BA456 - Emerging Markets



BA456 - Emerging Markets

NewBank Microfinance:

Microcredit in the Ukraine

Solution

Holly Dice

Andrew Khoo

Sara Kirchhoff

Robert Little

Hartaj Singh

Case Synopsis

This case explores the viability of setting up a microfinance institution in an emerging market. Oleksa Dovbush is a successful entrepreneur with ties to the Ukraine who wants to help microenterprises in Ukraine. He has been approached by a group who has suggested the establishment of a microfinance institution, NewBank, in the Ukraine to service microenterprises. The group is asking Oleksa for debt funding and while Oleksa is happy to make a donation with no expectation of great financial returns in the short-term, major concerns include the financial sustainability of the institution and the ability to source other funds. While proven business models exist such as Grameen Bank in Bangladesh or BancoSol in Bolivia, the risk involved in setting up any such facility in an emerging market requires a careful analysis. Consequently, the case requires critical analysis of the risks associated with both the microfinance industry and the sovereign risks of the Ukraine. In addition, financial analysis regarding the state of the cash flows, cost of capital, and interest rates will be necessary.

Objectives of the Case

By working through this case, students should develop an astute understanding of the microfinance industry, the political and economic environment in the Ukraine, and the potential real options and non-financial returns that should be factored into determining whether to accept or reject a project. Students will also be required to determine the appropriate cost of capital to use when analyzing the cash flows of NewBank in order to determine attractiveness to other investors. Students are encouraged to take both a qualitative as well as a quantitative approach to solving this case.

The main objectives of the case again are:

• Risk assessment of microfinance

• Risk assessment of the political and economic environment in th eUkraine

• Calculation of appropriate cost of capital and interest rates

• Identification of real options and non-financial returns

• Balancing financial and non-financial returns

Why the Ukraine?

The Ukraine was chosen for this case for both practical and aesthetic reasons. First, a great opportunity in microfinance exists in Ukraine due to the shortcomings of its traditional banking industry and a growing small and medium-sized business community. Second, Ukraine’s economy has exciting upside but it is accompanied with a great deal of risks. So far this potential is unrealized as the economy has been in a contraction since declaring its independence. In large part this is the result of excessive bureaucracy, corruption and political instability. Finally, the news from this economy has been extremely mixed. The optimism about the Ukrainian economy’s first year of growth in a decade has been tempered by new reports of corruption and brutality at the highest levels of government.

Why Use the Microfinance Structure?

The microfinance structure is an interesting model to analyze. With a foundation based upon poverty reduction and a not-for-profit basis it provides countless socio-economic benefits to an emerging markets: access to capital, job creation and promoting economic wealth. At the same time, microfinance is reaching a crucial point it its development. Government grants, world aid and subsidies are not without limit and microfinance institutions will have to approach the capital markets to obtain the necessary funding to continue making an impact. In order to do so, these institutions must not only show the ability to remain financially sustainable but must evolve into becoming profitable to entice third-party investors.

Risk Identification and Mitigation

There are several types of risks within this case that can be identified as being either 1) Firm Specific, related directly to the NewBank proposition and the microfinance industry, or 2) Sovereign Risks, including macroeconomic, political and legal risks. All parties involved in the NewBank venture are subject to these risks. The tables below identify the other risks and their mitigating factors. The assessment of how harmful and likely the residual risks are (after mitigating factors are considered) is a critical step in the decision-making process for lenders or investors in NewBank. Before each table is a description of the primary firm or country specific risk.

Firm Specific

Default Rate and Late Payment of Loans: Probably the greatest risk associated with this venture is the risk of poor asset quality. If loan officers do not perform proper due diligence of prospective debtors, this could lead to a poor loan quality. The case notes that the average percentage of problem loans for commercial loans denominated in hryvnias is about 20%, which is fairly high (compared to about 1.5% here in the states). Looking deeper, it is evident that this rate is a result of a high proportion of loans given to state-run institutions who have since defaulted due to the unhealthy credit nature of the government.

Ukraine Sovereign Risks

Political Instability: Political instability is a significant risk, because it is so interrelated with economic risk. Political changes could cause a country’s market to close, could impede liquidity, and reduce performance.

Economic Environment: The Ukraine has suffered severe economic decline in recent periods. The number of impoverished people has significantly increased. Ukraine has also recently restructured its debt and is still trying to re-establish itself in the international capital markets. Moderate economic growth is expected in the near future, pending the stability of the political environment.

Financial Analysis

Most of the assumptions used in the model are rather gross estimates based upon discussions, interviews and readings regarding the microfinance industry. While these estimates obviously have an impact on the profitability of the model, these details are not the focus of the case. The major figures are discussed below.

Interest Rate

To determine an appropriate interest rate to charge debtors, it is critical that we consider market conditions, loan volume, and our required return. Per the case, the commercial lending rate for hryvnia-denominated loans is approximately 7-10% above the NBU discount rate which is currently 38%. This gives us a rate of about 47% (for local denominated loans). To assess a reasonable rate for dollar denominated loans, we performed the following analysis;

The rates we will pay on the required deposits are set so that we can maintain a spread of about 40%. This is reasonable, given the current deposit rates in the Ukraine of about 5.05%. While the spread is incredibly high, given the risks associated with the lending environment, the key for NewBank will be to mitigate these risks and obtain a high quality loan portfolio that will not incur loan losses. We feel this is achievable.

Cost of Capital

Due to the proposed capital structure for the NewBank a cost of equity must be calculated for this project. Our recommended methodology for this calculation is to determine countrywide cost of equity and then make subjective judgments about the risk of this project versus the risk of the country. For comparison we will calculate the cost of capital using the Goldman-Integrated Method.

While there are several methods available for calculating the cost of equity capital in an emerging markets, this case solution will use the International Cost of Capital Calculator (ICCRC) developed by Campbell Harvey. The ICCRC calculates the cost of equity based on a regression with a country’s sovereign debt rating. Ukraine’s current Institutional Investor Rating is 17.7, which translates to a country cost of capital of 40.6%.

A cost of capital of 40.6% implies the Ukraine’s risk premium is 28.6% assuming a US cost of equity of 12%. Performing a simplistic breakdown of the Ukrainian risk premium can provide insight as to the appropriate NewBank risk premium. We assigned a 10% risk premium to currency risk, a 4% risk premium to expropriation, and 14.6% risk premium to political instability. Based on the business model detailed in the case a rough estimate of 80% of the currency and expropriation risk had been mitigated and need no longer be included in the discount rate. This was due to the use of US dollar denominated loans and the lack of idle cash or assets in the project. Subtracting these components of risk premium reduces it to 17.4%, which lowered the overall cost of equity to 29.4%.

|Risk Factors |% of Risk |% Mitigation |Cost of Equity |

|ICCRC Cost of Equity – Ukraine | | |40.6% |

|US Cost of Equity | | |12.0% |

|Ukraine Risk Premium | | |28.6% |

|Components | | | |

| Inflation/Currency |10% |80% |(8.0%) |

| Expropriation |4% |80% |(3.2%) |

| Political/Economic Stability |14.6% |0% |(0.0%) |

|Ukraine Cost of Equity | | |29.4% |

Goldman-Integrated Method – an alternate method

This model uses the sovereign yield spread on government debt as a proxy for the risk premium that should be assessed to transaction in foreign markets. Exhibit 2 illustrates the use of this model. The sovereign yield spreads were estimated using Ukrainian debt issued in February and current US treasury bills. A beta was estimated using by averaging the betas of small US regional banks. To account for the significantly increased risk involved in the microfinance model we doubled this average beta. Adding the sovereign yield spread to the CAPM derived discount rate calculated a discount rate of 23.4%.

Sources of Funding

Currently, the NewBank lacks a confirmed source of funding. Assuming Oleksa provides the $2.5 million in interest free debt, $3 million will be required from equity investors to sustain the NewBank. While the financial model demonstrates that this project can offer a reasonable rate of return to an equity investor, it is still fraught with uncertainty. Given the level risk investors may require a motivation above and beyond a purely financial return to fund this project. The most likely investors are businesses interested in attaining a foothold in the Ukraine that would allow them to capitalize on improved conditions within the country.

While the value of this foothold is uncertain due to its dependence on future status of the Ukrainian economy, it would certainly be valuable to many companies. Given Ukraine’s recent economic history there is a significant probability that a presence in the country would of limited value. However, this investment has a downside limited to the initial investment and a significant upside due to the long-term potential of the Ukrainian economy. This potential is based on a cheap and highly educated workforce, large stock of natural resources, and proximity to European markets. The ability to participate in the large upside of this economy should entice a foreign company to investment in this marginal project.

The companies likely to be interested in this opportunity include financial and small business services firms. These companies would directly benefit from investing the NewBank. This venture would test the viability of commercial banking in the Ukraine and also develop the country’s small and medium sized businesses that would be future clients. Additional companies interested in investing includes those interested in building relationships within the country either for potential new operations or gaining an inside track for future privatizations.

Financial Returns

The model indicates a positive NPV project of $138,000 which is marginally positive but does exhibit that NewBank can be sustainable. The assumptions used have been very conservative so it would be possible to be more aggressive in loan generation and increase profitability. In addition, the loan default rate has been assumed to be much higher than in typical MFIs which has a significant impact.

Real Options and Non-Financial Returns

Several real options exist that enhance the value of this proposition. While NewBank plans to start as a sub-prime lender to potential entrepreneurs, there are other services that it might decide to offer including credit card services, ATM machines, passbook savings, or larger loans to proven credit-worthy borrowers, etc. Alternatively, NewBank has the option to scale back its operations during periods of economic turmoil. NewBank could also choose to enter the asset-backed security market, whereby it could securitize its loans and sells them to investors.

In addition to the aforementioned options, there is value inherent in proving the financial viability of a business model such as NewBank to encourage the establishment of similar entities within Ukraine or other emerging markets to enhance the economy.

While we project a positive NPV, we are certain that the value of the NPV after consideration of these real options and non-financial returns only enhance this proposition.

Conclusion

Based upon this analysis and the assumptions used in the model, this project is a marginally positive NPV project. As expected there will be several years of losses and necessary capital infusion but the institution should then be able to financially sustain itself thereafter. However, much debate can be had about the assumptions used and it is extremely difficult to evaluate this project because of the dynamic situation in the Ukraine. However, there are a great number of non-financial returns that have to be considered in conjunction with the purely financial returns generated by the model. Beyond a basic NPV analysis, and perhaps more importantly, must be an analysis of the motivation of the equity and debt holders in such an investment. Financial sustainability for microfinance institutions is a great concern at the moment and it will be interesting to see the developments and evolution of the structures in the next several years.

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