in the future.

Despite these difficulties, MNCs such as IBM and PepsiCo have acquired privatized

businesses as a means of entering new markets. Hungary serves as a model country for

privatizations. Hungary’s government was quick and efficient at selling off its assets to

MNCs. More than 25,000 MNCs have a foreign stake in Hungary’s businesses

International Divestitures
MNCs periodically reassess foreign projects that they previously implemented to deter-

mine whether they should be continued or sold (divested). Some foreign projects that

were previously implemented may no longer be feasible if the present value of future

cash flows of the project as of today is lower than the price that the project could be

sold for today.

--- means that multinational corporations (MNCs) evaluate their foreign projects on a periodic basis
to determine if the projects are feasible and profitable. The MNCs may decide to sell off (divest)
some foreign projects if they are no longer viable or cannot achieve an acceptable return on
investment.

Here are common external forces that could reduce the present value of a foreign subsidiary’s
future cash flows:

■ a weakening economy in the host country could reduce expected cash flows to be

generated by the subsidiary,

■ a reduction in the local currency of the host country could reduce the exchange rate

at which the cash flows generated by the subsidiary would be converted to dollars,

■ higher taxes imposed by the host government would reduce the expected cash flows

of the subsidiary, and

■ an increase in the MNC parent’s cost of capital would increase the discount rate at

which expected future cash flows are discounted when determining the present value

of the subsidiary

EXPLANATION; Each of these points describes a scenario that could affect the profitability or
viability of a subsidiary or foreign project:

1. A weakening economy in the host country could reduce expected cash flows to be generated by
the subsidiary: If the host country's economy is not performing well, people may spend less, and
the company's revenue might decrease as a result. This would directly impact the subsidiary seen
reduced cash flow, and the parent company may need to reassess the subsidiary's financial
viability.

2. A reduction in the local currency of the host country could reduce the exchange rate at which
the cash flows generated by the subsidiary would be converted to dollars: If the local currency of
the host country drops against the parent company's currency (usually the US Dollar), then the
subsidiary's earnings in that currency will be worth less when they're converted. This can lead to
less profitability for the subsidiary, as it will not generate income worth the same amount in
dollars as before.

3. Higher taxes imposed by the host government would reduce the expected cash flows of the
subsidiary: If the host government increases the taxes on the subsidiary, then the after-tax income
of the subsidiary will decrease, and the parent company's investment may not generate the
expected ROI. This can lead the parent company to reconsider whether they should continue
operating the subsidiary.

4. An increase in the MNC parent's cost of capital would increase the discount rate at which
expected future cash flows are discounted when determining the present value of the subsidiary:
The cost of capital is the overall cost that a company must pay to finance its operations, and an
increase in this cost can lower the net present value of a subsidiary's expected cash flows, making
it less attractive to invest in. The higher discount rate implies that the future cash flows of the
subsidiary are less valuable than in the scenario of a lower cost of capital, and hence, the present
value of the subsidiary's future cash flows would be lower.

In summary, a weaker economy, unfavorable currency exchange rates, higher taxes, and an
increase in the parent company's cost of capital can all negatively impact the profitability and
viability of a subsidiary in a foreign country.

EXAMPLE: the Greece debt crisis in the spring of 2010 triggered concerns for many MNCs who had
established subsidiaries there. Greece experienced an excessive budget deficit, and lenders to its
government feared that it would be unable to repay loans. When the government attempted to
resolve its budget deficit by raising taxes and reducing its spending, economic conditions weakened.
Consequently, subsidiaries in Greece struggled to obtain adequate financing at a reasonable cost
because their ability to repay loans was in doubt.

Moreover, MNCs were concerned that their subsidiaries in Greece might be subjected to
higher corporate tax rates as Greece’s government searched for ways to correct its budget deficit.
Furthermore, the Greece debt crisis caused concerns about weakness of the euro, so euros earned
by subsidiaries in Greece might ultimately be converted to dollars at a lower exchange rate. Some
U.S.–based MNCs divested their subsidiaries so that they could avoid exposure to these conditions.
However, valuations of businesses such as these subsidiaries in Greece declined during the crisis
because their expected cash flows declined in response to the weaker economy. Thus, MNCs that
divested subsidiaries during this period had to accept a relatively low selling price. •

Many divestitures occur as a result of a revised assessment of industry or economic

conditions. For example, Pfizer, Johnson & Johnson, and several other U.S.–based MNCs
divested some of their Latin American subsidiaries when economic conditions deteriorated there.

Valuation Process The valuation of a proposed international divestiture can be

determined by comparing the present value of the cash flows if the project is continued

to the proceeds that would be received (after taxes) if the project is divested.

EXAMPLE: Reconsider the example from the previous chapter in which Spartan, Inc., considered
establishing a Singapore subsidiary. Assume that the Singapore subsidiary was created and, after 2
years, the spot rate of the Singapore dollar (S$) is $.46. In addition, forecasts have been revised for
the remaining 2 years of the project, indicating that the Singapore dollar should be worth $.44 in
Year 3 and $.40 in the project’s final year. Because these forecasted exchange rates have an adverse
effect on the project, Spartan, Inc., considers divesting the subsidiary. For simplicity, assume that the
original forecasts of the other variables remain unchanged and that a potential acquirer has offered
S$13 million (after adjusting for any capital gains taxes) for the subsidiary if the acquirer can retain
the existing working capital.

Spartan can conduct a divestiture analysis by comparing the after-tax proceeds from the
possible sale of the project (in U.S. dollars) to the present value of the expected U.S. dollar inflows
that the project will generate if it is not sold. This comparison will determine the net present value of
the divestiture (NPVd), as illustrated in Exhibit 15.3. Since the present value of the subsidiary’s cash
flows from Spartan’s perspective exceeds the price at which it can sell the subsidiary, the divestiture
is not feasible. Thus, Spartan should not divest the subsidiary at the price offered. Spartan may still
search for another firm that is willing to acquire the subsidiary for a price that exceeds its present
value.•