Corning Glassworks: Indonesia Free Cash Flow Analysis

1
Corning Glassworks IndonesiaFree Cash Flow
Analysis

• International Finance
• Dick Sweeney

2
Outline of Approach

• Go through systematically
• One issue after another
• Bit dull, but there are many, many things wrong
  with the pro formas, have to sort them out
  
• Basic problem the pro formas are way too
  optimistic
  
• Have to think about expected cash flows, best
  guess cash flows, not blue-sky, optimistic cash
  flows

3
Pro Formas in Real USD

• In the cases Exhibit 4, the net sales revenues
  reach a steady value of 17,577 in 1,000s of USD.
  
  
• In fact, these must be 1,000s of constant, or
  real or 1979 USD. The only alternative would be
  expected inflation of zero percent per year for
  the length of the projecthardly plausible now,
  and certainly not in 1979.
• Thus, the income statement and balance sheet are
  in real USDprobably constant 1979 USD.

4
Interest Rates

• The IFC will charge 11 per annum, the IFC
  participants 13 p.a. (Both in USD, presumably.)
  Some British banks will charge 9 this is a
  subsidized or concessionary rate. (Perhaps in
  GBP, but very likely in USDBritish banks are
  experienced in borrowing and lending in non-GBP
  currencies) (p. 8).
• Note No parent guarantee was contemplated. (p.
  9) No recourse.

5
Interest Rates (cont.)

• Are these nominal or real rates? On the one hand,
  these are loans to an Indonesia company, so the
  company is risky and justifies a substantial risk
  premium. On the other, a 13 real rate implies a
  huge risk premium.
• A key issue is What is the yield on
  comparable-maturity U.S. government bonds?
  
• Lending, foreign and domestic, is often quoted as
  a spread over governments. The spread for IAI
  is likely higher than for the government of
  Indonesia (though must take into account that IFC
  is involved).

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Interest Rates (cont.)

• The case is set in early September, 1979, so
  quotes are likely a bit earlier. From
  International Financial Statistics (International
  Monetary Fund), intermediate and long-term U.S.
  government bond yields in 1979 are
• Quarter Month
• I II III Mar Apr May June July
  Aug
  
• Inter. 9.34 9.27 9.26 9.38 9.43 9.42 8.95 8.94
  9.14
  
• Long 9.03 9.08 9.03 9.08 9.12 9.21 8.91 8.92
  8.97

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Interest Rates (cont.)

• T-bills averaged 10.38/year in 1979, and were at
  10.43 in September.
  
• U.S. CPI inflation in 1978 and 1979 was 9.03 and
  13.31/year. (!! Good-bye, Jimmy Carter)
  
• A reasonable guess from this might have been E
  ?P/P (1/2) (9.03 13.31) 11.17/year.
  
• Taking into account that some rates were
  concessionary and others had an implicit IFC
  warranty, it appears that the interest rates in
  the case are nominal. They are in the ballpark
  for a reasonable spread over U.S. Treasuries.

8
Rupiah borrowing

• IAI plans to finance working capital in
  substantial part (p. 9) with short-term rupiah
  borrowings from local branches of foreign banks
  and Indonesian commercial banks. at an annual
  interest rate of 18.
• Note that in Exhibit 4, the income statement
  shows short-term interest of 465 in 1988 the
  balance sheet shows short-term debt of 2,583 in
  1988 the ratio is .18 or 18.
• Because the accounting statements are in real
  terms, these statements appear to say that IAI
  pays an 18 real rate in USD for borrowing
  rupiahs.

9
Real Rate on Equity

• CAPM in nominal terms RReq,nom rf ? (E RWM -
  rf)
  
• CAPM in real terms is
• 1 RReq,real (1 RReq,nom) / (1 E
  ?P/P)
  
• The nominal risk-free rate is rf, and the
  estimated risk premium on the market is (E RWM -
  rf). Suppose (E RWM - rf) 6.
  
• Consider RReq,real for various combinations of
  rf, E ?P/P and the beta on the IAI project, ?IAI.
  
  
• Choose rf and E ?P/P that are reasonable values
  for end-2004, not 1980! Orprobably better to let
  them vary over time
  
• Suppose E ?P/P 3. Let rf run from 2.0 to
  8.0, and let ?IAI run from 0.3 to 1.50.

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Example

• To illustrate, suppose that rf 6 and ?IAI
  1.0, so
  
• 1 rf ? (E RWM - rf) 1 0.060 (1 x
  0.06) 1.12 ? 12 RRnom
  
• To be consistent with this nominal equity rate,
  suppose the nominal rate on debt is 8.161111, or
  216.11bp2.1611over the nominal rate on
  governments, 6
• Assumes real rate of governments is ? 3 really
  1.06 /1.03 1.0291262 ? 2.91262towards high
  end of historical record, but reasonable
  
• The USD 26,000 project is initially financed with
  total equity of USD 10,400 the equity-value
  ratio is 0.4 and the debt-value ratio is 0.6.

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WACC and PV of FCFs

• With a marginal tax rate of 40,
• RRFCF,nom w RReq (1 - w) (1 - t) RD
  (.4) RReq (.6) (1 - t)
  RD
  
• (.4) (12) (.6) (1 - .40) (8.16111)
• (.4) (12) (.6) (.6) (8.161111)
• 4.8 2.938 7.738.
• (1 RRFCF,real) (1 RRFCF,nom) / (1 E ?P/P)
  
  
• 1.07738 / 1.03 1.046 ? RRFCF,real 0.046 ?
  4.60
  
• This rate is then used to discount the FCFs
  (tables).
  
• Present Value of FCF, 1980 61,906.370
  ( ?1995t1981 DisFCFt)

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Sensitivity to Discount Rates

• Perhaps the 4.6 WACC is on the low side
• Experiment with different WACCs to find
  sensitivity
  
• NPV is very high in the discussion above
• But, do not need terribly high real WACC to get
  NPV down to zero
  
• Discount rates matter

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Problems with the Pro Formas

• (1) The plant is assumed to operate very close to
  theoretical capacity, much closer than the
  average dinnerware factory in Indonesia.
  
• (2) Chinas share in the dinnerware market has to
  fall greatly to accommodate the new Indonesian
  plants coming on line plus IAI. Will this happen?
  Can the Indonesia government make this happen?

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Problems with the Pro Formas

• (3) Asset depreciation is constant in real terms.
  But this can be true only if inflation is zero.
  Because depreciation is based on initial, nominal
  expenditure, depreciation for tax purposes in
  Indonesia is found in nominal terms. It is then
  converted to real terms in USD by adjusting for
  inflation and rupiah depreciation. Non-zero
  inflation reduces real depreciation over time.
  Positive, steady inflation means that constant
  nominal depreciation falls in real value over
  time. Robin Corporation (A), etc.

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Problems with the Pro Formas

• (4) The real exchange rate is constant.
  (Overvaluation Suppose the Rupiah is initially
  just right for the relative prices in Indonesia
  and the U.S. If the relative price goes up more
  than the increase in the number of rupiahs per
  USD, then the rupiah is overvalued.)
  Overvaluation is deadly for Corning. Intuition
  Corning has serious, effective competition from
  China right from the start. If there is inflation
  in Indonesia but the rupiah rate is unchanged,
  Corning faces an ugly choice. It can keep its
  margins by raising pricesbut lose market share
  to China. Or it can compete with China for market
  share, but have its margins fall.

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Problems with the Pro Formas

• (5) Real wages are constantsorry, no raises for
  you!
  
• (6) Amortization does not affect operating
  income. But amortization does affect after-tax
  income, and these effects are an asset that must
  be valued. See Corning Glassworks, Indonesia
  Notes on Taxes and Amortization for a
  discussion.
• More .

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Add Two Scenarios

• Second Scenario Net Sales 60 of Cases
  Assumptions
  
• PV, 1980 36,913.880
• Discounted Values of FCFs, Equal Probability
  Weights
  
• First Scenario 61,906.370
• Second Scenario 36,913.880
• Third Scenario 0.0
• Sum 98,820.250
• Probability-weighted average 32,940.083

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Get Tough with Scenarios

• First scenario is incredibly over-optimistic
• Probably deserves very little weight
• Suppose we go with last two scenarios, and give
  equal weight
  
• Second Scenario 36,913.880
• Third Scenario 0.0
• Sum 36,913.880
• Probability-weighted average 18,456.500
  
  
• NPV is negative

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Value to Corning

• Which (expected) cash flows go to Corning?
• Are these equity flows? Debt flows? Combination?
  
  
• Equity flows ? use equity discount rate, 7, not
  WACC, 4.6
  
• WACC is applied to combination of equity and debt
  cash flows
  
• Free cash flows are the total amount of cash
  flows available to pay debt and equity claimants,
  
  
• total amount available to pay interest
  dividends

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Cash Flows For Corning

• Dividends can find these from income statement
  in case (Excel files)
  
• What else? Technology transfer fees
• Why are these uncertain? Balance of Trade and
  Capital Account restrictions
  
• May have to settle for royalties
• Not up front
• Perhaps present value of technology transfer fees

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Terminal Value

• Common formula
• TV1995 FCF1995 (1 g) / (RR - g)
• g is expected growth rate, RR is discount rate
  ? WACC for project as a whole
  
• Problem Formula implicitly assumes that Gross
  Fixed Assets rise through time to keep Net Fixed
  assets constant or perhaps rising
  
• Not true in this foreign project
• Will have to build new plant
• TV1995 FCF1995 (1 g) / (RR - g) - 26m
• Discount TV1995 back to 1980
• Have to rebuild plant many time in future if use
  perpetuity formula