Raising capital in Global markets

MSc in Finance

Romain Boujiot Jen Huki Jhon Hitterman

You have been hired as an international investment banker by a large U.S. institutional

investor who is considering purchasing HPI stock. Provide an analysis of:

i) China as an investment destination

ii) key success factors

iii) HPI’s strengths and weaknesses.

World's largest country by population (nearly 1/5 of the world's population)

Largest country of Asia, one of the largest of the word: 9 596 961 km2

One of the largest economies in the world: since 1978, the Chinese economy had expanded at an average rate of nearly 9%.

Since the late 1970s, China set up reforms to open its market.

1989 1990 1991 1992 1993

Total Population (millions) 1,126 1,139 1,156 1,173 1,185

Growth rate 1.15% 1.49% 1.47% 1.02%

Source: EIU Country Report. September 9. 1994

1989 1990 1991 1992 1993

GNP at current market price (Rmb billion) 1,599 1,77 2,024 2,404 3,138

Real GNP growth 4.4% 4.1% 8.2% 13,00% 13.4%

Source: EIU Country Report. September 9. 1994

In the late 1970s: the government relaxed its control over many industries to move from a centrally planned economy to more of a market-oriented one.

In the 1980s: in order to facilitate modernization and encourage foreign investment and the import of advanced technology, China began establishing special zones for foreign investment: Special Economic Zones (SEZs) . The original four were Shenzhen, Zhuhai, Shandou, and Xiamen.

In the 1990s: ◦ The government wanted to move toward a socialist market economy. Under the

planned economic system, the state was determining production and pricing. In a market economy, the state creates a stable and competitive economic environment through the application of laws and regulations.

◦ The government allowed foreign investors to manufacture and sell a wide range of goods on the domestic market, eliminated time restrictions on the establishment of joint ventures, allowed foreign partners to become chairs of joint venture boards, and authorized the establishment of wholly foreign-owned enterprises.

◦ The government granted more preferential tax treatment for Wholly Foreign Owned Enterprises and contractual ventures and for foreign companies, which invested in selected economic zones or in projects encouraged by the state, such as energy, communications and transportation.

◦ The government authorized some foreign banks to open branches in Shanghai and allowed foreign investors to purchase special "B" shares of stock in selected companies listed on the Shanghai and Shenzhen Securities Exchanges.

Partly due to these reforms, since 1988, the amount of Direct Foreign Investments has almost been multiply by 10.

1988 1989 1990 1991 1992 1993

Direct foreign investments (M$) 3,194 3,392 3,487 4,366 11,007 27,515

Growth 6.19% 2.80% 25.20% 152.10% 149.97%

Source: Jetro, Financial Times, June 27, 1996

To invest in China, a foreign investor needs to: ◦ Understand PRC main strategic goals and needs:

Modern technology to improve the power's production Foreign capital to faster the growth in the economy Expand the capacity in the power sector to meet the increase in

demand. ◦ Invest with the right partner which to have:

Experience in dealing with foreign investors, Strong relationship with national and local governments A market leadership

◦ Be an investor of a powerful industrialized country in order to: Have a strong bargaining power Be protected from unfair treatment Gain from advantages from a strong currency and large stock

exchanges

Strenghts Weakenesses

Strong connections with central and local authorities: -HPIDC, a Chinese government-foreign joint venture, is the major shareholder (54%) of HPI, -Local government investment companies own the remaining shares, -HPI's managers are former top management of HPIDC and Ministry employees

Geographical dispersion of HPI's power plants: -1,600 kilometers among five coastal provinces -Far from coalfields regions -Primitive transportation infrastructures

Reliable plants: Using modern technology from abroad, more reliable than the average PRC power plant

Insurance issue: -No business interruption insurance -No third-party liability insurance

Fast-growing targeted market: 23% of the population, 31% of the national GDP

Allotments issue: -No guarantees that the company would continue to receive transportation, coal and oil allotments, and market prices are much more higher

HPI increasing profitability and efficiency: Net profit margin has grown by 1.1 pts, Plant completed on time and within budget

Skilled operational personnel issue: -If the expected rates of growth in electrical production materialize, the company could face a shortage of skilled operational personnel - High cost of foreign engineers

Sustainable profitable activity: HPI as the exclusive developer of new planned plants in provinces in which it currently operates, Guaranteed rate of return on electrical generating assets

HPI wants to access financial markets. What are the options available to the firm? Provide pros and cons of available options in particular, deal with:

a. Debt markets.

b. Equity markets:

i. In particular, what type of listing is suitable for Huaneng to pursue? i.e. domestically within China and internationally, listing in Hong Kong, London and the US. (In the US between different ADR levels)

ii. What are the benefits for a non-US firm that decides to list on a US exchange?

HPI has limited internal source of capital due to tight controls on credit.

HPI can access financial markets through debt or equity markets.

Advantages Disadvantages

Equity markets

Equity raised do not have to be reimburse; No obligation to pay dividends; Increase the number of investors: opportunity to raise new capital; Access to international investors.

Need to reach a certain rate of return in order to obtain enough cash to pay dividends; Additional costs due to reporting requirements registration costs and listing fees; Dilution of the old investors control.

Debt markets

Deductible interests; Bonds are generally a safer investment

Interest payments (unlike dividends, even in difficulties, the company must pay them); Increase in the company's risk of default; Fixed interest rate (opportunity cost).

Advantages Disadvantages

Chinese Stock Exchanges

Completely familiar with PRC companies Low liquid and low capitalized internal stock exchanges => the amount HPI wants to raise is too high for these markets

Hong Kong Stock Exchange

Familiar with PRC companies for more than one year. Index for PRC firms

Has never absorbed such Chinese large issue Mixed reception for PRC firms issuance => the market could be saturated to absorb all the HPI equity raising.

London Stock Exchange

One of the world's largest stock exchange. Has always been focused on international trades

Competitive for small issuances No listing premium for firms asking for large issuance => HPI issuance may be undersubscribed.

US Stock Exchange

NYSE and NASDAQ: promoting themselves as the best place for PRC firms to raise international capital. The SEC requires from PRC Companies only tow years audited earnings instead of the usual three years. NYSE: has already Chinese funds and companies among its listing. NASDAQ: Technology-oriented stock exchange and market guaranteed by its market maker.

NYSE: mixed reception of Shandong issuance.

One of the largest and more efficient market in the world for trading stocks

Strong regulatory environment Governance model which prevents controlling

shareholders to extract private benefits from the corporation

Ability to raise more funds internationally in the future and at lower cost

Highly liquid secondary market for company shares

Attraction of a listing premium: often, benefits of being listed in NYSE offset listing costs

ADR: A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange.

Program type Requirements Comments

Level I Allow a foreign company to have its shares traded on the OTC US market. (unlisted)

Filing of an F-6 registration statement, but allows for exemption under Rule12g 3-2(b) from full SEC reporting requirements.

Can only be traded over-the-counter and cannot be listed on a national exchange in the US. Does not allow the issuer to raise new capital.

Level II Allow a foreign company to be listed on major US exchanges. (listed)

Filing an F-6 and 20-F registration statements Complying with the SEC's other disclosure rules: submission of its annual report (prepared in accordance with US GAAP)

Does not allow the issuer to raise new capital.

Level III Allow a foreign company to be listed on major US exchanges and to raise capital through a public offering of ADRs. (listed)

Same requirement than for Level II Submitting a Form F-1 to the SEC to be allowed to raise money.

Allows the issuer to raise capital through a public offering of ADRs in the US.

Rule 144A Allow a foreign company to create restricted shares to be privately placed with institutional investors. (unlisted)

Not registered with the US Securities and Exchange Commission Not subject to US reporting requirements.

Allows to raise capital but only from Qualified Institutional Buyers (not from Retail investors).

US investors are eager to expand their horizons in search of new opportunities for capital growth.

The appetite for foreign equities continues to increase as investors seek geographic and sector diversification.

The level of US investment in foreign equities now exceeds more than $2 trillion, reflecting 100-fold growth since 1980, with a strong growth between 1992 and 1999.

What is the right cost of capital for the various Equity options? Measure and explain the cost

of capital for each equity option.

Raise equity in Chinese market Be listed and raise equity in USA markets

(NYSE) Be listed and raise equity on the Hong Kong

stock exchange (HKSE) Be listed and raise equity in UK (LSE)

The right cost of capital for the equity

options is the Weighted Average Cost of Capital (WACC) in each of these markets.

Ke = cost of equity Kd= cost of debt E = Equity Value = $ 612,995

D = Debt Value = $ 533,433 V = E + D = $ 11,464,228 E/V = 0.5347 D/V = 0.4653 T=Effective Corporate Tax Rate = 9%

All figures in 000$, for year 1994.

)1( TV

DKd

V

EKeWACC

The cost of debt does not depend on the market.

Interest on long term debt are assumed at a 8% cost.

Cost of Debt = 8%

The cost of equity depends on the market where the shares are issued and listed;

The company's stock price will bear a systematic risk with respect to that market;

The Cost of Equity need to be calculated for each market.

= risk free rate

=market risk premium

= Leveraged Beta for HPI

)( fMLf RRRKe fR

fM RR

L

In the Chinese market, the allowed rate is 15% on equity financed net fixed assets,

Cost of equity = 15%.

Risk-free rate: the interest rate on long-term government bonds is used as a surrogate for risk free rate. The Hong Kong Government does not issue government bonds. However, the HKMA's Exchange Fund Bills can be viewed as such. Exchange Funds Bills and Notes Hong Kong 5-year (oct.1994) = 8.16% (Hong Kong Monetary Authority)

Market risk premium: Hong Kong Hang Seng Index Market Premium 1969-1993 =13.05%

Unlevered beta of Chinese firms involved in the power industry = 0.30 (pages.stern.nyu.edu)

D/E ratio of HPI = 0.87

Levered Beta of HPI = 0.537

Cost of Equity=0.0816+0.537x0.1305=15.17%

))1(1(E

DTUL

Risk Free rate: U.S. Govt. LT Bond Yield (oct. 1994)= 8.09%

Market risk premium: S&P 500 LT Market Premium = 4.73%

Beta of Electrical Power Generating Industry in U.S=0.52

D/E ratio of Electrical Power Generating Industry in U.S=1.01

Unlevered Beta = 0.2709

D/E ratio of HPI = 0.87

Levered Beta of HPI = 0.49

Cost of Equity = 0.0809+0.49x0.0473=10.41%

E

DT

LU

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E

DTUL

Risk Free rate: 5-year UK. Government bonds (oct. 1994) = 8.84% (Bank of England)

Market risk premium: difference between the geometric average of the return of stocks and the geometric average of long-term bonds for UK (1970-1996): 4.61% (Market risk premium: required, historical and expected - Pablo Fernandez, 2004)

Levered Beta of HPI = 0.49 (assumed to be the same than the US one)

Cost of equity = 0.084+0.49x0.0461=10.66%

U.S. market provides the lowest cost of capital; Hong Kong and Chinese markets provide higher

cost of capital; US markets should be the best destination to

make the new issue of equity.

Cost of Debt Cost of Equity WACC

China 8% 15% 11.41%

Hong Kong 8% 15.17% 11.49%

U.S. 8% 10.41% 8.95%

U.K. 8% 10.66% 9.08%

Now imagine you are HPI’s investment banker and you are proposing an ADR on the NYSE.

You have to convince HPI’s bearer of the price at which they should issue the shares? What

is a reasonable share price? Why?

1994 1995 1996 1997 1998 1999

EBIT 107242 162599 186751 248589 334753 462657

Depreciation 76428 76429 112562 191829 262495 282295

Capital expenditure -225000 -628000 -905000 -912000 -535000 -344000

Operating Cash Flows -41330 -388972 -605687 -471582 62248 400952

Taxes 5836 14305 20835 29175 20120 25316

Free Cash Flows -47166 -403277 -626522 -500757 42128 375636 42703882

Discounted Cash Flows -43291 -339742 -484456 -355401 27443 224597 25533124

Firm value 24562274

Debt 533433 Figures from forecasts provided in exhibit 12

Equity value 24028841 Figures for 1994 have been doubled to represent the whole year

Price per ADR 19.22 Discount rate: 8.95%, WACC found for US

Growth rate: 8% (since 1978, the Chinese economy had expanded at an average rate of nearly 9%)

Terminal value

Estimation of the average Price Earnings ratio of recent IPOs by PRC firms in foreign markets.

Taking the multiple to estimate the value of HPI’s ADR.

Selection of IPOs with an offer similar to HPI's one.

Company Exchange P/E ratio

Shandong Huanheng Power NYSE 14

Dongfang Electrical Hong Kong 12

Tianjin Bohai Chemical Hong Kong 11.2

Yizheng Chemical Fibre Hong Kong 13.5

Beiren Printing Hong Kong 15.2

Shanghai Petrochemical Hong Kong 11.3

Tsingtao Brewery Hong Kong 16.3

13.35

Earnings per ADR for HPI 1.45

Price using P/E ratio

19.36

HPI valuation

Mean

Estimation of the average Price Earnings and Price to Book ratios of international power generating group.

Taking those multiples to estimate the value of HPI’s ADR.

International Power Generating Group P/E ratio P/B ratio

Asian Power Products 15.6 2.24

South American Utilities 23 2.27

U.S. Independent Power Products 14.1 2.47

U.S. Utilities 10.2 1.2

European Utilities 11.4 1.64

Mean 14.86 1.96

Earnings per ADR for HPI 1.45

Book value/ADR 9.67

HPI valuation Price using P/E ratio Price using P/B ratio

21.54 18.99

The lowest price estimated is $ 19.2 per ADR and the highest is $

21.5 per ADR.

Knowing the strengths of HPI (largest power firm in PRC, ambitious growth plans, attractive Chinese economy, Government support), the company is in a position to command better prices than other comparable firms.

We propose a price of $ 20.50 per ADR, which is in range with the different prices we found but which is, due to its dominant market position, slightly above PRC comparable firms.

Comparable with recent IPOs

Using P/E ratio Using P/E ratio Using P/B ratio

Price per ADR $19.22 $19.36 $21.54 $18.99

Comparable with International GroupsDCF

Multiples

What implementation strategy would you suggest? Present your recommendation on

whether, how and why HPI should have proceeded with the issue.

HPI needs $ 4.5 billion to finance its development plans

$700 - $860 million is being raised in form of equity offerings

HPI needs to explore international markets to raise funds due to: ◦ Internal sources are unable to fulfill debt requirements; ◦ Domestic stock exchanges are incapable of raising such

an amount of money; ◦ Missing out on expansion plans because of a lack of

capital could affect the future growth of the company.

The cost of capital for each equity option available to Huaneng is as follows:

The lowest cost of capital is offered by US Stock Exchanges.

HPI should issue ADRs in U.S. equity markets. HPI should issue ADRs through the NYSE because it

already has Chinese funds and companies among its listing

Cost of Debt Cost of Equity WACC

China 8% 15% 11.41%

Hong Kong 8% 15.17% 11.49%

U.S. 8% 10.41% 8.95%

U.K. 8% 10.66% 9.08%

HPI wants to raise capital ◦ Level I and Level II does not allow to raise capital, it only

enable the company to expand its investor base; ◦ Level III and rule 144-A enable the company to raise

capital: Rule 144A DR:

Easy and quick to establish, no GAAP reconciliation required, low cost to establish, no SEC registration

But: low visibility, and enables to reach only institutional investors

ADR Level III: Takes longer to establish, requires SEC registration and full GAAP

reconciliation for financials, most expensive to establish But: highest visibility and increased liquidity

Due to the difficulties Shandong faced when the company raised equity and listed on the NYSE, HPI should use the option which provide the highest visibility and liquidity.

◦ HPI should raise capital through a public offering of ADRs of Level III.

HPI needs to choose a depositary bank, legal counselors and an investment bank;

The depositary bank takes care of key action such as: ◦ File Form F-6 if Level One, 2 or 3 program ◦ Review draft registration statement or offering memorandum ◦ Coordinate with all partners to complete program implementation steps on schedule ◦ Prepare and issue certificates and/or direct registration statements ◦ Announce DR program to market (brokers, traders, media, retail / institutional

investors via news releases and internet

HPI will have to: ◦ Provide depositary with notices of stockholder meetings and corporate distributions; ◦ Provide custodian and depositary with notices of annual and special stockholder

meetings and corporate distribution (dividends and right offerings); ◦ Comply with any applicable regulations, including disclosure and reporting, and

corporate governance requirements; ◦ Execute US-focused investor relations plan.

HPI’s accountants will have to: ◦ Reconcile HPI’s financial statements to US GAAP ◦ Review registration statement

The depositary will play a key role, facilitating the dialogue between HPI and its shareholders, and coordinating closely with the HPI’s custodian in China on the issuance and cancellation of depositary receipts and underlying shares.

More especially, HPI will have to: ◦ Provide depositary with notices of stockholder meetings

and corporate distributions; ◦ Provide custodian and depositary with notices of annual

and special stockholder meetings and corporate distribution (dividends and right offerings);

◦ Comply with any applicable regulations, including disclosure and reporting, and corporate governance requirements;

◦ Execute US-focused investor relations plan.

As the investment banker of the institutional investor, would you have recommended to buy stock in this company at all? At what

price? Why?

Growth Opportunity: ◦ A mandate to develop and operate large coal-fired

power plants throughout the PRC;

◦ Spin-off of HPIDC , a well known brand in the power industry;

◦ HPI would be the exclusive developer of all new greenfield coal-fired plants throughout the PRC;

◦ HPI has Already acquired the rights to three plants currently under developement.

Diversification ◦ For US investor, possibility to invest in a security

uncorrelated with the US market. ◦ Emerging market with high potential returns.

Risk Management ◦ Investment realised in domestic currency ( no

exchange risk)

“We find negative correlation between host (US) market returns and those of the ADRs at NYSE. Also, US shocks have no significant impact on the conditional volatility (risk) of the ADRs. These results suggest that the ADRs offer significant diversification benefits to US investors.” in Determinants of Returns and Volatility of Chinese ADRs at NYSE , Kutan & Zhou (2006)

Even if China is a fast growing and developing economy the total control of PRC over the economy could lead to arbitrary decision over ownership of Chinese companies;

Lack of transparency: ◦ In term of accounting principles

◦ Obscure transaction

Weak investors' protection law.

Fast Growing Economy

Diversification Opportunity

Negative Correlation with US market

Lack of Transparency

Possibility of arbitrary decisions from the governement

Generally, we would advise our clients to invest in this kind of security. However , we still need to compute at which price they should buy it.

An American Investor would compare the price of ADR with the stock prices of similar industries in US. Additionally, he would like to have a risk premium for the chinese specificities.

◦ US Independent Power Product PER : 14.1

◦ EPS or ADR for Huaneng : $1.45

◦ Price per ADR : 14.1*1.45 = $20.44

HPI indicated a share price between $22.5 and $27.5 widely above the theoritical price. Moreover, we do not take into account any risk premiun in the theoritical price.

According to our analysis , the appropriate issuing price should be approximately 10% to15% lower : $17.3 - $18.4

Given the current international investor environment (and not in 1994), what steps could HPI and the Chinese government take

to make it easier for firms from China to raise capital internationally?

China widely opened its market since 1978 and passed from an organized economy to a liberal economy with a high state

control. The biggest liberation economic expansion

All the financial system needs to be improved: ◦ Need for a more efficient transfer of funds from the savers/lenders to the

borrowers

◦ In order to appeal international investments.

European Central Bank (2012)

Develop direct and indirect finance:

D. Aruna Kumar 2007

The aim of China's macro-economic policy is to maintain a steady economic growth to avoid big economic fluctuations and to enhance the people's living standards.

But China still needs to reinforce its liberalisation to allow its national firms to have a proper access to national and international funds.

First step: more intermediaries to develop and

rationalize the financial intermediation ◦ Initiate a bank reform program cleaning up

nonperforming loans and opening the sector to foreign participation and competition.

◦ Making more efficient the large Private and public savings and currency reserves. Those funds should be invested in the economy.

◦ Develop national private major financial indutries and not only sovereign funds such as China Investment Corporation

Step 2: Strengthen the financial sector by: ◦ Recapitalizing the banks. Government should provide more

liquidity within the banks to allow more easing from the financial sector. Every assets would be more liquid and more interesting for foreign investors.

Step 3: Develop financial markets: ◦ International funds need liquidity and a strong secondary

market to trade efficiently.

◦ Appealing chinese banks and firms to be more active in the financial markets. Stimulate IPO, SEO etc.

Step 4 : Release some control: ◦ The state should be less present in every deals such as IPO.

Foreign investors are feared by such practices.

Step 5 : Being more flexible on the exchange market and monetary policy: ◦ The opacity of Chinese policy in terms of currency limits the

capital inflows from abroad. ◦ It will be easier for companies and individuals to buy

foreign currency and invest in overseas capital markets. ◦ Allow companies to diversify their risks and get better

returns.

Step 6: ◦ Ask chinese companies to comply with US GAAP or IFRS

principles. Nowadays, chinese accounting standards are unsuitable for the firms who whish to appeal international capital.

◦ Modernize and standardize the accounting standards and practices.

Implement International accounting standards

Acting more like a modern company and avoiding too closed relations with PCC and HPDIC

Invest abroad to be more recognized in some key countries

Reassure foreign investors by being more transparent in the firm’s management.

P. Fernandez (2004), Market risk premium: required, historical and expected, University of Navarra

Depositary Receipts, Reference guide, JP Morgan

D. Aruna Kum (2007), An Overview of Indian Financial System, Lokamanya Tilak P G College of Management.

E.C.B. (2012), Financial stability.