<?page no="1"?> Eine Arbeitsgemeinschaft der Verlage Böhlau Verlag · Wien · Köln · Weimar Verlag Barbara Budrich · Opladen · Toronto facultas.wuv · Wien Wilhelm Fink · Paderborn A. Francke Verlag · Tübingen Haupt Verlag · Bern Verlag Julius Klinkhardt · Bad Heilbrunn Mohr Siebeck · Tübingen Nomos Verlagsgesellschaft · Baden-Baden Ernst Reinhardt Verlag · München · Basel Ferdinand Schöningh · Paderborn Eugen Ulmer Verlag · Stuttgart UVK Verlagsgesellschaft · Konstanz, mit UVK / Lucius · München Vandenhoeck & Ruprecht · Göttingen · Bristol vdf Hochschulverlag AG an der ETH Zürich UTB <?page no="2"?> Pierre Erasmus, Dietmar Ernst International Business Valuation UVK Verlagsgesellschaft mbH · Konstanz mit UVK/ Lucius · München <?page no="3"?> Online-Angebote oder elektronische Ausgaben sind erhältlich unter www.utb-shop.de. Bibliografische Information der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.ddb.de> abrufbar. Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen. © UVK Verlagsgesellschaft mbH, Konstanz und München 2014 Einbandgestaltung: Atelier Reichert, Stuttgart Einbandmotiv: © yuliaglam - Fotolia.com Druck und Bindung: fgb · freiburger graphische betriebe, Freiburg UVK Verlagsgesellschaft mbH Schützenstr. 24 · 78462 Konstanz Tel. 07531-9053-0 · Fax 07531-9053-98 www.uvk.de UTB-Nr. 4176 ISBN 978-3-8252-4176-6 <?page no="4"?> PPreface International corporate assessment has become a vital part of today’s business valuation. Within the scope of continued globalization, financial experts face the perpetual challenge of measuring the assets or capital equipment of their international subsidiaries or foreign direct investments in a reasonable and comprehensive manner. It is these cross-border acquisitions and dispositions in particular, for which sound valuation is indispensable, as proper assessment is indubitably a crucial factor when reviewing profitability and negotiating transaction prices. On these grounds international business valuation is a powerful tool in evaluating strategic choices. In addition to that it is already a useful instrument in establishing transparency and communicating effectively with investors and will gain importance in day-to-day corporate management, controlling and financial reporting across national borders. Transparency especially has become an essential issue during and after the recent financial meltdown, which in turn led to an increased importance of international business valuation to allay anxieties of investors and other stakeholders. Thus, the book’s message is to explain how international business valuation can be a critical success factor for good decision-making and effective communication. International business valuation raises the question whether distinctive features need to be factored in when assessing foreign businesses and, if so, how exactly these additional aspects can be incorporated into the appraisal. The country risk premium regarding the investment in emerging and high growth markets deserves special consideration in this context. In the scholarly debate, two different schools of thought have developed. While formal scientists prefer a theoretical approach, empirical scientists base their perceptions on more practiceoriented findings. Formal scientists could find notional proof that CAPM does not tolerate any country risk premiums. Hence, their perception clearly <?page no="5"?> 6 Preface postulates that the question whether such a risk premium should be included in international business valuation can be answered with a simple “No”. At the same time, empirical scientists - who, by nature, examine practical observations - are aware of the existence of country risk premiums and, therefore, stipulate their inclusion in corporate assessments. This view seems to be supported by two practical observations: a) When examining visible prices or correlating stock prices in emerging/ high growth markets, it becomes evident that the use of the traditional CAPM frequently leads to inflated values. High discounting rates are required in order to adjust these high values and phase them with actual prices. Such discount rates are often referred to as “country risk premiums”. b) An increasing number of auditing firms and investment banks deal with the challenge of assessing emerging/ high growth markets by actually using a country risk premium concept, so as to be able to align computed values, observed stock prices and transaction prices. With this in mind, there seems to be a need to incorporate country risk premiums into valuation models. Or should CAPM actually be a model that is universally valid even across national borders? The deduction of two different answers can be argued: a) It can be empirically proven that - against current economics literature and against experts’ opinions of auditors and investment bankers - the traditional CAPM also works for corporate assessment in emerging markets and high growth countries; or b) One needs to accept, that a more realistic assessment approach is imperative. The inspection of a country risk premium suggests that a realistic assessment approach also needs to consider the relevance of the non-diversified corporate risks or at least a part thereof. This is due to the fact that organizations in emerging/ high growth markets bear a higher risk in all aspects which in turn justifies additional capital costs. <?page no="6"?> Preface 7 Should the phenomenon of “country risk premium” indeed be empirically proven - and there are some indications that support this theory - then, existing approaches of modelling international business valuation must be constructively debated with the inclusion of these risk premiums. Consequently, research in this field will need to be intensified. This book is based on the fundamental principle of traditional business valuation and demonstrates how companies and business units are to be assessed outside their domestic markets. It presents different approaches of modelling a country risk premium as developed by investment banks and auditing companies and explains how an international corporate assessment is being conducted using South Africa as an example of an emerging/ high growth market. The contents are being depicted by the means of continuous examples. Every example can be found as an Excel data record on the UTB homepage (www.utb.de) and the DICF homepage (www.dicf.de) for the interested reader to practice and carry out some virtual international business valuation. Additionally, the reader gets some useful insight on how to obtain and process the data required for international business valuation. The book is the product of a joint research project between Stellenbosch University and the European School of Finance at Nuertingen-Geislingen University (NGU). We would like to thank the UTB-Verlag publishing house and its employees for the constructive and enjoyable collaboration. Dr. Jürgen Schechler deserves our special thanks. We greatly benefitted from his support and his ideas. You are welcome to contact us at info@dicf.de for any feedback you’d like to share. We are grateful for additional ideas, comments, criticism and (maybe even) praise. We wish all our readers an interesting and insightful read. Pierre Erasmus (Stellenbosch University) Dietmar Ernst (Nuertingen-Geislingen University; German Institute of Corporate Finance) <?page no="8"?> TTable of Content Preface ...................................................................................... 5 Table of Content....................................................................... 9 1 Introduction to International Business Valuation ...... 13 1.1 The Term International Business Valuation........................ 13 1.2 Reasons for International Business Valuations ................... 15 1.3 Specifics of International Business Valuations.................... 16 1.3.1 Differences in Accounting Standards and Taxation........... 17 1.3.2 Different Currencies ............................................................... 18 1.3.3 Exchange Rate Fluctuations and (Hyper-) Inflation .......... 19 1.3.4 Country Risks ........................................................................... 19 1.3.5 Transfer Risks .......................................................................... 20 1.3.6 Availability and Reliability of Information and Financial Data ........................................................................................... 20 1.3.7 Interpretation of Key Figures Derived from Local Market Data.............................................................................. 21 1.3.8 Applicability of Traditional Valuation Methods.................. 22 1.3.9 Legally Required Valuation Methods.................................... 23 1.4 Methods of International Business Valuation ..................... 25 1.4.1 Single Valuation Methods ...................................................... 26 1.4.2 Mixed Approaches .................................................................. 31 1.4.3 Total Valuation Methods........................................................ 32 1.5 Approaches in International Business Valuation ................ 41 <?page no="9"?> 10 Table of Content 1.5.1 Presentation of a 5-Step Model for International Valuation ........................................................................................... 41 1.5.2 Business Analysis and Business Planning............................. 43 1.5.3 Establishing the Framework Conditions for the Valuation and Choice of One or Several Valuation Methods ... 51 1.6 Literature on International Business Valuation................... 54 2 Initial Thoughts on International Business Valuation in Emerging Markets/ High Growth Markets ..59 2.1 Emerging Markets/ High Growth Markets .......................... 60 2.2 Consideration of Different Currencies in International Business Valuation .................................................................. 62 2.2.1 International Business Valuation in Local Currency of the Emerging Markets/ High Growth Markets ................... 63 2.2.2 International Business Valuation in the Hard Currency of the Reference Market ......................................................... 69 2.3 Applicability of CAPM in Emerging Markets/ High Growth Markets ...................................................................... 73 2.3.1 Critical Assessment of CAPM ............................................... 73 2.3.2 Can the CAPM be used in Emerging Markets/ High Growth Markets? ..................................................................... 77 3 A Closer Look at Important Model Parameters in International Business Valuation with the CAPM......87 3.1 The Market Risk Premium - Definition, Influencing Factors and Determination .................................................... 88 3.1.1 What is the Market Risk Premium? ...................................... 88 3.1.2 Determination of the Market Risk Premium....................... 89 3.1.3 Thoughts on the Risk Premium in Emerging Markets/ High Growth Markets............................................................. 94 <?page no="10"?> Table of Content 11 3.2 Country Risk - An Additional Risk Factor in Emerging Markets/ High Growth Markets ............................................ 95 3.2.1 The Need for a Country Risk Premium ............................... 95 3.2.2 How is the Country Risk Premium Calculated or Estimated? .............................................................................. 100 3.2.3 Attribution of the Country Risk Premium to the Individual Companies........................................................................ 110 3.3 The Beta Factor ..................................................................... 118 3.3.1 Methodological Questions about the Determination of the Beta Factor....................................................................... 118 3.3.2 Determination of Beta Factors in Volatile Markets if Financial Data is not Available ............................................ 120 4 International Business Valuation in South Africa..... 131 4.1 Expanded Model for International Valuation in Volatile Markets.................................................................................... 133 4.2 Adaptation of Business Planning and Cash Flows ........... 136 4.2.1 Adjustment of Cash Flows to Correct for Countryspecific Accounting Regulations ......................................... 137 4.2.2 Adjustment of Cash Flows to Correct for Excessive Management Remuneration ................................................. 142 4.2.3 Adjustment of Cash Flows to Correct for Excessive Expensing ............................................................................... 143 4.2.4 Adjustment of Cash Flows to Correct for Inflation......... 145 4.3 Adjustment of the Cost of Capital (Discount Rates) ....... 151 4.3.1 Determination of the Cost of Equity with the help of CAPM-based Models ............................................................ 151 4.3.2 Determination of the Cost of Equity with the help of models that are not based on the CAPM ........................... 182 <?page no="11"?> 12 Table of Content 4.3.3 Overview of the Calculations Needed for the Models of International Business Valuation.................................... 191 4.3.4 Comparison of the Models .................................................. 192 4.4 Model Selection ..................................................................... 195 4.4.1 An Overview of the Cost of Equity of the Various Models..................................................................................... 198 4.4.2 Determination of the Cost of Debt .................................... 199 4.5 Additional Adjustments for the Incorporation of Unsystematic Risk ................................................................. 201 4.5.1 Company Size (Size Effects) ................................................ 203 4.5.2 Block Premium (Majority Discount) .................................. 204 4.5.3 Mobility Premium (Liquidity, Fungibility Premium) ........ 205 4.6 Calculation of the Business Value ....................................... 207 4.6.1 Calculation of the Business Value with the WACC Approach ................................................................................ 207 4.6.2 Calculation of the Business Value with the Equity Approach ................................................................................ 221 Summary of this book ........................................................... 237 Bibliography .......................................................................... 239 Index .................................................................................... 245 <?page no="12"?> uvk-lucius.de 11 Introduction to International Business Valuation Learning Outcomes Understanding of the term international business valuation and its relevance as an academic method for the determination of the value of a company. Understanding of the reasons for international business valuations. Knowledge of the specific features of an international business valuation and the ability to use that knowledge in international business valuations. Ability to reproduce the most important approaches to international business valuation. Understanding of the 5-step approach towards international business valuation and the ability to present this approach. Ability to explain the difference between the single valuation method and the multiple valuation method. Knowledge of the literature on international business valuation. 1.1 The Term International Business Valuation The advancing globalization has significantly increased the demand for reliable valuation principles and mechanisms for crossborder transactions and the valuation of capital assets and current assets of subsidiaries abroad. Especially in the case of cross-border acquisitions and sales of companies, the determination of transaction prices, the related negotiations and any assessment of the economic consequences absolutely depend on a solid valuation. <?page no="13"?> 14 1 Introduction to International Business Valuation uvk-lucius.de And valuations also gain in importance with regard to controlling, accounting and transparent communication with the providers of capital. Especially the latter point has caused an increasing demand for business valuations during and after the recent global financial crisis. In the past, companies were able to finance acquisitions abroad with equity capital or unsecured bank loans, thanks to the availability of strong equity capital cushions. During the crisis, they were increasingly forced to raise available collateral by drawing on assets held abroad. The determination of the value of capital assets and current assets held abroad has posed great challenges for companies, financial auditors and banks. While pragmatic approaches for the valuation of companies abroad were developed by valuation practitioners, the academic literature has paid relatively little attention to the topic. In the following sections the term international business valuation refers to the determination of the value of entire companies or participations in companies with a specific focus on the peculiarities of foreign markets. The term foreign markets needs to be defined more precisely and refers both to countries with developed capital markets and also to countries which - in contrast to established industrial nations - do not possess developed capital markets. This poses specific challenges for valuation professionals. At issue is not only the question whether traditional valuation methods can be adequately applied, but rather how they can be included in the valuation process in the absence of appropriate information about country risk and transfer risk. Definition: International business valuation International business valuation is defined as the determination of the value of entire companies or participations in companies with a specific focus on the peculiarities of foreign markets. <?page no="14"?> 1.2 Reasons for International Business Valuations 15 uvk-lucius.de In the following, international business valuation is presented from the perspective of a German valuation expert. Thus “Home” refers to Germany in the following, while “Abroad” can be any foreign country. 11.2 Reasons for International Business Valuations As a consequence of the accelerating globalization and the growing international value chain, valuations in an international context are becoming more and more common in daily company business. Typical reasons for an international business valuation are (see Figure 1.1): Figure 1.1: Reasons for international business valuations Purchase or sale of companies or parts of companies abroad Project assessment in the context of investment decisions Expansion/ reduction/ liquidation of foreign holdings Joint ventures across borders <?page no="15"?> 16 1 Introduction to International Business Valuation uvk-lucius.de Valuation and management of participations Squeeze-out Impairment test Purchase price allocation Tax assessment, for example in the context of relocations of functions 11.3 Specifics of International Business Valuations The valuation of companies in “emerging markets” (also “high growth markets”) is subject to a number of specific considerations, which are described in the following. This also makes it possible to address the specifics of the situation by applying appropriate methods of international business valuation. Figure 1.2: Overview of problematic areas in international valuation in volatile markets <?page no="16"?> 1.3 Specifics of International Business Valuations 17 uvk-lucius.de Figure 1.2 provides a first overview of challenges and problems which valuation experts repeatedly face when dealing with international business valuation in high growth markets/ emerging markets. 11.3.1 Differences in Accounting Standards and Taxation One problem faced in international business valuations refers to the fact that local accounting regulations are often not comparable with international accounting standards, especially if their use - at a minimum for companies with a capital market orientation - is not mandatory. The comparability of financial figures of companies abroad with those of companies in developed countries is frequently rather limited because of the existence of country-specific rules. So even if a valuation expert is able to define a peer group, comparisons, for example of profitability, are made difficult. Annual reports or key figures must therefore first be adjusted in order to allow a suitable analysis or conclusions and to eliminate distortions of the true economic performance of the valuation object. Obtaining the necessary knowledge about country-specific accounting regulations is frequently associated with substantial effort and requires specific knowledge. This is an additional challenge for the valuation expert. While disclosure requirements have increasingly been tightened over the past years, especially in developed countries, less restrictive rules are frequently observable in emerging markets/ high growth markets. This trend is likely to continue for a number of years. And the mandatory use of international accounting standards has yet to be realized. But a tendency of increasing alignment and harmonization of the accounting and reporting systems of emerging markets/ high growth markets with international standards is observable. This will increase the transparency and attractiveness for international investors. The current tax regime and corresponding legal requirements are also relevant for valuation. At issue is not only the adequate consid- <?page no="17"?> 18 1 Introduction to International Business Valuation uvk-lucius.de eration of tax expenses that directly affect payments as a consequence of the legal form, but also the assessment of company structures driven by tax considerations, possibility and implications for the disbursement of funds as well as tax risks. 11.3.2 Different Currencies When valuing businesses in a single currency area, exchange rate effects and exchange rate calculations are not relevant. But if the perspective of the valuation expert is different with regard to the currency at home, a decision has to be made about the relevant currency for the valuation exercise. A valuation can be done either in the local currency of the home country of the company under consideration or in a reference currency. This is relevant for the aspect of currency equivalency in the valuation exercise. Once the base currency has been selected, consistency in conducting the valuation is important, especially when determining and calculating the cash flows and the discount rates. They need to be translated into the chosen currency using consistent assumptions. Due to the specific situation in emerging markets/ high growth markets with regard to the currency, valuation exercises can be problematic. As an example, a valuation in local currency can be difficult, because the riskless rate of interest, which is needed to calculate the cost of capital, is hard to determine due to a lack of long-term public bonds issued by the government of the emerging market/ high growth market. This, as well as other related features, can imply the significantly increased complexity of the valuation. <?page no="18"?> 1.3 Specifics of International Business Valuations 19 uvk-lucius.de 11.3.3 Exchange Rate Fluctuations and (Hyper-) Inflation Many foreign currencies are frequently very volatile, both with regard to exchange rate fluctuations and inflation (loss of purchasing power). And the standard practice of fixing the local currency to a stable foreign currency, such as Dollar or Euro should not mask this volatility. Frequently overlooked are revaluations of the local currency, which can be significant in some cases. Exchange rate fluctuations and inflationary developments can also lead to massive distortions in the annual financial statements. Thus they must be taken into consideration when determining cash flows or discount rates. 1.3.4 Country Risks Investments in emerging markets/ high growth markets are frequently rewarded with high growth rates. But these increased opportunities usually also correspond with additional macroeconomic risks. If investors take a stake in countries such as Brazil, Russia, India, China or South Africa (so-called BRICS countries), they are exposed to political or economic turbulences in these markets. No company that is active in the emerging market/ high growth market is able to escape the influence or the situation inside this country over the long term. If a country collapses politically or economically, this also affects the best run companies. Does this mean that an investment, for example in Brazil, generally has a higher risk than an investment in Germany, France or the United States? When the investment is considered in isolation, this question about the general relevance of country specific risks must be answered in the affirmative from the perspective of valuation experts and investors. In the context of a globally diversified group of companies, an investment in an economic region that is far away from the home <?page no="19"?> 20 1 Introduction to International Business Valuation uvk-lucius.de country and has its own currency can still make a positive contribution from a risk perspective. Examples are the manufacturing sites of major German automobile companies in the US, which achieve natural hedging against currency fluctuations in the Euro-Dollar relationship. There is fundamental agreement among valuation practitioners that country risks must be considered in the context of international business valuation. But there is disagreement about the determination of the relevant premium needed to compensate for the country risk in a valuation exercise. Of particular relevance in this regard is the aspect of risk equivalency, especially with regard to the determination of capital costs when assessing the net present value of earnings. 11.3.5 Transfer Risks Transfer risks can jeopardize the business success of foreign investments and relate to the repatriation of profits and capital. Transfer risks include exchange restrictions imposed by a government or the central bank, which make it impossible for the investor to be repaid. While the investor has deposited the respective amount in local currency, he does not get access to the needed foreign reserves, since the central bank does not provide them. Also considered a transfer risk is the possibility that payments from a country in financial difficulties are refinanced even though they are due. Such a transnational agreement reached by the Paris Club can delay payment by several years. 1.3.6 Availability and Reliability of Information and Financial Data The procurement of information and financial data for the company abroad which needs to be valued as well as for its environment and comparable companies often constitute additional problems when conducting an international valuation. As it turns out, the <?page no="20"?> 1.3 Specifics of International Business Valuations 21 uvk-lucius.de data history in emerging markets/ high growth markets often is of insufficient length or does not exist at all. In case data is available, it must be assessed how reliable and meaningful it is. The quality of the valuation result depends to a large degree on these factors and requires a major effort concerning research and analysis. Frequently fundamental data such as the intrinsic value or validity of sales and rental contracts for land and real estate must be questioned. And in many emerging markets/ high growth markets it cannot be assumed that the transfer of ownership does not impinge on the continuation of existing agreements concerning the calculation and payment of taxes, liquidity and trading lines at banks or distribution and service contracts. 11.3.7 Interpretation of Key Figures Derived from Local Market Data A frequently utilized approach in business valuation is the determination of parameters from data observed on the capital market. One example is the beta factor, which is obtained from a regression of the company returns on the returns of a suitable index. But how meaningful are these types of calculations in light of frequently observable features such as illiquidity, lack of transparency and high transaction costs on the financial markets in the emerging markets/ high growth markets? Does the share price reflect the adequate value of the company, even though there is very little trading in the stock and quotations are frequently not based on any trading? Thus ratios and indicators which are based on illiquid and less developed capital markets must be used with greater reservations compared to developed markets. Not only the general availability of financial market information but also its significance causes problems for the valuation expert. 1 1 See Damodaran, A. (2009), p. 5. <?page no="21"?> 22 1 Introduction to International Business Valuation uvk-lucius.de 11.3.8 Applicability of Traditional Valuation Methods It must be stated initially that in light of the conceptual difficulties and the scarcity of information, the task is not to develop a new valuation approach. The traditional valuation methods, predominantly the discounted cash flow (DCF) approach in all its variations, continue to be widely used by practitioners. And with regard to the existing capital market models for the determination of risk, the Capital Asset Pricing Model (CAPM) - despite all its limitations - continues to be the accepted standard for the determination of the cost of capital and is used by practitioners globally. But it remains questionable whether the CAPM is also a suitable model for the determination of the cost of capital in emerging markets/ high growth markets. As will be shown, CAPM cannot be used in its basic form and must be adapted accordingly. In this regard, several variants of the CAPM or alternative approaches are suggested. These variants are special in the sense that the relationship between model parameters - riskless return, beta, market risk premium and country risk premium - must be defined in a way that adequately captures all risks in emerging markets/ high growth markets risks, but also avoids double counting of these risks. Among academics and practitioners as well as in the current literature there is disagreement about how to implement the specifics of emerging markets/ high growth markets and which models should be used concretely in an international valuation. This disagreement is certainly also one reason for the current lack of a unified standard. Instead a large number of different models for international business valuation continue to exist. Partly this expresses a desirable plurality of methodologies, but it is also the unsatisfactory answer to the question of how to conduct valuations in incomplete markets. In summary it can be stated that a valuation expert is confronted with numerous problematic areas when conducting an international business valuation. Put differently, the existing conceptual <?page no="22"?> 1.3 Specifics of International Business Valuations 23 uvk-lucius.de difficulties in valuation exercises become more severe in the case of international valuations. Due to the many situational factors which interact in an international valuation, it is not always easy to point to a simple solution. It is the responsibility of the valuation expert to take these factors into consideration in his own valuation approach. The basic principle of an international valuation resembles that of a domestic valuation. For methods that rely on capital values, cash flows need to be determined, which are discounted using an adequate cost of capital. The market based approaches meanwhile rely on the calculation of multiples for a peer group, which are applied to the relevant reference value of the company to be valued. The difference and also the difficulty stem from the availability of data as well as the additional risk factors which are present in emerging markets/ high growth markets and must be taken into consideration when determining input parameters. This requires that cash flows and multiples are adjusted and the CAPM is modified or expanded. Of particular relevance in this regard is the assessment of the reliability of the future cash flows, initially in foreign currency, but ultimately in the reference currency which is preferred by the principal. 11.3.9 Legally Required Valuation Methods Mandatory legal regulations concerning the valuation of assets exist in some emerging markets/ high growth markets. In China for example this is the “Statutory Valuation” which is legally mandated whenever assets are purchased or transferred that directly or indirectly are owned by the Chinese state. With its “Decree 91” under the working title “Statutory Valuation”, the Chinese government in 1990 laid the foundations for the mandatory application of “Generally Accepted Valuation Practices” in China. The purpose was to prevent the sale of government assets by State Owned Enterprises (SOEs) below their value, or at least to make this more difficult. <?page no="23"?> 24 1 Introduction to International Business Valuation uvk-lucius.de Decree 91 mandates that the statutory valuation approach must be applied in case of: contributions in kind liquidation mergers which change the ownership structure share purchases The statutory valuation can only be conducted by one of 6,000 Chinese valuation companies that hold a government license. The selection and commissioning of the valuation firm is usually done by the seller of the government assets, in other words by the SOEs. The sales price of the transferred assets is only allowed to deviate by a maximum of 10% from the value assigned with the help of the statutory valuation (“90% Rule”). For publicly listed companies, public bidding via the equity exchange must take place. In this case the seller is required to publish information about the company and the assets that are for sale as well as the result of the statutory valuation. The offer must be made public within 20 working days. For companies that are not publicly listed, the business value is usually derived by valuing all assets (“Asset Approach”). Since the valuer is hired by the government, he will usually prefer valuation approaches that result in a particularly high total valuation. And he has a lot of leeway in this regard. For capital assets the valuer can use either historical acquisition costs or current replacement costs. Especially for machinery purchased abroad, this can have a massive effect on the valuation due to the volatility of exchange rates. And the choice of depreciation methods also leaves considerable scope. Frequently the approach “Economic Life” is chosen, even though the asset has long been completely amortized from the perspective of accounting. It holds in general that the value of an asset can never fall below the threshold of 15% of the purchase price. For buildings the residual value amounts to 30% of construction costs. The valuer furthermore has significant freedom when it comes to the valuation of provisions, current assets, contingent liabilities and goodwill. <?page no="24"?> 1.4 Methods of International Business Valuation 25 uvk-lucius.de International accountancy firms are usually not accredited as “Statutory Valuer”. However, they offer support in the process. This service is called “Statutory Valuation Monitoring” for example and is offered in combination with the implementation of legal, tax, financial and environmental due diligence. The aim of the consulting service is to supervise the valuation process and to support the interests of the interested foreign party in a dialogue with the Chinese valuer. It is frequently possible that adept arguments voiced by the adviser can convince the Chinese valuer to apply an approach that is more advantageous or at least neutral for the buyer or that he does not use the full scope that is given to him to the sole advantage of the seller. The aim is to achieve a more realistic valuation result from the perspective of the potential foreign buyer. It is important in this regard that the interested foreign party obtains knowledgeable support before the proceedings begin, since the transaction value can only deviate by a maximum of ten percent from the statutory valuation as discussed above. 11.4 Methods of International Business Valuation As already mentioned, the methods of international business valuation do not fundamentally differ from the known valuation approaches. In applied international business valuation, some methods appear to be particularly adequate and for emerging markets/ high growth markets a few specific valuation methods were developed. In the following, the methods which are preferred in international business valuation are briefly explained. As can be seen in Figure 1.3, the business valuation approaches can be broken down into single valuation methods, mixed methods and total valuation methods. Since the methods which focus on the capital value (DCF approaches) are of central relevance in the context of international business valuation, they are presented in detail in the following chapters and illustrated with the help of the Case Study. For this <?page no="25"?> 26 1 Introduction to International Business Valuation uvk-lucius.de reason it is sufficient to provide a short overview of the various valuation methods at this point. Figure 1.3: Overview of the most important business valuation methods 2 11.4.1 Single Valuation Methods The single valuation approaches are based on the idea that the total business value can be derived by adding up the various “components” (assets and liabilities) on a given date. This requires an initial valuation of the individual assets, which are then added up to arrive at a total business value. In order to arrive at the net asset value of Adapted from Ernst, D./ Schneider, S./ Thielen, B. (2012), p. 2. <?page no="26"?> 1.4 Methods of International Business Valuation 27 uvk-lucius.de the company, the liabilities of the company need to be subtracted. (See Table 1.1) Value of the individual assets Value of the liabilities = Net asset value Table 1.1: Determination of the net asset value When determining the net asset value of a company, either the continuation (reproduction value) or the liquidation (liquidation value) of the company can be assumed. In the following we first show the determination of the net asset value based on reproduction values and then based on liquidation values. N Net Asset Value Approach Based on Reproduction 1.4.1.1 Values As already mentioned, the determination of the net asset value based on reproduction values assumes the continued existence of the business (so-called Going Concern Principle). The intention of this approach is to replicate the business as it currently exists and to take the costs that accrue as the basis for valuation. The reproduction values which are generated are replacement values or current market values, which take into consideration the condition and age of the assets. Table 1.2 describes the structure of net asset value determination. Reproduction value of operating assets + Liquidation value of non-operating assets Value of liabilities = Net asset value based on reproduction values Table 1.2: Determination of the net asset value on the basis of reproduction values <?page no="27"?> 28 1 Introduction to International Business Valuation uvk-lucius.de The net asset value on the basis of reproduction values can be interpreted as the amount that needs to be paid in order to obtain a company with equivalent substance and in the same condition. Different approaches are available for the determination of reproduction values. The starting point for the first approach is the gross reproduction value of new assets. It is the amount which must be paid when completely acquiring all operating assets and does not consider liabilities. The net reproduction value of new assets is calculated by deducting liabilities. The net reproduction value of used assets results once depreciation is taken into consideration. It can also be interpreted as a replacement value (current market value). Table 1.3 summarizes the necessary steps in the calculation. Gross reproduction value, new Deduction of liabilities = Net reproduction value, new Consideration of depreciation = Net reproduction value, used = Replacement value (Current market value) Table 1.3: Determination of the net reproduction value, used The second approach differentiates between full and partial reproduction value. The full reproduction value takes all assets into consideration, while the partial reproduction value ignores the intangible assets. Table 1.4 compares the two approaches. <?page no="28"?> 1.4 Methods of International Business Valuation 29 uvk-lucius.de Table 1.4: Differentiation between full and partial reproduction value In applied work, the application of the net asset value approach leads to the problem that intangible assets are hard or impossible to quantify. For that reason the net asset value can in most cases only be determined as a partial reproduction value. In the valuation literature, the net asset value approach based on reproduction values is considered to be rather problematic. In the context of an international business valuation, this approach is regularly used, sometimes even unknowingly, if a choice must be made between the acquisition of a foreign company or a so-called greenfield investment. This comparison is based on the purchase price of a foreign company and the investment costs determined by the reproduction value of new assets. Full reproduction value Partial reproduction value All company assets are considered Both intangible assets (such as rental rights, patents) as well as other intangible assets (such as client relations, qualifications of staff) should be included Practical implementation could be problematic, since intangible assets cannot always be quantified Intangible assets are not considered <?page no="29"?> 30 1 Introduction to International Business Valuation uvk-lucius.de NNet Asset Value Approach Based on Liquidation 1.4.1.2 Values While the determination of the net asset value on the basis of reproduction values is premised on the continuation of operations, the determination of net asset values on the basis of liquidation values assumes the termination of the business. The liquidation value is determined in cases where the liquidation results in a higher value than the continuation of the operation or if the liquidation is planned for other reasons. The liquidation value is determined as follows (see Table 1.5). Proceeds from liquidating all company assets Value of liabilities Liquidation costs = Net asset value on the basis of liquidation values Table 1.5: Determination of the net asset value on the basis of liquidation values The liquidation value is equal to the proceeds from liquidating the company and selling all assets. Every attempt must be made to obtain the best possible price for the assets on the relevant market. A distinction must be made between a closing under time pressure (breakup) and under normal conditions (liquidation). In addition, the liquidation value is not only affected by the speed of dissolution, but also by its intensity (are assets sold individually or as aggregates? ). Depending on the assumptions made, different liquidation values are possible. <?page no="30"?> 1.4 Methods of International Business Valuation 31 uvk-lucius.de One criticism directed at the single valuation method refers to the fact that the assets are only considered in isolation and that any interactions within the business and the resulting future earnings are ignored. While this appears to be a material shortcoming, single valuation methods in international business valuation are used especially in the case of companies with a weak earnings situation or in an insolvency case. In the case of companies that are a going concern, the net asset value approach based on reproduction values is used. A greenfield investment serves as benchmark for potential purchase prices of existing companies. 11.4.2 Mixed Approaches Mixed approaches are an extension of the single valuation methods. In addition to the substance of a company, they also take the earnings power into consideration when determining the business value. Among the mixed methods, a distinction is made between simple average value approaches and excess profit approaches. Mixed approaches are considered to be unsuitable by both theorists and practitioners, especially because of the arbitrary combination of the business components “substance” and “earnings”. Lately, however, excess profit approaches are being reconsidered because of value based management. Among the methods of value based management are Economic Value Added (EVA © ) and Cash Flow Value Added (CVA). Value based management is used globally when controlling international businesses. Despite the fact that EVA © and CVA can be used not only as controlling, but also as valuation tools, these approaches have not been successful among practitioners in the field of business valuation. Still, they are a component of the value based management of companies and participations and are applied in modern approaches to controlling. In summary, it can be stated that the same methodological and conceptual difficulties are present as in the case of discounted cash flow approaches. In the following chapters of this book, we will no longer deal with these valuation approaches. <?page no="31"?> 32 1 Introduction to International Business Valuation uvk-lucius.de 11.4.3 Total Valuation Methods In contrast to the single valuation methods, where individual assets are considered in isolation, total valuation methods deal with the entire business as one valuation entity. The business value is determined exclusively by the future earnings power of a company, which results from the interaction of all parts of the company. Among the total valuation methods are discounted cash flow approaches, multiple approaches and the real options approach. 3 Discounted Cash Flow Methods 1.4.3.1 The Discounted Cash Flow Methods (DCF Methods) are among the approaches to valuation with the widest international acceptance. These methods - similar to the determination of the value of an investment - calculate a present value of the company by discounting the cash flows of the company that can be expected in the future. For that reason, they are also considered valuation methods with a capital market orientation. The cash flows constitute upcoming payouts of the company to the providers of capital and can be interpreted as the benefit than can be expected in the future. They are derived on the basis of business planning and for that reason not only take company-specific peculiarities into consideration, but also require a corresponding fundamental analysis of these plans. Cash flow planning is usually done in two steps. In a first step the cash flows are planned annually over a limited time horizon, the socalled detailed planning horizon. For the time period following the detailed planning horizon, the so-called terminal value is determined. It represents all cash flows that are available and can be sustained beyond the detailed planning horizon. The relative superiority of an investment in the company compared to an alternative investment is expressed with the help of the See Ernst, D./ Schneider, S./ Thielen, B. (2012), p. 8. <?page no="32"?> 1.4 Methods of International Business Valuation 33 uvk-lucius.de discount rate. The interest rate used for discounting is calculated with the help of theoretical capital market models such as the Capital Asset Pricing Model (CAPM). This capital market orientation significantly limits the use of subjective factors when determining capital costs and increases transparency and traceability. In the DCF approach, the total business value is finally determined by adding up all future cash flows discounted at the appropriate rate plus the value of the non-operating assets, which needs to be determined separately. Depending on the cash flows and discount rates used, different approaches such as the weighted average cost of capital (WACC) approach, the adjusted present value approach (APV approach) and the equity approach can be identified. In the context of international valuation, a number of specific approaches to international business valuation are also of relevance and will be presented in more detail in later chapters of the book, particularly in chapter 4. Especially the following models based on the CAPM deserve to be mentioned: Global CAPM Local and Adjusted Local CAPM Hybrid CAPM Models (Adjusted) Hybrid CAPM Lessard-Model Godfrey-Espinosa-Model Goldman-Sachs-Model Damodaran-Model Salomon-Smith-Barney-Model Among the models that are not based on the CAPM are: Estrada-Model Erb-Harvey-Viskanta-Model (EHVM) <?page no="33"?> 34 1 Introduction to International Business Valuation uvk-lucius.de Arbitrage Pricing Theory (APT) Simulation-based Approach 1.4.3.1.1 WACC Approach In the WACC approach, future excess cash flows which are available to all providers of capital, namely providers of equity as well as of debt capital, are discounted using an average interest rate that includes both the cost of equity capital and the cost of debt capital. The excess cash flows are called operating free cash flow (oFCF), the average interest rate that reflects both the cost of equity and debt capital is called WACC (Weighted Average Cost of Capital). In a last step, the market value of the interest bearing debt capital is subtracted in order to arrive at the value of the equity capital. 1.4.3.1.2 Adjusted Present Value Approach (APV Approach) The APV approach starts by determining the market value of the total capital of a company under the assumption that it has no debt. Following that, the tax advantage of debt capital for the company is taken into consideration by calculating the so-called tax-shield. It is equal to the advantage obtained from the fact that interest payments are a deductible expense for tax purposes. In line with the WACC approach, the market value of the interest bearing debt capital is subtracted to arrive at the value of the equity capital. 1.4.3.1.3 Equity Approach (Net Treatment) In the equity approach, excess cash flows that are attributable only to the providers of equity capital are discounted at the cost of equity of the company. This directly leads to the market value of equity. If identical assumptions are used with regard to the financing structure of the company, all three approaches yield the same result. <?page no="34"?> 1.4 Methods of International Business Valuation 35 uvk-lucius.de 1.4.3.1.4 Specific Methods of International Business Valuation The specific methods of international business valuation can be seen in principle as “extensions” of the classical business valuation approaches. A distinction can be made between approaches that are based on the CAPM model and those that are not based on the CAPM model. The distinguishing factor is the basis for calculating the relevant cost of equity capital. Table 1.6 provides an overview of the most frequently used models along these lines. Models that are based on CAPM Models that are not based on CAPM Global CAPM Estrada-Model Local CAPM and Adjusted Local CAPM Erb-Harvey-Viskanta-Model (EHVM) (Adjusted) Hybrid CAPM Arbitrage Pricing Theory (APT) Lessard-Model Simulation-based Approach Godfrey-Espinosa-Model Goldman-Model Damodaran-Model Salomon-Smith-Barney-Model Table 1.6: Overview of specific models of international business valuation At this point only a brief introduction to the models will be provided. A detailed presentation, including the relevant formulas and an assessment of advantages and disadvantages of the individual approaches, follows in chapter 4 of this book. <?page no="35"?> 36 1 Introduction to International Business Valuation uvk-lucius.de 1.4.3.1.1.1 CAPM-based Models The CAPM is a capital market model which serves to determine the cost of equity capital. Differences among the individual models result from the fact that different assumptions about the determination of the parameters used in the CAPM - market risk premium, riskless rate of interest, beta factor and the country risk premium - are made. The global CAPM, for example, is based on the assumption that markets are integrated globally and that capital and information can flow freely across borders. No barriers exist. International investors are thus able to invest in every market and are also free to exit that market again. If these assumptions hold, the global CAPM can be used to determine the cost of equity capital by determining a global riskless rate of return, a global company beta and a global market risk premium. In contrast to the global CAPM, the local CAPM assumes the existence of barriers, which lead to market segmentation. If markets are not integrated, existing country risks in these segmented markets cannot be eliminated via international or geographic diversification and must be taken into consideration in the cost of equity capital. Market risk premiums, riskless interest rates, beta factor and country risk need to be determined at the local level. The hybrid CAPM is a combination of global and local CAPM, which attempts to combine the advantages of both approaches. In order to avoid the problem of estimating important local parameters, the hybrid CAPM pursues the approach of adapting the global parameters, which have the advantage of easier availability, to the local realities. This is done by adapting the global market risk premium to the local market with the help of a country beta. An adjustment prevents the double counting of country risks. The Lessard-Model is almost identical to the hybrid CAPM. While the hybrid CAPM leaves open the choice of reference market, the Lessard-Model assigns this role to the US. <?page no="36"?> 1.4 Methods of International Business Valuation 37 uvk-lucius.de The Godfrey-Espinosa-Model also attempts to use the global parameters which have the advantage of easier availability. It is based on the fundamental assumption that the correlation coefficient between the reference market and the emerging market in question is equal to one. In other words, the two are characterized by a perfectly positive correlation. This also makes it possible to derive the cost of equity capital with the help of adjustment factors and corresponding corrections from global parameters. The Goldman-Sachs-Model is very similar to the Godfrey-Espinosa-Model, but contains an adjustment which helps to eliminate the problem of double-counting. The incorporation of a companyspecific risk premium also allows the calculation of a companyspecific cost of equity capital. The Damodaran-Model is very similar to the CAPM. It contains an additional company-specific country risk, which accounts for the fact that not all companies are exposed to the same market risks. The Salomon-Smith-Barney-Model is a modified global CAPM, which in addition to country risk takes company-specific risk into consideration. 1.4.3.1.1.2 Models Not Based on CAPM As a consequence of some of the methodological and conceptual weaknesses of the CAPM, academics and valuation practitioners have also proposed models for the determination of equity capital that are not based on the CAPM. In the Estrada-Model, which at a first glance resembles the classical CAPM, the beta factor is replaced with a measure that captures downside risk. The justification is the observation that rational investors only consider negative deviations from the expected value as a risk, while positive deviations are seen as an opportunity. But in the classical CAPM both positive and negative deviations are used to calculate the variance of returns. This point is frequently criticized. As needs to be demonstrated later, the measure for the downside risk in the Estrada-Model is obtained as the ratio of the <?page no="37"?> 38 1 Introduction to International Business Valuation uvk-lucius.de semi-standard deviation of the returns of the local reference market and the semi-standard deviation of the returns of the global market. While the Estrada-Model is quite manageable with regard to data collection requirements and can thus be considered an interesting alternative to the CAPM-based models, the same is unfortunately not true for the Erb-Harvey-Viskanta-Model (EHVM) and the Arbitrage Pricing Theory (APT). The latter two are so-called multifactor models, which consider several risk factors and for that reason also require more data. However, it is frequently not possible or not economical to obtain this data, especially for emerging markets. Interesting, but not quite completed in its development and applications is the simulation-based approach of ERNST/ GLEISSNER. Simulation-based valuation approaches allow the direct incorporation of country risks (such as uncertainty about inflation, the possibility of expropriations or government debt crises) into the modeling of uncertain future earnings and cash flows at the company level. In this book the focus will mostly be on the Estrada-Model. The EHVM, the APT and the simulation-based approach will only be covered in passing. M Multiples 1.4.3.2 Multiples utilize observable market prices in order to determine business values. As relative valuation approaches, they are based on the principle that the business value can be derived from share prices of listed comparable companies or realized market prices of comparable transactions (recent acquisitions). They are also classified as “market-oriented” valuation methods for that reason. An attempt is made to estimate the business value indirectly via comparable companies or transactions. Following WILLIAM STAN- LEY JEVONS’ “Law of indifference” 4 , it can be assumed that 4 “The principle [...] is a general law of the utmost importance in Economics, and I propose to call it The Law of Indifference, meaning that, when two objects or commodities are subject to no important differ- <?page no="38"?> 1.4 Methods of International Business Valuation 39 uvk-lucius.de identical investments (or at least very similar ones) must be valued identically; otherwise arbitrage opportunities would open up. In Germany multiple approaches are not considered to be independent methods according to IDW (Institute of Public Auditors), because they determine the price and not the value of a company. In order to obtain a company value, the market prices of the comparable companies or comparable transactions are considered in relation to certain company figures. The derived ratios are then applied to the expected reference values for the companies that need to be assessed. Multiples based on the “comparative public company approach” are also called trading multiples, while those that are based on the “recent acquisition approach” are called transaction multiples. The result of a company valuation based on the multiple approach can be interpreted as the potential market price of the valued company which should be obtained in the case of a sale. While the easy applicability and traceability of the results strengthen the case for the multiple approaches, the resulting lack of precision is frequently criticized and is the biggest weakness of this approach. Despite this criticism, however, multiples are frequently used in applied work and are very popular in the US under the label “market approach”. Even though critics consider the multiple approaches to provide only “rough estimates”, these estimates can still be used as a first guideline or plausibility check. ence as regards the purpose in view, they will either of them be taken instead of the other with perfect indifference by a purchaser. Every such act of indifferent choice gives rise to an equation of degrees of utility, so that in this principle of indifference we have one of the central pivots of the theory”. William Stanley Jevons: The Theory of Political Economy, 3rd ed., London: Macmillan, 1888. <?page no="39"?> 40 1 Introduction to International Business Valuation uvk-lucius.de RReal Options Approach 1.4.3.3 The real options approach is a valuation method which is not only used in business valuation, but also in investment analysis and as a management tool. Real options provide management with scope for action on the basis of information that becomes available in the future and is relevant for investment or disinvestment decisions. The ability to base investment decisions on the development of relevant environmental states and future information and to make them at a later point in time can be considered a monetary advantage. Due to this monetary advantage, real options are given a price, respectively value, and can be quantified. The aim of the real options approach is to quantify the monetary advantage that arises from managerial flexibility with regard to investment decisions. For that purpose, the various lines of action are assessed with the help of specific option price models, which are also used in finance, and expressed in monetary units. The intention of the real options approach is very similar to that of the decision tree method, which is a specification of the DCF model for multistage decision problems. The real options approach is most suitable if the valuation object is largely characterized by the existence of decision alternatives and is located in an uncertain market environment. The use of the real options model in international business valuation is most appropriate, if, for example in the case of a foreign investment, a negative capital value is initially obtained, but the investment provides the option of further investments, which taken together result in a positive capital value. Despite the importance of successful entrepreneurial activities for the increase of business value, which is reflected in the utilization of decision alternatives and thus in the exercise of options, the real options approach was not successful in applied work. On the one hand, this is due to the complexity of the approach and on the other hand, it reflects the necessity to collect input data that cannot be easily derived from market data. <?page no="40"?> 1.5 Approaches in International Business Valuation 41 uvk-lucius.de 11.5 Approaches in International Business Valuation In this section, the steps needed to arrive at an international valuation are described. The basic structure can serve as a guideline for practitioners who need to conduct an international valuation. The initial aim of this chapter is to establish a company planning tool which includes a pro-forma balance sheet and a pro-forma profit and loss statement. This serves as the foundation for the following parts, where the methods of business valuation with the help of discounted cash flow models are presented in detail and illustrated with reference to a case study. 1.5.1 Presentation of a 5-Step Model for International Valuation As Figure 1.4 makes clear, the international valuation model is roughly characterized by five steps. Figure 1.4: Five-Step-Model for International Business Valuation <?page no="41"?> 42 1 Introduction to International Business Valuation uvk-lucius.de [1] In the first step, a business analysis is conducted which serves as the basis for business planning. The aim of planning is to arrive at a strategic perspective for the future company output, based on insights from the company analysis. It can be used to develop forecasts which are reflected in the pro-forma profit and loss statement and the balance sheet. The result is an integrated pro-forma P&L and proforma balance sheet. [2] In the second step, the valuation methods for the international business valuation are chosen. Possible candidates are the valuation approaches already discussed. An important decision criterion is the question whether peculiarities of the foreign markets can be captured adequately with the help of the valuation approaches. At this point, the number of valuation models selected must also be determined. A distinction is made between the single valuation method and the multiple valuation method. The single valuation method relies exclusively on one valuation approach - the one which is most suitable for the given situation. In contrast, the multiple valuation method determines several business values on the basis of different approaches. These are either published as a range of possible business values or aggregated to form a single synthetic business value. [3] Once the valuation approaches have been determined, the third step serves to identify the relevant cash flows from the available planning figures. The relevance of the cash flows depends on the valuation approach chosen. A distinction is made among the DCF approaches for example between the operating Free Cash Flows (oFCF) and the Cash Flows to Equity (CFtE). [4] In the fourth step, the cost of capital is determined. It can be calculated in different ways depending on the valuation method. [5] In the last step, the business value is determined by discounting the cash flows which are relevant for the valuation <?page no="42"?> 1.5 Approaches in International Business Valuation 43 uvk-lucius.de using the cost of capital. Finally, the present value of the non-operating assets is determined separately and added, while liabilities are subtracted. The above outline merely focuses on the fundamental steps which are required, for example, when conducting a valuation exercise in a country such as the US. As will be shown, they do not differ from a valuation at home, except for the possibility of having to take different currencies or interest rate conditions into consideration. Additional aspects must be considered in a valuation of companies in emerging markets/ high growth markets. These markets are exposed to additional risks such as country risk, currency risk, unexpected inflation or heightened political uncertainty. The specifics of emerging markets/ high growth markets can be taken into consideration during international business valuation via risk adjustments and modifications of the cash flows or discount rates. This incorporates the fact that in some cases risks can be considerably higher in these countries. And depending on the degree of diversification of the investors, the possible existence of unsystematic risks must also be taken into consideration. We implicitly assume that during a valuation in industrialized countries such as the US, no country risks or unexpected inflation are present, and that the markets are integrated in such a way that unsystematic risks can be eliminated with the help of diversification. The topic of risk adjustment, especially with an eye on the emerging markets/ high growth markets, is taken up in chapter 4 and discussed in detail. In the following, the first two steps in the analysis will be discussed in more detail. Steps three to five, namely calculation of the cash flows, determination of the cost of capital and calculation of the ultimate business value are covered in chapter 4 of this book. 11.5.2 Business Analysis and Business Planning Every forward looking business valuation must be supported by plausible and traceable business planning. Frequently a difference is made between internal and external planning. The former uses internal data, while the latter relies on externally available infor- <?page no="43"?> 44 1 Introduction to International Business Valuation uvk-lucius.de mation. External information is all publicly available information about a company or an industry, while internal information refers to all company data that is not open to the public such as figures from accounting, controlling, production planning, order flow or distribution. A business valuation which is based on external information usually only allows planning based on value drivers. In contrast, a valuation on the basis of internal information makes it possible to employ a more precise planning, which includes a detailed assessment of prices and volumes. In an international context, the reason for the valuation determines whether internal or external data is available. Every planning process must begin with a comprehensive analysis of the company and its environment. Such an analysis puts decision makers in a position to assess strengths and weaknesses of a company and to obtain the necessary knowledge about the future potential for company success. In addition, the business analysis is frequently used to check for consistent business planning, since errors or wrong assumptions at that stage can affect the entire valuation exercise and massively change the business value. Small changes in the figures used for planning can already have a significant effect on the business value. The company analysis has both a quantitative and a qualitative aspect. The quantitative part relates to a financial analysis aimed at determining the company performance. It is based on annual reports of past years. The topic of the financial analysis is mostly the development of key figures for factors that are relevant for valuation. These reveal important information about relative valuations and can serve as a starting point for the financial forecasting needed for business planning. These quantitative insights are supplemented with qualitative findings from the analysis of the economic environment, the industry structure as well as the strengths and weaknesses of the company to be valued. This qualitative analysis needs to be conducted so that strengths, weaknesses, opportunities and threats can be identified, for example with the help of a SWOT-analysis. The following areas, among others, should be considered: <?page no="44"?> 1.5 Approaches in International Business Valuation 45 uvk-lucius.de Analysis of the political/ legal, economic, social and technological environment Analysis of the competitive environment via competitor and industry analysis Analysis of the value chain of the company Analysis of the balance sheet and key figures During the subsequent business planning it must be assured that the factors which were derived in the SWOT profile are addressed adequately. As an example, it does not make sense to assume sales growth for the company of 10%, if the industry has a growth rate of 5% at best, unless of course there are specific reasons that support such an unusual scenario. In business planning the quantitative and qualitative insights from the business analysis are initially used to develop a strategic perspective for the future company performance. In a next step, these strategic premises and guidelines are translated into forecasts for the profit and loss statement, the balance sheet and the cash flows. Since forecasts about the future success of a company are quite uncertain, planning always deals with expected values, which should incorporate both opportunities and risks to the same degree. Hidden behind the expected values is a probability distribution, which expresses the risk inherent in the planned values. “Practitioners rarely deal explicitly with probability distributions [...], but they have an interest in capturing these distributions via scenario analysis. Some practitioners then ask about the most probable scenario or the expected scenario for the value development. They are interested in the median values or the expected values of the probability distribution [...]. If the expected value development over the years, assessed on the basis of current information, is of interest, the expected values [...] provide the answer”. 5 For that reason, applied valuation work uses alternative scenarios for planning 5 Spremann, K./ Ernst, D. (2011), p. 38. <?page no="45"?> 46 1 Introduction to International Business Valuation uvk-lucius.de purposes. For the various scenarios, different environmental states with different implications for the success of the industry and the performance of the company are assumed and different financial forecasts are derived. This gives rise to differing business values based on different scenarios. In a final step, a weighted average based on the probabilities of the individual scenarios can be determined to arrive at an aggregated business value. In order to derive the variables which are relevant for the valuation of a company, be it at home or abroad, an integrated profit and loss statement and balance sheet is required. The first step is normally the planning of the profit and loss statement and the balance sheet. This information is used to derive the cash flows relevant for valuation. Frequently the annual financial statements abroad, which serve as a basis for planning, are not directly comparable to annual financial statements in the home country. “The accepted accounting principles in foreign countries frequently differ from the accepted accounting principles at home. This makes it necessary for the valuation expert to carefully assess the effects of these foreign principles on positions in the P&L or the balance sheet”. 6 At a fundamental level, an increasing international convergence is observable, for example as a result of the alignment of national accounting principles along accepted standards such as IFRS. Also problematic in this regard are the opportunities provided by accounting policies, which can also differ from the domestic ones due to specifics in foreign accounting principles. Especially earnings figures need to be adjusted for influences which can affect the assessment of the true performance of the company for which the valuation is conducted. In the following, important questions with regard to the individual planning values needed to establish a pro-forma P&L and a proforma balance sheet are formulated. 7 We will not deal with ques- 6 Starp, W.-D. (2009), p. 652. See Ernst, D./ Schneider, S./ Thielen, B. (2012), pp. 16-18. <?page no="46"?> 1.5 Approaches in International Business Valuation 47 uvk-lucius.de tions related to past performance. 8 The list of questions is not meant to be exhaustive, but should rather be seen as a starting point. Setting up a Pro-forma P&L With regard to the development of sales, the following questions must be addressed in business planning: Are the assumptions concerning future price and volume developments realistic and traceable? Does the planning horizon sufficiently consider product life cycles? Is it already foreseeable that contracts or orders are locked in and can be included in revenue planning? To what degree can competitors influence the future development of sales? To what degree can sales be influenced by future economic, political or technological developments? Is the sales planning realistic in light of existing distribution structures? Are the factors which are needed to realize the aims that are stated in sales planning, such as materials, personnel or services obtainable? With regard to the cost of materials and the services purchased, the following issues must be clarified: Which and how many factors of production are required for production, services, distribution and administration? When purchasing these factors, what issues need to be considered with regard to price, quantity and quality? 8 A comprehensive treatment of the historical analysis is found in Eayrs, W./ Ernst, D. / Prexl, S. (2011), pp. 99-137. <?page no="47"?> 48 1 Introduction to International Business Valuation uvk-lucius.de Are the factors of production subject to particularly severe price fluctuations or are long-term delivery and service agreements in place? Is the company dependent on external services? The planning of personnel expenses furthermore raises the following questions: To what degree are personnel costs and production capacity coordinated? To what degree does the organization of the company influence personnel planning? Which employees are essential for the company? What is the annual growth rate of personnel costs? Can parts of the personnel cost be considered fixed costs? What is the effect of obligations in the context of the company pension scheme? With regard to other operating expenditures and receipts, the following must be considered for example: To what degree are other operating expenditures and receipts dependent on sales? Are parts of these expenditures fixed costs? What is the reason for the other operating expenditures? Are all other operating expenditures and receipts considered? Are non-recurring and extraordinary expenditures and receipts included in planning? When planning amortization, the following needs to be critically assessed: What operating life should be assumed for fixed assets? <?page no="48"?> 1.5 Approaches in International Business Valuation 49 uvk-lucius.de At what point in time will replacement investments and expansion investments take place? What is the appropriate value for the sustainable reinvestment rate? When planning interest income and expenditure, the following questions arise: Are interest expenses and interest earnings appropriately related to the respective balance sheet positions of interest-bearing liabilities and liquid funds? Is it possible to infer future interest earnings or interest expenses from existing contracts? Are the interest expenses subject to possible future fluctuations? With regard to tax planning, the following questions are relevant among others: What is the level of cash-effective tax expenses? What is the level of the normalized company tax rate? Can losses carried forward be used or must they be considered? Are distributions from the profits subject to different tax rates? Setting up the Pro-forma Balance Sheet Balance sheet assets: Does investment planning exist? Is there a risk of future investment backlogs as a result of earlier failures to invest, which may entail repair costs, interruptions of production and future investments? Can the future development of sales be achieved with the planned inventory levels? Does this take the product range, the production process and the production factors into consideration? <?page no="49"?> 50 1 Introduction to International Business Valuation uvk-lucius.de What are the contractual regulations with regard to the terms of payment and when are the receivables due? What is known about the payment behavior of the clients and how is the payment reminders system organized? Does a minimum cash level need to be maintained? Balance sheet liabilities: Is trade credit used as a source of financing? Are there pension obligations in the company and how are they dealt with? Is the planning of pension reserves supported by expert opinions concerning future pension expenses and pension payments? When will the payments be due? Will the company face provisions for warranties because of quality problems? Will the company be confronted with quality problems or problems with preliminary order cost estimates? If yes, are these reflected in the establishment of provisions for warranties and provisions for contingent losses? Is there sufficient financing for the planned fixed assets and current assets and are the conditions in line with the market? Are possible funding shortfalls taken into consideration, which can be caused by deviations from planning? Is financing sufficient to support the realization of the individual items in the planning? Which alternative sources of financing can be accessed in addition? Is there a sufficiently strong focus on liquidity planning and are additional liquidity buffers available? <?page no="50"?> 1.5 Approaches in International Business Valuation 51 uvk-lucius.de 11.5.3 Establishing the Framework Conditions for the Valuation and Choice of One or Several Valuation Methods In the second step of the proposed model, the preferred valuation procedure must be chosen along with the framework conditions for the valuation. A choice must be made among the valuation procedures discussed above, namely single valuation method, average value method or total valuation method. When deciding how many valuation methods to use, three possibilities are available in principle: 9 Choose a single valuation method and determine a single business value Use several valuation methods and determine a number of possible values in the form of a value range Utilize several valuation methods and determine an aggregated synthetic business value Depending on the number of valuation methods used, a distinction is made between the single valuation method and the multiple valuation method. 10 Figure 1.5 provides an overview of the approaches. Figure 1.5: Single Valuation Method and Multiple Valuation Method 11 9 See Pereiro, L. E. (2002), pp. 61-67. 10 See Pereiro, L. E. (2002), pp. 62-63. Authors’ presentation; also see Pereiro, L. E. (2002), pp. 62-67. Single Valuation Method Multiple Valuation Method One Method Several Methods One Company Value Range of Company Values Synthetic Company Value <?page no="51"?> 52 1 Introduction to International Business Valuation uvk-lucius.de SSingle Valuation Method 1.5.3.1 Advocates of this method argue that only the valuation approach that is most suitable for the specific situation of the company in question should be used. They argue that a combination of several methods leads to a distortion of the valuation process and merely amounts to a numbers game. An obvious precondition is the availability and high quality of the data material needed for the approach. If, for example, the data needed for the DCF model is not available or unattainable because the company is not listed on the stock market, the model cannot be applied. If the decision is made in the valuation process to rely exclusively on one valuation model, the implementation hinges on the availability of the required data. But the choice of a single valuation method can also be advisable in some cases. When liquidating a business, for example, only the net asset value approach on the basis of liquidation values appears useful. A combination of several approaches would seem nonsensical in that case. Multiple Valuation Method 1.5.3.2 There are numerous situations when it is advisable to use several methods of business valuation. Frequently no singular approach exists that takes into consideration the complex framework conditions of a business valuation in its entirety and that can cover all aspects of the valuation problem. A single valuation method arrives at one value and thus provides only one perspective on a company, while several methods also provide several values and thus represent a more differentiated view of the company. Typical examples are the DCF methods, which have a strong focus on the specifics of the company and the multiple approaches, which derive the business value from market prices. The use of several approaches is advisable simply to check the plausibility of the results. On the other hand, it must be clear that the use of a multiple valuation method results in several different business values for the same company, which must be justified. These different business values result from variations in basic assumptions and from differences in <?page no="52"?> 1.5 Approaches in International Business Valuation 53 uvk-lucius.de the input parameters, which are possibly caused by different information asymmetries. Once a valuation expert has calculated several results, he needs to determine how he wants to report them. As already discussed above, he has two choices. He can either report a range of possible business values or he can calculate a single synthetic business value on the basis of the individual estimates. While the first method is self-explanatory, the different possibilities for calculating a synthetic business value are discussed in more detail below. 1.5.3.2.1 Implicit Weights in the Determination of the Synthetic Business Value With this method the valuation expert is free to choose a synthetic business value. 12 On the basis of several calculated business values and the insights obtained about the company during the valuation exercise, he arbitrarily assigns a business value. Frequently it remains unclear how the valuation expert arrived at the subjectively assigned business value. This lack of transparency frequently makes it very hard for outsiders to comprehend the choice of the valuation expert. For that reason this approach to determine the synthetic value is not suitable. 1.5.3.2.2 Explicit Weights in the Determination of the Synthetic Business Value In the case of explicit weights, the suitability of the various methods used is taken into consideration by the valuation expert when determining the synthetic business value. Valuation methods, and thus implicitly the corresponding business values which are most suitable for the circumstances of the valuation are given greater weight in this approach. See Pereiro, L. E. (2002), pp.63-64. <?page no="53"?> 54 1 Introduction to International Business Valuation uvk-lucius.de 11.6 Literature on International Business Valuation We would like to highlight the following influential readings on the topic of international business valuation: General Copeland, T./ Koller, T./ Murrin, J. (2000): Valuation: Measuring and Managing the Value of Companies, Third Edition, New York. Damodaran, A. (2006): Damodaran on Valuation: Security Analysis for Investment and Corporate Finance, Second Edition, Hoboken. Pereiro, L. E. (2002): Valuation of Companies in Emerging Markets: A Practical Approach, New York. Sabal, J. (2002): Financial Decisions in Emerging Markets, New York. Approaches based on CAPM Especially the papers by Damodaran are important for the CAPM-based approaches (some of them are included in the book by Damodaran listed above): Damodaran, A. (2003): Measuring Company Exposure to Country Risk: Theory and Practice, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ Country Risk.pdf, 29.01.2014. Damodaran, A. (2008): What is the Riskfree Rate? A Search for the Basic Building Block, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ riskfreerate.pdf, 29.01.2014. <?page no="54"?> 1.6 Literature on International Business Valuation 55 uvk-lucius.de Damodaran, A. (2009): Volatility Rules: Valuing Emerging Market Companies, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ emerg mkts.pdf, 29.01.2014. Damodaran, A. (2010): Equity Risk Premiums (ERP): Determinants, Estimation and Implications - The 2010 Edition, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ ERP20 10.pdf, 29.01.2014. Godfre -Espinosa Model: Godfrey, S. / Espinosa, R. (1996): A practical Approach to Calculating Costs of Equity for Investments in Emerging Markets, in: Journal of Applied Corporate Finance, Fall 1996, S. 80-89. Approaches not based on CAPM Erb-Harvey-Viskanta Model: Erb, C.B./ Harvey, C.R./ Viskanta, T.E. (1995): Country Risk and Global Equity Selection, in: The Journal of Portfolio Management, Winter 1995, S. 74-83. Estrada Model: Estrada, J. (2000): The Cost of Equity in Emerging Markets: A Downside Risk Approach, IESE Business School, Barcelona, in: http: / / faculty.virginia.edu/ wei_li/ em/ CoE_in_EMs.pdf, 29.01.2014. <?page no="55"?> 56 1 Introduction to International Business Valuation uvk-lucius.de Summary Business valuations in an international context are increasingly gaining in relevance in light of the accelerating globalization. International business valuation is defined as the determination of the value of entire companies or participations in companies with a specific focus on the peculiarities of foreign markets. Typical reasons for international business valuations are: Purchase or sale of companies or parts of companies abroad Project assessment in the context of investment decisions Expansion/ reduction/ liquidation of foreign holdings Joint ventures across borders Valuation and management of participations Squeeze-out Impairment test Purchase price allocation Tax assessment, for example in the context of relocations of functions When conducting a business valuation in foreign markets, especially in emerging markets/ high growth markets significantly more sources of risk and obstacles must be considered compared to business valuations at home or in developed capital markets. Peculiarities of international business valuation have their origins in international accounting rules and international taxation, different currencies, exchange rate <?page no="56"?> 57 uvk-lucius.de fluctuations and (hyper-)inflation, country risk, transfer risk, availability and reliability of information and financial data, meaning and interpretation of key figures derived from local market data as well as the applicability of classical valuation methods. In addition to the standard valuation approaches, specific methods are used in international business valuation such as the global CAPM, the local CAPM, the adjusted local CAPM, the (adjusted) hybrid CAPM, the Lessard- Model, the Godfrey-Espinosa-Model, the Goldman- Sachs-Model, the Damodaran-Model and the Salomon- Smith-Barney-Model as well as models that are not based on CAPM such as the Estrada-Model, the Erb- Harvey-Viskanta-Model (EHVM), the Arbitrage Pricing Theory (APT) and the simulation-based approach. International business valuation can be presented as a 5step model: It starts in the first step with a company analysis and planning. The next step determines the framework conditions for the valuation and selects one or several valuation methods. In the following step, the relevant cash flows can be calculated and the cost of capital can be determined. In the last step the business value is determined with reference to the cash flows and the cost of capital. <?page no="57"?> 58 1 Introduction to International Business Valuation Exercises [1] What is meant by international business valuation and how does it differ from a national business valuation? [2] State typical reasons for an international business valuation and explain these with reference to examples. [3] State the specific aspects of an international business valuation and explain these with reference to examples from the business press. [4] Discuss the differences between a single valuation method, mixed method and total valuation method. [5] Why is it necessary to apply unique valuation approaches in international business valuation? [6] Explain the differences between models that are based on CAPM and models that are not based on CAPM. [7] State the different models that are based on CAPM as well as the models that are not based on CAPM. [8] Explain in detail the 5-step model of international business valuation. <?page no="58"?> uvk-lucius.de 22 Initial Thoughts on International Business Valuation in Emerging Markets/ High Growth Markets Learning Outcomes Understanding and critical assessment of the problems and challenges inherent in an international valuation in emerging markets/ high growth markets. Knowledge of currency effects in an international valuation and ability to take them into consideration. Knowledge of the disadvantages of CAPM concerning cost of capital calculations in emerging markets/ high growth markets and ability to assess their relevance for applied business valuation. How does an international business valuation in an industrial country differ from that in an emerging market/ high growth market? What are the additional problems and challenges that the valuation expert faces? What should valuation experts look for when conducting business valuations in an emerging market? In this chapter we initially discuss typical problems and challenges of an international business valuation with regard to volatile markets. The focus is on problematic areas which readers will typically encounter when conducting their own international valuations in emerging markets/ high growth markets. In the following, a simple example will serve to illustrate how a business valuation can be conducted in a consistent fashion, despite the existence of different currencies - one of the problems in an international business valuation. As we still need to demonstrate, it does not matter for the resulting business value whether the valuation is conducted in the <?page no="59"?> 60 2 Initial Thoughts on International Business Valuation uvk-lucius.de local currency of the valuation object or in a reference currency such as Dollar or Euro. At the end of this chapter, the applicability of the classical CAPM for the calculation of the cost of equity in volatile markets will be analyzed and critically assessed. Can the CAPM in its basic form be easily applied to volatile markets or are adjustments required? This and other questions will be discussed. 22.1 Emerging Markets/ High Growth Markets The term emerging markets is used widely in applied work, but is rarely defined or captured more precisely. In the literature terms such as “Less Developed Countries” (LD Countries) are also used to describe emerging markets. In general, emerging markets can be defined as markets that are on their way to become developed markets with regard to size, activity level and degree of development. “Of course, the basic idea behind the term is that these countries ‘emerge’ from less-developed status and join the group of developed countries”. 13 Given the high growth dynamics in emerging markets, it must be asked whether the economic development which is targeted by many countries aims at catching up with the developed markets or whether the goal is to surpass them. For that reason, we use the term emerging markets/ high growth markets. In practice not only the terms used to describe the emerging markets are changing, but also the countries that are considered to be part of that group. Emerging markets/ high growth markets are not a homogeneous, but rather a heterogeneous group. At a basic level, three groups of emerging markets/ high growth markets can be distinguished: 14 13 Bekaert, G./ Harvey, C. R. (2002), p. 429. 14 See Errunza, V. R. (1983), pp. 51-52. <?page no="60"?> 2.1 Emerging Markets/ High Growth Markets 61 uvk-lucius.de Traditional and established markets, some of which were created already in the 19 th century, Markets with a development that can be traced to specific situations, and Young markets, which display a dynamic development thanks to the factors human capital, resources and/ or innovative power. Table 2.1 shows how emerging markets/ high growth markets can be differentiated relative to less developed countries and industrial countries. Differences to less developed countries Differences to industrialized countries High political stability Growth rates are higher than in industrialized countries Accepted legal system Privatization waves Access to the capital market for foreign investors Capital markets are not functioning efficiently High importance of the underground economy and corruption High volatility of the economic development Table 2.1: Differences of emerging markets/ high growth markets to less developed countries and industrial countries 15 15 Hofbauer, E. (2011), p. 9. <?page no="61"?> 62 2 Initial Thoughts on International Business Valuation uvk-lucius.de 22.2 Consideration of Different Currencies in International Business Valuation Up to this point, the existence of different currencies and the related currency effects was largely ignored in international business valuation. But it is frequently the case that annual financial statements or other financial data are only available in one currency, while the business valuation needs to be conducted in another currency. The translation of these values is therefore frequently unavoidable. Important is a consistent transformation in order to avoid distortions of the business value caused by the influences of the currency and inflation. The nominal business value depends on the choice of a currency. A company can be valued for example at 100 million US-Dollar or at 844 million South African Rand (ZAR) at an exchange rate (spot rate) of 8.44 ZAR/ $. And with regard to the cost of capital it also makes a difference whether 5% related to the US-Dollar are used, or 8%, related to the ZAR. When discounting the relevant cash flows, it is therefore absolutely necessary that the assumptions made for the cost of capital are identical to those made for the cash flows. Dollar cash flows are discounted with the cost of capital for the US and ZAR cash flows are discounted with the cost of capital relevant for ZAR investments. But the fundamental valuation approach remains unchanged. As before, cash flows are discounted at the respective cost of capital. Only the underlying currency must be taken into consideration. Choice of the Currency used for the Business Valuation Valuation experts can choose among two basic approaches in the case of international valuations (see Figure 2.1). They can either conduct the valuation in local currency or in a so-called “hard currency”. The local currency in this context is the frequently volatile domestic currency of the emerging market/ high growth market. The hard currency is a reference currency of a developed industrial country, for which the availability of sufficient financial data is assured. In principle it does not matter in which currency <?page no="62"?> 2.2 Consideration of Different Currencies 63 uvk-lucius.de the business valuation is conducted, as long as the underlying assumptions are consistently defined and applied. Figure 2.1: Choice of the currency in international business valuation In the next section, a simple example is used to show step by step how a valuation in local currency and in the following in a reference currency needs to be conducted in order to arrive at a consistent business value. It serves as a simple presentation of the most important features in preparation for the following Case Study, which will be conducted both in local currency and in the reference currency. 22.2.1 International Business Valuation in Local Currency of the Emerging Markets/ High Growth Markets In order to avoid distortions caused by currency translation, it is generally advisable to conduct the entire analysis and valuation initially in the local currency of the valuation object. For that purpose, the cash flows must be planned in the local currency and next the cost of capital, also expressed in local currency, must be determined. Problems arise whenever the parameters are not existent in the local currency or cannot be determined. The determination of the riskless rate of interest (and thus implicitly also the calculation of the cost of capital) expressed in local currency turns out to be rather difficult in the case where the local government does not <?page no="63"?> 64 2 Initial Thoughts on International Business Valuation uvk-lucius.de issue any bonds at all or does not issue any bonds in the home currency. In such a situation, valuation experts frequently choose the path of least resistance and determine the discount rates in US- Dollar only to apply them inappropriately to the cash flows in local currency. This inconsistency between the currency of the discount rate and the cash flows does lead to incorrect business values. Another mistake that can be observed frequently refers to the translation of local cash flows into US-Dollar, which is done incorrectly at the spot rate instead of expected future exchange rates. This implies that the current inflation expectations in the emerging markets/ high growth markets are included in the cash flows. In order to adequately consider inflationary developments it is important to use the relevant future exchange rates for currency conversion. 16 It must be stressed one more time that the assumptions concerning cash flows and discount rates need to be consistent. Otherwise faulty valuations will result. If a local valuation is requested, the discount rates need to be aligned with the currency of the cash flows and thus need to be determined on the basis of the local currency. The valuation in local currency can be broken down into several steps, depending on whether government bonds in local currency are available or not. Two cases can be distinguished. Case 1: A government bond in local currency is available SStep 1 Planning of the cash flows in local currency. The growth rate of expected inflation needs to be taken into consideration. Step 2 Determination of the cost of capital for the local market. The existence of a government bond represents the optimal case. The derivation of the discount rate follows the usual steps and involves the use of the government bond and consistent assumptions about 16 See Damodaran, A. (2008), pp. 17-18. <?page no="64"?> uvk-lucius.de the risk premium. This approach assumes that there is an active market for the government bond and therefore the stated yields are meaningful. SStep 3 Determination of the present value by discounting the cash flows with the calculated (local) discount rates. Step 4 Conversion of the present value into the reference currency at the spot rate (if needed). Case 2: A government bond in local currency is not available Step 1 Planning of the cash flows in local currency. Again, the growth rate of expected inflation needs to be taken into consideration. Step 2 Determination of the cost of capital for the local market. In this case, government bonds are either completely lacking or are only issued in a foreign currency such as Dollar. It is still possible to derive the cost of capital of the local market from the capital costs of a reference market. These capital costs of the reference market must first be determined and in a second step be converted into a discount rate for the local currency. In this conversion, the expected inflation differentials must be considered. The theoretical foundation is provided by the international Fisher effect and the theory of purchasing power parity. To determine the local cost of capital, Formula 2.1 is used: [2.1] <?page no="65"?> 66 2 Initial Thoughts on International Business Valuation uvk-lucius.de In the case where government bonds are only issued in foreign currency, no discount rate can be determined for the local currency. Thus either the method discussed above, which derives the discount rate from a reference market, must be used, or the complete valuation must be conducted in the currency of the reference market and all cash flows must be translated correctly into the reference currency. SStep 3 Determination of the present value by discounting the cash flows with the calculated discount rates. Step 4 Conversion of the present value into the reference currency at the spot rate (if needed). Applied Example 2.1 The approach is best illustrated with reference to an example. 17 The business value needs to be determined initially in local currency (ZAR) and then converted into US-Dollar. The cash flows and assumptions are provided in Table 2.2. Concerning the assumptions, the currency in brackets always states the basis for the determination of the parameters. As can be seen, only the cost of capital of the US market of 8.5% is known. It consists of the riskless rate of interest of 3.5% plus a risk premium of 5.0%. Meanwhile the cost of capital in ZAR is not known and it is assumed that no government bonds in local currency exist. The cost of capital must thus be determined from the US market in line with Case 2. Growth in the terminal value is set equal to the expected rate of inflation in the respective country. The current exchange rate (spot rate) is 8.4475 ZAR/ $. 17 Modified version of an example taken from Damodaran, A. (2008), pp. 18-22. <?page no="66"?> uvk-lucius.de Step 1: Planning of the local cash flows Table 2.2: Cash flows and assumptions made Step 2: Determination of the cost of capital in the local market The cost of capital for South Africa must be determined with the help of Formula 2.1: Table 2.3: Cost of capital in the US and South Africa <?page no="67"?> 68 2 Initial Thoughts on International Business Valuation uvk-lucius.de Step 3: Determination of the present value Now the cash flows can be discounted using the appropriate cost of capital (see Table 2.4): Table 2.4: Discounting of the cash flows and determination of the business value The cash flow in the terminal value is calculated as follows: Cash Flow Terminal Value = Cash Flow Year 6 in South Africa · (1 + Growth South Africa ) Cash Flow Terminal Value = 1,276.28 ZAR · 1.0575 = 1,349.67 ZAR The terminal value is equal to: A business value of ZAR 14,571.97 results. (2.2) <?page no="68"?> uvk-lucius.de 22.2.2 International Business Valuation in the Hard Currency of the Reference Market Since numerous emerging markets/ high growth markets do not issue any government bonds in local currency, the determination of the riskless rate of interest needed to calculate the cost of capital can be difficult. For that reason it is frequently appropriate to conduct the valuation in a reference currency such as Dollar or Euro. As explained earlier, business valuation is independent of the chosen currency. A business valuation in hard reference currency follows these steps: Step 1 Planning of the cash flows in local currency. This is done in order to prevent distortions of the cash flows due to accounting rules, tax regulations and the like. Step 2 The local cash flows are converted into the reference currency. It is important to use the respective future exchange rates and not the current spot rate. For that reason, expected future exchange rates need to be estimated for the years of the detailed planning period. It is problematic that they are available at best for the next 18 months. A way to determine expected future exchange rates is to derive them with the help of the purchasing power parity theory on the basis of expected inflation in the currency regions using Formula 2.3. Step 4: Conversion of the calculated business value into the reference currency In a last step, the business value in ZAR can be translated at the spot rate of 8.4775 ZAR/ $ or 0.11838 $/ ZAR. This leads to a Dollar amount of 1,725.00 $ (Inconsistencies are due to rounding errors). <?page no="69"?> 70 2 Initial Thoughts on International Business Valuation uvk-lucius.de These expected future exchange rates assure that the expected inflation in the cash flows is equal to the expected inflation in the cost of capital. Step 3 Now that the cash flows have been converted into the reference currency, they are discounted at the cost of capital in the reference currency and the business value is determined. Step 4 If required, the business value can finally be converted back into local currency at the spot rate. If the assumptions are applied consistently, valuation in the reference currency and valuation in local currency leads to the same business value. Applied example 2.1 - continued At this point the valuation which was started above is conducted one more time in the reference currency, namely in Dollar. The underlying cash flows and assumptions are identical (see Table 2.2). Step 1: Planning of the local cash flows See Table 2.2. ocal cash flows into the reference currency (2.3) <?page no="70"?> uvk-lucius.de Table 2.5: Expected future exchange rates for the respective years As an example, the expected exchange rate in year 2 of 9.0676 ZAR/ $ is calculated as follows: The estimated future exchange rates are used to convert the local cash flows into Dollar (see Table 2.6): Table 2.6: Discounting of the converted Dollar cash flows and determination of business value The expected future exchange rates must first be determined with reference to Formula 2.3 (see Table 2.5). <?page no="71"?> 72 2 Initial Thoughts on International Business Valuation uvk-lucius.de In this case, growth in the US is relevant for the cash flow in the terminal value (all calculations are now in Dollar). The cash flow in the terminal value is calculated as follows: Cash Flow Terminal Value = Cash Flow Year 6 in $ US ) For the calculation of the terminal value, US cost of capital and US growth must again be used: Step 3: Determination of present value Once the present value of the individual cash flows is determined by discounting at the US cost of capital, a business value of 1,725.00 $ results. The business value can once again be converted at the spot rate of 8.4475 ZAR/ $ or 0.11838 $/ ZAR and amounts to 14,571.97 ZAR. The example makes it clear that a consistent application of all assumptions leads to an identical business value, no matter whether the business valuation is conducted in ZAR or in Dollar. <?page no="72"?> uvk-lucius.de 22.3 Applicability of CAPM in Emerging Markets/ High Growth Markets In addition to the problems surrounding the currency conversion, the valuation expert must concern himself with the question of the appropriateness of the CAPM for the determination of the cost of equity in emerging markets. Among all the theoretical capital market models for the determination of the cost of equity, the Capital Asset Pricing Model (CAPM) continues to be the standard. As already specified above, the cost of equity is calculated in the CAPM by adding a company specific risk premium to the riskless rate of interest. Under the assumption of perfectly diversified portfolios, all unsystematic risk is eliminated. Meanwhile, systematic risk cannot be influenced by investors. In equilibrium, the company specific risk premium can be interpreted as compensation for that risk. The stress is on “company specific”, since it is not the general market risk premium that matters, but rather that part of the risk which is added to the market portfolio by the company. It is measured - as is known - with the help of the beta factor, which describes the behavior of the return of the company relative to the market return. The huge popularity of the CAPM in applied work cannot mask the fact that its application involves a number of problems, especially with regard to the determination of the cost of equity in less developed economies such as emerging markets/ high growth markets. The criticism of the CAPM mainly deals with the very restrictive assumptions on which the model is based, as well as the methodological approaches in the determination of the necessary parameters. In the following, this criticism will be considered in more detail and it will be analyzed whether the CAPM is suitable for the determination of the cost of equity in volatile markets. 2.3.1 Critical Assessment of CAPM A major criticism which is frequently levied against the CAPM is its focus on the past. It attempts to determine expected future <?page no="73"?> 74 2 Initial Thoughts on International Business Valuation uvk-lucius.de returns with the help of historical data. It is implicitly assumed that the systematic risk of a company will remain constant in the future or only change insignificantly. But this assumption seems more than questionable when considered against the backdrop of rapid market growth and the dynamic development of the company sector in many countries. 18 An additional critical issue is the insufficient consideration of unsystematic risk. As already discussed, the model assumes that only systematic risk matters for the determination of the cost of equity and that all unsystematic risk is eliminated by investors with the help of diversification. But some empirical studies have revealed that even in highly efficient capital markets, such as the US for example, equity returns are affected by unsystematic factors such as market capitalization, book value of the equity capital and price-earnings-ratio. 19 In addition, it is very difficult or even impossible to obtain perfect diversification in markets characterized by few takeovers and only a small number of buyers and sellers. But these are the conditions found in many emerging markets/ high growth markets. Less than perfect diversification implies an increase of unsystematic risk, and the CAPM is not constructed to accommodate this feature. But even if sufficient alternatives for diversification are available, it cannot be assumed that investors command sufficient resources to invest simultaneously in different assets in a way that assures perfect diversification. Additional studies also demonstrate that company specific risk can have a significant effect on the business value, especially for companies that are not listed at an exchange. One example is the much lower liquidity of these companies. In the case of a planned sale, the search for a buyer usually takes much longer than on the stock exchange and is associated with significantly higher transaction costs. This fact is even more relevant in emerging markets/ high growth markets, See Harvey, C. R. (2000), pp. 1-3. See Pereiro, L. E. (2002), pp. 103-104. <?page no="74"?> uvk-lucius.de where usually a smaller fraction of companies is traded on the stock exchange. 20 The fact that risk is defined by the CAPM as correlation between a market return and a company return is also frequently criticized. Numerous studies have demonstrated that this does not correspond to the actual risk perception of investors. According to this line of research, investors base their investment decisions not so much on variance of returns, but rather on the magnitude and probability of loss. Both are not represented in the classical CAPM. 21 The higher uncertainty with regard to returns and earnings makes investments in emerging markets/ high growth markets frequently appear riskier than those in developed industrial countries. Thus if the CAPM is used, this specific risk, also called country risk, must somehow be quantified. A major problem in the application of the CAPM is the assumption of perfect capital markets. It is frequently assumed that markets are completely integrated, which is mostly not correct for less developed countries. These countries are often characterized by a major degree of market segmentation. Compared to developed industrial countries, the emerging markets/ high growth markets tend to have rather small equity markets, which only consist of a small number of listed companies and mostly only have a low market capitalization. As a consequence, the liquidity in this market is lower and the number of market participants is smaller. Equity markets, measured by their share in gross domestic product only play a minor role for the overall economy in emerging markets/ high growth markets (to date). Frequently the concentration among a few major titles is fairly large, which can give rise to speculative price manipulations by individual investors. This in turn See Pereiro, L. E. (2002), pp. 105-107. See Miller, K. D./ Leiblein, M. J. (1996), pp. 92-93. <?page no="75"?> 76 2 Initial Thoughts on International Business Valuation uvk-lucius.de makes diversification ultimately more difficult and greatly limits overall market efficiency. 22 Efficient capital markets also assume high informational efficiency, which is frequently only poorly developed or non-existent in emerging markets/ high growth markets. Reasons for this are, for example, the lack of transparency in accounting standards, unsatisfactory publication requirements, as well as reporting systems in these countries which lack sufficient detail. All this favors information asymmetries and thus makes it more difficult to compare companies. Information tends to be concentrated in the hands of a few investors and for that reason is slow to reach the market place. Inflation, exchange rate volatility, the risk of expropriation, changing political and legal framework conditions, restrictions on capital mobility as well as corruption contribute to the lack of market transparency and furthermore make it significantly more difficult to obtain reliable information. It also appears problematic that equity markets are frequently characterized by high volatility, which makes a meaningful interpretation of average returns more difficult. In this context it should also be pointed out that the availability of statistically meaningful price and return data is frequently very limited. One reason is the still very young age of some equity markets which implies a relatively short history. It is also possible that the data is not very meaningful because of price manipulations or government interventions. 23 In the context of valuations of companies that are not listed on an exchange it is also problematic in emerging markets/ high growth markets that the small number of companies with a stock market listing severely limits the availability of comparable companies. These are needed, for example, to derive beta factors. 24 Also problematic is the composition and approximation of the market portfolio as a part of the CAPM with the help of local See Pereiro, L. E. (2002), p. 105. 23 See Pereiro, L. E. (2002), p. 106; Sabal, J. (2002), p. 6. See Pereiro, L. E. (2002), p. 106. <?page no="76"?> uvk-lucius.de indexes. As it turns out, local securities indexes in emerging markets/ high growth markets are frequently poor representatives of the local markets. This in turn is due to the lack of liquidity, the small number of listed companies and the concentration among a few major companies. Individual securities, which do not necessarily represent the development of the overall market, can frequently have a significant influence on the index development. In addition to conceptual problems, there are also empirical doubts about the applicability of the CAPM in emerging markets/ high growth markets. One of the reasons given is the unreliability of the beta factor in emerging markets. HARVEY and ES- TRADA show in studies that the calculated beta factors frequently do not correlate with the returns of the world market, which is also due to the high volatility of equities in emerging markets. A beta factor that is too low has the consequence that the systematic risk is set too low, which ultimately results in a cost of equity that is too low. 25 However, the increasing liberalization of the equity markets in the emerging markets/ high growth markets is likely to lead to an increased correlation between local equity markets and the world market. This is also in line with studies by BEKAERT & HARVEY and BEKAERT, HARVEY & LUMSDAIN, which claim that many emerging economies have liberalized their capital markets and will continue to do so. This implies an increasing correlation with the world market and means that it is now easier to justify the CAPM than it was ten years ago. Also the theoretical foundations of the CAPM have been solidified. 22.3.2 Can the CAPM be used in Emerging Markets/ High Growth Markets? The application of the CAPM in emerging markets/ high growth markets continues to be a controversial topic. The criticism directed at the CAPM which was discussed in the previous section See Harvey, C. R. (2001), pp. 3-4. <?page no="77"?> 78 2 Initial Thoughts on International Business Valuation uvk-lucius.de makes it clear that the CAPM in its simplest form is not suitable for valuations in emerging markets. But it remains open whether adjustments to the CAPM are possible, which avoid the problems discussed. Despite the ongoing discussion about its assumptions, some of which are not very realistic, the CAPM continues to be the standard model for business valuation and is still widely used by a majority of practitioners for international business valuations. Three arguments are mainly responsible for this: First of all, the popularity of the CAPM is certainly rooted in the fact that it is a very logical model which is simple to use. Compared to other models, this leads to cost advantages and time saved. Furthermore, a number of providers of financial information are now offering standardized market data. This makes it much easier to obtain the necessary information, even though the data frequently has a “black-box character”, meaning that it is not always easy to track how it was calculated. Compared to models that are not based on the CAPM, the effort can still be massively reduced, since these models require input that cannot be easily obtained from data providers and must be collected and calculated individually. Second, the CAPM is used internationally and has become the generally accepted standard of comparison. Valuation experts who simply ignore the model will be at a significant disadvantage during purchase or sales transactions. It is very likely that competitors work with the CAPM and thus have a strategic advantage. Finally it must be pointed out that a number of modifications of the CAPM have been proposed, which attempt to eliminate the stated weaknesses, especially as they relate to the valuation of companies in emerging markets/ high growth markets. Proponents of the adjusted CAPM claim that it is possible to calculate the cost of equity also in emerging markets/ high growth markets. The following variants of the CAPM were suggested: the global CAPM the local and the adjusted local CAPM <?page no="78"?> the hybrid (adjusted) CAPM the Lessard-Model the Godfrey-Espinosa-Model the Goldman-Sachs-Model the Damodaran-Model the Salomon-Smith-Barney-Model Whether these models can be taken seriously as alternatives to the CAPM, especially in emerging markets/ high growth markets, will be discussed in detail and with reference to a Case Study in the context of an adjustment of the capital costs during an international valuation in emerging markets. At this point it is sufficient to list the various approaches. Before the different variants of the CAPM can be discussed in more detail, the following chapter takes a closer look at some of the input parameters of the CAPM and specifically analyzes their determination in the presence of volatile markets. <?page no="79"?> 80 2 Initial Thoughts on International Business Valuation uvk-lucius.de Summary Compared to business valuations in developed industrial countries, international valuations in volatile markets are frequently characterized by additional problems. Almost always additional risk factors must be included in the valuation. Examples are differences in accounting regulations and taxation, different currencies, country risks, availability and reliability of information and financial data, the meaning and interpretation of key figures derived from local market data as well as the general applicability of classical valuation models such as the CAPM. It is frequently the case that annual financial statements or other financial data are only available in one currency and need to be converted into another currency for the purpose of valuation. In order to avoid distortions, a consistent currency translation must be assured. It is important that the various components in business valuation (cost of capital and cash flows) refer to the same currency. At a fundamental level, a business valuation can either be conducted in local currency or in the hard currency of a reference market. Using consistent assumptions, both procedures arrive at an identical business value. The business valuation in local currency basically follows these steps: 1. Planning of the cash flows in local currency 2. Determination of the cost of capital in the local market 3. Determination of the present value 4. Conversion of the business value determined into the reference currency The business valuation in a reference currency basically follows these steps: <?page no="80"?> uvk-lucius.de 1. Planning of the cash flows in local currency 2. Determination of the future exchange rates and conversion of the local cash flows into the reference currency 3. Calculation of the business value 4. (Optional: ) Conversion of the business value into the local currency Among the theoretical capital market models for the determination of the cost of equity, the Capital Asset Pricing Model (CAPM) continues to be the standard model. The huge popularity of the CAPM in applied work cannot mask the fact that its application raises a number of issues, especially with regard to the determination of the cost of equity in emerging markets/ high growth markets. Criticism of the CAPM is directed mainly at the very restrictive underlying assumptions as well as the methodological approaches in determining necessary parameters. Criticized among other features are the focus on past data, the missing incorporation of possibly relevant unsystematic risks, the definition of risk as correlation between market return and company return, the assumption of a perfect capital market and high informational efficiency, the lack of available comparable companies and suitable local indexes, as well as general doubts about the empirical validity of the CAPM. Despite the ongoing discussion about the assumptions of the CAPM, which are in some cases far from reality, it continues to be a standard model for the valuation of companies and is used by the majority of practitioners at home and abroad. This is certainly due to the easy implementation of the model and the widespread international use (the CAPM is considered to be the main “benchmark for comparison”). This criticism of the <?page no="81"?> 82 2 Initial Thoughts on International Business Valuation CAPM was taken up and different versions of the model were developed, which attempt to eliminate the stated shortcomings with respect to business valuation in emerging markets/ high growth markets. <?page no="82"?> uvk-lucius.de Exercises [1] What are the differences between international business valuations in volatile markets and valuations of companies in developed industrial nations? [2] State risk factors that are present in international business valuations in volatile markets. [3] How do emerging markets/ high growth markets differ from less developed countries and industrialized countries? [4] Explain the possibilities of incorporating different currencies when conducting an international business valuation. [5] Comprehensively discuss the international business valuation in the local currency of the emerging market/ high growth market. [6] Comprehensively discuss the international business valuation in hard currency of the reference market. [7] What are the capital costs in the US and in South Africa? The following values are given: Risk Premium: 5.0% Riskless Rate of Interest (US): 3.0% Inflation (US): 2.4% Inflation (ZA): 5.5% Spot Rate: 8.5 ZAR/ $ [8] What is the level of the exchange rate ZAR/ $ and $/ ZAR in the years (1) to (6)? The following values are given: Inflation (US): 2.4% Inflation (ZA): 5.5% Spot rate: 8.5 ZAR/ $ <?page no="83"?> 84 2 Initial Thoughts on International Business Valuation uvk-lucius.de [9] What is the total value in ZAR and in $? The following values are given in the context of an international business valuation in local currency: Cash Flow in Year (1) in ZAR: 1,000.00 Cash Flow in Year (2) in ZAR: 1,050.00 Cash Flow in Year (3) in ZAR: 1,102.50 Cash Flow in Year (4) in ZAR: 1,157.63 Cash Flow in Year (5) in ZAR: 1,215.51 Cash Flow in Year (6) in ZAR: 1,276.28 Cash Flow in Year (TV) in ZAR: 1,333.71 Growth rate for the Terminal Value (ZA): 5.50% Cost of Capital (ZA): 11.78% Exchange Rate in Year 0: 0.11838 $/ ZAR Use the future exchange rates determined in Problem 8. [10] What is the total value in ZAR and in $? The following values are given in the context of an international business valuation in hard currency of the reference market: Cash Flow in Year (1) in ZAR: 1,000.00 Cash Flow in Year (2) in ZAR: 1,050.00 Cash Flow in Year (3) in ZAR: 1,102.50 Cash Flow in Year (4) in ZAR: 1,157.63 Cash Flow in Year (5) in ZAR: 1,215.51 Cash Flow in Year (6) in ZAR: 1,276.28 Cash Flow in Year (TV) in ZAR: 1,333.71 Exchange Rate in Year (0): 8.500 ZAR/ $ 0.11765 $/ ZAR Expected Exchange Rate in Year (1): 8.757 ZAR/ $ 0.11419 $/ ZAR <?page no="84"?> Expected Exchange Rate in Year (2): 9.022 ZAR/ $ 0.11083 $/ ZAR Expected Exchange Rate in Year (3): 9.296 ZAR/ $ 0.10758 $/ ZAR Expected Exchange Rate in Year (4): 9.577 ZAR/ $ 0.10442 $/ ZAR Expected Exchange Rate in Year (5): 9.867 ZAR/ $ 0.10135 $/ ZAR Expected Exchange Rate in Year (6): 10.166 ZAR/ $ 0.09837 $/ ZAR Growth rate for the Terminal Value ($): 2.40% Cost of Capital (US): 8.00% [11] Explain the criticism directed against the CAPM. [12] Can the CAPM be used for business valuations in emerging markets/ high growth markets? <?page no="86"?> uvk-lucius.de 33 A Closer Look at Important Model Parameters in International Business Valuation with the CAPM Learning Outcomes Ability to state the problems that arise when determining the market risk premium in the context of volatile markets. Mastery of different approaches to determine the market risk premium in the context of volatile markets. Understanding of the necessity for a country risk premium in international business valuation in emerging markets/ high growth markets. Understanding of the approaches for the determination of the country risk premium and ability to apply these approaches. Ability to determine beta factors in emerging economies, even if the general approach is not available. The determination of important input parameters needed to calculate the cost of capital with reference to the CAPM is not always an easy task, even in developed industrialized countries. With regard to emerging markets/ high growth markets, additional problems can arise, which tend to increase the level of difficulty even further. As we will show, additional country risks and the related country risk premium need to be considered when estimating the market risk premium. The calculation of the needed beta factors entails further difficulties in light of frequently illiquid financial markets and the lack of data availability for companies that are not publicly listed. <?page no="87"?> 88 3 A closer look at important model parameters uvk-lucius.de Before the different versions of the CAPM can be discussed in the following chapter, it needs to be shown how the necessary input parameters can be determined. This is done with a particular focus on emerging markets/ high growth markets and the typical local realities. Initially, the term market risk premium is reviewed briefly and the determination in the context of emerging markets/ high growth markets is discussed. Next, the necessity of a country risk premium is analyzed. Should a country risk premium be considered and if yes, how can it be determined? Is every company exposed to country risk to the same extent or are there variations from company to company? This and related questions will be answered. Finally it will be shown how to determine beta factors in case the valuation object is not publicly listed and thus no time series on returns needed for the regression are available. How is it still possible to determine a “meaningful” beta? Techniques and approaches will be presented. 33.1 The Market Risk Premium - Definition, Influencing Factors and Determination 3.1.1 What is the Market Risk Premium? The market risk premium is among the most important input parameters of the CAPM. It is frequently interpreted as the market price of systematic risk. It expresses the amount of risk expected in a market as well as the price paid for that risk. The magnitude of the market risk premium has a major influence on the required rate of return of an individual investment. If the risk premium goes up, investors demand a higher price for risk and ultimately are willing to pay less for identical cash flows/ investments. In other words, the market risk premium can also be interpreted as a monetary incentive which is necessary to entice an investor to invest in a risky asset instead of a riskless security. The market risk premium depends on two major factors: The risk aversion of the investors and <?page no="88"?> 3.1 The Market Risk Premium 89 uvk-lucius.de The riskiness of a typical investment in the market under review. Risk-averse investors will always ask for a higher risk premium than risk-neutral investors, for example. If the expected riskiness of a typical market investment goes up, the risk premium will witness a corresponding increase as well. 26 There is broad agreement about the concept of a risk premium, but opinions differ concerning the determination and measurement of that premium. 33.1.2 Determination of the Market Risk Premium The determination of the market risk premium is among the most controversial issues in measuring the cost of capital. According to DAMODARAN, three approaches can be distinguished: 27 Determination of the market risk premium via surveys of capital providers about their demands concerning the risk premium, via estimates derived with the help of historical data on the market risk premium or via derivation from current market data and determination of an implicit market risk premium, similar to the approaches taken in option price theory to assess volatility. Determination via Surveys of Capital Providers 3.1.2.1 A straightforward approach, which nonetheless requires considerable effort, is to ask investors about the risk premium which they demand or expect in the future. Since the market risk premium is an average of the risk premiums of many investors, a survey of these investors should provide a valid answer. To keep the ap- 26 See Damodaran, A. (2006), pp. 36-37. See Damodaran, A. (2006), p. 38. <?page no="89"?> 90 3 A closer look at important model parameters uvk-lucius.de proach manageable, the surveys in practice focus on major investors such as portfolio managers, investment funds and similar institutions. 28 A disadvantage of this method comes from the fact that surveys like this are frequently influenced by current market sentiment and for that reason are subject to strong fluctuations over time. Furthermore, risk premiums obtained in such a way tend to have a short-term character, since the surveys are conducted only over short periods of time and not over several years. DDetermination via Estimates based on Historical 3.1.2.2 Data Another possibility for obtaining the market risk premium is the derivation from historical data. This is the most frequently used approach for the determination of the market risk premium and involves subtracting the long-term average government bond yield from the long-term average return of the equity market. In most cases an index is used for the equity returns. The calculated difference is equal to the historical market risk premium. While historical data most likely can be considered to be the best basis for the estimation of a future market risk premium, it still seems problematic that the premiums derived in that manner can deviate significantly in practice. Valuation experts frequently calculate different market risk premiums, even though the data basis is almost identical. Reasons for this can mostly be found in the assumptions used and the methodological implementation. It does make a difference, for example, which index or which asset is used for the determination of the risky return. And the length of the time series as well as the calculation of arithmetic or geometric average returns are ultimately decisive for the magnitude of the market risk premium. In light of the many choices that need to be made, it cannot come as a surprise that valuation experts can arrive at a different market risk premium even though the underlying See Damodaran, A. (2006), p. 38. <?page no="90"?> 3.1 The Market Risk Premium 91 uvk-lucius.de dataset is identical. In the following, the factors that can influence the results will be analyzed in detail. 3.1.2.2.1 Which Index Should be Used? A frequently discussed issue relates to the choice of the appropriate index for the determination of the average equity returns. Depending on the context of the valuation, several indexes tend to be available. As an example, for the determination of a global risk premium which is needed for the global CAPM, the S&P 500 or the MSCI World can be used. For local risk premiums, different local indexes can be used. Ultimately there cannot be an unambiguously correct choice, so the valuation expert must decide which index is most representative of the market portfolio for a given valuation object. 29 3.1.2.2.2 Which Time Horizon Should be Used? Are Longer or Shorter Time Series Preferable? Also hotly debated is the issue of the appropriate time horizon. Unfortunately the market risk premium appears to vary greatly depending on the time horizon chosen and for that reason the issue cannot be neglected. While one school of thought favors a time series that is as long as possible, other valuation experts only draw on recent data. Longer time series have the advantage that economic crises or recessions are not too important and cannot “distort” the risk premium. It is a disadvantage that current developments are only of relatively minor importance and structural changes are not taken into consideration. The question about the optimal length of the times series is thus always a tradeoff between the attempt to include as much information as possible in order to smooth out possible outliers caused by crises or recessions and the desire to base the estimate on cur- 29 See Pereiro, L. E. (2002), p. 120. <?page no="91"?> 92 3 A closer look at important model parameters uvk-lucius.de rent information in order to account for the latest structural changes and trends. 30 3.1.2.2.3 Which Asset Should be Used to Determine the Riskless Return? A related problem is posed by the choice of the adequate proxy for the riskless rate of interest. Is it preferable to use government bonds with a short or a long duration? If, for example, the yield curve is upward sloping (R f goes up as the time to maturity increases), the estimated market risk premium (R M -R f ) will be greater if short-term bonds are used as a proxy for the riskless rate. A lower riskless rate is subtracted from the market return. The choice of asset to determine the riskless return frequently leaves open several possibilities. Ultimately it is up to the valuation expert to make a choice. In applied work it is typical to use longer-term bonds. 31 3.1.2.2.4 Should Arithmetic or Geometric Means be Used? There is also disagreement concerning the issue of arithmetic or geometric averages for the return calculations. While the arithmetic mean is a simple average, the geometric mean incorporates the effect of compounding. Some observers argue that CAPM is an additive model and therefore the use of arithmetic means is justified, while other claim that geometric means are better estimators for future returns. 32 Again it is the responsibility of the valuation expert to make a choice among the competing methodologies. See Pereiro, L. E. (2002), p. 119. 31 See Damodaran, A. (2002a), p. 39. See Pereiro, L. E. (2002), p. 119. <?page no="92"?> 3.1 The Market Risk Premium 93 uvk-lucius.de DDetermination via Implicit Risk Premia that are 3.1.2.3 Observable in the Market Finally, the market risk premium can also be determined with the help of returns that are currently observable in the market. The market risk premium which is determined in that fashion is also called implied market risk premium. This market based approach does not suffer from the disadvantage of being based on historical data. An important precondtion for this approach is that the prices on the stock market truly reflect the fundamentals of the stock, this means the stocks are correctly priced. As long as this holds, the market risk premium can be determined with the help of the following formulas according to DAMODARAN (see Formula 3.1 and Formula 3.2). 33 A major advantage of such an implied market risk premium is its determination in the current equity market, which does not require any historical data. Fundamentally this is a dividend model, which determines the present value of the dividends under the assumption of a constant growth rate. All parameters of the model, with the exception of the expected market return can be determined quite easily. Solving Formula 3.1 for the expected return and providing the estimated parameters as inputs, an implied market return is obtained. Once the riskless rate of interest is subtracted from the implied market return, the market risk premium is obtained (see Formula 3.2). Market Risk P - Riskless Rate of Interest (3.2) The approach is demonstrated in the following example. 34 See Damodaran, A. (2006), pp. 45-46. The example is a modified version of Damodaran, A. (2006), pp. 45-46. (3.1) <?page no="93"?> 94 3 A closer look at important model parameters uvk-lucius.de Applied Example 3.1 S&P index level = 1,000 Expected dividend yield of the index in the next period = 5% Expected future dividend growth = 4% Riskless rate of interest = 2% - Riskless rate of interest - 3.1.3 Thoughts on the Risk Premium in Emerging Markets/ High Growth Markets The issue is complicated further if a market risk premium needs to be determined specifically for emerging markets/ high growth markets. Frequently no data history is available or the available data is not very meaningful, because of the high volatility in these markets. In order to determine a risk premium for these markets, it is frequently necessary to start with the risk premium of a developed market and add a country risk premium (See Formula 3.3). (3.3) <?page no="94"?> uvk-lucius.de Country risk premium (3.3) Since the determination of the country risk premium is not always easy, it is discussed in depth in the following section. 33.2 Country Risk - An Additional Risk Factor in Emerging Markets/ High Growth Markets According to DAMODARAN the following fundamental questions concerning country risk must be answered in applied valuation exercises: 35 Should a country risk premium even be included? If yes, how should it be estimated and quantified? Once a country risk premium has been determined, what is the relationship between the premium and individual companies? In other words, is every company in an emerging market/ high growth market exposed to this country risk to the same degree? These questions need to be answered in the following and discussed in the context of DCF-models and the CAPM. 3.2.1 The Need for a Country Risk Premium The increasing globalization leads to a heightened demand for business valuations in volatile markets. Especially the determination of the company-specific risk premium as an important component of the cost of equity turns out to be difficult. Should investors The approaches and views which are presented in the following are based on the work of Damodaran, in which he deals extensively with the issue of country risk: Damodaran, A. (2003), pp. 2-3; Damodaran, A. (2010), pp. 36-37; Damodaran, A. (2006), pp. 41-42. 3.2 Country Risk - An Additional Risk Factor 95 <?page no="95"?> 96 3 A closer look at important model parameters uvk-lucius.de demand a higher risk premium for an investment in South Africa compared to a comparable activity in Germany or the US? Is a utility company in South Africa exposed to more risks than a comparable company in Germany? Many observers would intuitively answer “Yes” to such a question and cite the geographical location of a company as an additional source of risk. Advantages of such an investment, for example attractive growth rates, a high return potential and additional opportunities to further diversify the portfolio, are always tainted by the increased risk, which investors must assume. Typical sources of risk in this context are political or economic unrest, wars, import restrictions, exchange rate fluctuations or similar. Thus it appears logical that investors ask for an increased premium - the so-called country risk premium - before investing in riskier countries. While this approach appears sensible, a number of counterarguments can be found as well: 36 Country risk could be diversifiable, in which case it should be ignored. The CAPM could be adjusted in a global context, in which case the country risk would be captured implicitly by the relevant company beta. C Country Risk could be Diversified Away 3.2.1.1 First it must be determined whether country risk can even be considered a systematic risk. As we already discussed, only systematic risk is reason for compensation in the theoretical capital market models such as the CAPM. It is assumed that unsystematic risk is eliminated by the investors. The key issue relates to this distinction: Is country risk unsystematic and thus diversifiable or systematic and thus deserving of a premium. In order to assess whether country risk can be eliminated with the help of diversification, DAMODARAN suggests a focus on the socalled marginal investor. The term marginal investor includes 36 See Damodaran, A. (2010), pp. 36-40. <?page no="96"?> uvk-lucius.de those investors that are most likely to trade the shares. If the marginal investor is a global investor at the same time, meaning that his portfolio has a global focus and is diversified across countries, country risk should be eliminated and thus not play a role. The ability to diversify country risk thus also follows from the degree of market segmentation or market integration. A market is called segmented if it displays significant barriers for international capital flows. The absence of those barriers leads to an integrated market. In segmented markets, the marginal investor will usually only be diversified within the market. In integrated and open markets in contrast, he will invest across countries. Whether he actually does that is a different question, but at least he has the opportunity to act in that way. Among the factors that determine the degree of capital market integration or segmentation are the volume of capital controls (restrictions of foreign capital and participations, taxes and regulations), the degree of information transparency (access to market information and its timeliness), the existence of transparent accounting principles, the predominance of institutional structures aimed at protecting investors and the degree of country-specific risks such as political risk, macroeconomic stability or liquidity risk. 37 The degree of market segmentation can be measured empirically with the help of correlations between returns of local and international assets. The strength of the correlation is an indicator for the degree of integration. Usually the relevant local indexes are employed as representatives for local assets and the correlation with a global market portfolio such as the Morgan Stanley Company Index World (MSCI World) is determined. A high correlation coefficient represents a high degree of integration and a low degree of correlation indicates little integration. Table 3.1 shows a number of correlation coefficients between the local equity market and the MSCI World. See Sercu, P./ Uppal, R. (1995), p. 583. 3.2 Country Risk - An Additional Risk Factor 9 <?page no="97"?> 98 3 A closer look at important model parameters uvk-lucius.de Table 3.1: Correlation between different markets 38 Table 3.2 shows the correlation coefficients between the MSCI South Africa, JSE Top 40, JSE All-Share, JSE Mid Capitalisation Indices and the MSCI World. Table 3.2: Correlation between MSCI World and different markets in South Africa 39 The results of this type of regression tend to suffer from severe methodological problems. Since the local equity markets in a number of emerging markets/ high growth markets are likely to be illiquid, tend to have only a short data history and local indexes that are often dominated by a few stocks which are not necessarily typical for the market, the findings must be questioned critically in applied work. Authors’ calculations based on index values for the years 1999-2009 (Source: Bloomberg and MSCI Barra). Authors’ calculations based on index values for the year 2012 (Reuters). <?page no="98"?> uvk-lucius.de In addition to the question of global diversification of the marginal investor, a second condition must be fulfilled before country risk can be diversified. It needs to be assured that the country risk is in fact country-specific, in other words that the correlation among the markets is low. Only in the case of low correlations is it possible to eliminate country risk from a globally diversified portfolio. If instead markets are characterized by a strong positive correlation, country risk has a systematic component and cannot be diversified. As a consequence, a premium is justified. Studies from the seventies and eighties show that the correlation among countries was indeed low, which supports global diversification and does not justify the existence of an explicit country risk premium. 40 Against the backdrop of increasing globalization, however, the past years have witnessed an increase in correlations across countries. As the financial crisis in 2008 made clear, markets are strongly interlinked and problems are transmitted from one market to the next. For the future it can be concluded that the increasing globalization implies that country risk will increasingly have to be interpreted as systematic risk and thus as general market risk. 41 PPossible Adjustments of the CAPM in a Global 3.2.1.2 Context An additional argument against a country risk premium is related to the observation that the CAPM can be adjusted with relative ease to a global market. If the same global market risk premium is used for all assets worldwide, country risk - according to this line of argument - would ultimately be reflected by the magnitude of the beta factor in the company-specific risk. Consequently a utility in South Africa would end up with a higher beta and thus with higher cost of equity capital compared to a similar company in Germany. What is subject to criticism in this approach is the ability of the beta to adequately capture country risk. At least theoretically it appears logical that in a regression against a global index, the See Damodaran, A. (2010), p. 37. See Damodaran, A. (2010), pp. 38-39. 3.2 Country Risk - An Additional Risk Factor 9 <?page no="99"?> 100 3 A closer look at important model parameters uvk-lucius.de country risk is implicitly included in the size of the beta factor. But according to a study by DAMODARAN it can be shown that companies in developed markets frequently have higher betas than companies in emerging markets/ high growth markets. The reason is the frequently applied market weighting of global indexes. The higher betas in developed countries would imply a correspondingly higher cost of equity, which appears nonsensical in this context. 33.2.2 How is the Country Risk Premium Calculated or Estimated? Once it is accepted that country risk is systematic and thus cannot be diversified, the next question relates to the methods needed to adequately determine or estimate country risk. The basic equation for the determination of the general risk premium is provided by Formula 3.4: Country risk premium (3.4) Risk premium of the developed market: The risk premium of the developed market can be estimated on the basis of the historically observed risk premium. For the US, for example, it is obtained by taking the geometric or arithmetic mean of the spreads between equity returns and bond returns over the past 80 years. It is assumed implicitly that the US market is a developed market, for which a sufficient amount of data is available. Country risk premium: The following approaches are available for the calculation of the country risk premium: 42 From the default spreads or the so-called “sovereign yield spreads” of publicly available bonds. From country ratings or corporate bonds. 42 The approach follows Damodaran, A. (2010), pp. 46-48. <?page no="100"?> uvk-lucius.de From the relative standard deviations of the equity markets. From a combination of default spreads and relative standard deviation of equity and bond markets. C Calculation from Default Spreads 3.2.2.1 The simplest and at the same time most popular method for the calculation of the country risk premium is the determination of the so-called default spread. The first input needed is a government bond from a developed industrialized country, which is assumed to have virtually no default risk. These could be bonds from the US or Germany. The return of this government bond is equivalent to the riskless rate of interest. The second input needed is a bond issued by the local government of the emerging market/ high growth market. The default spread is calculated as the difference between the average yields (geometric or arithmetic) of the two securities. Instead of average yields it is also possible to use the yields which are currently observable on the financial markets. However, this approach entails the risk that the current economic situation influences the calculation. The formation of averages avoids or alleviates this problem. Since the calculation only involves government bonds, the default spread is also called sovereign yield spread. When selecting the bond in the local market, it needs to be assured that its terms (for example with regard to maturity) resemble the terms of the government bond from the developed country as closely as possible and do not contain any additional features. It is also important to assure that both bonds are issued in the same currency, since returns in various currencies tend to differ. It does make a big difference whether a return of 5% is obtained in US- Dollar or a return of 9% is available in ZAR. The calculation of the country risk premium needs to take into consideration whether a business valuation is conducted in local currency or in a hard reference currency. 3.2 Country Risk - An Additional Risk Factor 101 <?page no="101"?> 102 3 A closer look at important model parameters uvk-lucius.de Applied Example 3.2 Geometric average yield of a 10-year US $ Treasury Bond = 1.77% Geometric average yield of a 10-year South African government bond in US $ = 7.09% Country risk premium in US $ for South Africa = 7.09% - 1.77% = 5.32% D Determination of the Country Risk Premium from 3.2.2.2 the Country Rating or on the Basis of Corporate Bonds The determination of the country risk premium as presented so far is only possible if the country which needs to be analyzed issues government bonds in a currency where the riskless rate of interest can be determined easily such as US $ or Euro. Problems arise whenever the local government does not issue any bonds at all or only issues bonds in local currency. Unfortunately, this is frequently the case in emerging markets/ high growth markets. Country Ratings A possible solution in such cases is provided by country ratings, which are issued for example by rating agencies such as Moody’s or Standard & Poor’s. Table 3.3 provides country ratings for a few countries published by DAMODARAN. Under the assumption that countries with the same rating should also share the same country risk, government bonds from a country with identical ratings can be used to determine the country risk. As an example, if the Bahamas does not issue any government bonds in US $, it is also possible to use a South African government bond in US $, since both countries share a rating of Baa1 (see Table 3.3 and 4.7). In that way, country ratings offer an easy solution for the determination of country risk. 43 43 See Damodaran, A. (2010), pp. 48-50. <?page no="102"?> uvk-lucius.de Table 3.3: Country ratings (as of January 2013) 44 But the disadvantages of using country ratings must also be addressed. Rating agencies frequently lag behind current market developments or are too slow in their reactions to possible changes in default risk. This became rather apparent during the financial crisis of 2008. Taken from Moody’s, http: / / v3.moodys.com/ Pages/ default.aspx. 10 Albania B1 Argentina B3 Armenia Ba2 Australia Aaa Austria Aaa Azerbaijan Baa3 Bahamas Baa1 Bahrain Baa1 Barbados Baa3 Belarus B3 Belgium Aa3 Belize Caa3 Bermuda Aa2 Bolivia Ba3 Bosnia and Herzegovina B3 Botswana A2 Brazil Baa2 Bulgaria Baa2 Cambodia B2 Canada Aaa Cayman Islands Aa3 Chile Aa3 China Aa3 Colombia Baa3 Costa Rica Ba1 Croatia Baa3 Cuba CAA1 <?page no="103"?> 104 3 A closer look at important model parameters uvk-lucius.de It is an additional disadvantage that rating agencies only consider default risk. Other risks, which can also have an influence on equity markets, are not taken into consideration. One example is the increase in the price of oil or other commodities, which can have a positive effect on the producers of commodities, but is disadvantageous for those countries that depend on the commodities as an input. Occasionally so-called country risk scores are used instead of country ratings. These are published by specialized information services and are based on similar principles as the country ratings. Corporate Bonds A further possible solution in the case where no government bonds in local currency exist is to make use of yields of corporate bonds with the same rating as the country under review. Again the assumption is made that securities with the same rating can be considered as substitutes and again it is a prerequisite that the country which is analyzed has a country rating. Despite identical rating, corporate bonds frequently exhibit a somewhat higher risk premium than corresponding government bonds. 45 Table 3.4 displays sovereign spreads and corporate bond spreads as determined by DAMODARAN for different country ratings. They were established on the basis of different government bonds of the countries as well as with reference to markets for credit default swaps (CDS). 46 See Damodaran, A. (2010), p. 49. Table from Damodaran, A. (2010), p. 49. <?page no="104"?> uvk-lucius.de Table 3.4: Default spreads for different country ratings (as of January 2010) 47 The values from Table 3.3 can thus be used as a quick and simple method for the determination of default spreads or the country risk premium. The only requirement is the availability of a rating for the country in question. CCalculation from the Relative Standard Deviation of 3.2.2.3 the Equity Markets The standard deviation of returns is frequently used in modern portfolio management as a risk measure. If this idea is transferred to the determination of the risk premium in emerging markets/ high 47 Damodaran, A. (2010), p. 49. 3.2 Country Risk - An Additional Risk Factor <?page no="105"?> 106 3 A closer look at important model parameters uvk-lucius.de growth markets, the standard deviation of the local equity market can be used as an approximation for this premium. Once the risk premium for the target country has been determined, the country risk premium can be extracted by subtracting the risk premium of a reference market from the obtained risk premium of the target country. The determination of the country risk premium according to this approach involves the following three steps: 48 [1] Determination of the relative standard deviation of the target country [2] Calculation of the total risk premium for the target country [3] Extraction of the country risk premium from the overall risk premium of the target country SStep 1 In a first step, the standard deviation of the market in the target country is scaled with that of the reference market. The result is a relative risk measure (see Formula 3.5). This relative risk measure provides information about the riskiness of the target country in comparison to the reference market. Step 2 Multiplication of the calculated relative standard deviation with the risk premium of an established reference market such as the US market yields the general risk premium for the market of the target country (see Formula 3.6). The idea behind the multiplication of the relative standard deviation of the target country is the adjustment of the risk in the reference market to the risk in the target country. This is obviously done under the assumption that the standard deviation is truly a suitable measure for risk. See Damodaran, A. (2010), p. 50. <?page no="106"?> uvk-lucius.de Risk premium Target country = Risk premium Reference market eviation Target country SStep 3 In the last step, the share which is attributable to the country risk premium is isolated from the calculated total risk premium of the target country by subtracting the risk premium of the reference market (see Formula 3.7). Country risk premium Target country = Risk premium Target country - Risk premium Reference market In the following, a simple example is presented which illustrates the determination of the country risk premium with the help of this measure. Applied Example 3.3 Target country South Africa Reference market US Risk premium US = 5% Standard deviation JSE All-Share = 11.23% Standard deviation US, S&P 500 = 13.01% Step 1: Determina tion of the rela tive sta nda rd devia tion of the ta rg et country (3.6) 3.2 Country Risk - An Additional Risk Factor <?page no="107"?> 108 3 A closer look at important model parameters uvk-lucius.de SStep 2: Ca lcula ting the tota l risk premium of the ta rg et country Risk Premium SA = Risk Premium US SA Risk Premium SA Step 3: Extra cting the country risk premium from the tota l risk premium of the ta rg et country Country Risk Premium SA = Risk Premium SA - Risk Premium US Country Risk Premium SA - - The determination of the country risk premium with the help of the relative standard deviation can be subject to significant methodological problems in applied work. One problem relates to the fact that equity market volatility depends on the liquidity in the market under consideration. In general, highly liquid equity markets are characterized by higher volatility compared to illiquid ones. As a consequence, the frequently illiquid markets of the emerging markets/ high growth markets would be characterized by a smaller country risk premium, which is clearly an underestimation. An additional problem refers to the fact that the standard deviations of the markets are expressed in the relevant local currency. As already discussed, key figures in different currencies must be treated carefully. One standard deviation in US $ should not be compared to one standard deviation in ZAR. This problem can be avoided if the returns or prices in the market of the target country are consistently converted into the currency of the reference market at expected future exchange rates. 49 See Damodaran, A. (2010), p. 52. <?page no="108"?> uvk-lucius.de Calculation as a Combination of Default Spreads and 3.2.2.4 the Relative Standard Deviations of the Equity and Bond Markets with Each Other A further method for the determination of the country risk premium in a country is the combination of the two approaches presented above. It was assumed that default spreads are a good indicator for the additional risk which must be accepted if an investment in the country is considered. In the case of the relative standard deviation it was assumed that the standard deviation is sufficient to describe the risk of the equity markets in the emerging markets/ high growth markets. But how is it possible to combine the two approaches? While the default spreads provide a first step in the determination of the risk premium for a country, they are related purely to the premium for the possibility of a default. But critics would argue that frequently the risk premium for equities needs to include more than just default risk, which is determined on the basis of government bonds in the country. For that reason, the increased risk of the equity market is included by multiplying the default spreads with a relative risk measure - in line with the approach applied in the last section. The relative risk measure in this case is the relationship between the standard deviation of the local equity market index of the target country and the standard deviation of the government bond. It is supposed to measure the increased risk of investing in equities compared to an investment in government bonds. According to this approach, the country risk is determined by Formula 3.8. The default spread is adjusted by a factor which measures the increased risk of equities relative to the government bond. The country risk premium goes up if either the country rating is lowered (implying that the default spread goes up) or the standard deviation of the equity market gets larger. 50 See Damodaran, A. (2006), p. 44; Damodaran, A. (2010), pp. 52-54. 3.2 Country Risk - An Additional Risk Factor <?page no="109"?> 110 3 A closer look at important model parameters uvk-lucius.de This approach, which involves the standard deviation of the government bond, requires active trading. This is frequently not the case in practice. Alternatively the default spread could be determined with the help of country ratings (see Table 3.3 of corporate and sovereign spreads). A further approximation would be the standard deviation of a major company in the country which is considered to be free of default risk. Otherwise one of the two methods described above needs to be utilized. Applied Example 3.4 Default spread South Africa = 5.31% Standard deviation JSE All-Share, ZAR = 10.36% Standard deviation Government bond, $ = 2.66% 3.2.3 Attribution of the Country Risk Premium to the Individual Companies Now that the country risk premium has been calculated in a first step, the question of attribution to the individual companies in the target country must be answered. What does attribution mean? A valuation expert is not interested in the general country risk premium, but rather in the relevance of that premium for a specific company under review. The decisive question for every valuation expert <?page no="110"?> uvk-lucius.de is thus whether country risk affects every company in the same way or whether some companies have a greater exposure to country risk than others. Depending on the assumption about the attribution of country risk, the premium needs to be included into the calculation of the cost of equity in several places. According to DAMO- DARAN, three approaches for the inclusion of country risk can be distinguished: 51 The additive approach (“bludgeon approach”) The beta approach The lambda approach TThe Additive Approach 3.2.3.1 The additive approach, which in the opinion of DAMODARAN is a “bludgeon approach”, assumes that country risk affects every company in the same fashion. As the name already indicates, the country risk premium is added to the riskless rate of interest (see Formula 3.9). C E = r riskless rate of interest Beta Market risk premium + Country risk premium Applied Example 3.5 Country risk premium South Africa = 5.32% Riskless rate of interest (US) = 1.77% Beta = 0.2898 Market risk premium (US) = 5% C E 51 See Damodaran, A. (2006), pp. 59-60; Damodaran, A. (2003), pp. 17- 18. 3.2 Country Risk - An Additional Risk Factor <?page no="111"?> 112 3 A closer look at important model parameters uvk-lucius.de It is important again to be consistent with regard to the currency. If, for example, the riskless rate is determined on the basis of US $, the remaining parameters must also be determined on that same basis. If needed, currency conversions must be applied. TThe Beta Approach 3.2.3.2 In contrast to the additive method, the beta approach assumes that country risk has a different effect on different companies in a country. The magnitude of this effect is expressed with the help of beta. It holds that the country risk of the company is proportional to the market risk. Accordingly companies with a high beta are more exposed to country risk than companies with a low beta (see Formula 3.10). C E = r Riskless rate of interest · [ Market risk premium + Country risk premium ] Applied Example 3.6 Country risk premium South Africa = 5.32% Riskless rate of interest (US) = 1.77% Beta = 0. 2898 Market risk premium (US) = 5% C E It is questionable in this approach whether the beta factor is a suitable variable to capture country risk. (3.10) <?page no="112"?> uvk-lucius.de TThe Lambda Approach 3.2.3.3 According to DAMODARAN, the lambda approach is the favored method of incorporating the country risk premium, since it allows for a deviation of the country risk of a company from the market oduced, which measures the individual country risks. Just like beta, lambda is scaled around 1. A lambda of 1 indicates a company with average country risk, while a lambda in excess of or below 1 means that the company has above (below) average exposure to the country risk. 52 With the introduction of the lambda factor, the original one-factor model is transformed into a two-factor model with country risk as the second factor and lambda as a measure for the magnitude of country risk. The calculation of the cost of equity in the lambda approach is done as follows (see Formula 3.11). 53 C E = r Riskless rate of return · Market risk premium + · Country risk premium But how can lambda be determined and which factors influence it? DAMODARAN lists the following three factors which decisively influence the lambda factor: Sales volume of the company in the country in question, Location of the production facilities and Risk management. It appears reasonable that a company which only has 20% of its sales in South Africa is much less exposed to country risk than a company which generates 80% there. 52 Damodaran, A. (2003), pp. 18-19. 53 Damodaran, A. (2003), pp. 18-19. 3.2 Country Risk - An Additional Risk Factor <?page no="113"?> 114 3 A closer look at important model parameters uvk-lucius.de Furthermore it is possible that a company which does not have any sales in a specific country is still exposed to country risk if it maintains production sites there. Political unrest or similar disruptions can cause severe delays in production plans. This is even more problematic in case the production sites cannot be relocated (for example mining industry). 54 And finally, companies which are actively engaged in risk management and obtain insurance or derivatives to protect against certain risks should have a lower exposure to country risk. As a consequence, their lambda should be lower. In this context, it must be pointed out that risk management is rather costly in many cases. Therefore a tradeoff between payment of insurance costs and acceptance of country risk is unavoidable. 55 Obviously there are more than three influencing factors and the country risk should ideally be determined from a number of possible influences. But again the availability of data can be a critical factor. A lot of the needed information is not publicly available, such as financial transactions used to hedge risk. For that reason, calculations based on that information are virtually impossible. What are the methods proposed by DAMODARAN for the determination and calculation of lambda? Unfortunately there is no unambiguous and formal definition of the lambda factor, similar to the definition of the beta factor. It is widely understood that the beta factor is derived from the CAPM by calculating the ratio of covariance and variance of returns. The lack of a formal definition in the lambda approach was criticized heavily in the recent past. 56 DAMODARAN suggests three possible approaches for the determination of lambda: 57 54 Damodaran, A. (2003), pp. 19-20. 55 Damodaran, A. (2003), pp. 19-20. 56 See Kruschwitz, L./ Löffler, A./ Mandl, G. (2011). 57 Damodaran, A. (2003), pp. 20-24. <?page no="114"?> 3.2 115 uvk-lucius.de Determination of lambda from sales data in the relevant country, Determination of lambda by comparing the changes in accounting profit over time, or Determination of lambda with reference to market price data. 3.2.3.3.1 Determination of Lambda from Sales Data in the Relevant Country As already suggested, it appears logical that companies which generate most of their sales in one country must be particularly exposed to country risk in that location. Since the average lambda across all equities in a market must be equal to 1 - somebody must hold the country risk - it is not sufficient to define the lambda factor as the percentage share of sales that is generated in the county in question. Instead it must be determined according to Formula 3.12. = In addition to the share of sales of the company in the relevant country, the share of sales of an average company must also be determined. While it is relatively easy to obtain the first figure with the help of company reports, determination of the second figure appears more problematic. DAMODARAN suggests the use of export statistics, which are published for example by the World Bank, as a simple proxy for the determination of the sales of an average company. If the export statistics are used to derive an approximation for the share of sales generated via exports by an average company in the country, the share of domestic sales can be determined as a residual. <?page no="115"?> 116 3 A closer look at important model parameters uvk-lucius.de Applied Example 3.7 Percentage share of exports in Gross Domestic Product = 60% Sales of Company A in the relevant country (in percent) = 10% Sales of Company B in the relevant country (in percent) = 90 % Determination of the share of domestic sales of an average company: 100% - 60% = 40% Calculation of Lambda with the help of Formula 3.12: = 10% 40% = 0.25 = 90% 40% = 2.25 As can be seen, lambda is much higher for Company B, since it generates a much larger share of sales domestically and is thus exposed to significantly higher country risk. 3.2.3.3.2 Determination of Lambda by Comparing the Changes in Accounting Profit over Time The second approach is based on the idea that profitability of a country should go up as country risk declines, and go down as it increases. A comparison of accounting profits over time allows an illustration of increases or decreases in country risk. DAMO- DARAN uses a chart which shows the percentage change of comuvk-lucius.de <?page no="116"?> pany profits as well as the percentage change in the value of a bond issued in the same country to draw conclusions about lambda. Unfortunately no explicit mathematical approach for the determination of lambda is provided for this method. The only evidence given is a visual display of the changes. 3.2.3.3.3 Determination of Lambda with Reference to Market Price Data A disadvantage of the approaches mentioned so far is the fact that the needed data in many cases is published only a few times per year. Equity prices meanwhile are available daily and more quickly reflect new information and the assessment of investors. If it is possible to derive a market based figure for the country risk, a sensitivity analysis of the company’s share price relative to this market based figure would allow an estimate of lambda. 58 As a measure for the country risk, DAMODARAN uses a bond issued by the country. Bond prices should go up as country risks are viewed more favorably by investors and decline as the assessment worsens. The slope of the regression line of equity returns of the company in question and the bond returns should thus provide a good approximation for lambda. A disadvantage of this approach also needs to be mentioned. Lambdas which are determined with the help of the above regression method tend to have large standard errors. The method also requires the availability of sufficient data material on the bond. This requires not only a high trading volume and correspondingly high liquidity of the bond, but also trading in a stable currency. 59 58 Damodaran, A. (2003), pp. 23-24. 59 Damodaran, A. (2003), p. 24. 3.2 Country Risk - An Additional Risk Factor <?page no="117"?> 118 3 A closer look at important model parameters uvk-lucius.de Applied Example 3.8 A regression of the returns of a company on a bond issued by the country in question returns the following regression line: Return Company This regression line implies a lambda of 0.23. 33.3 The Beta Factor The determination of the beta factor leads to questions in applied work which are similar to the ones that already had to be answered when deriving the market risk premium. The choice of the relevant market index needs to be discussed as well as the length of the data history used. Additional problems arise if no data history is available or published. 3.3.1 Methodological Questions about the Determination of the Beta Factor Not unlike the challenges in determining the market risk premium, the valuation expert is also confronted with the following problems when determining beta factors in applied work: 60 Which Index Should be Used? 3.3.1.1 As already discussed, the beta factor is determined with the help of a linear regression involving company returns and returns of the market portfolio. In applied work, an index needs to be chosen as a proxy for the market portfolio. Depending on the choice of the See Pereiro, L. E. (2002), pp. 122-123. <?page no="118"?> 3.3 T 119 uvk-lucius.de index, different values of the beta factor will result. In order to arrive at a beta factor that is as meaningful as possible, an index should be used where the regression has high explanatory power. This is revealed by a high coefficient of determination. H How Long Should the Data History be? Should Daily, 3.3.1.2 Weekly or Monthly Data be Used? The beta factor also depends on the length of the time series used, but it is not clear which interval leads to the best statistical results. A number of studies 61 for example revealed that very long time series of 15 to 20 years do not necessarily provide better results than shorter time series of 5 to 10 years. Considering that beta factors of a company fluctuate in line with the riskiness of the company, it appears preferable to apply more recent and shorter time series for the calculation of the company beta. This would assure that current risk factors are taken into consideration. But the valuation expert always needs to determine the appropriateness of the time period for the specific business valuation in a given situation. In addition to the question about the length of the time series the question about the adequate data frequency also needs to be addressed. To date it is not clear whether daily, weekly or monthly data series provide better results concerning the determination of a beta factor. In summary it can be stated that the determination of a beta factor leaves open many choices of input values. For that reason several beta factors can exist for one company. 62 Since applied work frequently relies on beta factors obtained from information providers, it needs to be kept in mind that beta factors may differ depending on the choice of service provider. In order to maintain consistency, beta factors obtained from external providers should all come from See Karels, G. V./ Sackley, W. H. (1993); Beaver, W.,/ Manegold, J. (1975). See Pereiro, L. E. (2002), p. 122. <?page no="119"?> 120 3 A closer look at important model parameters uvk-lucius.de the same source. If this is not possible, beta factors can also be determined as an average of betas from different data sources. 63 33.3.2 Determination of Beta Factors in Volatile Markets if Financial Data is not Available The determination of a suitable beta factor during a business valuation in volatile markets can turn out to be more complicated than in established markets. This is due primarily to the fact that the needed data series for the determination of the beta factor are frequently not available or not published in volatile markets. In the following, several approaches for the determination of adequate beta factors in such markets are outlined. 64 The choice of procedure depends on two factors: First it must be determined whether a company-based or an industry-based beta factor needs to be calculated. The industrybased beta factor usually requires considerably less effort compared to the company-specific approach. Second it must be ascertained whether the data needed to calculate the respective betas is available. Depending on the availability of data, alternative methods must be employed. Four different scenarios are possible based on the specifics outlined above. Figure 3.1 provides an overview. See Pereiro, L. E. (2002), p. 123. The approaches are based on Pereiro, L. E. (2002), pp. 123-130. <?page no="120"?> 3.3 121 uvk-lucius.de Figure 3.1: Different possibilities of determining the beta factor in volatile markets 65 Quadrant 1 If a decision is reached in favor of a company-based beta factor and in a best case the necessary data is available, a small number of listed companies, a so-called peer group, must be assembled. These companies should be comparable to the valuation object concerning the most important value drivers and similar with regard to the following attributes: Modified version, based on Pereiro, L. E. (2002), p. 170. <?page no="121"?> 122 3 A closer look at important model parameters uvk-lucius.de Portfolio of products and services, Customer structure, marketing strategy, market environment, Industry structure, Competitive situation, Management of materials and costs, Structure of equity capital and debt capital, Cost and earnings structure, structure of cash flows, dividend development. In an ideal case there will be 8 to 10 publicly listed comparable companies that share as many similarities as possible with the company that needs to be valued. In the next step, a beta factor is determined for all of the comparable companies. It can either be established with the help of a linear regression involving historical returns of the comparable companies and the index, or beta factors provided by external information services can be used. In both cases, levered beta factors are initially obtained, which account for the specific financing structures of the respective companies. Before these beta factors can be used for the further calculation of the cost of equity, they first need to be transformed into unlevered betas in order to eliminate the specific financing structures of the comparable companies. In the following, these unlevered betas of the respective companies are transformed into a relevered beta by calculating the median and by adjusting this figure to the financing structure of the company that needs to be valued. Only this relevered beta can be used for the determination of the cost of equity in CAPM-based models. 66 See Pereiro, L. E. (2002), p. 124. <?page no="122"?> 3.3 123 uvk-lucius.de Things can get problematic, especially in emerging markets/ high growth markets, if only very few comparable companies are available, for example, and these do not meet the above stated criteria or are not publicly listed. In these cases it may be advisable to utilize a different procedure for the calculation of a meaningful beta factor. 67 Quadrant 2 If no capital market data is available for the determination of a company-based beta factor, a different approach needs to be taken. It is also possible to obtain the beta factor with the help of accounting data or with reference to beta factors in a reference market. 68 When calculating the beta factor based on accounting figures, the sensitivity of the operating results or the net profits of the valuation object to the relevant figure in the entire market must be determined. 69 An advantage of this approach is the easier availability of accounting data compared to capital market data. At the same time, the relevant accounting data is strongly influenced by the accounting policy of the companies. This makes a consistent comparison rather difficult. In addition, the statistical significance can be criticized, since only data from the annual accounts is used for the sensitivity analysis and frequently only a limited number of years and thus only a few data points are available for a statistical analysis. 70 In case these disadvantages are decisive and no local capital market data is available, the company-specific beta can also be derived via publicly listed comparable companies in a reference market. This alternative approach is virtually identical to the first case. The fact See Pereiro, L. E. (2002), p. 124. See Pereiro, L. E. (2002), p. 125. See Pereiro, L. E. (2002), p. 125. See Pereiro, L. E. (2002), pp. 126-127. <?page no="123"?> 124 3 A closer look at important model parameters uvk-lucius.de that the comparable companies are not taken from the local market, but rather from a suitable reference market such as the US is the only difference. Once these companies are selected, the same steps as discussed above are implemented for the calculation of the company-specific beta factor. Quadrant 3 If a decision is reached to work with an industry-based beta factor or if no suitable comparable companies are available, it is also possible to work with the beta for the entire industry of the valuation object. Such an industry-based beta factor does not require a detailed analysis of specific comparable companies and thus the effort required is significantly reduced. Still, there is a danger that the company which needs to be valued is not influenced by the same value drivers as its industry. In such a case, the industry beta which is employed leads to misjudgements concerning the valuation object. If capital market data is available, the industry betas are generally calculated as averages of all betas of the companies in an industry, weighted by market capitalization. 71 Quadrant 4 If no capital market data for the determination of industry-based beta factors is available, either industry betas can be calculated based on accounting information or industry betas for a reference market such as the US can be used. If an industry-based beta factor is to be determined with the help of accounting information, a group of companies that is representative of the industry and that makes accounting information available is determined in a first step. For all of these companies, beta factors are determined from accounting figures, which need to be checked for their statistical significance. Only the significant betas are selected and the median, which serves as the industry beta, is calculated. See Pereiro, L. E. (2002), p. 124. <?page no="124"?> 125 uvk-lucius.de Simpler is the use of industry betas for a reference market. This alternative is interesting especially in situations where no comparable companies are available and the relevant industry does not exist in the country in question. This is a situation which especially in emerging markets/ high growth markets can occur more frequently. For that reason, industry betas for the US are frequently used. It must be kept in mind, however, that the use of an industry beta of a reference market implies the assumption of a positive relationship between the industry in the reference market and the industry of the valuation object. Summary The market risk premium is among the most important input parameters for the CAPM. It is frequently interpreted as the market price of systematic risk. It expresses the amount of risk perceived to be in that market and more importantly the price which needs to be paid as compensation for that risk. The magnitude of the market risk premium has a major influence on the return demanded for individual investments. The following three possibilities for the determination of the market risk premium are presented: 1 Determination via surveys among providers of capital about their assessment of the risk premium. 2 Determination via estimates of historically observed market risk premiums. 3 Determination via derivation from current market data and thus determination of an implicit market risk premium. This is also done, for example, in option price theory for volatility. <?page no="125"?> 126 3 A closer look at important model parameters uvk-lucius.de It was discussed whether the country risk premium should even exist, and if yes, how it can be assigned to individual companies in a country. As an argument against the country risk premium, it was asked whether country risk should even be seen as a systematic risk, respectively whether it can be eliminated via diversification. If the “marginal investor” is able to globally diversify the portfolio, the country risk premium only plays a minor role. Decisive for the ability to diversify is the degree of market segmentation or integration. Four procedures for the determination of the country risk premium were presented: 1 Determination from default spreads, so-called “Sovereign Yield Spreads” of publicly available bonds. 2 Determination from country ratings or with the help of corporate bonds. 3 Determination from the relative standard deviation of the equity markets with each other. 4 Determination from a combination of default spreads and the relative standard deviation of the equity and bond markets with each other. Once the country risk premium has been determined successfully, the question of attribution to individual companies in the country arises. The additive approach, the beta approach and the lambda approach can be distinguished. For the additive approach it is assumed that the country risk affects every company in the country in the same way. As the name already suggests, the country risk premium is added to the riskless rate of interest. <?page no="126"?> 127 The beta approach makes the assumption that the country risk affects the individual companies in the country in a differentiated manner. The magnitude of the effect is expressed with the help of the beta factor . Accordingly companies with a higher beta are exposed more strongly to country risk than companies with a low beta. vidual country risk. The introduction of the lambda factor transforms the original one-factor model into a twofactor model with country risk as the second factor and lambda as a measure for the intensity of country risk. Lambda, just as the beta factor, is scaled around one. A lambda of 1 implies average country risk, while a lambda above (respectively below) 1 implies that the company is exposed to country risk above (below) average. With regard to the determination of the beta factor, the problem of choosing an adequate benchmark index, as well as the length of the data history was discussed. Furthermore it was demonstrated how a beta factor can still be determined in volatile markets and in the absence of financial data. Depending on whether a company-based or an industry-based beta factor needs to be determined and whether data is available or not, different approaches were presented. <?page no="127"?> 128 3 A closer look at important model parameters uvk-lucius.de Problems [1] Discuss the determination of the market risk premium via surveys among providers of capital about their expectations concerning the risk premium. [2] Discuss the determination of the market risk premium via estimates of historically observed market risk premiums. [3] Discuss the determination of the market risk premium via derivation from current market data and hence calculation of an implied market risk premium. [4] Given are the following values: S&P Index value: 1,000 Expected dividend return of the index in the coming period: 6% Expected future dividend growth: 5% Riskless rate of interest: 2% What is the implied market return? What is the market risk premium? [5] Critically discuss the need for a country risk premium. [6] Which arguments speak against the use of a country risk premium? [7] Comprehensively discuss the calculation of the country risk premium from default spreads, respectively so-called “Sovereign Yield Spreads” of publicly available bonds. [8] What is the magnitude of the country risk premium in US $ for South Africa? Given are the following values: Geometric mean return of a 10-year US $ Treasury Bond = 5% <?page no="128"?> 129 uvk-lucius.de Geometric mean return of a 10-year South African government bond in US $ = 8% [9] Comprehensively discuss the calculation of the country risk premium from country ratings or with the help of corporate bonds. [10] Comprehensively discuss the calculation of the country risk premium from relative standard deviations of the equity markets. [11] What is the magnitude of the country risk premium for South Africa? The following information is provided: Target country: South Africa Reference market: US Risk premium US: 5% Standard deviation South Africa, JSE All-Shares: 32.0% Standard deviation US, S&P 500: 24.3% [12] Comprehensively discuss the calculation of the country risk premium from a combination of default spreads and relative standard deviation of the equity and bond markets. [13] What is the magnitude of the country risk premium for South Africa? The following values are given: Default spread South Africa: 4.5% Standard deviation, South Africa, JSE All-Shares, $: 34.2% Standard deviation government bond, $: 28.3% [14] What possible approaches for the attribution of the country risk premium to the individual companies in the country are suggested by DAMODARAN? <?page no="129"?> 130 3 A closer look at important model parameters uvk-lucius.de [15] Comprehensively discuss the additive approach. State the underlying formula. [16] What is the cost of equity of the company according to the additive approach? Given are the following values: Country risk premium South Africa: 7% Riskless rate of interest: 3% Beta: 0.8 Market risk premium: 5.5% [17] Comprehensively discuss the beta approach. State the underlying formula. [18] What is the cost of equity of the company according to the beta approach? Given are the following values: Country risk premium South Africa: 7% Riskless rate of interest: 3% Beta: 0.8 Market risk premium: 5.5% [19] Comprehensively discuss the lambda approach. State the underlying formula. [20] Which three approaches for the determination of lambda are suggested by DAMODARAN? Discuss these approaches and state advantages as well as disadvantages. [21] Determine the lambda for companies A and B from data about the sales generated in the country. Given are the following values: Percentage share of exports in gross domestic product: 55% Sales of company A in the country in question (in percent): 20% Sales of company B in the country in question (in percent): 80 % <?page no="130"?> uvk-lucius.de 44 International Business Valuation in South Africa Learning Outcomes Knowledge of the expanded model for the international valuation of companies especially in the context of volatile markets and ability to apply the model. Ability to implement adjustments to the cash flows in light of the risks in volatile markets. Knowledge of different versions of the CAPM and ability to understand and apply the specific methods to adjust the cost of capital. Ability to calculate the business value according to the various methods which are partly based on the CAPM and methods not based on the CAPM. Ability to conduct a valuation both in local currency and in a reference currency. Understanding of the value drivers of possibly existing unsystematic risks. Critical assessment of the results from an international business valuation in emerging markets/ high growth markets. The international valuation of companies especially in emerging markets/ high growth markets or other volatile markets frequently poses numerous challenges to valuation experts. In addition to macroeconomic risks, political or economic risks of the respective countries must also be taken into consideration in the valuation. Country specific accounting regulations as well as international taxation complicate matters further. Frequently the cash flows <?page no="131"?> 132 4 International Business Valuation in South Africa uvk-lucius.de which are derived from the annual accounts do not reflect the true performance of the company that needs to be valued and thus must be adjusted accordingly. But what needs to be considered when making these adjustments and in which areas are the distortions most pronounced? The classical valuation models derived from capital market theory such as the CAPM appear to be insufficient for a volatile market environment. Additional risks which are present in these markets are not captured adequately. The insufficient treatment of additional risks implies that the cost of capital is set too low and thus the calculated company values are too high. How can the CAPM be adjusted in order to adequately capture the additional risk? Which versions of the CAPM exist and are there other models which are not based on the CAPM that can be used for the calculation of the cost of capital? These and other questions will be answered in this chapter. Initially it is demonstrated how the CAPM can be expanded in order to be suitable for the valuation of a company in an emerging market as well. The aim is to provide the valuation expert with an approach that can serve as a blueprint during the preparation of an international business valuation. In addition to adjustments of the cash flows, the modification of the cost of capital is also an issue. The latter will focus on the presentation of various versions of the CAPM, but models that are not based on the CAPM will also be presented. Since diversification is incomplete in some areas, possible unsystematic risks must also be included in the valuation. The inclusion of these unsystematic risk factors is a controversial issue at the moment, which is hotly debated by practitioners and the subject of intense research activities, especially with regard to “whether” and “how” to incorporate these risks. For that reason, only a fundamental exposition of the various types of risks is presented. Thus it is the responsibility of the valuation expert to decide on the incorporation of unsystematic risks in his own model. Ultimately the valuation expert needs to choose a model which is utilized for the concrete valuation case. Practitioners will be provided with criteria to structure this task. <?page no="132"?> 4.1 133 uvk-lucius.de 44.1 Expanded Model for International Valuation in Volatile Markets In order to do justice to the environment and the increased risks in volatile markets, the 5-step-approach for an international valuation, which is familiar from Chapter 1.5.1 needs to be expanded. Among other things, the already discussed currency issue needs to be included, risks need to be adjusted and the cash flows as well as the cost of capital need to be modified. Finally the possible existence of unsystematic risk needs to be considered. Thus the expanded model for international valuation in volatile markets involves the following steps (see Figure 4.1). [1] In a first step, the valuation currency must initially be determined. This can either be the local currency or the currency of a reference market such as Euro or Dollar. With the currency setting, the basis for the calculation of all needed parameters is also implicitly determined. As stated repeatedly, uniform assumptions are essential for a consistent valuation. [2] In a second step, the analysis of the company and its environment is conducted. This is followed by business planning and the setting up of a pro-forma balance sheet and a pro-forma P&L statement, which serves as the basis for additional calculations. Cash flow planning is mostly done in local currency in order to prevent distortions from the annual accounts. If needed, these must be translated into the corresponding reference currency at expected future exchange rates. [3] The choice of valuation method, namely single valuation, mixed method or total valuation approach is made in step three. In the following, the focus will be on the WACC approach and the equity approach as typical DCF-methods. In addition, the framework conditions of the valuation must be determined in the third step. It must be decided whether only one valuation (single-valuation model) or several valua- <?page no="133"?> 134 4 International Business Valuation in South Africa uvk-lucius.de tions (multiple-valuation method) are used and whether the business value is published as a range or a synthetic value. Figure 4.1: Expanded model for an international business valuation [4] In the fourth as well as in the extended fourth step, the relevant cash flows are determined. Due to the volatile nature of many markets, they frequently need to be adjusted with regard to inherent risks. In addition to differing accounting regulations, especially international taxation and related issues need to be considered. <?page no="134"?> 4.1 135 uvk-lucius.de [5] In the fifth as well as in the extended fifth step, the cost of capital is determined with the help of theoretical models from capital market theory. Here as well, modifications and adjustments are needed due to the increased risk in emerging markets/ high growth markets. For that purpose, academics and practitioners have developed several modifications of the CAPM, such as the global CAPM, the local CAPM, the adjusted local CAPM, the (adjusted) hybrid CAPM, the Lessard-Model, the Godfrey-Espinosa-Model, the Goldman-Sachs-Model, the Damodaran-Model and the Salomon-Smith-Barney-Model. Also possible is the use of models that are not based on the CAPM, such as the Estrada-Model, the Erb-Harvey-Viskanta-Model (EHVM), the Arbitrage Pricing Theory (APT) and the simulationbased approach. Both approaches for the determination of the cost of capital will be presented and discussed in more detail in this chapter. [6] The sixth step deals with the risk adjustment and modifications due to unsystematic risk. These were ignored up to this point, since they are eliminated in the theoretical framework of the CAPM with the help of diversification. However, it is frequently the case, especially in emerging markets/ high growth markets, that this degree of diversification is not obtainable, since it cannot be easily implemented by investors. This raises the issue of whether, and especially how, unsystematic risk should be incorporated. [7] In the last step, the business value needs to be determined. Depending on the choice of model (single-valuation or multiple-valuation), either a valuation range or a synthetic business value will be determined. If needed, this business value can be translated into different currencies at the spot exchange rate. Since the choice of currency, the business analysis and planning as well as the selection of the appropriate valuation method was already described in previous chapters, the following sections will <?page no="135"?> 136 4 International Business Valuation in South Africa uvk-lucius.de focus on the steps four, five and six, namely the adjustment of cash flows and discount rates as well as on the unsystematic risk factors. With regard to the cash flows, it will be demonstrated how differences in accounting regulations, international taxation and distortions in the actual performance of the company need to be considered. Since it is clearly not possible to deal with all possible sources of distortions in the different markets, an attempt is made to develop an understanding of the possible questions that are likely to arise within the various problematic areas. For the determination and adjustment of the discount rates, different models with their underlying assumptions, which are partly based on the CAPM and partly based on other theories, will be outlined. Among other things it will be shown how country risks and similar issues can be incorporated in the CAPM. A number of topics which have been dealt with in theory so far will be repeated and demonstrated in an applied context. The calculations needed in the various steps will be clarified with the help of a case study. For didactic purposes, they will be shown both in local currency and in the currency of the reference market (again from the perspective of an international US $ investor). 44.2 Adaptation of Business Planning and Cash Flows For an international business valuation the business planning and the determination of relevant cash flows can cause substantially more problems than a valuation at home. This is due to the very dissimilar starting conditions in the respective countries. For that reason, the annual accounts of the past years must be adjusted to eliminate those factors that hinder a true assessment of the performance of the valuation object. Such influences are caused for example by country-specific accounting regulations, international taxation and currency translations or can be due to a lack of objectivity on the part of the company management. The latter case arises frequently for owner-operated companies in emerging markets/ high <?page no="136"?> 4.2 137 uvk-lucius.de growth markets, where the owners do not distinguish between management remuneration and profit participation or charge personal expenses to the company and thus costs are excessive. Since a comprehensive listing of accounting regulations or international taxation in various countries is beyond the scope of this book, an effort is made to highlight the most important issues within the various problematic areas. The aim is to provide the reader with a solid basic understanding of the relevant problems in the different areas. We refer to the specialized literature in that field for a more thorough treatment of the material. When considering the additional risks in volatile markets, the double counting of risks must be carefully avoided. Risks that are incorporated via the cash flows must not be considered again via the discount rates. Risk discounts in the cash flows and risk premiums in the discount rates will surely lower the business value. A valuation expert who uses a conservative approach and incorporates risks more than once - be this a conscious or unconscious decision - should not be surprised if companies in emerging markets/ high growth markets always appear overpriced. In the following, the adjustment of cash flows as a consequence of country-specific accounting regulations, excessive management remuneration, excessive expenses, differences in international taxation and inflation will be discussed in more detail. 44.2.1 Adjustment of Cash Flows to Correct for Country-specific Accounting Regulations As a consequence of country-specific accounting regulations, accounting policies or legal requirements, profit and loss statements as well as balance sheets are not directly comparable across borders. They frequently provide a rather distorted picture of the true <?page no="137"?> 138 4 International Business Valuation in South Africa uvk-lucius.de situation concerning net worth and earnings. This can make it very difficult to assess the economic situation of a company, especially in the emerging markets, which frequently work with very different balance sheet conventions than developed countries. While these differences across the globe are likely to continue, the harmonization of accounting standards is ongoing. Countries are increasingly adjusting their accounting regulations to IFRS (International Financial Reporting Standards) or US-GAAP. More countries are expected to follow and will sooner or later adopt the most frequently used standards IFRS or US-GAAP. This will simplify international comparisons and enhance transparency of companies for investors and valuation experts from all over the world. Furthermore, IFRS and US-GAAP have converged over the past years. With advances in these harmonization efforts, differences in international accounting standards should become less and less important in the future. It is also likely that companies in emerging markets/ high growth markets will increasingly embrace these standards. Until that day, however, different accounting rules will continue to cause problems in an international valuation exercise. Since the planning of cash flows is directly tied to accounting data from previous periods, the valuation can be materially affected. This is true in particular if cash flow forecasts are derived with the help of financial figures from emerging markets/ high growth markets. For that reason it must first be ascertained whether the balance sheets and P&L statements of previous years actually reflect the true standing of the company or whether suitable adjustments are needed. It may also be advisable to transform the annual accounts which were prepared on the basis of local standards into the international accounting standard IFRS. This standard is more meaningful for business valuation and performance assessment. Among the most important and most controversial differences in accounting rules is the balance sheet treatment of provisions, pensions, goodwill and other intangible assets, currency conversion, revaluation of assets, deferred taxes and consolidation. In the following, these issues will be addressed briefly. <?page no="138"?> 4.2 139 uvk-lucius.de For emerging markets/ high growth markets, several factors can be added to the list above. These include rules for accounting during inflationary times or hyper-inflation and for rapidly changing tax regulations, which can further complicate business analysis and planning. P Provisions 4.2.1.1 Provisions are set up for uncertain liabilities. At the time the balance sheet is prepared, the exact reason, payment date and amount is still unknown. They cover future costs or expected losses and these expenses are attributed to the financial year in which they are caused. Companies establish provisions by reducing their profits and establishing a “reserves” position on the liability side of the balance sheet. The rules for provisioning can vary from country to country. Some countries only accept provisions for specific and clearly identified future costs or losses, while other countries also accept provisions for unexpected costs. Companies in countries with flexible rules frequently use provisions for accounting policy. They manage their profits by increasing provisions in good years and lowering them in poor years. This has a direct effect on their tax liabilities. Since these types of accounting policies can lead to substantial distortions of the balance sheet and the P&L accounts, they need to be corrected in a business valuation. In addition, it also needs to be taken into consideration that provisions are tax deductible in some countries. Pensions 4.2.1.2 Pension and retirement systems differ massively from country to country. Some countries require that domestic companies appoint independent pension funds or insurance companies to manage their pension funds. In other countries, pension liabilities appear on the profit and loss accounts and need to be paid by the companies from current operating earnings. The correct treatment of pension liabilities and the determination of the correct pension costs for planning purposes are among the most complex issues during the course of a business valuation. <?page no="139"?> 140 4 International Business Valuation in South Africa uvk-lucius.de GGoodwill and Intangible Assets 4.2.1.3 Occasionally practitioners ask whether the business value obtained with the help of the DCF-approach needs to be augmented by goodwill, for example for knowledge or patents. This is not correct, since the DCF-approach is a total valuation method, which implicitly assumes that the business value is determined by the financial surplus which is generated through the interaction of all tangible and intangible assets in the company. In most cases the present value of these cash flows exceeds the sum of all individual tangible and intangible assets. It can thus be assumed that all tangible and intangible assets which are needed for the operations are already included in the present value of the financial surplus. Thus it is not appropriate to include them again in the business valuation, otherwise double counting will occur. Only the intangible assets that are not needed for operations are valued separately - in line with the other assets that are not needed for operations - and added to the present value of the cash flows. Since the balance sheet treatment of goodwill can again differ from country to country, possible distortions in the annual accounts need to be eliminated. Currency Conversion 4.2.1.4 Frequently problematic is the fact that companies possess tangible assets, sales, liabilities and so forth in foreign currency which need to be converted and aggregated in the annual accounts. The aggregation and conversion of the foreign currency holdings can in some cases lead to significant distortions in the annual accounts. This becomes particularly obvious if a subsidiary reports sales to the parent company in its local currency. Depending on the exchange rate, the subsidiary will always report different amounts. The treatment of currency conversions for annual accounts and balance sheets differs with the relevant accounting regulations. With the “current rate method” for example, all assets in foreign currency are translated at the current exchange rate. Another possibility is the “temporal method”, which involves the conversion of assets in <?page no="140"?> 4.2 141 uvk-lucius.de foreign currency at historical exchange rates. In order to eliminate this type of distortion from the annual accounts and include it in the valuation, it is absolutely necessary to have access to internal accounting data. In case of an external valuation, the only option in many cases is to have faith in the data from the annual accounts and to work with it. But this can turn out to be problematic in emerging markets. The aim must be to take these types of influences into consideration as much as possible during the business and cash flow planning stage. RRevaluation of Assets 4.2.1.5 In some countries it is possible to revalue tangible assets in order to account for inflation or price changes. The idea behind this revaluation is to present the company on the basis of current costs. In some countries these revaluations can be done annually, while other countries impose restrictive conditions or do not allow revaluations at all. If no revaluation takes place, the tangible assets always reflect historical costs of acquisition. For a business valuation, it is important to understand the methods used for the valuation of tangible assets in order to derive the appropriate cash flows. Deferred Tax Assets 4.2.1.6 Deferred tax assets arise whenever the value according to the accounting standards applied is smaller than the value on the tax balance sheet and there is a timing difference or a quasi-permanent difference. Since it frequently takes several years for the differences to equate, they are long-term in nature and need to be considered. Consolidation 4.2.1.7 Most countries expect balance sheet consolidation if a parent company owns more than 50% of the subsidiary or in case a so-called “controlling interest” has been established. Group linkages can render the derivation of cash flows considerably more complicated if not impossible. <?page no="141"?> 142 4 International Business Valuation in South Africa uvk-lucius.de 44.2.2 Adjustment of Cash Flows to Correct for Excessive Management Remuneration A frequent problem of companies that are not publicly listed and run by their owners - especially in emerging markets/ high growth markets - are distortions in the annual accounts related to management remuneration. Since owners and managers are frequently the same persons, the salaries paid by the owners for their management contributions frequently are significantly above the market average of comparable positions. This behavior is grounded in a poor understanding of the various types of payment for owners and managers. But owner and manager have different roles, which need to be distinguished and which are subject to different types of payment. While dividends are a form of interest payment to the owner to compensate for the capital investment and the assumption of risk, the management salary should normally only provide compensation for the individual work effort. Nonetheless many owner-managers combine both remuneration components into a “salary”, which they pay to themselves. Problematic about this approach is the fact that the salaries are part of the operating costs in the profit and loss statements and therefore these costs are too high. As a consequence, the cash flows relevant for the valuation are reduced and the resulting business value is too low. In such a situation it is recommended to adjust the profit and loss statement by the difference between the salary paid and the salary that is in line with market conditions. The difference needs to be interpreted as a dividend payment for future profits. In a company valuation, these earnings or company contributions need to differentiated carefully and added to the cash flows. Salaries in line with market conditions can be determined by comparisons and benchmarking with similar publicly listed companies. But several factors can lead to variations in this adequate rate of compensation. The economy in which the companies are active plays an important role. In a growing economic environment, salaries tend to be higher than in a stagnating economy. The state of the business cycle also plays a decisive role. During boom phases salaries are higher than in recessions, where they tend to decline. <?page no="142"?> 4.2 143 uvk-lucius.de Salaries also depend on the size of the company. Major companies tend to pay higher salaries on average than smaller ones. Young and growing industries are also willing to pay higher average salaries than established ones. As can be seen, the determination of salaries that are in line with market conditions is not always an easy task. Nonetheless, an attempt should be made to adjust profit and loss statements that are distorted by excessive management remuneration. 72 44.2.3 Adjustment of Cash Flows to Correct for Excessive Expensing In addition to excessive management remuneration, excessive expensing is an additional distortion of the profit and loss statements which affects the cash flows. Excessive expensing is caused by the insufficient separation of personal and companyrelated expenses by the owners and managers. Consequently the personal expenses of the owners are included in the profit and loss statements of the company, which results in lower cash flows and a reduced business value. In the context of a business valuation, all costs that are of a personal nature and unrelated to the operations of the company should be eliminated from the profit and loss statements by a thorough valuation expert. This is similar in nature to the adjustments made in the case of excessive management remuneration. The assessed difference can be interpreted as a dividend payment for future profits and added to the cash flows which determine the valuation. 73 Adjustment of Cash Flows to Correct for Differences 4.2.3.1 in International Taxation Tax systems vary greatly from country to country and are in constant flux. As an example, certain types of profits which are subject to taxation in one country are not necessarily taxed in all other See Pereiro, L. E. (2002), p. 95. See Pereiro, L. E. (2002), pp. 95-96. <?page no="143"?> 144 4 International Business Valuation in South Africa uvk-lucius.de countries. Business valuations therefore need to incorporate relevant country-specific tax laws. Furthermore it is necessary to be familiar with the effective tax rate of the company. The correct incorporation of the tax systems in the individual countries into the business valuation exercise frequently turns out to be a difficult task, because of the lack of transparency in many countries. In the context of a business valuation, the treatment of corporate and personal taxes is of major importance. In many countries the taxation of corporate bodies and individuals is integrated in order to eliminate or reduce the double-taxation of dividends. Several countries follow an approach of providing a corporate income tax credit for dividends, which credits shareholders with a part or all of the taxes already paid by the company. This tax credit thus implicitly increases the cash flow which goes to the shareholders by an amount that is effectively foregone by the state. It usually takes the form of a tax reduction or a tax credit. The crediting to the dividend can affect the business value in two distinct ways. First, a company domiciled in a country which grants some form of tax credit has higher after-tax cash flows to the investor and thus a higher value than a corresponding company in a country that practices the double-taxation of dividends. Second, the dividend policy can have an effect on its total business value in a system of income tax credit on dividends. With the dividend decision, the company leadership also makes a choice about the percentage of the potential tax credit that is made available to shareholders. However, this view of dividends is very controversial in a business valuation. There are valuation experts who do not want to include these personal tax credits in the business valuation. In the context of the DCF-approaches it must now be determined how to incorporate the tax effects. As it turns out, taxes can basically have an effect both on the cash flows and the cost of capital. First of all, taxes reduce the funds that are ultimately available to the providers of capital. For that reason they need to be subtracted from the cash flows that are relevant for the valuation. But there <?page no="144"?> 4.2 145 uvk-lucius.de are also DCF-approaches where the cash flows are left unchanged and this introduces a systematic error. As already discussed, this can be balanced when determining the discount rate. This means that the influence of taxes is not taken into consideration for the cash flows, but instead via the discount rate. With regard to the effects of taxes on the discount rate, a general distinction must be made between the cost of equity capital and the cost of debt capital. The cost of equity capital is purely influenced by the personal taxes of the owners. When calculating the cost of debt capital, however, all taxes on profits need to be considered with their respective rates, which were excluded when calculating the cash flows. It can be concluded that the incorporation of taxes requires a careful consideration of the parameters used to capture them - cash flows or discount rate - in order to prevent double counting. 44.2.4 Adjustment of Cash Flows to Correct for Inflation So far, the effects of inflation on the valuation have been ignored. Inflation is defined as a persistent and continuous increase of the price level. Without inflation, the purchasing power of money would remain constant over time. Put differently, a given amount of money would purchase the same basket of goods and services in the future as well. EUR 100 in one year would purchase the same goods as EUR 100 today. In the presence of inflation, more money is needed in the future to purchase an identical basket of goods. If an inflation rate of 10% is assumed as in Table 4.1, the cash flows need to be adjusted for the effects of inflation (right column). EUR 110 in one year has a “real” value of EUR 100 today. This means that the same amount of goods can be bought. 74 See Sabal, J. (2002), pp. 134-135. <?page no="145"?> 146 4 International Business Valuation in South Africa uvk-lucius.de Case Study Table 4.1: Inflation-adjusted cash flows With regard to inflation, a decision needs to be made whether business planning and thus the derivation of the pro-forma P&L and pro-forma balance sheet is based on nominal or real values. Since it is frequently the case that sales as well as individual cost components and investments can be subject to different price changes in the future, it is generally simpler and more appropriate to use nominal instead of real values for the planning. One advantage of a valuation on the basis of nominal values relates to the fact that the taxation of earnings and the financing of the changes in net current assets are also determined on the basis of nominal annual accounts. A disadvantage of nominal cash flows materializes in highly inflationary countries, where the figures relevant for the valuation frequently are not very meaningful due to the inflationary distortions. This renders them at least theoretically worthless. In most countries, annual accounts are not adjusted for the effects of inflation. Assets and liabilities are mostly carried at historical acquisition costs and are not revalued by incorporating the current rate of inflation and the value of the currency. As a consequence, the balance sheet positions tangible assets and inventories are distorted relative to other positions on the balance sheet and the profit and loss statement. In addition, the terminal value should be calculated with reference to real growth and real returns in order to adequately capture the true economic situation of the company after the detailed planning period. In order to check whether the effects of inflation are incorporated correctly it can be advisable to determine the values both in nominal and in real terms. If all assumptions are applied consistently, the results should not differ. Many valuation experts prefer to account for inflation in the cost of capital instead of the cash flows. Again it needs to be assured that <?page no="146"?> 4.2 147 uvk-lucius.de double counting is avoided and that the valuation remains consistent. If the discount rates are determined as real values, for example, the relevant cash flows also need to be stated in real terms. The same is also true for discount rates and cash flows in nominal terms. When nominal values are used in business planning, it is suggested in the literature to derive approximations for the inflation rates used as the difference between nominal interest rates for riskless government bonds and expected real interest rates. The expected inflation rate can also be derived from the term structure of government bonds, since nominal interest rates implicitly reflect the expectation of investors about a real return plus adequate compensation for expected inflation. 75 Practitioners frequently work with nominal data which they receive from financial information providers and use it to derive nominal cash flows. If instead they choose to conduct a valuation in real terms, these can be derived from the nominal values with reference to formula 4.1 and formula 4.2: The valuation on the basis of real variables will not be considered in more detail in this book. In the following, we will always work with nominal values. The company in the following case study is a fictitious South African packaging company, hereafter referred to as ZA Packaging. ZA Packaging is a non-listed company. Accounting data for the past three years serves as the basis for the business valuation. All figures are absolute amounts in ZAR million. The existing annual accounts were initially adjusted to eliminate distortions and the cash flows were adjusted accordingly. The planning assumptions were provided by the management. See Pereiro, L. E. (2002), pp. 99-100. <?page no="147"?> 148 4 International Business Valuation in South Africa uvk-lucius.de Case Study Profit and loss statement: Table 4.2: Pro-forma profit and loss statement of ZA Packaging % Change in revenues 0.2% 7.3% 7.4% 8.0% 7.7% 7.9% 8.2% 8.2% Changes in finished goods, inventories and work in progress 3.8 6.2 12.9 7.7 8.0 8.2 8.5 8.8 9.0 ./ . Cost of materials 1,550.8 1,506.3 1,670.8 1,774.8 1,916.6 2,063.9 2,226.7 2,409.0 2,606.2 in % of total revenues 69.4% 67.1% 69.2% 68.6% 68.6% 68.6% 68.6% 68.6% 68.6% in % of total revenues 30.6% 32.9% 30.8% 31.4% 31.4% 31.4% 31.4% 31.4% 31.4% ./ . Personnel expenses 175.7 224.4 246.6 243.2 262.6 282.8 305.1 330.1 357.1 in % of total revenues 7.9% 10.0% 10.2% 9.4% 9.4% 9.4% 9.4% 9.4% 9.4% ./ . Other operating expenses 206.1 211.2 235.7 245.8 265.4 285.8 308.4 333.6 360.9 in % of total revenues 9.2% 9.4% 9.8% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% + Other operating income 3.8 5.6 10.9 7.8 8.4 9.0 9.7 10.5 11.4 in % of total revenues 0.2% 0.2% 0.5% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% ./ . Depreciation and Amortization 85.9 84.1 79.2 54.4 56.0 57.8 59.6 61.4 63.3 in % of total revenues 3.8% 3.7% 3.3% 2.1% 2.0% 1.9% 1.8% 1.7% 1.7% + Interest income 0.8 1.4 2.0 0.7 0.8 0.8 0.8 0.8 0.9 in % of total revenues 0.0% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% + Interest incomefrom excess liquidity - - - 2.6 2.9 3.5 4.0 4.6 5.4 in % of total revenues 0.0% 0.0% 0.0% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% <?page no="148"?> 4.2 149 uvk-lucius.de <?page no="149"?> 150 4 International Business Valuation in South Africa uvk-lucius.de Balance sheet assets: Table 4.4: Pro-forma balance sheet liabilities and calculation of the excess liquidity of ZA Packaging Table 4.3: Pro-forma balance sheet assets of ZA Packaging Balance sheet liabilities and calculation of excess liquidity: Financial assets 3.8 4.9 4.1 4.2 4.4 4.5 4.6 4.8 4.9 Tangible assets 312.8 271.7 240.6 302.4 367.8 437.0 510.1 587.3 668.8 Intangible assets 8.4 7.6 7.5 7.7 8.0 8.2 8.5 8.7 9.0 Inventories 136.1 154.2 172.1 173.5 187.4 201.8 217.7 235.6 254.8 Trade receivables 993.3 918.5 1,000.0 1,071.5 1,157.1 1,246.1 1,344.4 1,454.4 1,573.5 Other current assets 77.6 109.1 101.8 108.7 122.9 129.4 139.6 151.0 163.4 Excess liquidity - - - 184.8 208.1 247.2 287.6 331.9 383.7 Subscribed capital 428.2 475.2 535.5 552.1 569.2 586.8 604.9 623.6 642.9 Reserves 150.5 147.4 181.7 255.8 337.1 426.1 523.5 630.5 747.7 Balance sheet profit (at the end of the year) 172.7 187.6 153.1 208.6 269.7 336.4 409.5 489.7 577.6 Long-term bank debt 244.9 208.9 183.7 181.9 180.0 178.2 176.5 174.7 172.9 Provisions 149.1 129.2 158.5 166.7 175.4 184.5 194.1 204.2 214.8 Financing gap - - - - - - - - - Short-term bank debt 92.9 78.5 64.8 64.8 64.8 64.8 64.8 64.8 64.8 Trade payables 453.3 373.8 375.7 452.6 488.7 526.3 567.8 614.3 664.6 Other short-term liabilities 24.3 20.1 21.3 23.3 25.1 27.1 29.2 31.6 34.2 Total assets without excess liquidity 1,720.9 1,902.0 2,083.1 2,282.8 2,501.5 2,735.9 Equity and liabilities without financing gap 1,905.8 2,110.1 2,330.2 2,570.3 2,833.4 3,119.6 Difference 184.8 208.1 247.2 287.6 331.9 383.7 Difference total assets and equity & liabilities - - - - - - Total assets = equity & liabilities? OK OK OK OK OK OK <?page no="150"?> 4.3 151 uvk-lucius.de 44.3 Adjustment of the Cost of Capital (Discount Rates) In addition to the cash flows, it is also possible to use the cost of capital, respectively the discount rates, for an adjustment during a business valuation in volatile markets. Both can be used to incorporate additional risks. The determination of the cost of capital can either draw on a CAPM-based model or a model that is not based on the CAPM. So far the CAPM continues to be the standard model in applied work. But in light of the criticism which was voiced, it appears that in its basic form it is unsuitable for a valuation in volatile markets. Academics and practitioners have suggested a number of versions of the CAPM, which make an attempt to eliminate or at least minimize the shortcomings when applied to emerging markets. With the help of these adjusted models it should be possible to calculate the cost of capital also in volatile markets such as emerging markets/ high growth markets. The calculation of the cost of equity frequently turns out to be more problematic and complex than the determination of the cost of debt capital. Next to the CAPM-based models, approaches that are not based on the CAPM will also be presented as alternatives for the calculation of the cost of capital. First we will deal with the CAPM-based models and then we will consider the models that are not based on the CAPM. The calculations and individual steps within the models will again be clarified with reference to a case study. The basis of the case study is the pro-forma P&L and the pro-forma balance sheet which was presented in the previous section. 4.3.1 Determination of the Cost of Equity with the help of CAPM-based Models The foundation for a CAPM-based model, as the name already implies, is the classical CAPM. But since it is not possible to apply the classical CAPM - as already mentioned - to volatile markets such as emerging markets/ high growth markets, the following <?page no="151"?> 152 4 International Business Valuation in South Africa uvk-lucius.de versions and modifications were proposed, which will be discussed in more detail in the following: 76 Global CAPM, Local and adjusted local CAPM, as well as Hybrid CAPM models. In applied work, these models tend to be given preference over models that are not based on the CAPM, since the procurement of data for the individual parameters tends to be easier, due to the wide dissemination of the CAPM. G Global CAPM 4.3.1.1 The global CAPM was used for the first time by SOLNIK. 77 Also found in the literature is the term international CAPM. The global CAPM 78 is based on the assumption that markets are integrated globally and that capital and information can flow freely across borders. Thus international investors are able to access and exit every market with ease. They can do so with minimal transaction costs. An investor who accepts the assumptions of integrated capital markets and the free flow of capital and information can apply the global CAPM. But if the assumptions are not satisfied and if barriers for international flows of capital are present, the global CAPM is not suitable for the determination of the cost of equity capital. Since these types of barriers are frequently in place for emerging markets/ high growth markets and other young markets, the model tends to be more applicable to developed econo- 76 The notation for the formulas which are used in the following is based on Pereiro. See Pereiro, L. E. (2006), pp. 39-40. This facilitates a comparison with the original source. 77 See Solnik, B. H. (1974a); Solnik, B. H. (1974b); Solnik, B. H. (1977). A fundamental discussion of the global CAPM can be found in the following publications: O’Brien, T. J. (1999); Stulz, R. (1999) and Schramm, R. M./ Wang, H. N. (1999). <?page no="152"?> 4.3 153 uvk-lucius.de mies, which are much closer to the conditions of a perfect capital market. 79 Formula 4.3 represents the global CAPM as follows: Formula for the global CAPM C E = Cost of equity capital R f,G = B L,G = Beta of the local target company comput R M,G = Case Study The cost of equity is determined by the global riskless rate, the global company beta and the global market risk premium. Determination of the global riskless rate In applied work it is customary to use the US market as representative for the world market when determining the global riskless rate of interest (R f,G ). The US comes closest to the ideal of an efficient market. For the valuation in this example, the global riskless rate was determined as the geometric average return of a 10-year US government bond of 1.77%. See Pereiro, L. E. (2002), p. 107. (4.3) <?page no="153"?> 154 4 International Business Valuation in South Africa uvk-lucius.de Determination of the global market risk premium The global market risk premium is equal to the difference between the expected return of the global market portfolio R M,G and the global riskless return (R f,G ). Numerous studies have already dealt with the determination of the global market risk premium. Depending on the assumptions used, values between 2.5% and 8.5% are obtained. 80 Ideally, the global market risk premium refers to a global index which has been observed over a long time period. Unfortunately the existing global indexes such as the MSCI World do not have a long data history. The use of such a global index is therefore problematic and must always be viewed critically. In the following a global market risk premium of 5% is assumed. Determination of the global company beta As can be seen from the equation for the global CAPM, the cost of equity for the company to be valued is obtained by multiplication of the global company beta with the global market risk premium. The company-specific beta expresses the risk which the company adds to the market portfolio and which thus requires compensation in market equilibrium. For the determination of the global company beta it was initially decided to derive a company-specific beta factor with the help of a peer group for which capital market data is available. Step 1: Search for a peer group In a first step, a peer group for the company from the packaging industry was determined. Step 2: Determining the (levered) beta factor of the peer group In the second step the (levered) betas for the peer group are determined with the help of a regression of the company returns of the peer group on the MSCI World. As is customary in ap- See Pereiro, L. E. (2002), pp. 118-120. <?page no="154"?> 4.3 155 uvk-lucius.de plied work, annual betas were determined based on the daily returns over the past 250 days. The upper half of Figure 4.2 shows the regression results - levered beta and coefficient of determination - for Bowler Metcalf Ltd, for Nampak Ltd and Mpact Ltd. The lower half of Figure 4.2 shows the regression results in an overview. Figure 4.2: Determination of the levered betas with the help of a regression of the peer group return on the MSCI Worlde Study ( Step 3: Conversion of the levered beta factors into unlevered beta factors In the third step, the levered betas as determined above were converted into unlevered betas u ) with the help of Formula 4.4. They are displayed in Table 4.5. MSCI World 250 days MSCI World 250 days MSCI World 250 days -0.0451 0.0000 0.0004 0.3118 0.0000 0.0372 0.1543 0.0000 0.0090 y = 0.0088x + 0.0004 3.00% 2.00% 0.00% 1.00% 2.00% 3.00% 4.00% Me 15.00% 10.00% 5.01. 0%00%0.00% 5.00% 10.00% Bowler tcalf Ltd MSCI World y = 0.1132x + 0.0003 3.00% 2.00% 0.00% 1.00% 2.00% 3.00% 4.00% 10.00% 5.00%1.00%0.00% 5.00% 10.00% Mpact Ltd MSCI World y = 0.0707x + 0.0003 3.00% 2.00% 0.00% 1.00% 2.00% 3.00% 4.00% Na 6.00% 4.00% 2.00% 1.00%0.00% 2.00% 4.00% mpak Ltd MSCI World lev. Beta R 2 0.1512 0.0040 -0.0451 0.0004 0.3118 0.0372 0.1543 0.0090 0.0018 0.0002 0.1148 0.0102 0.1512 0.0040 Nampak Ltd Transpaco Ltd MSCI World Astrapak Ltd Bowler Metcalf Ltd Mpact Ltd <?page no="155"?> 156 4 International Business Valuation in South Africa uvk-lucius.de Step 4: Aggregation of the unlevered betas by calculating the median In a fourth step, the unlevered betas are aggregated by calculating the median. Step 5: Adding leverage to the unlevered beta determined above In the last step, the median of the unlevered beta was relevered with the leverage factor of debt/ equity of 3.75% and the tax rate of 28%. The result is a global company beta for ZA Packaging of 0.1163 (see Table 4.5). Table 4.5: Determination of an aggregated beta factor based on delevered and relevered data Since the coefficient of determination for the peer group companies (see figure 4.2) is rather low, the explanatory power of the model appears unsatisfactory. In the absence of additional meaningful data about companies or the industry, an alternative approach had to be employed. The beta factor was determined with the help of a regression of the MSCI South Africa on the MSCI World. Implicitly assumed is that the MSCI South Africa is a stable representative of the re- ZAE000096962 Johannesburg 0.1512 0.0040 46.51% 28.00% 0.1132 ZAE000030797 Johannesburg -0.0451 0.0004 11.20% 28.00% -0.0417 ZAE000156501 Johannesburg 0.3118 0.0372 9.59% 28.00% 0.2917 ZAE000071676 Johannesburg 0.1543 0.0090 19.33% 28.00% 0.1355 ZAE000007480 Johannesburg 0.0018 0.0002 45.23% 28.00% 0.0013 0.1000 3.75% 28.00% 0.1132 relever Mpact Ltd Nampak Ltd Transpaco Ltd ZA Packaging Astrapak Ltd Bowler Metcalf Ltd <?page no="156"?> 4.3 157 uvk-lucius.de turn development in the packaging industry, which must be viewed critically. But in the absence of a convincing alternative for determining the beta coefficient, this is the best estimate of the required global company beta. Figure 4.3 shows the results for the regression of the MSCI South Africa on the MSCI World. Figure 4.3: Regression of the MSCI South Africa on the MSCI World Determination of the cost of equity with the help of the global CAPM Following the setting of the individual parameters, the cost of equity can be determined with the help of the global CAPM as follows (See Table 4.6). y = 0.5607x + 5E-05 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 MSCI South Africa MSCI World <?page no="157"?> 158 4 International Business Valuation in South Africa uvk-lucius.de Table 4.6: Determination of the cost of equity with the help of the global CAPM LLocal CAPM and Adjusted Local CAPM 4.3.1.2 The local CAPM was developed by PEREIRO. 81 Just like the global CAPM, it is a version of the classical CAPM. In the literature, the local CAPM is also called domestic CAPM or segmented CAPM. In some sense, the local CAPM is the opposite of the global CAPM. While the global CAPM assumes integrated markets, the local CAPM assumes segmented markets. Segmented markets are characterized by significant barriers which hinder the international flow of capital and information. The model is very suitable for well diversified investors which are limited to a local market. In contrast to the case of integrated markets, existing country risks (R C ) in segmented markets cannot be eliminated with the help of international and geographic diversification. For that reason, they must be incorporated when determining the cost of equity. 82 In segmented markets, the local CAPM can be used as a possibility for the determination of the cost of equity according to the following formula (See Formula 4.5 and Formula 4.6): Formula for the local CAPM 81 See Pereiro, L. E. (2001). 82 See Pereiro, L. E. (2002), pp. 108-111. (4.5) Global riskless rate 1.77% Beta of the local target company computed against the global market index 0.4637 Global market risk premium 5.00% Cost of equity capital <?page no="158"?> 4.3 159 uvk-lucius.de with C E = Cost of equity capital R f,L = Local riskless rate R f,G = Global riskless rate R C = Country risk premium B L,L = Local company beta computed against a local market index R M,L = Return of the local market Problematic about the local CAPM is the fact that it tends to overestimate risks. According to a study by ERB, HARVEY and VISKANTA (1995), the incorporation of the country risk in the simple local CAPM leads to a certain degree of double counting, since components of the country risk are already included in the market risk premium. 83 PEREIRO 84 suggests neutralizing this double counting with the help of a correction which is equal to the coefficient of determination (R i2 ) of the regression of the volatility of the local equity market on the variation of the country risk. R i2 thus stands for that part of equity volatility caused by country risk. The measure used for the country risk is the Morgan Stanley EMBI Index. A reduction of the local CAPM by the factor (1 - R i2 ) will lower the equity market risk by a magnitude which accounts for double counting. Only equity volatility that is not caused by country risk will be included. 85 See Erb, C. B./ Harvey, C. R./ Viskanta, T. E. (1995). 84 See Pereiro, L. E. (2001). See Pereiro, L. E. (2002), pp. 111-112. (4.6) <?page no="159"?> 160 4 International Business Valuation in South Africa uvk-lucius.de The formula for the adjusted local CAPM is as follows (See Formula 4.7): Formula for the adjusted local CAPM C E = Cost of equity capital R f,G = Global riskless rate R f,L = Local riskless rate R C = Country risk premium B L,L = Local company beta computed against a local market index R M,L = Return of the local market R i2 = Variance in the equity volatility of the target company i that is explained by country risk An additional problematic feature of the local CAPM is the fact that in today’s globalized economy it is very unlikely to find investors who hold a portfolio that is completely limited to a specific local market. Even if the portfolios of many investors are still characterized by a home bias, the practical relevance of this approach appears rather limited. Also criticized is the fact that the data needed for the calculation of the input parameters is frequently not available. And if it is available, it is frequently not very meaningful. This is due to the fact that the capital markets in many emerging markets/ high growth markets continue to suffer from weak development and inefficiency. <?page no="160"?> 4.3 161 uvk-lucius.de Case Study Determination of the local riskless rate of interest According to formula 4.6, the local interest rate (R f,L ) consists of the global riskless rate (R f,G ) plus a country risk premium (R C ). As can be seen, this is the additive approach for incorporating country risk, which was already discussed. Country risk affects all companies in the local market to the same degree. While the global riskless rate of interest was already determined in the context of the global CAPM at 1.77%, the country risk premium needs to be calculated in the following. Four possibilities are presented. Figure 4.4 provides an overview of the results of the calculation of the country risk premium based on the different methods. Figure 4.4: Different possibilities for the determination of the country risk premium <?page no="161"?> 162 4 International Business Valuation in South Africa uvk-lucius.de Determination with reference to default spreads (see 3.3.1.1) In the first approach, the country risk premium was determined as a default spread given by the difference between the geometric average yield of a government bond in the local market (7.09%) and the geometric average yield of the global riskless rate (1.77%). It amounts to 5.32%. Determination with reference to the relative standard deviation of the equity markets (see 3.3.1.3) In the second approach, the country risk premium was determined from the relative standard deviation of the equity markets. To arrive at this measure, the annualized standard deviations of the South African and the US equity index were calculated and a relative risk measure was derived from the ratio of the two standard deviations. This relative standard deviation was multiplied with the market risk premium of the US market, which is given as 5%. This provides the total risk premium of the South African market. Risk premium SA = Risk premium US SA = To obtain the country risk premium, the risk premium for the US market is subtracted from this total risk premium. Country risk premium SA = Risk premium SA - Risk premium US = - = - Determination by combining default spreads and relative standard deviation of the equity and bond markets (see 3.3.1.4) The third approach combines the first two methods. <?page no="162"?> 4.3 163 uvk-lucius.de First, the annualized standard deviations of the local South African equity market and the local government bond are determined. The ratio of the two serves as a relative risk measure. The calculated risk spread of 5.32% is adjusted with the help of this relative standard deviation to account for the additional equity market risk. Determination with reference to country ratings (see 3.3.1.2) The simplest way to determine the country risk premium involves the use of the South African country rating. From Table 4.7 follows a risk premium of 2.25% for the South African country rating of Baa1. As can be seen, the country risk premium varies with the method chosen and ranges from -0.69% to 20.72%. Ultimately the valuation expert needs to decide on the appropriateness of the approach. As a consequence of the volatilities which were observable in the year 2012, the approach involving the standard deviations is viewed with skepticism. In the following, the country risk premium will be represented by the default spread of 5.32%. Following the determination of the country risk premium, the local riskless return is finally determined as R f,L = R f,G + R C = + = Determination of the local market risk premium As already mentioned elsewhere, the calculation of a local market risk premium is a complex task, because of the frequently found high volatility of returns in emerging markets. Premiums calculated from existing market indexes frequently appear implausible. These implausible results can be the consequence of <?page no="163"?> 164 4 International Business Valuation in South Africa uvk-lucius.de the still very young capital markets, where only very short times series are available, which tend to be characterized by large volatility caused by the strong market dynamics. 86 If no local data is available, the market risk premium can also be derived from the premium of a developed market plus a country risk premium. Local market risk premium = ntry + Country risk premium The US capital market was used as the market risk premium of a developed country (R M,US - R f,US ). The country risk premium was already determined above (R C = 5.32%). This leads to a local market risk premium of 10.32%. Table 4.7 shows country risk premiums for South Africa as taken from the homepage of DAMODARAN as of 01.01.2013. Table 4.7: Values for the country risk premium of different countries 87 Determination of the local company beta For the calculation of the global company beta it was decided to use a company based beta factor with the help of a peer group for which capital market data is available. Step 1: Search for a peer group In a first step a peer group was identified. See Pereiro, L. E. (2002), pp. 120-121. 87 Source: http: / / pages.stern.nyu.edu/ ~adamodar/ New_Home_Page/ datafile/ ctryprem.html South Africa Africa Baa1 1.50% 8.05% 2.25% 2.03% 7.84% 2.04% <?page no="164"?> 4.3 165 uvk-lucius.de Step 2: In a second step the (levered) betas for the identified companies in the peer group were calculated. This was done for three different indexes, the JSE Top 40 Index, the JSE All-Share Index and the JSE Mid Capitalisation Index. The goal was to identify the index with the highest explanatory power for the calculated beta factors. Figure 4.5 shows the regression results - levered beta and coefficient of determination - for Mpact Ltd. Table 4.8 provides an overview of the regression results. Figure 4.5: Regression of the returns of Mpact Ltd on several indexes Table 4.8: Overview of beta factors and coefficients of determination for the regressions involving comparable South African companies and local indexes As can be seen, the best explanatory power was provided by the JSE Mid Capitalisation Index. For that reason it was selected as the representative index. JSE Top 40 250 days JSE All-Share 250 days JSE Mid Capitalisation Index 250 days 0.3262 0.0011 0.0375 0.3931 0.0010 0.0437 0.6841 0.0007 0.0664 y = 0.115x + 0.0006 3.00% 2.00% 1.00% 0.00% 1.00% 2.00% 3.00% Mp 10.00% 5.00% 0.00% 5.00% 10.00% act Ltd JSE Top 40 y = 0.1111x + 0.0006 3.00% 2.00% 1.00% 0.00% 1.00% 2.00% 3.00% Mp 10.00% 5.00% 0.00% 5.00% 10.00% act Ltd JSE All Share y = 0.0971x + 0.0008 2.00% 1.50% 1.00% 0.00% 0.50% 1.00% 1.50% .00% 5.00%0.50%0.00% 5.00% 10.00% Mp 10 act Ltd JSE Mid Capitalisation Index lev. Beta R 2 lev. Beta R 2 lev. Beta R 2 -0.1045 0.0018 -0.0997 0.0013 0.0726 0.0004 0.0827 0.0015 0.1067 0.0022 0.2941 0.0086 0.3262 0.0375 0.3931 0.0437 0.6841 0.0664 0.3548 0.0583 0.4215 0.0660 0.6974 0.0907 0.2024 0.0081 0.2299 0.0084 0.2202 0.0039 0.1723 0.0214 0.2103 0.0243 0.3937 0.0340 0.2024 0.0081 0.2299 0.0084 0.2941 0.0086 Astrapak Ltd Bowler Metcalf Ltd Mpact Ltd Nampak Ltd Transpaco Ltd JSE Top 40 JSE All-Share JSE Mid Capitalisation Index <?page no="165"?> 166 4 International Business Valuation in South Africa uvk-lucius.de In the third step, the levered betas determined with reference to the JSE Mid Capitalisation Index are used to calculate the unlevered betas using Formula 4.8. The values are shown in Table 4.9. Step 4: Aggregation of the unlevered betas by calculating the median In the fourth step the unlevered betas are aggregated by calculating the median. Step 5: Relevering of the unlevered beta In the last step the aggregated unlevered beta is relevered with the ratio of debt to equity of 14.98% and the relevant tax rate of 28%. The result is a relevered beta of 0.3015, which is equal to the local company beta. Table 4.9: Determination of the aggregated relevered betas (4.8) ZAE000096962 Johannesburg 0.0726 0.0004 46.51% 28.00% 0.0544 ZAE000030797 Johannesburg 0.2941 0.0086 11.20% 28.00% 0.2722 ZAE000156501 Johannesburg 0.6841 0.0664 9.59% 28.00% 0.6399 ZAE000071676 Johannesburg 0.6974 0.0907 19.33% 28.00% 0.6122 ZAE000007480 Johannesburg 0.2202 0.0039 45.23% 28.00% 0.1661 0.3490 14.98% 28.00% 0.2722 relever Mpact Ltd Nampak Ltd Transpaco Ltd ZA Packaging Astrapak Ltd Bowler Metcalf Ltd <?page no="166"?> 4.3 167 uvk-lucius.de Following Pereiro, the coefficient of determination is used as the correction factor. It is obtained from a regression of the local annualized monthly volatilities of the returns of the MSCI South Africa on the annualized monthly volatilities of the returns of the Morgan Stanley EMBI+. 88 It was assumed that the EMBI+ is a suitable index for measuring country risk. Since the coefficient of determination makes a statement about the share of equity volatility that can be explained by country risk, it needs to be used as a correction factor in the form (1-R i2 ). This states the portion of equity market volatility that is not explained by country risk. It is exactly the aim to eliminate the double counting of country risk in equity market fluctuations. The coefficient of determination for the regression was 0.0650. 89 A summary of the results leads to the following cost of equity for the local CAPM (see Table 4.10). Cost of equity capital: Table 4.10: Determination of the cost of equity with the local CAPM See Pereiro, L. E. (2002), pp. 111-112. Due to a lack of data, government bond returns were used in lieu of the EMBI+. Determination of the correction factor (coefficient of determination) for the adjusted l local CAPM <?page no="167"?> 168 4 International Business Valuation in South Africa uvk-lucius.de Hybrid CAPM Models 4.3.1.3 The determination of important parameters such as the local market risk premium or the local beta factor is made considerably more difficult by the high volatility which is present in many emerging markets. The problem of a lack of reliability of the local data series can be reduced by using hybrid CAPM models, which employ a combination of global and local data. 4.3.1.3.1 (Adjusted) Hybrid CAPM and Lessard-Model The hybrid CAPM 90 employs an adjustment of the global market risk premium (R M,G - R f,G ) to the local market with the help of the country beta (BC L,G ) (see Formula 4.9). The advantage of this approach is the use of world market data, which is easier to obtain. Formula for the hybrid CAPM C E = Cost of equity capital R f,G = Global riskless rate R C = Country risk premium BC L,G = Country beta (relative sensitivity of the returns of the local [emerging] stock market to the global market returns B G,G = Average unlevered beta of comparable companies quoting in the global market (relevered with the financial structure of the target company) R M,G = Return of the global market 90 See Pereiro, L. E. (2001). (4.9) <?page no="168"?> 4.3 169 uvk-lucius.de As in the case of the local CAPM, the double counting of country risk can again be eliminated with the help of the correction factor R i2 . For that reason, the model is also called adjusted hybrid CAPM. The term hybrid meanwhile refers to the fact that both local and global risk parameters are taken into consideration. Formula 4.10 presents the adjusted hybrid CAPM. 91 Formula for the adjusted hybrid CAPM C E = Cost of equity capital R f,G = Global riskless rate R C = Country risk premium BC L,G = Country beta (relative sensitivity of the returns of the local [emerging] stock market to the global market returns) B G,G = Average unlevered beta of comparable companies quoting in the global market (relevered with the financial structure of the target company) R M,G = Return of the global market R i2 = Variance in the equity volatility of the target company i that is explained by country risk 91 See Pereiro, L. E. (2002), pp. 111-112. (4.10) <?page no="169"?> 170 4 International Business Valuation in South Africa uvk-lucius.de Case Study For the calculation of the cost of equity with the adjusted hybrid CAPM, the values which were determined in the context of the other models can be used for the global riskless rate of interest (R f,G ), the country risk premium (R C ), the global market risk premium (R M,G -R f,G ) as well the correction factor R i2 . For the derivation of these values, we refer to the above discussions. In the following, only the country beta (BC L,G ) and the global beta (B G,G ) of the global comparative companies need to be determined. Determination of the country beta (BC L,G ) The country beta is used for the adjustment of the global market risk to the specifics of the local market. It is obtained from a regression involving the MSCI South Africa and the MSCI World. The country beta is thus equal to the company beta, which was already determined generally in the context of the global CAPM. As a reminder: Due to a lack of better data, it was derived using the same regression. Determination of the global betas (B G,G ) of comparable companies in the world market For the calculation of the global beta of comparable companies in the world market, an approach analogous to the local CAPM was chosen. Namely the determination of a company-based beta factor with the help of a global peer group on the basis of existing capital market data. The returns of the past 250 days of the comparable companies are to be used. Step 1: up In a first step a global peer group of companies in the packaging industry was determined. Again only comparable companies from the US where selected as representatives for the global market. <?page no="170"?> 4.3 171 uvk-lucius.de Step 2: In the second step, the respective (levered) betas for the identified companies in the peer group were determined. This was again conducted for three different indexes, the NYSE Composite, the S&P 500 and the Wilshire 5000. The aim was to identify the index with the highest explanatory power for the calculated beta factors. Figure 4.6 shows the regression results - levered beta and coefficient of determination - for Ball Corp. Table 4.11 provides an overview of the regression results. Figure 4.6: Regression of Ball Corp. on various indexes Table 4.11: Results for the regressions involving the US comparable companies and various US indexes NYSE Composite 250 days S & P 500 250 days Wilshire 5000 250 days 0.6612 0.0005 0.3413 0.8179 0.0005 0.3772 0.8020 0.0005 0.3782 y = 0.5163x + 0.0001 4.00% 3.00% 2.00% 0.00% 1.00% 2.00% 3.00% 4.00% 4.00% 2.00 1.%00%0.00% 2.00% 4.00% 6.00% Ball Corp. NYSE Composite y = 0.4612x + 6E 05 1.00% 2.00% 3.00% 0.00% 1.00% 2.00% 3.00% 4.00% 2.00% 0.00% 2.00% 4.00% 6.00% Ball Corp. S & P 500 y = 0.4716x + 7E 05 3.00% 2.00% 1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 2.00% 0.00% 2.00% 4.00% 6.00% Ball Corp. Wilshire 5000 lev. Beta R 2 lev. Beta R 2 lev. Beta R 2 0.6612 0.3413 0.8179 0.3772 0.8020 0.3782 0.6799 0.3911 0.8196 0.4104 0.8009 0.4088 0.9547 0.3482 1.1216 0.3470 1.1368 0.3718 0.6736 0.3504 0.8282 0.3824 0.8097 0.3813 1.2017 0.3890 1.4221 0.3934 1.4232 0.4110 0.7957 0.2062 1.0432 0.2559 1.0157 0.2530 0.8306 0.3625 0.9880 0.3703 0.9882 0.3864 1.2303 0.3549 1.5435 0.4033 1.5318 0.4143 0.7464 0.3427 0.9240 0.3793 0.9157 0.3885 1.1318 0.2919 1.3461 0.2981 1.3276 0.3025 1.0508 0.2195 1.3178 0.2493 1.3112 0.2574 0.6832 0.3247 0.8421 0.3563 0.8389 0.3688 0.8867 0.3269 1.0845 0.3519 1.0751 0.3602 0.8132 0.3455 1.0156 0.3738 1.0019 0.3798 Owens-Illinois Packaging Corp. Rock-Tenn 'A' Sealed Air Sonoco Products Bemis Co. CLARCOR Inc. Crown Holdings Inc. Graphic Packaging Intl Co Greif Inc MeadWestvaco NYSE Composite S & P 500 Wilshire 5000 Ball Corp. <?page no="171"?> 172 4 International Business Valuation in South Africa uvk-lucius.de As can be seen, the best results were obtained for the Wilshire 5000. For that reason, it is the index used in the following. The steps 3 to 5, namely the transformation of levered beta factors into unlevered beta factors, the aggregation of the unlevered betas by calculating the median as well as the use of the debt to equity ratio of 12.77% and the tax rate of 28% to relever the data are similar to the approach in the local CAPM. The result is a relevered beta of 0.8201, which is equal to the hybrid company beta. Table 4.12 summarizes the results. Table 4.12: Determination of the global aggregated delevered and relevered beta factors Now that all input parameters have been determined, the cost of equity according to the adjusted hybrid CAPM can be calculated as follows (see Table 4.13). Study (continued) BLL NYSE 0.8020 0.3782 49.65% 40.00% 0.6302 BMS NYSE 0.8009 0.4088 41.44% 40.00% 0.6564 CLC NYSE 1.1368 0.3718 0.70% 40.00% 1.1169 CCK NYSE 0.8097 0.3813 69.87% 40.00% 0.5836 GPK NYSE 1.4232 0.4110 104.04% 40.00% 0.8756 GEF NYSE 1.0157 0.2530 62.59% 40.00% 0.7584 MWV NYSE 0.9882 0.3864 44.38% 40.00% 0.7803 OI NYSE 1.5318 0.4143 107.84% 40.00% 0.9372 PKG NYSE 0.9157 0.3885 62.95% 40.00% 0.6707 RKT NYSE 1.3276 0.3025 68.74% 40.00% 0.6542 SEE NYSE 1.3112 0.2574 135.02% 40.00% 0.7437 SON NYSE 0.8389 0.3688 37.04% 40.00% 1.0782 0.7904 12.77% 28.00% 0.7510 relever Bemis Co. Ball Corp. CLARCOR Inc. Crown Holdings Inc. Graphic Packaging Intl Corp Owens-Illinois Greif Inc MeadWestvaco Packaging Corp. Rock-Tenn 'A' Sealed Air Sonoco Products ZA Packaging (hybrid CAPM) <?page no="172"?> 4.3 The Market Risk Premium 173 uvk-lucius.de Table 4.13: Calculation of the cost of equity with the (adjusted) hybrid CAPM A special case of the hybrid CAPM, which uses the US market instead of the global market, is the Lessard-Model. 92 In this model, the country risk is calculated by multiplying the beta of a comparable project in the US with the country beta of a project-specific beta: Formula for the Lessard-Model C E = Cost of equity R f,US = U.S. riskless rate R C = Country risk premium BC L,US = Country beta (relative sensitivity of the returns of the local [emerging] stock market to the US market returns) 92 See Lessard, D. R. (1996). (4.11) <?page no="173"?> 174 4 International Business Valuation in South Africa uvk-lucius.de B US = Beta of a US-based project that is comparable to the project R M,US = Return of the US stock market index 4.3.1.3.2 Godfrey-Espinosa-Model An additional model for the determination of the cost of equity is the Godfrey-Espinosa-Model, 93 named after the two developers GODFREY and ESPINOSA. It is determined in line with Formula 4.12 and Formula 4.13: Formula for the Godfrey-Espinosa-Model C E = Cost of equity R f,US = US riskless rate R C = Country risk premium B = Modified beta R M,US = Return of the US stock market index L = Standard deviation of returns in the local market US = Standard deviation of returns in the US equity market 93 Godfrey, S./ Espinosa, R. A. (1996). (4.12) (4.13) <?page no="174"?> 4.3 175 uvk-lucius.de A strict fundamental assumption of the model is a correlation coefficient of 1 between the reference market and the emerging market. In other words, a perfect correlation is assumed. Since it appears that a portion of the country risk is already contained in the market risk premium, the addition of the country risk premium will once again lead to the double counting of risk. In order to account for this fact, GODFREY and ESPINOSA correct the beta coefficient by a factor of 0.6. This correction factor is based on a study by ERB, HARVEY and VISKANTA, which shows that about 40% of equity market volatility can be explained by fluctuations in country risk. Thus only the remaining 60% need to be considered. 94 Case Study For the calculation of the cost of equity with the help of the Godfrey-Espinosa-Model, the data from the previous models can be used. Thus all data has already been introduced. The riskless rate of interest in the US (R f,US ) in the amount of 1.77% is based on the government bond with a maturity of 10 years. The country risk premium (R C ) in an amount of 5.32% based on the default spread approach is also used again. The market risk premium in the US (R M,US -R f,US ) is again considered to be 5%. The modified beta factor (B ) was determined with the help of the ratio between the standard deviation of the local market returns and the standard deviation of the US equity market adjusted by the factor 0.6 (see Formula 4.13). The standard deviations are the same ones used in the local CAPM for the JSE All-Share and the S&P 500. Case Study (continued) See Erb, C. B./ Harvey, C. R./ Viskanta, T. E. (1995), pp. 76-77 <?page no="175"?> 176 4 International Business Valuation in South Africa uvk-lucius.de The cost of equity is determined as follows (see Table 4.14): Table 4.14: Determination of the cost of equity according to the Godfrey-Espinosa-Model 4.3.1.3.3 Goldman-Sachs-Model The Goldman-Sachs-Model was developed by MARISCAL and HARGIS. 95 It is very close to the Godfrey-Espinosa-Model, but contains improved adjustments for the prevention of double counting. To avoid double counting, the calculated return is multiplied by (1-R) for example, where R represents the correlation of the Dollar returns between the local equity market and the government bond used to measure the country risk. In addition, the integration of a local company beta B L,L and a company-specific risk premium R Id , allow the calculation of a company-specific cost of equity. The company-specific risk premium follows from the specific character of the company (for example cyclical industry, share of earnings outside the home market, etc.). The company-specific cost of equity (see Formula 4.14) can be determined as follows: Formula for the Goldman-Sachs-Model 95 See Mariscal, J. O./ Hargis, K. A. (1999). (4.14) R f ,US US riskless rate 1.77% R C Country risk premium 5.32% L Standard deviation of returns in the local market 11.23% US Standard deviation of returns in the US equity market 13.01% Correction factor 0.6 R M,US Return of the US stock market index 5.00% Cost of equity 9.68% <?page no="176"?> 4.3 177 uvk-lucius.de C E = Cost of equity R f,US = US riskless rate R C = Country risk premium B L,L = Local company beta computed against a local market index R M,US = Return of the US stock market index L = Standard deviation of returns in the local market US = Standard deviation of returns in the US equity market R Correlation of dollar returns between the local stock market and the sovereign bond used to measure country risk R Idiosyncratic risk premium related to the special features of the target firm (e.g., specific firm credit rating as embodied in its corporate debt spread, industry cyclicality, percentage of revenues coming from the target country, etc.) From an applied perspective, the model can be criticized because it is not clear how to concretely calculate the company-specific risk premium. The significant leeway for the modeler introduces a large degree of subjectivity. Case Study The calculation of the cost of equity according to the Goldman- Sachs-Model can largely be based on the data from the previously used models. The riskless rate of interest in the US (R f,US ) in the amount of 1.77% is based on the government bond with a maturity of 10 <?page no="177"?> 178 4 International Business Valuation in South Africa uvk-lucius.de years. The country risk premium (R C ) in an amount of 5.32% is based on the default spread approach. The market risk premium in the US (R M,US -R f,US ) is again considered to be 5%. The standard deviations of the returns in the local market ( L ) of 11.23% and the returns in the US market ( US ) of 13.01% are taken from the Godfrey-Espinosa-Model. The local company beta (B L,L ) is 0.2894, based on a debt to equity ratio of 8.79% and the tax rate of 28%. For the adjustment factor R, the already determined coefficient of determination (see adjusted local and hybrid CAPM) was used and the square root calculated. Since the model does not provide a suggestion for the calculation of the companyspecific risk premium (R Id ), a value of 5% was assumed. Finally the cost of equity is obtained as follows (see Table 4.15): Table 4.15: Determination of the cost of equity with the Goldman- Sachs-Model 4.3.1.3.4 Damodaran-Model The Damodaran-Model 96 is based on the lambda approach by DAMODARAN, which was previously discussed in detail. In his approach from the year 2002, DAMODARAN incorporates the calculation of a company-specific country risk. This company- 96 See Damodaran, A. (2002), pp. 162 and 204. <?page no="178"?> 4.3 179 uvk-lucius.de specific country risk incorporates the fact that companies in the same country can have a different exposure to country risk, depending on their industry and their size. The company-specific country risk is obtained by multiplying the country risk premium -specific consideration of country risk. Formula for the Damodaran-Model C E = Cost of equity R f,US = US riskless rate R C = Country risk premium = Firm-specific exposure to country risk ranging from zero to one B L,L = Local company beta computed against a local market index R M,US = Return of the US stock market index The Damodaran Model constitutes only a slight modification of the traditional CAPM. For that reason it can be implemented quite easily in applied work. A critical point refers to the fact that the espond very loosely to the treatment of country risk in companies. 97 97 On this point also see the fundamental criticism by Kruschwitz, Löffler and Mandl of the Damodaran Model. Kruschwitz, L./ Löffler, A./ Mandl, G. (2011). (4.15) <?page no="179"?> 180 4 International Business Valuation in South Africa uvk-lucius.de Case Study For the calculation of the cost of equity with the Damodaran- Model, the data from the previous models can be used for the most part. The riskless rate of interest in the US (R f,US ) in the amount of 1.77% is based on the government bond with a maturity of years. The country risk premium (R C ) in an amount of 5.32% is based on the default spread approach. The market risk premium in the US (R M,US -R f,US ) is considered to be 5%. The local compa-ny beta (B L,L ) is 0.2898, based on a debt to equity ratio of 9.02% and the tax rate of 28%. For the lambda factor a value of 0.7 was determined. The cost of equity is thus calculated as follows (see Table 4.16): Table 4.16: Determination of the cost of equity with the Damodaran-Model 4.3.1.3.5 Salomon-Smith-Barney-Model ZENNER and AKAYDIN 98 have modified the global CAPM. In this approach the country risk premium is multiplied with company-specific risks and implemented as follows: Formula for the Salomon-Smith-Barney-Model 98 See Zenner, M./ Akaydin, E. (2002). (4.16) <?page no="180"?> 4.3 181 uvk-lucius.de C E = Cost of equity R f,H = Risk free rate of the home country of the multinational corporation doing the valuation R f,G = Global riskless rate R C = Country risk premium 1 = Firm-related score from 0 to 10 with a 0 indicating the best access to capital markets 2 = Industry score from 0 to 10 with a 0 indicating the least susceptibility of the industry to political intervention 3 = Home country firm score from 0 to 10 with a 0 indicating that the investment at the local level constitutes only a small portion of the firm’s total assets B L,G = Beta of the local target company computed against the global market index R M,G = Global market return A positive feature of this model is the incorporation of the company that plans the investment. This implies that different companies arrive at different costs of equity for the same investment in the same country. A critical aspect is the calculation of 1 , 2 and 3 . They need to be set by the company and are thus based on the subjective assessment of the valuation expert. An additional problem in applied work relates to the fact that the riskless rate of return of the home country R f,H already includes the country risk, which is however, incorporated again by multiplying the country risk premium with company-specific risks. In order to avoid double counting and to maintain the original idea of the Salomon-Smith-Barney- Model, it is suggested to work with the riskless rate of interest in the US, R f,US , instead of the riskless rate of interest of the home country, R f,H . <?page no="181"?> 182 4 International Business Valuation in South Africa uvk-lucius.de Case Study For the calculation of the cost of equity with the Salomon- Smith-Barney-Model, the previously used data can be utilized for the most part. The country risk premium (R C ) in an amount of 5.32% is based on the default spread approach. The market risk premium in the US (R M,US -R f,US ) is considered to be 5%. The global company beta (B L,G ) was determined in the global CAPM model with the help of a regression of the MSCI South Africa on the MSCI World and has a value of 0.4637. Values of 1 =4, 2 =2 and 3 =4 were assumed for the gamma factors. The cost of equity can now be determined as follows (see Table 4.17): Table 4.17: Determination of the cost of equity with the Salomon- Smith-Barney-Model 44.3.2 Determination of the Cost of Equity with the help of models that are not based on the CAPM So far it has not been possible to either completely confirm or refute empirically the results which were obtained with the numerous versions of the CAPM in emerging markets/ high growth markets. 99 In reaction to some of the methodological and conceptual See Pereiro, L. E. (2002), p. 113. <?page no="182"?> 4.3 183 uvk-lucius.de weaknesses of the CAPM, practitioners and academics have developed additional models for the calculation of the cost of equity that are not based on the CAPM. Four of these models will be presented in the following. the Estrada-Model, the Erb-Harvey-Viskanta-Model (EHVM), the Arbitrage Pricing Theory (APT) and the simulation-based approach. While the Estrada-Model can be seen as an interesting and workable alternative to the CAPM-based models with regard to data availability in applied work, the same is not completely true for the latter three models. The Erb-Harvey-Viskanta-Model (EHVM) and the Arbitrage Pricing Theory (APT) are so-called multifactor models, which attempt to capture risk with the help of several factors. The determination of these factors frequently requires significant additional effort with regard to the collection of data. The required data can frequently not be determined for emerging markets/ high growth markets, given the existing problems and challenges. The added benefit frequently does not justify the additional effort. 100 The simulation-based approach can fundamentally overcome the methodological gaps between CAPM-based models and alternative approaches and incorporate country risk into the cash flows. Problematic areas are the collection of data and the lack of acceptance of Monte Carlo simulation models in applied business valuations. An advantage of the models that are not based on the CAPM is the consideration of total risk. For that reason, they are frequently called total risk models. In contrast to CAPM-based models, which by definition only incorporate systematic risk, the models that are not based on CAPM at least partially include existing unsystematic risks in the calculation of the cost of equity. See Pereiro, L. E. (2002), p. 113. <?page no="183"?> 184 4 International Business Valuation in South Africa uvk-lucius.de Estrada-Model 4.3.2.1 The Estrada-Model, which is named after the Spanish economist JAVIER ESTRADA, at first glance resembles the classical CAPM (see Formula 4.17 and Formula 4.18). 101 Formula for the Estrada-Model C E = Cost of equity R f,G = Global riskless rate R M,G = Global market return RM i = Downside risk measure, the ratio between the semi-standard deviation of returns with respect to the mean in market i and the semi standard deviation of returns with respect to the mean in the world market semi- L,M = Semi-standard deviation of returns with respect to the mean in market i semi- G = Semi-standard deviation of returns with respect to the mean in the world market The decisive difference is the use of a so-called downside risk measure (RM i ) by Estrada instead of the beta factor. This is justified by the observation that rational investors normally only interpret negative deviations from the expected value as risk, while positive deviations are seen as an opportunity. In the classical See Estrada, J. (2000). (4.17) (4.18) <?page no="184"?> 4.3 The Market Risk Premium 185 uvk-lucius.de CAPM meanwhile, risk is defined as the variance of returns which includes both positive and negative deviations. This type of risk measure was frequently criticized about the CAPM. The incorporation of a measure of downside risk attempts to circumvent this problem of the CAPM. The downside risk measure is calculated as the ratio of the semistandard deviation of the returns of the local reference market with the semi-standard deviation of the returns of the global market (see Formula 4.18). Semi-standard deviations only take negative deviations from expected values into consideration. 102 Studies by ESTRADA (2000), HARVEY (1995), ERB, HARVEY and VISKANTA (1996) have shown that systematic risk in emerging markets frequently does not show a significant correlation with equity returns. This is most likely due to a lack of integration of these markets with the global market. On the other hand, a significant correlation of the downside risk with the equity returns was found, which lends support to the model of Estrada. 103 HARVEY and ESTRADA also determined that the beta factors calculated with the help of the CAPM frequently appear too small to justify the cost of equity which investors consider to be appropriate in actual transactions. 104 So ESTRADA argued that his model is better at capturing the partially segmented markets in emerging markets/ high growth markets, since it provides results which fall in between the values from the CAPM which appear too low and the values of other total risk models, which appear excessive. 105 See Estrada, J. (2000) and Pereiro, L. E. (2002), p. 113. See Estrada, J. (2000), p. 3 and p. 9. See Estrada, J. (2000), p. 3. See Pereiro, L. E. (2002), pp. 113-114. <?page no="185"?> 186 4 International Business Valuation in South Africa uvk-lucius.de Case Study Again the riskless return of the US (R f,US = 1.77%) as well as the global market risk premium ( R M,US - R f,US = 5%) can be used from previous models. To determine the downside risk measures it was initially necessary to calculate the semi-standard deviations of the local South African market and the world market. For the local market, the returns of the MSCI South Africa, and for the world market the returns of the MSCI World were used. For both return series, the negative deviations from the expected value were determined. Next the deviations were squared and their variance - the so-called downside variance - was determined. To calculate the semi-standard deviation of the indexes, the square root of the downside variance was determined. A value of 1.0670 was determined for the downside risk measure. According to the Estrada-Model, the following cost of equity results (see Table 4.18). Table 4.18: Determination of the cost of equity with the Estrada- Model R f ,US US riskless rate 1.77% R M,G -R f ,G Global market risk premium 5.00% RM i Downside risk measure, the ratio between the semi standard deviation of returns with respect to the mean in market i and the semi standard deviation of returns with respect to the mean in the world market 1.0670 C E Cost of equity 7.11% <?page no="186"?> 4.3 187 uvk-lucius.de EErb-Harvey-Viskanta-Model (EHVM) 4.3.2.2 For economies without equity markets, ERB, HARVEY and VISKANTA (1996) suggest the use of a model based on credit risk ratings of the country. These credit risk ratings incorporate political risks, exchange rate risks, inflation and other typical countryspecific risks. 106 Formula for the Erb-Harvey-Viskanta-Model R i = Semi-annual return in U.S. dollars for country i 1 = Regression constant 2 = Regression coefficient CCR = Country credit rating = Regression residual Since the EHVM-Model is a total risk model, it must be pointed out that the calculated cost of equity is normally higher compared to the downside risk models of ESTRADA. 107 The critics of this model mostly focus on two issues. First, the use of country-specific credit ratings does not incorporate companyspecific risk and second, the ratings frequently are rather subjective risk measures, which are often derived on the basis of qualitative inputs and arbitrarily chosen factor weights. 108 See Erb, C. B./ Harvey, C. R./ Viskanta, T. E.( 1996a); Erb, C. B./ Harvey, C. R./ Viskanta, T. E. (1995); Pereiro, L. E. (2002), p. 114. See Pereiro, L. E. (2002), p. 114. See Estrada, J. (2000), p. 4. (4.19) <?page no="187"?> 188 4 International Business Valuation in South Africa uvk-lucius.de AArbitrage Pricing Theory (APT) 4.3.2.3 The Arbitrage Pricing Theory (APT) can be seen as a general version of the CAPM, since it allows several factors for the determination of risk premiums. 109 For that reason, the APT is a multi-factor model. The cost of equity according to the APT can be determined as follows (see Formula 4.20): Formula for the Arbitrage Pricing Theory (APT) C E = Cost of equity R f = Riskless rate R M,k = Local market return of the factor k B k = Sensitivity of the jth asset to factor k Instead of only one factor for the systematic risk (market risk), which is the case for example in the CAPM, the APT allows for the incorporation of a theoretically unlimited number of different factors. The variables in brackets are the risk premiums for the factor in the model. The betas reflect the sensitivity of the returns with respect to the various factors. If the factors can be extracted from the available data, the APT is theoretically able to determine the cost of equity more precisely than the CAPM, respectively revealing the “value drivers” of the cost of equity. See Damodaran, A. (2006), pp. 33-34. (4.20) <?page no="188"?> 4.3 189 uvk-lucius.de But which factors are decisive? According to a study by CHEN, ROLL and ROSS (1986), the following five factors decisively influence the magnitude of the cost of equity. 110 Industrial production, Changes in default premiums, Changes in the term structure of interest, Unexpected inflation and Changes in the real return. The main criticism of the APT relates to the problems in practical applications. The factors, which by definition must be uncorrelated, frequently must be extracted from the available data material with considerable effort. Even though factor analysis and new statistical approaches offer solutions in this regard and thus allow an implementation of the model, the APT is still generally not used much in applied work. 111 With regard to the use of the APT in emerging markets, the known problem of unreliable underlying data material frequently arises as well. This makes it more difficult to determine the factors. 112 S Simulation-based Approach 4.3.2.4 An additional approach for the determination of country risks which is also not based on the CAPM relies on simulation-based valuation. 113 Simulation-based valuation approaches allow the direct incorporation of country risks (such as inflation uncertainty, possibility of expropriation or state insolvency) in the simulation of the uncertain future earnings and cash flows of the company. Starting from the business planning, Monte Carlo Simulations are used to generate a large number of future scenarios for the com- See Chen, N. F./ Roll,R. R./ Ross, S. A. (1986). See Sabal, J. (2003), p. 12. See Pereiro, L. E. (2002), p. 110. 113 See Gleißner, W. (2011). <?page no="189"?> 190 4 International Business Valuation in South Africa uvk-lucius.de pany and the implications for future cash flows. All country risks, including the examples mentioned above, can lead to deviations from planning and are taken into consideration when developing the scenarios. Ceteris paribus, this leads to a wider range of cash flows and an increased risk measure such as standard deviation or Value-at-Risk of the cash flows. An increase in the level of risk (that cannot be diversified) - for otherwise unchanged conditions - implies a higher risk-adjusted discount rate or a discount for risk (in the cash flows). Therefore the separate incorporation via the “country risk premium” is not necessary. An advantage of the simulation-based derivation of the relevant magnitude of risk of the uncertain cash flows is the automatic incorporation of diversification effects between “country-specific risks” and “other company risks” - no “arbitrary” separation is required. Additionally, an adequate valuation which is based on probability distributions of the uncertain cash flows is also possible if no historical capital market data (equity returns) is available as the basis for qualifying the risks (such as the determination of the beta factor in the CAPM). This is relevant for the valuation of companies in emerging markets/ high growth markets, since frequently no developed capital markets exist in these countries. Overall, the approach allows the consistent incorporation of country risk in the context of a valuation. The valuation which starts from uncertain cash flows takes the perspective of an investor who plans a long-term involvement and who needs to bear cash flow risks (but not temporary price fluctuations). This is the “narrowly defined” perspective of a business valuation (compared to the understanding of risk for an investor who takes a short-term perspective and needs to deal with the “risk of price fluctuations”). A disadvantage of the approach is the data requirement, which frequently includes subjective assumptions and assessments. Also problematic in the implementation is the fact that simulationbased approaches are rarely used by valuation practitioners. <?page no="190"?> uvk-lucius.de 4.3 The Market Risk Premium 191 44.3.3 Overview of the Calculations Needed for the Models of International Business Valuation Table 4.19: Overview of the calculations needed for the models of international business valuation 4.3 Adjustment of the Cost of Capital (Discount Rates) 191 <?page no="191"?> 192 4 International Business Valuation in South Africa uvk-lucius.de 44.3.4 Comparison of the Models Table 4.20 summarizes the advantages and disadvantages of the models presented. Advantages Disadvantages CAPM-based models Global CAPM Simple application Data availability reliable Limited integration of the emerging markets/ high growth markets Local CAPM Comprehensible approach Reliable data not available Emerging markets/ high growth markets are for the most part not fully segmented Adjusted local CAPM Comprehensible approach No doublecounting of country risks Reliable data not available Emerging markets/ high growth markets are for the most part not fully segmented Hybrid CAPM Differentiated treatment of the individual types of risks Calculation of a project-specific beta Global data reliably available Reliable local data not available <?page no="192"?> 4.3 The Market Risk Premium 193 uvk-lucius.de Adjusted hybrid CAPM Differentiated treatment of the individual types of risks Calculation of a project-specific beta Global data reliably available No double-counting of country risks Reliable local data not available Lessard- Model Differentiated treatment of the individual types of risks Calculation of a project-specific beta Global data reliably available Reliable local data not available US used as reference market Godfrey- Espinosa- Model Differentiated treatment of the individual types of risks Global data reliably available Country risk is not identical for all investments Improvised multipliers set at 0.6 Reliable local data not available Goldman- Sachs- Model Calculation of a company-specific cost of capital Global data reliably available Calculation of the company-specific risk premium Reliable local data not available Damodaran- Model Calculation of a company-specific cost of capital Global data reliably available Calculation of is only a rough estimate Reliable local data not available <?page no="193"?> 194 4 International Business Valuation in South Africa uvk-lucius.de Salomon- Smith- Barney- Model Calculation of a company-specific cost of capital Global data reliably available Calculation of 1 , 2 , 3 is based on subjective assessment Reliable local data not available Models not based on CAPM Estrada- Model Captures only negative deviations from forecast values (more in line with the common definition of risk) Downside risk measure still not widely known Lack of theoretical foundation Erb- Harvey- Viskanta- Model (EHVM) Simple application Data reliably available Application is also possible without equity market data or reliable market information Country risk is not identical for all investments Lack of theoretical foundation Arbitrage Pricing Theory (APT) Explanatory power partly higher than CAPM Choice of factors is difficult Reliable data not available Simulation-based approach Country-specific risks and other company-specific risks are automatically captured “Artificial” separation between systematic and unsystematic risk is not needed Data collection is difficult Monte Carlo simulation not used widely in applied valuation work <?page no="194"?> 4.4 195 uvk-lucius.de adequate valuation starting from probability distributions of the uncertain cash flows is also possible if no historic capital market data (equity returns) are available as basis for the qualification of risks Table 4.20: Comparison of the models based on CAPM and the models not based on CAPM 114 44.4 Model Selection Now the questions are which of these models should ultimately be used for the determination of the cost of equity and which model gives the “best” results in an applied business valuation. The fact is that there is no generally accepted answer to this question. There is not one method which is best for all valuation situations. Especially in an international context, it must be realized that the framework conditions can vary greatly from country to country when conducting a business valuation. Therefore the choice of model for the determination of the cost of equity should always be based on the specific situation of the business valuation as well as the underlying assumptions of the available models. This is the only way to assure that the models used are ideally matched with the valuation situation. When analyzing the circumstances, the degree of integration of the relevant market with the global market must be studied, for ex- 114 Based on Hofbauer, E. (2011), p. 126. <?page no="195"?> 196 4 International Business Valuation in South Africa uvk-lucius.de ample, and whether sizeable barriers for international capital flows exist. Also it needs to be ascertained whether the investor is globally or only locally diversified. Depending on the degree of market integration and the diversification of the investor, different models for the determination of the cost of equity can be applied. Additionally the availability of the required data basis must be checked. Without the necessary data, the respective model cannot be used. Once the underlying situation has been thoroughly analyzed, it must be checked whether it is in line with the basic theme and underlying assumptions of the chosen model. A closer look at the underlying assumptions will for example reveal that the global CAPM assumes an integrated market and is thus not really suitable for a business valuation in segmented markets. Markets which are characterized by severe barriers for international capital flows are thus better analyzed with the help of the local CAPM. But what appears problematic for the local CAPM in volatile markets are time varying market risk premiums and beta factors as well as the incompleteness and lack of reliability of local data. The hybrid CAPM attempts to sidestep this problem by adjusting the global market risk premium to the local market with the help of a country beta. An advantage is the easy availability of the needed data from the world market and the ability to consider both local and global risk parameters. Thus it appears more promising to use the hybrid CAPM in cases where the market of the valuation object tends to be segmented and local data series are not easily accessible or not meaningful. If instead the Godfrey-Espinosa-Model is considered, it becomes clear that the application of that model does not appear recommendable in every valuation situation. The assumed perfect correlation between reference market and local market is frequently not given, especially when applied to emerging markets. Furthermore, the assumed correction factor of 0.6 is unlikely to be constant over time. Also not every country is issuing Dollar denominated bonds, <?page no="196"?> 4.4 197 uvk-lucius.de which are absolutely required for the implementation of that model. If the use of the Estrada-Model is considered, two advantages become apparent. First, a part of the unsystematic risk is taken into consideration, which can be an advantage especially in volatile markets. Second, the definition of risk as downside risk appears more plausible. However, the Estrada Model requires functioning equity markets with regard to the data material. If the country in question does not have a functioning equity market, the use of the Erb-Harvey-Viskanta-Model makes more sense. Disadvantages of the model are the exclusion of companyspecific risks and the mostly subjective determination of the risk measures for the ratings. Simulation-based valuation approaches can be used regardless of the level of development of the capital market. An adequate valuation starting from probability distributions of the uncertain cash flows is possible even in situations where historical capital market data (equity returns) is unavailable as basis for the qualification of risks (such as the determination of the beta factor in the CAPM). Once the situation of the business valuation has been analyzed and the underlying assumptions of the various models have been carefully assessed, a decision can be reached about the appropriateness of the various models in the given situation. Ultimately the valuation expert needs to decide which model will yield the “best” result in a given valuation situation. If the specification of one model is to be avoided, it is also possible to work with several models. The resulting business values can either be displayed as a range or a synthetic average. 115 Figure 4.7 shows the decision tree and the available models. See Pereiro, L. E. (2002), p. 187. <?page no="197"?> 198 4 International Business Valuation in South Africa uvk-lucius.de Figure 4.7: Decision tree for the model selection 116 44.4.1 An Overview of the Cost of Equity of the Various Models The cost of equity in the case study varies greatly with the different models, which are based on different assumptions and rely on different input data. Case Study Table 4.21 summarizes the results of the various models, either based on CAPM or not based on CAPM, for the determination of the cost of equity: 116 Following Hofbauer, E. (2011), p. 128 and the literature listed there. <?page no="198"?> 4.4 199 uvk-lucius.de Table 4.21: Overview of the results from the various models In the context of the CAPM-based models, the global and the local CAPM provide the lower and the upper bound. The results for the other CAPM-based models are within these boundaries. In comparison, the models that are not based on the CAPM report higher values, since parts of unsystematic risk must also be incorporated. 44.4.2 Determination of the Cost of Debt Now that the cost of equity has been determined with the help of various methods which are partly based on the CAPM, the cost of debt capital must also be specified. As is already known, the interest rate on debt capital consists of two components, the riskless rate of interest plus a risk premium, which depends on the credit standing of the issuer (see Formula 4.21). C D = R f (4.21) Global CAPM 4.09% Local CAPM 10.21% Local CAPM (adjusted) 10.00% Hybrid CAPM 9.00% Hybrid CAPM (adjusted) 8.87% Godfrey Espinosa Model 9.68% Goldman Sachs Model 6.82% Damodaran Model 6.95% Salmon Smith Barney Model 5.87% Estrada Model 7.11% <?page no="199"?> 200 4 International Business Valuation in South Africa uvk-lucius.de If the company has a rating, the cost of debt capital can be determined from the riskless rate of interest plus the risk premium (spread) for corporate bonds with the same risk. Since the companies from emerging markets that need to be valued frequently do not have a rating, an alternative can be the use of ratings of comparable companies. If these are also not available, the approach cannot be implemented. An alternative and approximate approach is the use of the effectively paid interest rate. It is calculated as the ratio of interest expenses to interest-bearing liabilities (see Formula 4.22). Starting from this cost of debt capital, the implied risk premium can be determined by using Formula 4.21 and solving for the risk premium. It also needs to be taken into consideration that the return requirement of the providers of debt capital (C D ) is ultimately different from the cost of debt for the company, since interest expenses are partially tax deductible. The tax saving is equal to the tax shield. The cost of debt capital can be determined as follows (see Formula 4.23). C D f RP) f RP f RP) - t) C D = Return requirement of the providers of debt capital R f = Riskless interest rate RP = Risk premium f ) t = Tax shield (tax savings) t = Tax rate of the company (4.23) (4.22) <?page no="200"?> 4.5 201 uvk-lucius.de Case Study In the absence of a rating for the valuation object or for comparable companies, the cost of debt was determined from the interest that was effectively paid. The effectively paid interest rate can be taken from the planning assumptions and is equal to 9.3%. This leads to a value for the risk premium of 7.53% based on Formula 4.21. Taking the company-specific tax rate of 28% into consideration a cost of debt capital of 6.70% is obtained. Table 4.22 provides an overview of the calculation of the cost of debt capital. Table 4.22: Determination of the cost of debt capital 44.5 Additional Adjustments for the Incorporation of Unsystematic Risk In determining the risk premium, not the entire risk of an investment is taken into consideration. As already discussed previously, the CAPM assumes that in line with the premises of the model, investors have the opportunity to eliminate the unsystematic risk with the help of diversification. Therefore no premium is paid for assuming those risks. A risk premium is paid only for the systematic risk, which cannot be diversified. R f 1.77% company to be valued with rating: risk premium can be derived from corporate bonds with the same risk data not available risk premium company to be valued without rating: risk premium can be derived from the ratings of comparable companies data not available company to be valued and comparable companies without rating: risk premium can be derived from the ratio of interest expenses to interest-bearing liabilities minus riskless rate of interest 7.53% t tax rate at the date valuation 2.60% geometric average yield of a 10-year US government bond <?page no="201"?> 202 4 International Business Valuation in South Africa uvk-lucius.de As was pointed out during the critical discussion of the CAPM, a valuation is frequently conducted from the perspective of individual investors, who do not have the option to diversify. Examples are the acquisitions of entire companies or participations. And for small investors, the idea of diversification may also appear unrealistic, since they may have difficulty to assemble a market portfolio, which contains all individual securities. This holds even more strongly for investors in emerging markets/ high growth markets, who are faced with significantly larger market barriers than investors in industrialized countries. If relevant unsystematic risks are not included in the calculation in these cases, the cost of equity which is determined exclusively on the basis of the CAPM is too low and thus the business value too high. This is the reason why adjustments for those unsystematic risks which are relevant for the valuation object and the potential acquirer are incorporated when utilizing CAPM-based models in applied work. In this context, the value theory which is applied also plays a role. The adjustments can be incorporated by considering a risk premium in the cost of capital, by incorporating relevant unsystematic risk already when modeling the future cash flows or by calculating a discount on the estimated business value. In applied valuation work, a premium on the cost of capital is frequently used. The incorporation of these types of premiums involves the danger that risks are counted more than once. Furthermore, premiums for unsystematic risks are not in line with the CAPM, since they can be eliminated with the help of diversification. It also needs to be pointed out that no empirical or theoretical link exists between the premiums for systematic risk and for unsystematic risk. Thus the closed CAPM is distorted and severely misinterpreted if subjective premiums are added for unsystematic risks. It would be more reasonable to directly determine the return expectations of equity capital investors and use this value as the cost of equity instead of expanding the closed CAPM by considering unsystematic risk. Despite the known criticism of the approach described, applied business valuation works with premiums for unsystematic risks, <?page no="202"?> 4.5 203 uvk-lucius.de since the CAPM frequently does not reflect the concrete valuation situation with its model assumptions. As possible contributors to unsystematic risk, the following three value drivers will be discussed and their relevance with regard to valuation considered in more detail: Company size (size effects) Block premium (majority discount) Mobility premium (liquidity, fungibility premium) 44.5.1 Company Size (Size Effects) A value driver for the unsystematic risk is the company size and the resulting size effect. The size effect, which is discussed and debated intensely in the literature, states that smaller companies will generally be faced with higher demands on equity returns than bigger ones. One justification is the fact that smaller companies are frequently more vulnerable to negative news than bigger and established companies with a solid business development and credit rating. It appears that established companies frequently have more staying power during turbulent times than smaller companies. Still, the size effect cannot simple be generalized in the form of a “law”. It is nonetheless true in applied valuation work, that depending on the market capitalization, a premium of up to 4% is added to the cost of capital according to the CAPM for the size effect. Alternatively, the magnitude of the risk premium can also be estimated from the spread, respectively the difference between the loan rate of smaller companies and bigger companies available from commercial banks. 117 Size effects play a large role for companies in volatile markets, since the ability to offset adverse market movements is of existential importance. 117 See Pereiro, L. E. (2002), pp. 178-179. <?page no="203"?> 204 4 International Business Valuation in South Africa uvk-lucius.de 44.5.2 Block Premium (Majority Discount) The acquisition of a majority share also provides significant controlling rights and the opportunity to get actively involved in the business policy of a company. Therefore such an acquisition is considered to be less risky and thus more valuable than a minority share. Thus the acquirer is also willing to pay a higher price for the majority holding. Against this background, a so-called block premium is added for the purchase of major packages of company participations. The premium still needs to be added to a basis, which is calculated as an objectivied business value. If the acquirer is of the opinion that his influence on the company strategy will lead to a sustainable increase in cash flows and thus to an enhancement of the subjective business value, he will be willing to pay a block premium on top of the objectivied value. The maximum value of this block premium is given as the difference between the subjective and the objectivied business value. 118 As an alternative to the premium on the determined business value it is also possible to work with a lower discount rate. For that reason, the block premium is occasionally called majority discount. The block premium can be determined empirically by comparing the share prices of the same company in different situations. The prices of shares that are traded on a public stock exchange are compared to the share prices following the acquisition of a majority holding in the context of an M&A transaction. The premiums which are determined in that fashion have a size of up to 31%-36% of the value of the equity capital according to several older studies for the US market. 119 Controlling rights are of major importance in emerging markets/ high growth markets, since active company management is made significantly more difficult as a result of intercultural differences and dependencies on local co-owners. Negative experiences 118 See Ernst, D./ Schneider, S./ Thielen, B. (2012), pp. 80-82. 119 See Pereiro, L. E. (2002), p. 182. <?page no="204"?> 4.5 205 uvk-lucius.de of joint ventures where local partners held 50% + 1 share show that successful investments in emerging markets/ high growth markets require majority ownership. 44.5.3 Mobility Premium (Liquidity, Fungibility Premium) The liquidity or fungibility of an investment is seen as an additional unsystematic component. The shares of a publicly listed company can generally be traded faster, simpler, cheaper and with greater certainty concerning the transaction value than participations in companies that are not listed on an exchange. Investments with high liquidity and lower transaction costs are thus considered to be more valuable and preferred by investors. The liquidity of the investments and the absence of transaction costs are among the premises of the CAPM. Frequently, however, these conditions are not in place, especially when investing in companies that are not listed on an exchange. This severely limits fungibility and is even more relevant for emerging markets/ high growth markets. For that reason, a sales process can take a lot of time and involve costs that can be significant. In order to account for the lack of mobility (fungibility, liquidity), another premium is frequently added to the risk premium or a discount on the calculated business value is included. The magnitude of such as discount can be derived by comparing business values of unlisted and of similar listed companies. Depending on the underlying time period of the analysis and the geographic orientation, numerous studies have estimated values of the discount between 25% and 50%. For the case of Argentina, for example, Pereiro (2002) has determined a value of 35%, which is roughly similar to numbers obtained in the US and also frequently seen in applied work. 120 With regard to the mobility risk it needs to be pointed out that it merely provides compensation for the case that circumstances 120 See Pereiro, L. E. (2002), p. 180. <?page no="205"?> 206 4 International Business Valuation in South Africa uvk-lucius.de change in the future and that the provider of equity capital sees the need to deviate from the original plan and dispose of his holding. The important aspect is the change in plans. In such a situation, there is a risk that the sales price will be below the present value of the expected cash flows of the company at the time of disposal. This can occur, for example, in a situation where the sale needs to be implemented quickly. Thus mobility risk only captures the uncertainty that a necessary sale may lead to a situation that is inferior compared to the continuation of the company. Not covered is the risk that the originally held earnings expectation is disappointed. The latter risk is already covered by the risk premium for systematic risk or by a surcharge for unsystematic risk. In applied work, it can frequently be observed that significant surcharges are added to the risk premium in light of a poor liquidity situation (or alternatively discounts on the calculated business value). This however, does not seem to be unproblematic when looking at the definition of mobility risk. It must be assumed that these significant surcharges also include additional components of risk and that therefore certain risks are captured twice. In order to avoid such a double counting, the strict conceptual separation of the various components is absolutely necessary. In closing, a comment on the various premiums may be in order. These premiums are frequently used in applied valuation work to capture results from actual price negotiations in the business valuation model. This leads to the fundamental discussion about “value” and “price”. Only in perfect capital markets are “value and “price” identical. If this is not the case - as can be observed in practice - there will always be differences between the value of a company and the price, which is the result of negotiations. Whether it makes sense to bridge the gap between “value” and “price” in a business valuation exercise depends on the reason for the valuation and the goals of the valuation expert. At any rate, there is no academic justification for such an approach. <?page no="206"?> 4.6 207 uvk-lucius.de 44.6 Calculation of the Business Value Once the determination of the cost of equity and of debt capital plus possible adjustments has been shown, the business value can be calculated in a next step. At this point, several results for the cost of equity will be available, due to the different versions of the CAPM. If the specification of only one value for the cost of equity is to be avoided, a separate business value can also be calculated for each model. The approach for the calculation of the business value is identical in principle for all models, whether they are based on the CAPM or not. Only the values used for the cost of equity differ. The focus in the following will exclusively be on a detailed determination of the business value with reference to the cost of equity as derived from the hybrid CAPM. A business valuation based on the cost of equity derived with other models can be conducted along the same lines. For that reason, only a summary will be provided. The detailed calculation of the business value will be limited to the WACC approach and the equity approach. Both procedures are suitable for calculations in an international context either in local currency or in the hard currency of the reference market. In the following, the business value is first determined in hard currency - from the perspective of investors in US-Dollar - and next in local currency. 4.6.1 Calculation of the Business Value with the WACC Approach Calculation of the Business Value in Hard Currency 4.6.1.1 In the WACC approach, the operating free cash flows need to be discounted at the Weighted Average Cost of Capital (WACC) to arrive at the business value. Before the free cash flows can be discounted, the determination of the WACC poses a problem of circularity. The market value of the equity capital is needed for the <?page no="207"?> 208 4 International Business Valuation in South Africa uvk-lucius.de calculation of the WACC, which at the same time is the result of the business valuation. This problem can be solved with an iterative technique. Several estimates of the WACC are provided, until the market value of the equity capital from the business valuation is equal to the market value of the equity capital which is used for the calculation of the WACC. When the business value is calculated in hard currency, the discounting of the cash flows at the WACC requires that the discount rate and all cash flows are available in hard currency, namely in US $. Since the cost of capital in most cases is already based on US $, only the cash flows that were planned in local currency need to be converted. At this point, future expected exchange rates for the detailed planning stage need to be determined in order to conduct the conversion into a hard currency. Once this is done, the cash flows which were converted into US $ can be discounted at the interest rate which is also based on data in US $. Once the operating free cash flows have been discounted at the WACC and the non-operating assets which were valued separately have been added, the value of the total capital is obtained. To arrive at the value of the equity capital, the market value of debt capital must be subtracted. Before the non-operating assets and the value of debt capital can be added, respectively subtracted, these positions need to be converted into the relevant hard currency at the exchange rate in t = 0, the spot rate. In the following case study, the calculation of the business value in hard currency according to the WACC approach is shown step by step with reference to the fictitious South African company. <?page no="208"?> 4.6 The Market Risk Premium 209 uvk-lucius.de Case Study For the Case Study it was initially required to obtain the following data for the determination of the expected future exchange rates: 121 Table 4.23: Assumptions for the calculation of future expected exchange rates Using this data and the following formula, the expected future exchange rates can be calculated: Expected future exchange rate (ZAR/ $) in period (t) = Expected future exchange rates: Table 4.24: Calculation of future expected exchange rates With the help of the expected future exchange rates, the operating free cash flows as planned in ZAR are converted into US $: 121 Source for the exchange rates: Board of Governors of the Federal Reserve System (www federalreserve gov); Source for the inflation rates: International Monetary Fund (=> www.principalglobalindicators. org) and OECD Stats Extracts (=> Consumer Prices-Annual Inflation). Inf ation (US) in t=0 2.07% Inflation (South Africa) in t=0 5.75% Current exchange rate in t=0 8.4475 ZAR/ $ Exchange rate in t=-1 8.0894 ZAR/ $ Exchange rate in t=-2 6.6256 ZAR/ $ Exchange rate (ZAR/ $) 6.6256 8.0894 8.4475 8.7521 9.0676 9.3945 9.7332 10.0842 10.4477 Exchange rate ($/ ZAR) 0.1509 0.1236 0.1184 0.1143 0.1103 0.1064 0.1027 0.0992 0.0957 <?page no="209"?> 210 4 International Business Valuation in South Africa uvk-lucius.de Table 4.25: Conversion of the cash flows in US $ The value of the cash flow in the terminal value is calculated with the help of the following formula: Cash flow Terminal Value = Cash flow Year 6 in $ US ) Growth in the US was assumed to be at the rate of inflation in the US: Table 4.26: Determination of the cash flow in the terminal value in hard currency (WACC approach) (c The terminal value is calculated as follows: The WACC is used for the cost of capital. It was derived from the results of the hybrid CAPM. The precise determination of the WACC is discussed on the following page: % - Determination of the terminal value: Forward exchange rate 0.1143 0.1103 0.1064 0.1027 0.0992 0.0957 ZAR Operating free cash flows 198.8 140.4 162.7 171.2 182.9 198.7 $ Operating free cash flows 22.71 15.48 17.32 17.59 18.14 19.02 <?page no="210"?> 4.6 211 uvk-lucius.de Table 4.27: Determination of the terminal value in hard currency (WACC approach) Discounting of the cash flows can be done with the help of the following formula: The discount factor in Table 4.26 was introduced as an intermediary step in order to simplify discounting. Table 4.28: Discounting of the operating free cash flows in hard currency Study (continued) In the next step, the non-operating assets which are valued separately are added. The result is the total business value. Next, the market value of the debt capital is subtracted to arrive at the <?page no="211"?> 212 4 International Business Valuation in South Africa uvk-lucius.de market value of the equity capital. They must be converted at the exchange rate in t=0 into US $: Table 4.29: Determination of the market value of the equity capital in hard currency with the WACC approach In a next step, the estimated WACC must be employed to determine the precise value for the WACC. For the precise calculation of the WACC, the following formula is used: This leads to the following values for the hybrid version of the CAPM: In case the WACC is calculated with a spreadsheet program <?page no="212"?> 4.6 213 uvk-lucius.de such as Excel with the help of the above mentioned formula, Excel solves the circularity problem with an iterative procedure. Once all the formulas are tied together, the needed values are generated automatically: Figure 4.8: Solution for the circularity problem In summary, the following steps are required for a valuation in hard currency: (1) Initially a rough estimate for the WACC is needed (2) Before discounting the operating free cash flows, it must be assured that: - Currency of the cash flows = Currency of the discount rate (in this case both in hard currency) - Conversion of the planned cash flows in local currency is required: - Determination of future expected exchange rates - In the following conversion of the operating free cash flows planned in local currency at future expected exchange rates (3) Calculation of the cash flows in the terminal value (4) Determination of the terminal value (5) Discounting of the operating free cash flows and the terminal value <?page no="213"?> 214 4 International Business Valuation in South Africa uvk-lucius.de (6) Summation of the present values of the operating free cash flows and the terminal value (result = Enterprise Value) (7) Addition of the non-operating assets, which were valued separately and converted in US $ (result = Entity Value) (8) Subtraction of the market value of the debt capital, which also needs to be converted into a hard currency (result = Equity Value) (9) Market value for the equity capital is entered into the formula for the exact determination of the WACC (Excel automatically takes care of the circularity problem, as soon as the formulas for the calculation of the WACC are linked) Application of all the individual steps to all CAPM-based and alternative models leads to the following results for the determination of the WACC: Table 4.30: Results for the weighted cost of capital in the WACC approach The calculation of the business values in hard currency leads to the following results for the different models: <?page no="214"?> 4.6 215 uvk-lucius.de Table 4.31: Overview of the results of the calculation of the business value in hard currency using the WACC approach CCalculating the Business Value in Local Currency 4.6.1.2 When calculating the business values in local currency it must also be assured that the discount rate and the cash flows are available in local currency. Since the cash flows are usually planned in local currency and are thus already available in the required currency, only the discount rate needs to be determined in local currency. But frequently the data material required for the determination of the discount rate in local currency is unavailable or data is only available in the hard currency. For that reason, the discount rate can often only be calculated in hard currency. The discount rate which is calculated on the basis of data from the reference market can be transformed with the help of inflation rates of the involved countries into a discount rate for the local country. Only these “local” discount rates are adequate for discounting the cash flows in local currency. Once a decision has been reached about the valuation currency as well as the cash flows and discount rates are available in local currency, it is no problem to discount the cash flows. The following steps in the calculation of the business values are similar to the ones for the hard currency case. There is no need to convert the cash flows and the corresponding positions. Instead the discount rate is adjusted to the local currency in the first step. The following case study serves to illustrate the individual steps: <?page no="215"?> 216 4 International Business Valuation in South Africa uvk-lucius.de Case Study The required data is identical to the previous case where the business value was determined in hard currency: Table 4.32: Assumptions for the calculation of future expected exchange rates The first step involves the conversion of the discount rate for the reference market into a discount rate for the local currency, respectively the local market. The following formula provides the required value for the cost of capital: Table 4.33: Determination of the discount rates in the local market Study (continued) Again the cash flow in the terminal value must be calculated with the help of the following formula: Inf ation (US) in t=0 2.07% Inflation (South Africa) in t=0 5.75% Current exchange rate in t=0 8.4475 ZAR/ $ Exchange rate in t=-1 8.0894 ZAR/ $ Exchange rate in t=-2 6.6256 ZAR/ $ <?page no="216"?> 4.6 217 uvk-lucius.de Cash flow terminal value = Cash flow Year 6 in ZAR + Growth South Africa ) Again the inflation rate is used for the growth rate. Since the cash flows are specified in local currency, the South African inflation rate must be used: Table 4.34: Determination of the cash flow in the terminal value in local currency (WACC approach) The terminal value needs to be determined next. It should be assured that the inflation rate and the cost of capital are taken from the same country (South Africa in this case): Determination of the terminal value: <?page no="217"?> 218 4 International Business Valuation in South Africa uvk-lucius.de Table 4.35: Determination of the terminal value in local currency (WACC approach) The cash flows are again discounted with the help of the following net present value formula: Table 4.36: Discounting of the operating free cash flows in local currency In the next step, the non-operating assets which were valued separately are added and the total business value is obtained. Then the market value of debt capital is subtracted to arrive at the market value of the equity capital. In contrast to the calculation of the business value in US $, the components are determined in local currency in this case. <?page no="218"?> 4.6 219 uvk-lucius.de Table 4.37: Determination of the market value of the equity capital in local currency with the WACC approach Once the market value of the equity capital is converted into US $ at the exchange rate in t = 0, the market value of the equity capital in US $ is obtained. It needs to be identical to the result from the earlier calculation of the business value in hard currency: Market value of the equity capital = Market value of the equity capital local currency Exchange rate Market value of the equity capital 2247.8 Study (continued) As can be seen, the results of the local currency valuation and the hard currency valuation are identical. Figure 4.9: Identity of the results following the currency conversion Infation (USA) in t=0 2.070% Infation (South Africa) in t=0 5.750% Exchange rate ($/ ZAR) in t=0 0.1184 WACC (USA) 8.74% WACC (South Africa) Discount factor 0.888 0.788 0.699 0.621 0.551 0.489 0.489 ZAR Operating free cash flows 198.8 140.4 162.7 171.2 182.9 198.7 210.2 ZAR Terminal value ZAR ZAR ZAR + Non-operating assets - ZAR + Liquid assets 148.2 ZAR ZAR ./ . Financial liabilities t0 248.5 $ value ZAR Conversion in $ with the <?page no="219"?> 220 4 International Business Valuation in South Africa uvk-lucius.de If the individual steps are conducted for all versions of the CAPM with their respective costs of equity capital, the following figures are obtained: Table 4.38: Overview of the results of the business value calculation in hard and local currency with the WACC approach As can be seen, a conversion of the market values of the equity capital in local currency leads to the market values of the equity capital in US $. Once converted, the results of the business valuations in the different currencies are identical. Thus it does not matter for the business value whether it is determined in local currency or in the hard currency of the reference market. In summary, the valuation in local currency involves the following steps: [1] Initially a rough estimate for the WACC is needed [2] Before discounting the operating free cash flows, it must be assured that: Currency of the cash flows = Currency of the discount rate (in this case both in local currency) <?page no="220"?> 4.6 221 uvk-lucius.de Conversion of the discount rates in local currency: Determination of the discount rate of the reference market In the following, the discount rate of the reference market in combination with the inflation rates in the two countries can be used to determine the required discount rate for the local market [3] Calculation of the cash flows in the terminal value [4] Determination of the terminal value [5] Discounting of the operating free cash flows and the terminal value [6] Summation of the present values of the operating free cash flows and the terminal value (result = Enterprise Value) [7] Addition of the non-operating assets, which were valued separately in local currency (result = Entity Value) [8] Subtraction of the market value of the debt capital, which also needs to be converted into a hard currency (result = Equity Value) [9] Market value for the equity capital is entered into the formula for the exact determination of the WACC (Excel automatically takes care of the circularity problem, as soon as the formulas for the calculation of the WACC are linked) [10] If required, the business value can be converted into US $ at the current exchange rate in t = 0 44.6.2 Calculation of the Business Value with the Equity Approach For the equity approach, the cash flows to equity are determined in a first step. Since these are cash flows that are only available to the providers of equity capital, they cannot be discounted with the WACC, but only with the return requirements of the providers of equity. <?page no="221"?> 222 4 International Business Valuation in South Africa uvk-lucius.de Case Study For the discount rates, the previously determined cost of equity from the various models which are partly based on the CAPM can be used (see Table 4.30): Table 4.39: Results for the cost of equity in the various models Once the present value of the cash flows to equity has been determined, only the non-operating assets, which are valued separately, need to be added. In contrast to the entity approach, the market value of the equity capital is already determined at this point. There is no need to subtract the market value of debt capital. This is a consequence of the determination of the cash flows used, which already incorporates the effects of debt financing. Once again, the business valuation will be conducted initially in hard currency and then in local currency. In both versions, the currency effects are the same as in the entity approach. C Calculation of the Business Value in Hard Currency 4.6.2.1 In this case, the calculation of the business value follows the same steps as in the business valuation with the WACC approach in hard currency. The currency conversion, the calculation of the cash flows in the terminal value and the calculation of the terminal value are similar to the business value calculation in hard currency using the WACC approach. <?page no="222"?> 4.6 223 uvk-lucius.de The only differences relate to the following points: In this case, the cash flows are equal to the cash flows to equity, and not the operating free cash flows Instead of the WACC, the cost of equity of the indebted company is used as the discount rate Once the present values of the cash flows to equity and the terminal value have been summed up, the non-operating assets which have been valued separately must be added in order to determine the market value of the equity capital. At this point it is no longer required to subtract the debt capital, as was the case for the WACC approach. In summary, the following steps need to be taken: [1] The discount rate used is the cost of equity of the company [2] Before discounting the cash flows to equity, it must be assured that: Currency of the cash flows = Currency of the discount rate (in this case both in hard currency) Conversion of the planned cash flows in local currency is required: Determination of future expected exchange rates In the following conversion of the cash flow to equity planned in local currency at future expected exchange rates [3] Calculation of the cash flows in the terminal value [4] Determination of the terminal value [5] Discounting of the cash flows to equity and the terminal value [6] Summation of the present values of the cash flows to equity and the terminal value [7] Addition of the non-operating assets, which were valued separately and converted into hard currency (result = Equity Value) <?page no="223"?> 224 4 International Business Valuation in South Africa uvk-lucius.de Case Study For a detailed presentation of the calculation of the business value with the help of the equity approach in hard currency, the discount rate used is the cost of equity from the hybrid CAPM. Table 4.40: Determination of the market value of the equity capital in hard currency with the equity approach If all the other models are also used to calculate the cost of equity, the following results in hard currency are obtained. Table 4.41: Overview of the results of the business valuation in hard currency with the equity approach <?page no="224"?> 4.6 225 uvk-lucius.de C Calculation of the Business Value in Local Currency 4.6.2.2 The calculation of the business value in local currency also follows closely the procedure for the WACC approach in local currency. The currency conversion, the calculation of the cash flow in the terminal value and the calculation of the terminal value are done in local currency, just as in the WACC approach. As already pointed out above, the only differences refer to the fact that cash flows to equity and not operating free cash flows are relevant, that the discount rate is the cost of equity and not the WACC and in the end only the non-operating assets, which were valued separately need to be added in order to arrive at the market value of the equity capital. In summary, the following steps are required: [1] The discount rate used is the cost of equity of the company [2] Before discounting the cash flows to equity, it must be assured that: Currency of the cash flows = Currency of the discount rate (in this case both in local currency) Conversion of the discount rates in local currency: Determination of the discount rate of the reference market In the following, the discount rate of the reference market in combination with the inflation rates in the two countries can be used to determine the required discount rate for the local market [3] Calculation of the cash flows in the terminal value [4] Determination of the terminal value [5] Discounting of the cash flows to equity and the terminal value [6] Summation of the present values of the cash flows to equity and the terminal value [7] Addition of the non-operating assets, which were valued separately in local currency (result = Equity Value) [8] If required, the business value can be converted into US $ at the current exchange rate in t = 0 <?page no="225"?> 226 4 International Business Valuation in South Africa uvk-lucius.de Case Study For a detailed presentation of the calculation of the business value with the help of the equity approach in local currency, the discount rate used is the cost of equity from the hybrid CAPM. Table 4.42: Determination of the market value of the equity capital in local currency with the equity approach If all the other models are also used to calculate the cost of equity, the following results in local currency are obtained. Table 4.43: Overview of the results of the business valuation in hard currency with the equity approach in% Absolute numbers in ZAR m 7.84% 14.18% 13.96% 12.93% 12.79% Godfrey-Espinosa-Model 13.64% Goldman-Sachs-Model 10.67% Damodaran-Model 10.80% Salmon-Smith-Barney-Model 9.68% 10.93% Hybrid CAPM (adjusted) Estradaodel Cost of equity Equity value Global CAPM Local CAPM Local CAPM (adjusted) Hybrid CAPM <?page no="226"?> 4.6 227 The results of the business valuation in the local currency must always be equal to the results of the business valuation in hard currency, once they are converted at the exchange rate at t = 0. Table 4.44: Comparison of the results of the business valuation in local and hard currency with the equity approach <?page no="227"?> 228 4 International Business Valuation in South Africa uvk-lucius.de Summary An expanded model to conduct an international valuation in volatile markets was presented, which includes the following steps: 1. Choice of the currency used for the valuation 2. Business analysis and business planning 3. Choice of the valuation approach and determination of the framework conditions 4. Calculation of relevant cash flows (including possibly needed risk adjustments and modifications) 5. Determination of the cost of capital (including possibly needed risk adjustments and modifications) 6. Additional adjustments due to unsystematic risk 7. Determination of business value An international valuation poses significantly more challenges in business planning and the determination of relevant cash flows than a valuation at home. This is due to the different starting conditions in the respective countries, which can differ significantly from the environment at home. Therefore, the annual accounts of the past years need to be adjusted for factors that hinder the assessment of the actual performance of the valuation object. The following adjustments of the cash flows were discussed in more detail: Adjustments to correct for country-specific accounting regulations, Adjustments to correct for excessive management remuneration, Adjustments to correct for excessive expensing, Adjustments to correct for differences in international taxation, Adjustments to account for inflation. <?page no="228"?> 4.6 The Market Risk Premium 229 uvk-lucius.de In a business valuation in volatile markets it is also possible to adjust the cost of capital or discount rates in addition to the cash flows. It must be decided where the risks should be incorporated. The determination of the cost of capital can either utilize CAPM-based models or models that are not based on the CAPM. The following versions of CAPM-based models were presented: the global CAPM the local and adjusted local CAPM the (adjusted) hybrid CAPM the Lessard-Model the Godfrey-Espinosa-Model the Goldman-Sachs-Model the Damodaran-Model the Salomon-Smith-Barney-Model Among the models that are not based on CAPM, the Estrada-Model the Erb-Harvey-Viskanta-Model (EHVM) the Arbitrage Pricing Theory (APT) and the Simulation-based approach were discussed. There is no generally valid answer to the question which of these models should ultimately be used for the determination of the cost of equity and which model ultimately gives the “best” result. Especially in an international context, it must be taken into consideration that framework conditions can vary greatly from country to country when conducting a business valuation. <?page no="229"?> 230 4 International Business Valuation in South Africa uvk-lucius.de For that reason, the choice of model for the determination of the cost of equity should depend on the specific situation of the business valuation as well as the underlying assumptions of the available models. This is the only way to assure that the models used are aligned optimally with the valuation situation. When determining the risk premium, not the entire risk of an investment is considered. The CAPM assumes that the investor has the opportunity to eliminate unsystematic risk with the help of diversification in line with the assumptions of the model. For that reason, no premium is paid for these risks. Only systematic risk, which cannot be diversified, will receive a risk premium. But frequently a valuation is conducted from the perspective of an individual investor who does not have the potential for diversification. If this is the case, the resulting unsystematic risks need to be included in the valuation. The following three value drivers, respectively components of unsystematic risk were discussed and explored with regard to valuation: - Company size (size effects) - Block premium (majority discount) - Mobility premium (liquidity, fungibility premium) Once the determination of the cost of equity, the determination of the debt capital and possible adjustments were shown, the value of the company was calculated. Due to the availability of several values for the cost of equity from the various CAPM-based and alternative models, a detailed determination of the business value was only presented for the example of the hybrid CAPM. Furthermore, the valuation was limited to the WACC-approach and the equity approach and was conducted in each case for the local currency as well as for the currency of the reference market. The approach was exemplified with the help of a detailed case study. <?page no="230"?> 231 uvk-lucius.de Exercises [1] Comprehensively discuss the expanded model for conducting an international business valuation in volatile markets. [2] What are the problems that can arise during the determination of the relevant cash flows in the context of an international business valuation? [3] Which adjustments of cash flows are fundamentally possible? Discuss the underlying intentions. [4] Which CAPM-based models for the determination of the cost of equity are you familiar with? [5] Explain the basic ideas behind the global CAPM and the underlying formula. [6] What is the cost of equity according to the global CAPM? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Publicly listed comparable companies vs. CSI 300 Index: 0.7232 Index of the US capital market: 5% [7] Explain the basic ideas behind the local CAPM and the underlying formula. [8] What is the cost of equity according to the local CAPM? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Publicly listed comparable companies vs. CSI 300 Index: 1.1939 <?page no="231"?> 232 4 International Business Valuation in South Africa uvk-lucius.de Index of the US capital market: 5% Local market risk premium = Global market risk premium + Country risk premium: 6.10% [10] Explain the basic ideas behind the adjusted local CAPM and the underlying formula. [11] What is the cost of equity according to the adjusted local CAPM? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Publicly listed comparable companies vs. CSI 300 Index: 1.1939 Index of the US capital market: 5% Local market risk premium = Global market risk premium + Country risk premium: 6.10% Regression between annualized monthly volatility of the South African equity market returns (here: MSCI South Africa) and the monthly variance of the country risk as represented by the Morgan Stanley EMBI+: 0.0325 [12] Explain the basic ideas behind the hybrid CAPM and the underlying formula. [13] What is the cost of equity according to the hybrid CAPM? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Regression between MSCI South Africa and MSCI World: 0.7232 Average beta of comparable companies in the world market (here: US market): 1.6118 Index of the US capital market: 5% <?page no="232"?> 233 uvk-lucius.de [14] Explain the basic ideas behind the adjusted hybrid CAPM and the underlying formula. [15] What is the cost of equity according to the adjusted hybrid CAPM? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Regression between MSCI South Africa and MSCI World: 0.7232 Average beta of comparable companies in the world market (here: US market): 1.6118 Index of the US capital market: 5% Regression between annualized monthly volatility of the South African equity market returns (here: MSCI South Africa) and the monthly variance of the country risk as represented by the Morgan Stanley EMBI+: 0.0325 [16] Explain the basic ideas behind the Godfrey-Espinosa-Model and the underlying formula. [17] What is the cost of equity according to the Godfrey- Espinosa-Model? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Local equity market volatility of the MSCI South Africa (calculated): 32.48% Equity market volatility of the MSCI World: 26.93% Index of the US capital market: 5% Country risk premium (from default spreads): 1.10% <?page no="233"?> 234 4 International Business Valuation in South Africa uvk-lucius.de [18] Explain the basic ideas behind the Goldman-Sachs-Model and the underlying formula. [19] What is the cost of equity according to the Goldman-Sachs- Model? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Local equity market volatility of the MSCI South Africa (calculated): 32.48% Equity market volatility of the MSCI World: 26.93% Publicly listed comparable companies vs. CSI 300 Index: 1.1939 Index of the US capital market: 5% Adjustment factor to avoid double counting: 0.1803 Company-specific risk premium: 5% [20] Explain the basic ideas behind the Damodaran-Model and the underlying formula. [21] What is the cost of equity according to the Damodaran- Model? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Lambda factor: 0.7000 Publicly listed comparable companies vs. CSI 300 Index: 1.1939 Index of the US capital market: 5% [22] Explain the basic ideas behind the Salomon-Smith-Barney- Model and the underlying formula. <?page no="234"?> 4.6 The Market Risk Premium 235 uvk-lucius.de [23] What is the cost of equity according to the Salomon-Smith- Barney-Model? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Country risk premium (from default spreads): 1.10% Assessment capital market access: 4 Assessment political vulnerability: 2 Assessment share of the investment for the company: 4 Average beta of comparable companies in the world market (here: US market): 0.7232 Index of the US capital market: 5% [24] Which models for the determination of the cost of equity that are not based on CAPM are you familiar with? [25] Explain the basic ideas behind the Estrada-Model and the underlying formula. [26] What is the cost of equity according to the Estrada-Model? The following values are given: Average yield of a 17-year US T-Bond: 4.05% Index of the US capital market: 5% Semi standard deviation MSCI South Africa / Semi standard deviation MSCI World 1.9988 [27] Explain the basic ideas behind the Erb-Harvey-Viskanta- Model and the underlying formula. [28] Explain the basic ideas behind the arbitrage pricing model and the underlying formula. <?page no="235"?> 236 4 International Business Valuation in South Africa [29] Explain the simulation-based approach and point out differences to the approaches which are based on CAPM and which are not based on CAPM. [30] Show advantages and disadvantages of the individual models which are based on CAPM and which are not based on CAPM. [31] Which additional adjustments of the CAPM to incorporate unsystematic risks appear fundamentally possible? Critically assess the need for these adjustments. [32] Describe specific valuation situations in which the individual models based on CAPM and not based on CAPM are particularly suitable. <?page no="236"?> uvk-lucius.de Summary of the book Which conclusions can be drawn for international business valuations? Among the models for international business valuation in developed markets, the CAPM continues to be the most frequently used approach for the calculation of the cost of equity. It is a closed model that has become the standard in applied valuation work, due to the lack of a better, more general and simpler alternative model. While academics criticize the CAPM severely, they also defend it fiercely against alternative approaches, especially in international business valuation. In the discussion about the CAPM and its applicability in international business valuation, numerous researchers and valuation practitioners agree with KAPLAN, who summarized the discussion about the CAPM as follows: Keep in mind how lousy alternatives are when evaluating CAPM." If the unrealistic premises of the CAPM based on perfect markets are adjusted to capture reality more fully, this always compromises the theoretical foundations. The models which are partly based on the CAPM and partly not on the CAPM are attempts to model empirically observable features such as the existence of country risks, in order to provide answers to a number of problems in international business valuation. Applied work in international business valuation shows that only "handmade" models are available at the moment. <?page no="237"?> But the importance of international business valuation in a global world calls for theoretical foundations of the models used. A lot more research still needs to be done and academics and practitioners are asked to make their contributions. When making a choice for one or more of the models presented, the criteria to support the choice of a particular approach or several models need to be assessed and documented. The determination of the cost of equity requires that the valuation expert intensively deals with the factors that are incorporated or ignored in the various models. This allows the choice of the model which is closest to the valuation situation. As pointed out in our considerations, it is advisable to utilize several models in order to obtain a range of values and an understanding about the sensitivity of the value drivers. Let us summarize the current state of affairs in the field of international business valuation in the words of ESTRADA: “Evaluating investment opportunities in emerging markets is a mix of art and science […] Although much has been published about discount rates in emerging markets, there is probably a long way to go until a convergence of opinions finally arises”. 122 Estrada, J (2007), p. 77. 23 <?page no="238"?> uvk-lucius.de BBibliography Beaver, W., Manegold, J. (1975): The Association between Marketdetermined and Accounting-determined Measures of Systematic Risk: Some Further Evidence, in: Journal of Financial and Quantitative Analysis, 231-284. Bekaert, G., Harvey, C. R. (2002): Research in Emerging Markets Finance: Looking to the Future, in: Emerging Markets Review, Vol. 3, No. 4, 429-448. Chen, N. F., Roll, R. R., Ross, S. A. (1986): Economic Forces and the Stock Market, in: Journal of Business, Vol. 59, No. 3, 383- 403. Damodaran, A. (2002): Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 2nd edition, New York. Damodaran, A. (2003): Measuring Company Exposure to Country Risk: Theory and Practice, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ CountryRisk.pdf, 29.01.2014. Damodaran on Valuation (2006): Security Analysis for Investment and Corporate Finance, 2nd edition, Hoboken. Damodaran, A. (2008): What is the Riskfree Rate? A Search for the Basic Building Block, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ risk freerate.pdf, 29.01.2014. Damodaran, A. (2009): Volatility Rules: Valuing Emerging Market Companies, Stern School of Business, Working Paper, in: http: / / pages.stern.nyu.edu/ ~adamodar/ pdfiles/ papers/ emerg mkts.pdf, 29.01.2014. <?page no="239"?> 240 Bibliography uvk-lucius.de Damodaran, A. 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(2002): A Practical Approach to the International Valuation & Capital Allocation Puzzle, Salomon Smith Barney, July 2002. <?page no="244"?> IIndex 90% Rule 24 Abroad 15 Accounting Figures 123 Accounting Information 124 Accounting Policy 123 Accounting Profits 117 Accounting Standards 17 Additive Approach 111 Adjusted Hybrid CAPM 33, 168, 193 Adjusted Local CAPM 33, 158, 192 APV Approach 33, 34 Arbitrage Pricing Theory (APT) 34, 38, 183, 188, 194 Arithmetic Means 92 Arithmetic Return 90 Asset Approach 24 Average Value Approach 31 Average Yields 101 Beta Approach 112 Beta Factor 118, 120 Block Premium 204 Book Value 74 Breakup 30 Business Analysis 42, 43 Business Planning 42, 43, 136 Business Value 207 Capital Providers 89 CAPM 33, 73, 99, 132 CAPM-based Models 33, 36, 151, 192 Cash Flows 136 Cash Flows to Equity 42 Cashflow Value Added (CVA) 31 Coefficient of Determination 159 Collateral 14 Company Size 203 Company-based Beta Factor 121 Company-specific Risk Premium 176 <?page no="245"?> 246 Index Comparable Companies 77, 122 Consolidation 141 Corporate Bond Spreads 104 Corporate Bonds 102, 104 Correction Factor 167, 169 Correlation 75 Cost of Capital 18, 22, 42, 63, 64, 89, 151 Cost of Debt 199 Cost of Equity 167, 178, 198 Country Beta 168 Country Rating 102 Country Risk 14, 87, 95, 104 Country Risk Premium 95, 96, 100, 102, 110 Country Risks 19 Country Specific Risks 19 Country-specific Accounting Regulations 137 Country-Specific Tax Laws 144 Credit Default Swaps 104 Currency 18, 62 Currency Conversion 140 Currency Effects 62 Damodaran-Model 33, 37, 178, 193 Default Risk 103 Default Spreads 101, 109, 162 Deferred Tax Assets 141 Discount Rate 64, 136, 151 Discounted Cash Flow Methods 32 Dividend Model 93 Dividend Policy 144 Domestic CAPM 158 Double Counting 137, 147 Due Diligence 25 Economic Life 24 Economic Value Added (EVA) 31 Emerging Markets/ High Growth Markets 60 Entity Value 214, 221, 223, 225 Equity Approach 33, 34, 221 Equity Exchange 24 <?page no="246"?> Index 247 Equity Value 214, 221 Erb-Harvey-Viskanta-Model 33, 38, 183, 187, 194 Estrada-Model 33, 37, 183, 184, 194, 197 Excess Profit Approach 31 Excessive Expensing 143 Exchange Rate Fluctuations 19 Exchange Rate Risks 187 Expansion 15, 56 Explicit Weights 53 Financial Data 20 Foreign Markets 14 Full Reproduction Value 28 Fungibility Premium 205 General Risk Premium 106 Generally Accepted Valuation Practices 23 Geometric Means 92 Geometric Return 90 Global Beta 170 Global CAPM 33, 36, 152, 192, 196 Global Company Beta 154 Global Financial Crisis 14 Global Market Risk Premium 99, 168, 186, 196 Global Peer Group 170 Global Riskless Rate 153 Godfrey-Espinosa-Model 33, 37, 174, 193, 196 Goldman-Sachs-Model 33, 37, 176, 193 Goodwill 140 Government Bond 64, 92 Green Field Investment 29 Gross Reproduction Value of New Assets 28 Hard Currency 62, 69, 207, 222 Home 15 Hybrid CAPM 36, 168, 192, 196, 207 Hybrid CAPM 33 Impairment Test 16, 56 Implicit Weights 53 Index 91, 118 Industrial Countries 43, 61 Industry-Based Beta Factor 124 Inflation 19, 64, 145 <?page no="247"?> 248 Index Information 20 Informational Efficiency 76 Insolvency 31 Intangible Assets 140 International Business Valuation 14, 54, 59, 63, 69, 136 International Business Valuation Methods 42 International CAPM 152 International Fisher Effect 65 International Taxation 143 Joint Ventures 15, 56 Lambda 116 Lambda Approach 113 Less Developed Countries 60, 61 Lessard-Model 33, 36, 168, 173, 193 Levered Beta 154, 155, 165, 166, 172 Liberalization 77 Liquidation 30 Liquidation Value 30 Liquidity Premium 205 Literature 239 Local CAPM 33, 36, 158, 192, 196 Local Currency 62, 63, 66, 70, 73, 215, 225 Local Market Risk Premium 163 Local Risk Premium 91 Majority Discount 204 Management Remuneration 142 Market Based Approach 92 Market Capitalization 74 Market Integration 96 Market Portfolio 73, 77 Market Price Data 117 Market Risk Premium 22, 36, 73, 88, 89, 91, 92, 94 Market Segmentation 96 Methods of International Business Valuation 16, 25 Mixed Approaches 31 Mobility Premium 205 Monte-Carlo-Simuation 190 Multifactor Models 38 <?page no="248"?> Index 249 Multiple Valuation Method 42, 52, 135 Multiplies 38 Net Asset Value Based on Reproduction Values 27 Net Asset Values on the Basis of Liquidation values 30 Net Reproduction Value of New Assets 28 Net Reproduction Value of Used Assets 28 Nominal Business Value 62 Non-CAPM Based Models 33, 151, 182, 194 Operating Free Cash Flow 34, 42 Partial Reproduction Value 28 Peer Group 154 Pensions 139 Perfect Capital Markets 75 Price Manipulations 76 Project Assessment 15 Provisions 139 Public Bidding 24 Purchase or Sale of Companies 15 Purchase Price Allocation 16, 56 Rating 104 Rating Agencies 102 Ratios 21 Real Options Approach 40 Reasons for an International Business Valuation 15 Reference Currency 69 Reference Market 69, 123, 125 Relative Risk Measure 106, 109 Relative Standard Deviation 105, 109 Relevered Beta 122 Residual Value 24 Revaluation of Assets 141 Risk Adjustments 43 Risk Management 114 Risk Premium 66, 73, 89, 94, 100, 202 Riskless Return 22, 63, 92, 93 <?page no="249"?> 250 Index Salomon-Smith-Barney- Model 33, 37, 180, 194 Segmented CAPM 158 Semi-Standard Deviation 185 Simulation Based Models 194 Simulation-based Approach 34 Simulation-Based Approach 183, 189 Single Valuation Approaches 26 Single Valuation Method 42, 52, 135 Size Effects 203 South Africa 131 Sovereign Spreads 104 Specifics of International Business Valuation 16 Spread 200 Squeeze-out 16, 56 Statutory Valuation 23 Statutory Valuation Monitoring 25 Synthetic Business Value 53 Systematic Risk 96 Tax Assessment 16 Taxation 17 Terminal Value 32 Theory of Purchasing Power Parity 65 Time Horizon 91 Total Valuation Methods 32 Transfer Risks 14, 20 Unlevered Beta 122, 155, 166 Unsystematic Risk 43, 74, 96, 201 Valuation Methods 22 Valuation of Participations 16 Valuation Practitioners 14 Value Based Management 31 Volatile Markets 133 WACC Approach 33, 34, 207 <?page no="250"?> www.europa-im-wuergegriff.de Die täglichen Nachrichten über den aktuellen Krisenstand in europäischen Ländern sind für viele längst nicht mehr fassbar. 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Mit Wirtschafts-Blog Gerald Pilz Europa im Würgegriff 200 Seiten ISBN 978-3-86764-422-8 <?page no="251"?> Wilhelm Schmeisser, Dieter Krimphove, Claudia Hentschel, Matthias Hartmann Handbuch Innovationsmanagement 424 Seiten, Hardcover ISBN 978-3-86764-421-1 Wie wird die technische Entwicklung der nächsten Jahre aussehen? Welche Erfindung bringt welche Wettbewerbsvorteile? Fragen wie diese sind für Entscheider in Unternehmen überlebenswichtig. Es gilt, in enger Zusammenarbeit mit der Wissenschaft die Ideen und Produkte hervorzubringen, die im Markt der Zukunft bestehen können. Die Qualität des Innovationsmanagements entscheidet heute mehr denn je über den unternehmerischen Erfolg. Das »Handbuch Innovationsmanagement« erleichtert den Einstieg in das Thema und beleuchtet es aus unterschiedlichen Perspektiven. Forschung und Entwicklungsmanagement werden ebenso erläutert wie das Innovationsmarketing oder die personellen und organisatorischen Rahmenbedingungen des Innovationsprozesses. 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