HSBC’s Acquisition of KEB
Finance 663: International Finance
Professor Campbell R. Harvey
February 9, 2016
Prepared by:
Alok Chakraborty
Chris Donghui Lee
Arindam Mandal
Harsh Singh
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
Solution:
We used the cost of capital worksheet prepared by Professor Harvey to find out the approximate cost of equity
(Exhibit 12). Anticipating the adjustments on cost of equity based on the associated risks, we did a sensitivity
analysis around cost of equity, and return on equity in a stable state while valuating KEB share price using
abnormal earnings method. Additionally, we did a relative valuation, as well as a valuation based on 5 year
volatility, P/BV, and ROE of global banks - as these three parameters intuitively move together. Lower volatility,
higher ROE should ask for higher prices – hence higher P/BV.
Valuation in August, 2007:

Abnormal Earnings Method: As Korean economy has been growing at ~ 5% (on average) in past 5
years, we used a terminal growth rate of 5%. We also assumed payout ratio to be constant at 70%
for next few years, a stable ROE of 12.5%, and cost of equity (based on Exhibit 5) in the ballpark of
11%. However we understand that there should be a sensitivity analysis on cost of equity and ROE.
Based on our base assumption the implied share price at the end of 2007 came out to be 12,769
won. Based on realistic variations of ROE and Cost of Equity the sensitivity analysis in Appendix 2
gave us a range of 9,000 to 18000 won.

Relative Valuation (Korean Banks): We looked into the Exhibit 6, and taking out KEB from that list
the average ROE, and average Beta came out to be 17.80% and 0.925. Both these values when
compared almost matched ROE (16.70%) and 5 year Beta (0.95) of KEB. Hence we assumed that
averaging the P/BV can give us a fair relative valuation of KEB, which came out to be 1.52. KEB was
trading at 1.5 of Book Value at this point of time. Hence the last day trading value (14,600 won)
seemed to be reflecting the correct relative pricing.

Valuation using Price to LTM Book Value, 5 Year Beta, and ROE of Global Banks: Here we looked
into global banks and established a relationship based on P/BV, 5 Year Beta, and ROE (Exhibit 8).
Even though the number of data points were quite less, the equation we derived based on the
regression (Appendix 3) was quite intuitive in terms of signs (i.e. lower beta, higher ROE should be
priced higher). Lesser number of samples meant that the regression statistics does not add much
value, but based on the equation implied P/BV came out to be 1.642. Hence implied share price
came out to be ~16,000 won.
Valuation in August 2008:
For 2008, we understood that Global banks (apart from US banks) were not affected and Korean
markets were much unaffected by August 2008. Hence doing a relative valuation based on P/BV, ROE,
and Volatility will not give us the real value – as it will not incorporate the imminent major changes in
foreseeable future.
Thus we wanted to incorporate our expectations in the Abnormal Earnings model. To do this we
assumed that the ROE in 2008 will be 10%, and will further decline to 8% in 2009. 2010 onwards we
assumed an upward trend in ROE and finally reach a stable ROE in 2014 of 12.5% (Appendix 4). The
implied share price based on these base assumptions came out to be 10.907 won. And based on our
2
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
sensitivity analysis on ROE and Cost of Equity it came to be in a range of ~8,000 to ~13,000 won
(Appendix 5).
Recommendation:
Based on our analysis on valuation, it seems that the bid should be down by at a range of 20-30% from
the earlier bid of 18,045 won. But to get into a huge potent market such as Korea this premium can be
paid. But when we looked into the liquidity situation of HSBC where they decided to raise $17.7 billion
of equity in the hope of strengthening their capital ratios by 150 basis points, it was a red flag for us.
Moreover, Exhibit 12 shows us the possibility of getting this deal successful is 13% because of the
ongoing litigation issues with Lone Star. Thus it will not make much sense to hold up liquidity
anticipating a deal which has just 13% possibility. In fact, looking at the probability diagram, we raised a
more fundamental question – Should even HSBC bid for this deal in August, 2007. May be, HSBC was too
aggressive to get into this market and none of the banks were up for sale at that time. But standing in
August 2008, we do not recommend HSBC to go ahead.
Key Takeaways:
This case illustrates the significance of risk assessment, and how unforeseen risks can jeopardize an
entire project being considered. Right after the HSBC’s bid, research house CLSA commented early 10
per cent probability of the deal to through given the landscape of the industry. HSBC might have
underestimated the controversial legal disputes which Lone Star was trapped in and corresponding
uncertainty of regulatory approval. If legal and regulatory uncertainties delayed the implementation of
the deal, the fundamental reason which forced HSBC to pull off from KEB was its own illiquidity crunch
amid the global financial crisis. As can be seen through the case, a plausible deal can turn out to be de
quite risky bet under extreme macroeconomic environment.
What actually happened?
 Lone Star is facing tax evasion charges, and if it loses the case, KRW 352B worth of tax could be levied
upon the fund.
 KEB Credit Services lawsuit was filed initially in October 2005. First ruling by district court found Lone
Star guilty of stock price manipulation. After appeal of Lone Star, the case went up to high court where
the ruling was overturned. Prosecutor appealed, and the case moved up to the Supreme Court. Supreme
Court sent back the case to the high court for further review of the case in March 2011, indicating that
Lone Star should be found guilty. In October 2011, high court finally ruled against Lone Star; the Korean
representative of Lone Star was sentenced to three years in prison, and Lone Star was sentenced to the
fine of KRW 25B for the violation of Security and Trading Act. Immediately after the court ruling, Lone
Star lost its status as major shareholder of KEB and was ordered to sell 41.02% of its stake in KEB.
 Legal issues put Lone Star in an extremely difficult position to sell off KEB. However, in spite of its 8 year
lock-up with KEB, Lone Star was still able to collect more than its initial investment in KEB (KRW 2,155B)
merely through dividend income (KRW 1,710B) and sales of equities held by KEB (KRW 1,193). By selling
KEB to Hana Financial Group, Lone Star received KRW 3,916B sales proceeds. The fund realized 12.2%
CAGR, and 216.4% return on investment over 8 years, solely through KEB.
3
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
Appendix 1:
Abnorm al Earnings Model (All figures in Millions)
2002
Net Incom e
53,045.00
ROE
2003
(868,577.00)
2004
526,635.00
2005
1,933,891.00
2006
1,006,414.00
2007
800,505.75
2008
840,531.04
2009/TV
882,557.59
1.51%
-58.71%
19.21%
44.81%
16.66%
12.50%
12.50%
12.50%
11%
11%
11%
11%
11%
11%
11%
11%
Cost of Equity
Book Value(t-1)
Weighted Avg. Diluted Shares Out.
2,128,163.00
2,237,559.00
2,242,720.00
2,952,569.00
5,683,102.00
6,404,046.00
6,724,248.30
7,060,460.72
416.10
425.89
644.08
645.25
645.89
645.89
645.89
645.89
Dividends/Share
Payout Ratio
Excess Return
Retained Earnings
1000
744
781
820
64.2%
60%
60%
60%
96,060.69
100,863.72
1,765,115.18
320,202.30
336,212.42
353,023.04
90,868.22
1,432,607.08
PV(Beginning of 2008)
Value of Firm
8,247,723.60
Price/Share
12,769.61
Assumptions:
Korea Nominal GDP Grow th Rate
ROE
Payout Ratio in ROE
Cost of Equity
Stable ROE
5%
16.70%
70% '=1-grow th/ROE
11%
0.125 Payout ratio
60%
Appendix 2:
Cost of Equity
ROE
Im plied
Share Price
9%
10%
11%
12%
13%
14%
15%
16%
17%
9%
10,272
12,663
15,089
17,551
20,049
22,583
25,154
27,761
30,404
10%
8,420
10,312
12,232
14,180
16,156
18,161
20,195
22,257
24,348
11%
7,208
8,768
10,351
11,958
13,587
15,240
16,917
18,617
20,341
4
12%
6,361
7,685
9,028
10,391
11,774
13,176
14,598
16,040
17,502
13%
5,741
6,888
8,052
9,233
10,431
11,645
12,877
14,126
15,393
14%
5,272
6,282
7,307
8,347
9,401
10,470
11,555
12,654
13,769
15%
4,908
5,809
6,723
7,650
8,590
9,543
10,510
11,490
12,484
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
Appendix 3:
Model:
ROE-PB-BetaReg
Dependent Variable:
P_BV_LTM___Latest
Regression Statistics:
ROE-PB-BetaReg for P_BV_LTM___Latest
R - S qua re d
0.594
Sum m ary Table:
February 19, 2014 10:28 AM RegressIt Arindam Mandal ROE-PB-BetaReg
A dj.R S qr S t d.E rr.R e g.
0.459
Intercept
Beta
LTM_Return_on_Equity
Analysis of Variance:
t ( 2 .5 0 %,6 )
C o nf . le v e l
1
2.447
95.0%
(2 variables, n=9)
C o e f f ic ie nt
S t d.E rr.
t-Stat.
P - v a lue
Lo we r9 5 %
Uppe r9 5 %
0.824
-0.952
10.315
0.714
0.451
3.778
1.154
-2.114
2.730
0.293
0.079
0.034
-0.924
-2.055
1.070
2.572
0.150
19.560
ROE-PB-BetaReg for P_BV_LTM___Latest
Residual Distribution Statistics:
# R e s .>0
# M is s ing
9
0.404
ROE-PB-BetaReg for P_BV_LTM___Latest
V a ria ble
(2 variables, n=9)
# C ases
# R e s .<=0
(2 variables, n=9)
ROE-PB-BetaReg for P_BV_LTM___Latest
(2 variables, n=9)
A - D S t a t . M inS t dR e s M a xS t dR e s
4
5
0.363
-1.001
1.477
Anderson-Darling statistic is not significant at the 5% level (<0.787), indicating an approximately normal error distribution.
See the residual histogram for more details.
5
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
Appendix 4:
Abnorm al Earnings Model (All figures in Millions)
2002
Net Incom e
53,045.00
ROE
Cost of Equity
Book Value(t-1)
Weighted Avg. Diluted Shares Out.
1.51%
11%
2003
(868,577.00)
2004
526,635.00
-58.71%
19.21%
11%
11%
2005
2006
1,933,891.00 1,006,414.00
44.81%
11%
16.66%
11%
2007
800,505.75
2008
667,091.30
2009
555,019.96
2010
644,378.18
2011
667,575.79
2012
768,453.91
2013
839,151.67
TV
2014
867,218.69
12.50%
10.00%
8.00%
9.00%
9.00%
10.00%
10.50%
12.50%
11%
11%
11%
11%
11%
11%
11%
11%
2,128,163.00
2,237,559.00
2,242,720.00
2,952,569.00
5,683,102.00
6,404,046.00
6,670,913.00
6,937,749.52
7,159,757.50
7,417,508.77
7,684,539.09
7,991,920.65
6,937,749.52
416.10
425.89
644.08
645.25
645.89
645.89
645.89
645.89
645.89
645.89
645.89
645.89
645.89
Dividends/Share
1000
744
620
516
599
620
714
780
806
64.2%
60%
60%
60%
60%
60%
60%
60%
60%
96,060.69
(66,709.13)
(208,132.49)
(143,195.15)
(148,350.18)
(76,845.39)
(39,959.60)
320,202.30
266,836.52
222,007.98
257,751.27
267,030.32
307,381.56
335,660.67
346,887.48
(66,709.13)
(187,506.74)
(116,220.40)
(108,472.37)
(50,620.44)
(23,714.08)
927,301.05
Assum ed Grow th
Payout Ratio
Excess Return
Retained Earnings
PV(End of 2008)
Value of Firm
Price/Share
7,044,970.89
10,907.43
6
1,734,437.38
Finance 663.301
International Finance
Alok Chakraborty, Chris Donghui Lee, Arindam Mandal, Harsh Singh
Locker # 188
Appendix 5:
Cost of Equity
Im plied Share
Price(Won)
ROE
9%
10%
11%
12%
13%
14%
15%
16%
9%
10,538
12,139
13,740
15,342
16,943
18,544
20,145
21,746
10%
8,781
9,994
11,206
12,419
13,631
14,844
16,057
17,269
11%
7,557
8,515
9,472
10,429
11,386
12,343
13,300
14,257
7
12%
6,639
7,416
8,194
8,971
9,749
10,526
11,303
12,081
13%
5,911
6,556
7,201
7,846
8,491
9,136
9,781
10,425
14%
5,310
5,854
6,398
6,942
7,485
8,029
8,573
9,117
15%
4,799
5,263
5,728
6,192
6,656
7,121
7,585
8,049