Chapter 158 Uncertainty Surrounding A Foreign Targetrefer To Question ✓ Solved
Chapter . Uncertainty Surrounding a Foreign Target Refer to question 7. What are some of the key sources of uncertainty in Blore's valuation of the target? Identify two reasons why the expected cash flows from an Asian subsidiary of a U.S.-based MNC would be lower if Asia experienced a new crisis. 20.
Decision to Sell a Business Kentucky Co. has an existing business in Italy that it is trying to sell. It receives one offer today from Rome Co. for million (after capital gains taxes are paid). Alternatively, Venice Co. wants to buy the business but will not have the funds to make the acquisition until 2 years from now. It is meeting with Kentucky Co. today to negotiate the acquisition price that it will pay for Kentucky in 2 years. If Kentucky Co. retains the business for the next 2 years, it expects that the business will generate 6 million euros per year in cash flows (after taxes are paid) at the end of each of the next 2 years, which would be remitted to the United States.
The euro is presently $ 1.20, and that rate can be used as a forecast of future spot rates. Kentucky would only retain the business if it can earn a rate of return of at least 18 percent by keeping the firm for the next 2 years rather than selling it to Rome Co. now. Determine the minimum price in dollars at which Kentucky should be willing to sell its business (after accounting for capital gain taxes paid) to Venice Co. in order to satisfy its required rate of return. Chapter . Incorporating Country Risk in Capital Budgeting How could a country risk assessment be used to adjust a project's required rate of return?
How could such an assessment be used instead to adjust a project's estimated cash flows? 14. Country Risk Ratings Assauer, Inc., would like to assess the country risk of Glovanskia. Assauer has identified various political and financial risk factors, as shown below. Assauer has assigned an overall rating of 80 percent to political risk factors and of 20 percent to financial risk factors.
Assauer is not willing to consider Glovanskia for investment if the country risk rating is below 4.0. Should Assauer consider Glovanskia for investment?
Paper for above instructions
Assignment Solution: Valuation and Risks in International Business OperationsIntroduction
In the complex world of international finance and investment, evaluating foreign investment opportunities often entails navigating significant uncertainty, particularly when pertaining to valuation and country risk assessments. This solution comprehensively addresses the uncertainties in the valuation of a foreign target, particularly focusing on the scenario with Blore’s valuation and further explores the implications of country risk on project evaluations and cash flows.
Key Uncertainties in Blore’s Valuation of the Foreign Target
A multitude of uncertainties can emerge when conducting valuations on foreign targets, reflecting a range of macroeconomic and microeconomic factors. Two major sources of uncertainty include:
1. Political and Economic Stability: Changes in government policies, political unrest, and economic volatility contribute significantly to valuation discrepancies (Meyer & Nguyen, 2021). If a foreign country experiences a turbulent political environment, such as shifts in trade policies or regulatory frameworks, it could result in unpredictable impacts on operational costs, market demand, and potential profits.
2. Exchange Rate Fluctuations: Fluctuations in currency values can substantially affect a firm's expected cash flows. A depreciation of the local currency against the US dollar could reduce the actual dollar value of the expected revenue streams, thereby influencing valuation metrics such as Net Present Value (NPV) (Eiteman, Stonehill, & Moffett, 2020).
These uncertainties are particularly pertinent in the context of an Asian subsidiary of a U.S.-based Multinational Corporation (MNC). In the event of a new crisis in Asia, such as a financial downturn or natural calamity, the expected cash flows could be adversely impacted for several reasons:
1. Supply Chain Disruptions: An unforeseen crisis may disrupt supply chains, leading to delays and increased operational costs. If suppliers are unable to deliver materials timely, production may halt, causing a decline in sales and ultimately revenue (Khan & Shabbir, 2020).
2. Decreased Consumer Spending: A regional crisis often results in decreased consumer confidence and spending. Families and businesses typically cut back on discretionary spending during adverse conditions, leading to lower sales volumes (Menkhoff et al., 2019). Therefore, anticipated cash flows for an MNC’s subsidiary can significantly drop due to demand shocks.
Case of Kentucky Co. and Valuation of Business Sale
Kentucky Co. is currently faced with the dilemma of selling its Italian business immediately for million or retaining it for two additional years, expecting annual cash flows of 6 million euros each year. The valuation decision hinges upon whether the prospective cash flows would yield the minimum required rate of return of 18% if the business is held for two years.
First, the total cash inflows over two years from the operation of the business amounts to:
- Year 1 Cash Flow: 6 million euros
- Year 2 Cash Flow: 6 million euros
The euro is currently valued at .20. Therefore, converting the expected cash flows into USD yields:
- Year 1 Cash Flow: 6 million euros * 1.20 = .2 million
- Year 2 Cash Flow: 6 million euros * 1.20 = .2 million
Calculating Present Value (PV)
To determine whether holding the business will yield the desired 18% return, we calculate the Present Value (PV) of the expected cash flows:
\[
PV = \frac{CF1}{(1 + r)^1} + \frac{CF2}{(1 + r)^2}
\]
Where:
- \(CF1 = 7.2 million\) (Year 1 cash flow)
- \(CF2 = 7.2 million\) (Year 2 cash flow)
- \(r = 0.18\) (required return)
Calculating the present values:
- For Year 1:
\[
PV1 = \frac{7.2 \text{ million}}{(1 + 0.18)^1} \approx \frac{7.2}{1.18} \approx 6.10 \text{ million}
\]
- For Year 2:
\[
PV2 = \frac{7.2 \text{ million}}{(1 + 0.18)^2} \approx \frac{7.2}{1.3924} \approx 5.17 \text{ million}
\]
Summing these present values gives:
\[
Total PV \approx 6.10 + 5.17 \approx 11.27 \text{ million}
\]
Valuation Decision
Kentucky Co. should only retain the business if the PV of future cash flows (approximately .27 million) exceeds the immediate cash offer of million. Therefore, the minimum price Kentucky can accept from Venice Co. should ideally be higher than the present value. Given that .27 million is substantially lower than million, it is advisable for Kentucky Co. to opt for the immediate sale to Rome Co., as the opportunity cost of retaining the business outweighs the benefit.
Incorporating Country Risk in Capital Budgeting
Country risk assessments play a critical role in capital budgeting by enabling organizations to account for the multifaceted risks associated with investing in a foreign market.
Adjusting Required Rate of Return: A country risk assessment can identify specific risks an organization might face, such as political instability, changes in regulations, or economic downturns. Consequently, these identified risks can lead firms to increase the required rate of return on their projects to compensate for potential losses resulting from these uncertainties (Hennart, 2018).
Adjusting Estimated Cash Flows: Alternatively, a country risk assessment could also entail modifying the cash flow projections based upon anticipated changes in market conditions arising from country-specific risks. For instance, if political unrest is predicted, cash flow projections could be conservatively reduced to reflect the potential negative impact on sales and operational performance (Tugcu, 2017).
Assessment of Glovanskia’s Country Risk
When evaluating Glovanskia, Assauer, Inc. will incorporate results from its risk analysis, which has assigned an 80% weight to political factors and a 20% weight to financial factors. The combined risk rating assessment in a scale from 0 to 10 indicates that Assauer is unwilling to invest if the country risk rating is below 4.0. This necessitates the calculation of the final rating based on responses to political and financial risks.
Initially, if we assume the political risk is scored on a 10-point scale, an 80% weight implies that the political risk score can contribute a maximum of 8 points to the overall rating. Similarly, the financial risk would contribute up to 2 points at a 20% weight.
If Glovanskia is rated at:
- Political Risk: 5.0
- Financial Risk: 4.0
Then, the overall risk rating is calculated as follows:
\[
Overall Rating = (Political Risk \times 0.8) + (Financial Risk \times 0.2) = (5.0 \times 0.8) + (4.0 \times 0.2) = 4.0
\]
Given that the threshold is at 4.0, Assauer should consider Glovanskia for investment as it meets the minimum country risk rating required for investment.
Conclusion
In summary, the complexities involved in international investment valuation necessitate a rigorous assessment of uncertainty and country risks. When conducting business valuations, it is imperative to evaluate political and economic conditions diligently and forecast future cash flows prudently. Kentucky Co. serves as a case in point for weighing immediate versus future cash flows, while the evaluation of Glovanskia highlights the importance of integrating country risk into investment decisions.
References
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