To: From: Date: Re:

Alejandro Perez Wes Falik October 28, 2010 Exploring Forward Integration vs. Horizontal Expansion

In reviewing the facts presented to me it is my opinion, along with those of my colleagues at WIF Consulting, that your recommendation to horizontally expand the production of market pulp is the better decision when weighing it against the prospect of forward integrating into paper production. After doing an initial calculation, the net present value of the Valdivia project is roughly $3.7 billion (see Exhibit A), which yields a gain of almost $2.6 billion. Below are the key points weve identified to support this figure. Existing Competencies Within Araucos Contracted Workforce Because Arauco already has over 10,000 employees aiding in forestry and transportation operations under roughly 300 subcontracts, along with a workforce of independent workers operating all of Araucos sawmills, it becomes clear that several relationships are already being managed in order to ensure efficiency and effectiveness. By adding another workforce entirely dedicated to the production of paper, Arauco is taking on even more workers that are performing a series of operations that Arauco is not familiar with. Because of this, enforcement costs will be incurred to simply oversee the workforces numbers. Additionally, upper management will either need to be trained in a whole new set of competencies, or new employees must be taken on to optimize production performance. Additionally, to take full advantage of the potential sharing activities, will require an unknown amount of resources to coordinate interactions between the various functions of the company. If phase two of the Nueva Aldea project were to go through, Arauco would increase its pulp capacity and avoid the risk of undertaking a process it is unfamiliar with. Araucos Superior Forestry 33% of Chiles radiata pines are produced in Arauco owned that are notorious for having especially fertile soils and favorable weather. The soil itself allows for more pines to be planted per hectare. Additionally, the climate allows pines to be harvested for pulp in only 16-18 years compared to the 18-45 years needed to accomplish the same results in North America. Because of this, Araucos backward integration into forestry proved essential because it not only lowered economies of scale through the elimination of transaction costs, but also through the strategic placement of mills, which cut down transportation costs. Furthermore, Araucos throughput time is already significantly faster than that of the North American producers and affecting the market. Investing in the Valdivia plant would allow Arauco take advantage of these factors and produce more pulp, more rapidly, at already lower prices than the competition. The Paper and Pulp Industry

The paper industry has seen three consecutive years of no growth. The demand for paper, which is driven by consumer demand, has a direct correlation to pulp prices per ton, which makes both markets extremely volatile. This proves a benefit for Arauco when considering that four out of the five largest paper companies are vertically, integratedif not fully integrated. These integrated paper manufacturers benefit from higher pulp prices because they are not forced to buy at these higher levels. When prices are low, however, integrated operations find themselves at a disadvantage because they have already made substantial investments in their own forestry plantations and pulp production mills and, thus cannot take advantage of lower market prices. When considering this, increasing Araucos operating capacity by 800,000 to 3.2mm tons of pulp will only drive marketed pulp prices down, which will further hurt these large, integrated paper companies. Araucos Competitive Advantages in Market Pulp Arauco is also to adapt to the potentially lower pulp prices that will result in its increased presence in the pulp market because it has been able to sustain an advantage over its competitors. By producing its own energy, Arauco is not only able to provide enough energy to sustain its operations; it also has an excess amount being generated which is sold to the Chilean electricity grid at an average of $100 million annually. This means that adding the Valdivia plant would not result in avoid a major variable cost: power. If the competition were to engage in a similar activity, it would have to pay out almost $100 million to keep its lines moving. Furthermore, Araucos investment in log merchandising and genetic engineering through Bioforest has resulted in the ability to create higher quality trees with much lower levels of risk. Combining this with the superior Chilean climate and soil results in a competitive advantage that is valuable, rare, and, to some degree, nonimitable in that the years of initial investments and research have created a path of dependency causal ambiguity when looking at production quality and efficiencies. Concluding Words Arauco has already taken full advantage of several initiatives that have set the company in poised position to capitalize in market pulp. Engaging in forward integration, however, would prove a mistake because the operational economies of scope simply are not present. Integration will not reduce the cost of its current activities, and acquiring the competencies necessary to make the paper initiative a success would require putting valuable resources into a saturated market that is already at the mercy of an extremely volatile market. Furthermore, there are barriers to entry to consider. Going into paper would only result in the creation of an Arauco that is no different than the current leaders in the industry, and these companies have preexisting knowledge of how to leverage a fully integrated operation. Lastly, eight of the top twenty-five paper companies are located in North America and cater to US consumption, which accounts for 1/3 of the worlds paper consumption, while the four Japanese leaders are poised to provide the growing Asian paper market. When considering the logistical costs these markets will incur in order to obtain Araucos paper supply, it will prove extremely difficult for Arauco to remain competitively priced despite its innovation in the forestry phase.

Exhibit A Discount Rate: Rf + B(Rm-Rf) .04 +.9(.11-.04) = .9028 NPV Assumptions: Average between 30 and 40 years (30+40)/2 = 35 year lifespan $350million expected sales per year (provided) Initial investment of $1 billion (provided) NPV $3,684,210,526 Less Initial Investment ($1,000,000,000) Gain $2,684,210,526