General Electric – Risk & Cost of Capital

Aspects of a deal

Risk & Cost of capitalN

egot

iation

Strategy

DealStructure

ApproachTarget

TargetIdentifi-cation

ValuationValuation

DueDiligence

Incorporating risk in valuation is key

GE’s approach to risk - two fold

Mitigate

– Hedge transactions…currency, commodities

– Transactions backed by guarantees…corporate

guarantee, LOC, parent guarantee

– Back to back agreements

– Government approvals…country risk

– Deal covenants

– GE Management

Incorporate

– Higher cost of capital

– Adjust cash flows

Why is cost of capital important?

Objective

– Proxy for risk

– Reduces value of investment…faster pay back

– Should mirror cost of obtaining funds and

certainty and timing of recovery

Uses

– Purchase/ building of industrial facility

– Acquisitions/ investments

– Long term contracts

Computation of cost of capital

Cost of capital is -

– WACC or Discount rate

– Base rate usually anchored on US

Base rate adjusted for risk-

– Currency

– Industry

– Expropriation

– Demand

– Regulatory risk

– Environment reg.

Not all risks result in adjustment to cost of capital

Risk and cost of capital

People/ Management

Financial

Environment

No freedom to rationalize people

Trade unions

Cost of severance

Quality of management

Currency exposure

Inflation/ devaluation

Funding

Interest rates

Health and safety issues

Country/ industry environment

exposure

Cost of capital adjusted

Cost of capital adjusted

unless agreement reached

Cash flows adjusted

Cost of capital not adjusted

Usually hedged..cost of

capital not adjusted

Cost of capital adjusted

Cost of capital adjusted

more so if local borrowing

Cost of capital adjusted

Cost of capital & cash flows adjusted

Cost of capital & cash flows adjusted

Risk Examples Treatment

Risk and cost of capital

Country

Project/ investment related risks

Risk Examples Treatment

Political Instability

Regulatory reforms/ policies

Economic instability

Corruption

Supply interruption

Technology

Market risk – sell-side

Barriers to entry

Force Majure

Weak Exit Strategy

Tax exposure

Possibility of Unscheduled events/ delays

Cost of capital adjusted

Cost of capital not adjusted unless risk very high

Cost of capital adjusted

Cost of capital not adjusted

Cost of capital not adjusted

Cost of capital adjusted

Cost of capital adjusted

Cost of capital adjusted

Cost of capital not adjusted

unless exposure very high

Cost of capital adjusted

Cost of capital not adjusted…usually cash flows

Cost of capital not adjusted…unless risk quantifiable

Risk & Cost of Capital – Tools and Internal Process

Due Diligence Process

Objective

– To provide enough information to measure and assess risk in

deals and investment

– Internal and external parties involved - GE Audit Staff, KPMG

Process usually covers the following risks:

– People/ Management

– Project/ investment related risks

– Environment, Health and Safety

End result

– Information on risks…risks usually quantified

– Incorporation of risks and adjustment of cost of capital by Deal

team

– Process more art than science

Due Diligence Process

3

Due DiligenceThe Intensity of Due Diligence Varies by the Legal Stage of the Acquisition/J V Process:

Attempt To Limit Intensity And Resources Until A Clear Deal Exists -- Not Always Possible (e.g., Auction, Tender).

ContractContractSignedSigned

ConfidentialityConfidentialityAgreementAgreement

Letter ofLetter ofIntentIntent

ClosingClosing

Business & LegalDue Diligence(Pre-Signing)

ConfirmingDue Diligence/

Audit(Pre-Closing)

Audit/Deal Hand-Off

(Post-Closing)

PreliminaryDue Diligence

(Pre-LOI)

Valuation

Due Diligence Process

4

Each Due Diligence Plan is unique . . . and the goals vary by stage:

•Thoroughly understand targets current operations, outlook, assets, and liabilities. Both Financial and Strategic

•Identify Deal Killers/Shapers

•Confirm Valuation Assumptions/Synergies

•Probe legal concerns, confirm Disclosure Schedules

•Confirm Feasibility of Integration Plan

•Confirm representations true

•Ensure covenants being followed

•Verify no material adverse change

•Formulate closing net worth estimate

•Link with Integration Team

•Detect Representation Violations

•Prepare closing net worth statement

•Drive Integration

•Not applicable for Public Company deals

•Gain basic knowledge

– Products

– Sales

– Profitability

– Balance Sheet

– Rough Cut of Synergies

PRE-LOI PRE-SIGNING PRE-CLOSING POST-CLOSING

AUDITBUSINESS REVIEW

Each Stage Is Critical . . . If You Skip A Stage,You Miss A Chance To Manage Exposure.

Due Diligence

Due Diligence Process – EHS web-page

Country risks…GE Capital Risk Management

Objective

– To provide enough information to measure and assess country

risk in deals and investment

Process usually covers the following :

– Risk assessment by GE’s economists and risk management

team

– Comments of in-country teams incorporated

– Internal analysis verified with external reports

End result

– Information on country risks…risks usually quantified

– Cost of capital adjusted by Deal team

– Process highly scientific

Country risks: Web page

9 / 1 1 / 0 2

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C a p i t a l E x p e n d i t u r e & G D P G r o w t h C a p i t a l E x p e n d i t u r e & G D P G r o w t h

* I n d i c a t e s f o r e c a s t e d n u m b e r .

- M e x i c o -G D P G r o w t h G D P G r o w t h

C a p i t a l E x p e n d i t u r e & G D P G r o w t h C a p i t a l E x p e n d i t u r e & G D P G r o w t h

C a p E x

G D P

1 . 5 %1 . 2 %

0 . 0 %

- 1 . 9 %

- 0 . 9 %

- 2 . 6 %

0 . 0 %0 . 5 %

Q 1 ' 0 1 Q 3 ' 0 1 Q 4 ' 0 1

2 . 4 0 %

- 0 . 8 %

- 1 . 5 %- 2 . 7 %

1 . 1 % 1 . 1 % 1 . 2 % 1 . 0 %

Q 1 ' 0 1 Q 3 ' 0 1 Q 4 ' 0 1 Q 1 ' 0 2

- 1 . 4 %

1 . 4 %

2 . 0 %

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Q 1 ‘ 0 1 Q 3 ' 0 1 Q 4 ' 0 1 Q 1 ' 0 2- 1 . 5 % - 1 . 6 % - 2 . 0 %

2 . 1 %

Q 3 ' 0 1 Q 4 ' 0 1 Q 1 ' 0 2 Q 2 ' 0 2

K e y =

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Country risks: Sample analysis

Country risk: GE legal web-page

Financial risks…GE Treasury

Objective

– To provide enough information to measure and assess financial

risk in deals and investment

– Involvement of corporate and business treasury teams

Process usually covers the following :

– Risk assessment by GE’s economists and treasurers

– Internal analysis verified with external reports

– Hedging instruments identified

– Optimal capital structure identified

End result

– Information on currency risks…risks usually hedged

– Cost of capital adjusted by Deal team for funding, local

borrowing

– Process mix of art and science

Currency risks – GE Treasury web-page

Easy way out….

Target Company Information:

M&A News:

Current Borrowing Cost and WACC:

Links to sources of basic information regarding a company

Recent GE acquisitions in the news

GE’s current borrowing cost and WACC used for modeling acquisitions

Companies would centralize information…not to reinvent the wheel

Business case – GE Lighting acquisition of Tungsram

Deal Basics

Facts• Acquirer: GE Lighting

• Tungsram Company, Hungary

• 12 factories, 18K employees

• Low cost but low quality producer

• Annual sales: $300MM

Deal Structure

• Huge country risk

• Cash deal - $ 160MM

• Reduced exposure by limiting investment to 50% + 1 share

• DCRR: 19.1%

• Payback: 8.6 years

Strategic consideration

• Rapid Market share

• Low cost position

• Access to new product lines

• Access to distribution channels

Valuation Assumptions

• 2% growth

• Cost of Capital – 14%

• Reduction in overhead costs..10% workforce reduction

• 20% Hungarian tax

• Material efficiency..10% over 5 years

Cost of capital - adjustments

Overall weighted cost of capital 14%