Case study at BI Norwegian Business School - Case 1: The Procter & Gamble Company: Mexico 1991- Exam code and name: GRA 6544 – Multinational Corporate Finance Hand out date: 11. 09. 2012 Hand in date: 25. 09. 2012 Study place: BI Oslo Table of Contents Abstract:ii 1. Mexican economic conditions1 a. Change in Mexican economic and political conditions during the 1970s and 1980s1 b. Mexico’s economic and political climate in 19912 2. Financing options2 3. Financing risk, foreign exchange risk and business risk8 4. Attractiveness of Mexico’s capital market9 5. Conclusion:10 References:11
Abstract: Procter & Gamble (P&G) needs to borrow an average of $55 million over the next three years in order to expand and modernize its Mexican subsidiary. As four financing alternatives are currently available to the company, our analysis focuses on the several factors that could affect P&G’s final decision. Both the lowest cost of raising capital and an acceptable level of risk are at the basis of P&G Mexico’s rationale. Market factors include different interest rate levels, the Mexican tax law, devaluation probability and returns in Mexican money-market investments.
Country-specific factors include the Mexican economic and political environment. Given that interest rates in US dollars are significantly lower than in Mexican pesos, we compare the four financing options by also taking into consideration the positive returns provided by Mexican economic policy regarding domestic investments in monetary assets. We conclude with a sensitivity analysis of our assumptions by highlighting the prominent role played by estimated devaluation and the decline in Mexican interest rates. 1. Mexican economic conditions a.
Change in Mexican economic and political conditions during the 1970s and 1980s Mexico continued its trend of significant economic growth and prosperity throughout most of the 1970s. Now, as opposed to the last 40 years of growth after the Great Depression, the main driver was the discovery of the enormous Chiapas oil field, which brought with it a massive influx of foreign loans. This decade was, however, also characterized by a rapid increase in inflation, which forced the government to devalue the peso by as much as 58% in 1976. A twenty year long era of fixed exchange rate had come to an end.
To prevent capital flight when investors confidence disappeared, the Mexican government froze all hard-currency payments and converted all debt owed to foreign creditors into pesos. In addition, all principal repayments on this debt were deferred for five years. (Robert Looney, 1985) Highly expansionary fiscal policy reinforced further growth, but also made the peso chronically overvalued. This, together with the resulting unmanageable high levels of external debt, forced the country to undergo several peso-devaluation during the early 1980s, and in 1982 an unavoidable debt crisis occurred.
At this point in time the booming days were definitively over and the Mexican investment climate had been significantly deteriorated. In 1982 the oil-price bubble burst and the rest of the Mexican economy collapsed. The unemployment and inflation rate skyrocketed with the country experiencing zero-growth in GDP. (Robert Looney, 1985) At the end of the 1980s the Mexican economic policy was trying to combine a number of government/labor/private sector issues with traditional austerity measures where wage, price and exchange rate controls were predominant.
Investors slowly regained their confidence and the inflation was reduced, generating a net inflow of capital and thus avoiding a sharp long-lasting recession. The level of external debt, as a ratio of GDP, fell considerably (by 11%) from 1989 to 1991 and throughout the whole decade of 1980 a massive number of state-owned firms were privatized. (www. mongabay. com) b. Mexico’s economic and political climate in 1991 In 1991, the Mexican economy was slowly recovering after a brutal previous decade. Both the external debt, as a ratio of GDP, and the public-sector deficit had fallen to 36% and 1,5%, respectively.
The dependence on the petroleum export was reduced and it accounted for only 29% of exports in 1991, compared to 77% in 1982. There had been a tremendous structural shift within sectors where the ownership, market shares and responsibility between the government and the private sector became more evenly distributed. The government was highly involved in public utilities, petroleum, banking and some manufacturing industries, while the private sector dominated the remaining areas (especially manufacturing, mining, commerce, entertainment and service industries).
The main economic goals of the Mexican government in 1991 were to lower inflation, modernize the economy and improve the standard of living for the poorest inhabitants. In order to control the inflation, that had spiked to over 159% in 1987 (www. banxico. org. mx), the government introduced several new policies: 1) reduce the fiscal deficit and the public-sectors internal debt, 2) control aggregate demand, 3) temper real-wage increases, 4) limit price increases, and 5) sterilize capital inflows.
The government also developed different measures in order to encourage foreign direct investments in Mexico. This implied controlled devaluation rate of the peso (target per year of 5,5%), lowered corporate tax rate (max. 35%) and relaxed restrictions on foreign capital movements. The Mexican government also hoped to see some improvements, in form of increased investment and economic growth, as a result of the establishment of the North American Free Trade Agreement (NAFTA) between USA, Canada and Mexico, which were under negotiation from 1990 to 1994. (www. naftanow. rg) This set of undertakings resulted in regained economic growth (estimated expansion in GDP by 4%-5 %), increased social spending and a huge drop in inflation (to 8% per 22. 09. 1991 from 52% in 1988). 2. Financing options In order to pursuit its growth strategy in Mexico, Procter & Gamble (P&G) has four financing options available: a loan in Peso, a guaranteed dollar loan, an unguaranteed dollar loan, or a guaranteed medium-term maturity debt note (MTN). Our analysis yields four comparative tables, containing forecasted figures on the fours different scenarios.
The comparison of the four financing options entails a common approach to the analytical problem and it is based on calculating the final after-tax cost of each scenario. Exhibit 9 serves as a basis for the inputs regarding the average amount of outstanding debt, the choice of interest rates, the size of the devaluation effect, and the applicable tax rate. The pretax cost of debt is simply the sum of the interest expense, the structuring fee, and the devaluation effect. The applicable tax rate amounts to 10% social contribution together with 35% income tax, a total of 45%.
The inflationary component tax (ICT) is calculated as the tax rate times estimated inflation rate times average outstanding debt. The ICT stems from the application of a Mexican economic policy aimed at rewarding investments in the country with a tax benefit, while discouraging companies from borrowing by acting as a tax penalty. Figure 1 below provides the analytical framework in case P&G decided to raise financing via a loan in Mexican peso: Peso| 1991/1992| 1992/1993| 1993/1994| Outstanding debt (beginning of year)| - | 40. 00 | 70. 0 | Outstanding debt (end of year)| 40. 00 | 70. 00 | 110. 00 | Average outstanding debt| 20. 00 | 55. 00 | 90. 00 | Estimated interest rate| 29. 0%| 22. 0%| 15. 0%| Interest expense| 5. 80 | 12. 10 | 13. 50 | Structuring fee| - | - | - | Devaluation effect| - | - | - | Applicable tax rate| 45. 0%| 45. 0%| 45. 0%| Total pretax cost| 5. 80 | 12. 10 | 13. 50 | Tax relief on debt| 2. 61 | 5. 45 | 6. 08 | Estimated inflation| 14. 0%| 11. 0%| 9. 3%| Inflationary component tax (ICT)| 1. 26 | 2. 72 | 3. 77 | Total after tax cost| 4. 5 | 9. 38 | 11. 19 | Discount factor (net of taxes)| 0. 86 | 0. 77 | 0. 71 | Final after tax cost| 3. 84 | 7. 21 | 7. 95 | Total cost| 19. 01| According to the uncovered interest rate parity, P&G should be indifferent between choosing a high interest peso or a low interest dollar loan, as the exchange rate between the currencies would adjust itself an thus remove any arbitrage opportunities. However, in our case the Mexican peso/US dollar exchange rate was not freely floating, as the Mexican government was controlling the currency devaluation.
In such a situation, uncovered interest rate parity will clearly be violated, as monetary manipulations will overcome market forces. However, as the adjustment in the peso/dollar exchange rate was controlled by the Mexican government and not freely floating, uncovered interest parity cannot hold. As at 1991, one of the main assumptions of our financing analysis is a declining interest rate, averaging 22% over the three years. Nonetheless, the interest rate on Mexican peso remains intrinsically high on a comparative basis, with the addition of the uncertainty related to the floating rate.
This provides no guarantees regarding the estimated decrease presented in Exhibit 9, as the interest rate may hold at the high level of 29% or even increase. Overall, the already high cost of a loan in Mexican peso suffers from this implied uncertainty over the investment period. One advantage of the loan in Mexican peso lies in the absence of devaluation risk. By borrowing in peso, P&G would pay interest expenses in the same currency in which they earn revenues. In this case, the historically continuous devaluation of the Mexican peso vis a vis the US dollar will not increase its interest costs in real terms.
As the dollar value of revenues decreases with inflation, so does the value of the outstanding debt and the interest expenses, resulting in a so-called natural hedge. Figure 2 below shows the analytical framework in case P&G decided to raise financing via a unguaranteed loan in US Dollar: Unguaranteed $| 1991/1992| 1992/1993| 1993/1994| Outstanding debt (beginning of year)| - | 40. 00 | 70. 00 | Outstanding debt (end of year)| 40. 00 | 70. 00 | 110. 00 | Average outstanding debt| 20. 00 | 55. 00 | 90. 00 | Estimated interest rate| 12. %| 12. 0%| 12. 0%| Interest expense| 2. 40 | 6. 60 | 10. 80 | Structuring fee| - | - | - | Devaluation effect| 0. 94 | 2. 48 | 3. 87 | Applicable tax rate| 45. 0%| 45. 0%| 45. 0%| Total pretax cost| 3. 34 | 9. 08 | 14. 67 | Tax relief on debt| 1. 08 | 2. 97 | 4. 86 | Estimated inflation| 14. 0%| 11. 0%| 9. 3%| Inflationary component tax (ICT)| 1. 26 | 2. 72 | 3. 77 | Total after tax cost| 3. 52 | 8. 83 | 13. 58 | Discount factor (net of taxes)| 0. 94 | 0. 88 | 0. 83 | Final after tax cost| 3. 30 | 7. 7 | 11. 21 | Total cost| 22. 28| The intrinsic risk of a loan to P&G Mexico that is not guaranteed by the parent company lies in the potential bankruptcy of the subsidiary. As at 1991, P&G Mexico was highly ranked among P&G’s international subsidiaries. P&G’s positive outlook on the Mexican market was often signaled by several statements referring to the planned investments in the country in the short to medium term. This leads to the conclusion that management at the time considered country-specific risk to be quite low.
Figues 3 below depicts the analytical framework in case P&G decided to raise financing via a guaranteed loan in US dollar: Guaranteed $| 1991/1992| 1992/1993| 1993/1994| Outstanding debt (beginning of year)| - | 40. 00 | 70. 00 | Outstanding debt (end of year)| 40. 00 | 70. 00 | 110. 00 | Average outstanding debt| 20. 00 | 55. 00 | 90. 00 | Estimated interest rate| 7. 0%| 7. 0%| 7. 0%| Interest expense| 1. 40 | 3. 85 | 6. 30 | Structuring fee| - | - | - | Devaluation effect| 0. 94 | 2. 48 | 3. 87 | Applicable tax rate| 45. 0%| 45. 0%| 45. 0%| Total pretax cost| 2. 4 | 6. 33 | 10. 17 | Tax relief on debt| 0. 63 | 1. 73 | 2. 84 | Estimated inflation| 14. 0%| 11. 0%| 9. 3%| Inflationary component tax (ICT)| 1. 26 | 2. 72 | 3. 77 | Total after tax cost| 2. 97 | 7. 32 | 11. 10 | Discount factor (net of taxes)| 0. 96 | 0. 93 | 0. 89 | Final after tax cost| 2. 86 | 6. 78 | 9. 91 | Total cost| 19. 55| Were P&G to guarantee the loan granted to its subsidiary, the interest rate would significantly fall from 12% to 7%. This is the main driver behind the lower total cost of this financing option when compared with the previous one.
By considering both the unguaranteed and guaranteed US dollar loans, the main difference with the loan in Mexican peso is clearly the devaluation effect driven by the government-set goal of 5. 5 % per year. However, historical data show a rather unstable relationship between the US dollar and the Mexican peso. The resulting devaluation could eventually be higher, causing increased costs for the US dollar denominated loans. As we introduced above, the devaluation effect could suffer from a positive bias, mainly driven by a favorable outlook provided by the analyst Romero.
Since both US dollar loans are already more costly than a loan denominated in Mexican peso, a worsening of the economic conditions, reflected in a stronger currency devaluation, would negatively impact the total cost of the US dollar even further. Figure 4 below shows the analytical framework in case P&G chose to raise financing via a medium-term maturity debt note: MTN $| 1991/1992| 1992/1993| 1993/1994| Outstanding debt| 110. 00 | 110. 00 | 110. 00 | Average capital invested in P&G Mexico| 20. 00 | 55. 00 | 90. 00 | Average capital invested in monetary assets in Mexico| 90. 00 | 55. 00 | 20. 0 | Estimated interest rate| 6. 0%| 6. 0%| 6. 0%| Interest expense| 6. 60 | 6. 60 | 6. 60 | Structuring fee| 0. 44 | - | - | Devaluation effect| 5. 17 | 4. 95 | 4. 73 | Applicable tax rate| 45. 0%| 45. 0%| 45. 0%| Total pretax cost| 12. 21 | 11. 55 | 11. 33 | Tax relief on debt| 2. 97 | 2. 97 | 2. 97 | Estimated inflation| 14. 0%| 11. 0%| 9. 3%| Inflationary component tax (ICT)| 6. 93 | 5. 45 | 4. 60 | Total after tax cost| 16. 17 | 14. 03 | 12. 96 | Discount factor (net of taxes)| 0. 97 | 0. 94 | 0. 91 | After tax cost| 15. 65 | 13. 14 | 11. 76 | Total cost before ICT| 40. 6| Average capital invested in monetary assets in Mexico| 90. 00| 55. 00| 20. 00| Average investment return | 18. 50%| 14. 40%| 12. 80%| Return on investment after tax| 9. 16 | 4. 36 | 1. 41 | Devaluation effect| (0. 43)| (0. 41)| (0. 20)| Inflationary component tax| 5. 67 | 2. 72 | 0. 84 | After-tax benefit| 14. 40 | 6. 67 | 2. 05 | After tax benefit discounted| 13. 94 | 6. 25 | 1. 86 | Final after tax cost| 1. 72 | 6. 89 | 9. 90 | Total cost| 18. 51| According to our comparative evaluation the medium term maturity note (MTN) results to be the most profitable financing opportunity.
However, we must highlight that the Mexican regulatory environment plays a key role in our choice. Since the capital-investment program is expected to generate needs for US$110m, the minimum threshold that grants a public placement would be overcome by far. Even if characterized by the lowest rate, interest expenses related to the MTN loan are high due to the fact that they are calculated on the whole amount from the very onset. Moreover, the MTN is the only financing option that requires expenses related to the structuring fee. However, these costs will be more than offset by the ICT benefit.
In fact, by borrowing a lump sum of money upfront, P&G can invest its yearly capital surplus in monetary assets that will eventually earn a tax benefit. We have developed our analytical computation according to Exhibit 9, which presents average investment returns for the peso. Although declining, this return on monetary assets seems to be significantly higher than on the US dollar market. In order to shed some light on a possibly unclear passage in our calculations regarding the devaluation effect, we want to explain how it is accounted for under the assumption of investing the surplus cash in money-market assets.
For yearly-borrowed amounts in each scenario we used yearly devaluation rates, as this approach is consistent with the framework constructed in our tables. For invested amounts (as with the surplus cash for the MTN loan case) we used compounded devaluation rates. Another relevant passage is our assumption behind the construction of the decline in the peso interest rate, given only two constraints from the case: 29% in the first year and 22% average over the three years. We chose as initial values 29%-22%-15% in a way to make them more consistent with the Fisher equation.
In fact, for the last forecasted year we get values of: Nominal int. rate = Real int. rate + Exp. Inflation 15% = 5. 7% + 9. 3% As a final note we would like to mention two interesting cases we decided to develop a bit further. The first table below shows how much the Mexican peso should devalue each year in order to make P&G financially indifferent between the MTN and the loan in Mexican Peso. As we can see, the break-even point (BEP) yields values not far from the ones provided by the case, revealing a strong sensitivity to our assumptions. Peso devaluation (implied by BEP)| 4. 6%| 4. 65%| 4. 40%| Estimated devaluation| 4. 70%| 4. 50%| 4. 30%| On the other hand, the second table below shows different paths of declining peso interest rates and associated total costs of the financing option. The rationale behind this sensitivity analysis is the high uncertainty about the actual decline in rates that the Mexican government announced. It is clear that, also in this case, small changes in assumptions could affect our final ranking of financing options. Interest rate decline assumed (%)| 29-22-15 | 29-21-16 | 29-20-17 | 29-19-18| Peso loan total cost| 19. 1 | 19. 16 | 19. 31 | 19. 46 | 3. Financing risk, foreign exchange risk and business risk When planning to invest in the Mexican subsidiary, P&G the will face several kinds of risk, such as financing risk, foreign exchange risk and business risk. Financial risk is the probability of loss associated with financing methods that may weaken the ability to provide sufficient return. In simple terms this is the risk that the company’s cash flows will not be sufficient to meet its financial obligations.
Financial risk is closely related to the interest rate level. (Hodrick and Geert, 2009) In fact, P&G will increase its debt ratio through borrowing and eventually face a higher burden of financial risk. If the choice were the Mexican peso loan and the interest rate were to increase, it would then prove to be difficult to meet interest payment obligations. Foreign exchange risk is the risk of changes in the currency exchange rates resulting in changes in the value of investments. If the firm chooses to borrow in the U. S. apital market, then the ability to repay the loan will depend on the development of the currency exchange rates level; in this case a devaluation of peso will negatively affect the financial stability of the firm. According to the interest rate parity, the key drivers of the devaluation’s impact are the domestic and foreign currency interest rates and the spot exchange rate. If covered interest rate parity holds, a perfect hedge would result to be possible and thus grant P&G the opportunity to significantly reduce its risk exposure.
Following this consideration, the company can engage in a forward contract to buy dollars forward or in a foreign currency swap by selling dollars spot and buying dollars forward. The latter option is considered to be a more common way of hedging. (Hodrick and Geert, 2009) Business risk is reflected in the possibility that the business will report lower profits than anticipated (due to numerous internal and external factors of the business itself) and will not be able to generate a sufficient return on its investment.
For what concerns P&G, business risk might be caused by different factors, such as sales-volume, unit price, competition, input costs or others. By impacting the underlying profitability of the business, these factors can make it difficult for the company to generate sufficient funds to meet its debt obligations. As a consequence, the business risk and financial risk are intertwined, and together contribute to make a company more vulnerable to the possibility of missing an interest payment and thus potentially trigger bankruptcy. (Hodrick and Geert, 2009) 4.
Attractiveness of Mexico’s capital market According to uncovered interest rate parity, a flexible exchange rate will automatically adjust so that no excess return can be made from investing in a currency with a higher interest rate. (Hodrick and Geert, 2009) The expected return on investment in Mexican assets is 45,7% for the period 1991-1994 (Exhibit 9). Following the “theoretical” parity mentioned above we would expect that, by converting the return on investments into dollars, P&G will experience an unfavorable exchange rate so that any excess profit will be offset.
Since the Mexican government controls the exchange rate movements, uncovered interest rate parity will not hold and profit opportunities might exist. This would be the case if future spot rates do not move in an unfavorable direction enough to net off any possible gains. In fact history shows that arbitrage opportunities might well exist when markets are particularly volatile, as Mexico proved to be during the previous decade. Through time, Mexico has been troubled with a great deal of political risk. This has made market participants anxious about further large devaluations.
After all, in 1991 it had been less than 10 years since the economy abruptly collapsed. Since the Mexican government and local banks lacked credibility, financial institutions were forced to offer interest rates higher than elsewhere. The main consequence of this fact is that as long as a large unexpected devaluation or other country specific events does not occur, then considerable profit opportunities should exist in the Mexican capital market. 5. Conclusion: The outcome of our analysis is that the MTN loan appears to be the most convenient financing option for P&G Mexico.
This result is achieved by simulating the four financing scenarios presented in the case and by considering the assumptions on tax advantages, interest rate environment and investment returns in Mexico. However, we also find our conclusion to be highly sensitive to the assumptions made about the devaluation of the peso and the declining path in interest rate in the Mexican currency. We can then state that the MTN loan is currently the cheapest financing option, but a good deal of care must be taken in assessing the risk environment in which P&G Mexico operates.
The stability provided by international agreements such as the NAFTA contributes to strengthen our confidence in considering this choice the most suitable one. References: Books: Robert Looney (1985): Economic Policy Making in Mexico: Factors Underlying the 1982 Crisis Duke Univerity Press Hodrick, Robert J. and Bekaert, Geert (2009): International Financial Management Pearson Prentice Hall Internet: http://www. mongabay. com/reference/country_studies/mexico/ECONOMY. html 20. 09 14:03 http://www. banxico. org. mx/portal-inflacion/inflation. html 20. 09 15:11 http://www. naftanow. org/about/default_en. asp 20. 09 15:29