Problem 19.

1 Trefica de Honduras
Texas Pacific, a U.S.-based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named
Trefica. Texas Pacific estimates that Trefica will generate a free cash flow of 13 million Honduran lempiras (Lp) next year (2003), and that this
free cash flow will continue to grow at a constant rate of 8.0% per annum indefinitely

A private equity firm like Texas Pacific, however, is not interested in owning a company for long, and plans to sell Trefica at the end of
three years for approximately 10 times Treficas free cash flow in that year. The current spot exchange rate is Lp14.80/$, but the Honduran
inflation rate is expected to remain at a relatively high rate of 16.0% per annum compared to the U.S. dollar inflation rate of only 2.0% per
annum. Texas Pacific expects to earn at least a 20% annual rate of return on international investments like Trefica.
a. What is Trefica worth if the Honduran lempira were to remain fixed over the three year investment period?
b. What is Trefica worth if the Honduran lempira were to change in value over time according to purchasing power parity?
Assumptions
Expected free cash flow in 2003
Expected growth rate in free cash flow
Assumed sale multiple of FCF in year 3
Spot exchange rate, Lempiras/$ (2002)
US dollar inflation rate
Honduran lempira inflation rate
Texas Pacific required return (annual rate)

Values
13,000,000
8.00%
10
14.80
2.0%
16.0%
20.0%

a) Trefica's value if exchange rate fixed

0
2002

Trefica's expected free cash flow (Lp)

Expected sale value in year 3
Total expected free cash flow (Lp)
Expected exchange rate (Lp/$)
Trefica's expected FCF in US$
Present value factor
Present value of expected FCF in US$
Cumulative present value in US$

14.8000
$
1.0000
$
$

Trefica's expected free cash flow (Lp)

Expected sale value in year 3
Total expected free cash flow (Lp)
Expected exchange rate (Lp/$)
(PPP: spot * (1+inf in Lp) / (1 + inf in $)

14.8000

Trefica's expected FCF in US$

Present value factor
Present value of expected FCF in US$
Cumulative present value in US$

$
1.0000
$
$

2
2004

3
2005

13,000,000

14,040,000

13,000,000

14,040,000

15,163,200
151,632,000
166,795,200

14.8000

14.8000

14.8000

878,378 $
0.8333
731,982 $

948,649 $
0.6944
658,784 $

1
2003

2
2004

3
2005

13,000,000

14,040,000

13,000,000

14,040,000

15,163,200
151,632,000
166,795,200

16.8314

19.1416

21.7688

772,367 $
0.8333
643,639 $

733,483 $
0.6944
509,363 $

11,269,946
0.5787
6,521,959

7,912,725
0
2002

b) Trefica's value assuming PPP

1
2003

5,587,094

7,662,110
0.5787
4,434,091

Problem 19.5 Koch Refining Company

Privately owned Koch Refining Company is considering investing in the Czech Republic so as to have a refinery source closer to its European
customers. The original investment in Czech korunas would amount to K250 million, or $5,000,000 at the current spot rate of K32.50/$, all in
fixed assets, which will be depreciated over ten years by the straight-line method. An additional K100,000,000 will be needed for working
capital.
For capital budgeting purposes, Koch assumes sale as a going concern at the end of the third year at a price, after all taxes, equal to the net
book value of fixed assets alone (not including working capital). All free cash flow will be repatriated to the United States as soon as possible. In
evaluating the venture, the U.S. dollar forecasts are shown in the table below.

Variable manufacturing costs are expected to be 50% of sales. No additional funds need be invested in the U.S. subsidiary during the period
under consideration. The Czech Republic imposes no restrictions on repatriation of any funds of any sort. The Czech corporate tax rate is 25%
and the United States rate is 40%. Both countries allow a tax credit for taxes paid in other countries. Koch uses 18% as its weighted average cost
of capital, and its objective is to maximize present value. Is the investment attractive to Koch Refining?
Assumptions
Original investment (Czech korunas, K)
Spot exchange rate (K/$)
Unit demand
Unit sales price
Fixed cash operating expenses
Depreciation
Investment in working capital (K)
Project Viewpoint (in US$)
Initial investment
Revenues
Less costs of manufacturing
Gross profit
Less fixed cash operating expenses
Less depreciation
Earnings before taxes
Less Czech corporate income taxes
Net income

0
250,000,000
32.50
$
$
$

0
(7,692,308)
$
$

10.0

$
25%

27.50
900,000
10.30 $
1,030,000 $
500,000 $

7,000,000
(3,500,000)
3,500,000
(1,000,000)
(769,231)
1,730,769
(432,692)
1,298,077

2
$
$

$
$

769,231
$

25.00
1,000,000
10.60
1,060,000
500,000

$
$

$
$

769,231

10,600,000
(5,300,000)
5,300,000
(1,060,000)
(769,231)
3,470,769
(867,692)
2,603,077
769,231

(10,769,231) $

2,067,308 $

2,896,058 $

8,461,538
11,833,846

$
$

1.0000
(10,769,231) $
265,073

0.8475
1,751,956 $

0.7182
2,079,904 $

0.6086
7,202,444

18%

1
$

2,126,827 $
708,942
2,835,769 $

2,603,077
867,692
3,470,769

692,308 $
(432,692)
259,615 $

1,134,308 $
(708,942)
425,365 $

1,388,308
(867,692)
520,615

40%

1,298,077 $
432,692
1,730,769 $

Cash dividend less added US taxes

Initial investment & working capital
Plus sale value at end of 3 years
Parent cash flows (US$)

9,270,000
(4,635,000)
4,635,000
(1,030,000)
(769,231)
2,835,769
(708,942)
2,126,827

(3,076,923)

Dividends remitted to US parent

Add back Czech taxes deemed paid
Grossed up dividend

Present value factor

Present value of cash flow
Cumulative NPV

30.00
700,000
10.00 $
1,000,000 $
500,000 $

50%

Parent Viewpoint (US$)

Tentative US tax liability

Less credit for Czech taxes paid
Additional US taxes due on foreign income

100,000,000

Add back depreciation

Less additional working capital investment
Sale value
Free cash flow for discounting
Present value factor
Present value of cash flows
Cumulative NPV

1,038,462 $

1,701,462 $

2,082,462

(10,769,231)

(10,769,231) $

1,038,462 $

1,701,462 $

8,461,538
10,544,000

$
$

1.0000
(10,769,231) $
(2,249,812)

0.8475
880,052 $

0.7182
1,221,963 $

0.6086
6,417,404

18%