Solution - Fuqua School of Business



LogiTech:

“Closing Transportation Gaps”

Teaching Note

Synopsis

This case in set in March 2000. Characteristics of the Transportation and Logistics (T&L) industry in Latin America (LA) provide an excellent opportunity for new service providing. The current industry in LA is very fragmented and is increasingly concerned with security and productivity. In addition, the slow economic integration of LA countries increases the need for multi-mode transportation and multi-mode communication systems. LogiTech services will benefit from the trend of outsourcing logistic services and provide logistic integration to its clients’ supply chains. Boosted by several reforms to increase countries’ attractiveness to foreign capital, the economies of main Latin America countries have been developing considerably in the past decade, which has prospect of ensuing in a steady economic growth.

Mr. Camelo, an entrepreneur, clearly identified this opportunity. His challenge is to valuate it correctly and realistically, and attract potential interested partners and investors. Key issues to valuing this project correctly are:

1. Are the forecasted the revenues, costs and capital expenditures reasonable for the expected scenario? What are other possible scenarios or uncertainties?

2. What are the risks of this project that relate to the countries? How Brazil and Argentina differ in this sense? Which risks are project-specific? How can all those risks be mitigated?

3. What discount rate should be used to evaluate this project? Should the project be valuated for each country independently or together?

4. What are the main challenges to raise capital in LA? What financial instruments are more suitable?

5. Is there any other source of value to the project? Which Real Options should be considered in valuating this project?

Pedagogical Objectives

This case is designed for an Emerging Markets Corporate Finance course. The main focus goes beyond the stand-alone analysis of a project, business, or industry. It aims to illustrate the issues involved in investing or undertaking such enterprises in developing economies. The analysis of such issues is extremely important to any professional that will deal with any business outside USA, and especially in emerging markets.

This case aims to provide an understanding of all the important analyses to be performed to assess a project in an international setting. We address the valuation of a business in a volatile environment, facing two kinds of risks. The intrinsic risk of a business heavily based on technology, and the risk of undertaking businesses in emerging markets. These analyses are very important in a moment of global economic growth, when economies show very optimistic prospects and tend to be less risk averse, but even more crucial when growth, political stability, financial terms, and other key variables are loaded with uncertainty.

More specifically, the case has the following objectives:

1. Illustrate country-related risks in emerging economies and, in addition to operational risks, assess their effect on the project and discuss alternatives for risk mitigation

2. Present alternatives for cost of capital calculations for emerging markets and discuss their relevance to this specific situation

3. Illustrate some key aspects of corporate financing in Latin America

4. Identify and model real options related to this project, as well as estimate how they affect valuations and decisions.

Suggested Class Discussion

This case can be discussed in two one-hour classes. The first segment can focus on analyses and discussions on T&L industry in LA, country and operational risk assessment, as well as risk mitigating or enhancing factors. The second segment can be used to wrap up risk assessment discussions, discuss calculations of cost of capital, and assess the value of the firm. In addition, we suggest discussions on identifying and valuing real options available for LogiTech, and financing alternatives in emerging economies. Finally, we suggest a presentation of conclusion and recommended course of action. Please refer to Exhibit 1 for a suggested teaching plan.

Case Solution

The case solution is comprised of the following steps:

• Sovereign and operational risks assessment

• Cost of capital estimation

• Financing alternatives

• Real options discussion

• Company valuation

• Sensitivity analysis / real option valuation

• What happened

Risk Assessment

LogiTech business is exposed to two types of risks: country and operational risks. Country (or sovereign) risks are assessed in light of the nation’s political, economical and financial perspectives of average equity return of an average project in that environment. The most important or relevant risk factors of Brazilian and Argentinean sovereign risks are discussed below. Other existing risk factors are mentioned in Exhibit 2.

Operational risks inherent to the business itself (even if considering its implementation in a highly ranked, extremely low risk country) are also discussed. Moreover, we argue how some of these risks could be mitigated, and how should they be adjusted to reflect LogiTech’s inherent risk.

Brazilian Sovereign Risks

Economic Performance – MEDIUM HIGH

In 1999 the economy withstood the shock of the maxi-devaluation of the Real in January of that year much better than might have been expected, helped by a sharp increase in agricultural output, buoyant oil production and investment in privatized utilities. The economic recovery initiated after the final quarter of 1998 has displayed no signs of slackening in the first half of 2000. With interest rates continuing to fall and confidence rising, the economy seems set to achieve the government's 4% growth target in 2000.

However, keeping Brazil in its development path is conditional on continually passing some (unpopular) reforms. Since they heavily depend on a positive political mood (powerful parts of the society prefer the status quo) not much is expected from six months preceding an election, for instance. Some pending reforms are:

• tax system reform (to rationalize the probably most complex system of indirect taxes in the world’s through fusion of the federal tax on manufactured goods, the state sales tax, and the municipal services tax into one broad tax shared by the federal and state governments)

• fiscal responsibility law (to limit government personnel expenditure and tightens existing rules limiting state indebtedness and introduces criminal penalties in the case of irresponsible fiscal management)

• reform of the judicial system (a highly inefficient institution, with too few judges per capita)

• social security reform (achieve actuarial balance by changing calculating factors like age, life expectancy, and years of contribution)

• political reform (to curtail the number of parties in Congress, harden allegiance switching, and rectify current imbalances in regional representation)

Law and order tradition – HIGH

Reform of the highly inefficient judicial system is at present under discussion in Congress. The number of judges per inhabitant is currently very low, while an excessive number of institutions and magisterial responsibilities slow down the administration of justice even further. This still remains a significant risk in doing business in Brazil. Although one might argue that some progress was done in the past years, this is not even close to what is necessary to provide people with the necessary sense of responsibility and accountability for their actions that a stable, developed business environment requires.

As a result, it is still difficult and lengthy to sue in Brazil. Thus, losses can occur since others don’t have the incentive necessary to exactly abide to the rules stipulated when it is not of their best interest, and also because people tend to agree on less than favorable settlement terms to avoid the costs and hassle of going to court.

Internal Conflicts / National Tensions / Criminality – MEDIUM HIGH

The current level of internal conflicts and national tensions is relatively low, but it has a significant risk of increasing. As discussed before, the police forces and the judicial system are target for reforms to increase their effectiveness. Although this is very important for the country they are very controversial, so one should not expect some change in the short term. Another reason for the risk being significantly high is the fact that Brazil still has relative low levels of violence, internal conflicts, and national tensions if compared to other Latin American countries where governments offer similar levels of law enforcement.

Currency / exchange rate control – LOW

Since the devaluation in January 1999, the Real has been floating according to market forces, and the probability of another exchange rate control by the government is low. However, the Brazilian economy is still very susceptible to huge outflows of investment if levels of confidence drop significantly. Thus, the Central Bank is committed to interfere in the foreign currency market to maintain exchange rates in an “economic healthy” levels for the economy.

Argentine Sovereign Risks

Currency / exchange rate control – HIGH

The ability to maintain the currency board will depend on two factors. The confidence and expectations of the market on Argentina’s to effect very needed reforms to solidify its economic recovery, and also on high levels of foreign currency reserves to support attacks against the currency. The balance of those two factors are becoming increasingly weaker, thus increasing the risk of devaluation.

Economic output – MEDIUM HIGH

Argentina economy is currently extremely uncompetitive. Tied to the US dollar, its currency is extremely appreciated, once last years’ increase in productivity did not support this exchange rate. Economic performance improvement will heavily depend on the increase of competitiveness of the local industry to boost exports, and/or to increase attractiveness for foreign investments. A boost in competitiveness can be achieved through a lengthy process of reforming country’s institutions (specially decreasing government spending as a whole), or through a more drastic measure of revoking the Convertibility Plan, that pegged the Peso to the US dollar since 1991, and allowing a currency devaluation (as discussed above).

So far, the government is considering only the first option, and vehemently denies any possibility of devaluation. However, that does not reflect market expectations. The effect of devaluation would be drastic to the economy, especially because Argentina’s ability to support an attack on the Peso (or to recover from devaluation) is relatively lower than when compared to how Brazil was able to manage the crisis after the 1999 Real depreciation.

Political – MEDIUM HIGH

Current President De La Rua, opposition to the Peronists (most powerful, influential party in Argentina that ruled for the last 10 years), faces a delicate situation. Although now he has little opposition in Congress, this situation may well change if the economic situation does not improve. A relative political stalemate has sharply decreased the rhythm of reforms in the country in the last years, and this situation is not likely to improve in his mandate, making it harder to effect real changes in the country.

Operational Risks

Pre-Completion

Technology development – HIGH

Though the core technology needed is currently available, some further developments are needed for the service to become operational. These include the development of hardware and software to support operations. The main device (controlling the hardware inside the vehicle) is in trial and development stage. We estimate that another three months will be needed for the device to be fully operational. Any delay from the trials will directly impact the roll out of the project.

Time-to-market – MEDIUM

Time-to-market is a major concern. There is an increasing risk of loosing a first mover advantage if the project is delayed. Although no company is currently providing a service comparable to that of Logitech, many competitors would be able to provide this service in the near future.

Post-Completion

Service / technology adoption rate – HIGH

Latin American countries’ technology adoption has proven to be much faster than that of developed countries, in part attributable to a lesser need to educate a consumer that already knows about a technology when it is already available in developed countries. Technology adoption rate is one of the key drivers to sustain revenue growth and financial health, and would affect in particular the short-term to mid-term availability of capital needed to reinvest in the project. Deviations from this assumption will substantially change the health of the project.

One main issue that affects the adoption rate is the perception of LogiTech potential clients of the benefits of adopting such service, and of how much the benefits outweigh costs. Another main issue affecting service adoption rate would be competition from a firm that already provides similar service in the US and decides to enter the market.

Sustainability of competitive advantage – HIGH

Our initial estimation considers that LogiTech services would enjoy a strong competitive advantage. This advantage is supported by an entry with a substantially lower price than competition, a dramatically lower switching cost, and a considerable improvement on the technology offered in the market. As the project develops and competition reacts, this advantage will be weakened. The ability to incorporate further services is therefore a risk to sustain the competitive advantage. The business plan is set to start in Brazil and six months later enter Argentina. We could lose some competitive advantage in this second stage if Argentinean investors are able to introduce a competing service during this six-month delay.

B2B Growth – MEDIUM

This project has a higher-than-average exposure to the growth of Internet commerce between companies. The reliance on the Web for most of the operational procedures and relationship with clients strengthen the need of a high Internet penetration.

Higher value services adoption – MEDIUM

Additional services such as fleet management also impacts the health of the project. Variations in any of this assumed adoptions rate would impact the project.

Industry consolidation and Mercosur prospect – LOW

Fifty percent of the vehicles are part of fleets of two or less vehicles. Increased consolidation of the industry in the next years would increase the potential market size and bring customers economy of scale to justify their investment in our services. Mercosur aims to increase trade between countries, resulting in increased average mileage of cargo movement and increased complexity of the supply chain. Although the commercial relationships among Mercosur partners have been somewhat distant in the past years, it is expected that the agreement will go forward and boost trade among between countries.

LogiTech’s project risk

We adjusted LogiTech’s levels of risks to reflect the actual enterprise environment. The sovereign risks discussed so far reflect the average environment for business in a country. However, LogiTech faces overall risks that are different than an average equity investment. The adjustment in the credit rating is shown on Exhibit 2. Below we discuss major adjustments.

The currency risk is medium. In principle, it does not directly affect LogiTech’s revenues and operational costs, since they are all in local currency. However, LogiTech will hold US dollar denominated debt as a result from heavy capital expenditures on purchase of technological imported equipment. This represents a high risk of currency loss, unless some form of hedge was previously contracted. In addition, if foreign investors consider repatriating proceeds, then Argentina poses some significant risk of currency depreciation.

Since the project is almost totally directed to private clients, and does not depend significantly on governmental decisions, some political risks related to governmental functions can be considered mitigated, such as the influence of corruption, military, and religion in politics. Nevertheless, these factors have an indirect impact on the project for they influence economic development.

On the other hand, the project performance is very dependent on GDP per capita growth, and any downturn in the economy might reflect in an amplified fashion in the service adoption rate, or in the total number of customers. First, the transportation business performance holds a very tight correlation with consumption that can be measured by GDP. Second, the service provided by LogiTech can still be considered an innovation in the logistics industry, and usually firms tend to invest discretionary income in innovations only when the economic outlook is positive. In addition, part of the services will be web-based, so Internet penetration is also an important growth driver.

Interestingly, the risk factor related to national tensions has somehow to be considered differently. Although national tensions might affect adversely business and society, an increase in certain types of crimes can boost LogiTech’s business. If theft of cars, motorbikes, and trucks (including their loads) increase, it represents a business opportunity rather than a threat to this project.

Another component of risk adjustment is related to project-specific risks. One risk mitigating factors is partnering with local companies that could bring regional experience and industry knowledge. LogiTech would benefit from local partners in implementation (to assure that time-to-market is reduced), firm operations, and marketing (to educate customers about LogiTech’s added value services). Also in service / technology adoption we identified a mitigating factor. Offering customers the alternative of leasing devices, instead of being obliged to a considerable upfront payment to enjoy the service, could significantly boost service adoption.

Although some risks can be mitigated, we still consider that on the overall LogiTech project is riskier than an average project in those countries. It is a start-up company with new technology and service offering, entering in a market with an unmet need. In addition, the target market is still very informal to adopt this service right away. Moreover, the future adoption of the service depends on consolidation of the industry, education of customers, positive economic outlook, and availability of funds to invest in new technologies.

Cost of Capital

The estimation of the cost of capital is a crucial step to valuate any project’s cash flows and has immense impact on the enterprise’s value. Attempts to estimate the discount factor of projects undertaken in developed markets already provoke a lot of debates. Even more controversy is generated when the issue also includes a project in emerging markets. Several models to estimate cost of capital in an international environment are used by investors, firms, and financial consultants, and each of them has strengths and weaknesses. We decided to calculate and compare the results from three models we deem to be most applicable to this particular situation. We utilize the Goldman Integrated and the Country Risk Rating (ICCRC). Additionally, for the former model, we propose an alternative source for the country premium.

Goldman Integrated

This is the model that an investment banker or a consulting company would probably suggest applying to calculate the discount rate of this project. It assumes that LogiTech’s operations in Latin America are as risky as equivalent businesses’ operations in US, and then a premium for the country risk is added.

Cost of capital calculation

(Goldman Integrated model)

We use the sovereign bond yield spread between the US and the country in question as a proxy for the country premium (D). Since both Brazilian and Argentinean bonds are denominated in US$, it is not influenced by current or expected inflation or currency rates. We also used 1.5 as the company’s unlevered beta. This model yields a cost of capital of 20.3% for Brazil and 19.3% for Argentina. We considered these rates as being to low for LogiTech project in those countries, mainly because the risk premium added reflects the risk of the sovereign government debt, not necessarily the risk of doing business in those places.

Country Credit Rating (ICCRC)

The Country Risk Rating model uses the International Cost of Capital and Risk Calculator (ICCRC). This model fits a regression between a specific country credit rating and the average equity return of its stocks market. This model captures many of the essential factors surrounding sovereign risk, and calculates with better consistency the cost of capital in international capital markets.

The ICCRC yields a country rate of 25.8% for Brazil and 23.9% for Argentina, driven by each country credit rating. At the time of the project (March 2000), Institutional Investor credit rating was 38.5 for Brazil and 43 for Argentina in a scale from 0 to 100, where the latter is the lowest risk rating. We considered a risk-free rate of 5% (Treasury Bonds, 10 years), and the calculation anchored to the U.S. equity market, with a market risk premium of 5.5%.

Additionally, we considered some adjusting factors since we believe that risks that LogiTech is subject to are not represented by an average project risk in those countries. The main factors are discussed above. The International Country Risk Guide (ICRG) provides some criteria (subdivided in political, financial and economic) to adjust the ratings in those categories that the company is expected to have an exposure different that average (please refer to Exhibit 2). The original Brazilian rating of 64.8 was reduced to 62.5 for economic reasons (namely GDP and GDP per capita), since these factors represent a greater risk to the project than to the country average. For Argentina the rating went from 71 to 67.5, since we adjusted the political factor of government stability factor (that may impact the economy significantly), in addition to the economic factors adjusted also for Brazil. To account for these adjusting factors considered, we believe that the discount rates for Brazil and Argentina should be increased by 5% to represent actual risks that LogiTech is bound to face in these countries. This increase accounts for the net effect of both mitigating and enhancing risk factors. As a result, the discount rate is 30.8% for Brazil and 28.8% for Argentina.

Goldman Integrated – Alternative Approach to Country Premium

Additionally, we propose an alternative approach to estimate the project cost of capital. The Goldman Integrated model is used, but with a different estimation of country premium rates. This approach uses the ICCRC to deliver the spread between the average equity returns of the countries (F) and US (G), derived from the credit ratings. The US credit rating of 92.9 results in an average 10.3% return on equity, thus yielding a country premium (H) of 15.5% for Brazil and 13.6% for Argentina. We deem this alternative approach results to be more reliable and accurate, since the country premium considers the increase in risk of doing business in the country, rather than just for buying government issued bonds.

Cost of capital calculation

(Goldman Integrated model with ICCRC country spread)

This alternative approach to the Goldman-Integrative model results in a cost of equity (J) of 28.8% for Brazil and 26.9% for Argentina. These figures are very much in line with the results of the second model suggested (CCR and ICCRC) of 30.8% for Brazil and 28.8% for Argentina. Finally we decided to use 29% for Brazil and 27% for Argentina.

Financing Decisions

The solution should be divided in two parts: evaluating different financial opportunities, and deciding on having a partner. The analysis of this part should be more qualitative to analyze advantages and disadvantages of each financial decision.

Evaluating financial opportunities

There are different approaches to decide the best instrument to use. This analysis is made on the premise that a partner is found if Venture Capital funds are not available. The first part is comparing and deciding which financial instrument is better: Venture Capital, Local Currency, and Foreign Currency. After comparing that decision, the analysis shows the comparison of different financial options in different currencies.

The analysis should make clear that access to banks’ loan in emerging markets is extremely difficult compared to developed countries due to the lack of credit history of the company, and difficulty of getting long-term commitment from banks. The Venture Capital option is the most suitable in this case. It helps the company reduce risk and financial expenses, but at the same time there are differences on how Venture Capitalists invest in emerging countries.

The first analysis compares the three main types of financing. Venture Capital is the best choice because of it requires no interest payments at the beginning, no collateral in issuing debt, fewer fees to be paid, and no payment of capital until the Venture Capitalist decides to exercise his exit options.

| |Venture Capital |Local currency |Foreign Currency |

|Advanta|No interest payments until full operative |No exchange rate fluctuations on interest |No deep interest rate fluctuations. |

|ges |May not pay any capital until Venture |payments |Lower interest rate |

| |Capital decides to exit |Easier to get approval having the correct |Have 100% of company equity. |

| |Less possibility to put collateral to back |contacts | |

| |up VC’s funds |Have 100% of company equity | |

| |Less control over company |Deep interest rate fluctuations |Exchange rate fluctuations for interest |

|Disadva|Decrease of original owner equity |Interest payments from the beginning. |payments |

|ntages |proportion |Second most difficult to get approved |Interest payments from the beginning. |

| |Higher difficulty to close a deal with a |Highest interest rate |Most difficult to get approved |

| |Venture Capital because project is not |Having to put collateral to back up loans |Having to put collateral to back up |

| |extremely attractive | |loans |

The second table compares the four different financial instruments available in local currency. Here, the logic should go to leasing because of financial cost and lower collateral on loan. Even though the short-term debt is the least expensive, payment requirement is greater. For the amount of credit discussed, syndicated loan should not be an option, unless the company wants to have access to a group of banks.

| |Short term debt |Long term debt |Leasing |Syndicated Loan |

|Advant|No exchange rate fluctuations on|No devaluation risk in |No devaluation risk in interest |No deep interest rate fluctuations. |

|ages |interest payments |interest payments |payments |Lower interest rate |

| |No disbursement payment |Lower interest rate |Lower interest rate |Monthly fix payment throughout loan |

| |Easiest to get approval among |Monthly fix payment |Monthly fix payment throughout |life |

| |the different local currency |throughout loan life |loan life |Less collateral to back up loans |

| |products |Long period of time to pay |Less collateral to back up loans|Access to more banks, improving |

| | |back loan |Long period of time to pay back |credit rating |

| | | |loan |Long period of time to pay back loan|

|Disadv|Deep interest rate fluctuations |Interest payments from the |Risk of high interest rate |Risk of high interest rate |

|antage|Interest payments from the |beginning |fluctuations |fluctuations |

|s |beginning. |Difficult to get approved |Interest payments from the |Interest payments from the |

| |Most collateral to put to |Most collateral to put to |beginning |beginning. |

| |guarantee loan |guarantee loan |Second most difficult to get |Most difficult to get approved |

| |Highest interest rate |Disbursement fee |approved |Highest fee in disbursement and |

| |Must be paid back in less than 3| |Disbursement fee |structuring fee |

| |years | |Insurance of financed asset | |

| |Capital amortization every 3 | |Requirement of additional | |

| |months | |collateral | |

This next table analyses the difference between long-term debt and leasing, both in foreign currency. The terms are similar to the local currency products, so recommendations should be similar. If decided to go with foreign currency, leasing is the instrument to go.

| |Long term debt |Leasing |

|Advant|No deep interest rate fluctuations. |No deep interest rate fluctuations. |

|ages |Lower interest rate |Lower interest rate |

| |A monthly fix payment through out loan life |A monthly fix payment throughout loan life |

| |Long period of time to pay back loan. |Less collateral to back up loans |

| | |Long period of time to pay back loan |

|Disadv|Risk of currency devaluation |Risk of currency devaluation |

|antage|Interest payments from the beginning |Interest payments from the beginning. |

|s |Difficult to get approved |Difficult to get approved |

| |Most collateral to put to guarantee loan |Disbursement fee |

| |Disbursement fee |Insurance for financed asset |

| | |Requirement of additional collateral |

Exhibit 3 provides a summary of all financial instruments evaluated by Mr. Camelo.

Deciding on partnership

One of the key learning points in the financial solution is to evaluate advantages and disadvantages of having a partner. We are not suggesting a specific partner in the technological field or with specific know-how, but rather in the financial sense. Also, we are not suggesting which partner to select, but rather the need of a partner and the different advantages of a partnership. Also, we are not recommending which type of partnership should be considered, but once again the need of one. These last two items (partner and type partnership) are outside the scope of the learning points of the case.

This is probably the most important analysis to be done in the financial decisions, because the decision will affect the rest of the financial analysis. The addition of having a partner can be evaluated in strategic, financial, risk mitigation, and management.

Financial: The analysis should be concentrated in how the financial world is broadened if a partner is included , in the sense of accessibility to financial instruments, partner experience, rating, and lower interest costs.

Risk Mitigation: This part of the analysis should include the lower risk of credit due to partner experience and additional collaterals. An important issue here is the reduction of original risks by sharing risk among more equity holders.

Management: This part could lead to either direction. Depending on the partner chosen, the initial company holder could improve management quality (better experience and more accessibility to buyers/suppliers) or decrease it due to lost control over the company.

Strategic: Should summarize the advantages of the previous three mottos in order to make a strategic consideration of evaluating risk.

The table below summarizes some suggestions in the discussions of evaluating a partner.

|Motto |Having a Partner |Not Having a partner |

|Financial |Access to broader range of financial products |Limit financial product access due to lack of experience |

| |Knowledge of and experience with financial institutions |and credit history |

| |Partner credit rating and history |Limit number of collaterals to offer to back up credit |

| |Lower interest rate due to history and rating |Non-existing credit rating and credit history |

| |Possibility of partner’s collaterals to guarantee loans |Higher interest rate due to lack of credit history |

|Risk Mitigation |Lower risk due to experience, history, and rating |Highest risk |

| |Risk diversification for equity holders | |

| |In case of financial distress, costs are divided among | |

| |parts | |

|Management |Management experience |Lack of management experience |

| |Losing company control |More control over company |

| |Losing vote power in board of directors |Power on decision making |

| |Lower power in decision making |Control on board of directors |

| |Broader access to clients/suppliers |Limit access to clients and suppliers |

|Strategic |Broader and better access to financial institution and |Definitely not having a partner limits possibilities of |

| |financial credit due to lower credit risk and better |getting access to financial instruments, and to |

| |management. On the other hand, control of company is |continuation of business. The main disadvantage of |

| |reduced, but in general financial, risk and management |partnership is losing control over the company, but is a |

| |advantages outweigh reduction of control |trade off in which in general the advantages are greater |

| | |than the disadvantages |

Real Options

A real option is the ability to postpone an important decision to after the launch of a project. Real options represent the flexibility that business managers usually have to pursue the most attractive alternative, after considering certain conditions at the time of decision. The inclusion of LogiTech’s real options values in our financial projections represents the value of this inherent flexibility of postponed decisions.

Real options are especially valuable in emerging markets. Emerging markets are environments with higher conditions’ volatility, resulting in more volatile returns . The ability to postpone decisions, update all assumptions considered, and therefore review the expected decision has a much greater value in an environment where underlying conditions are constantly changing, or are intrinsically more unstable or unpredictable.

We identified three major options: the timing of the entry in the second target market (Argentina), the exit of the project in case it does not succeed in either market, and the opportunity to provide new services to more Latin American countries, once results are favorable in both Argentina and Brazil. Each option is discussed below, and other alternative options are presented thereafter. Options values are assessed in the Project Valuation section.

Option 1: Timing of entry in Argentina

LogiTech business plan considers sequential entry in the markets mentioned, with Brazil first and Argentina second. The timing of the Argentinean market entry is the most important option for LogiTech in the proposed plan. The original scenario considers that investments and services in Argentina would begin 6 months after the initial investment in Brazil. However, there are some uncertainties associated with this second market entry. The major uncertainty is the initial business performance in Brazil. First, it will give entrepreneurs a better idea of the market competition and potential adoption of services. Second, since this project is expected to have extremely low levels of debt, cash flows from initial operations in Brazil are expected to fund expansions in other markets. Moreover, during this period the economy outlook may change, and expectations of worsened economic conditions may lead entrepreneurs to review original plans. A third uncertainty on Argentina enter time is the level of the technical penetration curve after initial investment in Brazil. This penetration curve is explained in more detail in the assumptions of the model. In summary, the value of this option results from having the flexibility to postpone (or even to cancel) a second market entry.

This option was modeled in a way that, in every projection period, the decision of Argentine market entry is made and will only occur if some conditions are met. These conditions have financial (minimum cash available) and commercial (minimum client base) aspects. The inclusion of this option adds $1,225,879 to the project’s base case scenario value.

This real option should reduce negative scenarios, because it allows Logitech to reduce its entering costs into the Argentina market.

Option 2: Abandon and salvage option in either market

This option is also worth considering. The base case scenario considers that this business continues to operate regardless of its performance, and this is not what necessarily happens in real business situations. If businesses reach to a point where value is negative, shutting down a business might be the best alternative. The main uncertainty in this situation is the performance of countries’ operations, since they depend not only on market competition, but also on the overall economic situation, which can differ from country to country. The real options can be exercise in each country independently of the result of the other, allowing Logitech to keep working in countries that have positive cash inflows after the fourth year of operations. An exit would require stopping to service clients and selling assets to pay liabilities. For obvious reasons, a market reentry is not considered. The only disadvantage of this real option is the low salvage value of Logitech, because the assets are mainly technological assets that depreciate quickly overtime. The salvage value is estimated to be only US$ 10,000,000.

This option was modeled considering that every year the future NPV of a country operation is calculated. If after the fourth year the NPV becomes negative, the decision is to exit the project forever. The consideration of this option added $631,736 to the value of the project’s base case scenario.

This real option allows Logitech to reduce the bad scenarios by taking certain level of lost.

Option 3: Business expansion to other markets

This option considers the exploitation of other markets. If this project is successful, LogiTech will have the experience, expertise, and scale (in addition to funds) to pursue other opportunities. Business plans refer to these options as a strategic premium, since it allows expansion of the business to markets not initially projected and at the same time increase the total NPV of the project.

Since this is difficult to estimate in a detailed fashion, we picked two other Latin American countries with high potential as targets: Mexico and Chile. We used some multiples to estimate potential profits in both markets. This real option was activated into Mexico if Logitech’s NPV was in the top quartile (US$ 50,000,000) and in Mexico and Chile if the NPV was in the top 10% percentile (US$ 75,000,000). Once the real option was activated, it was estimated the NPV in Mexico would be 70% and Chile 10% of Brazil’s NPV. These percentages were calculated as percentage of size of the economy of Chile and Mexico compared to Brazil for the year 1999. As a result, an expansion to service the Chilenean market would add $3,466,000.

Project Valuation

Base Case NPV

As discussed in the cost of capital section, the discount rates for cash flows range between two of the presented models (CCR/ICCRC and Goldman-Integrated with CCR country risk spread) thus yielding 29% for Brazilian and 27% for Argentine operations. We chose to project LogiTech financials for five years, and use a perpetuity formula from there on. The reasons are that it is expected that the life cycle of such technology is shorter than this period, which it will not be the main driver of competitive advantage for so long, and therefore it is hard to predict in long periods of time. Other key assumptions used to project LogiTech’s revenues, costs, and investments are detailed in Exhibit 4.

Monte Carlo Simulation Project Value

We valuated the project using the discounted cash flow method. The ICCRC model was the basic to appraise the effect of most of systematic risk of the project, and the Monte Carlo simulation was used to assess project-inherent risk.

Key assumptions that affect project cash flow were tested using Monte Carlo Simulation. Due to their importance to the project bottom line, these assumptions also have significant risks, since their actual value is unknown and, therefore, should be modeled through an adequate probability distribution. Two types of risks assessed the effect on cash flows. These risks are:

­ Risks inherent to the project, since they are not included in the project discount rate.

­ Systematic risk, particularly important to the project and desirable to evaluate its effect on the project in greater detail

Risks inherent to the project. The main intrinsic project risks were modeled and tested in the simulation. Expected market share in the year previous to terminal value calculation, advance vehicle location technology penetration, fleet management penetration for both new subscribers and subscribers to basic RC service, initial variable costs, and variable costs evolution are included in this type of risk. Please see Exhibit 5 for a discussion on the modeling of these risks.

Systematic risks. The simulation accounted for market size growth, B2B growth in the region, and currency exchange risk exposure. Again, due to their importance to the project, these risks were modeled to understand the effect on the overall project. Please see Exhibit 5 for a discussion on the modeling of these risks

The following graph shows the risk profile for the project, including roll out in both Argentina and Brazil. The mean expected project value is $26,730,786. Please see Exhibit 6 for key statistics.

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Real Options Valuation

As discussed earlier under “Real Options”, three options were considered. The following graph shows the results from applying the real options to the valuation model. The probability of having net present value greater than zero does not change significantly, but the real options increase the mean value of the project and at the same time decrease downside risk and increase upside potential. The mean expected project value increase by more than $5 million to $32,054,403, if the real options are considered. Please see exhibit 6 for key statistics.

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Conclusion / Recommendation

We recommend that Mr. Camelo undertake this project, once interested investors commit necessary funds. This project has a high positive value (US$ 28.035 million) for its base case scenario, even after accounting for sovereign and operational risks either in cash flows or in discount rate. We also believe that entrepreneurs should give a close look at all real options available for this project, since they can significantly increase the project average value, by decreasing its downside risk and increasing upside potential.

Additionally, we recommend that LogiTech partner with companies that could leverage the project strategy. This partnership would allow Logitech to receive industry and technology know-how required to be a successful business. The partnership might include the following companies:

A telecommunications company: Telecommunication hardware and communications represent 75% of total variable costs, therefore a huge amount. A telecommunications company with a broad range of services in the region coupled with Logitech’s customer needs would benefit from the partnership by manufacturing and providing necessary hardware. The partnership also would benefit LogiTech by having a partner with a strong reputation, industry and regional knowledge, and a direct interest on the project.

A supply chain software provider: Supply Chain Management software is a key need to undertake this project. The availability of this software is essential to a timely business deployment. A software provider as a partner would decrease time-to-market and provide Logitech with further industry experience. The software company would also benefit from the partnership, because implementing its software to Logitech’s clients could represent a starting point to further business potential.

Small and large vehicles manufacturer: Deploying Logitech’s technology on vehicles while manufactured can represent a healthy partnership. The vehicles manufacture would provide a less costly solution to its clients on advance vehicle location, while Logitech would be able to lock clients proactively.

Finally, Logitech could consider further investing in other countries, as:

­ The business model can be easily replicable in other markets

­ Investing in other countries would tend to increase overall project value

­ Diversifying to markets in other countries increases significantly the likelihood of a positive net present value

­ The project systematic risk should be reduced when entering more markets.

What happened

This update reflects conditions as of the date of the writing of this case (February 2002).

Brazil

Overall, the economy has recovered from the 1999 devaluation and has been able to grow since then, although in low levels. High interest rates policy to contain inflation and to attract foreign capital still are one of the major contributing factors to restrain Brazil from attaining higher growth rates that would be more in line with the country’s actual growth potential. Since the time of this project’s valuation (March 2000), the Real followed a smooth devaluation trend, reaching its minimum of R$ 2.90:US$ 1.00 in Nov 2001, because of market suspicions that a crisis in Argentina could affect Brazil.

Congress passed some reforms, but other important ones to increase the country’s competitiveness are still to come. The political situation remains stable, but in this year controversial measures are not expected since presidential elections will take place in the end of 2002. Internal national tension is greater because of a significant increase in criminality levels, especially related to car and trucks theft. This is good news particularly to LogiTech, since customers might perceive a greater value on the service offering.

Argentina

From the base date of this project (March 2000), the Argentine economic, financial, and political situation only worsened. In addition to initially lacking political support, President De La Rua’s ability to govern and reform the country further decreased after some unpopular measures (such as income taxes increase).

The political instability and disunion, added to lack of confidence of Argentineans and foreign investors, pressured the overvalued peso in a way that the Convertibility Plan could no longer be sustained. In December 2001, Fernando De La Rua resigned, and the country entered in an political and economical chaos. Since then, the government is having a great difficulty to gather support and emergency loans from foreign institutions. Social unrest is becoming an issue since unemployment is rising dramatically, and as a result the scenario for Argentina does not look promising at all – GPD is expected to contract as much as 10% in 2002!!

Exhibit 1

Suggested Teaching Plan

Hour One

5 minutes Recapitulation of case main points

10 minutes Discussion of the Transportation and Logistics industry in Latin America (environment, current characteristics, unmet needs) and LogiTech’s objectives (service providing, goals)

15 minutes Discussion of projects-specific (operational) risks, and how to mitigate them

20 minutes Discussion of general country risks, and how to mitigate them

5 minutes Discussion of adjustment of risks to reflect the project environment

5 minutes Conclusions from the first hour of discussion.

BREAK

Hour Two

5 minutes Recapitulation of first hour of discussion main conclusions

10 minutes Discussion of appropriate cost of capital models for this project, strengths and weaknesses of each model, estimate discount rate

10 minutes Discussion of issues related to financing in Latin America

5 minutes Presentation of base case scenario and discussion of company valuation

10 minutes Identification and discussion of real options available, how to model them, and the value they add in the project

10 minutes Recapitulation of all discussion, and discussion of possible courses of action, conclusions, and recommendations

10 minutes Description of what actually happened to each country economic situation, and reevaluation of conclusions and decisions based on that

Exhibit 2

Country Credit Rating and Adjusting Factors

Obs.: Adjustments in bold

Exhibit 3

Financial Instrument Decision

This last financial instrument table summarizes the key finding of all the seven instruments discussed in the case. Again the recommendation should go to Venture Capital over any other option. Second option, could be leasing in local currency.

| |Short term debt local |Long term debt local |Leasing – local currency |Syndicated local currency|Short term debt local |Long term debt local |Venture Capital |

| |currency |currency | | |currency |currency | |

|Disa|Lost of control over the |Deep interest rate |Interest payments from the|Risk of high interest rate|Risk of high interest rate |Risk on devaluation of |Risk on currency |

|dvan|company |fluctuations. |beginning. |fluctuations. |fluctuations. |currency. |devaluation . |

|tage|Decrease of original |Interest payments from the|Difficult to get approved |Interest payments from the|Interest payments from the |Interest payments from the|Interest payments from the |

|s |owner equity proportion |beginning. |Most collateral to put to |beginning. |beginning. |beginning. |beginning. |

| |Higher difficulty to |Most collateral to put to |guarantee loan |Second most difficult to |Most difficult to get |Difficult to get approved |Difficult to get approved |

| |close deal with Venture |guarantee loan |Disbursement fee |get approved |approved |Most collateral to put to |Disbursement fee |

| |Capital because project |Highest interest rate. | |Disbursement fee |Highest fee in disbursement |guarantee loan |Insurance payment for |

| |is not extremely |Must be paid back in less | |Insurance payment for |and structuring fee |Disbursement fee |financed asset |

| |attractive. |than 3 years | |financed asset | | |Requirement of additional |

| |Capital amortization | | |Requirement of additional | | |collateral |

| |should be paid every | | |collateral | | | |

| |three mths. | | | | | | |

Exhibit 4

Discussion on the design of the Monte Carlo Simulation

The valuation model imbedded in the Monte Carlo Simulation is a common cash flow analysis. Key assumptions were tested on the model. Since all of them are not deterministic coefficients but resemble a probability distribution, adequate distribution were modeled to determine the overall effect on project value. Unless explicitly said, variables were set a triangle distribution, inputting expected 10th, 50th, and 90th values.

We calculated the project value for each country individually. To get the value of the project as a whole, we summed up net present values of the individual countries. Another approach that accounts for diversification would be to calculate a discount rate for the project as a whole and then evaluate the yearly cash flows.

Assumptions are categorized in market, variable cost, and fixed cost assumptions. The latter were assumed to be deterministic coefficients since they are many times smaller than total cost and the impact of any feasible change of fixed costs over the project can be neglected.

|Variable |Comment |

|Market Assumptions | |

|Market Share |This variable accounts for market share measured as percentage of market over total advance vehicle location market in each country. We expect a greater |

| |marker share in Brazil, as the transportation and logistics industry is more complex than in Argentina and competition is currently fragmented, offering |

| |disjointed services with considerably higher prices. |

|Discount Rate |Most of the project systematic risk is accounted in the discount rate. The most likely value was calculated based on the ICCRC model for each country. |

|Terminal Growth Value |Two main variables determine the proper terminal value growth rate. |

| |The growth of the available market (number of vehicles), highly correlated to future expected growth of the countries’ economies |

| |Technology penetration we forecasted of high rate in the first five years, and low to moderate afterwards. |

|Market Size Growth |Market size growth is the growth of the total fleet of vehicles in each country. The variable is divided in three segments. The growth of the segments is |

| |highly correlated to GDP growth, particularly to trucks segment. We recognized: |

| |Part of this variable (or risk) is taken into account in the discount rate. We will assume a small part of the growth is imbedded in the discount rate and, |

| |therefore, cash flows must be affected. |

| |Other factors such as settlement of Mercosur will also determine the growth, complexity, and degree of consolidation of the industry. To be conservative, we |

| |considered that these factors would not affect the project. |

|Fleet Management Penetration |Two aspects of Fleet Management (FM) Penetration were considered: |

| |The number of RC subscribers that would also subscribe to FM service |

| |Non-RC subscribers that would require FM service |

| |Both variables were modeled with a triangular probability representing percentage of variation over the base case |

|B2B Growth in the region |Transportation web portal is one of the project’s three revenue streams . Success of this service depends on B2B growth in the region. We used a triangular |

| |distribution representing percentage of variation over base case scenario to model this risk. |

|Technology Penetration Curve |This is a key risk on the project. We considered that the penetration of advance vehicle location technology will resemble that of cellular phones when |

| |launched in the mid 80s. The model accounts for: |

| |A strong early penetration for the first five years. A probability distribution affects this penetration as a percentage of the base case scenario growth |

| |rate |

| |A low to moderate penetration after year five, as clients adopt the technology and it is no longer a competitive advantage but rather a necessary condition |

| |for survival in the market |

|Currency Exchange Risk |Currency exchange risk is in part taken into account in the discount rate. However, given that a considerable part of the costs of the project are tied up to|

| |the dollar, and revenues are denominated in local currency, the project has a greater-than-average currency exchange risk. Different criteria were use for |

| |Argentina and Brazil: |

| |Argentina at the time of the case has its currency pegged to the dollar. We used square probability distribution to model for the probability of devaluation |

| |in the 5 years of cash flow projection. Given that devaluation takes place (conditional probability) a second probability distribution would model the |

| |fluctuation of Argentina currency against the dollar. |

| |Brazil had its currency floating at the time of the case. We model the currency value through the cash flow projection as triangular probability |

| |distributions in each of the years. |

| |There is not direct relation between a possible devaluation in a country and the effect on the other country. |

|Variable Cost Assumptions | |

|Device Cost |Device cost includes the initial cost of the device and its cost evolution. Initial cost is modeled with a triangular distribution. Cost evolution costs is |

| |modeled with a triangular distribution tied to a negative exponential that accounts for the decrease in cost through time. |

|Device Installation |Installation cost includes the initial installation cost of the device and its installation cost evolution. Initial cost is modeled with a triangular |

| |distribution. Cost evolution is modeled with a triangular distribution tied to a negative exponential that accounts for the decrease in cost through time. |

|Communication Costs |Similar to device cost and device installation costs. |

Exhibit 5

Results of Base Case Scenario Project Valuation

The following graph shows the results of the Monte Carlo simulation. The table below summarizes the simulation statistics. Comparing the composed value to countries’ individual value draw the following conclusions:

­ Then mean value of the project increases as a country is included

­ The variability of the expected value increases as a country is included

­ The probability of having a positive present value increases significantly, in this case about a 5%.

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|Statistic |Value |

|Trials |2000 |

|Mean |$26,730,786 |

|Median |$18,562,465 |

|Skewness |0.82 |

|Standard Deviation |$44,950,866 |

|Range Minimum |($293,386,429) |

|Range Maximum |$252,231,134 |

|Range Width |$545,617,563 |

Seventy percent of results imply a positive net present value. Standard deviation looks rather high, compared to the mean expected value. However, a few observations fall to negative and a few observations fall to positive. The two extreme percentiles (10th and 90th) account for the variation of 80% of the range (negative $293MM to negative $19MM and $83MM to $252MM respectively), while the range between the 2nd and 9th percentile is about $100MM. Therefore, standard deviation is not a good indicator of the project performance as extreme values exist. Rather, is more accurate to analyze the shape of the risk profile curve. Also, the skewness of 0.82 represents that a great percentage of the values range around the median.

The graphs and table below illustrate the results for Argentina and Brazil individually.

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|Statistic |Argentina |Brazil |

|Trials |2000 |2000 |

|Mean |$8,040,750 |$18,690,036 |

|Median |$4,574,801 |$10,713,337 |

|Standard Deviation |$15,399,226 |$34,796,967 |

|Skewness |1.55 |0.82 |

|Range Minimum |($20,346,675) |($273,039,755) |

|Range Maximum |$108,919,672 |$208,222,332 |

|Range Width |$129,266,346 |$481,262,086 |

Exhibit 6

Results of Real Options Applied to Base Case Scenario Project Valuation

The following graphs show the different values for the three real options discussed above. In each case we are presenting the values when the option is exercise. We are not considering when the option is not exercised because in this case the value of the option would have a value of zero and the probability of that is somehow high, thus not allowing seeing other results properly. Also, each real option is accompanied by a graph representing the different values of the option when they are exercised, and a summary of its statistics when the option is not exercised. In the statistical table, we add an extra line that represents the percentage of time the real option is exercised.

Real Option 1:

This option delays the entering to Argentina when the economic situation is bad, the project in Brazil is not doing well, and/or the technology learning curve is not reducing the costs at all.

The next table shows the summary of statistical values of the real option 1:

|Statistics |Value |

|Trials |1000 |

|Mean |$1,225,879 |

|Median |$0 |

|Standard Deviation |$2,447,792 |

|Skewness |2.59 |

|Range Minimum |$0 |

|Range Maximum |$17,882,879 |

|Range Width |$17,882,879 |

|Percentage Exercised |35% |

Real Option 2:

This option is to shut down the project if it is doing bad after the fourth year. Logitech will assume the lost until that year and will get a low salvage value of $10,000,000 for the sale of all assets.

The statistic summary table of exercising the option:

|Statistics |Value |

|Trials |1000 |

|Mean |$631,736 |

|Median |$0 |

|Standard Deviation |$8,331,282 |

|Skewness |25.94 |

|Range Minimum |$0 |

|Range Maximum |$243,698,808 |

|Percentage Exercised |6.8% |

Real Option 3:

This option allows Logitech to expand to other markets if results from Brazil and Argentina are very favorable. Logitech will enter the Mexican market when the combined NPV of Argentina and Brazil is above $50,000,000 and will enter Mexico and Chile if the combined NPV is above $70,000,000. Please find the graph and the statistics summary of exercising this real option.

And the statistical table of the third real option:

|Statistics |Value |

|Trials |1000 |

|Mean |$3,466,001.95 |

|Standard Deviation |$7,698,596.94 |

|Skewness |3.04 |

|Kurtosis |14.89 |

|Range Minimum |$0.00 |

|Range Maximum |$62,036,932.11 |

|Percentage Exercised |27.2% |

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Frequency Chart

.000

.005

.010

.015

.020

0

2.5

5

7.5

10

$0

$4,513,294

$9,026,587

$13,539,881

$18,053,174

500 Trials

325 Outliers

Forecast: Value of Real Option 1

Frequency Chart

Certainty is 27.20% from 0.01 to +Infinity

.000

.004

.007

.011

.014

0

1.75

3.5

5.25

7

0.00

11,057,351.99

22,114,703.97

33,172,055.96

44,229,407.94

500 Trials

364 Outliers

Forecast: Value of Real Option 3

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