Foreign acquisitions have become increasingly popular with the trend toward globalization. Changes in the political environment frequently spur increased acquisitions. For example, the death of Hugo Chavez in Venezuela has spurred increased acquisition activity of Venezuelan companies. Valuations there are depressed due to recent history but the future outlook is better (in the opinion of some).
Everyone learned in introductory finance class that one takes forecasted cash flows and discounts them by the weighted average cost of capital (WACC) to arrive at a valuation. What everyone missed in finance class (because you were texting) is that for foreign acquisitions you use the acquisition's cost of capital and not the acquiror's cost of capital. Sounds pretty simple, until one tries to do a calculation of, for example, WACC in a Venezuelan company.
The WACC formula (1) is :
WACC=E/V *Re + D/V *Rd*(1-Tc)
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
The problem in using this formula comes in determining the cost of equity (Re). Traditional theory says that one would use the Capital Asset Pricing Model (CAPM), defined as:
Cost of Equity= Rf + Be * (Rm-Rf)
Rf= Risk free rate
Be= Equity Beta
Rm= Expected return on the equity market
The problem in this formula is in determining Rm, expected return on the equity market, and Be (equity beta). Many countries have small publicly traded equity markets or stocks have very small daily or annual trading volumes. Such a shortage of reliable data makes the determination of Rm and Be questionable.
Instead of using CAPM I use the following formula:
Cost of Equity= Rd +(Rmu-Rfu) + (Rfx-Rfu)
Rd= cost of debt of the acquired company
Rmu= Expected return on the equity market in the U.S.
Rfu= Expected risk free rate in the U.S.
(Rm-Rfu is the premium for equity risk in the U.S.)
Rfx= Expected risk free rate in the country of the acquisition
(Rfx-Rfu is the country risk premium (based on the difference in yield for soveriegn bonds)
The advantage of this formula is that almost every company anywhere in the world has a cost of debt and debt cost is almost always a free market determination. To the cost of debt what the formula does is add the premium for equity in the U.S. plus a country risk premium, which adjusts the U.S. equity premium upward to consider country risk.
Question: what do you do if the foreign country has no sovereign debt? First I would reconsider the acquisition because the country is very undeveloped and it might be less capital at risk to build a company from scratch. If you still want to do an acquisition, I would use the interest rate of the largest company in the country that has issued public or private debt as a surrogate for sovereign debt (your local banker can tell you this rate). The government should have a lower cost of debt than a private company but this company's cost of debt is an objective number and a bit conservative (which is not a bad thing in a foreign acquisition).
I have used this cost of equity technique for years. It is not pure theory like CAPM but it use a logic based on theoretical finance (equity is more expensive than debt) to determine cost of equity and it can be used in every country in the world to calculate realistically the WACC.