FIN 336 Module 7 Project Two Example

Recommendation to the Board: Entering Brazil in Two Stages

[Student Name]

Southern New Hampshire University

FIN 336: Multinational Corporate Finance

Project Two

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Recommendation to the Board: Entering Brazil in Two Stages

Executive Summary

Management recommends that the board approve a plant near Rondonópolis, Mato Grosso, built in two stages. Stage one, R$100 million in 2026 and 2027, would roll steel bin panels and assemble dryers using controls shipped from Sioux Falls. Stage two, about R$80 million, would add capacity in 2028 only if Brazilian sales reach agreed milestones. After subtracting the export margin the plant would replace, the full project is worth about $7.2 million more than the investment, compared with about $6.3 million for licensing and about $3.6 million for a joint venture. The plant also keeps control of the company's dryer technology. Two thirds of the debt would be borrowed in reais, forecast remittances would be partly hedged, and anti-bribery controls would be in place before construction starts.

The Opportunity

Brazilian farm cooperatives have bought the company's bins for eight years, and Brazil's share of company sales has climbed to roughly a tenth. Grain output in central Brazil has outgrown storage, so demand should keep rising. Project One found Brazil's risks manageable for a manufacturer, with currency swings and high local interest rates as the largest, and recommended a country risk premium of about 2.5 points. The Module Five valuation found the plant worth R$69.3 million, or $12.7 million, above its R$180 million cost, discounted at 11.5 percent in dollars.

A Correction to the Valuation

That valuation counted the plant's own cash flows but not the profit the firm would lose by no longer shipping bins from South Dakota. Exports to Brazil earn about $0.8 million a year after tax today, and that margin is shrinking as freight costs, the import tariff and a weaker real eat into it. Valued as a stream falling 3 percent a year and discounted at 11.5 percent, it is worth about $5.5 million. The plant's true gain over continuing to export is therefore $12.7 million minus $5.5 million, or about $7.2 million. This is still positive, but it is a thinner margin of safety than the earlier figure suggested.

Alternatives Considered

Licensing. A São Paulo manufacturer has offered to build bins to the company's designs in return for a 4 percent royalty on its sales. On sales like those forecast for our own plant, royalties would run from about R$6.0 million to R$9.2 million a year. After Brazil's 15 percent withholding tax on royalties and the U.S. tax remaining after credit for it, the company would keep about 79 percent. Converted at parity-based rates and discounted at 11.5 percent, the royalties are worth about $11.8 million, or $6.3 million after the same lost export margin, with no capital invested. The risk is that the licensee learns the dryer controls and competes once the agreement ends.

Joint venture. A manufacturer linked to a large cooperative group has proposed a 50-50 venture. It would bring land, permits and customer relationships and would halve the capital required, but it would also halve the gain, to about $3.6 million, and decisions on pricing and expansion would need the partner's agreement.

Entry options compared (dollar values in millions)

Why Two Stages

Building in two stages lowers the capital at risk while demand is still being proven. Stage one costs about $18.3 million at today's rate. If the plant reaches R$175 million of sales by its second year, as forecast, stage two adds capacity; if not, the company can keep the smaller plant and continue exporting premium dryers from Sioux Falls. Kogut and Kulatilaka (1994) showed that a multinational's plants in several countries have option value because the firm can shift production as exchange rates change. A Brazilian plant gives this company such an option for the first time, since in a year when the real is very weak it could ship Brazilian panels to other South American buyers.

Financing Plan

The company would fund stage one with R$40 million of equity from the parent and R$60 million of debt. About R$40 million of the debt would be borrowed in reais, half from development bank equipment credit and half from a Brazilian commercial bank, and about R$20 million would be lent by the parent in dollars. Debt in reais matches the plant's revenue, so a weaker real lowers its debt and revenue together. The parent loan provides interest deductions in Brazil at its 34 percent tax rate and must be priced at arm's length. Stage two would be financed the same way once stage one is profitable.

Hedging Policy

Two exposures need a policy. First, until the plant opens, Brazilian orders remain export sales, so every confirmed receivable in reais should be sold forward through non-deliverable forwards, as in the Module Three example. Second, once the plant is running, the company should hedge half of the next twelve months of forecast dividends from Brazil with forwards and leave the rest open. Froot et al. (1993) argue that hedging is worth its cost when it protects the cash needed for planned investment, which describes the stage-two decision exactly. Longer-term currency exposure is best handled by the plant's real costs and real debt, not by contracts.

Political Risk and Controls

Bekaert et al. (2014) found that much of the political risk priced in emerging market bond spreads can be reduced by insurance and contractual protections. The company should secure the Mato Grosso state tax incentive in a written agreement before buying land and should price political risk insurance from the U.S. International Development Finance Corporation or a private insurer for the equity invested. It should also appoint a compliance officer for Brazil, screen every customs broker and permit agent and train local managers on the U.S. Foreign Corrupt Practices Act and Brazil's Clean Company Act before construction begins.

Implementation Timeline

Milestones

Conclusion

The board is asked to approve stage one, R$100 million, with the financing, hedging and compliance conditions above, and to review stage two at the end of 2028. A two-stage plant offers the highest value of the options studied, keeps the company's dryer technology in its own hands and limits the money at risk until Brazilian demand is confirmed. If sales fall short or the real weakens sharply, the company keeps a profitable smaller plant and its export business.

References

Bekaert, G., Harvey, C. R., Lundblad, C. T., & Siegel, S. (2014). Political risk spreads. Journal of International Business Studies, 45(4), 471-493. https://doi.org/10.1057/jibs.2014.4

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Kogut, B., & Kulatilaka, N. (1994). Operating flexibility, global manufacturing, and the option value of a multinational network. Management Science, 40(1), 123-139. https://doi.org/10.1287/mnsc.40.1.123