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MSc in Finance

Raising capital in Global markets

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) HPIs strengths and weaknesses.

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

Total Population (millions) Growth rate Source: EIU Country Report. September 9. 1994 1989 1,126 1990 1,139 1.15% 1991 1,156 1.49% 1992 1,173 1.47% 1993 1,185 1.02%

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%.
GNP at current market price (Rmb billion) Real GNP growth Source: EIU Country Report. September 9. 1994 1989 1,599 4.4% 1990 1,77 4.1% 1991 2,024 8.2% 1992 2,404 13,00% 1993 3,138 13.4%

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

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.
Direct foreign investments (M$) Growth Source: Jetro, Financial Times, June 27, 1996 1988 3,194 1989 3,392 6.19% 1990 3,487 2.80% 1991 4,366 25.20% 1992 11,007 152.10% 1993 27,515 149.97%

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

Invest with the right partner which to have:

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

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 Reliable plants: Using modern technology from abroad, more reliable than the average PRC power plant Fast-growing targeted market: 23% of the population, 31% of the national GDP

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

Insurance issue: -No business interruption insurance -No third-party liability insurance Allotments issue: -No guarantees that the company would continue to receive transportation, coal and oil allotments, and market prices are much more higher 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

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

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 Equity markets Disadvantages
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.

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.

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).

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

London Stock Exchange

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

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
Filing of an F-6 registration statement, but allows for exemption under Rule12g 3-2(b) from full SEC reporting requirements. 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) Same requirement than for Level II Submitting a Form F-1 to the SEC to be allowed to raise money.

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

Level I

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

Level II

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

Level III

Allow a foreign company to be listed on major US exchanges and to raise capital through a public offering of ADRs. (listed) Allow a foreign company to create restricted shares to be privately placed with institutional investors. (unlisted)

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

Rule 144A

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.

E D WACC Ke Kd (1 T ) V V

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.

Ke R f L ( RM R f )


= risk free rate

RM R f =market risk premium

= Leveraged Beta for HPI

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 ( D D/E ratio of HPI = 0.87 L U (1 (1 T ) ) E Levered Beta of HPI = 0.537 Cost of Equity=0.0816+0.537x0.1305=15.17%

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 D/E ratio of HPI = 0.87 1 (1 T ) E Levered Beta of HPI = 0.49 Cost of Equity = 0.0809+0.49x0.0473=10.41%

L U (1 (1 T )

D ) E

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%

Cost of Debt China Hong Kong U.S. U.K.

Cost of Equity 15% 15.17% 10.41% 10.66%

WACC 11.41% 11.49% 8.95% 9.08%

8% 8% 8% 8%

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.

Now imagine you are HPIs investment banker and you are proposing an ADR on the NYSE. You have to convince HPIs bearer of the price at which they should issue the shares? What is a reasonable share price? Why?

1994 EBIT Depreciation Capital expenditure Operating Cash Flows Taxes Free Cash Flows Discounted Cash Flows Firm value Debt Equity value Price per ADR






107242 76428 -225000 -41330 5836 -47166 -43291 24562274 533433 24028841 19.22

162599 76429 -628000 -388972 14305 -403277 -339742

186751 112562 -905000 -605687 20835 -626522 -484456

248589 191829 -912000 -471582 29175 -500757 -355401

334753 262495 -535000 62248 20120 42128 27443

462657 282295 -344000 400952 Terminal value 25316 375636 42703882 224597 25533124

Figures from forecasts provided in exhibit 12 Figures for 1994 have been doubled to represent the whole year 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%)

Estimation of the average Price Earnings ratio of recent IPOs by PRC firms in foreign markets. Taking the multiple to estimate the value of HPIs ADR. Company Exchange P/E ratio
Shandong Huanheng Power Dongfang Electrical Tianjin Bohai Chemical Yizheng Chemical Fibre Beiren Printing Shanghai Petrochemical Tsingtao Brewery NYSE Hong Kong Hong Kong Hong Kong Hong Kong Hong Kong Hong Kong Mean 14 12 11.2 13.5 15.2 11.3 16.3 13.35 1.45 HPI valuation Price using P/E ratio 19.36

Earnings per ADR for HPI

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

Estimation of the average Price Earnings and Price to Book ratios of international power generating group. Taking those multiples to estimate the value of HPIs ADR.
International Power Generating Group Asian Power Products South American Utilities U.S. Independent Power Products U.S. Utilities European Utilities Mean Earnings per ADR for HPI Book value/ADR HPI valuation Price using P/E ratio 21.54 P/E ratio 15.6 23 14.1 10.2 11.4 14.86 P/B ratio 2.24 2.27 2.47 1.2 1.64 1.96 1.45 9.67 Price using P/B ratio 18.99

DCF Price per ADR


Comparable with recent IPOs Using P/E ratio $19.36

Multiples Comparable with International Groups Using P/E ratio 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.

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:
Cost of Debt China Hong Kong U.S. U.K. 8% 8% 8% 8% Cost of Equity 15% 15.17% 10.41% 10.66% WACC 11.41% 11.49% 8.95% 9.08%

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

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:

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

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.

Takes longer to establish, requires SEC registration and full GAAP reconciliation for financials, most expensive to establish But: highest visibility and increased liquidity

HPI needs to choose a depositary bank, legal counselors and an investment bank; The depositary bank takes care of key action such as:

HPI will have to:

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

HPIs accountants 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.

Reconcile HPIs 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 HPIs 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.


Risk Management

For US investor, possibility to invest in a security uncorrelated with the US market. Emerging market with high potential returns. 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 firms 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.