Ch 15 Multinational Restructuring

Chapter 15

Multinational Restructuring

Lecture Outline

Background on Multinational Restructuring

Trends in International Acquisitions

Model for Valuing a Foreign Target

Assessing Potential Acquisitions After the Asian Crisis

Assessing Potential Acquisitions in Europe

Factors that Affect the Expected Cash Flows of the Foreign Target

Target-Specific Factors

Country-Specific Factors

Example of the Valuation Process

International Screening Process

Estimating the Target’s Value

Changes in Valuation Over Time

Why Valuations of a Target May Vary Among MNCs

Estimated Cash Flows of the Foreign Target

Exchange Rate Effects on the Funds Remitted

Required Return of Acquirer

Other Types of Multinational Restructuring

International Partial Acquisitions

International Acquisitions of Privatized Businesses

International Alliances

International Divestitures

Restructuring Decisions as Real Options

Call Option on Real Assets

Put Option on Real Assets

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Chapter Theme

This chapter emphasizes that the strategic plan of an MNC can be modified continuously in response to changing global conditions, and multinational restructuring may be needed to achieve the plan. Some of the more critical issues related to multinational restructuring are discussed.

Topics to Stimulate Class Discussion

Why do MNCs consider multinational restructuring?

How should MNCs determine whether multinational restructuring is worthwhile?

What are common ways by which an MNC can conduct multinational restructuring?

What role does valuation play in the multinational restructuring process?

POINT/COUNTER-POINT:

Can a Foreign Target Be Assessed Like Any Other Asset?

POINT: Yes. The value of a foreign target to an MNC is the present value of the future cash flows to the MNC. The process of estimating a foreign target’s value is the same as the process of estimating a machine’s value. A target has expected cash flows, which can be derived from information about previous cash flows.

COUNTER-POINT: No. A target’s behavior will change after it is acquired by an MNC. Its efficiency may change depending on the ability of the MNC to integrate the target with its own operations. The morale of the target employees could either improve or worsen after the acquisition, depending on the treatment by the acquirer. Thus, a proper estimate of cash flows generated by the target must consider the changes in the target due to the acquisition.

WHO IS CORRECT? Use InfoTrac or some other search engine to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

ANSWER: Some targets may continue their business in the same manner as before, and their cash flows may not change significantly. Others are restructured due to the acquisition, so their cash flows might deviate substantially from before the acquisition.

Answers to End of Chapter Questions

Motives for Restructuring. Why do you think MNCs continuously assess possible forms of multinational restructuring, such as foreign acquisitions or downsizing of a foreign subsidiary?

ANSWER: MNCs continuously assess possible forms of multinational restructuring so that they can capitalize on changing economic, political, or industry conditions across countries. These conditions may present opportunities not available in the U.S.

Exposure to Country Regulations. Maude Inc., a U.S.-based MNC, has recently acquired a firm in Singapore. To eliminate inefficiencies, Maude downsized the target substantially, eliminating two-thirds of the workforce. Why might this action affect the regulations imposed on the

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subsidiary’s business by the Singapore government?

ANSWER: One of the benefits of direct foreign investment from a host government’s viewpoint is the potential reduction of unemployment. If a U.S. -based MNC such as Maude contributes to growing unemployment in the host country, the government may impose special taxes or requirements that would render further expansion in Singapore undesirable.

Global Expansion Strategy. Poki Inc., a U.S.-based MNC, is considering expanding into Thailand because of decreasing profit margins in the U.S. The demand for Poki’s product in Thailand is very strong. However, forecasts indicate that the baht is expected to depreciate substantially over the next three years. Should Poki expand into Thailand? What factors may affect its decision?

ANSWER: Poki faces a tradeoff. Demand for its product in Thailand is very strong, while it is deteriorating in the U.S. However, the baht is expected to depreciate substantially, which would reduce the dollar value of any baht remitted back to the parent.

Poki’s decision should be affected by the amount of cash flows that is subject to the baht’s depreciation. If Poki plans to keep the funds in Thailand until the baht begins to appreciate again, it is not subject to the depreciation. Also, even if baht-denominated funds are remitted to the U.S. on a regular basis in periods when the baht is depreciating, the strong demand in Thailand may generate satisfactory profits; Poki may even be able to increase the price of its product. Poki may also consider investigating the demand for its product in other foreign countries whose currencies are not expected to depreciate.

Alternatives to International Acquisitions. Rastell Inc., a U.S.-based MNC, is considering the acquisition of a Russian target to produce personal computers (PCs) and market them throughout Russia, where demand for PCs has increased substantially in recent years. Assume that the stock market conditions are not favorable in Russia, as the stock prices of most Russian companies rose substantially just prior to Rastell’s assessment of the target. What are some alternatives available to Rastell?

ANSWER: There are at least two alternatives available to Rastell Inc. First, it could enter into a licensing agreement with the Russian target to manufacture and distribute PCs with the Rastell name throughout Russia. Second, it could enter into a joint venture with the potential Russian target. Both of these methods would allow Rastell to access the Russian PC market. Furthermore, when stock prices in Russia decline, Rastell could make a bid for the potential Russian target.

Comparing International Projects. Savannah, Inc., a manufacturer of clothing, wants to increase its market share by acquiring a target producing a popular clothing line in Europe. This clothing line is well established. Forecasts indicate a relatively stable euro over the life of the project. Marquette, Inc., wants to increase its market share in the personal computer market by acquiring a target in Thailand that currently produces radios and converting the operations to produce PCs. Forecasts indicate a depreciation of the baht over the life of the project. Funds resulting from both projects will be remitted to the respective U.S. parent on a regular basis. Which target do you think will result in a higher net present value? Why?

ANSWER: The European target will likely result in a higher NPV. First, the euro has generally been more stable than the Thai baht. The Thai baht is expected to depreciate, which would result in a reduction in dollar cash flows remitted to Marquette, which would reduce the net present value associated with that project. Second, Savannah will likely continue the operations of the acquired European target, while Marquette will substantially change the target’s existing

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operations. Consequently, there is much greater uncertainty regarding the Thailand project, which would result in a higher required rate of return. A higher required rate of return will reduce the net present value associated with a project.

Privatized Business Valuations. Why are valuations of privatized businesses previously owned by the governments of developing countries more difficult than valuations of existing firms in developed countries?

ANSWER: There are several reasons why the valuation of a privatized business may be more difficult than the valuation of an existing firm in a developed country. First, future cash flows associated with a privatized business are very uncertain because the businesses previously have been operating in environment of little or no competition. Second, there are very limited data in some of these countries. Third, economic conditions in these countries are very uncertain. Fourth, exchange rate estimates are very uncertain. Fifth, the cost of local financing for projects in developing countries is very uncertain. Sixth, the lack of established stock markets in developing countries prevents an MNC from deriving a value for a business based on comparable publicly held firms. Seventh, the government may retain part of the firm, which could lead to control conflicts in the future.

Valuing a Foreign Target. Blore Inc., a U.S.-based MNC, has screened several targets. Based on economic and political considerations, only one eligible target remains in Malaysia. Blore would like you to value this target and has provided you with the following information:

Blore expects to keep the target for three years, at which time it expects to sell the firm for 300 million Malaysian ringgit (MYR) after any taxes.

Blore expects a strong Malaysian economy. The estimates for revenue for the next year are MYR200 million. Revenues are expected to increase by 8% in each of the following two years.

Cost of goods sold are expected to be 50% of revenue.

Selling and administrative expenses are expected to be MYR30 million in each of the next three years.

The Malaysian tax rate on the target’s earnings is expected to be 35 percent.

Depreciation expenses are expected to be MYR20 million per year for each of the next three years.

The target will need MYR7 million in cash each year to support existing operations.

The target’s stock price is currently MYR30 per share. The target has 9 million shares outstanding.

Any remaining cash flows will be remitted by the target to Blore Inc. Blore uses the prevailing exchange rate of the Malaysian ringgit as the expected exchange rate for the next three years. This exchange rate is currently $.25.

Blore’s required rate of return on similar projects is 20 percent.

Prepare a worksheet to estimate the value of the Malaysian target based on the information provided.

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ANSWER:

Valuation of Malaysian Target Based on the Assumptions Provided

(numbers are in millions)

The value of the Malaysian target based on the information provided is $69.9 million.

Will Blore Inc. be able to acquire the Malaysian target for a price lower than its valuation of the target?

ANSWER: The Malaysian target’s shares are presently valued at MYR30 per share. Thus, the 9 million shares outstanding are worth MYR270 million. At the prevailing exchange rate of $.25, the target is presently valued at $67.5 million (computed as MYR270 million × $.25). The MNC’s valuation of the target is $69.9 million, which is only about 3.5% above the market valuation. However, Blore will have to pay a premium on the shares to entice the target’s board of directors to approve the acquisition. Premiums commonly range from 10 percent to 40 percent of the market price. Therefore, it is unlikely that Blore could purchase the target for a price that is below its valuation of the target.

Uncertainty Surrounding a Foreign Target. Refer to question 7. What are some of the key sources of uncertainty in Blore’s valuation of the target? Identify two reasons why the expected cash flows from an Asian subsidiary of a U.S.-based MNC would have been lower as a result of the Asian crisis.

ANSWER: There is much uncertainty regarding the assumptions employed. For example, the

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growth rate in revenues may be overestimated if Blore has overestimated the growth rate of the Malaysian economy. The estimates of expenses may be inaccurate. Also, the exchange rate of the Malaysian ringgit may be weaker than what was assumed. Blore would prefer to purchase the target for an amount that is substantially less than its valuation of the target because it provides Blore with more of a cushion if the target’s value turns out to be less than what was estimated.

Divestiture Strategy. The reduction in expected cash flows of Asian subsidiaries as a result of the Asian crisis likely resulted in a reduced valuation of these subsidiaries from the parent’s perspective. Explain why a U.S.-based MNC might not have sold its Asian subsidiaries.

ANSWER: The valuation of the subsidiaries would have declined because of the reduction in cash flows, so potential buyers may not have been willing to pay an amount that even reflects the present value of the expected future cash flows. Thus, the parent should have retained the subsidiaries if it could not sell them for an amount at least equal to their respective values.

Why a Foreign Acquisition May Backfire. Provide two reasons why an MNC’s strategy of acquiring a foreign target will backfire. That is, explain why the acquisition might result in a negative NPV.

ANSWER: The MNC may overestimate the cash flows to be generated by the target, due to overestimating the revenues or underestimating the cost of operating the target. In addition, it may overestimate the future salvage value of the target.

Advanced Questions

Pricing a Foreign Target. Alaska Inc. would like to acquire Estoya Corp., which is located in Peru. In initial negotiations, Estoya has asked for a purchase price of 1 billion Peruvian new sol. If Alaska completes the purchase, it would keep Estoya’s operations for two years and then sell the company. In the recent past, Estoya has generated annual cash flows of 500 million new sol per year, but Alaska believes that it can increase these cash flows by 5 percent each year by improving the operations of the plant. Given these improvements, Alaska believes it will be able to resell Estoya in two years for 1.2 billion new sol. The current exchange rate of the new sol is $.29, and exchange rate forecasts for the next two years indicate values of $.29 and $.27, respectively. Given these facts, should Alaska Inc. pay 1 billion new sol for Estoya Corp. if the required rate of return is 18 percent? What is the maximum price Alaska should be willing to pay?

Alaska, Inc. should not pay more than $468.62 million for Estoya Corp. Estoya is asking for 1.2 billion new sol, which translates to $348 million at the current exchange rate of $.29. Therefore, Alaska, Inc. should purchase Estoya Corp.

Global Strategy. Senser Co. established a subsidiary in Russia two years ago. Under its original plans, Senser intended to operate the subsidiary for a total of four years. However, it would like to reassess the situation, since exchange rate forecasts for the Russian ruble indicate that it may depreciate from its current level of $.033 to $.028 next year and to $.025 in the following year. Senser could sell the subsidiary today for 5 million rubles to a potential acquirer. If Senser continues to operate the subsidiary, it will generate cash flows of 3 million rubles next year and 4 million rubles in the following year. These cash flows would be remitted back to the parent in the U.S. The required rate of return of the project is 16 percent. Should Senser continue operating the Russian subsidiary?

ANSWER:

NPV d  $165 ,000 ($72 ,413 .79 $74 ,316 .29 )

$18,269 .92

Senser Co. should consider divesting its subsidiary, since the present value of the cash flows is less than the price it could sell the subsidiary for today.

Divestiture Decision. Colorado Springs Co. plans to divest either its Singapore or its Canadian subsidiary. Assume that if exchange rates remain constant, the dollar cash flows each of these subsidiaries would provide to the parent over time would be somewhat similar. However, the firm expects the Singapore dollar to depreciate against the U.S. dollar, and the Canadian dollar to appreciate against the U.S. dollar. The firm can sell either subsidiary for about the same price today. Which one should it sell?

ANSWER: It should sell the Singapore subsidiary because the forgone cash flows to the parent will be less. If the Singapore dollar depreciates, the dollar cash flows received by the parent will

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decline.

Divestiture Decision. San Gabriel Corp. recently considered divesting its Italian subsidiary and determined that the divestiture was not feasible. The required rate of return on this subsidiary was 17 percent. In the last week, San Gabriel’s required return on that subsidiary increased to 21 percent. If the sales price of the subsidiary has not changed, explain why the divestiture may now be feasible.

ANSWER: As a project’s required rate of return increases, the present value of cash flows decreases. Also, the present value of foreign cash flows would decrease and may now be lower than the proceeds received from the divestitures.

Divestiture Decision. Ethridge Co. of Atlanta, Georgia has a subsidiary in India that produces products and sells them throughout Asia. In response to the September 11, 2001 terrorist attack on the U.S., Ethridge Co. decided to conduct a capital budgeting analysis to determine whether it should divest the subsidiary. Why might this decision be different after the attack as opposed to before the attack? Describe the general method for determining whether the divestiture is financially feasible.

ANSWER: The divestiture decision may be different because cash flow estimates may have changed since the attack. Estimated revenue generated by its U.S. subsidiary may decline because of friction between the U.S. and some consumers in central Asia. In addition, the expenses associated with security and insurance would likely increase. However, the potential salvage value may have declined as a result of the attack also.

The divestiture decision involves a comparison of the dollars that would be received from selling the subsidiary versus the present value of dollar costs associated with keeping the subsidiary.

Feasibility of a Divestiture. Florida Inc. has a subsidiary in Bulgaria that it fully finances with its own equity. Last week, a firm offered to buy the subsidiary from Florida Inc. for $60 million in cash and the offer is still available this week as well. The annualized long-term risk-free rate in the U.S. increased from 7% to 8% this week. The expected monthly cash flows to be generated by the subsidiary have not changed since last week. The risk premium that Florida Inc. applies to its projects in Bulgaria was reduced from 11.3% to 10.9% this week. The annualized long-term risk-free rate in Bulgaria declined from 23% to 21% this week. Would the NPV to Florida Inc. from divesting this unit be more or less than the NPV determined last week? Why? [No analysis is necessary, but make sure that your explanation is very clear.]

ANSWER: The NPV of the divestiture would be higher because a higher discount rate would be used as the required rate of return applied to the subsidiary’s cash flows. The risk-free rate increased by 1% while the risk premium is reduced by .4%, so the required rate of return has increased by .6%. The present value of the forgone cash flows should be lower this week, which means that the NPV from divesting the unit should be higher.

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Accounting for Government Restrictions. Sunbelt Inc. plans to purchase a firm in Indonesia. It believes that it can install its operating procedure in this firm, which would significantly reduce the firm’s operating expenses. However, the Indonesian government may approve the acquisition only if Sunbelt does not lay off any workers. How can Sunbelt possibly increase efficiency without laying off workers? How can Sunbelt account for the Indonesian government’s position as it assesses the NPV of this possible acquisition?

ANSWER: Sunbelt should first consider the profile of the workers who it would lay off if it could after improving the operations. Then, it could decide how it could revise the job descriptions so that those workers who are no longer needed for normal operations can be utilized in a different manner. Then, Sunbelt should estimate the NPV of this potential acquisition after considering these conditions. It may not be able to reduce labor expenses in the way that it desired if layoffs are prohibited, but it may achieve increased production, which could lead to higher revenue, and therefore the acquisition may be feasible.

Solution to Continuing Case Problem: Blades, Inc.

Using a spreadsheet, determine the NPV of the acquisition of Skates’n’Stuff. Based on your numerical analysis, should Blades establish a subsidiary in Thailand or acquire Skates’n’Stuff?

ANSWER: (See spreadsheet attached.) The analysis indicates that the acquisition will result in a net present value (NPV) of $6,641,949 to Blades, Inc. after accounting for the cost of the acquisition. Thus, the establishment of a new subsidiary in Thailand would be more profitable by $8,746,688 – $6,641,949 = $2,104,739.

If Blades negotiates with Skates’n’Stuff, what is the maximum amount (in Thai baht) Blades should be willing to pay?

ANSWER: If Blades, Inc. were to negotiate with Skates’n’Stuff, it should attempt to pay a price that would render the acquisition of Skates’n’Stuff more attractive (in terms of net present value) than the establishment of a subsidiary. Since the difference in NPVs between the two options is $2,104,739, Blades, Inc. should attempt to reduce the purchase price by $2,104,739/$0.023 = 91,510,391 Thai baht. Consequently, it should offer a maximum of THB1,000,000,000 – THB91,510,391 = THB908,489,609 for Skates’n’Stuff.

Are there any other factors Blades should consider in making its decision? In your answer, you should consider the price Skates’n’Stuff is asking relative to your analysis in question 1, other potential businesses for sale in Thailand, the source of the information your analysis is based on, the production process that will be employed by the target in the future, and the future management of Skates’n’Stuff.

ANSWER: Yes, there are other factors Blades, Inc. should consider in reaching its decision. First, Blades did not previously consider the acquisition of an existing business in Thailand. There may be other, more attractive, roller blade manufacturers for sale that Blades has not yet considered. Second, Blades should investigate the reason Skates’n’Stuff wants to sell its operations. Based on the low price the company is asking compared to Blades’ analysis (see question 1), the company’s outlook seems to be unfavorable.

Third, the assumptions gathered by Ben Holt rely on information from unaudited financial

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statements, and the accuracy of these numbers may be questionable. Fourth, Blades should consider whether the lower quality of the roller blades manufactured by the existing Skates’n’Stuff plant will hurt its international reputation in the long run, given its high-quality roller blades in the U.S. This is of particular concern if Blades is contemplating the sale of some of the roller blades produced in Thailand in the U.S., where the quality of its roller blades is higher.

Fifth, Blades Inc. has to consider the management of Skates’n’Stuff after the acquisition. For example, Blades may maintain the existing employees of Skates’n’Stuff but restructure the operations in a manner that would increase the quality of the roller blades produced there.

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Solution to Supplemental Case: Redwing Technology Company

The earnings performance translated in dollars is misleading because they are distorted by varying exchange rates. The actual earnings in each local currency in each subsidiary should be assessed, since the subsidiary has no control over the exchange rate used for translation. The translation causes earnings to be overstated when the local currency is strong (against the dollar) and understated when the local currency is weak. The following table shows the earnings of each subsidiary when measured in the local currency. Based on this table, the Canadian subsidiary experienced a consistent growth in earnings over time, averaging about a 14 percent increase per year. Conversely, the South African subsidiary experienced consistent declines in earnings over time, with an average annual earnings growth rate of –4.38%. The Japanese subsidiary experienced a decline in earnings in all but one year, and its average annual earnings growth rate was –1.03%. When measured in this way, the executive in charge of the Canadian subsidiary appears to have achieved the best performance. The results are much different when earnings are measured in U.S. dollars for all subsidiaries. The Canadian performance would not be as high while the South African and Japanese performance would be higher. Yet, the chief executives of the respective subsidiaries cannot control the translated exchange rate. It can be argued that they should not be rewarded or penalized because of the translation effect caused by a volatile exchange rate (although there could be exceptions when they are personally responsible for hedging any remitted earnings or any inflows of funds coming from other countries).

Earnings (in millions) Denominated in the Local Currency

Based on its high annual growth rate of earnings, the Canadian subsidiary would likely deserve a cash infusion from the parent to push for additional growth. The parent would probably feel that its funds are more likely to generate decent returns there than in other countries.

Even if the earnings are remitted, Canada would still be the best bet. There was an assumption that last year’s exchange rate would be a reasonable guess for exchange rates in future years for each currency. This means that the parent will invest funds at the same exchange rate as the rate in which subsidiary earnings will be converted back to dollars in the future, for each subsidiary. Thus, no subsidiary is expected to have an exchange rate advantage over the others.

The earnings of the Canadian and South African subsidiaries only appear to be highly correlated when translated in U.S. dollars. Their earnings in local currencies were not highly correlated. Thus, some diversification benefits would be lost if the Canadian subsidiary was sold (not to mention that it is the best-performing subsidiary) or if the South African subsidiary was sold.

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Small Business Dilemma

Multinational Restructuring by the Sports Exports Company

Are there any reasons why the business that has been so successful in the United Kingdom will not necessarily be successful in other European countries?

ANSWER: When this business was first created, it was based on a perception that British consumers would become more interested in U.S. football, and that American-style football would become a popular hobby in the United Kingdom. However, Jim should consider whether the other European countries have similar characteristics before spreading the business throughout Europe.

If the business is diversified throughout Europe, will this substantially reduce the exposure of the Sports Exports Company to exchange rate risk?

ANSWER: No. The European expansion will result in payments of euros for the exports. So the receivables will be pounds and euros, which tend to move in the same direction against the dollar. Furthermore, the extra European business will result in a larger absolute amount of business that is subject to exchange rate risk.

Now that several countries in Europe participate in a single currency system, will this affect the performance of new expansion throughout Europe?

ANSWER: It may make it easier for the distributor to deal with stores throughout Europe, but the Sports Exports Company will still be exposed to exchange rate risk.