Cost of capital in international business acquisitions: Stumbling block on the way to determining an appropriate purchase price


updated on 20 October 2022| reading time approx. 3 minutes

Globalisation and low interest rates altogether have led to a significant increase in national and international M&A transactions in recent years. Even the global coronavirus pandemic only slightly hampered the M&A market. The current Ukraine crisis, geopolitical tensions, such as those between China and the USA, and the emerging interest rate turnaround are now leading to new challenges in which the accurate consideration of country risks is becoming increasingly important.


In order to determine the enterprise value when determining the purchase price, the so-called "valuation using multiples" methods are often used in negotiations, where a multiple is applied relative to an earnings indicator, e.g. sales revenue, EBITDA or EBIT. In the background, professional buyers also rely on the theoretically better founded net present value methods such as the discounted cash flow (DCF) method or the income approach. This is because, in comparison to the “valuation using multiples” methods that are widely used in practice, the future expectations of the investor regarding business development or potential (dis)synergies can be explicitly mapped in the net present value methods. Especially in the case of a “fairness opinion” and a valuation for legal or accounting purposes, a detailed procedure is indispensable. In order to apply the methods, it is necessary to determine the rate of return on an alternative investment equivalent to risk. The rate of return is also called the cost of capital and is used to discount the cash flows of the target to the valuation date.
Not only in transactions, however, but also in valuations by a neutral appraiser, such as in impairment tests, valuations required for reasons arising from company law or for tax purposes, the cost of capital plays a major role.
This article focuses on the DCF method being more popular worldwide and thus the cost of capital known as “WACC” (Weighted Average Cost of Capital). The WACC corresponds to an average cost of capital of all (equity and debt) financing providers of the company.

Country risks are considered in the purchase price by adjusting the cost of capital

As a rule, net present value methods require equivalence between the numerator (cash flow of the respective target abroad) and the denominator (cost of capital). Specifically, this means that the cash flows and the cost of capital used for discounting must have the same profile in terms of maturity, taxes and operational and financial risks. If this is not the case and the cost of capital has, for example, a lower risk profile, the cost of capital will be too low, the resulting enterprise value will tend to be too high and investors will run the risk of having to pay excessive purchase prices. This can additionally lead to a situation where it will be necessary to make an immediate impairment write-down in the next annual financial statements. Conversely, too high a cost of capital leads to too low an enterprise value, which can result in investors dropping out of the bidding process because the bid will be too low.
Particularly in the case of international transactions, care must be taken to ensure that the cash flows on which the valuation is based and the discount rate have consistent currency and inflation profiles and that any country-specific risks are adequately accounted for. The most common country-specific risks are increased default risks in business transactions, lack of legal certainty, risks arising from weak product and brand protection, possible unrest or uprisings, and high volatility of macroeconomic variables. Current events that increase country-specific risks are, for example, the Ukraine crisis, bilateral trade wars or country-specific lockdowns as a result of coronavirus outbreaks that lead to massive disruptions in local production (e.g. in China).
Every valuation should be based on the business plan of the respective foreign target, which is usually prepared in the local currency. To ensure equivalence, the local cash flows can be discounted at a risk-equivalent local cost of capital rate and the resulting enterprise value translated at the exchange rate on the valuation date. Alternatively, the cash flows can be converted into euros on the basis of adequate exchange rate forecasts and discounted at risk-equivalent costs of capital in euro. To avoid double counting of country-specific risks, they can either already be taken into account when forecasting cash flows or, alternatively, as is widely used in practice, when deriving the cost of capital.
An example below presents adjustments that are necessary when determining the WACC if the cash flows on which the valuation is based are presented in the local currency and do not take country-specific risks into account.

Consideration of the inflation differential in the risk-free interest rate

The risk-free interest rate or base rate reflects the investment in a risk-free alternative investment. To be equivalent to local cash flows, the base rate must be relative to the local currency and the corresponding expected local inflation. To adjust the base rate to the inflation expected abroad, the internationally accepted "Fisher formula" can be applied, where a German base rate is adjusted for the difference between the German and the foreign expected inflation (inflation differential). Alternatively, especially in mature, stable economies, local quasi-risk-free bonds can also be used whose interest rate already takes into account expected inflation (e.g. treasury bonds in the USA).

Country risk premium

Typical country risks are difficult to quantify in the business plan and thus in the cash flows, which is why they are often reflected in the cost of capital in the form of a country risk premium. Since the risks affect equity and debt financing providers equally, such a country risk premium is factored in costs of both equity and debt.

The approach of a country-specific premium is debated in theory, but can be empirically proven, which is why it is used in most cases in valuation practice. Various theoretical approaches have been developed for determining the respective level of the country risk premium. The best known of these include, for example, the determination on the basis of country ratings by rating agencies such as Standard & Poor's or Moody's, or on the basis of credit default swaps available in the market.


The option presented here is the most common method in valuation practice, but there are also alternative methods that apply the beta factor to the country risk premium, for example.

Non-adjustment of the cost of capital leads to excessive purchase prices in company acquisitions abroad

If German companies decide to acquire a company abroad, this often takes place in emerging economies in growth regions or already established countries where, however, market access is limited for foreign investors. Depending on the country, there are a variety of risks that do not exist in the same form in Germany. It is clear to everyone that acquiring a company in Greece, the Philippines or Brazil entails different (sometimes higher) risks than acquiring a company in Germany.
If the risks abroad are not adequately accounted for in a company valuation, the valuations do not reflect the real enterprise value. In addition to a possibly excessive purchase price in transactions, this can lead to significant valuation errors, especially in valuations required for reasons arising from company law or for tax purposes.


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