The project proposal
Mr. Zaven Demarchek, president of Port Arthur Timber Company (Canada) was approached and proposed by Cascamon – Industrial S.A, a Brazilian Company for a joint venture. The proposal stated that PATCO should provide Cascamon with milling equipments costing around 13,393,596 Real which is approximately around 7,250,756 Canadian dollars (Exchange rate = 1.8427) and expert operating staff for the mill. In return to this PATCO will be allowed to cut 150,000 cu. metres equivalent to 63,610,000 board feet of lumber every year for next five years. Any other profit other than this would belong to Cascamon. The proposal also stated that all needed working capital will be provided by Cascamon but operating cost including the salary of operating manager would be divided in the proportion to the amount of lumber cut. In terms of depreciation PATCO will be allowed to depreciate its investment fully for tax purposes.
Evaluation of the project
The policy of PATCO is that they do not accept proposal which gives a return less than 15 percent, but according to Mr. Zaven and company’s finance director Mr. Zablocki this project has additional risk involved such as foreign risk they tend to look for a return which is near to 20 percent in Canadian dollars and that too after the payment of foreign taxes. Hence, projected income statement was prepared at the end of December 2007 taking into consideration the current price of lumber which is 155.14 Real the agreed 150,000M[pic]/year lumber cut. This gave a cash flow of 4,232,016 Real which is approximately 2287947 Canadian dollars. After this projection they found that though the project was not giving the required return of 20 percent but in this highly volatile market the project was very attractive to the company as it gave an internal rate of return of 17.5%.
Scenario suggested by PATCO
Future is something which no one can predict but their can a number of ways through which approximation about the future can be achieved. Zablocki and Demarchek suggest one of the way through which future inflation affecting lumber price index, general price index and labour wage index can be predicted. He suggested that the future index prices of these indexes for the next five years will be the same as that of the previous five years (for eg. the rise in inflation from 2002 to 2003 will be same as rise from 2007 to 2008 which is 11.8).
(Trend shown in appendix 8)
Since the inflation in 2007 was approximately 60 percent [(501.1-311.5)/311.5*100] of the general price index it is inappropriate to assume that in 2008 the inflation will be 14.9 as assumed by Zablocki and Demarchek. Thus, I would like to reject this inappropriate assumption and put forth my following assumptions and scenarios which I think would be more appropriate.
Common assumptions in all the scenarios:
1) The change in the general price index is due to inflation prevailing in the country.
2) Exchange rate inflation is calculated using purchasing power parity (unless mentioned) and the inflation rate of the foreign currency is assumed as the change in the GPI (General Price Index)
3) Canadian Inflation is assumed to be the same for all the scenarios which is take as 5%, 4%, 6%, 5%, 4% for 2008 to 2012 respectively.
4) Lumber price index, labour wage index, coeff. of depreciation and exchange rate index are all directly or some times inversely affected by general price index. Sometime there is no effect even if there in a change in the general price index due to some abnormal situations.
5) The tax rate will remain at 35 percent of profits before taxes. Taxes were payable shortly after the end of the operating year.
6) Discounting factors taken in all the scenario is the average inflation of GPI in the five years otherwise anyone would take a fixed interest term loan at a lower rate and enjoy the real inflation rate difference.