Estimate the required rate of return to be used in Pozitron valuation by usingeach of the methods suggested above.b. Which method you think should be used in Pozitron Valuation? Why? Explain your reasoningc. What are the problems with using discount rate adjustments in cross-border capital budgeting and valuation projects? Discuss the problems associated with using inflated discount factors and possible solutions to avoid poor investment decisions.
The parent company Airtel is contemplating the acquisition of Pozitron, a Brazilian electronics components manufacturer. The location and specific attributes of Pozitron suggested that it did not have the typical risk profile of the parent company investments. The fact that the project is located in a foreign market signaled exposures to various risk factors usually absent in local investment projects. The parent company Airtel finances its investment activities almost exclusively with equity. It is essentially an unlevered company, and its cost of capital was equal to its cost of equity. Capital Asset Pricing Model (CAPM) is widely used in practice to estimate their cost of equity. However, for many reasons, Airtel analysts found out that this model is not readily applicable in emerging markets. One such frequently articulated reason is that CAPM underestimates the inherent risks in the emerging market settings and produces discount rates that are “too low”. The concern about “the underestimation of project risks” led some companies to make adjustments on the discount factor. This practice implied that industry practitioners are more concerned about adopting risky projects rather than bypassing valuable investment opportunities. Further research by Airtel analysts revealed that among the alternative methodologies developed by academics and practitioners, several models stood out. Airtel analysts recognized that unlike the CAPM, which is based on financial theory, these models are rather ad-hoc. In addition, because these models assess and incorporate risk in quite different ways, they may also yield quite different estimates of the discount rate. In order to properly evaluate the investment opportunities, then, it was necessary to consider the discount rates obtained from these different methodologies and to assess the value of Pozitron in light of each of them. The financial information necessary to estimate all four discount rates is provided in the following table: Risk-free rate 4.40% World market risk premium 5.00% Brazil’s sovereign yield spread 2.00% Pozitron Beta 1.4 Brazil’s Country Beta 1.2 Brazil’s stock market volatility 20.50% World stock market volatility 14.71% Correlation between Brazil’s stock market and bond market 0.35 Access to Capital Markets Score (1) 10 Susceptibility of Investment to PR (2) 7 Importance of Investment (3) 8 One of the models analysts debated about was developed by a highly respected finance professor at M.I.T., Dr. Dan Lassard1. Dr. Lassard suggested that project risk should be adjusted for the country risk. He argued that this could be done by using a “country beta” which measures the sensitivity of foreign market equity index returns to global market index returns. If the project is located in a market with high beta, then the project risk would be adjusted to reflect this risk. He also cautiously warned against adding a country risk premium such as sovereign yield spread, and suggested that such adjustments should be made in cash flows. While he cautioned the practitioners about the importance of accounting for the risks in the cash flows, he indicated that an adjusted discounted factor may be a good first cut in evaluating offshore projects. Lassard’s risk adjusted discount factors are given as follows. Note that the first discount factor does not include a downside adjustment for the country risk. The analysts noted that project beta reflected project’s risk in the US market because of the unreliability of the data in the foreign markets. A model suggested by Bank of America’s Godfrey and Espinoza2 argued that using a project beta calculated with respect to investor’s home market underestimates the risks in the foreign market. Accordingly, they suggest an adjusted beta that reflects the relative volatility of the foreign market with respect to global market or home market (depending on segmented or integrated market assumptions). Godfrey and Espinoza define “adjusted beta” as the ratio of foreign market volatility to the global market volatility adjusted for an overlap between equity market risk and sovereign yield spread. The relative volatility is downward adusted by 40% under the assumption that the overlap between the equity market volatility and the sovereign yield spread is approximately 40%. A third model proposed by Goldman Sachs analysts3 simply propose a different adjustment for double counting than that included in the Godfrey-Espinosa model. More precisely, these analysts propose to substitute fixed adjustment factor of “0.60” by one minus the observed correlation between the stock market and the bond market of the country in which the project is based. In other words, the adjusted beta proposed by Goldman Sachs analysts is: Finally, analysys at Solomon-Smith Barney suggested the following model: The proposed model incorporates the firm-specific country risk depending on the nature of the project, where γ1 measures the fact that large firms with wide access to capital markets are likely to have fully diversified investors and, therefore, will most likely be concerned only about the systematic risk captured by the CAPM beta and less concerned about any diversifiable or country-specific risk. The Salamon Smith Barney model incorporates γ2 because if the political risk premium represents a cash flow loss from expropriation, it should be most relevant for industries that are highly susceptible to political intervention. The γ3 captures the fact that if the investment constitutes a minor part of the firm’s assets, then the asset is not likely to significantly increase the total risk of the firm, but in fact may decrease it because of diversification. In contrast, if the new investment constitutes a major part of the firm’s assets, then political uncertainty in the host country could significantly affect the investing firm’s risk profile. a. Estimate the required rate of return to be used in Pozitron valuation by using each of the methods suggested above. b. Which method you think should be used in Pozitron Valuation? Why? Explain your reasoning c. What are the problems with using discount rate adjustments in cross-border capital budgeting and valuation projects? Discuss the problems associated with using inflated discount factors and possible solutions to avoid poor investment decisions. (40 pts)