This paper will analyze the Greenfield investment appraised by BAYER Cropscience; consisting in the establishment of a manufacturing plant for the production of agro-allied chemicals in Nigeria.
The profile comprises a capital budgeting estimate with future cash flows for a period of ten years, which will lead to the calculation and consequent evaluation of a Net Present Value (NPV) for the expressed project. The investment will both take a subsidiary, BAYER AG Nigeria (Naira), and a parent perspective, BAYER AG Germany (€), in relation to the international complexities involved in the project. The initial investment was estimated at €75 million, which equals approximately 1.67 billion Naira. The project has been considered financially viable due to a positive NPV of €6.6 million, with the possibility of being accepted by the parent company.
The investment will contribute to satisfy the growing demand for fertilizers in Sub-Sharan countries, especially Nigeria, developing a solid network of relations in the African agricultural sector and enhancing employment opportunities. Eventually, BAYER presence and supply of agrochemical products will be a further contributor to develop a more diversified economy in Nigeria, with agriculture being one of the key potential areas of growth.
Cash Flows – Subsidiary and Parent View
Due to unavailability of data and estimates concerning the establishment of a manufacturing plant for agrochemicals, some evaluations have been carried out through BAYER annual report (2014), nevertheless, a personal interpretation has been indispensable.
Capital Invested and Loan Repayments
BAYER believes that the total investment involved in establishment of the manufacturing plant will amount to €75 million, which at a rate of 222.831 N/€, is equivalent to 16,712 million Naira. The €75 million will cover the whole cost base including construction costs, infrastructure improvements, machineries, cost of raw materials; sales, marketing and labour expenses. The initial outlay would be financed with 40% home equity; 20% debt which will be issued in Nigeria and 40% debt issued in Germany as shown in the table. The cost of capital (WACC) for the project was estimated at 11.3%, taking into account the country and political risk involved. The table below shows the percentages of debt and equity issued in Germany and Nigeria (Xe.com, 2016).
The Nigerian loan has a fifteen-year maturity and based on the previous assignment assumptions it would be issued at a local-fixed-annual rate of interests of 13%. Yearly interests’ payments of 869.041 million Naira, will be made directly from the subsidiary to the Nigerian bank. These were calculated multiplying €30M × 0.13, the rate of interest, and multiplying the given result by 222.831 N/€ in order to get a real value in Naira. The German loan, which has been guaranteed by the parent, will be repaid in yearly instalments by the Nigerian subsidiary to the parent, therefore being deducted from the subsidiary cash flow. This loan entails a high translation risk because the Naira/Euro conversion could lead to financial losses and it has been calculated multiplying €15M × 0.0217, the rate of interest in Germany, and the given figure has been multiplied by the exchange rate calculated via Purchasing Power Parity (PPP) (See ‘Yellow cells’ in the Cash Flow). As a consequence, the interests’ payments increase and decrease over time due to a forecasted fluctuation of the Naira.
The figures have been calculated as percentages of BAYER subsidiaries total sales and have been projected throughout the years. This was the best estimate that could be done based on the lack of data.
Total sales by region for the Cropscience segment amount to almost €3 billion involving Latin America, Africa and Middle East, which together account for 44 subsidiaries (See Appendix 1.3). Latin America represents 75% (33/44), Africa 4% (4/44) and Middle East 16% (7/44). The sales have been estimated by calculating the average total sales for each region and dividing these amount by the number of affiliates in each region. As shown in the table below, this allowed to have a hypothetical figure equivalent to the yearly sales for each subsidiary. For the first year, being Nigeria a big and prominent market, it was assumed that total sales of the new Nigerian subsidiary would account for approximately 40% of the yearly €67,500,000, hence estimating €30 million (6.6 billion Naira) sales (See Appendix 1.2) (Annualreport2014.bayer.com., 2016).
Sales are expected to grow progressively during the length of the project due to a forecasted increase in agricultural production and further expansion of the business. An expected 5% growth in the second year, 10% in the third and fourth, 15% from the fifth to the eighth year and 20% in the following two years of the project. This rapid increase is justified by the size of the market which is also unexploited and expected to upsurge in future years. The second sales* figure shown in the cash flow includes the Nigerian inflationary rate of 11% (See Appendix 1.2) (FAO, 2012) (BAYER AG, 2015) (World Bank, 2016).
The costs have been estimated as percentages of the sales (See Appendix 1.4). The manufacturing costs for agrochemicals’ such as power plant, machineries and raw materials have therefore been predicted to be approximately 40% of sales. Sales & marketing being 5%, assuming that the Group will have to invest a generous sum in order to establish itself in the new market. Other costs include labour, utilities, plant improvements, etc. and have been estimated to be 7% of the sales. Moreover, according to BAYER AG (2014), their cost of good sold ratio is equal to 48%. ‘Total costs’ (3,859 million Naira) have been divided by ‘sales’ (7,420 million Naira) in order to get a figure which could ideally reflect this proportion in the project, giving a ratio of 52%, thus very realistic. After the first year BAYER subsidiary in Nigeria will be able to deliver a surplus before tax and interests of 3,562 million Naira (See Appendix 1.5) (BAYER AG, 2015).
Tax and Dividend Payments
According to the Investment Climate Statement (2015) about Nigeria, the Nigerian tax authorities are encouraging foreign investments to the country by promoting several incentives and limiting restrictions for foreign investors. The Nigerian Investment Promotion Commission (NIPC), for example, authorize 100 percent foreign ownership of firms, apart from the oil and gas sector. Furthermore, the Nigerian government provides a 100 percent five-years-tax-holiday (extendible to seven) to pioneer industries considered beneficial to the economic development of the country and agricultural related sectors are included, hence also BAYER Cropscience would benefit from it. According to Eitman (2016), when a country has territorial tax approach such as Germany, taxes are paid only on income earned within the country in which the firm operates (Nigeria). BAYER is discharged from paying taxes for the first five years in Nigeria, however, whether a firm is exempt from tax payments in the host country, German tax authorities would extend tax coverage on repatriated profits. Therefore, after receiving earnings from the subsidiary, the parent will be paying 30% corporation tax in Germany for a five-year period (See Appendix 1.6). Whereas, after the fifth year, it will be only the subsidiary to pay 20% corporation tax in Nigeria (See Appendix 1.7), which is the amount charged to companies engaged in agriculture. BAYER also planned to pay immediate 2% dividends to its shareholders, starting from the first year (See Appendix 1.6). Dividend payments will be made by the parent once the profits are repatriated and BAYER could potentially suffer a partial loss due to transaction risk. The dividend disbursements will be made in Germany, thus, the company will incur in a German withholding tax of 25% which will lead to a ‘Profit after Dividends and Withholding tax’ of €7.38 million in the first year. (Department of State – U.S.A., 2015) (FAO, 2012) (PwC, 2015) (Eitman, D., 2016) (Matheson, T. 2013) (NIPC, 2016) (Arcnigeria.org. 2016) (Nipc.gov.ng. 2016).
Cash Inflows and NPV
After the profits are sent to the parent, before deducting corporation tax and dividends in Germany, BAYER’s ‘Cash Flow’ amounts to €10.8 million. ‘Net Cash Flow’ after tax and dividends equals to €7.38 million, which is then discounted to €6.6 million in the first year and it will grow progressively over time due to an expected increase in sales. BAYER’s discounted cash flows have been calculated multiplying the net cash flows by the discount factor associated with the cost of capital of 11.3% which was established in the previous assignment (See Appendix 1.8). Although the project it seems to entail a very high exchange risk exposure when translating the profits in the home currency, it resulted in a low-positive NPV of €6.6 million which, could potentially be accepted (Cimaglobal, 2016).
Multinational enterprises (MNEs), by inherent nature have large operational facilities situated around the world, meaning that they manage different currencies between the subsidiaries, hence, they could be exposed to changes in foreign exchange (FOREX), which may lead to decrease the company’s value. In fact, shifts in foreign exchange rates could have the power to weaken the competitiveness of the company as well as damage earnings. (Akhidime, A. 2011) (Smith, 2015) (Eitman, D., 2016).
Purchasing Power Parity (PPP) and Exchange Rates
The ‘purchasing power parity’ (PPP) is a theory that believes that adjustment are needed on the exchange rates and inflations between two countries so that a unit of currency of one country will have the same purchasing power in the foreign country (Sarno, L. 2002) (Taylor, A. 2004) (Eitman, D., 2016). By investing in Nigeria, BAYER is undoubtedly exposed to fluctuations between the Naira and the Euro, at present being 222.831N/1€. In fact, during recent years, the Nigerian currency has been depreciating substantially due to oil prices collapses and poor economic performance, therefore it is necessary to include the PPP in projection of a long-term investment. The PPP taken into consideration in this project is used when cash is transferred from the subsidiary to the parent; it does not grow progressively but fluctuates based on the Naira’s instability and on averages of its forecasted values and inflations over the period 2012-2021 (Xe.com, 2016).
According to Madura (1989), FOREX risk relates to the consequence that unforeseen exchange rate movements have on the value of the firm. Changes in values of FOREX between the Naira and Euro could impact the Group under different point of views. For instance, BAYER could be affected in (1) receiving income from the affiliate; (2) in the value of its assets and liabilities; (3) on the long-term feasibility of Nigerian operations; and eventually (4) in the acceptability of the whole investment; so potential future changes generated by expected FOREX movements must be taken into consideration (Eitman, D., 2016) (Papaioannou, M. 2006).
Types of Risks
The main foreign exchange risk that could affect BAYER cash flows in this project are ‘Transaction’ and ‘Economic’ risk. Although transaction risk is mainly associated to import-export activities, it also arises when companies invest overseas and the subsidiary repatriates funds to the parent, which could be vulnerable to exchange rates between the two currencies. Similarly, economic risk is concerned with the effect of FOREX movements on profits and operating expenditures. This risk is generally applied to the present value of future cash flows of the company’s parent and subsidiaries (Arnold, 2013) (Eitman, D., 2016) (Papaioannou, M. 2006).
Managing Risk and Hedging
Treasury managers use various currency risk management techniques depending on the type of risk and the size of the company in order to reduce the firm’s exposure. In order to reduce this risk and whether the project will be accepted, BAYER needs some hedging strategies, first being developed internally and, if necessary, externally. Economic risk, which is very difficult to estimate due to its long-term repercussion, could be partially offset by enhancing flexibility in the company’s structure, therefore making BAYER more agile in a market characterised by unexpected changes. This could mean quick changes in suppliers and sources of production. Also, but to a certain extent, through the usage of forwards markets. With concerns to transaction risk, BAYER will look at various techniques such as matching or netting, identifying whether cash flows from other subsidiary reduce or cancel out the loss, thus creating a natural hedge through a more favourable currencies exchange. However, considered the high degree of risk, internal coverage may still leave uncertainty to the company’s cash flows and future value. Therefore, whether BAYER would incur in the investment, the best possible decision would be to hedge the firm through a forward, future, or option hedge. Forward hedging will remove risks considerably, however, the Group would still incur in relatively high threats. Future hedges are similar to forwards, however, they are standardized, and hence, the Group would have a lower degree of flexibility in the choice of range of currency available, quantity and delivery date. Option hedging will be the best choice for BAYER, seen that this gives you the right, but not the obligation, to buy or sell a definite quantity of currency at an exact rate, on or before the definite date. With the ‘option’, the Group would have to pay a premium to the writer, nevertheless, this would allow more safety to BAYER giving the opportunity to take advantage of both favourable and unfavourable economic conditions, depending on whether they own a call or put option. (Arnold, G. 2013) (Papaioannou, M. 2006) (Eitman, D., 2016).
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