Business Acquisitions as Most Important Strategic Investment Decisions - Essay Example

BUSINESS ACQUISITIONS PART 1 FDI and Cross-border M&A An example of an FDI is US drug company Pfizer’s infusion of $60 million in a stem cell research center in Cambridge (Hawser, 2009). Pfizer’s presence in the UK is evident in its European R&D headquarters in Sandwich, with a workforce of approximately 3,500 people (Pfizer, 2008). An example of an acquisition is Kingfisher plc’s acquisition of five leasehold hypermarket stores from privately-owned Chinese company, PriceSmart, in 2005. For £6.95 million (US$13.5 million) cash, the payment was conditioned upon the full transfer of each store. Kingfisher expected the acquisition to advance the expansion of its B&Q business in China. 1.2 Country Risks Faced by Organisations in FDI and M&A The location of businesses in other countries, either in the form of greenfield FDIs, crossborder M&As or other forms of direct investment, entails a set of challenges and risks which impact on the business that seeks to gain entry into another country. One of this is the risk associated with currency exchange rates, which will be discussed in the succeeding section of this report. At this point, more attention shall be devoted to discussing the other sources of organisation risk. Economic nationalism. In a report by the Economist Intelligence Unite (Chance, 2006), certain events the author chose to call “backlash” after decades of liberalisation and openness to FEI and crossborder M&As (more pronounced against M&As). Recent resurgence in protectionism against FDIs and M&As, for instance, is seen in the attempt to block the acquisition by Lenovo (China) of the personal computer (PC) division of IBM (US), and the takeover bid by Mittal Steel (Netherlands) for Arcelor (Luxembourg). Both of these deals, despite the attempts to prevent them, were consummated. Some deals, however, failed because they were successfully blocked by the local elements: CNOOC (China) of Unocal (US); Dubai Ports World of P&O Steam Navigation Company (UK), and Pepsi (US) of Danone (France). Behind some of these cases is the negative sentiment with which developed countries perceive takeover bids by companies in emerging markets, because of the impression (not necessarily justified) that these less-developed countries were more prone to undesirable behaviour such as poor standards of governance and less socially responsible behaviour. The shock of seeing Chinese and Asian companies, for instance, take control of prominent brand names, acquire technology, or securing natural resources has prompted a German politician to compare such investors to “the biblical plague of locusts” (Chance, 2006). This type of risk is more pronounced for Greenfield FDIs that maintain the image of their home countries, rather than an M&A that may assume the image of the host country component. In both cases, however, the risk of economic nationalism would not have been so significant had the business entry method been a joint venture or franchising. High political risks. Another challenge to the success of FDIs and M&As are the conditions pertaining to the political and peace-and-order situation in the host countries. Again, this problem affects greenfield FDIs and M&As more than other forms of FDIs, because in greenfield FDIs and M&As the company’s physical presence adds to the severity of the real risk to personnel and equipment, unlike in a mere capital infusion where the risk is limited to financial loss. The deteriorating law and order situation, the slowing of the privatisation process, lesser reforms mechanism, and higher levels of corruption were cited by Hafeez (2008) as important risk considerations in FDIs and cross-border mergers and acquisitions. Lack of free information flow. Dodge (2006) underscored the vital role that free flow of information plays in the environment where FDI and M&A are situated. Where management seeks to make important decisions as to alternative investment projects and the appropriate strategies to adopt in response to changing business environment, the necessity of acquiring information that may or may not portray the country or its government in a favourable light may spell the difference between the survival or failure of the firm. At times this failure to timely source vital information that is complete and relevant is not so much a matter of policy as it is of technical capability and communications infrastructure. Whether political or technical, where such conditions impede the flow of information as to adversely affect managerial decision-making, then this becomes a risk posed against the success of the FDI or M&A. Tax inefficiencies. Hansen (2006) observed that because of the growing volume of cross-border mergers and acquisitions, there has emerged an increased urgency in understanding and managing complex tax systems and the effects they have on international expansion. CFOs have begun to focus on the various due diligence requirements needed to comply with taxation requirements, and how to best minimise liabilities and reduce costs. The CFO in the home country, certainly, would have made a proper comparison of tax systems among the target host countries and uncover issues that might prove contentious to the firm’s business. By uncovering the controversial issues before closing the transaction, the home country firm could factor these into the negotiations and avoid being caught unprepared by an unforeseen tax liability in the future. The problem should be approached from the perspective of the tax laws of both the home and the host countries. Tax laws may also influence not only the location of the acquisition, but also whether or not to finance the deal with debt or with equity, depending on the tax implications of the transaction. Inadequacies of legal framework. Cummings (2008) highlighted the need for a strong legal structure that would protect businesses entering another jurisdiction only to find that their presence in that location had compromised the integrity of their distinctive product or production processes. Issues such as questionable business practices, environmental exposure, and inadequate intellectual property protection would tend to expose the business to unethical business undertakings and possibly piracy and IPR infringement in the design and production of their licensed products. One example is the prevalence of piracy in China, which has been chosen as the host country for many M&A and FDI ventures. Those production functions situated in China have given occasion to certain enterprising but unscrupulous partners to acquire the secrets of the trade or product design and reproduce unlicensed and unauthorized copies of these very products, to be sold at prices that undercut the legitimate outputs. Culture shock. The problem of insulating cross-border M&As against the effects of culture shock is an often overlooked but nevertheless critical issue in the determination of company risks (Cummings, 2008). Cultural differences exist that set countries apart, and commensurately alter the winning formula such that a successful operations strategy or market mix in the home country may not be so easily replicated in other countries. Cummings quoted Len Gray, Americas head of Mercer’s global M&A consulting business, as stressing that the way to overcome cultural difference and to work within their constraints is to “create a common focus and vision” towards those directions that would maximize the factors which, in the context of the social milieu, would allow the firm to succeed. This may be pronounced in countries where either the acquired or acquiring firm will be of a strong cultural orientation (e.g. a Muslim country) and the other of an entirely different but equally strong cultural background (e.g. the United States). In these undertakings it becomes vital to seek out a commonality of purpose and direction that takes into consideration the cultural sensibilities of both nations, but moreso the host country in which the business is situated. In conclusion, the risks which pose the greatest challenge to Greenfield FDIs and crossborder M&As at present gravitate to two kinds: that of security, and that of economic patriotism. It is essential for government to find ways and means by which essential interests may be safeguarded, while at the same time maintaining transparency and openness. Host countries have introduced more stringent regulations that appear to stifle foreign investment even as their policies welcome and even attract them. “At a global level, this in turn could have larger implications on investment and economic growth” (OECD, 2006). PART 2 Currency Hedging 2.1 Hedging: Definition and Rationale Hedging, in general, is a strategy that is used to eliminate investment risk (Downes and Goodman, 1995). Specifically, hedging is “the taking of a position, acquiring either a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position” (Eiteman, Stonehill & Moffett, 2004, p. 199). Hedging seeks to shield the investor from losses due to unexpected adverse price movements. However, since in hedging an offsetting position is taken, any gains realised due to favourable price movements are also offset by the hedging loss; thus in a perfect hedge, neither loss nor gain is realised (Downes and Goodman, 1995; Eitemen et al., 2004). Applied to foreign currency transactions, hedging seeks to minimise or at best eliminate the risks of holding a currency other than that of the home country. Currency risk is approximately defined as the variance in expected cash flows that materialise as a result of unexpected changes in the currency exchange rate (Eiteman, et al., 2004). A company assumes currency risk when its finances, originally in the home currency, is converted to a foreign currency in order for it to engage in business transactions in that country’s market. The results of these investments as well as the capital being intended for future repatriation, there is thus a risk of loss inherent in the volatility of the currency conversion rate between the two currencies. There is, therefore, the added risk of exposure in a foreign currency to which investments in offshore markets are susceptible to, and investment in domestic markets are not. 2.2 Kinds of hedges There are various types of hedges, namely the forward market hedge, the money market hedge, and the options market hedge. The forward and money market contracts are usually perfected when the funds required to fulfill the particular contract is available at the time the contract is entered into, in which case the hedge is “covered” or “square” and no residual foreign exchange risk is incurred. However, when the funds are not available, the hedge is “open” or “uncovered” and is attendant with higher risk because the covering funds will have to purchased in the spot market at a later date in order to fulfil the contract. A third type of hedge is the options market hedge, which is favoured because it allows the purchaser to speculate on the upside potential while limiting the downside risk to the cost of creating the option, known as the option price. Thus the options hedge is usually considered less risky than the forward or money market hedge (Eiteman, et al, 2004). 2.3 Effectiveness of Hedging There is evidence that the use of corporate derivatives creates an impact in influencing the foreign exchange risk exposure. Al-Shboul and Alison (2009) found that the use of foreign currency derivates is associated with the reduction to currency risk exposure among Australian multinational firms. However, they also found that different parties – in this case, directors, block-holders, and institutionals – hold varying and at time divergent sentiments concerning the use of derivatives for hedging. This study dovetails other inquiries, such as that of Chiang and Lin (2005) and Nguyen, et al (2006) that provide empirical evidence of the positive causal relationship between hedging with foreign currency derivatives and the reduction of foreign currency risk exposure. This is not to say that there is no evidence to the contrary. For instance, Copeland and Joshi (1996) found that although derivatives hedging does reduce currency risk, this reduction is too insignificant to provide potential benefits to the investor. The implication is that the hedging activities, with its attendant transaction costs, constituted a wasteful exercise from the point of view of the firm’s shareholders. Furthermore, not only was there no benefit to them, but it also increased currency risk exposure due to the additional offsetting position taken. 2.4 Issue: Should companies resort to hedging or not? From the empirical studies conducted, there appear to be as many reasons to hedge as not to hedge. On the positive side, hedging tends to enhance planning because if the hedge is effective, as the above studies revealed, firms are better able to control the outcome of their business transactions requiring dealing in foreign currencies. The elimination of currency risk allows businesses to explore alternatives that they otherwise would have avoided for fear of exchange rate fluctuations. This is particularly comforting in a regime where the markets are volatile, in which case hoarding of currencies in the spot market tend to create artificial demand and exacerbate the already restive situation. On the other hand, as Copeland and Joshi (1996) had proven, hedging does not increase the expected cash flows to the firm and may even cost the firm more in resources, for little or no tangible benefit to shareholders. Furthermore, as elaborated on by Eiteman, et al. (2004), shareholders are much more adept and flexible in diversifying their own currency risks than the management of the firm, which better satisfies their own individual risk tolerance. Probably, a happy compromise would be to diversify only those large projects that involve transactions in substantial amounts of foreign currency, and with a homogeneous pronounced currency risk. In this manner, the hedging function will be better decided by management, and a real risk is averted by careful and decisive hedging strategy. PART 3 Currency exchange rate forecasting Exchange rate forecasting models assume that all fundamental information are discounted in the exchange rate, and econometric or technical analysis is capable of predicting on the basis of past exchange rate levels. Tan and Tan (2000) compared three classes of exchange rate models: the ARIMA (auto-regressive integrated moving average), the structural, and the long-run models, to try to distinguish them on the basis of which performed better as a forecasting model. They concluded that the forecasting of exchange rates based on the long-run equilibrium concept is “only an illusion” (p. 265). Their conclusion was based on two salient findings: first, that the ARIMA and structural models suggested that the foreign exchange market is not only efficient, but that it is efficient even in the weak form. This implies that traders in the currencies market could not hope to obtain returns above the market average merely on the basis of observing past values of spot rates. Furthermore, market participants who take rational market positions can expect to outperform those who trade on the basis of technical analysis and charting techniques. The only exception that Tan and Tan found to this general rule is the performance of the yen, which tended to conform to ARIMA model predictions more accurately. This is attributable to the wide fluctuations of the yen during the forecast horizon, September 1994 to August 1995, which demarcated the period of the dollar crisis. The second salient finding of the Tan, et al. study is that long-run models were found to register poor performance during periods of disequilibrium. The unstable period tends to render the predicting model flawed and unreliable. They found that an individual who studies past exchange rates and tempers this assessment with additional information, using economic fundamentals and financial relationships, will usually outperform one who resorts to econometric modelling of long-run exchange-rate behaviour under a floating regime. These findings of Tan and Tan are a corroboration of an much earlier study by Gooman (1978) that confirmed the futility of econometric forecasts of foreign exchange rates. The more recent study of Chambers and McCrorie (2006), as if following through on the Tan study, sought to incorporate fundamental variables to econometric modelling to obtain improved forecasting performance. The study did not arrive at any clear consensus, for lack of a clear indication of which variables actually constitute fundamentals, since in the empirical attempt any form taken for the fundamentals tended to be misspecified. 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