UVA-F-1578TN
Rev. Aug. 11, 2010
MILAGROL LTDA.
Teaching Note
Synopsis and Objectives
facing Peterson is twofold. First, Peterson must develop a method to value Milagrol that
addresses the fact that Peterson will value Milagrol in U.S. dollars (USD), not reais. Second, the
valuation must address risks unique to a Brazilian investment—particularly the risk of a future
currency devaluation.
Suggested Questions for Advance Assignment to Students
1. What are the reasons Peterson Valve is interested in the acquisition of Milagrol?
2. What are the principal risks associated with this acquisition?
3. Generate four base-line valuations of Milagrol using the approaches enumerated below.
a. Convert the U.S. dollar (USD) discount rate to a Brazilian real (BRL) discount rate
using 10-year government bond rates, discount the BRL cash flows, and convert to a
USD valuation using the spot rate.
1
The singular reference to the Brazilian currency is real, and the plural reference is reais.
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b. Forecast future exchange rates using the same 10-year bond rates as above, covert future
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d. Use the exchange rate forecast provided by Econo-Metrics to convert future BRL cash
flows to USD cash flows, and then discount at a USD discount rate.
4. There were many unique risks associated with a Brazilian investment. For example, in
discussions among Peterson management, there was a strong sense that a decline in the
a. Adjust the valuation of part 3b to explicitly acknowledge the effects of the devaluation
b. Adjust the valuation in part 3b by adding the sovereign spread to the USD discount rate.
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Suggested Supplementary Material
A student spreadsheet (UVA-S-F1578) is available for distribution to students.
An instructor spreadsheet (UVA-S-F-1578TN) is available for instructors. This case also benefits
from prior exposure to the concepts related to international parity conditions, which
are summarized in a technical note entitled, “Parity Conditions in International Markets” (UVA–
F-1572).
2
Teaching Plan
This case has been used in an international corporate finance elective at the graduate
level. It can be easily used at the undergraduate level as well. The case is self-contained in that it
includes a brief overview of the basic analytic approaches. Nevertheless, students should be
familiar with parity conditions and need to know how to construct an enterprise valuation from
cash flows.
An effective teaching plan quickly addresses the first suggested question—“Why is
Peterson interested in Milagrol?” An important observation is that there are no anticipated
changes in the operations of Milagrol. Thus, the cash flow forecast is an acceptable base case for
addressing the issues related to valuation mechanics. After that, the instructor can either lead
students through the various valuation scenarios, emphasizing the different implicit assumptions,
or simply ask a student what they believe is an appropriate valuation and address other scenarios
as they might arise.
Case Analysis
Reasons for acquisition
Peterson is interested in the acquisition of Milagrol for a number of reasons. Milagrol is
well-positioned in the Brazilian market. Milagrol has products that save water, which represents
an important future market given global concerns about water and sustainability (some have
argued that water will be the next oil). Most importantly, Milagrol has manufacturing expertise
related to water-saving valves which would be of benefit to Peterson for its own products. As for
Milagrol, it needs cash to sustain its research and development activities. Assuming Milagrol
might otherwise obtain the needed financial resources, the essential synergies are those that
might be realized from manufacturing improvements by Peterson at its domestic operations. The
case states explicitly that these potential synergies are not part of the valuation challenge—
Milagrol will accept a fair value for its Brazilian operations.
2
Marc Lipson, “Parity Conditions in International Markets” (UVA-F-1572) (Charlottesville, VA: Darden
Business Publishing, 2008).
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Risks
The major risks associated with this acquisition are those arising from the fact that
Milagrol is located in Brazil and the cash flows are denominated in BRL. There are a number of
dimensions to this risk. First, the anticipated BRL cash flows will have to be converted to USD
cash flows at some future, and unknown, exchange rate. An important first step is to base the
valuation on reasonable exchange rate expectations. The risks associated with significant
departures from reasonable expectations can be lumped under the general notion of “political
risk” since these departures are typically a result of governmental policy changes. At the political
level, there is also the possibility of government intervention in the firm or industry that might
directly affect cash flows.
Base case valuations
The analysis proceeds through a series of valuations that emphasize various techniques
and the conditions under which they are appropriate. The most useful starting place is with the
two identical valuations that arise if one assumes markets are at (and remain at) parity. A general
and important observation is that if markets are in parity, there are no economically meaningful
effects generated by changes in exchange rates. In effect, all markets will adjust so that the
underlying economic facts, those related to real cash flows and the risks associated with those
real cash flows, remain constant. In the case of cash flow valuations, it means any changes in
exchange rates are offset exactly by the discount rate, and a valuation based on assumptions that
reflect parity will generate identical results. The first two assigned valuations are intended to
make this point.
The instructor may be familiar with similar analyses where identical valuations are
obtained from a converted discount rate and an exchange rate forecast based on inflation rates. In
those analyses the interest rate is converted using the inflation rates and the inflation rates are
assumed constant over time. Milagrol is designed to be more realistic by including time-varying
inflation rates. Also, converting discount rates using interest rates (rather than inflation rates) is
more common. Thus, Milagrol develops the intuition regarding parity from interest rates and
addresses inflation rates separately. One fact at the time that is notable is that real interest rates in
Brazil were much higher than in the United States over this time—a violation of the typical
parity assumption that real rates of return are equal across countries.
3
The remainder of this note discusses the essential approaches available for valuing
foreign currency denominated cash flows and methods for acknowledging political risk. The
discussion below expands on many of the points contained in case Exhibit 3.
3
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Convert discount rates
Assuming that international differences in discount rates are due only to differences in
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USD discount rate is appropriate.
One issue to be addressed, since this is an enterprise valuation, is the appropriate
assumptions regarding terminal values. One can use a multiple (and information is given for this)
or one can calculate the value assuming a long-term growth rate for cash flows. The exhibits in
presented in Exhibit TN1.
Convert cash flows using an exchange rate forecast
In general, the most common method for valuing foreign currency denominated cash
flows is to convert the cash flows at an expected exchange rate and then discount with a
4
Whether a country is domestic or foreign is implied by the exchange rate used: the foreign currency will be
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For Milagrol, an important starting point is to forecast exchange rates based on the
interest rates used to convert the discount rate. This assumes that interest and future spot
5
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basically establishes that the methods are theoretically the same when markets are in parity.
Of course, we have just used the same 10-year interest rates that were used in the discount rate
predictors of exchange rates over the long run and are often provided for each year.
With changing interest rates over time (yield curve data), one would have to generate
time varying discount rates to apply the discount rate model.
5
6
This note does not address the valuation of cash flows using forward rates rather than expected future spot
rates—for a number of reasons. First, the analysis based on forward rates derived from interest rates will be the same
as the analysis based on expected spot rates derived from inflation as long as parity is assumed. Second, forward
rates are not likely to be relevant in many valuation contexts since cash flows are expected, rather than contracted,
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One may have a detailed exchange rate forecast that uses much more than just the
information in inflation and interest rates. Such a forecast can include a careful
consideration of government policy effects.
The assumptions underlying the above analysis should be emphasized. As in most
valuations, the discount rates are assumed to be constant over the duration of the cash flows. This
analysis assumes further that exchange rates will change in accordance with those constant rates.
But the data themselves raise questions as to the validity of this assumption. In particular, we see
based on interest rates.
7
There are many possible analyses that might begin to address these
issues. This note will focus on a valuation that forecasts exchange rates.
8
Exchange rate forecast based on inflation rates
The basic calculation is
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implement as well as evaluate.
8
Exchange rate forecasting is a complicated art, especially in the short run, where exchange rates are often
dramatically affected by governments pursuing policy goals. Over the long run, however, exchange rates tend to
move as predicated by purchasing power parity—as predicted by changes in relative prices of goods. This is why
inflation-based forecasts are common.
9
possible, of course, to be given a yearly interest rate or an inflation rate that applies over a multiyear period, but
these are less common. The formulas presented in this note reflect common quoting conventions.
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USD/BRL5179.0
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inflation rates.
10
One could also, of course, use the exchange rate forecast provided by Econo-Metrics.
Such a valuation is also presented in Exhibit TN2. Comparing the forecast rates with the
lower.
Yet another approach would be to use the yield curve data to generate an exchange rate
forecast (this approach was not included in suggested advance questions so that the questions can
be more focused on core concepts). This is also presented in Exhibit TN2. Here we have linearly
interpolated to find two and four year rates. The interest rate differences indicate an even greater
11
The point of these various calculations is not that some approaches are clearly better than
others. It is that the very process of forecasting an exchange rate allows us to focus on the
favor of a particular approach.
Political risk and scenario forecasts
People are not always clear as to what, exactly, is meant by “political risk.” The phrase
ends up being a catch-all for anything that might go wrong with an international investment—
10
As pointed out, the sovereign spread accounts for some of that difference and can be adjusted out. Such an
adjustment does reduce the discrepancy somewhat.
11
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devaluation of the real might occur and it is clearly a time of economic uncertainty. Thus,
arguably, political risks are high.
Discount rate adjustment
Exhibit TN3 presents the discount rate adjustment. The usual adjustment is to add to the
discount rate some rate that reflects the political risks. A common approach is to use the
USD10 million—a decrease of roughly 6% in the value of Milagrol.
The discount rate adjustment employs a blunt tool to address a subtle problem.
Furthermore, there is an implicit bias with this approach—cash flows in the future are penalized
explicit scenarios.
Exchange rate adjustment
The study questions provide explicit parameters with which to make an exchange rate
adjustment. The results are shown in Exhibit TN4. One simply starts with a forecast—in this
reduces the expected value by only about 3%.
Cash flow adjustment
In some instances, it is not the exchange rate that is a source of political risk, but the
specific actions by governments targeting firms or industries. The second part of Exhibit TN4
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value of the company. Again, it should be emphasized that none of these scenarios is expected to
be the actual outcome. But the method allows a consideration of the value effects of these
various outcomes, including their likelihood. In the two scenarios considered in Exhibit TN4,