Monday, June 1, 2015

Exchange Rates and Cross Border M&A: Free Lunch or Expensive Banquet?

Ralph’s post raises some interesting valuation issues. A strong USD is supposedly aiding an increase of domestic firms acquiring foreign firms. The argument is, for example, the 25% appreciation of the USD against the Euro over the past years makes Euro zone targets cheaper. This, however, only looks at half of the exchange equation. You indeed pay less USD for the Euro assets (assuming the target does not change their price). You also receive less-the expected value of the future Euro cash flows when converted back to USD is also lower. This is the reason why many U.S. multinationals are now experiencing earnings declines. Some argue the translation effects should be ignored as noncash accounting noise. This of course assumes the FX effects will reverse. It also ignores the opportunity loss on the depreciated target cash flows during the interim period.

Others allege you are still better off buying today at a lower price and receiving depreciated Euro cash flows than buying last year at the higher prices. This assumes you can correctly forecast FX movement and market time your purchases. If you can, then why bother with M&A? Probably better to speculate directly on FX  rather than using the firm’s balance sheet.

I highlighted  approaches to valuing foreign assets based on parity among foreign exchange, interest and inflation rates. The first approach involves converting foreign cash flows into the home (e.g. USD) currency using interest rate parity relationships; then discounting the converted cash flows using appropriate USD discount rates. The second reflected below values cash flows in foreign currency terms:

Forecast target cash flows in local terms:

1)     Discount the target cash flows in local currency (e.g. Euros)
2)     Discount the Euro cash flows using local rates to calculate Euro NPV; expected change in FX rates reflected in local rates.
3)     Spot the Euro NPV into USD

Under this approach, FX movements should not have a material effect on cross border acquisitions as the decreased price reflects the lower valued cash flows. Yet, as the Erel, et al article highlights FX rate movements do appear to be correlated with M&A activity. Perhaps, acquirers in strong currency countries are better performing because their economies are stronger. This may make these acquirers more confident as they feel wealthier and have higher risk appetites. Alternatively, they could be confused by the depressed Euro prices and interrupt them as being cheaper hence better buys than domestic USD dominated targets. A more sinister view is it may reflect disguised currency speculation.

My basic view remains unchanged; focus on the fundamentals. There “ain’t no free lunch”. You get what pay for. There are many complications in cross border M&A. Do not get side tracked with dubious “bargain” FX arguments. 


No comments:

Post a Comment