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International Corporate Finance

In: Business and Management

Submitted By tgao
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On August 3, 2005, Adidas-Salomon AG announced its plans to buy all outstanding shares of Reebok International Ltd.'s stock at $59.00 per share, for a total of $3.8 billion. Upon announcement, Reebok stock rose 30% while Adidas climbed 7%. As stated by Herbert Hainer, CEO of Adidas, "This is a once-in-a-lifetime opportunity to combine two of the most respected and well-known companies in the worldwide sporting goods industry. Together, we will expand our geographic reach, particularly in North America, and create a footwear, apparel and hardware offering that addresses a broader spectrum of consumers and demographics" ( The three leading sportswear companies in the world are Nike, Adidas and Reebok. In August 2005, Nike was the leader in global market share with 32.9% compared to the recently constituted Adidas-Reebok organisation that had 26.3% market share. In the largest market in the world, the United States (US), Nike had 36.3% market share in August 2005. Following the acquisition of Reebok in August 2005, the market share of Adidas-Reebok in the US jumped to 21.1% from 8.9%. A primary goal of the acquisition has been to challenge industry leader Nike for a higher share of the United States sporting goods market as well as the global sporting goods market. The acquisition has prompted much discussion as to what the future holds for the sporting goods industry and its major players.

Today, the sportswear trade is a vast and dynamic operation involving huge economies of scale. The low-cost countries are gaining foothold in international markets leading developed countries to import and outsource so as to meet their requirements. The athletic shoe segment is highly competitive in nature with the major players such as Nike, Adidas, Reebok and New Balance striving to retain their market share and the smaller players such as Puma trying to gain market share. Important features of this competitive segment are heavy advertising, celebrity endorsements, brand awareness programs etc. Until the 1970s, Adidas, the German sports company, was the market leader in the US due to its product innovation. In the 1970s and 1980s, Nike & Reebok grabbed their share by redefining the product offering and aggressive marketing. Adidas failed to retaliate. Their market was undergoing several crises due to changes in leadership. In the 1990s, though Adidas was revived by a turn-around specialist, it was not a challenge to Nike. Adidas expected its takeover of Reebok to give increased clout with dealers' leverage of endorsement deals and sponsorships and access to wider consumer base. The Adidas-Reebok merger vaulted the combined entity into the second place in the American athletics shoe market behind Nike. The takeover of Reebok doubled the German group's North America sales. The Adidas Group's purchase of Reebok North America showed an obvious attitude to ensuring that the Corporation's overall objectives will be achieved. With the acquisition, a focus on increasing the band's apparel offerings and sharpening the brand's image has been set. This will allow for an expansion of global position and gaining a broader presence in key markets. To emphasize this fact, Adidas has now replaced Reebok as the official apparel supplier to the American National Basketball Association for the next 10 years. With the two company's combined strengths, an aim to widen the organization's overall profile and global dominance is now more than ever possible.

Standing at the perspective of Adidas, we are supposed to look forward to the future and foresee what would Adidas confront after the merger. Here comes a short analysis using SWOT model.

Adidas-Reebok SWOT Analysis (After the merger)
• More products for different customers • Increase in product line • Acclivity in market share • Now both upper and middle priced markets are covered. • Shared R&D, Patents, technology & innovations
• Differing values among management • Complexity of joining two corporate cultures • Both companies belong to different countries
• Reduction in costs • Decreased competition • Cross-over promotion by sponsored athletes • Enter to new market/Segments
• Nike. • Nike's possible acquisition of Puma. • Danger of collision between the two separate brands.

Since we have already done a brief forecast of the future of the acquisition, we should move to further study about the Adidas’ budgeting analysis.Standing at Adidas’ perspective before merging Reebok, we are going to forecast whether the acquisition is feasible or not using data and information available to Adidas at that moment.

THE TARGET BUDGETING ANALYSIS To begin with, let us come to the part of the target budgeting. As we all know, before tax earnings of the target equal revenue minus total expenses. However, referring to multinational acquisition, the problem becomes more complicated than the case that only focused on a single company's budgeting.
Brand effect When the target is taken over, the revenue generated by it may change over time owing to some changes in subjective factors such as consumer preference. For instance, the revenue may experience a sharp increase after the acquisition which increases the clout of Adidas and more consumers may prefer Adidas' products than ever. However, the brand effect may work in different ways depending whether the acquisition is succeed or failed. If the acquisition turn out to be very successful, more consumers can be attracted to buy Adidas' products, which can magnify the positive effect on revenue. On the other hand, if the acquisition is failed, a large number of consumers even the loyal consumers of Adidas may divert to buy other brands' product and the revenue would decrease sharply.

elasticity of demand It has been proved that the elasticity of demand on international market is much greater than that in domestic market holding other factors in constant. In other words, when compared with domestic demand, international demand is more sensitive to changes of price. Considering this fact, MNC may have chances to make greater profits by lowering the price of its product. Specifically, a little cut in price of the product with enormous elasticity demand of that product is likely to bring about a great amount of increase in the MNC's sales. The sharp increase in sales is deem to enlarge Adidas' market share in international sportswear market and to increase its revenue to large extent.
agency costs As we talked above, the method of computing total expense is believed to be different from previous view because we have to take agency costs into consideration. Agency problem is the conflict of interest that exists between owners of firms (shareholders) and their agents(management). In large companies, shareholders hold a relatively small percentage of the total shares outstanding. When shareholders own a portfolio of assets, with their equity positions in any given company constituting a relatively small percent of their total assets, they do not have a big incentive to oversee the operations of the company. It is same with Adidas, it owns several brands and can hardly manage all of them effectually. In addition, even if Adidas wanted to, as the its percentage of total shares outstanding declines, it has less ability to influence the operations of the sub company—even if it wanted to devote time to doing so. For this reason, shareholders must trust that managers will really run the business in a manner that maximizes shareholder wealth. One of the concerns that shareholders have is that managers will pursue their own personal goals and will not run the sub company in a manner that will maximize Adidas's shareholder's wealth. If managers do pursue policies that Adidas's oppose, their relatively small share holdings often do not allow them to take actions to effectively oppose management. Adidas have to put their trust in the board of directors and hope that they will look after their collective interests when they monitor management. This is the essence of the board's fiduciary duties. When directors are insufficiently diligent and do not require managers to act in shareholders' interests, they violate their fiduciary duties.
Free cash flow hypothesis asserting that the assumption of debt used to finance leveraged takeovers will absorb discretionary cash flows and help eliminate the agency problem between management and shareholders. It is assumed that with the higher debt service obligations, management would apply the company's cash flows to activities that are in management's interest and not necessarily in shareholders' interests. Adidas will never be able to eliminate agency costs and they will always exist to some level. So when merging Reebok, agency costs should be analyzed in the framework of estimation system. Looking into several papers, we found empirical analysis usually postulates that agency problems induce the gross profit of a joint venture to reduce 10%. On accounting this fact, we just do the same with our data.

international economies of scale
Since agency costs work in the way to increase total costs, international economies of scale can contribute to reduction of costs to some extent, however. When acquisition takes place, Adidas will take steps to merge and enlarge some of its good performance subsidiaries abroad to make better use of economies of scale and it may manage to reduce average costs. On the other hand, to close those ineffective subsidiaries can also make it more productive and bring about reduction in average costs in contrast to the previous cost tendency we predicted about Reebok. In general, international economies of scale is believed to bring about reduction in average cost of Adidas after merging Reebok. Given this information, Adidas is able to take advantage of international economies of scale to lower its average costs so as to make greater monopoly profits across nations.

Along with these factors that can have effects on revenue and expenses, inflation also plays a vital important role in computing revenue and costs, which we will discuss later in risk analysis.

|Budget analysis |
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Inflation Risk
Why is Inflation a risk
If a country's inflation rate increases relative to the countries with which it trades, its current account will be expected to decrease, other things being equal. Consumers and corporations in that country will most likely purchase more goods overseas (due to high local inflation), while the country's exports to other countries will decline.
Estimating the inflation rate
Estimating the inflation of Germany is necessary when evaluating the acquisition plan. We use the ARMA(1,1) model to analyses the inflation rate time series. The inflation rate series of Germany is from January 1955 to December 2004, totally 600 observations. The regression result is as follows:


The inflation rates of Germany from 2005 to 2009 are listed in the following table:
|Year |2005 |2006 |2007 |2008 |2009 |
|Inflation rate |0.021473 |0.022464 |0.023245 |0.023862 |0.024349 |

Incorporate inflation in the budget analysis

Capital budgeting analysis implicitly considers inflation since variable cost per unit and product prices generally have been rising over time. In some countries, inflation can be quite volatile from year to year and can therefore strongly influence a project's net cash flows. In countries where the inflation rate is high and volatile, it will be virtually impossible for a target to accurately forecast inflation each year. Inaccurate inflation forecasts can lead to inaccurate net cash flow forecasts.

Although fluctuations in inflation should affect both costs and revenues in the same direction, the magnitude of their changes may be very different. This is especially true when the project involves importing partially manufactured components and selling the finished product locally. The local economy's inflation will most likely have a stronger impact on revenues than on costs in such cases.

The joint impact of inflation and exchange rate fluctuations on a target's net cash flows may produce a partial offsetting effect from the viewpoint of the Adidas. The exchange rates of highly inflated countries tend to weaken over time. Thus, even if target earnings are inflated, they will be deflated when converted into the Adidas's home currency (if the target's currency has weakened). Such an offsetting effect is not exact or consistent, though. Because inflation is only one of many factors that influence exchange rates, there is no guarantee that a currency will depreciate when the local inflation rate is relatively high. Therefore, one cannot ignore the impact of inflation and exchange rates on net cash flows.

|Budget analysis before incorporating inflation risk |
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|2005 |2006 |2007 |2008 |2009 | |1. Revenue in $ 000s |4,785,284 |5,585,434 |5,927,758 |6,270,079 |6,612,400 | |2. Total Expenses =in
$ 000s |4,220,051 |4,907,154 |5,181,650 |5,568,738 |5,770,791 | |3. Before-Tax Earnings of target = (1) – (2) in $ 000s |565,233 |678,280 |746,108 |701,341 |841,609 | |4. Host Government Tax
(25%) in $ 000s |73,480 |88,176 |96,994 |91,174 |109,409 | |5. After-Tax Earnings of target in $ 000s |491,753 |590,103 |649,114 |610,167 |732,200 | |6. Net Cash Flow to target
= (5) +depreciation in $ 000s |495,553 |593,903 |652,914 |613,967 |736,000 | |7. US Dollars Remitted by target (100% of CF) in $ 000s |495,553 |593,903 |652,914 |613,967 |736,000 | |8. Withholding Tax on Remitted
Funds (10%) in $ 000s |49555.271 |59390.3252 |65291.35772 |61396.67626 |73600.01151 | |9.US Dollars Remitted After
Withholding Taxes in $ 000s |445,997 |534,513 |587,622 |552,570 |662,400 | |10. Salvage Value in
$ 000s | | | | |4,584,615 | |11. Exchange Rate of $ |€ 0.75 |€ 0.77 |€ 0.78 |€ 0.80 |€ 0.81 | |12. Cash Flow to Adidas = (20) × (22) |€ 334,498.08 |€ 408,902.39 |€ 458,521.62 |€ 439,793.85 |€ 4,259,653.42 | |13. PV of Adidas Cash Flows
(25% Discount Rate) |€ 290,867.90 |€ 309,188.95 |€ 301,658.96 |€ 252,755.08 |€ 2,118,176.74 | |14. Initial Investment by
Adidas |3,100,000 | | | | | |15. Cumulative PV |€ -2,809,132.11 |€ -2,499,943.15 |€ -2,198,284.19 |€ -1,945,529.11 |€ 172,647.63 | |

Exchange Rate Exposure

When we come to analyze the cash flow crossing boundaries, we are supposed to take currency exchange rates into account. There are several accounting subjects in budgeting closely related to currency exchange rate. Firstly, the currency initial invested in Reebok stocks must be denominated in Euro requiring currency conversion. In addition, when the revenue generated by the target is sent back to the Adidas, still the currency conversion is necessitated.
Considering that exchange rate is changing almost every time in every foreign exchange market, the Adidas is definitely exposed to great deal of uncertainty which may hold back acquisition to some extent. Exposure to exchange rate fluctuations comes in three forms: Transaction exposure, Economic exposure, Translation exposure. The empirical computing is as follows.
Measuring exposure
Transaction Exposure The sensitivity of the firm's contractual transactions in foreign currencies to exchange rate movements is referred to as transaction exposure.

Measuring Transaction Exposure
Transaction Exposure Based on Value at Risk A related method for assessing exposure is the value-at-risk (VAR) method, which measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements.
It estimates the standard deviation of daily percentage changes of the Mexican peso to be 0.98 percent over the last 100 days. If these daily percentage changes are normally distributed, the maximum 1-day loss is determined by the lower boundary (the left tail) of a one-tailed probability distribution, which is about 1.65 standard deviations away from the expected percentage change in the peso. Assuming an expected percentage change of 0 percent (implying no expected change in the peso) during the next day, the maximum 1-day loss is
Maximum 1-day loss= E(et)-(1.65*σU.S dollars) =0%-(1.65*0.98%) =-0.617

Economic Exposure The value of a firm's cash flows can be affected by exchange rate movements if it executes transactions in foreign currencies, receives revenue from foreign customers, or is subject to foreign competition. The sensitivity of the firm's cash flows to exchange rate movements is referred to as economic exposure (also sometimes referred to as operating exposure). Transaction exposure is a subset of economic exposure. But economic exposure also includes other ways in which a firm's cash flows can be affected by exchange rate movements.

Measuring Economic Exposure Use of Sensitivity Analysis. One method of measuring an MNC's economic exposure is to separately consider how sales and expense categories are affected by various exchange rate scenarios. Use of Regression Analysis. Adidas' economic exposure to currency movements can be assessed by applying regression analysis to historical cash flow and exchange rate data. To control influence caused by the fluctuation of other currency, the exchange rate of GBP and euro is added to the equation. [pic] The result indicates that the coefficient of change in dollar's value is negative and significant; this implies an inverse relationship between the change in the US dollar's value and the Adidas' cash flows.

Translation Exposure An MNC creates its financial statements by consolidating all of its individual subsidiaries' financial statements. A target's financial statement is normally measured in its local currency. To be consolidated, each target's financial statement must be translated into the currency of the MNC's Adidas. Since exchange rates change over time, the translation of the target's financial statement into a different currency is affected by exchange rate movements. The exposure of the MNC's consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, target earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates. To translate earnings, MNCs use a process established by the Financial Accounting Standards Board (FASB). The prevailing guidelines are set by FASB 52 for translation and by FASB 133 for valuing existing currency derivative contracts.

Determinants of Translation Exposure Some MNCs are subject to a greater degree of translation exposure than others. An MNC's degree of translation exposure is dependent on the following:
• The proportion of its business conducted by foreign subsidiaries
• The locations of its foreign subsidiaries
• The accounting methods that it uses Proportion of Business by Foreign Subsidiaries. The greater the percentage of an MNC's business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure.
Locations of Foreign Subsidiaries. The locations of the subsidiaries can also influence the degree of translation exposure because the financial statement items of each target are typically measured by the home currency of the target's country.
Accounting Methods. An MNC's degree of translation exposure can be greatly affected by the accounting procedures it uses to translate when consolidating financial statement data. Many of the important consolidated accounting rules for U.S.-based MNCs are based on FASB 52:
1. The functional currency of an entity is the currency of the economic environment in which the entity operates.
2. The current exchange rate as of the reporting date is used to translate the assets and liabilities of a foreign entity from its functional currency into the reporting currency.
3. The weighted average exchange rate over the relevant period is used to translate revenue, expenses, and gains and losses of a foreign entity from its functional currency into the reporting currency.
4. Translated income gains or losses due to changes in foreign currency values are not recognized in current net income but are reported as a second component of stockholder's equity; an exception to this rule is a foreign entity located in a country with high inflation.
5. Realized income gains or losses due to foreign currency transactions are recorded in current net income, although there are some exceptions. Under FASB 52, consolidated earnings are sensitive to the functional currency's weighted average exchange rate.
Managing transaction exposure But how can we deal with the exchange rate fluctuations in order to minimize the following exposure? The answer is to hedge.

Hedging exposure to payables Referring to initial investing, An MNC may decide to hedge part or all of its known payables transactions so that it is insulated from possible appreciation of the currency. It may select from the following hedging techniques to hedge its payables:
• Futures hedge
• Forward hedge
• Money market hedge
• Currency option hedge Before selecting a hedging technique, MNCs normally compare the cash flows that would be expected from each technique. The proper hedging technique can vary over time, as the relative advantages of the various techniques may change over time.
Forward or Futures Hedge on Payables Forward contracts and futures contracts allow an MNC to lock in a specific exchange rate at which it can purchase a specific currency and, therefore, allow it to hedge payables denominated in a foreign currency. A forward contract is negotiated between the firm and a financial institution such as a commercial bank and, therefore, can be tailored to meet the specific needs of the firm.
The futures rate is normally very similar to the forward rate, so the main difference would be that the futures contracts are standardized and would be purchased on an exchange, while the forward contract would be negotiated between the MNC and a commercial bank. Forward contracts are commonly used by large corporations that desire to hedge.
Money Market Hedge on Payables A money market hedge on payables involves taking a money market position to cover a future payables position. However, many MNCs prefer to hedge payables without using their cash balances. A money market hedge can still be used in this situation, but it requires two money market positions: (1) borrowed funds in the home currency and (2) a short term investment in the foreign currency.
If interest rate parity (IRP) exists and transaction costs do not exist, the money market hedge will yield the same results as the forward hedge.
Call Option Hedge on Payables A currency call option provides the right to buy a specified amount of a particular currency at a specified price (called the strike price, or exercise price) within a given period of time. Yet, unlike a futures or forward contract, the currency call option does not obligate its owner to buy the currency at that price. The MNC has the flexibility to let the option expire and obtain the currency at the existing spot rate when payables are due. Notice that the cost of the forward hedge or money market hedge can be determined with certainty, while the currency call option hedge has different outcomes depending on the future spot rate at the time payables are due.

Hedging exposure to receivables Referring to remitting revenue back to Adidas, MNC may decide to hedge part or all of its receivables transactions denominated in foreign currencies so that it is insulated from the possible depreciation of those currencies. The methods discussed above can be used in the opposite way to hedge exposure to receivables.

CONCLUSION After considering all of above from Adidas’ perspective, the Cumulative Present Value we predicted is positive leading to our conclusion that the acquisition is worth a shot to Adidas though some uncertainties still presented ahead.

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