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MASTER OF BUSINESS ADMINISTRATION

MBA (EVENING)

Course Name: Capital Investment Decision


Course Code: F 601

Case Solution on
3P TurboCross 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 TurboCross Border Investment in Brazil

Dear Sir,
We are pleased to present this Case Solution on 3P TurboCross 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 supportive 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 TurboCross 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 members for
showing us their support 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 TurboCross 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 countrys 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.

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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

Brazils 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 countrys

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 well-

thought 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 Brazils

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 mid-

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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 members, 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 Temers policy to scale back Rousseffs 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

countrys economic future and answer a lot of question of the investors mind. Whether the

economy will continue its abysmal performance in the upcoming 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 governments 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. Brazils 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 Brazils 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 3P-

Turbo 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. Threat of new entrance (high)

II. Threat of substitutes (high)

III. Bargaining power of customers (high)

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IV. Bargaining power of suppliers (high)

V. 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 join as well. If any firm from the member

countries of Mercosur (Mercado Comn 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, 3P-

Turbo 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.

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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 3P-

Turbos 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

countrys 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 members 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 terms 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 support 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 consumers 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.

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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 doesnt 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:

CPFER (Brazil) = 0.5 (PR + FR + ER)

Where, CPFER = 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 Total Achieved(sub component


point ) achieved
Government Government Unity 4 3
Stability

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Legislative Strength 4 3
Popular Support 4 2
12 8
Socioeconomic Unemployment 4 1
conditions
Consumer 4 2
Confidence
Poverty 4 2
12 5
Investment Profile Contract Viability 4 3
Profit Repatriation 4 3
Payment Delays 4 1
12 7
Internal Conflict Civil War 4 3
Terrorism/Political 4 1
Violence
Civil Disorder 4 2
12 9
External Conflict War 4 4
Cross-Border 4 4
Conflict
Foreign Pressure 4 3
12 11
Corruption 6 2 2
Military in Politics 6 5 5
Religious Tension 6 5 5
Law and Order Law(Judicial 3 2
System)
Order(Crime rate) 3 1
6 3
Ethic Tension 6 4
Democratic 6 4
Accountability
Bureaucracy 4 2
Quality
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. Brazils economy in the

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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 91.49% 5 3
Real GDP Growth 0.7 10 6
Annual Inflation Rate 9% 10 7.5
Budget Balance as a Percentage of -12.31% 10 2
GDP
Current Account as a Percentage of 15 11.5
GDP
50 30

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

FINANCIAL RISK

Components Result poin Achieved


t Point
Foreign Debt as a Percentage of GDP 46.50% 10 5.5
Foreign Debt Service as a Percentage of Exports of 38.10% 10 5.5
Goods and Services
Current Account as a Percentage of Exports of 12.79% 15 11
Goods and Services
Net International Liquidity as Months of Import 14.38% 5 4.5
Cover
Exchange Rate Stability (4.82%, - 10 9
7.06%)
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.

CPFER (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 companys debt ration very high which will
consequently make 3P Turbos financial risk very high. The desired capital structure is 1:1 Debt-
Equity ratio. On the other hand, 3P Turbos 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 10%


Inflation in USA 2%
Inflation in Brazil 9%
Relative Inflation in Brazil 7%
Inflation Adjusted Cost of Equity Capital 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

After Tax Cost of


Cost Tax Rate Debt

German Vendor 2.00% 34% 1.32% *lowest


German Bank 6.00% 34% 3.96%
USA Bank 8.00% 34% 5.28%
Brazilian Bank 15.00% 34% 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% 0.009138
Equity 17.70% 40000000 30.77% 0.054462

Total 130000000 1
WACC 6.36%

MODEL-2 (Desired Capital Structure)

Component Cost (K) Amount in R$ Weight (W) WxK


Debt (from German Vendor) 1.32% 65000000 50%
0.0066
Equity 17.70% 65000000 50% 0.0885

Total 130000000 1
WACC 9.51%

The information given in this case suggests us that, 3P Turbo will prefer MODEL-2. Thus we
calculated the other terms 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) 27,048.62


NPV (US$'000) 7,232.25
IRR 16.13%
MIRR 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 terms of USD.

NPV, IRR and MIRR with maximum debt ratio:


NPV (R$000) 43,039.25
NPV (US$'000) 11,507.82
IRR 16.13%
MIRR 14.00%

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 account
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 possibilitiesthe
outcomes of going for broke and for the most conservative decisionalong 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, administrative 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 50,000
Base Case 16.13%
Mean 16.12%
Median 16.13%
Mode '---
Standard Deviation 1.11%
Variance 0.01%
Skewness -0.0172
Kurtosis 2.93
Coeff. of Variation 0.0687
Minimum 11.45%
Maximum 20.32%
Mean Std. Error 0.00%

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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.

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Graph-8: NPV Frequency

Graph-9: Probability of NPV Generation

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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

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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%

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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%

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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 projects cash flows by taking
different actions during the projects 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 Variance
Inflows
0.1 107554058.72 -15.04% -1.50% 0.013256614
0.2 122918924.25 -2.91% -0.58% 0.011783657
0.4 153648655.32 21.37% 8.55% 1.2326E-33
0.2 184378386.38 45.64% 9.13% 0.011783657
0.1 199743251.91 57.78% 5.78% 0.013256614

Expected Return 21.37% 5.01%

SD 22.3787%

PV of 153648655.32
Expected
CF

Option Pricing Calculation

Current Asset Value S $153,648,655.32 d1 0.8776


Exercise (Strike) Price X $ 126,600,000.00 d2 0.4900
Time to Maturity
(Years) T 3.00
Riskless Interest Rate
(% p.a.) rf 2.38% N(d1) 0.8099
Volatility (% p.a.) s $0.22379 N(d2) 0.6879

Real Option, C $ 43,352,740.33


Real Option, C
(in US$) $ 11,591,641.80

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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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