International Finance the Three CompaniesTerm Paper

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[. . .] Foreign exchange rate risk with Sony is therefore low.

There is some measure of economic risk, however. Though Japan is a wealthy and stable country, it is in an interesting macroeconomic position, which gives rise to some financial risk. The overnight rate is 0.1%, and the bank rate in Japan has basically been at zero for almost all of the last fifteen years (Global Rates.com, 2014). This means that the central bank has limited flexibility to deal with recessions and spur economic growth through conventional monetary policy. As a result, Japan may well be more susceptible to economic downturn, particularly in Asia, than just about any other country. The long-run economic sluggishness has also put the Japanese banking system in a precarious position, something that a company about to take stake in a major Japanese corporation should bear in mind (IMF, 2012).

The political environment in Japan is considered to be stable, and Japan is valued as a business partner because of its stable democracy and well-educated, wealthy populace. Political risk would be categorized as low. There is basically no risk of nationalization. Sony is not keiretsu, so there is less likely to be government involvement in any sale of a Sony company, particularly if Sony management promotes the idea with the Japanese government. As a general rule, Dorchester can expect few difficulties with such an acquisition, particularly if it commits to maintain employment levels, which is the only real touchy political issue.

Culture is definitely going to be an issue in Japan, which does not have a great history of successful mergers with Western companies. Though one example, Renault-Nissan, shows that it can work given enough time and effort, there is something in the language and culture barriers that increases the risk that the acquisition will not mesh well with the parent company, and this will make it more difficult to extract value from the investment.

Overall, Japan is a fairly low-risk company in which to invest, particularly if the local management of Sony (or its subsidiary) is essentially left in place. To do this would reduce political risk. Sony has a diversified revenue flow from around the world, in major currencies, something that reduces foreign exchange rate risk. While there is some risk in the Japanese economy and banking system, this a major world economy and it is unlikely to even if a crisis hurt the Japanese economy that it would be out of commission permanently.

Xiaomi

Xiaomi is a Beijing-based company that is much smaller and more focused than the other acquisition targets. It was founded in 2010 and has rapidly built a business in consumer electronics and apps, to the point where estimated revenues in 2014 are CN¥33 billion, or around $5.3 billion USD. Being a smaller company, Xiaomi's operations are mainly in China, which is the company's primary market, though it has moved into other Asian markets as well. That this is a Chinese company makes it much riskier than carving out an acquisition from within the extensive LG or Sony families.

The first element of risk is the overall financial risk. First, this is a young company and while its growth has been nothing short of astonishing, those cash flows are not nearly as reliable as those of LG and Sony, both of which have been around for decades and built global market shares. If Xiaomi can grow that rapidly, it stands to reason that another company could emerge and win market share from Xiaomi just as quickly.

Foreign exchange rate risk is also much, much higher with the Chinese yuan than with either the yen or the won. The yuan is not a freely-traded currency. The rate is set by the central bank, which sets a bound in which the yuan can trade. This is roughly based on the USD, but the problem is that the lack of free float means that many observers believe not only is China manipulating the value of its currency but that such manipulations are unsustainable (Palmer, 2012). So while the value of the CNY is pretty stable, that value is not reflective of the intrinsic value of the yuan, and as such there is the risk that the yuan is undervalued. This is especially given the high rates of inflation reported in the country -- though current rates are at five-year lows (BBC, 2014).

Of particular concern as well is the fact that China has currency controls. This means that while it encourages foreign direct investment, getting money out of China can be difficult. For a firm that hopes to invest in the country and build market share, this is not a big deal because retained earnings would be reinvested back into Xiaomi anyway, but the inability to repatriate profits over the long run does increase the risk. The risk is already high because the international market for the yuan is illiquid. The controls and the artificial price, as well as official Chinese policy, make exchanging the yuan for hard currency difficult. There is tremendous risk associated with this lack of liquidity, and that risk must be priced into the acquisition.

Financing costs are another major risk. Whereas Sony and LG represent opportunities for Dorchester to acquire a subsidiary from countries where financing options are myriad, Xiaomi is a privately-held company in a country where investment banking options are perhaps not as well developed as in Korea or Japan. Dorchester will need to pay cash, and financing a deal like this in China is a lot more difficult than in more developed economies.

Political risk is another consideration, and it is higher in China. The government is not open, and this creates a situation where there is tremendous corruption and abuse. Foreign companies can often take the brunt of this, facing political action to a level that would be unheard of in South Korea or Japan -- companies like Google and Starbucks have had major clashes with the Chinese government that cost them millions in revenue. As a Communist state, China remains a risk for nationalization as well. All told, the vagaries of the Chinese legal-political system, the corruption and the occasion direct hostility from government towards foreign-owned companies results in a higher degree of political risk than might be the case in a stable modern democracy. It is unlikely that a full takeover would even be feasible, and Dorchester at best would be able to acquire a minority stake in Xiaomi, especially if it intends to minimize political risk.

Culture is also going to be a challenge in the PRC, though arguably only to the same degree that would be found in South Korea or Japan. Dorchester would be advised to be more of a silent partner or take Xiaomi products to the international audience, allowing Xiaomi a reasonable level of autonomy, in order to minimize destabilizing and expensive culture clashes between the acquired company and the purchasing company.

Recommendation

Each of these companies carries with it a different risk-reward profile. The final decision would come down to what is best for Dorchester shareholders, and what is within the scope of Dorchester's long-term strategy. This report is not going to guess what that strategy might be, but will make conclusions about these three potential acquisitions.

The riskiest of the three acquisitions is Xiaomi in China. China has far greater risk in terms of its currency, which is not freely traded, and in terms of market risk and political risk as well. That said, this is a company that has grown from nothing to $5.3 billion USD in revenue in four years, and that is an astonishing rate of return. Typically, the project that has the highest risk should have the highest rate of return. Xiaomi remains almost entirely a Chinese company, but it is beginning to internationalize to some extent. There are significant, overriding political and cultural issues that only add to the risk. Further, with Xiaomi's performance to this date, it is quite likely that a high rate of growth will be priced into the company's asking price. This is an incredibly risky purchase for a number of reasons, but depending on Dorchester's confidence in their revenue streams, Xiaomi offers the best upside by far, to go along with that risk.

Sony, or a subsidiary thereof, represents the safe route for Dorchester. Sony's revenue streams are diversified, coming from all of the world's major economies in fairly even numbers. There is also a relatively low level of political and economic risk, and most of the risks associated with the Japanese market are not existential in nature, and the currency exposure can be almost completely hedged. Sony has a long-term track record in its businesses, and as a result its revenue streams are fairly reliable. This is the safest of the three options, by quite a wide margin, thought it also offers little upside, as most of Sony's major businesses are fairly mature at this point.

LG… [END OF PREVIEW]

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