The Cemex Request-for-Proposal: An Auto-Generation Energy Project01-234-567

The Cemex Request-for-Proposal:

An Auto-Generation Energy Project[1]

Teaching Note

I. Synopsis and Objectives

This case serves as a unique application of project finance analysis. It is intended for students studying project finance, emerging markets, and/or global macro-economics, especially those students who have already reviewed more introductory and traditional project finance cases. Instead of being used to determine a go vs. no-go investment decision, the overall objective of this case is to determine the lowest possible pricing structure that the fictional company should be willing to submit as a bid for the TEG Project. Because of the nature of the bidding event (or any bidding event, for that matter), competition will likely drive the price (and subsequent value to the bidder) downwards, eventually settling on a price whereby the winning company is able to just break even.

The analysis is carried out by first setting NPV equal to zero (before options analysis), then estimating the appropriate discount rate and costs, and finally backing out the pricing structure necessary to allow for the NPV to most likely equal zero. Normally, acceptance of an NPV 0 project in an emerging market would not be advised. However, in this situation there are difficult to value real options which are not included in our adjustments to cash flows or discount factor and will probably push total NPV well above zero. Furthermore, we believe that it is our company’s unique inclusion of these option values in total NPV that will allow us to outbid (under-price) the other bidders.

In order to solve this case, students will be required to:

  1. build an income statement and discounted free cash flow analysis to calculate NPV;
  2. consider the minimum acceptable “Capacity Charge” as the bid price for electricity;
  3. identify and explore different risks involved in the development of this project;
  4. adjust the discount factor for risk mitigation strategies; and
  5. consider possible real options involved in developing this project.

The remainder of our analysis suggests a possible outline for a professor to follow during post-case discussion. We do not suggest that our solution is the only solution or that it is the best solution. However, it may be useful for the purpose of organizing class discussion and analysis. Section II discusses the major reasons an equity investor would be interested in investing in this project and in this country. Section III summarizes the approach to and results of determining an appropriate country cost of capital. Section IV identifies the poignant sources of risks as well as their potential mitigating factors. Section V appropriately adjusts the country cost of capital for the project specific risks and risk mitigating factors. Section VI suggests the appropriate analysis of cash flow projects and equity returns. And section VII will summarize the real options and present the final pricing recommendation.

II. Why Mexico and Why This Project?

Why Invest in Mexico?[2]

Mexico, with a land area of 2 million square kilometers, ports, industries, agricultural, tourism, gastronomy, beaches, and attractive opportunities for investment—is referred to by much of the world as a “future window” with nearly untapped financial, manufacturing, and exportation opportunities.

In recent years the Mexican government has been very active in liberalizing the economy with the aim at attracting foreign investors. Some of the key issues that helped pave the road to an inflow of capital are listed below.

  • A Foreign Investment Law, passed in 1993 and amended several times since, was designed to foster foreign investment that favors national development. The law more or less disposed of the 49% share-holding limit on foreign investment. Foreign investors can now purchase up to 100% of capital stock in Mexican companies, acquire fixed assets, penetrate new areas of economic activity, and operate establishments.
  • The North American Free Trade Agreement (NAFTA, 1994) was a basic step towards a more investor-friendly business environment. It stipulates amongst others limits on the expropriation of property. Mexico also signed important free-trade accords with the European Union and other countries in Latin America.
  • In light of failed businesses and the flight of foreign capital that followed the infamous peso devaluation of 1994, Mexican authorities have been determined to renovate the nation’s investment climate. During the 1990’s, under President Zedillo’s Administration, regulatory frameworks had been loosened and preferential loan packages established.
  • In 1995, the Agreement for the Deregulation of Business Activity designated an Economic Deregulation Council, empowered to alter or remove regulations it deemed prohibitive to foreign-capital flow. The council’s stated purpose was to institute “a systematic deregulatory process that amends or repeals outdated regulations, curbs the creation and ensures the quality of new regulations, and places the burden of proof on the institutions that introduce and administer them.”
  • Investment disputes are handled through resolution mechanisms within either the World Trade Organization (WTO) or NAFTA. Sometimes both organizations have jurisdiction, in which case the nation in question may select which forum to use.
  • Mexico’s infrastructure has benefited form the recent surge in economic activity. The number of serviceable telephone lines in the nation has doubled since the industry was freed from governmental control in 1990. Mexico’s ports, which have received heavy investment from the private sector in the last five years, are considered among the best in Latin America.

Although the above includes many good reasons to consider Mexico for investments, some issues remain as reason for concern:

  • Companies must be aware of taxation on the state level. In addition to state property taxes, a corporate payroll tax of varying percentages is charged in at least 18 states of the Mexican union.
  • The government has worked diligently to forge international tax treaties that avoid double taxation and to date has negotiated such treaties with the United States, Germany, France, Sweden and Canada. Many other treaty’s are either already established or in the process of being established.
  • Mexico’s population represents a sizable potential workforce for foreign businesses looking to fill unskilled labor positions. The market for skilled positions, however, is tight. Labor unions are currently not very strong, but workers are protected by a national labor law that sets the maximum work-week at 48 hours (still more than in developed countries).
  • Privatization has led to an influx of foreign money, which has strengthened Mexico’s infrastructure. These improvements have led to greater investor confidence. However, an absence of concession laws for the provision of a legal framework has continued to hinder investment in these areas. Presently, concessions are given on a case-by-case basis, which means that procedures could vary from sector to sector. As a result, investors are left with little or no recourse in disputed cases.
  • Foreign companies must take into account potential long-term risks associated with Mexico’s social and political reality. Following the peso devaluation and the consequent disappearance of thousands of jobs, street crime surged in major urban areas and has yet to be sufficiently curtailed. Corruption at all levels, from police officers to elected officials, is a timeworn problem in Mexico. Government agencies, however, have made advances in solving the problem and have passed strict anti-corruption laws that carry penalties of up to 10 years in prison.
  • Despite clear progress, however, Mexico has yet to become a foreign investment utopia. Fiscal reform measures are often arbitrary and unclear. A stubborn bureaucracy has stifled the passage of concession laws that would go a long way toward ensuring greater security to foreign companies. A lack of transparency in regulatory processes has also inhibited foreign investment. A clear understanding of the investment environment – of both its potential rewards and its potential pitfalls – is essential when making the decision of whether to do business in Mexico.

The possibility that the Institutional Revolutionary Party (PRI) loses the presidency for the first time in 70 years should not pose a serious threat to the continuity of the nation’s economic policy (remember that the case is situated in 1998). However, pronounced economic inequities in Mexico—where the industrialized north reaps the lion’s share of the benefits of globalization and the agricultural south continues to languish in poverty—make its future somewhat unpredictable. If Mexico stabilizes itself, it must translate its macro-economic success into a more equitable distribution of benefits between north and south and the creation of much-needed employment.

Problems notwithstanding, Mexico’s outlook for the 21st century is bright. As more sectors of the economy open up to foreign investors, the nation’s position in the global market will improve. A solid communication and transportation infrastructure, inexpensive labor, modern export and import facilities, competitive tax rates, incentive programs, and the many opportunities generated by NAFTA make Mexico one of the most attractive world markets available to foreign investors.

Why the TEG Project?

The imaginary company SBS is operating all over the world and always looking for opportunities to increase shareholder value. It has a very diversified portfolio of activities, ranging from shipbuilding to construction and power generation in which the TEG Project fits very well.

The uniqueness of the TEG Project is very interesting for SBS despite its location. Some of the risks associated with emerging market uncertainties can be properly mitigated (see section on “Risk Identification and Mitigating Factors”). SBS has the expertise as a constructor to build power generation plants and could possibly form an operating alliance with a power plant operator with widespread experience.

Most importantly, the TEG Project is also the first private power project to be financed under Mexico’s energy self-supply legislation. As this may set a precedent and possibly open doors to further work, it is important for SBS to get involved. By itself, this may not invoke real options, but in the case of SBS, its winning consortium has vast production capabilities in Mexico and could therefore profit from numerous locally manufactured goods. This so called “local content” can be leveraged both financially and politically with local and national governments (by saving and or creating extra jobs). As a result of this option and other options discussed below (“Real Options and Pricing Recommendations”), SBS will still consider bidding for the project despite the pre-option zero NPV.

III. Cost of Equity Capital

The instructor should open the discussion of cost of equity capital by reviewing the results of applying the capital asset pricing model to this project. According to CAPM, the cost of equity capital should fall somewhere around 5.54% (see Exhibit TN-1). Students should be pretty comfortable with the rationale for discarding this discount factor as inappropriate for this project. Further, they should view this as further evidence that the CAPM cannot and should not be used in valuing emerging market projects.

Class discussion should then focus on the application of the International Cost of Capital and Risk Guide Calculator. Before considering the project specific risks and risk mitigating factors, the class should utilize the calculator to ascertain a better estimate for the country cost of capital for a project of average risk in the country of Mexico. According to the September, 2002 calculator, the ICCRG estimates Mexico’s cost of equity capital to equal 18.02% (see Exhibit TN-2). Later in the class, after project-risks and mitigating factors have been identified, we will revisit the ICCRG and adjust the results appropriately.

IV. Risk Identification and Mitigating Factors

The table provided on the next two pages summarizes the risks associated with this project, as well as how the risks are allocated or mitigated. As shown in the table, this is generally a low risk project for SBS. The major risk, which would be difficult to mitigate, is related to the legal framework governing liberalization of the energy sector, which is ambiguous and subject to swinging political views. Another major risk relates to the (relatively low) return obtained from the project—if there are cost overruns, for example, it is possible that the pre-options NPV will become negative. Nonetheless, given the real options associated with the project, it may be beneficial for SBS to absorb the negative NPV in order to enter the market at this time and demonstrate its success as an IPP in Mexico (see section below on “Real Options and Pricing Recommendation”). Other major risks are environmental and social. Although the contract can be amended for changes in environmental regulation, there is still the risk that the project may fail to meet current guidelines of Mexico or the IDB, or that the local community might insist on more stringent controls. Similarly, the community may view this project as another large industrial facility which is infringing on their tranquil quality of life.

Another key mitigating factor in this project is the presence of international organizations such as the Inter-American Development Bank (IDB) and Coface, which are providing political risk insurance and subordinated debt and have imposed stricter environmental regulations. In addition, Cemex itself is a risk-mitigating factor, since it is one of the largest and most respected companies in Mexico.

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The Cemex Request-for-Proposal: An Auto-Generation Energy Project01-234-567

Type of Risk / Degree of Risk / Nature of Risk / Risk Allocation and Mitigating Factors
OPERATING
A. Pre-Completion
Construction / Low / Cost overruns, construction delays, failure to meet minimum performance requirements, excluding exogenous factors (social or political) / Operator required to absorb full construction risk and was required to deposit a Completion Guarantee which could be accessed if operation not active within 42 months of award date of contract. Risk minimized by experience of operator.
Technology / Low / Technology does not live up to standards for efficiency, quantity of output or environmental standards / Cemex requires use of specific technology that operates within certain standards. Technology is proven. Operator can choose to submit a bid based on latest technology available.
B. Post-Completion
Supply / Low - Medium / In the past, Pemex has trouble supplying outputs for other projects. Risk of change in price of fuel inputs. / Electricity price charged to Cemex reflects any variability in the market price of petcoke.
Market / Low / Change in price of outputs. / Power Supply Agreement guarantees all electricity generated will be sold, whether to Cemex or to CFE.
Performance/
Throughput / Low / Facility does not reliably provide the output required under contract. / Risk bourn by operator. Agreement with operator can be terminated if capacity falls below certain limit.
C. Sovereign
Expropriation
a. Direct / Low – Medium / Government seizure of assets / Risk bourn by operator; Government has no propensity to expropriate, but regulatory environment unclear. Another mitigating factor is involvement of IDB/Coface and Cemex.
b. Diversion / Low / Cemex seizure of assets / Unlikely based upon Cemex’s reputation
c. Creeping / Medium / Change in taxation / Risk of any change bourn by operator.
Electoral Politics / Medium / Changes in energy sector policies / Mitigated by the fact that Cemex is one of the largest, most respected companies in Mexico
Type of Risk / Degree of Risk / Nature of Risk / Risk Allocation and Mitigating Factors
Legal System / High / Vague laws regarding self-generation could be changed / Cemex bears risk during construction since it guarantees all permits and licenses. Subsequently, operator assumes all risk.
Exchange Rate / Low / Risk of exchange rate fluctuations / Mitigated by Cemex paying US$ for electricity and paying pesos for peso-denominated expenses.
FINANCIAL
Changes in Cost of Capital / Low / Another crisis may trigger cost of debt for such a project to increase. / Risk of changes in interest rates (positive or negative changes) shared between operator and Cemex. Bidders have option to receive compensation for hedging interest rates.
Default / Medium / Probability of default, especially given high leverage of project. / Financial risk absorbed fully by operator. Although debt coverage ratio is very low, the project has steady cash flow and all market risks are mitigated .
IRR vs WACC / High / The return on the project maybe lower than the cost of capital. / Financial risk absorbed fully by operator; likelihood of NPV falling below zero is high (before options taken into consideration)
ENVIRONMENTAL
Air pollution; Changes in Regulations / High / Facility produces significant amount of sulfur dioxide as well as wastewater that is dumped after treatment into local river. Risks include changes in laws regarding environmental regulation and failure to comply with existing/future regulations. / Responsibility for compliance assumed by operator. Developer also required to prepare Environmental Impact Statement. Changes in environmental regulations that effect production costs can be renegotiated. Risk mitigated by use of state of the art technology which removes most environmental contaminants, creation of buffer zone, continuous environmental monitoring. Overall project enables pert-coke produced by Pemex to be disposed of in a more environmentally friendly manner. Project must comply with IDB environmental guidelines, which are stricter than those of Mexico.
SOCIAL
Impact on Community / High / Project has big impact on small town. Local community effected in positive (job creation) and negative ways (environmental impact, air quality, noise) / Risk absorbed by operator. Cemex already has factory in place, so town is accustomed to this type of industrial presence.