Valuing Foreign Subsidiaries

Valuing foreign subsidiaries of multinational companies follows the same basic approach and employs the same principles as valuing business units of domestic companies. However, several wrinkles need to be considered:

• Translation of foreign currency accounts.

• Differences in foreign tax and accounting regulations.

• Interrelationship between transfer pricing and foreign taxes.

• Determining the appropriate cost of capital.

• The effect of foreign exchange hedging on value.

• Dealing with political risks.

This chapter is organized around a step-by-step process for valuing a foreign subsidiary and covers the first four issues above. Foreign exchange hedging is discussed at the end of the chapter. Dealing with political risk is covered in Chapter 19, ''Valuation in Emerging Markets."

Exhibit 17.1 illustrates the cash-flow pattern for a hypothetical U.S.-based parent company with a wholly owned subsidiary domiciled in England that receives revenues from France (as well as from England), pays for raw materials supplied from Denmark (in addition to labor and raw material costs in England), and borrows in Switzerland (as well as in England). The English subsidiary receives capital and materials from its U.S. parent and returns cash flow in the form of dividends and license fees. Taxes are paid by the parent in the United States and by the subsidiary in England. This example is sufficiently rich to show most of the complexities of valuing a foreign subsidiary, and we will follow it throughout this chapter. We assume that this valuation is from inside the parent company—that is, that we have full access to internal financial and planning data.

Exhibit 17.1 Cash Flow for a U.S. Company's Foreign Subsidiary r

The steps for valuing a foreign subsidiary are summarized in Exhibit 17.2. The starting point is to understand the historical performance of the subsidiary. Second, forecast free cash flow in the currency of the foreign subsidiary. For our example company, we forecast English revenues in pounds sterling and French revenues in Euros. Third, we convert nonpound cash flow into pounds by using forward foreign exchange rates. Once we have converted all expected cash flow to pounds, the fourth step is to discount it at the English subsidiary's cost of capital, and convert the resulting value to dollars, the home currency, by using the spot foreign exchange rate.1

Exhibit 17.2 Steps in Valuing a Foreign Subsidiary

Issues spccîfk to foreign subsidiaries

1. Analyze historical performance

Foreign currency translation accounting

Crosi country taxation

Tax minimization and transfer pricing

2. Forecast cash flow in subsidiary's home currency

Forecasting future exchange rates

3. Estimate foreign currency discount rate

Local cost of equity and debt Country risk Capita! structure

4. Discount FCF and translate to parent currency v_y

4. Discount FCF and translate to parent currency v_y

1 An equivalent approach would be to use dollars as the currency for the English subsidiary—dollar-forecasted cash flows and a dollar discount rate. Given this approach, it becomes unnecessary to convert the value of the English subsidiary from pounds sterling to dollars at the spot foreign exchange rate (in the last step).

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