By Mohamed Damilola Olajide

The wave of divestiture process, the process of transferring ownership of a state owned enterprise to the private sector (or privatization) which has been blowing across African countries represents a fundamental change in the revealed preference of these countries. However, this shift in behavior has not been matched with consistent analytical frameworks and procedures for valuation and pricing for the purpose of selling state owned enterprises generally.

In the case of Nigeria, this neglect has led to unnecessary delay in implementing the program since inception of the privatization policy in 1988.

The policy statement issued by the Technical Committee on Privatization and Commercialization (TCPC) in 1988 can be regarded as the most recent documentation of the objectives of divestiture of the Government of Nigeria. Another government agency, the Bureau of Public Enterprises (BPE) has since been established to replace the TCPC. The socioeconomic objectives of divestiture that have been mentioned on several occasions include seeking relief from fiscal and budgetary pressures; increasing efficiency in the economy; and widening the share of ownership to the welfare of the Nigerian society.

There seems to have been more concentration on the commercialization and deregulation aspects of divestiture. This is evidenced in the number of SOEs, which have been sold to date. Of the 99 SOEs, which had been listed for divestiture in Nigeria by the World Bank since 1988, only 34 had been sold, through selling Federal Government's equity holdings. Most of the privatized enterprises are financial institutions and industrial sector enterprises.

Since inception to date, divestiture program in Nigeria has largely remained a characteristic feature of annual budgetary speeches by successive governments. There appears to be a culture of incredibility of government announcements. Therefore, the resulting continuous delayed full implementation of the program may have cast a dark cloud on the realization of the stated objectives. This is in view of the recent disclosure of the chairman of BPE that the process would continue to be delayed as long as there are disagreements in some quarters on the principle and procedure for selling listed SOEs.

1.1: Fundamental issues in divestiture decision in Nigeria:

Perhaps the most controversial issue in any divestiture process/decision is that of valuation and pricing enterprises earmarked for sale. Divestiture itself is not controversial if Nigeria economy operates in a competitive market environment, or if market prices are good representation of social opportunity costs (or economic prices) in the economy. That is if there were no significant price distortions and market imperfections. There are three basic issues that the government agency in Nigeria needs to tackle in order to have an efficient and successful divestiture program. If these issues are not properly addressed in the most fundamental approach, the program will continued to be delayed. These issues include:

Procedures and standards for valuation and pricing of the enterprises earmarked for sale, particularly industrial enterprises; 
Determination of the potential implications of any divestiture decision on the welfare of Nigerian citizens; and 
Lack of information base for both the government agency and prospective buyers/investors. It is uncertain that any foreign investor would want to stake his money on a company in which he has no sufficient information.
Much have been written on the issue of divestiture in Nigeria generally in the very recent past. Several approaches had been put forward under various disciplines and different point of views such as political economy, accounting methods, and estate valuation techniques. However, these fundamental issues have not been discussed in detail or in terms of suitable analytical framework and procedures. A powerful but consistent analytical framework which hitherto has not been tested for its applicability and which has the potential for handling all the three issues to a greater extent is the modern Cost-Benefit Analysis (CBA) framework. This is not saying that CBA has all the answers to all aspects of divestiture process, but it has greater roles to play in the most controversial issues surrounding divestiture most important of which is the issues of valuation and pricing.

Recent writings in Nigeria had touched on some issues considered to be less important to the divestiture decision, or generally in a developing country context. Michael C.N. Ikedianya titled " Privatization: methodology for optimal success" published on the Post Express Wired web site in early May, 1999 appears to be the closest attempt on some relevant issue of techniques for valuation. But, the issue of how divestiture translates into the welfare of Nigerian citizens on the basis of the objectives seems to be more important. In most of these there is still the implicit assumption that market prices equal to the real economic prices in the Nigerian economy.

Therefore an objective of this article is to attempt to address the fundamental issues within the analytical framework of applied welfare economics, also known as Cost-Benefit Analysis (CBA) methodology. It considers the welfare implications of valuation and pricing when a particular enterprise is to be sold to the private sector.

2.1: A Brief review of methods and procedures and the basis for CBA framework:

The methods and procedures that had been adopted in many African cum developing countries especially Nigeria had relied on the experiences of developed countries. These methods and procedures had largely depended on the type of transaction envisaged. Methods such as public offering of shares, private sale of shares, and sale of government or assets of enterprises, to mention just a few, are merely for divestiture transaction purposes.

The problem of valuation and pricing has long been recognized. The experience of France and the United Kingdom are cases in point. Often, only very rough guidelines have been set for valuation and pricing of SOEs. This is not consistent. Pricing an SOE has always remains a difficult matter where the company being offered for sale is an industrial plant with possibility of generating externalities in its operations. This problem tends to be compounded where the shares have not been traded before or where there are no directly comparable companies. Consequently, some developing countries such as Nigeria have resorted to seeking technical assistance from international organizations on valuation and pricing. Yet other African countries rely on the experience of advanced and transition economies. In most cases, divestiture decisions have been carried out by trial and error, or as a mere experimentation in the interest of achieving successful divestiture at a fair price for the tax payers and the investors. And comparatively little emphasis has been placed on the possible externalities, the interest of the society, or the future viability of the projects earmarked for sale.

Unfortunately, the problem of valuation and pricing has remained largely because of the view accorded divestiture. There has been the narrow view that divestiture of SOEs is primarily a financial transaction. In other words, this is assuming that divestiture is an end in itself. But where goals and objectives are clearly stated a priori, divestiture does not seem to be an end, but a means to achieve an end; which in most cases, as in the case of Nigeria, include the improvement in the welfare of the Nigerian society. If SOEs are profitable or viable financially and economically, or if the objectives is being realized with their existence, there tends to be little basis for wishing to dispose them via privatization/divestiture, except for political or other reasons.

Thus over-concentration on the transaction mechanisms has reduced valuation and pricing to a mere experimentation in the interest of achieving divestiture at any price for the tax payers and the investors. Methods and procedures such as public offering of shares, private sales, management and employee buy-outs, and seeking strategic foreign investors, to mention just a few, are based on the type of transaction envisaged. They may or may not be influenced by the approach adopted for valuation and pricing. However, if valuation and pricing are carried out consistently, it may also signal to the best mechanism to be adopted for transaction.

In the Nigerian case, to the extent that the main objectives of divestiture include increasing efficiency and widening the share of ownership to the welfare of the whole economy, valuation and pricing, and decision making regarding divestiture should be carried out from the point of view of the society whose improved welfare it sought to achieve. Thus, the expected change in social welfare from a decision to sell an enterprise will largely be influenced by the adopted approach to the valuation and pricing of the enterprise.

The practice that concentrates largely on mere valuation of assets and liabilities of an object to be privatized necessarily limits divestiture decisions to the financial interests of the parties. The approach is not sufficient. Although it may capture the financial values of the enterprise to potential buyers (as an asset), but the interest of the society, (the only economic element in divestiture), tends to be ignored.

Thus, the issue of valuation and pricing for the purpose of selling or transfer of ownership of an enterprise from the public to private needs a flexible but comprehensive approach, which can be tested according to a countrys objectives of divestiture. It should be based on both financial and economic analyses, while externalities, the country investment risk profile, and the dynamics of an enterprise need to be properly weighted.

Given that the Nigerian economy seeks relief from budgetary pressures, both the financial and the socioeconomic effects of divestiture tend to be significant. Generally, the effect of divestiture decision on a government's finances may be incidental to the program's main purposes. Given this assumption, the potential application of Cost-Benefit Analysis (CBA), where gains and losses are measured in the applied welfare economics tradition cannot be overemphasized. Inherent in Nigeria is some problems, which make the CBA approach more appealing for valuation and pricing for the purpose of selling SOEs than previous approaches. First, the capital market in Nigeria is largely segmented from the world capital markets. It is still in the developing stage, especially the stock markets; so that there may information gaps, which make pure market valuation tends to be an imperfect approach, and often result in artificial manipulations. Secondly, previous approaches assume zero price distortions in the economy; so that, market prices necessarily reflect real or social values. The prices at which the SOEs are being offered for sale, or the prices which investors buy and sell are financial market prices. These prices are distorted significantly. Price distortions are not of concern to the investor. Thus there is need to correct for the significant price distortions.

Thirdly, the issue of profitability of an SOE has been confined only to the maximization of profits or returns on investments; other things are not necessarily relevant to the investor or the prospective buyers. However, there is much more to the concept of profitability than mere financial returns. There is need to redefine profitability more broadly to include economic profitability under private ownership. Economic profitability thus looks at other priorities in divestiture decision such as the value added, synergies, externalities, etc. These other priorities seem to have been overlooked. In addition, there has been the tendency to use present prices as the base for future projection. This practice tends to give wrong values in real terms, either in costs or revenue; hence wrong value for SOEs to be sold. In this case, there is need to consider future cash flows of enterprises in constant prices.

Moreover, inadequate attention has been given to the social aspects or the welfare foundations of divestiture decisions. The social aspects include a project's contribution to the welfare of the society. Ironically, it is not uncommon to find, among the objectives of divestiture, a desire to increase efficiency and welfare of society. A project to be sold will translate into people's lives, not merely through its outputs, but also through its value added or its multiplier effects. In this case, a government's continuous 'hidden' subsidy on or protection of the project after the sale or under private ownership can be argued for even where the projects does not seem to be profitable economically. Therefore, it is only sufficient to determine the basis for such argument during valuation. Such decision might be based on the project's value added in terms of employment effects and net foreign exchange effects, among others including externalities.

The problem of hyperinflation may also pose difficulties in the divestiture decision in Nigeria, and in African countries generally. When inflation rate is high, say 45%; the value of assets tends to increase significantly. However, the rate of controlling inflation in the economy may be lower than this rate, say 10% or it may be getting lower. If we compared these rates together during valuation, it is only obvious that the project under valuation will be liquidated. On the other hand, if inflation proceeded uniformly, relative prices would not be a poor measure of real costs and benefits or revenues. But for institutional and political reasons, this has not always been the case. In some cases government had often resorted to price controls.

Finally, an appropriate valuation and pricing mechanism should take into consideration the issue of time. A project earmarked for divestiture should be enhanced by time; for the expected life of the project after divestiture, and not at a point in time.

In view of these problems among others, the issue of valuation and pricing purposes needs a flexible approach, which can be tested empirically according to a countrys objectives of divestiture. This test would be carried out in terms of both the financial analysis and socioeconomic analysis including externalities, and the dynamics of a project. Therefore sufficient flexibility in analyzing such decision tends to result in a more accurate estimates of a projects welfare impact; a broad information base for divestiture decision-making process, (available to both sellers and buyers); better capturing the variety of different factors or determinants that can affect the future performance of a company; and permit the determination and comparison of both financial and economic values and prices that correspond realistically to the level of interests in the private sector.

More broadly, focusing on valuation and pricing will shed some light on the following basic divestiture questions:

Should the enterprise be sold? as an asset or as a going concern? 
At what price(s) should it be sold? 
Should the government hidden subsidy or continued government intervention in the enterprises? 
What is the most efficient transaction mechanism?
3.1: The Methodology of Cost-Benefit Analysis (CBA):

Cost-Benefit Analysis is based on Jules Dupuit's (1844) concept of Consumers Surplus (CS) in a study entitled "On the Measurement of the Utility of Public Works". CBA has been developed extensively in the USA since 1930s. It was first used in planning water-related projects, especially under the Congressional Mandate of 1936.

The Cost-Benefit Analysis (CBA) methodology identifies and evaluates Net Benefits (NB) (i.e. Benefits minus Costs), associated with alternatives for achieving the objectives of a given project (here a given SOE). In its policy context, CBA can be considered as any analytical framework that enumerates the advantages (benefits) and disadvantages (costs) of alternative decision/ action. It is a pragmatic realization of the theory of welfare economics, which provides specific analytical framework and a set of procedures to summarize information and show the tradeoffs associated with these actions, generally in monetary terms

In strict economic terms, CBA judge actions based on the objective of efficiency of resources allocation. In this case, positive Net Benefits imply the prospects for an improvement in resources allocation. Economic efficiency requires that resources be allocated to their next highest productive uses or values. In a marketoriented economy, individuals are considered to be their own best judges of the values derived from the goods and services being provided. This is the idea of the principle of consumer sovereignty.

3.2: Financial- versus Economic Analysis:

In modern CBA, distinction is often made between financial analysis and economic analysis. In estimating costs and benefits, the basic criterion is the Present Value (PV) in which all items are discounted to the present. In its applicability to divestiture decisions, financial analysis is often made from the point of view of the individuals making investment or potential buyers of an enterprise, using the Discounted Cash Flow (DCF) approach. It has to determine whether it is attractive to invest in the project compared to other projects. The financial analysis can be used to derive the various financial values of an enterprise. Such financial values include the shareholders value, the residual value, the corporate value, and the value of equity.

The economic analysis, on the other hand, follows from the perspective of the society or national economy as a whole. It forms the basis of CBA. It is sometimes called socioeconomic analysis. It is mainly directed at the maximization of the socioeconomic welfare of a society, and commonly based on the value added of a project to a society's development.

An important methodology of economic analysis is Shadow Pricing (sometimes called accounting prices). In which case, significant items of direct and indirect costs and benefits are adjusted to their economic or real, social values. This is based on the premise that market prices of inputs and output tend to differ significantly from their social values, due mainly to the presence of externalities and price distortions in the economy. In Nigeria and in a developing country context, the presence of monopolies, subsidies, tariffs, and other forms of taxes necessarily induce price distortions in the economy. Therefore, shadow pricing is essential to guiding the direction of policy change. Thus, as these items are valued in terms of their social opportunity costs, price-distorting items such as taxes and subsidies are disregarded. It should be noted, however, that estimation of shadow prices does not imply that prices are being set in strict sense of the term, they are proxy prices, which are approximations of real (social) prices that would prevail in the absence of market imperfections or price distortions.

Several criteria can be used in a CBA framework. It depends on the problem at hand, the objectives, and the specific circumstances surrounding the project being valued. Criteria that can be used to select or rank projects, include (among others) the NPV, the Economic Rate of Return (ERR), the Benefit-Cost Ratio (BCR), the value added criterion, the various efficiency tests, and others as may be specified by the analyst. These criteria are used in comparable way, but they tend to represent different quantities, which are based on distinct estimations.

Moreover, in modern CBA, the results are not necessarily confined to 'yes' or 'no' decision. Sometimes, CBA criteria may indicate negative results. By definition, a negative result implies that the project is not viable economically. In practice however, a negative result might not automatically imply that such a project is rejected outright. Such results would have provided information such as identifying some bottlenecks or built-in problems within the project, which might have necessitated the result or which would indicate potential problems with the implementation of the project. In some cases, a government agency may have reasons other than the result of a CBA study for supporting an unprofitable project or enterprise. In this way, the decision-makers can take their decision in full awareness of the magnitude of the financial and economic burden, which the project or enterprise causes.

In a nutshell, the main differences between the financial - and economic analyses lie in the interpretation of what has to be considered as costs and benefits, and the nature of prices used for estimation. In the financial analysis, items of direct costs (inputs) and direct benefits (outputs or revenue) are estimated at the constant market prices. Items which are not of direct market transactions such as depreciation, subsidies, and interest payments are disregarded. For the economic analysis, on the other hand, the benefits (both direct and indirect) are the incremental economic revenues in monetary terms, which result from the consumption of project outputs. This is generally measured as the consumers' willingness to pay, WTP, and is represented by the area under the social demand curve. Any point on this social demand curve represents WTP. Consumer surplus is hereby defined as the different between the total benefits and total payments. Benefits, which are not necessarily limited to monetary benefits and all contributions to the increased social welfare, are considered.

Finally, in economic analysis, intranational transactions, such as subsides, taxes are disregarded, but international transactions are regarded. Since price distortions cause goods and services to diverge from their true socioeconomic values, it implies that all goods and services are priced by means of efficiency shadow pricing to determine their true economic values.

3.2: Application to divestiture:

The role of CBA in divestiture (or privatization) decision include its capability of answering the critical divestiture questions, in determining the various financial values and sales prices of an object of divestiture, and testing the relative efficiency of a divestiture decision. Others include testing the net economic contribution of an object of divestiture to the whole economy with the aim of determining continued government intervention or taxation, and testing the financial and economic viability of the object.

No doubt previous practices that limit divestiture decisions to the financial interests of the parties may enable the financial values of the enterprise to the potential buyers to be captured. But it is not sufficient as the interests of the society, which tends to be the only economic agent of the divestiture, tends to be ignored. The view is that the government agency should be concerned with behavioral changes brought about by divestiture. In this case, the government should be concerned with the fiscal impact of the divestiture and its external affects such as the environment, employment, and foreign exchange effects.

The application of the CBA methodology involves making assumptions and explicit value judgements that include, first, that the government intends to maximize social welfare. Second, that social welfare is the sum of welfare of all the different economic actors, consumers, producers, and other individuals in the economy; and third, private enterprises are assumed to pursue their own financial interests, which is the maximization of returns on their investments, (i.e. profit). The CBA framework is applicable even in cases where government rather than being a welfare maximizer, simply responds to interest groups (stakeholders) in a way consistent with reinforcing its hold on to power. The private/financial values in the above assumption indicates privately appropriated profits that the enterprise will generate during its expected useful life, whereas social values will refer to the sum of welfare of all economic agents influenced by the divestiture decision.

The valuation procedure is broken into logical steps, which connects systematically the essential elements of the financial valuation with the economic valuation. The essence of the various steps and procedure is the preparation of what can be regarded as an Economic Profitability Statement (EPS). The EPS converts financial statement to economic statement. It shows clearly the adjustments in the financial analysis with respect to the transfers, to consideration of externalities such as environment, the shadow price valuation of material and human inputs, and output, etc. It also shows the interdependency of the valuation issues (financial and economic), and the behavioral changes that accompany divestiture.

The CBA framework consists of a set of three key variables and four parameters of the enterprise, and the national parameters that could be estimated.


Key variables of the enterprise:
(i) Financial value: (represents the fair value of the enterprise) is defined as the present discounted value of the stream of expected Net Cash Flow, å PV (NCF) from the point of view of new owners. Where NCF = GOP (T + D K). It is equivalent to the fair value of the shares. GOP is the expected or projected Gross Operation Profit for the expected life of the enterprise after sale. T is taxes, and D K represents the expected change or increase in investment.

(ii) Economic value of the enterprise: can be defined as the present discounted value of the stream of Net Benefits å PV(NB) accruing to the new owners from the socioeconomic or national economy point of view.

(iii) Economic value under continued government intervention: is the net contribution of the enterprise to the national economy. This is based on the present discounted Net National Valued Added (NNVA) i.e. PV (å NNVA).

2.) The parameters to be estimated:

(i) WACC: - Weight Average Cost of Capital. It is the discount rate applied to the stream of net cash flows, NCF, to reflect the opportunity cost to the providers of capital by their relative contribution to the investment risk borne by each enterprise. It is useful in that it adjusts for systematic risk borne by each provider of capital, since each investor expects a return that compensates for the risk undertaken. It is normally made up of observed market value weight of the publicly traded enterprise in a comparable company in the industry. It is equivalent to the opportunity of capital in similar enterprise in the private sector. It represents the cut-off rate below which the enterprise may be judged financially unprofitable.

(ii) IRR: Internal Rate Return indicates the actual profit rate of the total investment outlay. It is the rate at which the Net Present Value of the stream of yearly Net Benefits is Zero. (NPV = 0). It equates the PV of cash inflows to cash outflows, so that PV (NCF) = 0. In relation to the WACC, it is required that IRR is at least equal to WACC (IRR 3 WACC) for the enterprise to be judged financial viable.

(iii) SDR: the Social Discount Rate: is the social opportunity capital invested in the enterprise. It is the rate at which the value placed by the society on future benefits and costs declines overtime. The long-term interest rate on US dollars is often used as a base for estimation, and adjusted for the prevailing financial and economic conditions of the country carrying out privatization/divestiture (here Nigeria) as a capital borrower. Thus an estimated risk premium is added to the international interest rate.

(iv)ERR:- Economic Rate of Return. It represents the opportunity cost of government revenue. In relation to the SDR, it is required that ERR is at least equal to the SDR (ERR 3 SDR) for the project to be judged economically viable. ERR = SDR is usually assumed in the literature.


National parameters: In most cases National parameters are already estimated by the relevant
government ministries such as the Ministry of National Planning. But they may have to be re-estimated by the analyst where the need arises. These include

(i) SER: Shadow Exchange Rate can be derived by adjust the foreign exchange rate to reflect the changes in demand and supply of foreign exchange. The rationale for this approach is that in developing countries such as Nigeria had been having balance of payment deficits. Thus there has been a larger demand for foreign exchange, which would induce higher foreign exchange rate relatively. Unofficial market rate can be used as a second best alternative.

(ii) SWR: Sometimes only unskilled workers are considered and based on the Marginal Productivity of Labor in the sector.

 

The relationship(s) which will be derived between the variables and the parameters will define the four set of sale prices for the enterprise:

The minimum price acceptable to the government (as a going concern); 
The maximum that the buyer will be willing to pay, WTP, (as an asset); 
The actual price at which sale will be executed ( the settled price); 
The magnitude of government 'hidden' subsidy;
A systematic quantitative description of existing conditions is central to the analysis. This would be accomplished by converting from the private logic of financial statements (profit and loss statement, and Balance sheet) to the economic or public logic of national welfare (or income). The conversion would be accomplished by shadow pricing of significant items of costs (inputs) and benefits (outputs) both direct and indirect. The essence of this conversion is the preparation of Economic Profitability Statement, which converts items of financial analysis to economic (social) analysis. Next, would be to continue with the derived relationships, general formulas and expressions with the specific data of the case company in order to generate the explicit value(s) that answer the basic divestiture questions. Finally, the implications would then be summarized in a Sensitivity Analysis.

4.1: Establishing relevant relationships and analytical tools among defined variables and parameters:

The valuation procedure would consist of both financial valuation and economic valuation.

(i.) Financial valuation: - is made from two points of view: as a going concern and as an asset. All assets and liabilities possessed by the enterprises are valued at constant prices. The value as a going concern is the fair value or financial value of the company. It should be noted, however, that this does not indicate the profitability of the enterprise. The Profitability criterion is that Net Present Value should be positive, NPV 3 0. This can be obtained by equating financial value, PV (NCF) to the total investment costs. That is PV (NCF) = Investment cost (K), so that PV (NCF) - Investment cost (K), = NPV = 0. Thus, If NPV was positive, then profitability is equal to the cut-of- rate. A negative NPV implies that enterprise is not financially viable.

An enterprise may be financially profitable implying a positive NPV, but this is not sufficient since it does not show the exact profitability rate. As mentioned in section 3.2, the exact profitability rate or rate of return on capital of the enterprise requires that the estimated IRR 3 WACC. Since at IRR, NPV = 0, therefore it is sufficient that the higher the IRR, the higher will be the returns in the project, so that IRR should be at least equal to the weighted opportunity cost of capital, WACC.

On the other hand, if the value of assets were greater than the value as a going concern, this suggests a liquidation of the enterprise. This signals that the assets of the enterprise should be sold, which tends to raise additional problem of valuation of the assets.. But if the objective of the enterprise has not been for profit maximization, then its contribution to the economy would have to be tested. We come to this later on.

(ii.) Economic valuation:- The data from the financial valuation are used in economic analysis. Items of both direct and indirect cost (inputs) and outputs (benefits), including externalities are identified. Financial analysis alone is not sufficient for divestiture because it emphasis only the financial interests of an enterprise and does not show the enterprises' contribution to the welfare of the society, and because market prices by which it is carried out are significantly distorted, therefore do not represent socioeconomic prices in the economy. Thus, the issue here is to test the national (economic) profitability of the project for these reasons.

Economic value: The stream of future Net Benefits (positive or negative) are discounted at the estimated SDR to obtained PV (NB). This represents the economic worth of the enterprise to the society. This will be compared to the investment costs, K, to obtain the NPV (NB). The PV (NB) is expected to be equal to the investment cost, so that NPV (NB) = 0. This represents the minimum cost at which the enterprise should be offered for sale. It should be noted that this value might not represent the buyer's WTP. The question of whether it represents the WTP is an open question, since the buyer is assumed to base his/her decision on the opportunity cost of capital invested and the possibility of synergies. Therefore, whether it represents WTP by the buyer largely depends on the opportunity cost of capital in the sector compared to the economic profitability rate in alternative investment (ERR).

As noted earlier it is required that PV (NB) 3 Investment cost (K), so that NPV (NB) 3 0, for the enterprise to be judged economically viable. The borderline is if PV (NB) = K and NPV (NB) = 0, then social opportunity cost of capital should be equal to the economic opportunity cost of government revenue, i.e. SDR = ERR, the project is judged economically viable, where ERR is greater than (>) 1. Other possibilities include: If ERR > SDR Û PV (NB) > K, and NPV > 0, it is economically viable. If ERR < SDR Û PV (NB) < K, and NPV < 0, It is not economically viable. Generally, for the enterprise to be judged viable economically, ERR 3 SDR Û PV (NB) 3 K, and NPV 3 0. That is, the economic rate of return on investment should be at least equal to the social opportunity cost of capital. These relationships show the analytical tools needed for the analysis of divestiture decision.

4.2: Synergies: (e.g.) Taxes

The result that PV (NCF) represents maximum WTP of potential buyer and the financial value as a going concern is based on the assumption that tax is neutral. However, asymmetric taxes on future incomes tend to create synergies that may alter the WTP relative to the enterprises value as a going concern. This implies that enterprise will throw off a stream of incomes whose PV is to a considerable extent, but not entirely independent of the buyer, but the value of that stream of earnings tend to vary with the circumstances of the individual buyer.

5.1: Valuation procedures:

The starting point of the analysis is the assumption of a base state of affairs given from the base year to the assumed life of the enterprise and the current operation of the enterprise as reflected in its financial statements. Valuation is accomplished by making series of value judgments and assumptions to this base state. For instance, the private buyer would adjust for such factors as improved efficiency and possible synergies, whereas the public seller or public agent would adjust for elements such as controlled prices and the opportunity cost of labor, wages, foreign exchange requirements, externalities, and so on. Valuation is intended for the valuation of assets and liabilities to derive relevant statements of information. These include the Cash Flow Statement (using balance sheet items), the Income Statement, the Net Worth (Present Value of Net Cash Flow), and the Net Operation Profit, NOP, necessarily quasi-rent (public profit) to distinguish it from the traditional private profit. From these statements will be derived the required financial values for the enterprise. The problem here will be to identify appropriately, the benefits and costs from the point of view of different actors. That is from the private perspective and from the economic (public) or society point of view. For financial analysis, constant prices are used to obtain the financial values. For economic analysis, all significant prices are converted to their social values. The valuation procedure can best be captured under when we observe the enterprise's behavior under two scenarios competitive and government maximization of sales revenue.

5.2: Scenario I: Establishing a general (competitive) result:

As said earlier, Privatization/divestiture is not controversial in a competitive setting. Thus in order determine what happens here, assumption of a trivial case is made initially, where ERR = IRR (or SDR = WACC). Here, if the premium on government revenue (or expected returns under government, ERR) were the same as on private profit (IRR) after divestiture, then we have a trivial case. The rationale here is that if public behavior were the same as the private behavior in investment terms, and market prices reflect real, socioeconomic prices, then divestiture cannot change societys welfare but only its distribution. In this situation, distribution does not matter. Thus the government should be indifferent completely as to whether the enterprise is in public or private hands. To say ERR = IRR is equivalent to saying that the financial value of the enterprise as a going concern is equivalent to its value to the national economy, that is PV (NCF) = PV (NB).

In order to simplify this initial exposition, other assumptions are needed such as; that only an operating capital good is being sold, (i.e. as if there are no debts, working capital or non-operating assets), and that the capital good yields a stream of profits (NOP) (necessarily quasi-rents) in perpetuity. Additional assumptions are there are no change in wealth and that income distribution neutrality. In this situation, the government would be willing to accept, WTA, the amount that a given potential buyer is willing to pay, WTP (or the value of the assets) or the maximum price acceptable to the private buyer (whatever it might be) for the enterprise. On the other hand, the government agent would equally be willing to accept (WTA) any other price for the enterprise, or indeed to compensate (or subsidize) the private sector in order to take over the enterprise. That is WTA =WTP. In this case trivial or competitive case;

WTP (max.) = S PV (NCF)t PV(NB) t = 0/0 = undefined. (1)

(ERRIRR) t t t

Since there are assumptions of Zero price distortions, and ERR = IRR

In short, in a competitive setting, enterprise's behavior or conduct is not expected to change. If so, then government revenue does not matter either, then nothing else matters, and there is no need to bother estimating PV (NCF), PV (NB), or anything else.

5.2.1: Financial value(or a particular buyer's maximum WTP) when enterprise's behavior does not change:

When enterprise's behavior is not expected to change, a particular buyer's maximum WTP (the financial value) can be estimated using the expression for a particular year t,

WTP(max) = S PV(NCF) t = S PV GOP (T + D K) t (2)

(1 + WACC)t

where T = direct taxes paid, D K = change (increase in investment), and WACC = weighted average cost of capital (the discount rate to be estimated for the financial analysis).

GOP (T + D K) is preferred to GOP (1T) + D K, because the applicable corporate tax rate, T is not charged on quasi-rents, but on the Gross Operating Profit (GOP) less Interests, depreciation, and other accounting charges. The value to society of this outcome would differ only in the values attached to GOP and T: i.e. Expected social value under private operation

PV(NCF) t = IRR(GOP) + (ERRIRR) -t (T + D K) t (3)

(1 + WACC)t .

In the event of continued public operation, the government revenue premium (i.e. the rate of return on government investment) applies to the entire stream of quasi-rents: i.e.

å PV (NCFt) = å PV IRR(GOP) (4)

(1 + WACC)t .

From eq.(1), for selling criterion:

Minimum selling price for government, minimum WTA = S PV (NB) t PV(NCF)t

(ERRIRR) t

t
By substitution, WTA = å PV IRR(GOP) - IRR(GOP) + (ERRIRR) - t (T + D K)

(1 + WACC)t (1 + WACC)t

(ERRIRR) t

t
Rearranging will give:

Min WTA by government agent = WTP(max) = å PV(NCF) = å PV GOP (T + D K) (5)

(1 + WACC)t

which is expected to be precisely private buyers WTP.

The general result in this case is therefore, that in the absence of behavioral changes, or price distortions based on the financial interest of potential buyers, minimum WTA by government agent = a particular buyer's WTP. That is the minimum price at which the government would be willing to sell is just equal to the buyers WTP that the private sector is willing to pay.

In contrast with special weights assigned to the opportunity cost of government expenditure and private investment, ERR and IRR respectively are useful in these estimations as they can be observed. In addition, they seem to be the basic parameters, which are of most interest to potential investors, and buyers, and will influence their decisions, whether to invest or not in the firm being offered for sale. Note that for simplicity, any measure of consumer welfare are excluded since this is unaffected by divestiture when behavior in unchanged.

The result implies that the public estimation (expectation) is precisely the same as (identical to) as the private estimation (valuation) except that benefits and costs are now reversed (the buyer gives up cash now for a future claim). The public minimum thus becomes the private maximum. This resulting equivalence is all that can be established at the general level. The determination of actual values would require data whose extraction is from the enterprises level accounts.

5.2.2: Implications for privatization/divestiture:

 

At a more policy oriented level, an implication is that there can be no pure revenue motive of the sale of public enterprises. In the present of market and price distortions, it is expected that revenue affects would occur as second-order effects, but without behavioral changes (or distortions) the government and private sector can exchange only streams of equal value. Although liquidity effect can take pace as well but its level (income effect) tends to be unchanged.
 

The second implication is that under these conditions, no sale is likely to occur. The rationale is that there tends to be transactional costs which may increase (the minimum acceptable price to the government), while a particular buyer's maximum WTP) may fall, leaving no mutually acceptable actual sale price, P*
 

Another implication is that selling is socially desirable only if the max. WTP is extracted from the private sector. In this case, if there is certainty as to what this number is, as the case may be if the bidding process is less than perfectly competitive then the chances of extracting the max. WTP will be reduced substantially.
In these circumstances, it is only prudent that a government agent (or the responsible Minister) will hesitate to sell or at least delay the sale, as there appears to be little to gain. The best that can be achieved is to breakeven, by making the actual sale price, P* = government WTA = Buyer's WTP.

If P* is less than Buyer's WTP, theres the possibility of making the country worse off and subject the government, hence the honorable minister to political charges of giving away the national patrimony.

In short, this section would represent a zero-sum game, given information asymmetries, the government is likely to lose. No sale is likely to take place under these conditions. The current situation cannot be far from this proposition.

However, since there are price distortions in the economy, and enterprise conduct tends to change, there is potential for positive sum game.

5.3: Scenario II: Governments revenue motive and answering divestiture questions:

Here, ERR 9 IRR or SDR 9 WACC. That is in reality, government revenue does matter, since one of the major objectives or motives for divestiture is to minimize fiscal constraints. A revenue concern may be introduced by assuming that public goods and externalities exist, and that lump-sum taxes are not feasible, so that ERR > 1 (SDR >1) as normally assumed in the literature. Also, in reality private profit matters, as there are distortions in the capital market, and in market prices generally. Thus assumption is made that income (return) from capital is taxed, so that IRR is greater than 1 (or WACC >1). The initial assumptions under the general result are now relaxed, with no loss of generality. The possibilities and implications under this scenario can be discussed by attempting to provide answers to the divestiture questions and looking the necessary tradeoff between cost efficiency and allocation efficiency under the two scenarios.

5.3.1: The divestiture expression:

The divestiture expression shows the actual price, P* at which the enterprise will be sold eventually. Since divestiture is expected to result in a change in social welfare, D W. In this case, it is required that: D W = PV (NB) - PV (NCF) + (ERR -IRR)P* (6)

This is the expression for divestiture decision. The first term gives social welfare after sale to the private sector. The second term shows the welfare before sale, while the last term shows the welfare effect of the sale transaction plus any transaction cost.

Since the objective of the government is to maximize D W, the answers to the divestiture questions can now be obtained.

5.3.1.1: Should the enterprise be sold? : Decision criteria:

For social welfare to be maximized, D W should be at least Zero or positive. Therefore, the enterprise should be sold if D W = PV (NB) - PV (NCF) + (ERR -IRR)P* > 0.

Rearranging gives; PV (NB) + (ERR -IRR)P* > PV (NCF) (7)

This expression says that the enterprise should be sold if social welfare under expected private ownership is greater than that under current (public) government ownership plus any sales premium. Thus, if the social opportunity cost of capital was greater than the weighted average cost of capital in the private sector, i.e. if ERR > IRR, then the decision criteria becomes:

P* 3 S PV (NB) - S PV (NCF) (8)

(ERR IRR)n

n = expected useful life of the enterprise. This is the selling criterion. It represents the Minimum price, P*min that the government should accept, WTA, for the enterprise. Where the ERR is very high relative to IRR, sale is more likely. This may explain the observed greater interest in divestiture in some developing countries, following fiscal and balance of payment problems. Thus, in constant efficiency terms, whenever social welfare is higher under government control, (i.e. PV (NB) < PV (NCF), but ERR > IRR the minimum price, P* min may be negative. This indicates that government should be willing to pay or 'compensate' the private sector to take over the enterprise. This may happen where the enterprise is loosing money or PV (NCF) is less than the investment costs, but becomes viable by divestiture.

Nevertheless, whether the government should subsidize or protect the enterprise may be determined by testing the net national contribution of the enterprise to the economy. We come to this later. The rationale is that if the nation was economically better off in terms of social surplus with the enterprise in private hands but the enterprise was not financially profitable, then the government should be willing to subsidize or protect the enterprise in order to accomplish this improvement defined in terms of the social surplus. At the extreme is where the government is neutral between funds in private hands and public funds.

On the other hand, if economic rate of return (ERR) was less than the Internal(or financial) rate of return, IRR, (ERR < IRR), then the higher the minimum price, P* min charged by the government, the lower will be the change in social welfare, and vice versa. Thus the direction of the inequality in actual P* is reversed. In this case, the government has no minimum price, but only a maximum price. This implies that the government will not accept a price higher than the given. This is because it may involve an excessive drain of funds from the private to the public sector. But this does not seem plausible, hence ERR should be greater than IRR. The result here is that based on the premise that ERR > IRR, the minimum price at which government should sell is obtained.

5.3.1.2: At what price should the enterprise be sold? : Determining the sale price:

We are interested in obtaining P* which maximizes social welfare, D W. From the divestiture expression, which shows the Net social effect of divestiture for a given buyer, the sale price P* affects social welfare only through the difference between ERR and IRR. That is

6 D W/6 P* = (ERR - IRR) (10)

This says that as price, P* rises, social welfare rises at the rate (ERR- IRR). This is based on the assumption that the government to improve the welfare of the society will use the revenue from the sales price. Three variants of this result can be observed:

(i.) Where ERR=IRR, there is no premium on government expenditures, therefore 6 D W/6 P* = 0. Social welfare gain is unaffected by the sale price. Therefore accords no particular value to it. In this case, the sale price does not matter, any price, (positive or negative) is just as good as any other price. However, the fact is that in reality ERR 9 IRR. ERR=IRR is rarely observed. This is the trivial case.

(ii.) Where ERR < IRR, change in social welfare will be negative, indicating that the enterprise is not economically viable so that government would want to minimize the sale price.

(iii.) Where ERR > IRR, so that 6 D W/6 P* > 0, and the government should therefore attempt to obtain the highest possible sale price for the enterprise from any given buyer. However, it may not represent the particular buyer's WTP, because the sale transaction may not be competitive. This may warrant a buyer offering this amount, because of the relatively size of the private sector.

In any case, for the government, the aim is to maximize the sale price, the buyer on the other hand, aims to minimize cost, or the Income Statement value. The third party, which unfortunately has been overlooked in the past, is the society. The interest of the society is economic value defined as the present value of net benefits. Obviously, there tends to be conflict of interests, especially between the government agency and a prospective buyer. The society is the main economic elements in the divestiture scenario as the two other parties are more interested in their financial returns. The point of view of the society therefore is relevant. Relaxing the zero society interest, the problem facing privatization in terms of valuation and pricing could be solved. In this case, where P* is negative, the government might 'subsidize' the enterprise after subjecting the enterprise to the absolute efficiency test, or 'protect' it. As an illustration;

Let PB (NCF) = $120m, and Investment cost, K = $160m all expressed in real (economic) terms. If it was sold for PV (NB) = $120m. It implies that there is a hidden subsidy of $40m to cover Investment cost. However, if the real value (economic value) PV (NB) to the society = $140m; then the actual loss to the society is worth $20m.

That is: Financial value (buyer's WTP) = $120m

Subsidy = $40m

$160m Þ K

Less PV(NB) (social value) $140m

$20m

The $20m is the real value of the enterprise to the society with divestiture, whatever the value. Thus, if project was sold at the PV (NB) to the private sector, while maintaining the hidden subsidy, the divestiture process tends to be a success. The main problem is that prices are grossly distorted in Nigeria and in developing countries in general.

The minimum as a going concern, PV (NB) and the maximum (as an asset) representing WTP, provide only boundaries for the actual sales price, P*. If minimum (as a going concern) is greater than maximum (as an asset), no immediate transaction can take place, or actual transaction may be delayed. But given the negative supply price, i.e. PV (NB) is less than PV (NCF); there is likely to be a considerable economic range of values for bargaining. Within this range, and given a set of terms and conditions for sale, the sale answer is indeterminate where there is a small number bargaining environment, and it will depend upon the skills of the two bargaining parties. In practice, the terms and conditions of sale are predetermined and are the focus of negotiations.

5.3.1.3: Should the government 'compensate' the enterprise?

An area in which bargaining takes place between buyers and government agents (sellers) is the effective protection that could be provided to the enterprise after divestiture. Typically government either undertakes to provide a protective tariff by maintaining a certain level of subsidies as an inducement to prospective buyers. However, this approach may lead to strains on the economy because it tends to promote highly protected industries, unless economic justification for such a decision by the government is provided. Within the framework of modern CBA, the issued can be addressed by testing the expected net contribution of the enterprise to the national economy, based on the Net Value Added (NVA). This is also known as efficiency test of the enterprise.

In this case, additional criteria are established by which, this decision can be based. The parameter of importance is the Net National Value Added (NNVA). Thus, Social Surplus (SS), externalities such as environmental effects, Net Foreign Exchange effect, and Net linkage effects are measured by their social values. All the mentioned constitute what can be called the supplementary criteria. All of them but environmental effects (negative) are expected to be positive. The sum of these additional criteria should be greater than the social or economic value of the enterprise in order to induce the government willingness to 'compensate' the enterprise. Actual compensation is the Net of the two values. As suggested earlier on, compensation may take the form of 'hidden' subsidy, effective protection, or by removing tariffs specifically for the enterprise.

5.3.1.4: What is the most efficient transaction mechanism?

The form of payment or transaction mechanism is a key element of the privatization/divestiture decision. The equity/distribution question partly depends on the adopted transaction mechanism.

When planning a given divestiture, the ancillary advantages likely to be brought by private investors or buyers needs to be carefully weighted before the underlying transaction is approved. A government agency should have a specific procedure of its own regarding employed techniques.

In Nigeria, as in many developing countries there is a lack of common strategy and policy in carrying out divestiture transaction. The expenses incurred per transaction tend to vary among different government agencies, and among different projects. This is often due to the different divestiture approach and policy adopted by the agencies. The interest in this case is to provide an economic justification for a likely divestiture method. For easy of exposition, three major techniques commonly employed may be considered. These include: (i.) Public Offering of shares; (ii.) Private Sales to buyers; and (iii.) Seeking strategic foreign investors.

On the other hand, the necessary variables of interest here include, (i) the estimated sales price, which is the expected revenue from divestiture, (ii) transaction costs, i.e. the estimated expenses to be incurred for the realization of privatization transaction and (iii) the liabilities of the enterprise to be privatized. Others include an estimated investment risk premium for the type of sector or industry and an estimate of the countrys investment risk premium.

A useful approach is to carry out a Relative Efficiency Test (RET) of the three divestiture mechanisms. The efficiency test can be carried out by correlation between the economic costs and economic revenue from transaction. That is, the ratio of expenses to the revenues (in real terms). This correlation may be used to rank the three selected types of transaction mechanisms.

The decision can be based of the following variants or ranges:


Highly efficient (less than 10%) iv. inefficient (20-24%)
Fairly efficient (10 -14%) v. highly inefficient (25% above)
efficient (15-19%)
It should be noted that the final decision may be influenced by political considerations particularly the issue of suitable distribution of shares. Also, the magnitude of the economic benefits of each mechanism may not be captured entirely in monetary terms, so that value judgements and qualitative description of benefits of each mechanism tend to play some role. This is necessary for the treatment of liabilities of the enterprise.

In addition, where more than one methods of transaction are envisaged, the efficiency of each method may be weighted according to proposed proportions. For instance, the government in Nigeria plans to allocate at least 20% to Nigerians, 40% to foreign investors and the remaining 40% to public offering of shares. This is where the various risk premiums are relevant. In this case, the 20% allocate to Nigerians would be weighted by the country's investment risk premium. That of foreign investors would be weighted by the industry risk plus the country risk premiums. The public offering of shares would be weighted by the industry or sector risk premium.

5.3.2: The Trade-off between economic efficiency and allocation efficiency:

The economics of divestiture becomes more interesting only when enterprises conduct is expected to alter as a result of sale. If divestiture did not cause conduct to change, it is unlikely that any sale could take place. This resembles a perfect competitive equilibrium case, in which case, the max. WTP price that any private buyer would offer would be equal to the min. WTA price government will be willing to accept. However, the presence of any transactions cost of the sale itself tends to drive a wedge between these two prices, and make sale almost impossible.

Thus, there is need to allow for behavioral changes and price distortions in order to make the analysis meaningful.

The subject of discussion and analysis here is the perceived fundamental trade-off necessarily involved in a divestiture decision. The rationale is that not only is the divested enterprise likely to become more efficient after sale, but also that it may behave more in the private hands than in the public interest when exercising market power. More specifically, the question is that what kind of behavioral changes might we expect after divestiture? Proponents of divestiture argue that private management tends to improve static operating efficiency and dynamic entrepreneurial innovation. On the other hand, opponents argue that private motivation tends to lead to exploitation of consumers, workers, and/or the environment. Considering these views, there is a potential trade-off between the possibility that the private objectives will be less desirable socially, and the possibility that the private sector will pursue these objectives more efficiently. Hence the fundamental trade-off of divestiture. The trade-off can occur at any level of the operation of the enterprise.

During valuation and pricing, the focus should be on the most common manifestations of potential trade-off, namely, the possibility that divestiture tends to in crease cost-efficiency through better management, but may also reduce allocation efficiency through exploitation of market power. A simple approach may be to extend the simple model (expressions obtained earlier) and then apply it to the market structure that is relevant to the case company. Therefore the major task is to analyze in greater detail the variables for divestiture decision discussed earlier, based on the assumption that our enterprise produced a single product say, Cement. The relevant variables in this case include; (i) levels of output under existing operation, Qg and expected private operation, Qp, both for the expected economic life of the enterprise. (ii) Corresponding constant output prices, Pg and Pp. (iii) Marginal costs of production, Cg and Cp (alternatively, increase in investment costs, Kg and Kp may be used). (iv) Present value, PV of stream of annual profits, NOP for financial profit, and NB for economic profit. (v) PV of stream of social surplus accruing to domestic consumers, SSg and SSp. (vi) PV annual corporate taxes after divestiture, T

These variables will be used to derive some relationships, which explain the enterprise as an independent gong concern, and the social value after transfer to private ownership. For the former, for particular year t the max. WTP for the operating assets (including financial assets and transaction costs) of the enterprise can be represented by the relationship (in PV terms) and discounted at WACC, (assumed to be constant) for the expected life of the enterprise. The expression has shown in Eq. 2. It can be simplified to give

WTP (max) = NCFt (11)

(1 + WACC)t

Note that, GOP = (Pp Cp)Qp i.e. the Gross Operation Profit is obtained (before taxes) as the product of quantity of output expected to be produced and the different between the price and average cost. And NCF = GOP (T + D K) as in Eq.2. In a nutshell, to determine the best sales price (financial value) we need Eq. (6) above. This implies that in order to find the financial value, we need estimates only of the extent to which cost will be reduced and output increased.

Thus the amount a private buyer is willing to pay for an enterprise is highest if the buyer feels that efficiency gains in the enterprise are feasible. In fact if bidding is competitive, the amount a potential buyer bids for the enterprise may be an indication of just how much the buyer expects to improve efficiency. Unfortunately, the bid is also affected by synergies the enterprise may have with the buyers other activities. So it is impossible to choose a bid solely on its magnitude.

6.1: Measuring the welfare of the different agents (social/economic value):

An essential point in measuring the social value, given the necessary is the need to consider not only the future returns to the enterprise but also to other agents with which the enterprise is expected to relate in the economy. The agents would include consumers of the output of the enterprise, other firms in the same industry or sector, owners of factor inputs, including labor, and the government. For simplification, three agents may be considered initially. These are the enterprise, the consumers and the government. It may be extended to other agents under certain specifications. It should be noted that the issue of factor inputs is considered during shadow pricing of items of costs based on the marginal productivity of labor in the sector.

In order to measure the welfare impacts of the proposed divestiture on the three identified agents, certain parameters are relevant: the economic profits for the enterprise, consumer social surplus (CS) for the welfare of the consumer, and the expected government revenue from t