Dow Chemicals Bid for PBB

Executive Summary
The case is about Dow Chemicals bid for the privatization of Petroquimica
Bahia Blanca (PBB). PBB, a producer of both Ethylene and Polyethylene in
Argentina, is being privatized by the local government. Dow holds a leading
market position in Ethylene and Polyethylene, and wants to utilize this
opportunity to expand into Argentina. Dow has developed a three-stage
operational strategy for expansion of its polyethylene operations in
Argentina. The acquisition of PBB represents the first stage of the strategy
and provides a gateway to the second and third stage. The cash flows from
each stage of the project have been valued using the discounted cash flow
(DCF) approach. The discount rate for the valuation has been adjusted for
the country risk premium, and a modified version of CAPM has been used to
calculate a best case and a worst case estimate of the discount rate. This
gives us a range of possible acquisition values for PBB. Given that the
acquisition also enables Dow to benefit from the from the high cash flows of
the second and third stage of the project and that other parties are also
interested in the acquisition, it is recommended that Dow bids a relatively
high price of $280 million for PBB.

Introduction
Dow had been interested in the Argentina market since the 50s when it
asked the Argentine government to develop a petrochemical complex. The
government developed the complex in the late 70s and this led to the
creation of PBB. In a bid to become more open and attract foreign direct
investment, the government decided to privatize PBB in 1995. The expected
growth of Argentina and the high forecasted demand for Polyethylene made
PBB an attractive acquisition. Dow was a multinational company with 94
plants across 30 countries. Dow had a presence in several countries of Latin

America, including Argentina. Polyethylene represented about 15% of Dows

total revenue and roughly 35% of its profits. It saw the PBB acquisition as
once in a lifetime opportunity to establish a stronghold in the Argentinean
market. Dow faced some competition in its bid for PBB. Copesul, a Brazilian
company and Perez Company, a local Argentinean firm, had teamed up to
bid against Dow.
There were significant complications with respect to the benefits from a
potential acquisition of PBB by Dow Chemicals. Dow expected the cash flows
to be generated in three separate stages. The first stage involved an
upgrade of the PBB facilities to make them internationally competitive. The
second stage comprised of an acquisition of two polyethylene plants. The
company would have to negotiate with a private company Ipako that was
owned by a local businessman. The stage comprised of building new plants
to expand capacity. Dow was looking for a partnership with YPF for the
supply of ethane for the upgraded facilities. This deal was crucial to the
success of the third stage. The Argentinean market was volatile and the
countrys currency had experienced many currency devaluations in the past.
Before making a bid, Dow has to decide on country risk premium and
exchange rate risk before deciding on an appropriate discount rate for the
cash flows.

Analysis
As far as polyethylene market is concerned, Dow Chemical lacks a strong
footing in Argentina. If Dow Chemical decides against operating in a strong
growth region like Argentina, it might be risking its leading position in
polyethylene. On the other hand, Dow has sufficient operating experience in
Argentina through Dow Quimica. The PBB project fits Dow Chemicals
strategy to be a cost leader through horizontal/vertical integration,
technological leadership, and global presence. PBB is large Argentinean
Company which represents 25% of the total Mercosur production. Due to its

economies of scale, its local competitors in Argentina will have a cost

disadvantage. If will be difficult for Dow to impose its dominance in the
Argentinean market if another company acquires PBB. The three project
stages represent a unique opportunity to rapidly build a large scale
operation. Nevertheless, there are certain uncertainties involved with the
second and third stages. More importantly, the later stages cannot be
undertaken independently; they depend on stage one - the acquisition of
PBB. Therefore, the acquisition of PBB represents a vital step Dows plan to
expand into Argentina.

Additional Risk in Argentina

Due to the interests of other competitors and the advantages offered by this
unique opportunity, Dow Chemicals has to make a serious bid offer for PBB.
The cash flows from each stage of the project have already been estimated.
The discounted cash flow (DCF) approach can be employed to discount the
cash flows and obtain the intrinsic (present) value of PBB. However, investing
in the Argentinean market pose certain risks that need to be taken into
account before the DCF approach can be employed. Two of the major risks
are the country risk and exchange rate risk. It is believed that the exchange
rate risk has substantially subsided because of the recent measures taken by
the Argentinean government to stabilize its currency. Moreover, if the
company feels that the exchange rate risk is significant at any time in the
future, it can hedge this risk by entering into currency futures contracts.
Similarly, other hedging techniques can also be employed to minimize the
exchange rate risk. Therefore, such a risk does not need consideration when
determining the worth of PBB.

The CAPM Approach

On the other hand, Exhibit 12 clearly indicates the presence of a significant
country risk. We will adjust the discount rate to reflect the additional country
risk of operating in Argentina. One possible approach is to adjust the CAPM
equation for the country risk premium. In the equation, the country risk

premium is added to the market risk premium before multiplying it by the

companys beta. Therefore, the CAPM equation becomes:
Rs = Rf + * (MRP + CRP)1
We do know that required return without the country risk premium is
between 8% and 10%. If we can estimate the risk-free rate and the market
risk premium, we can use that information to get a range of possible betas
for the company. Exhibit 12 gives us information about the riskfree rate in
the US. It remains at 5% for a long period of time; then it slightly in mid1993; it shaping to get back at the 5% level towards the end of 1995. Based
on the evidence from exhibit 12, it is assumed that the riskfree rate is 5%.
Based on the results of surveys and historical information, the market risk
premium can be reliably assumed at around 5% ( Fernandez and Baonza, 2010).
Using this information, the beta can be calculated to range from 0.6 (when
US discount rate is taken to be 8%) to 1 (when US discount rate is taken to
be 10%). The calculation is shown in the attached spreadsheet. Once the
information about the riskfree rate (Rf), the market risk premium (MRP) and
the beta is available, we only need to calculate the market risk premium to
arrive at the appropriate discount rate for Argentinean market.

Country Risk Premium

One of the methods of calculating the country risk premium is to calculate
the bond yield spread between the Argentinean and the US market and then
adjust it for the relative equity market volatility for Argentina. The bond yield
spread is meant to account for the difference in risk free returns between the
US and the Argentina market. The higher riskfree yield is Argentina is
intended to compensate for the higher default risk of operating in
Argentinean market. It also compensates for the difference geopolitical and
environmental factors. The bond yield spread can be estimated from exhibit
1 Rs is the discount rate, Rf is the risk-free rate, is the companys asset beta, MRP
is the market risk premium and CRP is the country risk premium

12. The dotted line in exhibit 12 is the estimate of the bond yield spread over
the stated period. The spread becomes insanely high during periods of crisis,
but for the majority of the period between 1991 and 1994, the spread
remains between 5% and 7%. The spread can be seen to be returning to this
level at the end of 1995, after the stabilizing measures taken by the
government. It is believed that a bond yield spread of 6% will be an
appropriate measure to use on a long-term basis. The recent country ratings
for Argentina by Moodys rating agency confirm this assumption. The bond
yield spread of 6% needs to be adjusted for the equity market volatility
factor. The equity markets are more volatile than the bond market and the
volatility factor, therefore, accounts for the added risk. The volatility factor
can be calculated by dividing the standard deviation in equity market by the
standard deviation in bond market. The equity market volatility factor has
been found to be averaging around 1.5 times in the developing markets
(Damodaran, 2012). It is assumed that Argentinean market has the same
volatility. Using the bond yield spread and the equity market volatility, a
country risk premium of 9% has been calculated for Argentina (calculations
shown in attached spreadsheet).

The Adjusted Discount Rate

This estimated of country risk premium can be utilized in the CAPM equation
above to calculate the discount rate for Argentina. Our estimates of beta
vary from 0.6 to 1 because of the range of US discount rates used. Therefore,
the Argentinean discount rate also varies depending on the US discount rate
used. For a US discount rate of 8%, the beta comes out to be 0.6 and the
Argentinean discount rate is calculated to be 13.4%. For a US discount rate
of 10%, the implied beta is 1, and the Argentinean discount rate is calculated
to be 19%. Therefore, the appropriate discount rate for PBB is between
13.4% and 19%. We can use both these estimates to calculate the
discounted cash flows for the three stages of Dows planned acquisition. The
cash flows with 13.4% discount rate are termed the best case cash flows,

while the cash flows with 19% discount rate are termed the worst case cash
flows. They will give us a range of possible acquisition values for PBB.

Other Relevant Factors

Besides the explicit cash flows, there are other factors that might influence
the decision of Dow Chemicals regarding acquisition of PBB. PBB has very
good competitive attributes: proximity to two of the largest gas basins in
Argentina, easy access, proximity to Buenos Aires the largest market, and
good infrastructure and human resources. All these factors will enable Dow
to manufacture high quality, cost effective product. The probability of risk
from foreign exchange fluctuations is limited and can be hedged. The freight
charges and duties are also limited because majority of the product will be
sold locally within Argentina. The regulations regarding capital repatriation
have been improved and are not expected to change in the future. All of
these factors make PBB an attractive acquisition for Dow Chemicals.

Conclusion
The minimum bid, as required by the privatization rules, is $150 million. The
intrinsic value of PBB, as calculated by DCF approach is between $384
million and $545 million. However, only 51% of the total value of PBB is
being sold, while the remaining 49% will be retained by the government. For
a 51% stake, the range of intrinsic values is between around $200 million
and $280 million. However, this is only the intrinsic value for the stage 1 of
the project alone, Besides giving a 51% claim on the stage 1 cash flows, the
acquisition of PBB will also provide Dow with an option to proceed with stage
2 and stage 3 of the project. The value of such an option should also be
taken into consideration when deciding on a bid price for PBB.
Although there are significant uncertainties attached with the second and
third stage, their cash values translate into significant value for Dow. The
cash flows from stage 2 are valued between $200 million and $280 million,
but Dow will also need to acquire Ipako to realize them. Similarly, the cash

flows from are valued between $130 million and $430 million, but Dow will
have to reach a deal with YPF. These contingencies and uncertainties will
take a considerable tool out of the cash flows from the later stages, but they
will still add value to Dow Chemicals. Therefore, Dow Chemicals needs to
make sure that it acquires PBB so that it can realize the cash flows from the
later stages. We recommend that Dow bids a value for PBB that is close to
the upper bound of $280 million.

References
Fernandez, P and Baonza, J (2010) Market Risk Premium Used in 2010 by Analysts
and Companies: A Survey with 2,400 Answers, Working Paper
Damodaran, A (2012) Country Default Spreads and Risk Premiums, New York
University (Stern)