Relationship Benefits between Japan Venture Partners and Omnicom - Case Study Example

1. Introduction Omnicom Group is a strategic holding company that has companies in several markets. This U.S. based multinational company is planning to raise its investments in Japan by about two billion U.S. dollars over the next 12 months. Omnicom has enlisted the assistance of Japan Venture Partners (JVP) to help them evaluate options available to finance this investment and manage it as well. This paper will identify the various options available to Omnicom, including critical analysis/evaluation of the financial implications of each option, and provide a recommendation as to which finance option Omnicom should choose. Japan Venture Partners "designs and executes business strategies in Japan and China for North American technology companies."1 This organization provides management expertise to help foreign investors run subsidiaries in Japan or China. 1.1 Current Financial Structures Japan Venture Partners provides the knowledge and relationships needed for foreign companies to establish local (Japan) subsidiaries. JVP manages negotiations and structuring of equity investments. JVP uses its relationships with local Japanese corporate and financial investors to help North American companies establish a foothold in the Japanese markets. JVP leans more toward investments from a small group of Japanese corporate and financial investors. 2. Various Financial Options Japan Venture Partners offer several financing options to its clients. This organization shares the financial risk while its clients maintain control of the subsidiary. Japan Venture Partners encourages forming, managing, and financing subsidiaries in Japan through the use of local equity or debt financing2. In certain situations IPO's (initial public offerings) are possible in the Japanese market. Local financing in Japan is important in establishing long-term relationships in markets as well as local financial results. Another important aspect of JVP's management of subsidiaries is its ability to keep foreign companies in compliance with local securities laws and ownership structures that are compliant with local laws. It is worthy to note here that an agreement between JVP and Omnicom would be a joint venture. Financing options would be those best suited to a joint venture agreement. 2.1 Identification Of Different Finance Options and Risk As stated earlier there are two main financing options available to Omnicom if they choose to use JVP's services to enter the Japanese market: issuing new equity and issuing new debt. These financing options are further broken down to internal financing and external financing. Internal financing consists of using funds from the parent company, from sister subsidiaries, and subsidiary borrowing with parent guarantee.3 External Financing consists of borrowing from sources in the parent country, borrowing from sources outside the parent country, and local currency debt. The internal choice should minimize worldwide taxes and political risk. The external choice should minimize the cost of funds (foreign exchange risk)4 2.1.1 Issuing New Equity Issuing new equity would raise funds to support Omnicom's entry into the Japanese market. Omnicom's choices are to issue domestic securities or foreign securities (or both). Both types of security's objectives are to maximize the rate of return and minimize risk. Investors in foreign securities face possible currency and political risk (addressed in section 2.4). The securities must appeal to both domestic and foreign portfolio investors to be successful in funding the joint venture. Equity calculations should be forward looking using historical performance records. By selling equities in the foreign markets the company is able to maintain some liquidity. 2.1.2 Issuing New Debt Omnicom also has the option of issuing debt securities to fund its larger presence in the Japanese market. These loans could come from domestic or international sources. Omnicom would enter into agreements (contracts) with the interest rates, interest payments and capital repayment dates set. Loan capital has its own measure of risk of default. Again, internal and external options are available. Internal options are selected to minimize international exposure to taxes and political risks. External options are selected to minimize cost. As stated earlier internal funding comes from the parent company, the sister subsidiaries, and those generated internally by the foreign subsidiary. External funds are borrowed from sources in the parent country, outside the parent country, individual shareholders, and joint venture partners. 2.2 Critical Comparisons The idea of going into debt to fund a new venture is not appealing to many. But, issuing new equity has it downfalls as well. It is risky to do either unless it is absolutely known how the markets will react to the growth of the parent company, its entry into a new market, and currency/political risk. An initial public offering (IPO) in the new market may prove a successful way to fund a new subsidiary. Decisions makers in both Omnicom and Japan Venture Partners need to be careful about making decisions that favour one organization over another. Issuing new equity could dilute future earnings of stockholders while new debt could lower the company's performance rating. Also, the company is not required to pay dividends to common shareholders (it just might choose not to!). Higher levels of debt could equate to lower levels of liquidity. It may be more advantageous to borrow from the international market where the borrower has access to different currencies, repayment structures, and loan maturity dates. 2.3 The Chosen Option and Its Justification The chosen option is a combination of the various options available. A diverse package using various options in a well planned manner serves to distribute the risk associated with each option. By choosing one option over all the others Omnicom is in effect "putting all its eggs in one basket". Managers at JVP and Omnicom would best serve their goals by looking at how the joint venture could benefit by using various sources of funding. So, issuing new equity in the form of stocks and bonds and borrowing from sources within the parent country and international sources could prove a good plan for funding the joint venture. A failure in one area of the package would not necessarily bring the whole project to its knees. 2.4 Company's Duration Gap and Currency Exchange Risk Duration gap is a method used to calculate a company's interest rate risk. It involves comparing a company's changes in values of assets and liabilities that are affected by interest rate changes. The duration of the asset/liability equals the time period that needs to be assessed. 2.4.1 Company's Duration Gap To determine Omnicom's duration gap the interest rate risk is measured by comparing the weighted average duration of assets with the weighted average duration of liabilities. If asset duration is greater than liabilities duration then rising interest rates will mean that the market value of equity will fall. The idea is to get duration gap as close to zero as possible. To calculate the duration gap the duration of assets and liabilities needs to be calculated. For example: DA = (A/TA) * duration + (A/TA) * duration = duration of total assets DA is Duration of Assets A is Market Value of Asset TA is Total Assets In the above example two different assets were added together. Duration of liabilities is calculated in much the same way: DL = (L/TL) * duration + (L/TL) * duration = duration of total liabilities DL is duration of liabilities. The duration gap is then calculated using the above results: DGAP = DA - (L/TL) * DL 2.4.2 Currency Exchange Risk Currency exchange risk is that risk associated with having assets denominated in one market and the uncertainty associated with the exchange rate when the currency is exchanged to another market. For example, as of the writing of this paper, the exchange rate for the Euro to the dollar is .77. If I have my investments in Euros and the rate of exchange goes down (a drop in the value of the Euro) my investment would lose value if I chose to exchange my currency for dollars. I.e. it would take more Euros to equate to the value of the dollar. I would be smart to leave the investment in Euros until the exchange rate went up. 3. Literature Review and Major Debate in Capital Structure Theory (CAPM WACC) Capital Asset Pricing Model (CAPM) is a valuation model meant to describe the relationship between risk and return.5 The Weighted Average Cost of Capital (WACC) is another model that describes the relationship between risk and return.6 The WAAC is calculated by combining the cost of equity with the cost of debt.7 The cost of capital can best be defined using the CAPM. Capital valuations should be "forward-looking" using historical data as a base for the prediction of future outcomes.8 There are advantages and pitfalls associated with the use of CAPM. CAPM is supposed to be able to look at historical returns to help predict future returns. CAPM was created to explain the differences in risk premiums across assets. These differences are caused by the riskiness of the returns on the assets.9 CAPM is commonly known as the portfolio approach to risk10. CAPM is a useful tool for estimating expected returns. WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing11: Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D =market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc =corporate tax rate For example: WACC = 3948/19867 *3948+15919/19867*15919*(1-%15) WACC = 11492.55 So, which valuation method is best to use WACC is a standard means of expressing the cost of capital while CAPM is the dominant model for estimating the cost of equity.12 Using both rather than one or the other would be advantages to the portfolio manager. 4. NPV (Net Present Value). Projects are best scheduled to take advantage of Net Present Value. NPV is a valuation and measurement tool used to calculate the time value of money. It is used to determine whether the present value of capital is enough to cover the future costs of the initial investment. This would be a good tool for Japan Venture Partners and Omnicom to determine whether their present value of capital is enough to cover the future costs of their initial investment. 5. Gearing Ratios. Gearing ratios compare a company's equity (capital) to borrowed funds. It is a measure of a company's leverage. There are several gearing ratios such as debt to equity ratio, debt ratio, and equity ratio. Investors can use gearing ratios to determine the health of a business such as whether or not a company is a bankruptcy risk 6. Summary. This paper has examined the relationship benefits between Japan Venture Partners and Omnicom. JVP can assist Omnicom with their desire to invest two billion U.S. dollars in the Japanese market. JVP is a partner that could help ease the entry of a subsidiary into the Japanese market. JVP is a relationship manager as well as a partner who can provide funding options not readily available to Omnicom as a foreign investor. JVP also offers Omnicom the knowledge of an insider when it comes to maintaining compliance with local securities laws. Financing options such as issuing new equity and issuing new debt were examined. Internal and external financing was examined as a possibility of funding this project. Different financing options were compared and methods of assessing risk were also examined. This case analysis has presented many options available to both JVP and Omnicom. The best option available is to take advantage of all tools available to measure the advantages and disadvantages of this joint venture. Instead of choosing one financing option both JVP and Omnicom would benefit from a diversified package of funding this joint venture. This would allow the risk to be spread over many different options (risk management). References/Bibliography 1. Japan Venture Partners. Services. What We Do. www.japanvp.com/whatwedoprint.html 2. Japan Venture Partners. Services. What We Do. www.japanvp.com/whatwedoprint.html 3. Exhibit 13.3 Internal Financing of the Foreign Subsidiary. PPT presentation from course 4. Exhibit Financial Structure of Foreign Subsidiaries. PPT session 09 presentation 5. Kayne Anderson Rudnick Investment Management. Glossary http://www.kayne.com/glossary.shtml 01/08/2007 6. DSM Investor Relations. Glossary http://www.dsm.com/en_US/html/invest/glossary.htm#W 01/08/2007 7. PPT Presentation Provided by Instructor (PPT #10) 8. IBID 9. Jagannathan, Ravi. And Ellen McGrattan. The CAPM Debate. Research Department Federal Reserve Bank of Minneapolis. http://minneapolisfed.org/research/qr/qr1941.pdf 01/08/2007 10. Goetzmann, William. An Introduction to Investment Theory. Yale School of Management. Online Textbook http://viking.som.yale.edu/will/finman540/classnotes/notes.html . 11. http://www.investopedia.com/terms/w/wacc.asp. Retrieved 9 Jan 2007. 12. Bruner, Robert. Kenneth Eades. Robert Harris. And Robert Higgins. Best Practices in Estimating the Cost of Capital: Survey and Synthesis. Spring/Summer 1998 Read More