238 Corporate Finance
Exhibit 1 Forecast of free cash flow
($ ‘000)
1998 1999 2000 2001 2002
Argentina 6,930 7,117 7,331 7,617 7,990
Brazil 10,920 11,215 11,551 12,002 12,591Cash flows are expected to grow at 6 percent per annum, after 2002, in perpetuity. The cash flows from local currency were
translated into US dollars, using the estimated exchange rate for each period. The only task remaining is the estimation of
discount rate. Smith discovered that the businesses in Latin America had no pure play proxies. Most of the competitors
were subsidiaries of large, diversified companies. So, the determination of beta for each country operation was difficult. In
addition, the efficiency of the local stock markets was questionable and so was the estimate of risk premium.
The analyst obtained the dollar borrowing rate, tax rates and target capital structure information from relevant sources
(displayed in Exhibit 2).Exhibit 2
Subsidiary Borrowing rate (percent) Tax rate (percent) Target D/V (percent)
Argentina 8 35 20
Brazil 12 35 20To calculate the cost of equity, the analyst can choose between two approaches under the CAPM method. The first approach
involves usage of local CAPM parameters. The second approach involves estimation of parameters (and cost of equity) for
the US, which would then be adjusted, for individual country risk, to yield estimates for these subsidiaries. Other relevant
data are given here:
Foreign currency debt rating:Moody’s S&P
Argentina B1 BB-
Brazil B1 B+US treasuries are yielding:YTM (percent)
1 year T-Bill 5.92
10 years 6.80
30 years 7.0Median beta and capital structure information for comparable US industries:12 34
Un-levered median beta^10 0.86 0.79 0.74 0.76
Mean D/V ratio 0.2 0.18 0.17 0.19
(market value)Refer to other data in this chapter. Estimate an appropriate discount rate for, and the value of, each of the divisions.(^10) beta when leverage is zero. The relationship between levered and un-levered beta is:
βL = βU [1 + (1 – T)D/E]