© Sundaram 2003

Issues to Keep in Mind inCross-border Valuation

Anant SundaramAssociate Professor of Finance

THUNDERBIRD-AGSIM<sundaram@thunderbird.edu>

© Sundaram 2003

Issues to Keep in Mind in Cross-border Valuation

Valuing a company across borders issimilar, in principle, to valuing one athome.

But there are a few additional twists tokeep in mind:

(1) Choice of currency;(2) Earned vs. remitted income;(3) Tax rates;(4) Cost of capital; and(5) Treatment of country risk.

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(1) Choice of Currency

You can choose either the home or theforeign currency in determining cashflows.

But foreign currency cash flows shouldbe discounted at the foreign currencydiscount rate, and the home currencycash flows at the home currencydiscount rate.

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(1) Choice of Currency

If a project’s value is likely to beparticularly sensitive to exchange rates,it might be helpful to explicitly forecastthe foreign currency cash flows andthen convert them into home currencycash flows using a specific set offorecasted exchange rates.

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(2) Earned versus RemittedIncome

It is preferable to use earned cashflows, whether or not those cash flowsare actually remitted to the parent.

The idea is that, the cash flow, even ifretained in the subsidiary, ultimatelybelongs to the firm’s shareholders.

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(2) Earned versus RemittedIncome

However, this assumes that thesubsidiary earns a rate of return that isat least as high as its cost of capital.

(If not, should such a subsidiary beretained in the firm?)

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(3) Taxes

Different countries have different tax rates,requirements for timing of tax payments,and tax treaties with the home country.

Other than to make the observation thatyou should: (a) Spend time learning aboutthe tax situation in the foreign country (vis-a-vis the home country), and (b) Alwaysuse the marginal tax rate applicable to theproject in question, there is little to be said!

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(4) The Appropriate Cost ofCapital

It may be expedient (and probably accurate)to assume that the investors are indigenousto the home country in which the parent firmis headquartered.

This means that you can use the home-country-benchmarked cost of capital(adjusted, of course, for the riskcharacteristics of the project vis-a-vis thehome country).

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(4) The Appropriate Cost ofCapital

If you need to convert the WACC from onecurrency to another, use UIP.

The cost of equity will also depend onwhether equity markets are integrated orsegmented.

If markets are segmented, you should usethe home country market index; if integrated,a world index (e.g., MSCI index).

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(4) The Appropriate Cost ofCapital

If a non-US company has an ADRtrading on the NYSE or NASDAQ, it isprobably reasonable to assume thatprice moves in the US are affecting itsexpected returns in a much moresubstantial way than its home market.

It is probably OK to derive the US$ rE,and to then calculate a home currencyrE (if needed) by using UIP.

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(5) Treatment of Country Risk

It really depends on two judgments that youmust make: (i) Whether or not the countryrisk can be considered ‘systematic’; (ii)Whether or not it is already captured in theproject ß . If the judgment is that countryrisk is unsystematic, you should ignore it.

In general, if country risk is a serious issue,it can be reflected in the cash flows or thediscount rate. This is also a judgment call.

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(5) Treatment of Country Risk For bonds it is necessary to add a country

risk premium. What about equity? It gets a bit complicated, especially with

respect to emerging markets….

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The Case for a Country Risk EquityPremium in Emerging Markets

EM returns during 1976-92 averaged20% (in $ terms), about 50% higher thanUS, yet, their collective CAPM-ß againstthe S&P500 was 0.5. (Harvey 1996).

During the 1985-2000 period, the EMannual return was 16% (the US was19%), and EM ß was 0.37. (My analysis)

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The Case for a Country Risk EquityPremium in Emerging Markets

For instance, during 1985-00, LatinAmerica returned 26% annually, with aß of 0.98; Asia returned 17%, with a ßof 0.08%.

Obviously, the single-factor CAPM(measured against the S&P 500) ismissing something major in explainingEM returns: returns seem much higherthan would be predicted by EM ß’s.

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The Case for a Country Risk EquityPremium in Emerging Markets

Regression of individual EM returnsagainst their market betas produces R2

of 1% to 2% –– essentially, a ‘flat’ SML, But a similar regression against total

risk (σ) results in significant R2 of 30% -40%, and an upward-sloping relationthat looks like SML.

© Sundaram 2003

The Case for a Country Risk EquityPremium in Emerging Markets

Cross-correlation in returns amongEM’s equity markets is quite high.

Suggests contagion of returns and risksacross EMs (Such contagion alsoevident in peso crisis of 1994-95, andAsia crisis of 1997-98).

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The Case for a Country Risk EquityPremium in Emerging Markets

Implication: There are, quite possibly,factors other than a CAPM-beta at workin pricing EM returns.

Explanation: There is probably an‘emerging market risk’ factor at work.Source of this risk unclear.

Major Wall Street firms and consultingfirms derive EM discount rates asthough such a country risk factor exists.

© Sundaram 2003

The Case for a Country Risk EquityPremium in Emerging Markets

The Country Spread Model: Simple method. The spread between

EM’s and US government bond yield inUS$ is added to the riskfree rate.

Also done with the spread between LTEurobond yields (in same currency) ofcorporate issuers in similar lines ofbusiness between the EM and the US.

Most commonly used method.

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The Case for a Country Risk EquityPremium in Emerging Markets

CSFB Model: Complicated: Calculates the riskfree

rate by stripping yield of the EM’s Bradybonds, multiplies MRP by a ratio of thecoefficient of variation in returns in EMvs US market, and multiplies by somesort of an ‘adjustment’ factor.

Makes absolutely no sense!

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The Case for a Country Risk EquityPremium in Emerging Markets

Damodaran Model: Multiplies the US MRP by an EM equity

risk premium factor: EM equity premium factor =

(EM Yield Spread)*(σEM,e/ σEM,b)Where σEM,e is the volatility of the EM’sequity markets and σEM,e is that of theEM’s bond markets.

Weak conceptual justification.

© Sundaram 2003

The Case for a Country Risk EquityPremium in Emerging Markets

Harvey et. al. Model: Regresses realized returns of the EM

against (log of) country credit riskratings. Uses CCR’s to predict return.Produces R2 of 30%+, which is prettygood.Data updated every six months.

But the CCR’s are highly correlated(80%+) with country yield spreads (themost common method).

© Sundaram 2003

Bottom Line?Use the simple country yield spread

approach:» Either add the spread between EM’s

and US government bond yields inUS$ to the riskfree rate, or

» ….add the spread between LTEurobond yields (in same currency) ofcorporate issuers in similar lines ofbusiness between the EM and theUS.

© Sundaram 2003

Summary: Cross-border Valuation

Forecast foreign currency free cash flows[Remember to: (a) Incorporate foreign currency inflation rates; (b) Use

the appropriate marginal tax rate; and (c) Include the terminal value.]

METHOD A(Step 2) Determine foreign

currency discount rates, usingproject-specific capital

structure and the project-specific ß;

(Step 3) Calculate the PV in theforeign currency;

(Step 4) Convert to homecurrency PV using the spot

exchange rate.

METHOD B

(Step 2) Forecast exchangerates and convert FCF into

home currency;(Step 3) Determine home

currency discount rates usingproject-specific capital

structure and project specificß;

(Step 4) Calculate the PV inthe home currency.