___________________________________________________________________________________________

Fuqua School of Business

Emerging Markets Corporate Finance BA456
Irina Antsiferova, Canan Aydemir, Oscar Farfan, Nijat Valiyev
Spring 2005
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The Bolivian Tropical Wood Consortium (TWC)

Case Solution

The following case solution will evaluate TWC’s wood processing

project using the International Cost of Equity Capital Calculation
model (ICECC). The results will be then compared with the appraisal
made by TWC and other different scenarios.

Our valuation suggests that the country risk premium poses a real
burden to the project’s cost of capital. We found however well-founded
risk mitigating factors - including real options – that make the project
viable.
 The Bolivian Tropical Wood Consortium

1. Project Finance Overview

Following consultations and negotiations with several international finance agencies, as well as
potential partners, TWC has estimated a 35/65 debt-equity financial structure. The different
sources and the estimated cost of debt are shown below.

Exhibit 1: TWC Financial Structure

U$000 %

Total Investment 12,922 1.00

Debt 4,523 0.35 Cost Weight Weight * Cost

IIC-IADB 2,500 0.19 0.080 0.55 0.044
IFC-WB 1,500 0.12 0.082 0.33 0.027
Commercial 523 0.04 0.093 0.12 0.011

Equity 8,399 0.65 Cost of Debt (Kd) 0.082

Tahuamanu 3,877 0.30
Brazil/Ecuador Partners 1,034 0.08
SMEs 775 0.06
International Furniture 646 0.05
Technology Supplier 646 0.05
USAID-GDA 646 0.05
PUMA Foundation 388 0.03
Andean Development Corporation* 388 0.03
*Subordinated loan (Quasi-equity)

2. Cost of Capital Computation

Exhibit 2 summarizes the ICECC worksheet used to compute the project’s cost of capital. In
computing the country risk premium, the Sep/04 Bolivian Institutional Investor Country Credit
Rating has been lowered by 3 points in order to account for the escalating social conflicts in the
first quarter of 2005. The scores and weights corresponding to the risks specific to the project
have been assigned on the basis of different assumptions regarding mitigating/attenuating factors
(a detailed description is provided in Appendix 1). After considering the impact of all different
risk categories, the ICECC arrives at a cost of capital of 18.12%, which is significantly lower
than the country’s risk premium. Among the most important mitigating factors are the project’s
low exposure to currency risks, the likely involvement of international partners and financial
agencies, the project’s insulation from major operational disruptions caused by political
instability as well as real options. Factors contributing to the project’s risk are for the most part
related to the learning costs of diversifying into a new industry and mastering new technologies.
Needless to say, the prevailing political instability included in the country risk premium has a
considerable impact on the project’s cost of capital.

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 The Bolivian Tropical Wood Consortium

Exhibit 2: TWC Cost of Capital

Risk Premium Calculation

Inputs Output Category
4.00 U.S. risk free in %
3.50 U.S. risk premium in %
93.70 Current U.S. Credit Rating
24.40 Institutional Investor country credit rating (0-100)
31.32 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

23.82 Country Risk Premium

Industry Adjustment
1.05 Beta (Industry)
-3.50 Sector adjustment

Project Risk Mitigation

(-10 to 10; where 10=risk completely eliminated, 0=average for country)

Impact on Country
Weights Score Premium Risks
Sovereign
0.35 6.00 -5.00 Currency (convertibility)
0.05 3.00 -0.36 Expropriation-direct
0.04 0.00 0.00 Expropriation-diversion
0.04 6.00 -0.57 Expropriation-creeping
0.04 3.00 -0.29 Commercial International partners
0.04 5.00 -0.48 Involvement of Multilateral Agencies
0.03 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism
0.03 -3.00 0.21 Sensitivity of Project to natural disasters

Operating-Precompletion (setting up the plant)

0.02 -4.00 0.19 Resources available (quantity/quality) -part not in discount rate
0.02 -6.00 0.29 Technology (proven technology) -part not in discount rate

Operating-Post-completion
0.03 7.00 -0.50 Sensitivity of operations to blockades, riots and other disruptions associated with political instability
0.02 3.00 -0.14 Market risks (prices of outputs and demand)
0.02 8.00 -0.38 Supply/input risk (availability)
0.01 8.00 -0.19 Throughput risk (material put through plus efficiency of systems operation)
0.02 -5.00 0.24 Operating costs

Financial
0.03 4.00 -0.29 Probability of Default
0.02 0.00 0.00 Political Risk Insurance

Real Options (some handled through cash flows)

0.02 7.00 -0.33 Input mix or process flexibility
0.02 6.00 -0.29 Output mix or product flexibility
0.01 0.00 Abandonment or termination
0.02 6.00 -0.29 Temporary stop or shutdown
0.02 4.00 -0.19 Intensity or operating scale
0.02 7.00 -0.33 Expansion
0.03 8.00 -0.57 Interproject/intraproject
0.02 -3.00 0.14 Shadow costs
0.03 8.00 -0.57 Financial Flexibility

1.00 Sum of weights

3
Project Cost of Capital
Case Solution
18.12
 The Bolivian Tropical Wood Consortium

It has come to our attention that real options have a significant contribution to reducing the risk
burden and adding value to the project. Among the most important real options are production
flexibility that facilitates input/output innovation, process flexibility that allows for a better
management of uncertainty/opportunity, optimization of economies of scope/scale, the synergies
created with Brazil nut production and financial flexibility (see Appendix 1 for a detailed
analysis). The importance of real options for the project becomes more evident when computing
the cost of capital without considering them. As expected, the ICECC arrives at a value much
higher than the previous case (exhibit 3).

Exhibit 3: TWC Cost of Capital (no real options)

Risk Premium Calculation
Inputs Output Category
4.00 U.S. risk free in %
3.50 U.S. risk premium in %
93.70 Current U.S. Credit Rating
24.40 Institutional Investor country credit rating (0-100)
31.32 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

23.82 Country Risk Premium

Industry Adjustment
1.05 Beta (Industry)
-3.50 Sector adjustment

Project Risk Mitigation

(-10 to 10; where 10=risk completely eliminated, 0=average for country)

Impact on
Weights Score Country Premium Risks
Sovereign
0.35 6.00 -5.00 Currency (convertibility)
0.06 3.00 -0.43 Expropriation-direct
0.05 0.00 0.00 Expropriation-diversion
0.05 6.00 -0.71 Expropriation-creeping
0.05 3.00 -0.36 Commercial International partners
0.05 5.00 -0.60 Involvement of Multilateral Agencies
0.04 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism
0.04 -3.00 0.29 Sensitivity of Project to natural disasters

Operating-Precompletion (setting up the plant)

0.05 -4.00 0.48 Resources available (quantity/quality) -part not in discount rate
0.05 -6.00 0.71 Technology (proven technology) -part not in discount rate

Operating-Post-completion
0.03 7.00 -0.50 Sensitivity of operations to blockades, riots and other disruptions associated with political
instability
0.04 3.00 -0.29 Market risks (prices of outputs and demand)
0.04 8.00 -0.76 Supply/input risk (availability)
0.01 8.00 -0.19 Throughput risk (material put through plus efficiency of systems operation)
0.02 -5.00 0.24 Operating costs

Financial
0.04 4.00 -0.38 Probability of Default
0.03 0.00 0.00 Political Risk Insurance

1.00 Sum of weights (make sure = 1.00)

20.31
Project Cost of Capital
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Case Solution
 The Bolivian Tropical Wood Consortium

Exhibit 4 shows the valuation of TWC’s project using a weighted average cost of capital for
discounting cash flows. The results present a positive NPV of U$ 6.2 million and an IRR-WACC
margin that exceeds 10% (see appendix 2 for cash flow data). The second scenario was
constructed to estimate the net present value of real options, by subtracting the NPV discounted
with the “cost of capital with no real options” from the NPV discounted with the “cost of capital
with real options” (NPV Scenario 1 – NPV Scenario 2). The estimated value is U$ 1,3 million.

Exhibit 4: Valuation (U$ 000)

Scenario 1 Scenario 2
with real options no real options

Ke 18.12 20.31
Kd 8.19 8.19
t - -
D 0.35 0.35
E 0.65 0.65
WACC 14.65 16.07

NPV $6,248.43 $4,947.86

IRR 25% 25%
Pay-Back 6.1 6.1

Net Present Value of real options $1,300.57

3. TWC’s Project Appraisal

Using a discount rate of 11.2%, TWC has arrived at a net present value of U$ 8.6 million (see
Appendix 3 for cash flows). There is no information regarding the assumptions made in the
projections of cash flows and the value of the hurdle rate. The conservative values however,
suggest that some of the risks may have been accounted for in the cash flow projections and
therefore taken off the discount rate.

Exhibit 5: TWC’s valuation

Hurdle rate 11.20

NPV $8,658.29
IRR 24%
Pay-Back 6.1

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Case Solution
 The Bolivian Tropical Wood Consortium

4. Alternatives Scenarios

In the last part of the analysis, we compare five different case scenarios. The first two, which
have been already discussed, underline the extra value real options bring to the project. Scenario
3 highlights the uncertainty regarding the formation of the consortium and examines the case
where no - or only a few - equity partners are found. In such an event, TWC will be forced to use
a higher leverage (60/40), which delivers an NPV lower than the first scenario but higher than
the situation with no real options. Note that scenario 3 presumes a higher cost of debt (Kd) due to
the added financial distress, as well as a higher cost of equity (Ke) to account for the lower
financial flexibility and the higher probability of default. Finally, the fourth scenario tests the
possibility of removing the city’s legal status as an export processing zone, which will result in a
20% income tax effectively imposed. While this lowers the WACC by about 1%, the NPV
reduces considerably.

Exhibit : Comparative Scenarios (U$ 000)

Scenario 4
Scenario 1 Scenario 2 Scenario 3
effective tax of 20% TWC valuation
with real options no real options different leverage
imposed
Ke 18.12 20.31 19.60 18.12
Kd 8.2 8.2 11.5 7.2
t - - - 0.20
D 0.35 0.35 0.60 0.35
E 0.65 0.65 0.40 0.65
WACC 14.65 16.07 14.74 13.80 11.20
- - - -
NPV $6,248.43 $4,947.86 $6,156.27 $4,372.78 $8,658.29
IRR 25% 25% 25% 22% 24%
Pay-Back 6.10 6.10 6.10 6.10 $6.10
TWC is unable to find Tax is imposed (export Some risk accounted
equity partners and has processing zone for in cash flow
to leverage more. ceases) projections
Implies higher financial
distress and reduces
future growth options

Concluding Remarks

After valuating the project and looking at different case scenarios, it is our conclusion that the
necessary elements for assuring its feasibility are present. In spite of the risks associated with
political instability and industrial diversification, the project has been designed with enough
flexibility to manage uncertainty and take advantage of real options. Its strategic location
compensates to a large extent for the lack of domestic infrastructure and supporting industries,
while at the same time insulates operations from major disruptions caused by the prevailing
political environment.

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Case Solution
 The Bolivian Tropical Wood Consortium

Appendix 1

Impact on
Country
Weights Score Premium Risks Mitigating factors Aggravating factors

Sovereign
0.35 6.00 -5.00 Currency (convertibility) -Most of the production will be priced and sold -Nearly 30% of production expected
in international markets (90%). to be sold in regional markets that are
-The U$/Bs exchange rate has been stable in more prone to exchange rate volatility
the last 20 years. (Argentina, Brazil).
-Diversified markets (US, Europe, South -Operational costs are to be incurred
America, possibly Asia). in two currencies (Brazil, Bolivia).
-Growing fiscal deficit.
0.05 3.00 -0.36 Expropriation-direct -Bolivia has shown a strong commitment to
market reforms and property rights.
-The forestry sector in general is not
considered strategic for the
economy/government.
-The project will own no land (supply of raw
material through concessionaries)
0.04 0.00 0.00 Expropriation-diversion -Government with no stake in the project.

0.04 6.00 -0.57 Expropriation-creeping -Project located in a tax-free export processing
zone.
-The government has recently enacted a
comprehensive forestry law.
0.04 3.00 -0.29 Commercial International partners -TWC will work closely with long-established
supporting and related industries in Brazil.
-TWC is reaching out to Brazilian and
Ecuadorian wood processors to join the
consortium.
-USAID, Andean Development Corporation.
-Increasing legal uncertainty; a)
changes in the legal framework for
the energy sector, b) A French utility
company forced to terminate its
contract.
- No international partner directly
involved in the initial phase of the
project.

0.04 5.00 -0.48 Involvement of Multilateral Agencies -Financing likely to include loans from WB-
IFC, IIC-IADB, KFW, CAF

0.03 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism

0.03 -3.00 0.21 Sensitivity of Project to natural disasters -High levels of humidity in the Bolivian forest -Vulnerability to wood fires and floods.
reduce the likelihood of wood fires.

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Case Solution
 The Bolivian Tropical Wood Consortium

Operating-Precompletion (setting up the

plant)

0.02 -4.00 0.19 Resources available (quantity/quality) -part not -No experience in setting up a wood
in discount rate processing plant.
0.02 -6.00 0.29 Technology (proven technology) -part not in -TWC seeking local and international partners -Learning costs associated with
discount rate to acquire the necessary expertise in wood adapting and mastering new
processing technology. technology.

Operating-Post-completion

0.03 7.00 -0.50 Sensitivity of operations to blockades, riots and -The project is located in a border city far
other disruptions associated with political from the regions more prone to social unrest.
instability -Flexibility to use the transportation and
communication systems of bordering
Brazilian/Peruvian cities in case of domestic
disruptions.

0.02 3.00 -0.14 Market risks (prices of outputs and demand) -Demand/price of processed tropical wood -Some price volatility observed in low-
expected to increase steadily in the medium value added products.
term (ITC). -Increasing substitution of wood for
non-wood products (bio-composite,
plastic, aluminum etc.).
-Central and Eastern European wood
suppliers expected to capture part of
the EU market.

0.02 8.00 -0.38 Supply/input risk (availability) -The seventh largest and most diverse
forests in the world at 2% of full capacity.
-Experience in forest management and
working with indigenous communities.
-The nut-wood synergy guarantees a year-
round availability of labor with no reallocation
costs.

0.01 8.00 -0.19 Throughput risk (material put through plus -The plant is designed to process 35 species
efficiency of systems operation) of hard, soft and precious wood in order to
maximize throughput and reap economies of
scale.
-Nut-wood synergy expected to reduce
extraction and transportation costs.

0.02 -5.00 0.24 Operating costs -Learning through inter-firm cooperation. -Learning costs (no experience in
-Outsourcing to Brazilian supporting wood production).
industries (transportation, extraction, -Expensive and unreliable
maintenance). transportation through Bolivia.
-Flexibility to use Brazilian/Peruvian road -Operational risk due to political
networks. instability (road blockades, strikes,
-Plant located far from the regions more riots).
prone to social conflict.

Financial

0.03 4.00 -0.29 Probability of Default -Tahuamanu has a high credit record (it has -No experience/expertise in wood-
never defaulted on its debt). processing
0.02 0.00 0.00 Political Risk Insurance

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Case Solution
 The Bolivian Tropical Wood Consortium

Appendix 2
Real Options

TWC-Wood Project Cash Flow

0.02 7.00 -0.33 Input mix or process flexibility - Only 35 out of 360 wood species will be
U$ 000
initially exploited.
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
CASH IN 0 1932 2760 6823 8,733 9,606 10,471 11,204 11,876 12,232 12,477 12,602 12,728 12,855 12,984 13,113
0.02 Sales - 6.00
Sawed -0.29 Output mix0or product
1,932 2,760
flexibility 5,519 5,519 -Technology
6,071 6,617
can be7,080
easily7,505 7,730
adapted to 7,885 7,964 8,044 8,124 8,205 8,287
Sales - Laminated 0 0 0 1,304 1,863 manufacture
2,049 2,234
other2,390
types of2,534 2,610
products 2,662
in the 2,688 2,715 2,742 2,770 2,797
Sales - Sliced 0 0 0 0 1,351 future.
1,486 1,620 1,733 1,837 1,892 1,930 1,949 1,969 1,989 2,009 2,029

0.01 CASH OUT 4,630

0.00 Abandonment 2,000 4,643
or termination 8,935 6,047 7,020 TWC
-Since 6,845 7,230
will own 7,571
no land and 7,642 7,700
outsource 7,804 7,863 7,948 8,038 8,098
Total Investments 4,630 579 2,725 4,047 289 652 0 0 0 0 0 0 0 0 0 0
many activities, the cost of termination is
Sawer 3,130 579 193 715 0 0 0 0 0 0 0 0 0 0 0 0
relatively low.
Laminator 0 0 2,532 502 175 634 0 0 0 0 0 0 0 0 0 0
-Marketable technology/infrastructure (easy to
Slicer 0 0 0 2,830 114 18 0 0 0 0 0 0 0 0 0 0
be resold).
Energy 1,500 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Total Operational Costs - 1,406 1,856 4,701 5,460 5,951 6,428 6,813 7,154 7,225 7,283 7,341 7,400 7,459 7,519 7,579
Operational Costs - Sawing 0 1,406 1,856 3,537 3,537 3,855 4,164 4,414 4,634 4,681 4,718 4,756 4,794 4,832 4,871 4,910
0.02 6.00 -0.29 Temporary stop or shutdown -Since TWC will own no land and some of the
Operational Costs - Laminating 0 0 0 1,164 1,551 1,691 1,826 1,935 2,032 2,052 2,069 2,085 2,102 2,119 2,136 2,153
processes are outsourced, the cost of
Operational Costs - Slicing 0 0 0 0 372 405 438 464 487 492 496 500 504 508 512 516
temporary shutdown is relatively low.
Other costs 0 15 62 187 298 417 417 417 417 417 417 463 463 489 519 519
-Labor-intensive processes to be outsourced
Depreciation/amortization 0 404 404 630 887 (extraction,
887 transportation).
887 887 887 887 887 522 522 312 71 71
Sawing 0 404 404 404 404 404 404 404 404 404 404 39 39 39 39 39
Laminating 0 0 0 225 225 225 225 225 225 225 225 225 225 16 16 16
Slicing 0 0 0 0 257 257 257 257 257 257 257 257 257 257 16 16
0.02 4.00 -0.19 Intensity or operating scale -Plant designed with overcapacity to allow -Full capacity reached in year 6
Working Capital 0 0 0 0 0 production
0 flexibility
0 0 0 0 0 according
0 to projections.
0 0 0 3777

0.02 7.00 -0.33 Expansion -Availability of inputs (wood forest)

NET CASH FLOW -4,630 -68 -1,883 -2,112 2,686 2,586 3,626 3,974 4,305 4,590 4,777 4,797 4,865 4,907 4,946 8,792
-Relatively simple infrastructure/technology.
-Technology supplier likely to be part of the
consortium (easy access to technology for
Scenario 1 Scenario 2 expansion/upgrading).
with real options no real options

Ke 18.12 20.31
0.03 8.00 Kd 8.19 8.19
-0.57 Interproject/intraproject -The synergy between nut and wood
t - - processing will make both industries more
D 0.35 0.35 competitive and allow for future expansion
E 0.65 0.65 projects to take place.
WACC 14.65 16.07
0.02 -3.00 0.14 Shadow costs -Project design and implementation requires -Brazil nut production reaching
NPV $6,248.43 $4,947.86
IRR
Tahuamanu's management and engineering saturation (not many expansion
25% 25%
Pay-Back 6.1 6.1 time. opportunities).

0.03 8.00 -0.57 Financial Flexibility -Low initial leverage (0.35 debt/equity ratio)
Net Present Value of real options $1,300.57

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Case Solution
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Appendix 3

TWC-Wood Project Cash Flow (TWC's valuation)

U$ 000
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
CASH IN 0 1,932 2,760 6,824 8,734 11,176 11,176 11,176 11,176 11,176 11,176 11,176 11,176 11,176 11,176 11,176
Sales - Sawed 0 1,932 2,760 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519 5,519
Sales - Laminated 0 0 0 1,304 1,863 3,726 3,726 3,726 3,726 3,726 3,726 3,726 3,726 3,726 3,726 3,726
Sales - Sliced 0 0 0 0 1,351 1,931 1,931 1,931 1,931 1,931 1,931 1,931 1,931 1,931 1,931 1,931

CASH OUT 4,630 2,000 4,643 8,934 6,047 8,019 7,367 7,367 7,367 7,367 7,367 7,413 7,413 7,439 7,469 7,469
Total Investments 4,630 579 2,725 4,047 289 652 0 0 0 0 0 0 0 0 0 0
Sawer 3,130 579 193 715 0 0 0 0 0 0 0 0 0 0 0 0
Laminator 0 0 2,532 502 175 634 0 0 0 0 0 0 0 0 0 0
Slicer 0 0 0 2,830 114 18 0 0 0 0 0 0 0 0 0 0
Energy 1,500 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Total Operational Costs 0 1,406 1,856 4,700 5,460 6,950 6,950 6,950 6,950 6,950 6,950 6,950 6,950 6,950 6,950 6,950
Operational Costs - Sawing 0 1,406 1,856 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537 3,537
Operational Costs - Laminating 0 0 0 1,164 1,551 2,971 2,971 2,971 2,971 2,971 2,971 2,971 2,971 2,971 2,971 2,971
Operational Costs - Slicing 0 0 0 0 372 443 443 443 443 443 443 443 443 443 443 443
Other costs 0 15 62 187 298 417 417 417 417 417 417 463 463 489 519 519

Depreciation/amortization 0 404 404 630 887 887 887 887 887 887 887 522 522 312 71 71
Sawing 0 404 404 404 404 404 404 404 404 404 404 39 39 39 39 39
Laminating 0 0 0 225 225 225 225 225 225 225 225 225 225 16 16 16
Slicing 0 0 0 0 257 257 257 257 257 257 257 257 257 257 16 16

Working Capital 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 3777

NET CASH FLOW -4,630 -68 -1,883 -2,110 2,687 3,157 3,809 3,809 3,809 3,809 3,809 3,763 3,763 3,737 3,707 7,484

Hurdle rate 11.20 (probably CAPM)

NPV $8,658.29
IRR 24%
Pay-Back 6.1

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Case Solution