Cid Term Paper Final 36585f

MASTER OF BUSINESS ISTRATION MBA (EVENING)

Course Name: Capital Investment Decision Course Code: F – 601

Case Solution on “3P Turbo—Cross Border Investment in Brazil”

Submitted to Dr. M. Sadiqul Islam Professor, Department of Finance, University of Dhaka Prepared by AQEEBUR RAHIM

32050

MAZHARUL ISLAM

32035

MD. SAIFUR RAHMAN

32053

Date of Submission 10th April, 2017

Letter of Transmittal April 10, 2017 Dr. M. Sadiqul Islam Professor Department of Finance University of Dhaka Subject: Submission of Case Solution on “3P Turbo—Cross Border Investment in Brazil”

Dear Sir, We are pleased to present this Case Solution on “3P Turbo—Cross Border Investment in Brazil”. This is to inform you that we have successfully completed the Case Solution.

Working on this Case Solution has been really interesting & informative experience for us. We learned many unidentified facts which we believe will be ive to our academic & professional career in the future. We have enjoyed working on this and we hope that our Case Solution will meet the level of your expectations. We would try our best and shall be obliged to provide you with any clarification regarding the Case Solution.

Sincerely, AQEEBUR RAHIM

32050

MAZHARUL ISLAM

32035

MD. SAIFUR RAHMAN

32053

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ACKNOWLEDGEMENT Firstly, we would like to thank the Almighty Allah for giving us the strength, the patience, and the knowledge to do this Case Solution on “3P Turbo—Cross Border Investment in Brazil”. We would also like to take this ultimate opportunity with pleasure to thank our course instructor, Professor, Dr. M. Sadiqul Islam, for giving us the opportunity to do the Case Solution. He has been very helpful to us throughout the entire process and has always been there to help us heartily even through his hard times.

Moreover, we would also like to thank the people who helped out in providing solution to every problem through discussion, without any faulty. We really appreciate even the minor sacrifice they made in doing that. Without their efforts, it would have been impossible for us to finish this Case Solution at such convenience. We would also like to thank our friends and family for showing us their and help us in every possible ways throughout the entire work process. With presence in every aspect, completing this task seemed as festive and interesting as ever.

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Table of Contents “3P Turbo—Cross Border Investment in Brazil” .......................................................................................... 0 CHAPTER 1 ................................................................................................................................................. 4 INTRODUCTION .................................................................................................................................... 4 INTRODUCTION OF THE COMPANY................................................................................................. 5 CHAPTER-2 ................................................................................................................................................. 6 ANALYSIS OF THE ECONOMY ........................................................................................................... 6 HOW THE INDUSTRY IS AFFECTED BY THE CHANGE ............................................................ 7 FORECAST OF NEXT FEW YEARS ................................................................................................. 8 CHAPTER 3 ............................................................................................................................................... 10 ANALYSIS OF THE AUTO INDUSTRY ............................................................................................. 10 PORTERS 5 FORCES ........................................................................................................................ 10 PESTEL ANALYSIS .......................................................................................................................... 13 SWOT ANALYSIS ............................................................................................................................ 16 RATIO ANALYSIS .................................................................................................................................. 18 CHAPTER 4 ............................................................................................................................................... 19 ANALYSIS OF THE COMPANY ......................................................................................................... 19 COUNTRY RISK ANALYSIS .......................................................................................................... 19 PROBLEM STATEMENT ......................................................................................................................... 22 CHAPTER 5 .................................................................................................................................................. 23 ANALYSIS OF EACH ALTERNATIVE .................................................................................................. 23 Invest Analysis (Cost of Capital) ............................................................................................................ 23 Investment Analysis (Capital Budgeting): ............................................................................................... 24 Monte Carlo Simulation: ......................................................................................................................... 25 CHAPTER 6 ............................................................................................................................................... 38 ALTERNATIVE COURSES OF ACTION ............................................................................................ 38 RECOMMENDATION .......................................................................................................................... 40

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CHAPTER 1 INTRODUCTION In modern day, Turbochargers are used in cars to improve the fuel efficiency of the engines. Though in the past, Turbochargers were somewhat of a luxury product, used for mainly street racing and in high performance cars only. Nowadays it is an essential part of a car which increases the average mileage and enhances the fuel burning capacity of the cars. That is why the overall market demand for turbochargers is steady high. Jason Park, the founder of such Turbocharger manufacturing company- “3P-Turbo”, was considering to establish another turbocharger manufacturing unit in Brazil. At that time, the country was going through some political turmoil and many of the renowned politicians were accused in the “Petrobras scandal”, including the president of the country, Dilma Rousseff. It was also aligned with the country’s worst economic recession in the last twenty years, with unemployment rate rising more than 10 percent and overall growth of the economy decreasing in the last few years. However, trade agreements like “Mercosur” makes a country with a rich history in manufacturing cars like Brazil, much more attractive to foreign car manufacturers to open up new units which would enable them to reach cross border markets of South America with zero tariff. As an aspiring investor, Jason is considering a market forecast from a financial specialist to decide whether he should proceed opening a new unit in Brazil or will the investment be too much risky to generate the required return. Now, the main objective of this paper is to determine whether Jason should go for the investment now or wait for a year until a new elected government takes control or look somewhere else with better odds of getting success. 4

INTRODUCTION OF THE COMPANY 3P Turbo is a U.S.A. based turbocharger manufacturing firm which specializes in manufacturing aftermarket turbochargers. The name 3P stands for powerful, precise and high performance which the company claims to deliver in its product lines. The company was founded by Jason stacks, who is considering an investment for opening a new manufacturing unit in Brazil. Apart from high performing superchargers, the company produces fuel injectors, waste gates and heat exchangers. It also has a wide range of SKUs. Because of the wide range of quality products, 3P-Turbo was awarded ISO9001:2008-certified company in 2013. The reputation of the turbochargers performance had increased the demand for 3P-Turbo products countrywide. The firm now pledges to start a new operation in Brazil, the 9th largest manufacturer of cars in the world. The fuel saving efficiency of 3P-Turbo made turbochargers would help them capture the auto market of the 5th largest country in the world.

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CHAPTER-2 ANALYSIS OF THE ECONOMY Brazil’s economy was in a spot of bother during the mid-2016 time and had its worst economic crisis in last 20 years. As a result, the growth rate suffered tremendously from 7.5 percent in 2010 to 3.7 percent in 2015 and budget deficit rose to 10.5 percent of the GDP by 2015. However, the inflation rate decreased as the unemployment rate increased over 10 percent. Although a few years back the economy was in a healthier position with President Cordoso guiding the country’s economy to be a more sustainable one and overcoming the age old problem of hyperinflation. Even his successor President Lula also maintained a pro-business environment by implementing wellthought out fiscal and social policies. A decrease in the poverty rate with over 50 percent of the population upgraded to the middle class fragment, it was also one of the reason of Brazil’s economic boom during those years. But after his tenure ended, his successor, President Rousseff took over and implemented a more of an interventional approach in her fiscal policies. She increased the government expenditure by increasing the public funding of the Development Bank of Brazil. The Bank gave out huge loans to the large corporations and totally abandoned the private sector lending resulting a total abandonment of the fiscal policies that her previous presidents maintained. Moreover, the central bank lowered the interest rate to pursue more investment and as a result income level rose as well as the inflation. To maintain the inflation appreciation, Rouseff started intervening in operations of organization and reduced prices of commodities by giving subsidies, as a result the government expenditure increased more creating a larger budget deficit. The policy backfired as the burden increased and the growth rate took a big hit, losing almost 0.5 percent of growth per year. Although the central bank increased the interest rates after the policy backfired, but it had a little to no effect as the inflation rate would still be above 9 percent. By mid6

2016, political turmoil added more imbalance to the economy which was already facing a recession. Scandals like “Petrobras” also added to the economic turmoil as some of the renowned politicians were accused of taking bribes from contractors to provide them with overpriced deals and in the process increasing the burden of the budget deficit. This budget deficit was one of the key reason for the country to go into a recession. The interim president, Temer has made his intentions clear of reducing the huge budget deficit by appointing new dynamic cabinet , slowly abolishing the intervening methods that his previous president started and restore the growth of the economy with a low inflation rate. It was assumed that a change in the then government officials would bring a positive effect in the economy. The possible replacements of the former president Rousseff, were known to be business friendly and are capable of turning things around the Brazilian economy. Many of the foreign firms were refraining themselves investing until 2018, after the presidential elections takes place and a capable person take over the government duties and make a positive impact to the economy. HOW THE INDUSTRY IS AFFECTED BY THE CHANGE The change in the government had a very adverse effect in the economy of Brazil. A high inflation rate means a devalued currency against foreign currencies. The foreign investors will have less profit after they convert their Brazilian Real into their own currency. With poor infrastructure, high tax burden in a developing country like Brazil, a high inflation would certainly repel foreign investors from setting up manufacturing units costing millions of dollars. But even though the economy was suffering with an inflation rate over 9 percent and unemployment rate over 10 percent, the auto industry had a great potential to flourish as the Brazilian government was trying to promote the domestic auto manufacturing market. The Brazilian government had a trade agreement with its neighboring South American countries for trading freely among them with zero

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tariff benefit. The agreement known as “Mercosul”, was more effective for the growth of an auto manufacturing sector because of the tariff imposed on the foreign auto imports to make the domestic market more attractive to the foreign investors. So, domestic investors would gain access in almost all member nations of “Mercosul”, without costing any tariff. Investing in those environment with a market size of a continent is really tempting for foreign investors, yet the overall economic and political climate is forcing them to stay away from investing. With President Temer taking over the hot seat up until the 2018 presidential election, many market

specialists predicted that he will be able to deliver some positive outcome. The policies that he decided to implement before the economy gets anymore worse, were to reduce the budget deficit by lowering the inflation rate. Eventually the inflation rate declined in the third quarter of 2016 coming down from 8.97 to 8.48. In fact, this is the lowest inflation rate recorded since October 2015. So, President Temer’s policy to scale back Rousseff’s intervention policy did have a positive impact on the Brazilian economy. FORECAST OF NEXT FEW YEARS The next few years are one of the most important period in Brazilian history as a lot of transformation will take place in the economy. The 2018 presidential election would shape up the country’s economic future and answer a lot of question of the investors mind. Whether the economy will continue its abysmal performance in the year or will there be a growth oriented environment. There are some speculations about some possible candidates for the president position including the governor of Sao Paolo, Geraldo Ackmin and Aecio Neves, who already participated in the previous election but lost to former president Rousseff. After the previous government’s dismal approval rating, the new government would want to change that and try to maintain a higher approval rating. As we already discussed that the economy

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was already in a recessionary phase. So, the unemployment is supposedly increased and a huge portion of the economy would be in need of work. The government would want to create some more job availabilities by encouraging investors to open new manufacturing units in Brazil. For that the government will try to relax on some of its policies; like a rebate in the tax rate for a specific period of time (something that the previous government also did). Reviewing the data of the inflation rate for the past few months, the inflation rate is declining as the interim government of President Temer, took some steps to reverse the causes for which it increased in the first place. If this continues, we can assume that the inflation rate will be kept at an investment friendly zone.

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CHAPTER 3 ANALYSIS OF THE AUTO INDUSTRY The automobile Industry is one of the most important sources of the GDP for Brazil and their economy is very much rely on it. Brazil’s economy has slowed down because of political problems in 2015 and 2016 years. As all the measures of the economy like the growth rate plummeting and inflation rate, unemployment rate rising over the last few years, this economic down fall had big influence on the automobile market of Brazil. As a result, in 2015 Brazil’s annual car sales fell 26.5% compared to the previous years, which was the worst annual decline since 1987. And in 2016, the situation became even worse with the rate plummeting to 20.2%. (Source: Forbes) As the market conditions are favorable and there are no or few turbocharger manufacturer, so 3PTurbo has a lot of potential in Brazilian auto industry. The impact of economic recession may be high in the car business, but in turbo chargers market it will have a less impact. Turbo chargers makes the engine more efficient and keeps the environment cleaner. So it will become more popular to the car owners. The change in the economy has an impact in every industry of the economy still it is new in Brazil. So it is expected to be more successful. Some of the key analysis of the overall auto industry of Brazil is stated in the following portion. PORTERS 5 FORCES The porters 5 forces model discusses about the nature of the competition 3P-Turbo will face in the Brazilian auto industry. These 5 forces are: I. II. III.

Threat of new entrance (high) Threat of substitutes (high) Bargaining power of customers (high) 10

IV. V.

Bargaining power of suppliers (high) Rivalry among the competitors

Threat of new entrants Threat of new entrants refers to the threat new competitors pose to existing competitors in an industry. If 3P turbo enters into the market of Brazil, they will be a threat for the existing producers of turbocharger there. As the reputation of 3P-Turbo is widely known and their product quality is quiet good, it can be said that they can be a fierce competition for the existing competitors. But after they become successful, more competitors will as well. If any firm from the member countries of Mercosur (Mercado Común Del Sur) wants to enter the industry, they will have a competitive advantage as the tax system and labor laws are pretty strict and burdensome in Brazil.

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The new entrants will have competitive advantage over 3P-Turbo as they are producing in another country with a different tax system and labor laws. Threat of substitutes As Brazil is trying to go green and be environment friendly, turbochargers could certainly add value to that cause. Compare to normal fuel engines, turbo chargers can burn fuel more efficiently. But consumers can be reluctant to use a special product just for that cause as the price of turbochargers are somewhat high. There are some alternative options for the consumers like electricity driven cars, other alternative fuel driven vehicles etc. These substitutes can be a threat in the long run, when there will be more growing consciousness among consumers to purchase environment friendly vehicles. Bargaining power of customers The auto parts industry can be very much price sensitive at time. Even though 3P turbo produces quality turbochargers, nonetheless, it is still an optional product to make the engine more efficient. If 3P turbo charges price too high, consumers might be reluctant to pay a high amount to buy their product. Moreover, over firms may also provide turbochargers at a cheaper price, which can also be a threat for them in conquering a fair market share. Bargaining power of suppliers In an open market economy, sellers are not obliged to one single customer. In case of Brazil, 3PTurbo will have to convince the suppliers for a fair price for the spare parts, to keep themselves more competitive in the market. 3P-Turbo is currently operating in the US territory. So, when they will start operating in Brazil, the cost of supplies may increase due to the sheer distance of those two countries. Suppliers can have a bargaining option in this situation as they r operating in a different territory now. 12

Rivalry among the competitors 3P turbo is growing very well and they have expanded dramatically over the years. They have a wide variety of products with thousands of SKUs for customers to choose from. They had manufactured award winning turbochargers for race cars and with the superior product quality, 3P turbo become an ISO9001:2008-certified company in 2013. The performance of 3P turbo is very good after the foundation in 1992 but still have less market share to compete the toppers. But it is expected that they can be in the competition with any large company in future if they continue this growth rate.

PESTEL ANALYSIS A PESTEL analysis framework is used here to

analyze

and

monitor

the

external

marketing environment that have an impact on 3P-Turbo. The general purpose of this analysis is to identify all of the political, economic, social, technological, legal and environmental factors that might affect 3PTurbo’s business in Brazil. After the completion of the analysis, we would assess the risks that the identified factors possess and use that knowledge to take future decisions.

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Political Factors For the last few years, situation in Brazil is unfavorable for business because of political instability. It became worse with the government involvement in the corruption scandal involving Petrobras and people demanded the former president Dilma Rousseff to be either resigned or to be impeached. Later in 2016 she was impeached by the vote and the vice president Michel Temer replaced her and become the president. In 2017 there is less chance to the situation to be better under the new president. Economic Factors The economic factors are not showing Brazil to be much friendly for business as well. Political problems cause economic instability in Brazil. GDP growth rate was declined by 3.8 and 3.6 percent in 2015 and 2016 respectively while unemployment increased by 10.2 percent in that time and unemployed people was more than ten million. By 2014, 35 million people who emerged from poverty in the decade but in last 2 years, 10 percent of them have fallen back down to the ladder again. Social Factors In Brazil, social factors seemed to be unfavorable to business. The gap between rich and poor is higher than many countries. The richest 10% of people in Brazil have access to over 40% of the country’s income. On the other hand, the poorest 10% receive about 1% of the income. Also Brazil is burdened with lots of crime. As the poverty and unemployment rate is going up, crime is increasing in Brazil. The mass media is constantly full with the news of crime in this country include mugging, robbing, kidnapping and gang violence around the Brazil where police is unable to deal with them. For that reason, criminal have little respect for police and therefore, the Ministry

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of Justice created the National Public Security Force to handle major emergencies and crisis instead of the local police force. Technological Factors Compared to the developed country, technological infrastructure is weaker in Brazil. But they have achieved a significant position in the international market in the last decades. In 2016, Brazil was fourth in production of vehicle. They produced 1,778,464 cars and 377,892 commercial vehicles in that particular year. (Source: http://www.tradingeconomics.com)

As the turbocharger is an optional part of car, the sale of car and the possibility for turbocharger business is directly related. Environmental Factors There are huge forests and trees including Amazon rainforest in Brazil and their environment have been very well although deforestation and illegal poaching have been major problems. The government is putting much effort to save the environment by planning to cut the emission of carbon up to 37% by 2025. Using turbocharger will be environment friendly as it increases the efficiency of fuel and cuts down carbon emission.

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Legal Factors Brazil government increased the tariff on imports of car and car parts. This tax is applicable for the all countries except custom union, Mercosur which went into effect in 1995. As Brazil was the full member of Mercosur, they imposed a Common External Tariff for the countries who are not the of the union. For this reason they developed in the locally manufactured car and car parts and became one of the top manufacturers of cars in the world.

SWOT ANALYSIS SWOT analysis is a framework that analyzes external factors Strength and Weakness and internal factors, Opportunities and threats to understand a company. It helps a manager in strategic planning and decision making. The component of SWOT in of 3P Turbo can be identified as: Strength Strength is the internal positive factors that an organization leads an organization towards its goal and objectives and helps to sustain in competitive market. 3P Turbo has the following strengths: 

3P Turbo has dramatic company growth since 1992.



Their turbochargers are compatible to every vehicle, from cars to pickup trucks.



They provide full technical for every single product they sell.



Their product variety with thousands of SKUs for customers to choose from.

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Weakness Weakness is the negative internal factors that an organization needed to overcome to prevent any unwanted result. 3P Turbo has some weaknesses like: 

Their products are optional products which are not mandatory. So even if customers get used to them, in case economy faces any problem, the sale will be affected in a huge amount.



They have a challenge of adoption in the economy of Brazil.

Opportunities Opportunities are the external positive factors that company can turn into advantage and generate profit. The opportunities of 3P Turbo are: 

Wide range of product lines to grab the market share, which are high performance turbocharger to products such as injectors, waste gates and heat exchangers.



Their products are environment friendly as it makes the engine more efficient. So it reduces the use of fuel and exerts less gas.



In Brazil, they will have tax facility as they are manufacturing car parts.



With the regulatory pressure and consumer’s love of power and economy in their vehicles, their business is expected to grow dramatically.

Threats Threats are the external negative factors that can cause trouble and hamper company profit. The threats of 3P Turbo can be: 

With the fuel efficiency of turbocharger, some analysts claimed that turbochargers unintentionally slowed the adoption of alternative fuel vehicle. 17



If the political and economic problems are not sorted out, they might face crisis of more expenditure and less sales.

RATIO ANALYSIS Return on Asset: Return on asset shows how profitable a company is related to its total assets. It indicates how efficiently the company is utilizing to make profit. It shows the efficiency of utilizing asset to make profit, so the higher it is the better. Here, with desired capital structure and with maximum debt, Return on asset is 13.20%. It means that company will be generating 13.2 BRL by utilizing asset of 100 BRL. Return on Equity: Return on equity indicated how efficiently a company is generating profit with their money from shareholders. It shows the efficiency of utilizing the equity, so the higher it is the better. In this case, Return on equity with desirable capital structure is 26.40% and with maximum debt is 42.90%. That means the company will be generating 26.4 BRL with the desirable capital structure and 42.9 BRL with maximum debt by utilizing 100 BRL of equity. In the second situation, debt is more and total capital is also more which brings more profit. But after paying those extra debt holders, the profit is more than desirable capital structure. Profit Margin: Profit margin shows at what percentage the company is generating profit from their sales. So it doesn’t consider the capital structure and whatever the debt-equity ratio is, profit margin will be same. It shows the profit percentage of sales, so the higher it is the better. Here, in both situations profit margin is 25.54% which means by selling 100 BRL, the company is going to make 25.54 BRL profit. Fixed Asset Turnover Ratio: Fixed asset turnover ratio measures how efficiently the company utilizes their fixed assets to generate sales. As it shows the efficiency of utilizing asset, so the higher it is the better. In the both situations, fixed asset turnover ratio is 67.20% which means company will be generating 67.2 BRL net sales by using 100 BRL of fixed assets. Total Asset Turnover Ratio: Total asset turnover ratio measures how efficiently the company utilizes their total assets to generate sales. As it shows the efficiency of utilizing asset, so the higher it is the better. In the both situations, total asset turnover ratio is 51.69% which means company will be generating 51.69 BRL net sales by using 100 BRL of total asset.

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CHAPTER 4 ANALYSIS OF THE COMPANY COUNTRY RISK ANALYSIS The International Country Risk Guide (ICRG) rating comprises 22 variables in three subcategories of risk which are: political, financial, and economic. A separate index has been created for each of the subcategories. The political risk rating contributes 50% of the composite rating, while the financial and economic risk ratings each contribute 25%. The Political Risk index is calculated based on 100 points, Financial Risk on 50 points, and Economic Risk on 50 points. The following formula is used to calculate the aggregate political, financial and economic risk: FER (Brazil) = 0.5 (PR + FR + ER) Where, FER = Composite Political, Financial and Economic Risk Ratings PR =Total Political Risk score FR = Total Financial Risk score ER = Total Economic Risk score POLITICAL RISK Brazil is recently going through some significant changes in their political environment. So, for determining the points for this section, we had to carefully examine the past, present and the probable future political environment of Brazil. The political risk is calculated in the following context:

Components

Subcomponent

point

Government Stability

Government Unity

4

Total point

Achieved(sub ) 3

component achieved

19

Legislative Strength

4

3

Popular

4

2 12

Socioeconomic conditions

8

Unemployment

4

1

Consumer Confidence Poverty

4

2

4

2 12

Investment Profile

5

Contract Viability

4

3

Profit Repatriation

4

3

Payment Delays

4

1 12

Internal Conflict

Civil War Terrorism/Political Violence Civil Disorder

7

4 4

3 1

4

2 12

External Conflict

Corruption Military in Politics Religious Tension Law and Order

Ethic Tension Democratic ability Bureaucracy Quality

War Cross-Border Conflict Foreign Pressure

4 4

4 4

4

3 12 6 6 6

Law(Judicial System) Order(Crime rate)

9

3

2 5 5 2

3

1

11 2 5 5

6 6 6

3 4 4

4

2

100

65

So, the total political risk is about 61 out of 100 ECONOMIC RISK The recent political trouble has created an economic imbalance as well. Brazil’s economy in the 20

recent past was plummeting as price of commodities were in a rise and people losing their jobs. There were many key factors to consider while determining the economic risk of the country. The economic risk is calculated in the following context:

Components

Result

point

component achieved

GDP per Head Real GDP Growth Annual Inflation Rate Budget Balance as a Percentage of GDP Current as a Percentage of GDP

91.49% 0.7 9% -12.31%

5 10 10 10

3 6 7.5 2

15

11.5

50

30

So, The Economic Risk is about 30 points out of 50

FINANCIAL RISK Components

Result 46.50% 38.10%

poin t 10 10

Achieved Point 5.5 5.5

Foreign Debt as a Percentage of GDP Foreign Debt Service as a Percentage of Exports of Goods and Services Current as a Percentage of Exports of Goods and Services Net International Liquidity as Months of Import Cover Exchange Rate Stability

12.79%

15

11

14.38%

5

4.5

(4.82%, 7.06%)

10

9

50

35.5

So, The Financial Risk is about 35.5 out of 50

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COMPOSITE POLITICAL, FINANCIAL AND ECONOMICAL RISK RATINGS So, from the above calculation, we can find the composite political, economic and financial risk rating of Brazil. FER (Brazil) = 0.5 (PR + FR + ER) =0.5 (65+30+35.5) =65.3

PROBLEM STATEMENT The problem statements are given below:

1. Why would 3P Turbo consider investing in Brazil? What are the advantages and disadvantages to locating its operations in Brazil? 2. What discount rate would we use to discount the cash flows from the project? Does this adequately capture the risk of investing in Brazil? 3. Based on the five-year life of the project, does this project look attractive for 3P Turbo? Should Jason invest now, while the Brazilian real was still relatively weak and his competition was unlikely even to consider Brazil, or should he wait it out until after the election in 2018?

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CHAPTER 5 ANALYSIS OF EACH ALTERNATIVE Invest Analysis (Cost of Capital) 3P Turbo has a significant competitive advantage of a good business relation with its vendor in German. The vendor is willing to provide credit facility up to R$ 90 million at 2% interest. However, taking full loan facility will make the company’s debt ration very high which will consequently make 3P Turbo’s financial risk very high. The desired capital structure is 1:1 DebtEquity ratio. On the other hand, 3P Turbo’s cost of equity capital in USA is 10%. We have estimated the cost of equity for Brazil operation adjusting the relative inflation as following:

Cost of Equity Cost of Capital in USA for similar project Inflation in USA Inflation in Brazil Relative Inflation in Brazil Inflation Adjusted Cost of Equity Capital

10% 2% 9% 7% 17.70%

There are four options available for 3P Turbo to take loan from. We have calculated after tax cost of debt for all options. Cost of Debt

Cost German Vendor German Bank USA Bank Brazilian Bank

2.00% 6.00% 8.00% 15.00%

Tax Rate 34% 34% 34% 34%

After Tax Cost of Debt 1.32% *lowest 3.96% 5.28% 9.90%

After estimating cost of debt and equity we have estimated WACC based on the desired capital structure and for the highest debt to equity ratio.

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MODEL-1: (Maximum Debt) Component

Cost (K)

Amount in R$

Weight (W)

WxK

Debt (from German Vendor)

1.32%

90000000

69.23%

Equity

17.70%

40000000

30.77%

0.009138 0.054462

130000000

1

Total

WACC

6.36%

Weight (W) 50%

WxK

MODEL-2 (Desired Capital Structure) Component

Cost (K)

Debt (from German Vendor)

1.32%

Amount in R$ 65000000

Equity

17.70%

65000000

50%

130000000

1

Total

WACC

0.0066 0.0885

9.51%

The information given in this case suggests us that, 3P Turbo will prefer MODEL-2. Thus we calculated the other on the basis of Model-2.

Investment Analysis (Capital Budgeting): Based on our estimated WACC we have calculated NPV, IRR and MIRR NPV, IRR and MIRR with desired capital structure: NPV (R$000) NPV (US$'000) IRR MIRR

27,048.62 7,232.25 16.13% 14.00%

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If 3P Turbo go for 50-50 debt-equity ratio while financing this project, this will yield 16.13% internal rate of return when MIRR will 14.0% assuming that the reinvestment rate is 10.0%. This project will add value to the company by R$ 27,048.620 or $ 7,232,250 in of USD. NPV, IRR and MIRR with maximum debt ratio: NPV (R$000) 43,039.25 NPV (US$'000) 11,507.82 16.13% IRR 14.00% MIRR

If 3P Turbo go for maximum debt financing its NPV increases to R$ 43,039,250 or US$ 11,504,820. We have assumed that 3P Turbo will be able to exchange the cashflows into US$ in forward exchange rate of 3.74 for R$/$.

Monte Carlo Simulation: Monte Carlo simulation is a computerized mathematical technique that allows people to for risk in quantitative analysis and decision making. The technique is used by professionals in such widely disparate fields as finance, project management, energy, manufacturing, engineering, research and development, insurance, oil and gas, transportation, environment and so on. Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the probabilities they will occur for any choice of action. It shows the extreme possibilities—the outcomes of going for broke and for the most conservative decision—along with all possible consequences for middle-of-the-road decisions. We ran Monte Carlo simulation for the base case scenario using crystal ball add-on for excel. We took cost of capital, price per unit & growth, production cost, selling cost, istrative cost as input variable and NPV, IRR, MIRR as Forecast Variable.

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Graph-1 NPV Frequency

From the above graph we can see that there is a 95% probability that the NPV will be in between R$ 14,716,930 and R$ 40,509,930. Graph-2 : NPV Sensitivity

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The simulation shows that NPV is highly sensitive with WACC, which is -46.9%. The relaitonship is inverse. NPV is also sensitive with Price per unit and production cost at 31.9% and -14% respectively which is shown in Graph-2. This implies that NPV will increase by 31.9% of increase in Price and decline by 14% of increase in production cost. Table: Statistics forcast values for NPV

Trials

50,000

Base Case

27,048.62

Mean

27,222.92

Median

27,089.29

Mode

'---

Standard Deviation

6,599.54

Variance

43,553,882.70

Skewness

0.1292

Kurtosis

3.02

Coeff. of Variation

0.2424

Minimum

2,386.26

Maximum

59,394.86

Mean Std. Error

29.51

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Graph-3: IRR Frequency

The above graph shows the normal distribution of IRR in Monte Carlo Simulation for 50000 trials at 100% certainty level.

There is a 95% probability that the IRR will be in between 13.95% and 18.29%.

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Graph-6: IRR Sensitivity

The simulation shows that IRR is highly sensitive with price growth. When price rises, IRR also rises by 54.9% of the rise of price per unit. IRR is also sensitive with production cost by -31.6% which implies that IRR will decrease by 31.6% of the increament in the production cost. Statistics forcast values for IRR are as follows: Trials Base Case Mean Median Mode Standard Deviation Variance Skewness Kurtosis Coeff. of Variation Minimum Maximum Mean Std. Error

50,000 16.13% 16.12% 16.13% '--1.11% 0.01% -0.0172 2.93 0.0687 11.45% 20.32% 0.00% 29

Graph-7: MIRR Frequency

The above graph shows the normal distribution of MIRR in Monte Carlo Simulation for 50000 trials at 100% certainty level.

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From the Monte Carlo Simulation, we can say that there is 95% probabilty that the MIRR will be in between 12.57% to 15.40%.

Forecast Statistics Values for MIRR Trials

50,000

Base Case

14.00%

Mean

13.99%

Median

14.00%

Mode

'---

Standard Deviation

0.72%

Variance

0.01%

Skewness

-0.0280

Kurtosis

2.97

Coeff. of Variation

0.0513

Minimum

10.96%

Maximum

16.63%

Mean Std. Error

0.00%

We also run Monte Carlo Simulation for the other optioin with maximum debt financing. 31

Graph-8: NPV Frequency

Graph-9: Probability of NPV Generation

32

From above graph we can say that there is a 95% probability that the project will generate a NPV in between RS$ 30,948,390 and R$ 55,925,250.

Graph-10: Sensitivity of NPV

The simulation shows that NPV is highly sensitive with price, which is 43.5%. The relaitonship is positive which indicates NPV will increase by 43.5% of the increment in price. NPV is also sensitive with WACC and production cost by -29.1% and -18.0% respectively which is shown in the above graph. This implies that NPV will decrease by 29.1% of increase in WACC and decline by 18% of increase in production cost. Table: Statistic Forecast values for NPV: Trials

50,000

Base Case

43,039.25

Mean

43,156.18

Median

43,080.87 33

Mode

'---

Standard Deviation

6,398.64

Variance

40,942,636.11

Skewness

0.1081

Kurtosis

3.01

Coeff. of Variation

0.1483

Minimum

19,399.83

Maximum

73,773.21

Mean Std. Error

28.62

Graph-11: Frequency of NPV

There is a 95% probability that the IRR will be in between 13.95% and 18.30%.

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Graph-12: Sensitivity of IRR

The simulation shows that IRR is highly sensitive with price growth. When price rises, IRR also rises by 54.7% of the rise of price per unit. IRR is also sensitive with production cost by -31.5% which implies that IRR will decrease by 31.5% of the increment in the production cost. Statistic Forecast values for IRR Trials

50,000

Base Case

16.13%

Mean

16.13%

Median

16.13%

Mode

'---

Standard Deviation

1.11%

Variance

0.01%

35

Skewness

-0.0149

Kurtosis

2.97

Coeff. of Variation

0.0690

Minimum

10.84%

Maximum

20.57%

Mean Std. Error

0.00%

Graph-12: Frequency of MIRR

There is a 95% probability that the MIRR will be in between 12.60% and 18.38%.

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Graph-12: Sensitivity of MIRR

The simulation shows that IRR is highly sensitive with price growth. When price rises, IRR also rises by 60.5% of the rise of price per unit. IRR is also sensitive with production cost by -26.0% which implies that IRR will decrease by 26% of the increment in the production cost.

Statistic Forecast values for MIRR TRIALS

50,000

BASE CASE

14.00%

MEAN

14.00%

MEDIAN

14.00%

MODE

'---

STANDARD DEVIATION

0.71%

VARIANCE

0.01%

37

SKEWNESS

-0.0234

KURTOSIS

2.96

COEFF. OF VARIATION

0.0508

MINIMUM

11.08%

MAXIMUM

16.97%

MEAN STD. ERROR

0.00%

CHAPTER 6 ALTERNATIVE COURSES OF ACTION Real options exist when managers can influence the

risk of a project’s cash flows by taking

different actions during the project’s life in response to changing market conditions. As discussed earlier, the economy and the industry in Brazil has a real option for 3P Turbo. We assumed that, it will require additional investment of R$130 million. It is expected that the benefits can be realized for 5 years. And the firm can exercise the real option within 3 years. We calculated the value of real option at 9.51% discount rate with a risk free rate of 2.38% and expected (assumed) returns and probabilities are as follows:

Net Cash Flows in Brazilian Real

Probability Year 1

Year 2

Year 3

Year 4

Year 5

0.1

18001200.00

20064030.00 25526754.96 30721857.00 52897769.92

0.2

20572800.00

22930320.00 29173434.24 35110693.71 60454594.20

0.4

25716000.00

28662900.00 36466792.80 43888367.14 75568242.75

0.2

30859200.00

34395480.00 43760151.36 52666040.56 90681891.30

0.1

33430800.00

37261770.00 47406830.64 57054877.28 98238715.57

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Probability PV of Return Inflows 0.1 107554058.72 -15.04% -2.91% 0.2 122918924.25 21.37% 0.4 153648655.32 45.64% 0.2 184378386.38 57.78% 0.1 199743251.91

Variance

Expected Return

-1.50% -0.58% 8.55% 9.13% 5.78%

0.013256614 0.011783657 1.2326E-33 0.011783657 0.013256614

21.37%

5.01%

SD PV of Expected CF

22.3787%

153648655.32

Option Pricing Calculation Current Asset Value

S

$153,648,655.32

d1

0.8776

Exercise (Strike) Price Time to Maturity (Years) Riskless Interest Rate (% p.a.)

X

$ 126,600,000.00

d2

0.4900

T

3.00

rf

2.38%

N(d1)

0.8099

Volatility (% p.a.)

s

$0.22379

N(d2)

0.6879

Real Option, C Real Option, C (in US$)

$ 43,352,740.33 $ 11,591,641.80

39

RECOMMENDATION The cost of capital is lowest if 3P Turbo take 90% seller financing from the Germen Vendor. The NPV of the project is more than $11 million in that case. IRR and MIRR are also higher than the rate of cost of capital. So, this project will be a profitable one. The Monte-Carlo Simulation of this study demonstrated that the NPV, IRR and MIRR of this Project are highly sensitive to Price per unit, Cost of Capital and Production Cost. So, the reduction of risk of the project required to take appropriate action to maximize the production cost and cost of capital. A proper forecasting and timely use of real option add extra value as well increase the profitability of a project. Again a true NPV always add value of real option. In this case, the project may have an alternative real option; which is the possibility of establishing business operation in Brazil. The calculation of real option results as the call option of R$ 43,352,740.33, which means that establishing business in brazil will increase the NPV as well as benefit both for the project and company. From the above all assumptions, calculations and forecasts the project can be recommended as an acceptable project. 3P Turbo should go for the project as it will add a value of $ 7,232,205 even without considering the value of real option. With consideration of real option it would be a huge profitable for the company.

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