Transcript camp harvey - Duke University`s Fuqua School of Business

General Electric –
Risk & Cost of Capital
Aspects of a deal
Strategy
Target
Identification
Approach
Target
Risk &
Cost of
capital
Valuation
Deal
Structure
Due
Diligence
Incorporating risk in valuation is key
GE’s approach to risk - two fold

Mitigate
– Hedge transactions…currency, commodities
– Transactions backed by guarantees…corporate guarantee, LOC, parent guarantee
– Back to back agreements
– Government approvals…country risk
– Deal covenants
– GE Management

Incorporate
– Higher cost of capital
– Adjust cash flows
Why is cost of capital important?

Objective
– Proxy for risk
– Reduces value of investment…faster pay back
– Should mirror cost of obtaining funds and certainty and timing of recovery

Uses
– Purchase/ building of industrial facility
– Acquisitions/ investments
– Long term contracts
Computation of cost of capital

Cost of capital is – WACC or Discount rate
– Base rate usually anchored on US

Base rate adjusted for risk– Currency
– Industry
– Expropriation
– Demand
– Regulatory risk
– Environment reg.
Not all risks result in adjustment to cost of capital
Risk and cost of capital
Examples
Risk
People/ Management
Treatment

No freedom to rationalize people
Cost of capital adjusted

Trade unions
Cost of capital adjusted
unless agreement reached
Financial

Cost of severance
Cash flows adjusted

Quality of management
Cost of capital not adjusted

Currency exposure
Usually hedged..cost of
capital not adjusted

Inflation/ devaluation
Cost of capital adjusted

Funding
Cost of capital adjusted
more so if local borrowing

Interest rates
Cost of capital adjusted

Health and safety issues
Cost of capital & cash flows adjusted
Environment
Cost of capital & cash flows adjusted

Country/ industry environment
exposure
Risk and cost of capital
Examples
Risk
Country
Project/ investment
related risks
Treatment

Political Instability
Cost of capital adjusted

Regulatory reforms/ policies
Cost of capital not adjusted unless risk very
high

Economic instability
Cost of capital adjusted

Corruption
Cost of capital not adjusted

Supply interruption
Cost of capital not adjusted

Technology
Cost of capital adjusted

Market risk – sell-side
Cost of capital adjusted

Barriers to entry
Cost of capital adjusted

Force Majure
Cost of capital not adjusted
unless exposure very high

Weak Exit Strategy
Cost of capital adjusted

Tax exposure
Cost of capital not adjusted…usually cash
flows

Possibility of Unscheduled events/ delays
Cost of capital not adjusted…unless risk
quantifiable
Risk & Cost of Capital –
Tools and Internal Process
Due Diligence Process

Objective
– To provide enough information to measure and assess risk in deals and investment
– Internal and external parties involved - GE Audit Staff, KPMG

Process usually covers the following risks:
– People/ Management
– Project/ investment related risks
– Environment, Health and Safety

End result
– Information on risks…risks usually quantified
– Incorporation of risks and adjustment of cost of capital by Deal team
– Process more art than science
Due Diligence Process
Due Diligence
The Intensity of Due Diligence Varies by the Legal Stage of the
Acquisition/ JV Process:
Confidentiality
Agreement
Letter of
Intent
Preliminary
Due Diligence
(Pre-LOI)
Contract
Signed
Business & Legal
Due Diligence
(Pre-Signing)
Confirming
Due Diligence/
Audit
(Pre-Closing)
Closing
Audit/ Deal
Hand-Off
(Post-Closing)
Valuation
EL
LEV
Y
T
N SI
IN TE
Attempt To Limit Intensity And Resources Until A Clear
Deal Exists -- Not Alw ays Possible (e.g., Auction, Tender).
3
Due Diligence Process
Due Diligence Process – EHS web-page
Country risks…GE Capital Risk Management

Objective
– To provide enough information to measure and assess country risk in deals and investment

Process usually covers the following :
– Risk assessment by GE’s economists and risk management team
– Comments of in-country teams incorporated
– Internal analysis verified with external reports

End result
– Information on country risks…risks usually quantified
– Cost of capital adjusted by Deal team
– Process highly scientific
Country risks: Web page
Country risks: Sample analysis
- Japan -
Capital Expenditure &GDP Growth
1.5%
1.2%
CapEx
GDP
- Australia -
Capital Expenditure &GDP Growth
2.40%
0.5%
0.0%
Key =
International Economic Indicators
August ‘02
1.1%
0.0%
1.1%
1.2%
1.0%
-0.9%
-2.6%
-1.9%
Q1 '01
Q3 '01
Q4 '01
Q1 '02
-0.8%
-1.5%
-2.7%
Q1 '01
Aug ' 02 Jul '02 Jun '02 May '02 Aug '01
5.5
NA
5. 4
5.4
5.0
0.17
0.21
0.22
0. 25
0. 25
0.65
0. 8
0.80
0. 88
0. 92
Unemploym ent (%)
Cost of Money - 3 Yr
Cost of Money - 7 Yr
Unemploym ent (%)
Cost of Money - 3 Yr
Cost of Money - 7 Yr
Q3 '01
Q4 '01
Q1 '02
Aug ' 02 Jul '02 Jun '02 May '02 Aug '01
6.2
6. 2
6. 3
6.3
6.8
5.99
6.13
6.36
6. 47
5. 35
6.68
6.84
6.92
6. 95
5. 83
- Canada -
- Mexico GDP Growth
2.0%
2.1%
1.4%
1.0%
-1.4%
Q1 ‘01
-1.5%
Q3 '01
Unemploym ent (%)
Cost of Money - 3 Yr
Cost of Money - 7 Yr
*Indicates forecasted number.
Aug '02
7. 6
4.05
4.95
Q4 '01
Q1 '02
Jul ' 02 Jun '02 May '02 Aug '01
7.5
7.5
7.6
7. 0
3.97
4. 43
4. 63
4.68
5.1
5. 28
5. 38
5.40
Q3 '01
Unemploym ent (%)
Cost of Money - 3 Yr
Cost of Money - 7 Yr
-1.6%
Q4 '01
-2.0%
Q1 '02
Aug '02 Jul ' 02
NA
NA
9.95
10. 2
11.35
11.45
Q2'02
Jun '02 May '02 Aug '01
2. 4
2.7
2.3
10. 90
9.45
NA
11. 70 10.80
NA
9/11/02
Country risk: GE legal web-page
Financial risks…GE Treasury

Objective
– To provide enough information to measure and assess financial risk in deals and investment
– Involvement of corporate and business treasury teams

Process usually covers the following :
– Risk assessment by GE’s economists and treasurers
– Internal analysis verified with external reports
– Hedging instruments identified
– Optimal capital structure identified

End result
– Information on currency risks…risks usually hedged
– Cost of capital adjusted by Deal team for funding, local borrowing
– Process mix of art and science
Currency risks – GE Treasury web-page
Easy way out….
Target Company
Information:
Links to sources of basic information
regarding a company
Recent GE acquisitions in the news
M&A News:
Current Borrowing Cost
and WACC:
GE’s current borrowing cost and
WACC used for modeling
acquisitions
Companies would centralize information…not to reinvent the wheel
Business case –
GE Lighting acquisition of Tungsram
Deal Basics
Facts
Strategic consideration
•
Acquirer: GE Lighting
•
Tungsram Company, Hungary
•
12 factories, 18K employees
• Low cost position
•
Low cost but low quality producer
• Access to new product lines
•
Annual sales: $300MM
• Rapid Market share
• Access to distribution channels
Deal Structure
Valuation Assumptions
• Huge country risk
• 2% growth
• Cash deal - $ 160MM
• Cost of Capital – 14%
• Reduced exposure by limiting investment to 50% + 1
share
• Reduction in overhead costs..10% workforce
reduction
• DCRR: 19.1%
• 20% Hungarian tax
• Payback: 8.6 years
• Material efficiency..10% over 5 years
Cost of capital - adjustments
Overall weighted cost of capital
14%