Getting hurdle rates is a corporate ritual in this country–simply determine your incremental cost of capital and don’t undertake any investment with a lower expected return. But try exporting that rate overseas, where multinationals can find themselves confronted with hyperinflation, currency risks, and volatile, underdeveloped capital markets, and the task becomes decidedly more difficult.
And less precise. Just ask Timothy Smith, director of capital and business planning for the Latin American unit of U.S. automaker General Motors Corp. His unit, which also oversees GM operations in Africa and the Middle East, sells about 800,000 of the 10 million cars and trucks sold annually by GM worldwide. For years, senior managers at GM headquarters in Detroit have set the hurdle rates for the company’s far-flung international operations (see “What’s Good for General Motors,” August 1996). But when Smith tried to determine how accurately those rates reflected the cost of operating in the parts of the world for which his unit was responsible, he came up empty-handed. And that was unsettling.
“We had traditionally earned more than our target, but we knew that with competition coming into our markets it would become tougher to earn that target in the future,” Smith says. “We thought we had been doing well, but we also felt that we didn’t really have any basis on which to judge ourselves.”
For Smith and others like him, getting the numbers right is critical to making good investment decisions and accurately compensating offshore managers. Most companies look to history for guidance. Using a process that draws on the fundamentals of the capital asset pricing model, they compare the volatility between their home country and foreign equity markets and then, where foreign markets are more volatile, simply mark up their home-country rate to reflect the perceived increase in risk.
But that’s backward-looking. Might it not make more sense, Smith recently began asking, for multinationals to determine what level of returns equity investors are demanding in foreign markets today, and then invest only in those markets–and reward managers only there–when they beat those hurdle rates? And if it did make sense, how would you do it?
FOLLOWING THE LEADERS
For help, Smith turned to consulting giant Arthur Andersen LLP, which put him in touch with The Applied Finance Group Ltd. (AFG), a small, capital-markets advisory firm based in Chicago whose co-founders, Rafael Resendes and Daniel Obrycki, were attracted to Smith’s theory. “Let’s say I’m a U.S. investor in General Motors,” says Resendes, explaining the logic. “If GM isn’t earning a rate of return in Brazil comparable to what I’d make investing in a Brazilian fund, then they are not doing a service to any U.S. investor.”
Together, Smith, Arthur Andersen, and AFG addressed the problem in two ways. First, to get a better understanding of what other companies were doing, they polled 30 multinationals last summer about how they actually calculate their cost of capital and set hurdle rates around the world. Eleven, all from the United States, responded (see “Room to Move,” page 80).
“One of our most interesting findings is that there seems to be a follow-the-leader mentality out there,” says Smith. “Many of these companies were saying that they hadn’t really looked at what the rate of return should be in foreign countries, but that these were growing markets, that that’s where their customers and competitors were going, and so that’s where they were going.”
Smith also says he was disappointed that none of the surveyed firms had developed a methodology for setting international hurdle rates that was as rigorous as he was seeking. “I was disappointed that there wasn’t a more concrete approach,” he says. “On the other hand, I also felt that we should have thought about this before, too.”
Could the current state of affairs really be that bad? John Ferguson, for one, thinks so. Ferguson is a senior vice president for New York-based consultants Stern Stewart & Co., and runs its Latin American practice. “The majority of companies take their U.S. cost of capital and say, ‘OK, we’re putting money in India. We think that’s twice as risky, so let’s add big premiums to our hurdle rate,’” says Ferguson. “They have these ill-defined premiums that are hard to quantify, usually based on gut instinct, and they just load them in [to their planning models] and go with it. We see a lot of big mistakes being made.”
While the survey was being conducted, AFG also undertook a quantitative study to determine the level of returns equity investors were expecting around the world. To do that, the firm calculated what it calls market derived discount rates, or MDDRs, for eight countries. How? By forecasting a stream of cash flows for the industrial companies in each country and then solving for the discount rate that equated that cash flow stream to the sum of the market value of each company’s equity plus the book value of its debt.
The process was similar to solving for a bond’s internal rate of return, except that a corporation has uncertain future cash flows, while a bond has fixed coupon payments. AFG dealt with that issue by assuming that over time, a company’s investment returns would equal its cost of capital (that is, that competition would force economic profits to zero). It used the median MDDR for all of the companies analyzed to represent the equity market’s expected rate of return in that country. Adjustments for different accounting standards were made to the raw data to make the numbers comparable across markets.
AFG calculated MDDRs for industrial companies in the United States, the United Kingdom, Japan, Hong Kong, Singapore, Brazil, Chile, and Argentina, and then assigned a benchmark rating of 1.0 to the U.S. Based on that work, AFG researchers found, for example, that Brazil had the highest MDDR, equal to 221 percent of the U.S., or a multiple of 2.21. Thus, a company with a hurdle rate of 10 percent in the U.S. would, if it bought into the AFG model, want a hurdle rate of 22.1 percent in Brazil. Among the other companies that AFG analyzed, Argentina weighed in with a multiple of 1.36; Hong Kong with 1.19, the U.K. with 1.14, Chile 1.13, Singapore 0.78, and Japan 0.50.
“We came up with two very distinct ways to take this information and start to construct hurdle rates,” says Resendes. “One is to look at the risk differential between countries and mark up the target returns relative to the home country. The other is to simply set the target returns using each country’s unique MDDR.”
The more similar a company’s foreign operations are to the home country, the more likely it is to want to use the first method. The more segregated a project or business is from the company’s home operation or where the business risks are more different, the more likely a company is to use the second method.
“If your investment is local, that is, if the business will rise and fall on the strength of the local economy, then one might say, yes, let’s use the rate of return that people want in the local economy,” observes Stewart Myers, Billard professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management. But, says Stern Stewart’s Ferguson, “If you’re a multinational with a global approach, you have a home market and foreign markets, and you’re more likely to set your hurdle rate in the foreign markets based on their risk, but recognize a relationship between those markets and the home market.”
WORK IN PROGRESS
At GM Latin America, Smith and regional CFO Joseph Florez are using both approaches to determine what the hurdle rates should be in Latin America, Africa, and the Middle East, although theirs remains very much a work in progress. Neither methodology has been adopted corporatewide at this point. Since it hasn’t been evaluated by headquarters yet, it is also not being used to set compensation for GM’s international managers.
Smith declines to disclose the actual hurdle rates that GM is using around the world or explain how they are determined, but he does say that the methodology developed in conjunction with AFG suggests that the automaker’s hurdle rates in Latin America should be somewhat higher than they are now. “We’re comparing this higher rate to our [corporate] target and using it to help us guide our business,” Smith says. “We’re using it for project review and approval. We’ll review it on a yearly basis.”
What if a proposed project meets the hurdle rate set by GM but not the hurdle rate set by the Latin American unit–or vice versa? “We’d challenge Detroit on that,” says Smith, “but to date, we haven’t had cause to do it.”
Stern Stewart’s Ferguson says that while the AFG methodology makes some sense, it’s unlikely to be foolproof. “What this methodology does is forecast the future, and everybody knows that forecasts are smoother than history,” Ferguson says. “Although this methodology comes up with a cost of capital based on a forecast and on a rigorous analysis of history, it might tend to forecast less volatility than exists.”
MIT’s Myers also warns companies not to ignore the impact of diversification when they’re setting hurdle rates for foreign operations, regardless of how they calculate those rates. While the risk of investing in one foreign country may be greater than the risk of investing at home, investing simultaneously in many foreign markets will diversify the company’s overall risk. Investing overseas may actually reduce the weighted average cost of capital, because diversified investors will see it as risk reducing.
Ferguson agrees. “For a multinational penetrating a foreign market, the cost of capital could be lower than the cost of capital for a domestic player, because the multinational is capturing the diversification benefit,” he says. “Of course, when you tell a U.S. CFO that the cost of capital should be lower in Latin America than in the U.S., they think you’re crazy. But if you talk about the international cost of capital in isolation, you’re missing the boat.”
For Resendes, such arguments don’t weaken the value of the MDDR approach to setting international hurdle rates. “If you think about it, so long as I’m sourcing my funds at a cost that’s lower than the return I’m generating in a given market, I’m incrementally creating value for everybody,” he says. “If my source of funds in Japan costs 4 percent and I’m investing at 5 percent, I’m creating value–a 1 percent economic margin that all of my shareholders are benefiting from.”
Randy Myers is a contributing editor of CFO.
NO SINGLE SOLUTION
BLACK & DECKER’S SCHOEWE IS LEERY OF HURDLE RATE FORMULAS
———————————————————————— ——————- Black & Decker Corp. senior vice president and CFO Thomas Schoewe isn’t inclined to put too much faith in any one formula for calculating hurdle rates in foreign markets. His own $4.9 billion company, which derives just under half its revenue outside the United States selling such consumer products as power tools, door knobs, and water faucets, uses a single hurdle rate for all of its worldwide businesses, but is flexible in its use of that hurdle rate.
“If somebody thinks there’s a cookie-cutter recipe for this, I’d like to see the results,” says Schoewe. “The way you do it is by running businesses in a worldwide environment for many years. I’ve lived through enough economic turmoil in Brazil to know how consistently difficult it is to earn a profit there. That means you need to earn a return that’s based on the risk inherent in the local jurisdiction.”
Black & Decker, in Towson, Maryland, calculates its weighted average cost of capital at about 12 percent, and seeks to earn an aftertax return on net assets (RONA) of at least 25 percent from each of its worldwide lines of business. The company sets the bar high, says Schoewe, in part to cover assets not included in its RONA formula, which excludes such items as cash, debt, and goodwill that are managed at the corporate level.
When a Black & Decker business fails to meet the 25 percent hurdle, it isn’t abandoned. “Nothing is black and white, but if somebody’s return on net assets was less than 15 percent, we would go into a fix or exit mode, with total dedication to fixing the returns of the business,” Schoewe explains. “As you move from 15 to 20 percent, we would say yes, we want to improve the overall return of the business–we want to take net asset investment out and improve overall margins–but we can start considering more of an emphasis on growth. As you move north of 20 percent to 25 percent, more emphasis is placed on profitable growth within the business. And as you get north of 25 percent, your preoccupation is aggressive, profitable growth of the business.”
When it comes to making decisions about investing in new products, Schoewe simply shuns hurdle rates of any kind. “When I got to Black & Decker, there was a rule that any new product had to meet a hurdle rate–in this case, an internal rate of return (IRR)–of 30 percent,” Schoewe says. “It’s not going to come as any surprise to you that every single new product that crossed my desk was marginally better than 30 percent..”
The problem, he explains, is that financial managers knew which levers to tweak to project the required returns. “I would much rather understand the realistic returns of a project,” he says. “For example, if I had a project forecasted to show a 20 percent IRR, but had a very high likelihood of success, I would rather invest in it than in a project that showed a 35 percent IRR but was far more risky.”–R.M.