Huaneng Power International, Inc.: Raising Capital in Global MarketsAs management of Huaneng Power International Inc. (HPI), you must decide howto proceed with the company’s planned initial public offering.1. Was the chosen issue price for HPI a reasonable value? Present yourrecommendation on whether, where, how and why HPI should haveproceeded with the issue.• Use WACC for valuation.• “Allowed rate of return” can be interpreted as “rate of return to induceforeign investors to invest in Huaneng.” That is, it is the required rate ofreturn on equity. Although we do not have a good data for beta, you canback down beta from the required rate of return.• Use numbers in Exhibits 8 and 12 to calculate free cash flows.As you will notice, the valuation will heavily depend on growth rate anddiscount rate. Thus a sensitivity analysis on these would be essential.2. Is this the right time for HPI to raise capital overseas, and will foreigninvestors be interested in investing in this company? As an institutionalinvestor, would you have bought stock in this company?3. Are there alternatives to a stock offering at this time?4. What criteria are important in determining the market for this firm’s stock?

InternationalCorporateFinance&GovernanceProfessor Florencio Lopez-de-Silanes

HUANENG POWER INTERNATIONAL

INC.

Raising Capital in Global Markets

-A case analysis

Submitted by: Group 30Abhishek Lohia (Msc RAM) 23980Satendra Yadav (Msc Finance) 23799Noel Khoury (Msc RAM)

1

Question No. 1

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, and iii) HPI's strengths and weaknesses.

China, officially the People's Republic of China is the world's largest country by population and one

of the largest by area, measuring about the same size as the United States. The country's varied

terrain includes vast deserts, towering mountains, high plateaus, and broad plains. Beijing, located in

the north, is China's capital and its cultural, economic, and communications center. Shanghai,

located near the Yangtze, is the most populous urban center, the largest industrial and commercial

city, and mainland China's leading port. One-fifth of the world's population--1.2 billion people--live

in China. China recognizes more than 5O national minorities and many different regional languages.

As a result of the reforms of the 1980s and 1990s, the Chinese economy grew almost 10 percent a

year from 1980 to 2005, making it one of the largest economies in the world in the early 21st

century.

China also opened its market to the outside world. To help quicken the pace of modernization, the

state encouraged foreign investment and the import of advanced technology. In 1980 China began

establishing special zones for foreign investment. The original four were called Special Economic

Zones (SEZs) and consisted of Shenzhen, Zhuhai, Shandou, and Xiamen, all in southeastern China. By

the late 1990s a variety of similar types of zones had been added, including a fifth SEZ, Hainan Island.

Most zones are located in urban economic centers, particularly coastal cities, cities along the

Yangtze River, provincial capitals, and cities and towns along China's borders.

In 1992 the government announced the goal of establishing a socialist market economy, meaning a

market economy led by the CCP. To accommodate this change and other economic reforms, the

government has shifted its role in the economy. Under the planned economic system, the state

determined production and pricing. In a market economy, however, consumer demand for goods

and services determines production and pricing. The Chinese government's new role involves

creating a stable and competitive economic environment through the application of laws and

regulations.

Deng and Jiang's reforms in the 1990s were particularly successful at stimulating economic growth,

but they also created problems for the Communist leadership. China's foreign debt began to

increase rapidly, and growing consumer demand led to rising inflation.

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Since the early 1990s, the government has 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, provided some assurances against nationalization, allowed foreign partners to become

chairs of joint venture boards, and authorized the establishment of wholly foreign-owned

enterprises, now the preferred form of FDI. In 1991, China 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.

China also 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.

During the four years to 1993, GNP (at current market prices Rmb million) had expanded by +96% or

+18% CAGR 1989-93 (reviewed from inflation +51% or 11% CAGR 1989-93) to Rmb 3,138.0 billion.

Foreign investors often quote China as having 1.3 billion consumers, and with urban incomes

growing 14% a year since 1978, often think that great numbers of unserved customers are there for

the taking.

1989 1990 1991 1992 1993

Population (m) 1 126 1 139 1 156 1 173 1 185

Growth 1,2% 1,5% 1,5% 1,0%

GNP at current market prices (Rmb bn) 1 599 1 770 2 024 2 404 3 138

Growth 10,7% 14,4% 18,8% 30,5%

Real GNP growth 4,1% 8,2% 13,0% 13,4%

Total debt (USD bn) 44,8 52,5 60,8 68,3 77,0

Growth 17,2% 15,8% 12,3% 12,7%

Current Account (USD bn) -4,3 12,0 13,3 6,4 -11,9

Growth -379,1% 10,8% -51,9% -285,9%

Consumer price inflation 17,5% 1,6% 3,0% 5,4% 13,0%

Figure 1 MACROECONOMIC DATA

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1990 1991 1992 1993

Total population 1135 1151 1165 1178

Growth 1,4% 1,2% 1,1%

Urban Population (m) 299 307 317 327

Growth 2,7% 3,3% 3,2%

Rural Population (m) 836 844 848 851

Growth 1,0% 0,5% 0,4%

Figure 2 DEMOGRAPHIC TREND

II) The key success factors can be divided into 3 elements:

A) Understand PRC main strategic goals:

a. The need of a modern technology to improve the power's productivity

b. The need of foreign capital to faster the growth in the economy, this capital will

finance positive NPV projects, and investment opportunities for the Chinese

company at a low price.

c. The need to expand the capacity in the power sector to meet the increase in

demand.

B) Choose the right partner to invest:

a. He should have the experience in dealing with foreign investors,

b. Should have strong relationship with national and local governments

c. Should have a market leadership

C) Be an investor of a powerful industrialized country

a. It gives a strong bargaining power

b. It protects from unfair treatment

c. It offers important advantages as strong currency and large stock exhanges

HPI (Huaneng Power International) created in 1994, develops, constructs, operates and manages

large power plants throughout China. It's the larger power firm in the PRC and operates five plants in

the fastest-growing provinces of China.

The company is a spin-off of HPIDC and its shareholding in 1994 was as follows:

4

HPIDC: 54%

Local governments: 46%

Today, HPI is seeking for capital to conduct planned projects

HuanengPower ShandongPower HPIcompared International International toShandong

Assets 906,0 449,0 +457,0

Sales(1993)inUSDm 470,8 146,9 +323,9

NetIncome(1993)inUSDm 96,2 47,3 +48,9

As%ofSales 20,4% 32,2% -11,8%

Earnings/share(expected'95)inUSD 1,45 1,02 +0,4

Price-Earningsratio(Expected'95) 14 14 +0,0

Figure 3 Competitive analysis

iii) HPI Stengths' and weaknesses

Strengths:

1- HPI's 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

2- Reliable plants: Using modern technology from abroad, more reliable than the average PRC

power plant

3- Fast-growing targeted market: 23% of the population, 31% of the national GDP

4- HPI increasing profitability and efficiency: Net profit margin has grown by 1.1 pts, Plant

completed on time and within budget

5- 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 5

Weaknesses:

1- Geographical dispersion of HPI's power plants: 1,600 kilometers among five coastal

provinces, Far from coalfields regions particularly the Shanxi province coalfields, Primitive

transportation infrastructures

2- Insurance issue: No business interruption insurance to protect company from unanticipated

events , No third-party liability insurance coverage for accidents on company property

3- Allotments issue: No guarantees that the company would continue to receive

transportation, coal and oil allotments, Going prices are much more higher

4- Skilled operational personnel issue: Insufficient trained personnel to operate the planned

plants, High cost of foreign engineers

Question 2.

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 wants to access to financial markets, in fact the internal sources of capital are strained for many

reasons:

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1- HPI has a limited internal investors because of a i) tight controls on credit (1988 and 1992)

and ii) Low liquid and low capitalized internal stock exchanges

2- The rise in inflation has led to a moderation in the GNP: The reforms and planned prices

relaxing put pressure on consumer prices, the controls implemented to struggle inflation

caused have been reduced.

3- Competition against other vital sectors for scarce capital

The advantages and the drawbacks of 1) equity and 2) debt

1) Debt:

a. Advantages: Interest deductibility from profits allows paying fewer taxes or in other

words it leads to a tax economy (M&M capital structure theory), bonds are generally

a safer investment.

b. Drawbacks: Weight of interest payments (bond interest payments are made even if

the company is loosing money), issuing bond increase the company's risk of default,

Bonds often offer a fixed interest rate unrelated with free-risk rate ( we may loose

some opportunity cost).

2) Equity:

a. Advantages: Funds received do not have to be repaid, The firm do not have the

expense of paying interest (no obligation for the dividends), the equity enlarged the

investor's base, it leads to an opportunity to raise new capital, the equity issuing can

overcome barriers to international investment (if the investors are international.

b. Drawbacks: The firm should reach a certain rate of return in order to obtain enough

cash to pay dividends, the Opex will rise due to additional costs such as reporting

requirements, registration costs and listing fees and it dilutes the old investors'

share power (control).

If the company would raise capital through equity issuance in China, then it may have some

difficulties concerning the amount (Rmb 34,3 bn), it's too high to be integrally issued internally. But

7

if HPI issues debt then a huge amount of debt would generate too high interest expenses and the

domestic banks can't afford huge capital requirements.

But what's the most suitable stock exchange for HPI?

LSE (London Stock exchange) ?

i) Advantages: One of the world's largest stock exchange, it has always been focused on

international trades

ii) Drawbacks: Competitive for small issuances, No listing premium for firms asking for large

issuance

So the HPI equity issuance (between $700m and $860m) may be undersubscribed

HONG KONG STOCK EXCHANGE?

i) Advantages: The Stock Exchange is familiar with PRC companies for more than one year,

there's an index for PRC firms

ii) Drawbacks: It Has never absorbed such Chinese large issue, it has mixed reception for PRC

firms

Maybe a saturated market which would gather little attention on HPI equity raising

NYSE

i) NYSE PresidentWilliamDonaldsoninterest inwinningthe listingsforPRCfirms

ii) Favorable measures announced by the SEC: Encouragement of American investors to invest

in Chinese firms equity, Submission of only two years audited earnings instead of three

iii) Limits: recent lackluster performance of U.S. markets, and there's a mixed reception of

Shandong issuances

BENEFITS OF BEING LISTED IN U.S.

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1) It's one of the largest and more efficient market in the world for trading stocks, The

regulatory environment: securities laws and regulations, regulatory oversight and

enforcement by the SEC, and "monitoring by gatekeepers such as analysts and institutional

investors"

2) Better Governance: to prevent controlling shareholders to extract private benefits from the

corporation

3) Ability to raise more funds internationally in the future and at lower cost

4) Existence of highly liquid secondary market for company shares

5) Attraction of a listing premium: often, benefits of being listed in NYSE offset listing costs

THE MOST SUITABLE ADR: LEVEL III

1) ADRs (American Depositary Receipts) are negotiable certificates that indirectly represent

ownership of shares the overseas company for American investors. They facilitate the

purchase and sale of foreign firms.

2) What choice to make:

a. Level I, Level II: not suitable for capital raising

b. Level III: it concerns foreign companies that wish to be listed in major U.S. Stock

Exchanges. But it is demanding much disclosure and accounting requirements

c. Rule 144A: it concerns foreign companies that wish to raise equity through Private

U.S. Placement. It is cheaper, simpler and demanding less disclosure and accounting

requirements than the ADRs level III

3) Nevertheless, the SEC revised GAAP requirements downward

Question No. 3

What is the right cost of capital for the various Equity options? Measure and explain the cost of

capital for each equity option.

The equity options available with HPI are as follows:

· Raising equity in Chinese markets

· Listing and raising equity in USA markets (NYSE)

· Listing and raising equity on the Hong Kong stock exchange (HKSE)

· Listing and raising equity in UK (LSE) 9

The right cost of capital for the above equity options shall be the Weighted Average Cost of Capital

(WACC) in each of these markets:

· The cost of debt shall be same in all the above markets, since debt component is fixed for

the company.

· The cost of equity shall depend on the market where the shares are issued and listed, since

the company's stock price will fluctuate in that particular market and will bear a systematic

risk with respect to that market.

· The company's asset will have different betas (a measure of systematic risk) for different

markets. Thus, the stock will behave in a different manner on NYSE than on HKSE and so

both will have different measures of their beta.

The WACC is calculated as per the following formula:

WACC = [Ke x (E/V)] +[ Kd x (D/V) x (1 tax rate)]

Where,

Ke = cost of equity

Kd= cost of debt

E = Equity Value ; D = Debt Value

V = E + D

E/V = proportion of equity in the capital

D/V = proportion of debt in the capital

Thus, we need to calculate the Cost of Equity Ke for HPI in each market, by using the CAPM formula:

Ke = Rf + ßL (Rm Rf), where

Rf = risk free rate

Rm-Rf = market risk premium

ßL= Levered Beta for HPI

The information available with regards to HPI is as follows:

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Cost of Debt (interest) 8%

Effective Corporate Tax Rate 9%

Equity Finance $ 612995

Debt Finance $ 533433

E/V 0.5347

D/V 0.4653

D/E Ratio 0.87

The WACC in each market is calculated as below:

1) Chinese market

In the Chinese market, the allowed rate was 15% on equity financed net fixed assets, and so the cost

of equity is taken as 15%.

Ke 15%

Kd 8%

WACC (15%*.53)+(8%*.47)(1-.09) 11.37%

2) The American market

The beta given of the electric power generating industry in the US is first unlevered using the

formula :

ßU = ßL/ [1 + (1-tax rate)(D/E)]

and then the levered beta for HPI is re-calculated using its debt-equity ratio of 0.87. Doing so, we get

the levered beta for HPI in the U.S. market as 0.49.

U.S. Govt. LT Bond Yield - Risk Free rate 8.09%

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 of above 0.3218

11

D/E ratio of HPI 0.87

Levered Beta (ßL) of HPI 0.49

Ke = Rf + ß(Rm - Rf) 10.41%

WACC 8.94%

3) Hong Kong

For the Hong Kong market, the risk free rate used is the 1 year Exchange Funds Bills and Notes as of

3rd October, 1994, published by the Hong Kong Monetary Authority.

The beta average of 1994 for two major electricity players in Hong Kong, namely, China Light and

Power Company, and Hong Kong Electric Holdings Limited is used as a proxy of the levered beta for

HPI in the Hong Kong market.

Hong Kong Hang Seng Index Market Premium 1969-1993 ( Rm - Rf) 13.05%

Exchange Funds Bills and Notes Hong Kong 1 year 1994 (Rf) 5.89%

Beta of Electrical Power Hong Kong 0.87

Ke =Rf + ß ( Rm - Rf) 17.24%

WACC 12.61%

4) London Stock Exchange

The risk free rate used is the UK I year government liability bonds, as of 3rd October, 1994. The

market risk premium is the historic returns on the LSE, as per the report by Bank of England.

The beta for HPI on LSE is assumed to be same as that in the US markets.

UK Govt. 1 year liability 1994 8.40%

LSE Market Risk Premium 5.28%

Beta of HPI on LSE 0.49

12

Ke = Rf + ß ( Rm - Rf) 10.99%

WACC 9.25%

Thus, the cost of capital for each equity option is as follows:

China US Hong Kong UK

Ke 15% 10.41% 17.24% 10.99%

WACC 11.37% 8.94% 12.61% 9.25%

Thus, we see that lowest cost of capital is possible only at the equity markets in the USA, whereas

Hong Kong has the highest cost of equity and capital. So, US markets should be the destination for

making the new issue of equity.

Question 4:

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?

The price at which the issue should of shares should be made must be devised carefully after

analysing all possible means of arriving at the fair price for the company's shares. The three possible

ways of estimating the fair value are:

· Discounted Cash Flows of the free cash flows of the firm.

· P/E Comparable with PRC based companies going for recent IPOs in international markets

· Trading Multiples, viz. P/E ratio and Price/Book Value of International Power Generating

Groups.

1) Discounted Cash Flows

· The EBIT and depreciation figures for half-year 1994 have been doubled to reflect the figures

for the entire year.

13

· The discount rate is the cost of capital (WACC) arrived at in Q3 for the US markets, i.e. 9%.

· The forecasts provided in Exhibit 12 have been used.

· Taxes have been taken at the forecast level. However, post 1999, it is assumed that long-

term effective tax rate of 17.37% will be in force when temporary tax holidays now received

will expire.

· The perpetual growth rate is taken at a conservative level of 4%, much below the GDP

growth rate of China.

· It is assumed that after 1999, the capital expenditure incurred would be just enough to

offset the depreciation and maintain the existing capacity.

all figures in

thousands

1994 1995 1996 1997 1998 1999 Perpetuation

(doubled for full

year)

EBIT 1,07,042 1,62,599 1,86,751 2,48,589 3,34,753 4,62,657 481163.28

Depreciation 76,428 76,429 1,12,562 1,91,829 2,62,495 2,82,295

Capital Expenditures 2,25,000 6,28,000 9,05,000 9,12,000 5,35,000 3,44,000

Operating Cash - - -

Flows -41,530 3,88,972 6,05,687 4,71,582 62,248 4,00,952 481163.28

Less: Taxes 2,918 14,305 20,835 29,175 20,120 25,316 83578.06

- - -

Free Cash Flows -44,448 4,03,277 6,26,522 5,00,757 42,128 3,75,636 397585.22

Year of Discount 1 2 3 4 5 6

Discount rate (9%) 0.917431 0.84168 0.772183 0.708425 0.649931 0.596267

Discounted Cash

Flows -40778 -339430 -483790 -354749 27380.31 223979.5

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PV of Free Cash Flows -967387

Discounted Perpetuity 4930995

Total Enterprise Value 3963608

Less: Net Debt 533433

Equity Value 3430175

Price/ADR 27.4414

2) P/E Comparable with recent PRC based company IPOs

Another method adopted is to estimate the mean and median P/E Ratio of recent IPOs by PRC

companies in foreign markets, and taking that multiple as the proxy for estimating the fair value of

shares of HPI. For this purpose, we have eliminated IPOs where offer size was too low compared to

that 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

Median 13.5

Mean 13.35714

Value of HPI shares:

EPS/ADR $ 1.45

Median 19.575

Mean 19.367857

15

3) P/E and P/BV multiples compared to International Power Generating Groups

Comparable with International PE Ratio Price to Book Ratio

Power Generating Groups

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

Median 14.1 2.24

Mean 14.86 1.964

HPI Valuation As per P/E As per P/BV

EPS/ADR 1.45

Book value/ADR 9.67

Median 20.445 21.6608

Mean 21.547 18.99188

We have also already discussed the key strengths of HPI arising from its being the largest power firm

in PRC, its ambitious growth plans, the attractive Chinese economy, the Government support and

various other privileges it enjoys, that put it in a position so as to command a premium over what

Shandong Huaneng Power is trading at.

The lowest price estimate we get from the above is $ 19.4 per ADR and the highest we get is $ 27.44

per ADR (as per the DCF model). Thus, we can safely fix the price to be at $ 24 per ADR so as to

attract the foreign investors into value buying. The company is in a position to command better

prices than other comparable firms because of its market power and unique position, while the said

price of $ 24 is also below the real intrinsic value of the shares at $ 27.44.

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This price would ensure that the potential investors take note of the company and are happily willing

to pocket in the benefit to the tune of $ 3.44 per ADR. Thus, such a pricing should create a win-win

situation for both the company as well as the investors.

Question 5

What implementation strategy would you suggest? Present your recommendation on whether,

how and why HUANENG should have proceeded with the issue.

Huaneng needs $ 4.5 billion to finance its development plans, from which $700 - $860 million is

being raised in form of equity offerings, which is 15.5%-19% of the total amount.

In order to achieve the figure of $4.5 billion the best option for Huaneng would be to raise debt

instead of equity. Debt is available at low rates and a n optimum level of debt will maximize the

company's value by the way of tax shield.

Huaneng is exploring international markets to raise funds primarily because of two reasons.

· Internal sources were unable to fulfil the debt requirements.

· Domestic stock exchanges were still in the nascent stage and hence were incapable of

raising adequate amount of liquidity.

Missing out on expansion plans because of lack of capital would mean lose of great opportunity

which can hamper the future growth of Huaneng power limited. So Huaneng should definitely foray

into international markets to raise funds required for its expansion plans.

The cost of capital for each equity option available to Huaneng is as follows.

China US Hong Kong UK

Ke 15% 10.41% 17.24% 10.99%

17

WACC 11.37% 8.94% 12.61% 9.25%

Thus, we see that lowest cost of capital is possible only at the equity markets in the USA, whereas

Hong Kong has the highest cost of equity and capital. So, US markets should be the destination for

making the new issue of equity.

Huaneng can raise adequate funds from Issuing ADRs in US market which will also provide

international exposure and wider access to more institutional investors. Huaneng should look at a

level 2 listing which will allow it to get registered on major US stock exchanges like NYSE & NASDAQ.

Level 1 won't be able to fulfill the requirements as Huaneng is not a known name worldwide. Private

placements to only institutional investors wont be able to fulfill the entire capital requirements and

level 2 again requires only partial reconciliation of financial; statements as per GAAP.

A level 2 ADR listing will augment Huaneng's image in USA market and will broaden the investor's

outlook, increasing the demand for the stock. Level 2 listing will also pave the way for future US

listing and capital formation. This seems like a decent strategy and will serve the purpose of

Huaneng.

The procedure for ADR Level 2 issuing is as follows:

1) Hire an Underwriter (an investment bank) and negotiate the terms and capital raising

details and get the depository agreement signed..

2) Hire other advisors who are specialists in the field of American Chinese corporate law and

security law and consulting companies specialized in ADR listing and issuing procedures and

18

requirements. Huaneng needs also to hire auditors and certified accountants to help with

Huaneng financial statements partial reconciliation with GAAP (required for ADR Level 2).

3) Assisted by underwriter, Huaneng has to complete and file with US Securities and Exchange

Commission (SEC) the registration statement form F-6.

4) Apply to list on exchange after waiting about 20 days named "cooling off period", time in

which Huaneng will have to distribute "Preliminary Prospectus" or " red herrings" to

potential clients. This will outline all the material facts about the company. In the same time

the underwriter will travel with company management to give presentations to people in

the brokerage industry; in this way they will get indication on the interest of potential

investors.

5) After the "cooling off period, comply with SEC deficiency memorandum requirements.

6) Price meeting during which price and the volume of offering is established as well as

underwriter's commission and commitment, and the over-allotment options. Huaneng

should try to achieve a Firm-commitment agreement with its underwriter through which the

underwriter agrees to purchase the whole issue from the firm at a given price and than

resale it to the public. This will safeguard Huaneng' from under subscription risks.

7) Finally file the final prospectus with SEC.

Question 6.

As the investment banker of the institutional investor, would you have recommended to buy stock

in this company at all? At what price? Why?

19

I would definitely recommend investing in Huaneng stocks to the institutional investors. The

rationale for the same can be summed as under:

· Poised to grow: HPI is all set to grow as a leading supplier of power to mainland china. This

company was a spinoff of HPIDC, which is a well known name in the power industry.

· Risk Management: From a risk management perspective, ADR provide a mean to invest

overseas in order to diversify the portfolio without the inconveniences of foreign currency

and lack of information published. HPI shares are recommended to American investors in

order to diversify portfolios. There is low correlation between U.S. market and Chinese

market at that time. According to the Kutan and Zhou's paper (2006), using data from 16

April 1998 through 30 September 2004, no negative correlation between host U.S. market

returns and those of the ADR was found. However, U.S. market volatility has no significant

impact on the conditional volatility of Chinese ADRs. These results suggest that the Chinese

ADRs offer significant diversification benefits to US investors.

· Diversification: Another advantage of adding HPI ADRs to the investor's portfolio is holding

stocks from an emerging market with high potential and opportunity of growth will diversify

the portfolio.

· Economy: China is fast growing and developed economy and investing in china will not only

diversify the risk buy also yield positive results.

At What Price - An American Investor would compare the price of ADR with the stock prices of

similar industries in US. Additionally he would like to make an risk premium on the ADR for the

currency devaluation exposure, the unfamiliar business practices in china, the lack of transparency

and the weak investors' protection law and possible corporate governance problem. We are

assuming that he would like to purchase the ADR at 10 % discount rate.

Comparable with International PE Ratio Price to Book Ratio

Power Generating Groups

20

U.S. Independent Power Products 14.1 2.47

EPS/ADR 1.45

Price = 14.1* 1.45

= 20.44

Additional discount = 20.44* 10%

= 18.4

I as a Banker would recommend the Institutional investor to buy the ADR at 18.4.

Question 7

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?

PRC was a completely state run economy and centrally planned economy before it decided to open

up its gate for free market reforms .China's communist party (CCP) did surrender to demands of

opening up to the global economy. The CCP had great pressure both from Internal and external

business houses to bring about the change in its reforms and make it more liberal. China began its

economic reforms and open-door policy in December 1978. The aim of China's macro-economic

policy is to maintain a steady economic growth, to avoid big economic fluctuation and to enhance

the people's living standards. The economic growth rate reached 10.2% in 1995 and 9.7% in 1996.

The Chinese economic system was on its way from a centrally planning system to a market oriented

one.

Steps the Government should take to make it easier for Chinese firms to raise capital:

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As China continues its economic transition, perhaps the biggest challenge for the government will be

to move away from direct interventions in product and financial markets towards providing the

institutional and policy frameworks which help markets work efficiently. Within this shift of

governance "philosophy", structural reform will be the key to further economic progress.

The key areas for structural reform are as below:

1. Streamlining the SOEs & recuperating corporate governance

SOEs accumulated large savings because of poor self governance by the government, private

enterprises, especially the SMEs, have done the same because poor financial intermediation

has limited their access to bank credit. In the early 2000s, China needs to initiate a bank

reform program cleaning up nonperforming loans, recapitalizing banks, and opening the

sector to foreign participation and competition.

2. Recapitalizing the financial sector

Government needs to recapitalize the financial sector by providing them adequate capital at

cheap costs. Government should provide additional tax benefits to corporates and other

incentives for companies who pull in funds from international markets.

3. Liberalising the capital markets.

Government should work towards better financial intermediation. Authorities should push

for further improvements in the banks' commercial operations, internal controls, and

governance. They should also lift the cap on deposit rates, which would not only help push

up the cost of capital but also allow smaller and more aggressive banks to compete better

against large state-owned banks and provide an incentive for big banks to expand credit to

small and medium-scale enterprises. Continued government control over bond and equity

issuance is a again a serious impediment to these markets.

4. Relaxed rules for currency exchange and investment abroad for increased capital flows.

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The government should liberalize China's tightly controlled and much criticized foreign

exchange regime, which will make it easier for companies and individuals to buy foreign

currency and invest in overseas capital markets. Also allowing the companies to diversify

their risks and get better returns.

5. Accounting Standards to allow for simpler and faster transactions

The Chinese system of accounting is widely considered to be unsuitable for managing

corporations in a market economy. As a result, Chinese corporations are gradually moving

toward International Financial Reporting Standards. This has proven to be a massive

undertaking. One consequence of this system is that Chinese companies who offer shares

for sale in the United States must prepare three sets of statements, one using Chinese

accounting standards, one using international standards, and one using North American

GAAP standards. So china

Should work towards modernize and standardized their accounting standards.