M&A: Cross Border Deals, Joint Ventures and Strategic Alliances

Cross border M&A deals: acquirer and target firms are registered in two different countries.

Foreign Expansion/Entry Modes:

• Representative Office:
• is an office established by a company to conduct marketing and other non-transactional operations, generally in a foreign country where a branch office or subsidiary is not warranted.
• Easier to establish than subsidiary or branch, simple, low cost model and less incentives to be regulated.
• Strategic Alliance: 
• an agreement between two or more parties to pursue a set of agreed upon objectives need while remaining independent organizations. 
• The alliance is a cooperation or collaboration which aims for a synergy where each partner hopes that the benefits from the alliance will be greater than those from individual efforts. 
• The alliance often involves technology transfer (access to knowledge and expertise), economic specialisation, shared expenses and shared risk.
• Forming a contract between foreign partner and local company.
• Joint Ventures:
• a business agreement in which the parties agree to develop, for a finite time, a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets. 
• Co-own a local entity between foreign partner and local partner.
• Greenfield Investment:
• the investment in a manufacturing, office, or other physical company-related structure or group of structures in an area where no previous facilities exist.
• set-up a new factory, start from scratch.

Why Multi National Company (MNC) chooses M&As as the expansion mode?

• Difficulty in selling directly into domestic market --> production cost too high, transaction cost too high, lack of local knowledge.
• Difficulty in establishing a local factory --> lacks of local knowledge, uncertainty in the return of investment.
• Difficulty to entering another expansion mode beside M&A (eg joint venture or an alliance) --> uncertainty about such relationship due to lack of local knowledge and how to resolve conflicts (potential hold-out problems in the future)

How to view cross-border M&A?

An entry mode that acquires local knowledge but allows the MNC to retain control.

Strategic fits between foreign firms and domestic firms:

• Foreign Firms: 
• transfer of technology, brand, governance and organisation, cost of capital/diversification
• Domestic Firms:
• Country-specific marketing skills, distribution channel, connections, tax incentives.

Barriers to cross-border M&A:

• Home bias: cross border M&A targets tend to be from countries that neighbour and have strong links with home country.
• Tax differences.
• Capital control restrictions.

Issues with Cross-Border M&As

• Issues-1: M&A Deal constraint
• M&A necessitate (make something necessary, force to do something) a sale of control of the entire target firm.
• A sale can be difficult when the target and the acquirer have non-overlapping ZOPA. Why can be that the companies create synergies have non-overlapping ZOPA? Yup, maybe because lack of knowledge of other firm assets to value their synergy benefits.
• In this context, a joint venture allows the synergies to be capture.
• Issues-2: Incentives compatibility
• After the target being absorbed, M&A mostly provide no clear performance measures, difficult to design incentives scheme for the target's managers (division). Thus, only an acquirer's shareholders can monitor progress.
• In contrast, a joint venture allows both the acquirer and target to share ownership in a common project --> compatible incentives.

Analysing Strategic Risks and How To Measure

Strategic risk, definition:

• an unexpected event or set of conditions that significantly reduces the ability of managers to implement their intended business strategy (Simons, 2000)
• uncertain future events which could influence achievement of the organisation's objectives, including strategic, operational, financial and compliance objectives (PricewaterhouseCoopers)

Operations risk: 

• breakdown in a core operating, manufacturing or processing capability, example: defective products, neglected maintenance leads to breakdowns, lost in customer packages.
• critical product or process failures, example: toxic substance mixed with a product formulation. 
• often triggered by employee error, mostly are unintended and/or accidental.

Competitive risk:

• results from changes in the competitive environment that could impair the business's ability to successfully create value and differentiate its product and services.
• Example: actions of competitors in developing superior products and services, changes in regulation and public policy, shift in customer tastes or desires (such as fashion fads), and changing in supplier pricing and policies.
• Porter five forces.

Asset impairment risk:

• when it loses a significant portion of its current value because of a reduction in the likelihood of receiving those future cash flows.
• 3 potential types:
• Financial impairment: result from a decline in the market value of a significant balance sheet asset held for resale or as collateral. Example: currency devaluation decreased the expected value of future cash flows, a long-term bond portfolio may sink dramatically due to a rise in market interest rates.
• Intellectual property rights impairment: related to intangible resources, example: due to unauthorised use of intellectual property by competitors (patent infringement), unauthorised disclosure of trade secrets to competitor or third party, etc.
• Physical impairment: dur to physical destruction of key processing or production facilities, because of fire, flood, terrorist, or other catastrophe. 

Franchise risk (reputation risk):

• when the value of the entire business erodes due to a loss in confidence by critical constituents.
• occurs when business problems or actions negatively affect customer perceptions of value in using the business's goods or services.
• can negatively influence public perception and drive away customers.

Risk Assessment Template:

• Risk factor, eg. price fluctuation, competitive rivalry
• Description, eg: 
• Oil, natural gas & chemical prices can vary due to changes in supply and demand for products.
• Product innovations, technical advances, intensifications of price competition by competitors, industry consolidation can impact operating results.
• Risk Category: operation risk, competitive risk, asset impairment risk, franchise (reputation) risk.
• Strategic impact: Low, Medium, High.
• Reputation Risk: Low, Medium, High.
• Uncontrollable --> Low, Controllable --> High.

The risk exposure calculators:

Analysis the pressure points inside a business that can cause strategic risks to "blow up" (occur).

If the pressure builds too high, operations risk, asset impairment risk and competitive risk can cause irreparable damage. High score --> high risk (1 = no risk, 2 = medium risk, 3 = high risk).

Three key analysis areas:

• Growth: --> fundamental goals of the business but also bears risk pressure
• Pressure for performance: 
• goals are set at demanding levels with high performance expectations (or else risk punishment or possible replacement).
• Rate of expansion: 
• rapidly expanding scale of operations -- companies grow bigger, but resources, people and system often work beyond their normal capacity. 
• As a result, mistakes and breakdowns may occur, operations error, increase credit risk, downgrade of product and services, etc.
• Inexperience of Key Employees: 
• growth also means hiring large number of new people, sometimes in the rush, background employee check may be waived and minimum performance standard and education qualification may be lowered.

• Culture: --> history and top-management leadership style bears risk pressure
• Reward for entrepreneurial risk taking: 
• individual are motivated to be creative in finding and creating market opportunities, although it's a good thing, but in the risk taking management, such as: investment may be made in risky asset, deals may be struck with counterparts who have limited ability to honor contract, commitment made but difficult to fulfil, or employees may engage in behaviours that damage the reputation of business.
• Executive resistance to bad news: 
• culture also influence the willingness of subordinates to inform superiors about potential risks in the business. 
• Early warning systems? How much employees fear in bearing bad news and communicate to senior management? Fear of sanction or other personal repercussions?
• Level of internal comparison: 
• cultures also foster spirit of internal competition, which bring a unique set of issues. Intense competition among subordinates targeting for bonuses or promotion. 
• To enhance short-term performance and advance own careers, individuals may gambling with business assets, credit exposure, firm reputation. The payoff and costs are asymmetric, the worst situations the employees could lose their job and business fall to financial loss.
• Information Management: -->
• Transaction complexity and velocity:
• high transaction volume and increased processing speed --> increase the possibility of operation risk.
• As transaction become more complex, fewer people may fully understand the nature of transactions and how to control them.
• Example: cross border agreement in international operations, creative financing, consortium agreement.
• Without fully understanding contractual obligations and the nature of cash flows, asset impairment risk will increase substantially.
• Gaps in diagnostic performance measures:
• management may be unaware of potential problems, cannot take remedial action to contain the risk. All type of risk need to diagnostic appropriately to track current risk level and early warning indicators about changes in competitive risk and franchise risk should be in place.
• may require specialised information processing system that can consolidate information across dispersed operations.
• Degree of decentralised decision making:
• In decentralised business, individuals are encouraged to make decisions autonomously and creates opportunities without constant monitoring and oversight by superiors.
• Due to freedom environment, operating rules and constraints may be neglected. Consequently, they may be able to engage in activities that increase risk without requiring approval from corporate level managers.
• Also, by decentralising credit approval, will increase the magnitude of credit risk.

Example: Case Study - Luvano Wine Group (Australian Wine Company)

• Growth:
•  Pressure for performance: 2 to 3
• intense competition and rivalry in Australia's wine industry.
• Profit and growth target increased.
• lots of competitors and very high competitive landscape.
• Rate of expansion: 2
• no rapidly growing, highly dependen to Australia wine market.
• but, there's an increase of intense to expand to new areas outside Australia, such as Asia, America and European market as they already has good relationship with international distributor and perform an international joint venture
• Inexperience of Key Employees: 1
• strong management teams and only employs 570 people, including highly skilled and experienced vintrepreneurs. 
• Culture:
• Reward for entrepreneurial risk taking: 1
• not enough information from case study
• Executive resistance to bad news: 1
• not enough information from case study
• Level of internal comparison: 1
• not have divisions, 
• not enough information from case study
• Information Management: 
• Transaction complexity and velocity: 2
• Medium, not very highly complex but not to simple, as they develop several international brands
• Gaps in diagnostic performance measures: 1
• Friendly and close related family business, not so hard to disclose bad news.
• Degree of decentralised decision making: 2
• Possessed subsidiary in England and US, not enough information about the constraint of operating rules and freedom of credit approval risks.
• Total score: 13 to 14

Risk Management and Controls (Simon)

• Belief Systems --> Beliefs and core values empower employees to make decisions that align with the company's interests. Help organisation to manage risks (what employee have to do)
• Example in Royal Dutch/Shell Group Statement of General Business --> "Shell companies insist on honesty, integrity and fairness in all aspects of their business and expect the same in the relationships with all those with whom they do business."
• Boundary Systems --> Boundaries for business conduct provide clear, enforceable sanctions.
• Example in Royal Dutch/Shell Group Statement of General Business --> "The direct or indirect offer, payment, soliciting and acceptance of bribes in any form are unacceptable practices". "Employees must avoid conflict of interest between their private financial activities and their part in the conduct of company business" 
• But, we can recommend to Shell to state enforceable sanction, in which not clearly stated in their Group Statement.
• Internal Control Systems --> Internal controls ensure any errors of omission and commission that do occur are detected.

M&A: Brazos & Comark LBO Case Study

Source: Harvard Business School Publishing, February 2004, Ref journal No. 9-202-090

Introduction:

• Brazos equity fund --> US middle market Leverage Buyout group (LBO).
• LBO firms made money by buying established companies, fixing them or selling off various portions of assets, and eventually selling the enterprise itself. Usually these transactions were funded by significant amount of debt. As long as the company could carry the debt, selling the healthy parts or improving performance would generate cash to yield. When the company was sold, the bank loan would be repaid and the excess went to the partners in the fund.
• Even when a buyout firm found a good target, obtaining a necessary leverage to complete the deal was a challenge. Generally two types of leverage were used:
• Senior Debt:
• provided by financial institutions such as insurance companies and commercial bank.
• Saving and loans scandal (early 1990s) inspired government to tighten regulations on senior debt, created a significant degree of risk aversion among lenders.
• Another contraints: the consolidation of the banking market.
• Subordinated Debt --> consist of high-yield (junk) bonds, issued in the name of the acquired company, or privately placed debt (unsecured debt with an equity conversion feature)
• Increasingly, buyout funds were moving away from the mega-buyout into new strategies, which included investing in less-efficient small-company segment, establishing investment focus, developing operating expertise, diversifying geographically, and into broader areas of private equity, such as venture capital and mezzanine financing:
• a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.
• gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back.
• it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing

Brazos

• Brazos targeted firms with enterprise value between $25 million and $250 million, solid management teams and well-defined niches.
• Most deals were relationship driven, local and offer real value. Need to be able to grow the company's cash flow organically and efficiently.
• Developed a strategic relationship with Maverick Capital, a large fund that traded large-cap public equities, used it network and public market relationship to help Brazos research industries, conduct diligence and source deals.
• How Brazos-LBO add value?
• Differentiation through the Generation Transfer Transaction (GTT). 
• Partnership with the family and the management team.
• GTT is tax efficient, provides liquidity,  and continued operating control for the owner along with a flexible capital structure to accomodate future growth.
• Owner would reinvest a sum to maintain 50.1% of the common stock of the new company.
• Managers achieved liquidity and retaining significant equity ownership.
• Transaction was an exchange of securities, thus cash would not be taxed until the new shares were liquidated. 
• Brazos would buy 49.9% of the common stock and a block of preferred shares with attached warrants for the purchase of common stock. Also, arrange the senior debt financing for the balance of the purchase price.
• Ensured the family could still control the firm as long as it met certain performance targets, if the performance not achieved, Brazos would own more of the firm and receives greater purchase price when it was sold.
• Brazos as a minority had protections, such as significant board representation, supermajority right to block major changes, and in the case of severe under-performance, they had the right to take control of the board.

 The Comark Deal

• CoMark, a speciality manufacturer of commercial modular buildings. As of September 2001, CoMark's revenues were $35 million with an adjusted EBITDA of $10.6 million. CoMark sold to 3 major segments: government agencies (73%), education (22%) and private entities (5%).
• Brazos interested to CoMark deal, because 
• Comark has solid cash flow, good management, and a well-defined niche in building modular structures.
• Comark is family based company and Brazos had experienced before in dealing with this type of business as they could leverage the operational efficiency and successfully deal with the family issues.
• Diverse market segments and end-users, a good company in a good industry and was selling to the government effectively. 
• Operating performance:
• growing business.
• government procurement provides stability.
• high margin (custom-designed) products.
• there seems to be a customer concentration issues, but this is where Brazos sees undervaluation.
• Asset structure :
• Mainly cash, inventory and physical assets.
• Cash Holding:
• Cash rich relative to size.
• Capital structure :
• zero debt.
• banks do not understand the company.
• comparable firm (Modtech): debt/asset = 21%
• Government issues/management incentives:
• good management, improving sales force
• management incentives will decline after the transaction.
• but this can be structured using earn outs.
• Ownership structure:
• Family business
• No hold out problem, as the deal is subject to negotiation only
• easy to set up contingent payment
• easy to set up seller financing
• Other issues about the company :
• mixing up of personal and company expenses
• mixing up of capital expenditure and operating expenses
• poor record keeping
• a night mare for any due diligence team.
• Price:
• CoMark's founders wanted $40 million.
• But, the fund offered $38 million in cash at closing, with a deferred $2 million payment for each of the next 2 years if CoMark hit its 2002 and 2003 EBITDA projections. 
• Financing:
• CoMark's founders agrees to contribute through the provision of seller financing and reinvestment of capital into the company. Managers encouraged to reinvest $4 million of the purchase price in the form of equity (27% of firm's equity).
• Provide 10 year 8% subordinated seller note, which gave Brazos a leverage to meet its return threshold and keep the founders involved, not only motivated by the earn-outs and substantial equity stakes, but they would also receive the seller note.
• Seller note is more preferable rather than a mezzanine note, because of: 
• mezzanine players sought return of 20%, which decrease Brazos return.
• Going to mezzanine market, added a complexity to the deal.
• Difficulty in financing environment.
• Brazos could attracted bank interests, because: big loan ($16 million senior term loan, at a rate of LIBOR plus 425 basis point, or 6.25%) --> higher than 10 year Treasury Bond (4.65%)
• "bank book" for potential lenders --> investment memorandum.
• Structure:
• Stock Purchase:
• LBO purchase a portion of equity (73%)
• No dissolution/liquidation of firms
• Buyers assume all kinds of existing liabilities.
• Sellers can automatically retain some ownership stakes (27% in this case). They can delay paying capital gain tax on this portion.
• Asset purchase:
• Purchase (and liquidation) of firm's assets.
• Often involves the repayment of debt, and contracting of new debt.
• Owners get 100% of residual value after debt repayment.
• If they want to hold on to some equity stakes, they have to reinvest (purchase) equity of new firm.
• Immediate capital tax gain to owners/sellers.
• But assets sales create a goodwill amount, which can be depreciated and result in a tax shield for the firm.
• may help avoid unwanted liabilities.

Analysing Strategic Pricing and Product Profitability

Strategic importance of pricing and profitability decisions:

• Price is the only marketing mix that generate money, which affects revenue growth and buyer behaviour.
• Heavily influence to long-term and short term decisions of corporate strategy, which directly affects the creation of shareholder and customer values.
• Major consideration of repositioning the company's competitive landscape, customer perceives about the company's products/services, which includes tangible/intangible attributes.

Pricing approaches:

• Economic Approaches
• Based on laws of supply and demand --> to increase sales need to decrease sales price, thus marginal revenue will decrease as sales volume increase.
• Therefore, it's argued that profits can be increased by increasing sales to the point where marginal revenues equal marginal costs (point of maximum profit: break even point)
• Problems: 
• Difficult to predict demand, up/down trends of uncertainty.
• There're some other business considerations that more important than profit maximisation, for example: gives subsidise price to poor community in order to obey regulation and be a responsible corporation citizen, added price due to funding ecological sustainable process or first mover market penetrations that require lower prices to introduce new product/process.

• Cost-based Approaches
  

• Common approach --> based on % mark-up on identified costs.
• However, the price set still need to be acceptable by customers and also must consider the competitor's reaction to price as well.
• Pricing Process:
• Determine customer wants --> 
• Design product to meet customer wants (step 2)
• Determining manufacturing or service procedures // determine necessary raw materials   --> 
• Determine price (predict selected costs, add mark-up for other costs, add additional mark-up to achieve desired profit) -->
• Evaluate the resulting price:
• If acceptable, manufacture and sell.
• If unacceptable, redesign --> back step 2.
• Determining the mark-up price:
• Variable Cost Approach : 
• Avoids possible misinterpretation of fixed cost behaviour.
• most useful in determining short-term pricing decisions.
• Absorption cost approach:
• Full manufacturing cost
• Fairness in calculating mark-up.
• Activity based approach
• Drawbacks:
• Relies on accurate cost assignment.
• Assumes that customers are willing to pay the price set.
• Can increase the time and cost of bringing new product to market.

• Target Costing Approaches

 

• Customer oriented approach to costing/pricing --> start with what customer is willing to pay and design a product to meet the price.
• Target Cost = Sales Price - Acceptable Profit Margin
• Strength:
• Proactive approach to cost management --> pricing toward meeting customer needs
• Encourage design for manufacture --> To meet the requirements of functionality, quality and price of customers perspectives, thus the company must consider cost of manufacturing and servicing of a product.
• Reduce time to market --> break down barriers and meet directly to customer
• Minimise non-value-adding activities --> reduction or elimination in the activity/process selection to meet target costs requirements.
• Advantageous for products with short-life cycles --> encourages effective planning and design, less opportunity to make continuous improvements.
• Drawbacks:
• Detailed cost data required --> to choose the best activity alternatives
• Required more cooperation and coordination between functional units --> may be problematic if there are cultural/political tensions between functional areas.

• In seeking greater profitability, managers may be attempted to use pricing to gain unethical advantages over competitors, such as:
• Predatory pricing --> reducing prices (to a low level) with the intentions of forcing competitors out of the market.
• Price discrimination --> different prices, discounts, services or payments terms are offered to different customers for the same goods/services.
• Resale price maintenance --> when a supplier dictates the minimum resale price
• Price-fixing contracts --> fixing, controlling, or maintaining prices between competitors.
• To control: Trade Practices Act 1974, and Australian Competition and Customer Commissions (ACCC)

Pricing for Internal Customers -- Transfer Pricing

• To accomodate the growth of internal customers and to make divisions accountable --> management must consider how transfer goods to internal customers should be reported
• Internal value assigned to a product/services provided by one division to another.
• Methods to charge price"
• Market Price:
• used when there is an established (and competitive) market price for the good/service transferred.
• Compare to outside sales, managers may choose to remove their selling expenses.
• free to source requirements from outsider.
• Variable Costs:
• appropriate methods if company has excess capacity.
• However, the supplying divisions could not report profit from transfers made/loss equal to fixed costs.
• Absorption Cost plus mark-up
• include all variable and fixed manufacturing costs.
• avoids problems due to fixed costs from supplying division.
• allows for recovery of unallocated costs
• Considerations: individual divisions may attempt to maximise their own performances, but this may be to detriments overall corporate performances.

Profitability Analysis

• Cost-Volume-Profit (CVP) Analysis
• Contribution Income Statement

Analysing Strategic Projects and Shareholder Value Creation

The need for organisation to create and sustain value for shareholders:

• Shareholders have claims on the firm based on "ownership"
• Arguments for:
• Shareholders provide the capital for the organisation --> need pay attention to return on investment
• Maximising SHV ic compatible with interests of all stakeholders, if the company successfully increase  SHV, thus all stakeholders will also benefits.
• Arguments against:
• Other stakeholders also provide the capital for the firm an need pay more attention as they argue more about human capital and return on debt investment from debt holders.
• Shareholders are residual claimants after the company fulfil the needs of debt holders.

Traditional measurement for SHV: Dividend Payout Ratio, capital appreciation (increase of share price). Example: EPS, ROI, RONA, ROE.

Stern Stewart's Economic Value Added (EVA) --> the spread between the return on capital and the cost of capital multiplied by the "economic book value" of the capital employed to produce that return.

• EVA = NOPAT - (WACC X Capital Employed)
• Note: 
• EVA is dollar figure, not a rate of return (%). 
• Relates to profit to the amount of resources required to achieve that profit.
• Emphasis after-tax operating profit and actual cost of capital, and eliminates distortions due to financing (not operating) decisions. 
• Strategies to increase EVA:
• Improve operating profits without tying up further capital.
• Draw down more capital, so long as the additional profits management earn by investing the funds in its business more than covers the cost of the additional capital.
• Free up capital and pay down the line of credit, so long as any earnings lost are more than offset by a saving on the capital charge.
• EVA Strength:
• Adjusts for some non-cash flow items (eg amortisation)
• WACC; reflect risk, time value of money and opportunity cost of equity.
• Highly correlated with share prices.
• EVA Weaknesses:
• Complexity (via adjustment)
• Short-term focus, single period measure.
• Comparison across firms may be difficult due to many possible adjustments.

Economic Value of a Project: NPV and IRR.

• Shareholder (and project) value is driven by:
• sales growth rate --> expected Net Cash Flow (NCF) from project
• operating profit margin --> expected Net Cash Flow (NCF) from project
• cash tax rate --> expected Net Cash Flow (NCF) from project
• fixed and working capital requirement --> initial investment + other investment during project life.
• Planning period --> expected project life
• Cost of capital --> hurdle rate/discount rate.
• Strategic issues in project appraisal --> may not profitable in short-term financial perspective, but in long-term and strategic decision, may be different. There are some important factors affecting competitiveness, which often overlooked or excluded in the quantification of project cash flow, for example:
• higher market penetration due to shorter lead times.
• increased product quality and consistency of that quality.
• ability to produce small batches economically.
• flexibility and reduce uncertainty.

Interest Rate and Foreign Currency Swaps

Basic purpose:

• Allow firm to change the nature of their liabilities from fixed to floating interest rates or vise versa.
• Currency swaps: allow firm to change the currency of denomination liabilities. An agreement between two parties to exchange the cash flows of two long-term bonds denominated in different currencies.
• To seek out low-cost financing without sacrificing their preferred type of debt.
• Credit default swap: was devised by JP Morgan bankers --> bilateral insurance contract between a protection buyer and a protection seller Why??
• Due to subrime mortgage and financial crisis in the late 2000s, as the prevalence of increasing speculative investing and the sellers were in trouble.
• Thanks to financial crisis, nowadays many countries considering to regulate this to protect against default on a specific bond or loan issued by a corporation or sovereign.

Swaps

• Agreement between two counter-parties to exchange a sequence of cash flows or to exchange different types of debt.
• maturities extend from 1 -30 years or more, structured like the cash flows of bonds.
• Can be used to speculate.
• Used to manage interest rate and currency risks.
• Suggested best practices: International Swaps and Derivatives Association (ISDA) --> control legal aspects of swap cash flows.
• Notional principal --> the amount of outstanding debt, the basic principal amount on which the cash flow of the interest rate swap depend.
• Early form of swap: parallel loans and back-to-back loans.
• Parallel loans: 
• a means of securing low-cost funding for foreign subsidiaries.
• to circumvent various government regulations such as currency controls.
• avoid taxation of inter-company multinational transactions.
• Back-to-back loans:
• simultaneous loans between multinational parent corporations in two different countries.
• Contain the right to offset

Interest rate swaps

• Why use interest rate swaps?
• Allow MNC to change the nature of its debt from a fixed interest rate to floating interest rate or vice versa.
• Fixed versus floating rate debt:
• Many corporations have revenue cash flows that are pro-cyclical, which means their revenue are high during booms and low during recessions. And, short term interest rates are also pro-cyclical. That is, short-term interest rates tend to rise during expansions in the business cycle and fall during recessions.
• This cyclical patterns increases the corporation's risk of default, as banks may prefer to enter into relatively long-term contracts to receive floating interest rate cash flows, but on the other hand, many investors prefer the certainty of long term, fixed interest debt.
• Changed circumstances: 
• Over, time, the firm's circumstances might be changed. For example: the firm's cash flow forecast is likely to be deteriorated at a time when long term interest rates are higher, thus the firm's might want to survive in its financial difficulties by swapping out its fixed-rate debt into a short-term debt with a lower interest rate.
• Views of the future --> allow corporation to manage their interest rate risk or to speculate on the direction of interest rates and minimising the cost of debt.
• Minimising the cost of debt --> In many cases, a large corporation determines their preferred kind of debt and the cheapest way to raise the funds, thus they uses the swap market to convert the actual debt into the desired debt. By doing so, the firms could minimise the cost of debt -- access counterpart's credit spread and change from fixed to floating (or vice versa)
• Manipulating earnings --> "window dressing" swap activity
• No exchange of principal is necessary because the principal is an equal amount of the same currency. 
• Nature of IR swaps contract:
• commercial/investment bankers serve as market makers.
• the bank's bid IR is the fixed rate that the bank is willing to pay for receiving semiannual payments corresponding to 6-month LIBOR.
• the bank's ask IR is the fixed rate it will receive if the bank is willing to pay 6-month LIBOR.
• Swap spread --> a number of basis points that are added to the yield to maturity on a US-government bond corresponding to that maturity.
• Profits and risks for swap dealers --> as long as the bank matches the amount of IR swaps for a given maturity in which it will give and receive fixed interest rate payments, it will earn the bid-ask spread on that aggregate amount (if not, it has interest rate risk).
• Dealing with credit risk --> 
• Even though interest rate swaps carry the right to offset, banks could also stop making its side of payment if the corporation defaults, and so the bank will widen its bid-offer spread in dealing with less creditworthy corporate.
• Alternatively, bank may ask for credit enhancement in the form of collateral, which is what the International Swap and Derivative Association now recommends.

Foreign Currency Swaps

• An agreement between two parties to exchange the Cash Flow of two long-term bonds denominated in different currencies.
• Swaps the principal amount and interest rate.
• Parties exchange initial principal amounts (at spot).
• Parties pay interest on the currency they initially receive, receive interest on the currency they initially pay, and reverse the exchange of initial principal amounts at a fixed future date.
• The mechanics of modern currency swaps --> transformation of both currency and the interest rate. For example:
• USD: 5.25% bid and 5.35% offered against 6-month dollar LIBOR.
• GBP: 8.00% bid and 8.10% offered against 6-month dollar LIBOR.
• Absolute borrowing advantage: in both currencies because its all-in costs are lower.
• Comparative borrowing advantage: in one currency only, by issuing euro debt for example.

Using a financial intermediaries in a currency swap

• Financial intermediaries would know of two counter parties that could benefits by swapping the interest and principal payments on bonds denominated in different currencies, they would arrange the swap, ast as counterpart, and walk away with a handsome profit.
• Bank wants each firm to make the interest and principal payments in return for receiving cash flows that are equivalent to the interest and principal payments that each firm owes its bondholders.
• The challenge is to make the swapping of these cash flows attractive to both counterparts. Also, bank bears the credit risk of each counterpart and it must be compensated for bearing this risk.

The rationale for currency swap

• Low transaction cost instrument for changing the currency of denomination of debt financing.
• Can issue bonds in any currency and swap into their desired currency at the lowest AIC.
• Difference in spreads over risk-free rates --> provides an opportunity for lowering the cost of debt using swaps (market inefficiency) that can be exploited for profits.
• Can issue debt in their least expensive currencies and to enter into a swap in their most preferred currencies.
• Regulations on type of debt instruments and also accounting/tax differences.
• Why use swaps and not forwards?
• Long-dated forward markets are illiquid.
• Associated cash flows of swaps are just like bonds.

Risk Management in Futures & Options - To Hedge or Not To Hedge??

To hedge or not to hedge?

• Hedging = risk mitigation by using forward contract, futures and option.
• Against Hedging: costly, difficult, not suitable for risk-averse investors, and can create bad incentives (attempt for currency speculations).
• For Hedging: can reduce firm's expected taxes (tax-loss carry forward & convex tax code), lower the costs of financial distress, improve firm's future investment decisions. --> If firm did not hedge and its value fell, (+) NPV projects may be missed. 

Futures Contract

• Allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day.
• Differences between forward contract and futures contract:
• Futures: traded on an exchange (NYSE, Tokyo Financial Exchange), forward: made by bank and their clients.
• Futures: standardised smaller amounts of currencies, forward: larger.
• Futures: have only a few maturity dates, fixed and generally 6 month. Forward: a client can request any future maturity date with maturities of 30, 60, 90, 180 or 360 days.
• Credit risk --> 
• Forward contract: Bank willingly trade it with large corporations, hedge funds, and institutional investors. But not trade with individual investors or small firm with bad credit risk.
• Futures: all contracts are between a member of the exchange and the exchange itself. Retail clients buy it from futures brokerage which must be registered with CFTC (Commodity Futures Trading Commissions) as FCM (Futures Commissions Merchant). Clearing member/clearinghouse.
• Margins
• Credit risk is handled by setting up an account called a margin account --> deposit an asset to act as collateral.
• 1st asset --> initial margin
• Asset can be cash, US government obligation, securities, gold or letter of credit.
• Marking to market --> deposit of daily losses/profits
• Maintenance margin --> minimum amount that must be kept to guard against severe fluctuations in the futures price.
• Margin Call --> when the value of the margin account reaches the maintenance margin. --> the account must be brought up to its initial value.
• Pricing:
• Payoff on forward contract --> S(t) - F(t) ; S(t): future spot rate, F(t): forward price
• Payoff on futures contract  -->  f(T) - f(t) ; f(T): futures price at maturity time, f(t): futures price 
• Potential problems with Futures Contract:
• Futures contracts are sold only in standardised sizes (ex: $125,000). Problem: if you need to hedge an amount that is not a multiple of the standard size.
• Relative low number of delivery date, which sometimes the maturity date of futures contract not match with a settlement date of the company's asset and liabilities.
• Basis risk: if the price of futures contract does not move one-for-one with the spot exchange rate (not perfectly hedge). The basis is the differences between the spot price at time t, S(t), and the futures price at time t, f(t,T), for maturity date at time T.

Foreign Currency Option Contract

• Gives the buyer the right, but not the obligation to buy (call) or sell (put) a specific amount of foreign currency for domestic currency at a specific forex rate.
• Price is called premium.
• Traded by money centre banks and exchanges (e.g. NASDAX OMX PHLX)
• European vs American option: European --> exercise only at maturity date; American --> exercise any time.
• Strike/exercise price --> forex rate in the contract, compare with the current spot exchange rate. 
• Intrinsic value --> revenue from exercising an option
• in the money: if some revenue could be earned by exercising the option immediately.
• out of the money: no revenue
• at the money: option has a strike price equal to the current spot rate.
• at the money forward: option has a strike price equal to the forward rate for that maturity.

Exchange-listed currency warrants

• Longer maturity foreign currency options (> 1 year)
• Issued by major corporations.
• Actively traded on exchanges such as the American Stock Exchange, London Stock Exchange, or ASX.
• American-style option contracts
• Allow retail investors and small corporations which is too small to participate in OTC market to purchase L/T currency options.

Synthetic forward contract: Using put and call options (same K) simultaneously --> Ex: purchase a $ put option and write a $ call option for revenue. Both are at strike price K.

Combination of Options and Exotic option:

• Exotic options: options with different pay-off patterns than the basic options.
• Range forward contract:  allows a company to specify a range of future spot rates over which the firm can sell or buy forex at the future spot rate --> no money up front.
• Cylinder options: allow buyers to specify a desired trading range and either pay money or potentially receive money up front for entering into the contract.
• Both can be synthesized: buying a call and selling a put (at a lower K) and for range forward.
• Average-rate option: where S defined as the average forex rate between the initiation of the contract and the expiration date.
• Barrier options: regular options with additional requirement that either activates or extinguishes the option if a barrier forex is exchange.
• Lookback option: option that allows you to buy/sell at least/most expensive prices over a year (more expensive than regular options).
• Digital options ("binary" options): pays off principal if K is reached and 0 otherwise (think lottery). 

Analysing Corporate Social Responsibility

Corporate Social Responsibility (CSR) --> could be argued on a 'normative' vs 'business' case:

Normative --> stems from a desire to do good.
Business --> 'enlightened' self-interest.

Why are community relationships important?

• There is a growing recognition within the business community of the importance of building relationship with the community.
• Corporations today face profound pressure to manage responsibility, as well as profitability.
• Pressure for this emphasis on socially responsibly behaviour derive from three broad sources.
• Primary stakeholders
• Secondary stakeholders
• Societal Pressures

Westpac Community Involvement 2007 report -- "... banks can, and should, lead beyond their corporate walls when it comes to doing the right thing for communities and the environment... However, we are not driven simply by benevolence but by enlightened self-interest. After all, successful and prosperous businesses cannot sustain if the communities in which they operate are not successful and prosperous. There is a mutual flow of benefits. "

Pressure from Primary Stakeholders:

• Shareholders/Investors:
• Ultimately own the organisation, so demand strong corporate financial performance and growth.
• Corporate financial performance is strongly linked with responsible corporate practices.
• Have a growing interest in investing in socially screened equities.
• Employees:
• Perceptions about responsibility management are often a key decision criteria when assessing a potential employer.
• Employee considerations include: salary and benefits; health and safety; and fair and ethical treatment (incl. labour standards)
• Customers:
• May base their purchasing decisions on perceived level of corporate responsibility.
• Example some of considerations: quality standards, ethical treatment of animal, "green"friendliness.
• Suppliers:
• With increasing supply alliances, companies are now judged on supplier behaviours.
• Some industries, particularly consumer products, have been seriously affected by negative publicity surrounding labour practices in supplier facilities (e.g. protests against Apple).

Pressure from secondary stakeholders:

• Government: 
• Regulatory obligations including compliance, transparency and anti-corruption.
• Also asking for a social contribution.
• Community:
• Expectations of corporate involvement in the community are significant.
• Activists and NGOs
• Demand for improvement human rights, labour rights and environmental performance.

Societal pressures:

• Institutional pressures have led to pressures for responsibility management and have created a need for greater transparency of an accountability for corporate impacts.
• Evidence by: best of rankings, global principles and standards, triple bottom line reporting.

Question Mark:

• Q: Whether business has a “responsibility” to help solve the planet's problems? Some argumentation stated that: business of business is making a profit to reward shareholders, just simply by jobs being created, taxes being paid and investments being made, it's enough. On the other hand, some concept like "Corporate Social Responsibility" are solely based on moral imperative or obligation for business to do the right thing. 
• Is the "business of business" simply to maximise shareholder value? Explain your position about this statement and clearly support your point.
• Possible Answer:
• Basically, I could say that CSR is not ultimately going to solve the planet's problems, but CSR is a way the company could benefits themselves (normative), while also benefits society/stakeholders (business) by enlightened self-interest.
• Yes, I could say that company should embrace CSR in their business process and contribute more effort than just simply maximise shareholder value, because of:
• By implementing CSR, the company could get a step ahead of your competitor by providing not only strong financial performance and revenue growth, but also wider range of benefits by building strong relationship with the community and responsible practices. 
• Bad or ugly information about environmental, social or governance practices can spread simultaneously and dissolve years of goodwill and corporate brand recognition on spot.
• CSR will influence the perception of employee regarding the company's brand recognition, since how company responsibly threat the community, will also reflect a responsible management fairness and ethical practices in labour standard.   
• CSR will influence customer's purchasing decision and considerations, because the product reflect an additional value such as: quality standard, ethical treatment of animal and "green" friendliness.
• Q: Identify two (2) ways in which companies benefit from being proactive in managing and reporting on corporate social responsibility (CSR) issues?
• Possible Answer: 
• Participating and encouraging employees involvement in charitable, community volunteering, payroll giving and fund raising --> could initiate employee to promote pride and increase self-belonging to the company. These activities transform into loyalty, commitment and productivity.
• Customer nowadays will choose to purchase product from a company that develop reputation on being social responsible. Thus, the company makes a great deal by positioning themselves attracted by investors and also customers compare to competitors.
• Complying with regulatory requirements and involvement in local community will be an ideal opportunity to generate positive press coverage, make doing business easier and reduces sudden damage to corporate reputation.
• Q: Provide two (2) pieces of guidance that may help David Jones develop an effective CSR strategy.
• Possible Answer:
• Should reflect organisation's mission and values
• "David Jones is committed to investing in its people and providing a work environment where all employees are supported, recognised and rewarded."
• David Jones's vision of being the "best place of our people to work" by investing in its people and providing an environment that ensures every employee is valued, recognition and reward for contribution, commitment to safety and commitment to environmental responsibilities.
• Thus, CSR strategy should covered employees engagement and retention, communication, training, development, recognition and reward.
• "David Jones continues to support the community at large through contributions to its philanthropic partners, with particularly focus on women and children's health."
• Thus, CSR strategy should build strong partnership with not-for-profit organisations that benefits the Australian community and meet social needs, in particular those focused on cancer-related issues for women and children.
• Should identify obligations to customers, employees, suppliers and community.
• David Jones is committed to responsible management of environmental and social impacts along its supply chain.
• David Jones has imposed obligations to its supplier that merchandise supplied to David Jones is under considerations that meet Australian labour standard in relation to anti-discrimination, equal opportunity, safe working conditions.
• Improve environmental outcome by reducing greenhouse gas emissions, protecting and conserving natural resources, optimising water use.
• Motivate cultural change, by encouraging behavioural change and integrating sustainability into decision making.
• Stakeholder engagement should be at the core.
• David Jones will continue to strive forward an integrated approach to corporate social responsibility and aims to ensure that its community programs remains relevant with its key stakeholders.
• Requires developing appropriate metrics for measuring social performance.
• Q: Identify the three (3) bottom lines that comprise ‘triple bottom line’ reporting and for each bottom line, suggest one (1) measure that the Commonwealth Bank may use to assess its performance in demonstrating CSR.
• Possible Answer:
• Economic performance: total economic impact of the company on the community. Example measures: Economic Value Added (EVA), Value of Donations ($), value of donations as percentage of EBIT (%).
• Social performance: impact of the company on people in the communities in which they operate. Example measures: number of women completing free breast screening services, number of employees joining fund raising and community volunteering activities, number of children participating in children cancer screening services.
• Environmental performance : impact of the company on the natural environment sustainability. Example measures: Greenhouse gas emissions from David Jones buildings (tonnes CO2 emitted), electricity consumption (MWh emitted), energy efficiency based on trading hours (watts emitted), waste and water usage. Sustainable packaging design, carry bags and paper based process and materials.

Analysing Knowledge as a Strategic Resources

Study case: Global Management at Danone (Harvard Business School Publishing)

Karl-Erik Sveiby

Professor of Knowledge Management at the Hanken Business School in Helsinki, Finland.

He is often described as one of the "founding fathers" of Knowledge Management ' having pioneered many of the fundamental concepts.
Faithful to his own teachings he does not believe in lectures or information as methods of transferring knowledge so he has founded Sveiby Knowledge Associates (SKA).
SKA clients include large global industrial groups, such as ABB, Ericsson, Siemens, Motorola, Nortel, and Microsoft; financial services companies such as Westpac Australia or Nedcor South Africa; public sector utilities, such as Queensland Rail in Australia and China Light and Power in Hong Kong; local and federal governments such as GippsIand Shire and Department of State and Regional Development in Australia; global professional services firms, such as PricewaterhouseCoopers and Deloitte Touche Tohmatsu.

Introduce: Sveiby's Three Intangible Asset families
Employees use their competence to create value internally (for organisation) and externally (for customers).

Individual Competence: the competence of individual professional staff --> people who plan, produce, process or present the product or solutions.
Indicator of growth: Number of years in the profession, level of education, competence turn-over.
Indicator of renewal: competence-enhancing customers, training and education costs.
Indicator of efficiency: proportion of individual competence, leverage effect, profit per professional.
Indicator of risk: average age, seniority, individual competence turn-over rate.

• Internal Structure: includes support staff, patents, concepts, models, and computer (IT) and administrative systems.
• Indicator of growth: Investment in IT, Investment in internal structure.
• Indicator of renewal: organisation enhancing customers, proportion of new products/services, number of new process implemented.
• Indicator of efficiency: proportion of support staff
• Indicator of risk: age of the organisation, support staff turn-over, "seniority" support staff ratio.
• External Structure: includes brand names, image, and relationships with suppliers and customers.
• Indicator of growth: organic growth.
• Indicator of renewal: image enhancing customers, sales to new customers.
• Indicator of efficiency: profitability per customer, sales per customer, win/loss index.
• Indicator of risk: satisfied customer index, proportion of big customers, age structure.

Example:

• Academic/lecturer reads Knowledge@ASB newsletter to learn about current research on climate change --> KM Strategy: Internal Structure to Individual Competence.
• Marketing academic writes an article for Knowledge@ASB --> KM Strategy: Individual Competence to Internal Structure.
• ASB Academic Counsellor writes an article for ASB Connect Newsletter --> KM Strategy: Between internal structure.
• Accounting academic presenting a research paper at Melbourne Business School --> KM Strategy: Individual Competence to External Structure
• Alumni contribute ab article to Knowledge@ASB --> KM Strategy: External Structure to Internal Structure.

Global Knowledge Management at Danone

"At Danone we don't talk about strategy, we react to the context around us. For me, it's like a Lego box that you buy for your children. They start to play, trying to find a way to build the image on the Lego box. At the end of the day, they give up, throw out the box, and put the pieces away. The next weekend you put all the Lego pieces on the floor and then the strategy starts. They try to imagine something. Not what was on the box, but what they have in their heads. That is strategy at Danone for me: It's Lego. (Frank Riboud, Chairman and Chief Executive Officer, Groupe Danone)

Main Point:

• Groupe Danone implement a concept called Networking Attitude to accelerate knowledge sharing across Country Business Unit (CBU) with employees in 120 countries world-wide.
• "We want our time to market to be shorter than that of our competitors, who are much bigger than us. If we can not be big, at least we can be shrewd."
• In general, they developed knowledge "marketplaces" and "sharing networks" -- to help employees connect with each other and share good practices horizontally and peer-to-peer. Danone employees shared almost 640 good practices with colleagues, making practical information accessible to some 5,000 of Danone's 9,000 managers around the world.
• Programs:
• Co-building events --> employees from different Danone units networked to create new practices and products rather than to share existing ones. Example: Danone's merketing staff sharing problems & solutions with Danone's Operation staff, or Danone's Finland with Danone's French unit --> KM Strategy: between Individual Competence
• Growth Too Program & Acceleration Units --> KM Strategy: Internal Structure to Individual Competence
• Identifying, analysing and formalising good practices and promoting their adoption by all 70 Danone's CBU.
• Sharing brand assets among CBU to develop block bluster brands.
• Identify good practices within a specific area and then formalize and circulate them (simulation on-line, charting).
• Implementing Enterprise Resource Planning (ERP) software.
• Encourage direct discussion between departments about the software.
• Market place and sharing network --> KM Strategy: Between Individual Competence
• Facilitators arranged and ran marketplaces, acting as an intermediaries to organise the exchange of practises. They chose a strategic business topic and act as givers (offering good practices, or solutions, or problems). The rest of participants are act as takers (managers with problems or issues to resolve.
• The Little Book of Good Practices --> KM Strategy: Internal Structure to Individual Competence
• Each page of the book recorded one good practice, summarising the problem, presenting a solution, its tangible advantages, and practical implementation details. 
• Using Powerpoint is banned (not eligible), but encouraged the use of videos, stories and symbolic objects.
• Message-in-a-bottle --> KM Strategy: between individual competence
• brought takers with problems to a smaller audience of potential givers. It's like an Alcoholics Anonymous meeting.

Why is knowledge management important?

Knowledge management facilitates decision making, builds learning decision making, builds learning organisations by making learning routine, and stimulates cultural change and innovations. (Quast, 2012).

M&A: Question and Answer - Negotiation and Takeover Strategies

Negotiation and Takeover Strategies

• Why can't acquirer retain control by simply purchase shares on market?
• Regulations --> limit the purchase amount of shares and transparency
• Shareholders hold-out problems.
• Difficult to buy large ownership blocks on publicly traded market, since they not actively trade their shares.
• What is the theoretical final offer price in a tender offer if shareholders are rational and there is no info asymmetry?
• Final offer price is the final decisions made by acquirer about their offer price and target wouldn't accept more than this.
• Reservation price reflect all synergies and all available benefits.
• No extension --> clear and final
• Does the holdout problem come back to hurt target shareholders and how do they deal with this problem?
• Target shareholder will probably lose the deal and lose the premium price.
• They could deal this situations by performing:
• Collective voting / auction environment, in order to attract more acquirer or potential white knight. Thus, this will push-up the bid price, close to target's reservation price. 
• Wait & see -- attract multiple acquirer and discover their reservation price (target's board play for time to attack acquirer's financing strength and earn more profits).
• What are some tactics that acquirer can use to overcome the holdout problem?
• Purchase a toehold --> purchase less than 5% of target's stock in the market (not required to register and explain one's purchase to the SEC until one meets the 5% threshold). In the instance of a shareholder vote, toehold shareholders hold a significant place in such votes.
• Partially tender offer for target's share --> to discover the price and obtaining necessary control with minimum amount of capital.
• Partially asset acquisition --> Dictate and create an implicit threat to holdout shareholders that they interest may not be protected. Creating an option to acquire the asset fully in the future.
• Intense negotiation with large block of shareholders --> no collective actions, only to communicate with 1 block. --> create a threat that holdout shareholders interest may be diluted or expropriated. 
• Private Bear Hug --> Bypass CEO, go directly to board. Intense on board to board communication.
• Public Bear Hug --> media rumours to create pressure to shareholders. 
• Why is it important for acquirers to achieve control of the M&A process? What are their common bargaining chips?
• To dictate the negotiation process.
• Limit target flexibility and extract the reservation price.
• Bargaining chips: 
• Final price bid --> final offer, acquirer's final decisions, price will not going up no more, exit  negotiations if target continue to ask more.
• Deadline: timing of the offer price, not valid any more in certain due date.
• Offer reasonable price for more synergies and benefits. Push more target to negotiation table.
• Penalty and limit of the offer.
• Should you set your reservation prices based on the theoretical boundary formulae? How should you set your initial bid price?
• Due to information asymmetry --> acquirer should limit the reservation price and be prepared to switch to other target.
• Initial bid price: reasonable low, but not too low. Push target to negotiate and place a bid and discover they true value, try to dictate and renegotiate the bid price close to acquirer's reservation price.
• What is the value created from an auction environment? Why do you think that most auctions in M&As are a hybrid between open and sealed bid auctions?
• Auction environment could trigger multiple acquirer and push-up the bid price.
• Give control of the process back to the seller.
• Save time and effort (of target management), high probability that the target will be sold.
• Open Auctions: First bidder advantages, since no body will put the first bid forward close to their reservation price. The last bidder can free-ride previous bidders by offering higher bid price.
• Sealed Auctions: Overpayment risk, since overall the bidder will place their best price as high or close to reservation price.