Dow Chemical’s Bid for PBB in Argentina Essay

1. (5 pts) Using the values from exhibits 9, 10 and 11, a terminal growth rate of 0%, and a discount rate of 20%, what is the value of each of the three investment stages? 2. (30 pts) Describe the two most relevant factors (only those related to the fact that the acquisition is in Argentina and not in the U.S.) that in your opinion add uncertainty to those cash flows. Please list each factor with a short explanation of why it is relevant, whether it is a diversifiable risk (assume Dow’s investors are global) and the likelihood that it will affect PBB. 3. (20 pts) For question 3 please state which statement you agree with and why. The numbers shown are there to provide an idea of sensitivity, they are not precise and there is no precise answer to these questions. That is, in the absence of much, much more information, there is no clear â€Å"right† answer (though there are many â€Å"wrong† ones). Your reasoning is what matters most. Suppose that â€Å"today† is 1997 (there’s nothing particularly special about 1997, I could have chosen any other year near 1995, the beginning of the valuation). a. The sensitivity of 1998 revenues, measured in US$, to 1997 changes in the Argentinian peso against the dollar is such that: a.i. a 40% devaluation of the Argentinian peso would translate into a 40% fall in revenue, measured in US$, a.ii. a 40% devaluation of the Argentinian peso would translate into a 20% fall in revenue, measured in US$ a.iii. a 40% devaluation of the Argentinian peso would translate into no fall in revenue, measured in US$, a.iv. a 40% devaluation of the Argentinian peso would translate into a 20% increase in revenue, measured in US$, a.v. a 40% devaluation of the Argentinian peso would translate into a 40% increase in revenue, measured in US$. b. The sensitivity of 2010 revenues, measured in US$, to 1997 changes in the Argentinian peso against the dollar is such that: b.i. a 40% devaluation of the Argentinian peso would translate into a 40% fall in revenue, measured in US$, b.ii. a 40% devaluation of the Argentinian peso would translate into a 20% fall in revenue, measured in US$, b.iii. a 40% devaluation of the Argentinian peso would translate into no fall in revenue, measured in US$, b.iv. a 40% devaluation of the Argentinian peso would translate into a 20% increase in revenue, measured in US$, b.v. a 40% devaluation of the Argentinian peso would translate into a 40% increase in revenue, measured in US$. c. The sensitivity of 1998 costs, measured in US$, to 1997 changes in the Argentinian peso against the dollar is such that: c.i. a 40% devaluation of the Argentinian peso would translate into a 40% fall in costs, measured in US$, c.ii. a 40% devaluation of the Argentinian peso would translate into a 20% fall in costs, measured in US$, c.iii. a 40% devaluation of the Argentinian peso would translate into no fall in costs, measured in US$, c.iv. a 40% devaluation of the Argentinian peso would translate into a 20% increase in costs, measured in US$, c.v. a 40% devaluation of the Argentinian peso would translate into a 40% increase in costs, measured in US$. d. The sensitivity of 2010 costs, measured in US$, to 1997 changes in the Argentinian peso against the dollar is such that: d.i. a 40% devaluation of the Argentinian peso would translate into a 40% fall in costs, measured in US$, d.ii. a 40% devaluation of the Argentinian peso would translate into a 20% fall in costs, measured in US$, d.iii. a 40% devaluation of the Argentinian peso would translate into no fall in costs, measured in US$, d.iv. a 40% devaluation of the Argentinian peso would translate into a 20% increase in costs, measured in US$, d.v. a 40% devaluation of the Argentinian peso would translate into a 40% increase in costs, measured in US$. 4. (10 pts) Based on your answers to question 3, a. What would Dow’s short-run net exposure to the Argentinian peso be? b. What would Dow’s long-run net exposure to the Argentinian peso be? c. If Dow wanted to hedge its short-run net exposure to the Argentinian peso, what would it have to do? Please provide three different alternatives it could use to hedge that risk and explain which one is likely to be the cheapest. d. If Dow wanted to hedge its long-run net exposure to the Argentinian peso, what would it have to do? Please provide three different alternatives it could use to hedge that risk and explain which one is likely to be the cheapest. 5. (30 pts) In light of what you’ve answered in questions 2 through 4 and other material from class, please state whether the discount rate that Dow should use for this valuation is larger, smaller, or the same as in the U.S. 6. (5 pts) Based on your previous answers, should Oscar Vignart bid for PBB, and if so, how much? (Maximum 100 words.) 1. (Exhibit 1) The first stage has a value for the 51% of PBB of 160.833 million of dollars. The second stage has a value (100%) of 182.62 million of dollars. The third stage has a value of 92.66 million of dollars. The first problem that involves a risk factor for investors to Dow is political risk. The economic and monetary policy implemented by the Argentine government at this time, in recent years has allowed the country to recover from a decade of crisis and seems to work pretty well. However, the risk that these maneuvers are counterproductive in the long run is alive. In that case Dow suffer some problems. In fact, most of the production in the three stadiums and sold locally (PBB 100%, 89% Polisur, 31% of capacity due to the widening of stage 3) and, if there were problems due to the political instability, most of its current and potential customers (formed by small and medium-sized businesses that use POLYETHILENE to produce good consumer) could struggle and eventually fail. That would be a serious reduction in the margins of the Dow and in its cash flows. The second problem is related to foreign exchange risk. Regarding this risk factor should make some clarifications. For the moment the government is pursuing a policy of currency pegging, for which the exchange rate and artificially set at 1. However, this condition may no longer be sustainable. In this case if it were abandoned is easy to imagine the effect it would have on markets, putting in serious condition, the Argentine economy because of lack of confidence in its solvency and this would lead to a sharp appreciation of the dollar on the weight. This situation is not particularly influential on the budgets of 3 stages where Dow is going to invest because both revenues and the variable cost (about 90% of total costs) are in dollars and only a small amount of variable and fixed cost are in Peso, and anyway with devaluation of Argentinian currency would lead to an advantage per Dow (needed fewer dollars to pay in Peso, and those costs are slower to adapt to new exchange rates). On the contrary the negative effect of the abandonment of the peg you would in Argentine petrochemical market. In fact, polyethilene prices are in U.S. dollars and with the devaluation of the peso (the currency in which the players downstream of Dow are cashing) Dow’s Argentinian customers could find themselves in difficulty to support prices in dollars, which are international based. That would lead to a radical decline in the profitability of Dow. Finally, it is important to emphasize that, also selling outside the country, Dow would see margins decline due to higher costs of transportation and duties. 3. a. ii. PBB Is cashing in dollars so a fall of 40% of Peso would not have a direct impact of translating the cash flow of PBB into dollors. However PBB operates in Argentina, and its revenues are tied to the ability of its customers to buy in dollars. With such a devaluation of the Argentine pbb customers may find it difficult to pay but it is said that everyone is unable to do so because they could be covered in the market for coins. pbb also may move and take advantage of the amount of unmet demand in Latin America. However, this in a year is not feasible to perfection then a reduction in revenues of 20% is predictable. b. iii. The reasoning is similar to that outlined above. However, in this case one can imagine that pbb reacted to the change occurred 3 years before or however that the situation has changed. If the economy has recovered, it’ll be exporting outside of Argentina for the amount of capacity can not be sold in argentina, decreasing their margins because of the cost of export revenues, but keeping to the level in the case of PEG. c. ii. Talking about the good things are different costs. Even tough much of the costs are in U.S. dollars for pbb there is a part of them that is paid in pesos. It is part of the variable costs and fixed costs. However a devaluation of the peso would be a gain for PBB, which, cashing in dollars, will convert fewer dollars to pay in pesos. As mentioned, however, this effect would be taken with a not too substantial part of the costs of pbb, and also it can be assumed that during the year some of these costs are aligned in part to the conversion values ​​before the write-down for an inflationary process. d. iii. The reasoning is similar to that described above, however, it is assumed that in the course of 3 years, the monetary costs of PBB align to those pre devaluation, thus not allowing to benefit from the effect devaluing. a. the net peso short run exposure is about the fixed cost, other variable cost and taxes, for an amount of (EXHIBIT 1) of 116.7 million of dollars. b. the net long run peso exposure is 374.22 million of dollars. c. to hedge a currency risk the alternatives are: forwards (or future) contract options currency swap. The best alternatives in the short run are the forward, they are cheap (no entry expense) and very versatile. To hedge the amount the just have to enter in a contract of the opposite direction of what they need. In this case they have to buy the total cost in pesos ad the current exchange rate in dollars. Using options it would much costly because of the option premium which has to be paid once you entered in such a contract. Anyway, because you will only exercise your right if it the exchange rate is favorable, they leave gain opportunities in exchange rates. The currency swap doesn’t fit well the short run exposure because of the length of such a contract and and the cost to be inside that kind of contract if there is not an existent debt. d. In the long term forward could be costly for the premium that the controparty may put in the exchange rates (they are commonly banks in over the counter markets), and because for long term the market could be illiquid. In this particular case the long term are just 3 years so using forward could still be a good choise. Options in the long term are not good because it is difficult to find in markets contract with such long expiring date (and exact date in order not to incur in basis risk) and because you have to buy several contract. Swap could be an idea, but as forward don’t allow gains on favorable exchange rate; a currency swaption (option on a currency swap) could be an idea, but looks costly at time of entering in the contract. The discount rate that Dow should use, should be higher than that used for evaluating such an investment in the United States. This is due to the fact that the rate of between 8-10% used in US incorporates a risk premium relative to the U.S. market, which is different from that required for a similar investment in the Argentine market. In fact, looking at the performance of American and Argentine sovereign bonds, we see that the latter are higher than the U.S.. this difference is no more than the country risk premium that an investor requires to invest in Argentina compared to investing in the U.S.. this spread can be introduced into the calculation of the value of the correct discount rate using the following formula: Keu is identified with the unlevered cost of capital, or the return required to invest in certain asset class. With rf the risk-free return to us, ï  ¢u with the unlevered beta for the sector (plastic and specialized chemicals) with rm the market return and cpr country risk premium. Now, in the specific case under investigation in research on international databese you identify that the unlevered beta of the sector is close to the unit. You can also add that in the long term all beta approaching market beta (as a consequence of the Efficient Market Theory that states that as all information becomes known, the market will settle to its proper level as everyone will be able to make correct choices), and therefore since our beta in databese is equal to one, the hypothesis of adjusted beta only reinforce this assumption. So in this particular case it can be assumed that the country risk premium can be simply added to the discount factor used for an American investment. The problem is now correctly assessing the market risk premium. You can see from the exhibits proposed (Exhibit 2) that in recent years, with the PEG CPR has fluctuated around an average of about 700 basis points. Despite the markets already incorporate the possible abandonment of the peg and its causes is not difficult to think that if that happened the â€Å"cpr† suffer a considerable leap and this estimate might be not prudent, but we must remember that the market is not only Argentina in the presented 3 stages, and potentially due to the increased demand in Latin America (exhibits 3), Dow could be exported elsewhere. A CPR of around 5-7% is so reasonable, for a total discount rate between 13-17%. By using the rate of growth proposed in the case of 3.3% per annum and a discount rate of 16%, the NPV of 51% of PBB is of U.S. $ 207,476 million. This amount is not however the correct the price of the bid. Just the cash flows are not enough to assess the correct price to offer the Argentine government. As first analysis the two competitors do not seem serious bidder in the auction because they do not meet the request of combined 5 billion net worth. There are still 10 days at the closing of the auction and if they succeed caming forward with a capital increase bringing their combined wealth over 5 billion, then Dow should also consider the fact that it can benefit not only the cash flows of PBB but also those of the 3 stage of the project, which provide in part an increase in production capacity of PBB and especially of its efficiency. A price around $ 300 million should keep out other potential bidder, which they cannot reach the advantage of being the mainly argenitian producer . However, this scenario is not credible given the close smebra operating times were competitors to meet the demands of the government, then the minimum bet request for $ 150 million should be sufficient and would allow Dow generate a significant positive NPV. 150 ultimately is ultimately the value to offer.