Case IV.1 Plano Cruzado
Part IV Case Studies
On February 28, 1986, President Jose Sarnay of
Brazil announced the Plano Cruzado. At the time,
Brazilian inflation was running at an annualized
rate of more than 400%. The plan slashed infla-
tion by freezing prices and wages. The purpose of
the plan was to impose “shock treatment” on the
economy and break the cycle of “inertial infla-
tion” caused by high inflationary expectations.
However, in a move that foreshadowed the
splits that bedeviled the Plan, workers were
granted pay hikes of 8% to 15%, just before the
freeze. At the same time, government spending
went largely unchecked, and the public-sector
deficit—financed largely by printing more cruza-
dos—grew to 4.5% of gross domestic product.
In November, the Plan achieved its first
incontrovertible success: Government parties
swept the congressional and gubernatorial races.
Price controls were eased just after the election.
However, the government found it politically
impossible to remove subsidies to state industries
because these industries formed the base for
political power. Instead, large price hikes for
state companies were granted by imposing huge
increases in indirect taxes and tariffs on their
products, and an attempt was made to disguise
the effect of these increases on inflation by alter-
ing the basket of goods on which inflation was
calculated. “They wanted me to tamper with
inflation—simple as that,” commented the head
of the National Statistics Office, who immediately
resigned.
Questions
1. What were the likely consequences for Brazil of
controlling prices while gunning the money
supply? Consider the effect on production and
the availability of products in the stores.
2. How did the Plano Cruzado affect Brazil’s
huge trade surplus?
3. What would be your forecast of the Plan’s effect
on Brazil’s ability to service its foreign debts?
4. President Sarnay terminated Plano Cruzado in
February 1987, one year after it began. What
impact do you think the Plan had in reducing
inflation expectations? How would you go
about measuring the effect of the Plan on infla-
tion expectations?
5. What was the likely price response to the
removal of price controls?
6. If you were a banker, how would seeing such a
Plan put into effect affect your willingness to
lend money to Brazil? Explain.
Source: Based on a report in the Wall Street Journal, February 13,
1987, p. 27.
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Case IV.2 Multinational Manufacturing, Inc.
Part I
Multinational Manufacturing, Inc. (MMI), is a
the world. Some product lines enjoy outstanding
success in new fields developed on the basis of
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Case IV.2 •Multinational Manufacturing, Inc. 511
Each domestic product line and foreign affiliate
is a separate profit center. Headquarters influences
these centers primarily by evaluating their man-
agers on the basis of certain financial criteria,
including return on investment, return on sales
and growth in earnings.
Division and affiliate executives are held
responsible for planning and evaluating possible
new projects. Each project is expected to yield at
least 15%. Projects requiring an investment
below $250,000 (about one-third of the projects)
are approved at the division or affiliate level
without formal review by headquarters manage-
ment. The present cutoff rate was established
three years ago as part of a formal review of cap-
ital budgeting procedures. The conclusion at the
time was that the company’s weighted average
cost of capital was 15%, and it should be
applied when calculating net present values of
proposed projects. In announcing the policy,
Mr. Thomas Black, Vice President – Finance, said,
“It’s about time that we introduced some modern
management techniques in allocating our capital
resources.”
Now Mr. Black is concerned that the policy
introduced three years ago is having some unin-
tended consequences. Specifically, top manage-
ment gets to review only obvious investment
candidates. Low-risk, low-return projects and
high-risk, high-return projects seem to be sys-
tematically screened out along the way. The basis
for this screening is not entirely clear, but it
appears to be related to the way in which man-
Questions: Part I
Make recommendations to Mr. Black concerning
the following points:
1. Should MMI lower the hurdle rate in order to
encourage the submission of more proposals, or
should it drop the hurdle rate concept com-
pletely?
2. Should MMI invest in lower-return projects
that are less risky and/or in high-risk projects
that appear promising? What is the relevant
measure of risk?
3. How should MMI factor in the additional
political and economic risks it faces overseas
in conducting these project analyses?
4. Why are projects at the extremes of risk and
return not reaching top management for
review?
5. What actions, if any, should Mr. Black take to
correct the situation?
Part II
In line with this current review of capital budget-
ing procedures, Mr. Black is also reconsidering
certain financial policies that he recently recom-
mended to MMI’s board of directors. These poli-
cies include the maintenance of a debt/total assets
ratio of 35% and a dividend payout rate equal to
60% of consolidated earnings. In order to achieve
these ratios for the firm overall, each affiliate has
been directed to use these ratios as guidelines in
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512 Part IV •Case Studies
them into a financial straitjacket designed by head-
quarters. In their view, they must be left free to
respond to their own unique set of circumstances.
The executives of the Brazilian affiliate, for
example, felt that their financing should not follow
the same pattern as that of the overall firm
because inflationary conditions made local borrow-
ing especially advantageous in Brazil. Executives of
other foreign affiliates stressed the need for varying
capital structures in order to cope with the
exchange risks posed by currency fluctuations. The
general manager of the Mexican affiliate, which is
owned on a 50–50 basis with local investors, has
argued forcefully that, despite effective headquar-
ters control over the policies of this operation,
joint ventures such as his cannot and should not
be financed in the same manner as firms wholly
owned by MMI. In addition, the tax manager of
MMI has expressed his concern that implementing
a rigid policy of repatriating 60% of each affiliate’s
earnings in the form of dividends will impose sub-
stantial tax costs on MMI. Moreover, Mr. Black
recently attended a seminar at which it was point-
ed out that overseas affiliates can sometimes be
financed in such a way that their susceptibility to
political and economic risks is diminished.
Questions: Part II
Make recommendations to Mr. Black concerning
the policies that should be adopted as guides in
planning the capital structure and dividend pay-
out policies of foreign affiliates, taking into
account the following key questions:
1. What are the pros and cons of using the follow-
ing sources of funds to finance the operations of
the foreign affiliates: equity funds versus loans
from MMI, retained earnings of the affiliates,
and outside borrowings? Consider cost, politi-
cal and economic risks, and tax consequences
in your answer.
2. Given these considerations, under what cir-
cumstances, if any, should the capital struc-
ture of foreign affiliates include more or less
debt than the 35% considered desirable for
the firm as a whole?
3. How will the resultant capital structures affect
the required rates of return on affiliate pro-
jects? The actual rates of return?
4. How should MMI’s dividend policy be imple-
mented at the affiliate level?
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