Group Ariel S.A.

Parity Conditions and Cross

Border Valuation
Cross-border cash flow valuation and
international parity conditions
Adding Currencies to a Basic DCF Analysis
A Projected Violation of PPP
 Group Ariel S.A.:
Cross-Border Valuation
 This case uses international parity conditions to conduct
cross-border discounted cash flow valuation of Group
Ariel S.A.
 The setting is a 2008 proposal from Group Ariel’s
Mexican subsidiary to purchase and install a cost-saving
automated equipment in its plant in Monterrey to recycle
and remanufacture toner – and printer cartridges.
Cartridges recycling had become an important part of
Ariel’s business in many markets and promised continued
growth.
 Arnaud Martin, a financial analyst for a global
manufacturer of printing and imagining equipment,
request additional information about investment proposal
from Ariel Mexico.
 Business Profile
 Group Ariel is a global manufacturer of printers,
fax machines and other document production
equipment.
 The company provides consulting and document outsourcing
services, with after-sales service contracts constituting about
18% of overall revenue.
 Company sales were projected to be €3.35 billion, down from
2007 due to a global recession.
 The company’s low profitability was typical of the industry in
2008; all of its competitors were similarly affected by recession.
 Operating profit was expected to be €61.2 million in 2008, and
the company projected a small net loss for the year. Exhibit 1
presents a selected consolidated financial data for Group Ariel.
Exhibit 1:
Selected Consolidated Financial Data (millions, except
as noted)
2008 2007 2006 2005 2004
Sales €3,345.3 €3,561.8 €3,576.9 €3,078.9 €3,050.3
Operating income € 61.2 €189.2 €172.9 € 163.5 €149.9
Net income € (0.7) €85.7 € 61.2 € 88.2 €85.7
Total assets €2,809.3 €2,764.9 €2,899.6 €3,129.0 €2,445.5
Total debt € 660.6 € 616.0 € 613.0 € 578.4 € 504.2
Equity € 782.6 € 819.5 € 829.7 € 941.0 € 865.1
Capital expenditures € 87.6 € 100.0 € 95.1 € 240.9 € 234.1
Depreciation € 195.0 € 209.4 € 214 € 152.9 € 155.0
R&D expenditures € 17.5 € 20.0 € 19.0 € 48.2 € 46.8
Earnings/share (Euros) 0 1.0 0.7 1.1 1.0
Dividend/share (Euros) 0.7 0.7 0.7 0.7 0.7
Return on sales 0.0% 2.4% 1.7% 2.9% 2.8%
Return on equity (%) -0.1% 10.5% 7.4% 9.4% 9.9%
The Proposed New Equipment and
Cost Savings
 Ariel-Mexico’s plant began its cartridge cycling program in 2005.
 The plants’ recycling process consisted of a sequence of operations
carried out almost entirely by hand, with the help of hand tools and a
simple machine.
 The investment proposal called for replacing this process by new
automated machinery from Germany incurring an estimated cost of
3.5 million pesos (approximately €220,000).
 The new equipment could process the Monterrey plant’s
projected volume using 4 employees rather 10, resulting in
saving both direct labor and training costs.
 Under favorable circumstances, only 3 workers would be
required.
 It would also eliminate some human error, which currently
resulted in cracked or damaged cartridges which had to be
destroyed rather than reused.
 Exhibit 2 compares projected operating data for the existing
recycling process and the proposed automated process, assuming
future Mexican inflation of 7% per year.
Other Considerations of New and Old
Equipment
 The new equipment would have a useful life of 10 years and would
be depreciated under the straight-line method for both tax and
financial reporting purposes.
 Salvage value was likely to equal disposal costs at the end of the
useful life. The manual equipment being replaced had a book value
and tax basis of 250,000 pesos and three years of straight line
depreciation remaining.
 However, its market value was thought to be lower, at about 175,000
pesos.
 After considering Group Ariel’s consolidated tax position, Martine
determined that his analysis would use Mexico’s corporate tax rate
of 35%.
 Real GDP growth in Mexico was 4.2% in 2004 – the year in which
Ariel built its Monterrey plant. By 2006, Mexico’s real GDP had risen
by 5.1%, but subsequently dropped substantially as global recession
arrived.
Discounted Cash Flow Analysis
 Ariel considers carrying out a DCF analysis and making an estimate of
NPV for capital of this size in its newer foreign subsidiaries.
 One of the questions confronting the analyst at headquarter in
Mulhouse, France, is whether to perform DCF analysis in Euro or peso.
 Thus Martin had yet to decide whether to perform DCF analysis in euro
or pesos or indeed, whether NPV would be affected by the choice of
currency.
 No consideration is given to complicating factors such as
 Industry and competitive analysis,
 Country risk premia
 International tax factors, remittance policy, etc.
 Forward exchange rates between the peso and the Euro are not
used, partly because in 2008 long-dated forwards were not
available at reasonable spreads for these currencies, but also
because the case focuses on parity conditions and links among
goods, capital, and currency markets.
 The case assumes that students have some familiarity with
parity conditions and basic DCF calculations.
 Discounted Cash Flow Analysis and
the Discount Rate
 Ariel’s euro hurdle rate for such a project, if
undertaken in France, would be 8%. However,
the borrowing cost in France and Mexico are
clearly different:
 French bank’s prime rate for Euro loans was
4.99%, while the rate in Mexico on short-term
peso loan was about 8.10% (Exhibit 3-4)
 Long-term peso-denominated corporate bonds
were yielding 9.21% (Exhibit 3-4), compared with
long-term Euro-denominated corporate issue at
4.75%
 The spot rate on June 23, was MXP15.99/Eur.
Selected Macroeconomic and Financial Market Data for Mexico

Year-End Short-
Spot Term JP Morgan
Exchange Bank Mexico 7-1
Consumer Real Rate Lendin Year 10-year
Price Growth (MXN/EU g Rate Corporate Government
Year Inflation GDP (%) R) Date (a) Bonds (b) Bonds (c)

2000 9.5% 6.6% 9.4 31-Mar-06 7.78% 8.20% 8.47%

30-Jun-06 7.68% 9.35% 9.06%
2001 6.4% -0.3% 9.5
29-Sep-06 7.50% 8.22% 8.24%
2002 5.0% 0.9% 10.4 29-Dec-06 7.60% 7.42% 7.42%

2003 4.3% 1.4% 12.9 28-Mar-07 7.68% 7.50% 7.58%

27-Jun-07 7.82% 7.68% 7.19%

2004 4.7% 4.2% 15.3
26-Sep-07 7.77% 7.86% 7.82%
2005 3.3% 3.2% 13.3
31-Dec-07 8.00% 8.17% 8.08%
2006 4.1% 5.1% 14.4 26-Mar-08 7.94% 7.42% 7.49%

2007 3.8% 3.3% 16.2 23-Jun-08 8.10% 9.21% 9.12%

 Selected Macroeconomic and
Financial Market Data for France
Year-End JP Morgan
Real Spot Mexic
Consumer Growt Exchan o 7-1 10-year
Short-Term Year Gove
Price h ge Rate Bank Corpo rnme
Inflati GDP (MXN/ Lendin rate nt
Year on (%) EUR) g Rate Bonds Bond
Date (a) (b) s (c)
2000 1.7% 4.2% 9.4
31-Mar-06 3.08% 3.73% 3.79%
2001 1.6% 2.1% 9.5
30-Jun-06 3.27% 4.03% 4.08%
2002 1.9% 1.1% 10.4 29-Sep-06 3.63% 3.69% 3.72%
2003 2.1% 0.5% 12.9 29-Dec-06 4.07% 3.96% 3.98%

2004 2.3% 2.3% 15.3 28-Mar-07 4.42% 4.08% 4.11%

27-Jun-07 4.69% 4.60% 4.62%
2005 1.7% 1.9% 13.3
26-Sep-07 4.91% 4.36% 4.41%
2006 1.7% 2.4% 14.4
31-Dec-07 5.13% 4.34% 4.42%
2007 1.5% 2.3% 16.2 26-Mar-08 4.81% 4.00% 4.11%
23-Jun-08 4.99% 4.75% 4.81%
Two Alternative Approaches for
DCF Analysis
 There are two alternative approaches to a basic analysis.
Both aim to estimate the Euro NPV of the project
because Ariel’s investors are presumed to want Ariel to
maximize its value in Euros.
 However the starting point for either approach is the estimated
future cash flows, which are given in Exhibit 2 of the case.
 The first approach is to discount these peso cash flows at
a peso discount rate to arrive at a peso NPV, which is
then translated into Euros at the spot exchange rate to
obtain a Euro NPV.
 The second approach translates the annual peso cash
flows into Euros at the expected future exchange rates
(using ex ante PPP), and then discounts the translated
cash flows at a Euro discount rate to get an NPV in Euros
Peso Cash Flows
 The relevant cash flows for the project include the
following:
 Initial outlay
 After-tax salvage value of the existing equipment
 After-tax cost savings from the new equipment
 Loss of the depreciation tax shields on the old equipment
 Benefit of depreciation tax shields on the new equipment.
 The old equipment will be worthless by 10 years if not
sold now, and the new equipment will have no salvage
value at the end of years 10
 These cash flows are presented in Exhibit 2.
 Peso Cash Flows
 The old equipment is sold in year 0 for 175,000 pesos. It generates
a loss of depreciation for three years is 75,000 pesos, given the
book value of 250,000. The resulting tax shield of 26,250
(=0.35*75,000).
 Thus the after tax salvage value is 175,000+26,250 = 201,250
pesos.
 After-tax cost savings are computed from Exhibit 2 as follows:
 Cost saving = (old operating costs – new operating
costs)X(1-0.35)
 Old depreciation tax shields come from a book value of 250,000
pesos with three years remaining of straight line depreciation:
250,000/3 = 83,333. So the tax shield is 29,167 = (0.35*83,333). So
this tax shield will be lost when new equipment will be installed.
 With the installation of new equipment with a value of 350,000, new
depreciation tax shields are simply the straight-line depreciation on
the new equipment of 350,000 pesos/per year, times the tax rate of
35%. That is the new tax shield depreciation is 122500 peso
(=(3,500,000/10)*0.35).