Pozitron is a wholly owned subsidiary of Airtel US, an electronics components manufacturer. Airtel manufactures integrated circuits (IC) for computers, automobiles and robots. Airtel has been serving the Brazilian market through its distribution firm Pozitron since mid 1990s. The remarkable performance of the Brazilian economy and its growing domestic market prompted Airtel to consider a sizable investment in Pozitron to transform the distribution company to a manufacturing facility. Airtel projects that the Pozitrons products would be sold in Brazil. Pozitron Balance Sheet Beginning Balance Sheet (Year 0 ) BRL (000) USD (000) Cash Balances 18000 9000 Accounts Receivable 0 0 Inventory 32,000 16,000 Net Plant and Equipment 150,000 75,000 Total 200,000 100,000 Accounts Payable 20,000 10,000 Common Stock Equity 180,000 90,000 Total 200,000 100,000 Initial Outlay An analysis of the optimal plant size indicated that initial investment is expected to be around $90,000,000. Upon the incorporation of the subsidiary, Pozitron will issue BRL180m worth of stocks for the parent company. The subsidiary fixed assets will be depreciated straight line over an 8 year period. At the end of the fifth year, subsidiary is expected to be liquidated at an estimated market value of BRL30m. As per the agreement with the Brazilian government, the company will not incur any capital gains taxes on liquidation. During the operational life of the project, parent company expects to expatriate 65% of the profits as dividends. The remaining amount will be retained to support the subsidiary growth. Project Cash Flows Market research conducted by the company indicated that companys first year sales would be BRL 500m. Company projects a working capital requirement equal to 20% of the sales to support the projected sales levels. After the initial investment, about 50% of the increase in working capital requirement is expected to be financed by spontenous liabilities1

. The remaining 50% of the increse will be financed by the subsidiary. The local price level is expected to increase at a rate of 6% annually. Company analysts think that they can reflect the price increases into sales prices without any impact on the projected demand. In the meanwhile, the material input prices are expected to

1 Spontenous liabilities are increases in accounts payables and accruals.

Pozitron Brazil /Dr. Bulent Aybar

2 increase at a rate of 2%. In contrast, labor costs are expected to increase above inflation levels at 8%. Despite inflation and increasing input costs, company analaysts project 8% real growth in sales volume. During the project life, U.S. producer prices are expected to increase at 3%, Assumptions used by Company Analysts: Brazilian general price level +6% pa Pozitrons average sale price +6% pa Brazilian Raw Material Cost +2% pa Brazilian Labor Cost +8% pa US general Price Level +3% pa Estimated First Year Sales BRL500m Change in Sales Volume +8% pa Working Capital Requirement 20% of Sales Once the subsidiary is established, it is expected to purchase key inputs excluding materials and labor from the parent company. Parent company will sell the inputs to Pozitron with a mark up. The cost of the inputs sold to the subsidiary is 96% of the sales price to Pozitron. For instance, and input sold to Pozitron for $100, cost 96$ to the parent company2 .

Pozitrons first year material costs are projected to be BRL80m. The cost of matrial used will increase with the production volume and the cost of materials procured in the subsidiary country. Company analysts estimated direct labor costs at BRL100m first year of operations. Similarly cost of direct labor will also increase by the production volume and the cost of labor. General and Administrative expenses are expected to be BRL120m first year and is expected to increase by 1% per year. Pozitron will use BRL165m worth of parent supplied components. The cost of these inputs will increase by the production volume, producer price level increases in the US and the exchange rate change3 . Parent company is also expected to charge royalties for know how and technology that is used by the subsidiary to produce final products. The 2% running royalties will be charged on the annual sales of the subsidiary. The royalties constitue revenues for the parent company and tax deductable cost for the subsdiary.

2 Accordingly, parent company generates $4 profit from $100 sale to the subsidiary. 3 If we assume that the exchange rates will change according to PPP, annual change in exchange rates are expected to be (1+0.06)/(1+0.03)-1=2.91%

Pozitron Brazil /Dr. Bulent Aybar

3 Airtels marginal US tax liability is 34%. Pozitron subsidiary is expected to subject to 25% effective corporate tax rate in Brazil. Project Evaluation and Discount Factor The parent company Airtel had an established capital budgeting process in place. This process required estimation of the projects expected cash flows and then discounting them at the companys cost of capital to obtain the projects NPV. However, in this particular case project location and specific attributes of the project suggested that Pozitron did not have the typical risk profile of the parent company investments. The fact that the project located in a foreign market signalled exposures to various risk factors that are usually absent in local investment projects. The parent company Airtel finances its investment activities almost exclusively with equity. It is eseentially an unlevered company and its cost of capital was equal to its cost of equity. Capital Asset Pricing Model (CAPM) is widely used in practice to estimate their cost of equity. However, for many reasons, Airtel analysts found out that this model is not readily applicable in emerging markets. One such frequently articulated reason is that CAPM underestimates the inherent risks in the emerging market settings and produces discount rates that are too low. The concern about the understimation of project risks led some companies to make adjustments on the discount factor. This practice implied that industry practicioners are more concerned about adopting risky projects rather than bypassing valuable investment opportunities. Further research by Airtel analysts revealed that among the alternative methodologies developed by academics and practitioners, several models stood out. Airtel analysts recognized that unlike the CAPM, which is based on financial theory, these models are rather ad-hoc. In addition, because these models assess and incorporate risk in quite different ways, they may also yield quite different estimates of the discount rate. In order to properly evaluate the investment opportunities, then, it was necessary to consider the discount rates obtained from these different methodologies and to assess the project in light of each of them. The financial information necessary to estimate all four discount rates is provided in the following table: Risk-free rate 4.40% World market risk premium 5.00% Brazils sovereign yield spread 2.00% Project Beta 1.4 Brazils Country Beta 1.2 Brazils stock market volatility 20.50% World stock market volatility 14.71% Correlation between Brazils stock market and bond market 0.35 Access to Capital Markets Score (1) 10 Susceptibility of Investment to PR (2) 7 Importance of Investment (3) 8

Pozitron Brazil /Dr. Bulent Aybar

4 One of the models analysts debated about was developed by a highly respected finance professor at M.I.T., Dr. Dan Lassard. Dr. Lassard suggested that project risk should be adjusted for the country risk. He argued that this could be done by using a country beta which measures the sensitivity of foreign market equity index returns to global market index returns. If the project is located in a market with high beta, then the project risk would be adjusted to reflect this risk. He also cautiously warned against adding a country risk premium such as sovereign yield spread, and suggested that such adjustments should be made in cash flows. While he cautioned the practitioners about the importance of accounting for the risks in the cash flows, he indicated that an adjusted discounted factor may be a good first cut in evaluating offshore projects. Lassards risk adjusted discount factors are given as follows. Note that the first discount factor does not include an downside adjustment for the country risk. f Country oject US Pr k R EMRP

The analysts noted that project beta reflected projects risk in the US market because of the unreliability of the data in the foreign markets. A model suggested by Bank of Americas Godfrey and Espinoza argued that using a project beta calculated with respect to investors home market underestimates the risks in the foreign market. Accordingly, they suggest an adjusted beta that reflects the relative volatility of the foreign market with respect to global market or home market (depending on segmented or integrated market assumptions). Godfrey and Espinoza define adjusted beta as the ratio of foreign market volatility to the global market volatility adjusted for an overlap between equity market risk and sovereign yield spread. The relative volatility is downward adusted by 40% under the assumption that the overlap between the equity market volatility and the sovereign yield spread is approximately 40%. 0.6 F adj

W

Accordingly discount factor for a project in a foreign market is given as: f adj k R CRP EMRP {0.6 } F

f

W k R CRP EMRP

A third model proposed by Goldman Sachs analysts simply propose a different adjustment for double counting than that included in the Godfrey-Espinosa model. More precisely, these analysts propose to substitute fixed adjustment factor of 0.60 by one minus the observed correlation

Pozitron Brazil /Dr. Bulent Aybar

5 between the stock market and the bond market of the country in which the project is based. In other words, the adjusted beta proposed by Goldman Sachs analysts is:

/ (1 ) F adj S B W where S/B denotes the correlation between the stock and bond markets of the foreign country. In addition, as in the Godfrey-Espinosa model, the Goldman Sachs model includes the adjustment for country risk.

/ (1 ) F f S B W

k R CRP GEMRP

Finally, Solomon-Smith Barney suggests the following model:

1 2 3 Pr 30 f oject k R GEMPR CRP

The proposed model incorporates the firms specific country risk depending on the nature of the project, where Rf = the risk free rate of the home country project= the global CAPM beta for company i corresponding to the optimal capital structure and the industry of the investment GEMRP = the global equity market risk premium 1= access to capital markets score (score from 0 to 10 with a 0 indicating the best access to capital markets) 2 = susceptibility of investment to political risk (score from 0 to 10 with 0 indicating the least susceptibility to political intervention) 3 = importance of the investment for the investing company (score from 0 to 10 with a 0 indicating that the investment only constitutes a small portion of the firms assets) CRP = unadjusted counry risk premium 1 measures the fact that large firms with wide access to capital markets are likely to have fully diversified investors and, therefore, will most likely be concerned only about the systematic risk captured by the CAPM beta and less concerned about any diversifiable or country-specific risk. The Salamon Smith Barney model incorporates 2 because if the political risk premium represents a cash flow loss from expropriation, it should be most relevant for industries that are highly susceptible to political intervention. The 3 captures the fact that if the investment constitutes a minor part of the firms assets, then the asset is not likely to significantly increase the total risk of the firm, but in fact may decrease it because of diversification.

Pozitron Brazil /Dr. Bulent Aybar

6 In contrast, if the new investment constitutes a major part of the firms assets, then political uncertainty in the host country could significantly affect the investing firms risk profile.

The figure above outlines how the political risk premium weights 1, 2, and 3 are applied.

Pozitron Brazil /Dr. Bulent Aybar

7

Questions: A. Estimate Pozitron Cash Flows in the next five years. B. Estimate the discount rate Ariel should use to evaluate the Pozitron investment. C. Calculate the project NPV from subsidiary perspective D. Calculate the project NPV from parent perspective. E. Should Airtel go ahead and invest in Pozitron? Discuss.

NOTE: It is possible that some critical information may be left out. If you think that there is missing information in this question, simply make an assumption, provide a brief justification for your assumption and develop your answer accordingly.