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Huaneng case

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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
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

 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%.
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

 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.

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

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

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
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 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.

Deductible interests;
Bonds are generally a safer investment
Debt markets

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
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.

One of the world's largest stock exchange.
London Stock Exchange
Competitive for small issuances
Has always been focused on international trades
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
 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)

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)

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

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

Does not allow the issuer to raise new capital.

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

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
 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  E V

 Kd
 D  (1  T )
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.

 The cost of debt does not depend on the
 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.

 R f

= risk free rate
 R f
 L (RM
 Rf )

 RM
  L
 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/E ratio of HPI = 0.87
 Levered Beta of HPI = 0.537

L  U (1  (1  T )  )
 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/E ratio of HPI = 0.87

U 
 L
1  (1  T )  D

L  U
(1  (1  T )  D )
 Levered Beta of HPI = 0.49 E
 Cost of Equity = 0.0809+0.49x0.0473=10.41%

 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 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%

 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 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

Terminal value
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%)

 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

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

Earnings per ADR for HPI 1.45

HPI valuation Price using P/E ratio

 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
 Taking those multiples to estimate the value of
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


Comparable with recent IPOs
Comparable with International Groups
Using P/E ratio Using P/E ratio Using P/B ratio
Price per ADR $19.22 $19.36 $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
 $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 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%

 The lowest cost of capital is offered by US Stock
 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:
 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
 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

 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

 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
 D. Aruna Kum (2007), An Overview of Indian Financial System, Lokamanya Tilak P G College of Management.
 E.C.B. (2012), Financial stability.


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