LOWERING THE BAR
Value-at-Risk is used widely in the US and Europe. But can CFOs rely on this statistical method in volatile Asian markets?
By Andrew Osterland

There are plenty of good reasons why CFOs don't invest beyond their borders. Not only are the political and economic risks often greater than at home, so is the challenge of operating in a foreign market with different laws, consumer tastes, and business customs. So why bother? The answer is growth, says Robert Gluck, vice-president and treasurer of US-based Bestfoods, which has 130 manufacturing plants around the world producing soups, mayonnaise and other foods for 110 different markets. Its performance recently attracted a lucrative acquisition bid from Dutch food giant Unilever Plc.

While strategic planners are often willing to make large IT investments of uncertain benefit, the same isn't true of foreign investments, whose risks and rewards are similarly difficult to quantify. The reason, says Justin Pettit, a partner in the New York office of consulting firm Stern Stewart, is that companies often set arbitrarily high hurdle rates of return for international projects. Many large multinationals, in fact, tack on premiums as high as ten percentage points over the firm's domestic cost of capital - even after accounting for inflation differentials, he says. Granted, low hurdle rates for investments can come back to haunt businesses. Just ask the Japanese companies whose loose purse strings in Asia during the 1980s continue to handicap the Japanese economy. But, says Pettit, "many companies are stifling good growth opportunities because of the high-risk premiums they use on foreign investments."

Where the Growth is

For Bestfoods, overseas investment makes solid sense. In a good year, the highly competitive food industry can expect 2 to 3 percent organic volume growth in North America and Western Europe. Very often, the only opportunity for increasing profits in these mature markets is through cost-cutting or acquisition. That's not the case in overseas markets. Unlike other US-based food manufacturers such as Campbell's, Sara Lee or Hershey, Bestfoods has significant international operations, with about 22 percent of its revenues coming from outside the US and Western Europe. And the aggressive international strategy has certainly paid off for shareholders. While competitors' stock prices remain mired in a slump, Unilever offered Bestfoods a hefty 40-plus percent premium late last spring. "It was [Bestfoods's] emerging-markets exposure and its distribution abilities that got the deal done," says Lehman Brothers analyst Andrew Lazar.

While Bestfoods has been inclined toward foreign markets ever since predecessor companies Corn Products and Swiss-based Knorr merged in 1959, its investment planning, until recently, was largely driven by the same gut instincts that most large companies use. In Bestfoods's case, however, in-country experience and local management inclined it to take risks rather than play it safe. Then, in 1998, as part of its implementation of economic value added (EVA), Bestfoods and Stern Stewart began developing a more analytical model for setting investment hurdle rates in different markets.

The standard practice is to apply the principles of the capital asset pricing model (CAPM), where the net present value (NPV) of estimated future cashflow from an investment is calculated. If the NPV is greater than the cost of the project, then the investment makes sense. For North American investments, the future cashflow is discounted using the firm's average weighted cost of capital. With overseas investments, the process gets more complicated. Not only does the investment carry more systematic risk (such as inflation and currency devaluation) and sovereign risk (such as unfavorable legal or tax changes, expropriation of assets, or war), but it also carries more non-systematic risk - risk specific to the venture at hand. These could include product acceptance, start-up cost overruns, or labor problems.

Rather than isolate and quantify these elements of risk, most companies simply add on a premium to the firm's domestic cost of capital to reflect the extra risk. Thus, a hurdle rate for an investment in China might be set at cost of capital plus 5 percent. "There's a lot of ad hoc decision-making when it comes to setting hurdle rates," says Rafael Resendes, of capital markets advisory firm Applied Finance Group in Chicago. Instead of systematically analyzing risks and potential returns, executives end up making or not making investments for subjective, strategic reasons. The problem is, because of home market bias, many executives end up artificially inflating the costs of capital in foreign markets, and consequently passing up good projects.

Country Costs of Capital

Bestfoods, with the help of Stern Stewart, decided that rather than arbitrarily jack up its domestic hurdle rates for investments in other markets, the better approach was to calculate specific costs of capital for those markets. One method of doing so is to work from the equity and debt markets of the countries in question. These expected yields on investments, or market-derived discount rates, as Resendes calls them, give companies an idea of the returns investors are demanding in different markets. The rates are calculated by comparing the market values of local companies' equity and debt with the estimated future cashflows from those companies.

This local approach to the CAPM, however, fails to reflect valuable diversification benefits that a multinational company gains by investing in multiple markets. Gluck and Pettit decided to use what they call a hybrid version of the CAPM. They begin by estimating a US-dollar-based risk-free rate of return for each country, using stripped Brady bond or global eurobond yields where available. In contrast to conventional applications of the CAPM, however, they incorporate portions of sovereign and inflation risk into the rate. In the case of Brazil, for example, the modified risk-free rate is 14.5 percent (by taking into account the US-dollar equivalent). Subtracting that from yield on the local currency - the so-called sovereign yield - gives a sovereign risk premium of 9.35.

Step two of the method is the calculation of country betas, which indicate both the relative volatility of a foreign market to the US market and the correlation between the two. This is where the diversification benefits - or lack thereof - are determined. In Brazil's case, the low level of correlation with the US market makes up for its high volatility, giving it a beta of 0.81.

With the risk-free rates and country betas, Gluck and Pettit then calculate local and global costs of capital for Bestfoods. Using Brazil again: say Bestfoods's US dollar-based cost of capital is 8.5 percent. Add to that Brazil's currency risk of 9.34 percent and sovereign risk of 9.35 percent, then subtract a 2.56 percent diversification benefit, and the local currency cost of capital is 24.7 percent, or 15.3 percent in US dollar terms.

Testing the Waters

As aggressively as Bestfoods pursues growth in new markets, it does not dive in headfirst. It usually partners with other companies to share the risk, and looks to gain experience in markets before committing larger amounts of capital. In the early 1990s, for example, Bestfoods started an import operation in Russia, using a small sales force to sell bouillon and soups from Polish and Slovak firms. "We were testing the waters," says Gluck. It wasn't until 1995 that the company bought its first facility in Tula, a city south of Moscow, and began manufacturing product. Although the return on the Tula investment has fallen since the Russian financial crisis of 1998, the company is committed to its business there. "We believe in the first-mover advantage," says Gluck. "When stability returns, we'll be in a favored position."

Bestfoods's global presence clearly made the company far more attractive to Unilever than US firms that are tied more closely to the domestic market. With cross-border deals on the rise, other companies may be shortchanging shareholders by failing to retool their own foreign hurdle rates.

Andrew Osterland is a senior editor at CFO, CFO Asia's US-based sister publication.