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1-11 Part 1 Framework

3. Joe Smith argues that “learning how to do business analysis and valuation using fi-
nancial statements is not very useful, unless you are interested in becoming a finan-
cial analyst.” Comment.
4. Four steps for business analysis are discussed in the chapter (strategy analysis,
accounting analysis, ¬nancial analysis, and prospective analysis). As a ¬nancial
analyst, explain why each of these steps is a critical part of your job, and how they
relate to one another.

1. G. Akerolf, “The Market for ˜Lemons™: Quality Uncertainty and the Market Mechanism,”
Quarterly Journal of Economics (August 1970): 488“500.
Korea Stock Exchange 1998

n July 1998 Hong In-Kie, Chairman and CEO of the Korea Stock Ex-
change, was pondering on how best to attract a signi¬cant amount of long-term capital
into the Korean stock market. Mr. Hong, a graduate of Harvard Business School AMP
85, avid mountain climber, church leader, and accomplished tenor, was aware that there
were stiff challenges ahead. At the pinnacle of a successful career as a bureaucrat and as

ex-president of a large conglomerate in one of the world™s most dynamic economies, he
had a unique birds-eye view of Korean society and the economy.
During the past 30 years, the Korean economy had grown at 8.6 percent annually. At
the end of 1996, South Korea became the eleventh largest economy in the world and a
member of the Organization for Economic Cooperation and Development (OECD). Used
to hosannas as a worldwide leader in areas as diverse as shipbuilding, construction, semi-
1 conductors, and automobiles, Korea found itself in the unenviable position of having
practically depleted its foreign exchange reserves by November of 1997, and having had
A Framework for Business Valuation Using
Financial Statements
to seek assistance from the International Monetary Fund (IMF). As a result of the eco-
nomic crisis, the Korea Composite Stock Price Index (KOSPI) closed at 376.31 by the
end of 1997, down 42.2 percent from the closing index of 651.22 in 1996 (see Exhibit 1
for selected economic data).
Mr. Hong described the current situation as follows: “It is like a movie unfolding ev-
ery day, and we are all watching and on stage at the same time. Events are occurring so
fast that the headlines in the evening version of the paper and the morning version of the
same paper are often substantially different.” Mr. Hong was convinced that ¬nding a way
to spur the development of the stock market was a crucial part of the change needed to
shepherd Korea out of its current economic predicament.

Prior to the 1997 economic crisis, the Korean economy was viewed by many, both inside
and outside the country, as a dramatic success story. While there were many facets to the
export-oriented economic strategy of Korea, two features stood out: a bank-centered ¬-
nancial system that ¬nanced the rapid industrial growth, and the chaebol system that
created globally competitive enterprises.

Professors James Jinho Chang (The Wharton School), Tarun Khanna, and Krishna Palepu prepared this case as the
basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situa-
tion. Copyright © 1998 by the President and Fellows of Harvard College. Harvard Business School case 9-199-033.
Note: All references in this case to the country of Korea mean South Korea.

A Framework for Business Analysis and Valuation Using Financial Statements

1-13 Part 1 Framework

Bank-Centered Financial System
Unlike the U.S. and the U.K. economies™ reliance on the stock market, the Korean econ-
omy relied heavily on the banking system for channeling savings to industrial invest-
ments. In this respect, Korea followed the example of Germany and Japan in the
development of its ¬nancial system. Many commentators, both in Korea and abroad, be-
Korea Stock Exchange 1998

lieved that the bank-centered ¬nancial system facilitated long-term investments, largely
due to the close relationships between industrial enterprises and ¬nanciers. Because stock
market investors typically had no long-term relationship with the ¬rms that they invested
in, the U.S.-style stock market system was alleged to lead to “myopic management.”
Even though Korean banks operated in the private sector, the national government
had signi¬cant in¬‚uence on the banking industry. Through ownership and the appoint-
ment of bank directors, the Korean government could in¬‚uence banks™ lending decisions
to further its economic development plans. For example, in the 1970s government poli-
cies favored the development of heavy industries, such as construction, machinery, and
shipbuilding. The government encouraged companies to expand business in these indus-
tries and provided favorable capital related to that expansion through banks.

Business Groups
The Korean economy was dominated by multibusiness organizations known as
chaebols. The largest chaebols, such as Samsung, Daewoo, Hyundai, LG, and the SK
Group, operated in a wide variety of industries such as construction, shipbuilding, auto-
mobiles, consumer electronics, computing, telecommunication, and ¬nancial services.
The 30 largest chaebols accounted for 51.8 percent of the total industrial output of Korea
in 1996. The top four chaebols, Hyundai, Samsung, LG, and Daewoo, accounted for
31.2 percent of the total industrial output of Korea in 1996.
Historically, government policy favored the growth of chaebols. These policies
included granting industrial licenses, distributing foreign borrowings, and providing
favored access to bank ¬nancing.1 The promotion of chaebols was seen by the Korean
government as a way to create domestic industry that could compete in global markets.
Indeed, Korean chaebols played a very critical role in the export-led growth of the
Korean economy. By 1996 the top seven trading companies of chaebols accounted for
47.7 percent of Korea™s total exports.2
The chaebol organizational structure conferred several advantages in the early growth
stage of the Korean economy by enabling entrepreneurs to overcome the problem of un-
derdeveloped product, labor, and ¬nancial markets. At this stage, many of the institutions

1. In the early 1970s, the interest rate on foreign borrowing was 5“6 percent, whereas the interest rate on domestic
bank debt was 25“30 percent. The interest rate for nonbank borrowing was higher than that from banks. The privi-
lege of using foreign borrowing and bank loans signi¬cantly contributed to the accumulation of the chaebols™

2. The top seven trading companies are Hyundai, Samsung, LG, Daewoo, SK, Ssangyong, and Hyosung.
14 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Valuation Using Financial Statements

that underpin the functioning of advanced markets were either missing or underdeveloped
in Korea.
In advanced markets, intermediary institutions and legal structures address potential
information and incentive problems. These institutions permit individual entrepreneurs
to raise capital, access management talent, and earn customer acceptance, and they
require all parties to play by the same rules. Entrepreneurs and investors can be sure of

Korea Stock Exchange 1998
the stable legal environment in advanced markets to protect property rights, giving en-
trepreneurs the con¬dence that they will reap the fruits of their entrepreneurial activity.
In this context found in advanced markets, it is less likely that the entrepreneur will ben-
e¬t signi¬cantly by being associated with a large corporate entity. Hence, the costs of
business diversi¬cation are likely to exceed any potential bene¬ts.
In an emerging market like Korea, in contrast, there were a variety of market failures,
caused by information and incentive problems. For example, the ¬nancial markets were
characterized by a lack of adequate disclosure and weak corporate governance and con-
trol. Intermediaries such as ¬nancial analysts, mutual funds, investment bankers, venture
capitalists, and the ¬nancial press were either absent or not fully evolved. Finally, secu-
rities regulations were generally weak, and their enforcement was uncertain. Similar
problems abounded in product markets and labor markets, once again because of the ab-
sence of intermediaries.
The absence of intermediary institutions made it costly for individual entrepreneurs
to acquire necessary inputs like ¬nance, technology, and management talent. Market and
legal imperfections also made it costly to establish quality brand images in product mar-
kets, and to establish contractual relationships with joint venture partners. As a result, an
enterprise could often be more pro¬tably pursued as part of a large diversi¬ed business
group, a chaebol, which acted as an intermediary between individual entrepreneurs and
imperfect markets.
Af¬liates of chaebols also enjoyed preferential access to ¬nancing from domestic
banks because of their strong connections with bankers and government of¬cials. In ad-
dition, established companies in a chaebol often provided cross-guarantees on loans to
new af¬liates, making it easier for new ventures to raise ¬nancing from domestic and
foreign lenders.
Korean chaebols such as Samsung and Daewoo were also able to use their size and
scope to invest in world-class brand names. These brand names enabled new companies
promoted by these leading chaebols, even in unrelated ¬elds, to gain instant credibility
in export markets and with technology partners.
Chaebols were the preferred employers for students graduating from prestigious Ko-
rean universities. Because of their size and scope, chaebols could offer job security in an
economy with no safety nets. Further, chaebols such as Samsung and the SK Group
made extensive investment in the training and development of their employees, in effect
creating their own “business schools.” Due to their size, they could hire professors from
top business schools around the world to lead their in-house training programs. Because
Korea did not have many world-class business schools, the in-house “business schools”
of chaebols were in a unique position to develop management talent.
A Framework for Business Analysis and Valuation Using Financial Statements

1-15 Part 1 Framework

As a result of the above advantages, chaebols were uniquely positioned to launch new
ventures in the Korean economy. Chaebols relied extensively on domestic and foreign
debt to ¬nance their rapid growth. Reliance on domestic debt arose as a result of the
bank-centered nature of the ¬nancial system. Further, with a view to keep the control of
Korean businesses in Korean hands, government policy restricted foreign direct invest-
ment in Korean chaebols. While foreign investors could invest through the stock market,
Korea Stock Exchange 1998

banks and other ¬nancial institutions were a more signi¬cant channel through which for-
eign money was invested in Korean companies.3
One of the key characteristics of a chaebol is family ownership and cross-holding. In
1995 the average family ownership in the top 30 chaebols was 10.6 percent and the av-
erage ownership through cross-holding equity ownership among member ¬rms was 32.8
percent. Cross-holdings increased the founder family™s control on large business
groups.4 Traditionally, the voting rights of institutional investors, such as securities ¬rms
and insurance companies, were limited by the law and minority shareholders were not
active.5 As a result, the founder or founder™s family could effectively control the business
group with relatively small direct ownership, and family members took top management
By 1996, prior to the economic crisis, the median debt-to-equity ratio of the top 30
Korean chaebols stood at 420 percent (see Exhibit 2). While each company in a chaebol
borrowed money independently, bankers often demanded and received cross-guarantees
from the other ¬rms in the chaebol. Since Korean ¬nancial accounting rules did not
require the disclosure of these cross-guarantees, it was dif¬cult for outsiders to assess
the true debt commitments of a given Korean company.

The “IMF Crisis”
The Korean economic crisis in 1997 was part of a broader Asian ¬nancial crisis that ¬rst
started in Thailand, when the baht weakened as foreign investors lost con¬dence in the
Thai economy. Amid the Asian currency crisis, foreign ¬nancial institutions, concerned
about potential ¬nancial distress for Korean ¬rms, started calling in their loans rapidly.
Foreign portfolio investors also began to sell their investments and repatriate the sales
proceeds for fear of the depreciation of the Korean won.7

3. The details of the institutional investor market in Korea can be found in “The growing ¬nancial market importance of
institutional investors: the case of Korea,” by Yu-Kyung Kim, OECD Proceedings: Institutional Investors in the New
Financial Landscape, 1998.

4. Suppose that a family owns 20 percent of Company A and manages it, and Company A has a controlling owner-
ship of Companies B and C, which in turn own 20 percent each of Company A. Through these cross-holdings, the
founder™s family can effectively own 60 percent of Company A, and control B and C as well.
5. Under these regulations, institutional investors were restricted to so called “shadow voting,” which essentially meant
that they voted with the management. After the recent crisis, this practice was abolished.
6. In 1995, among the top 30 chaebols, only one, KIA Motors, had a CEO who was not related to the founder™s family.

7. 1997 Fact Book published by Korea Stock Exchange.
16 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Valuation Using Financial Statements

The out¬‚ow of foreign portfolio investment funds continued for four consecutive
months, from August to November, bringing Korea close to depleting its foreign ex-
change reserves. On November 21 the Korean government requested the IMF™s assis-
tance to avoid a potential default on its obligations. After frenzied negotiations, the IMF


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